The Balance of Payments

Question 1

Define the balance of payments.

Answer 1

The Balance of Payments is a systematic record of all economic transactions between the residents of Australia and the residents of the rest of the world.

Question 2

Can some economic transactions be one sided?

Answer 2

Most transactions involve an exchange, but some are one-sided.

Question 3

What is included in economic transactions?

Answer 3

• Exports and imports of goods, such as iron ore, coal, gold, wheat, wool, computers, motor vehicles and machinery.
• Exports and imports of services, such as shipping, freight, insurance, and expenditure by tourists and overseas students.
• Income flows, such as dividend and interest payments associated with foreign investment.
• Transfers, such as foreign aid and funds brought by migrants.
• Financial flows, such as investment in shares and securities and leans.

Question 4

Will the balance of payments always balance? Why?

Answer 4

The balance of payments will always balance because the floating exchange rate will ensure the total credits will always match the total debits.

Since for each transaction there is a matching credit and debit entry, the overall record of payments must always balance.
So, if the current account recorded a deficit of $10 billion, then the KFA would record a surplus of $10 billion.

Question 5

What accounts is Australia’s BoP divided into?

Answer 5

Australia’s balance of payments is divided into two broad accounts- the current account and the capital and financial account.

Question 6

What is the current account?

Answer 6

The current account is concerned with transactions involving goods, services, and income.

Question 7

What is the capital account?

Answer 7

The capital account records capital transfers and the acquisition/disposal of non-produced, non-financial assets (e.g. copyrights).

Question 8

What is the financial account?

Answer 8

The financial account includes transactions in financial assets and liabilities.

Question 9

Australia imports a TV from Japan. Where would the associated transactions be recorded?

Answer 9

The value of the imported TV will be recorded in the current account as a $1,000 debit, while in the financial account it will be recorded as a $1,000 credit, because $1,000 of Australian currency is exported to Japan (which in in exchange for $1,000 of Japanese currency which comes into Australia as the credit, and we use this Japanese currency to pay them for the TV)

Question 10

What is a credit? Give examples.

Answer 10

A credit is recorded when there is ‘currency coming in’ to Australia.
E.g. Exports of goods and services, income receivable, increase in foreign liabilities (foreign investment into Australia), and export of currency.

Question 11

What is a debit? Give examples.

Answer 11

A debit is recorded when there are ‘debits departing’ form Australia.
E.g. Imports of goods and services, income payable, increase in foreign assets (Australian investment abroad), and import of currency.

Question 12

Into which three categories does the current account record transactions. Which is the largest?

Answer 12

The currents account records transactions between Australian residents and non-residents in three categories:
Goods, Services, and Income (primary and secondary).

In terms of absolute size, trade in goods is the largest item in the current account.

Question 13

Give an example of an investment income credit and a debit.

Answer 13

An example of an investment income credit would be if an Australian resident received a dividend payment from an overseas company.
An example of an investment income debit would be the payment of interest by an Australian firm to an overseas resident.

Question 14

Is there a net inflow or net outflow of investment income in the current account? Why?

Answer 14

Foreign investment into Australia far exceeds Australian investment offshore resulting in a net outflow of investment income in the current account.

Question 15

Which is normally the largest component of the CAD?

Answer 15

The overall balance in the primary income was a deficit of $34 billion- which is normally the largest component of the current account deficit.
It is the result of the large amount for foreign investment that flows into the Australian economy each year (have to pay it back).

Question 16

What does the secondary income category involve?

Answer 16

The secondary income category involves ‘one-sided’ transactions.
E.g. foreign aid, gifts, donations and pensions.

Question 17

How is the overall balance on the current account obtained?

Answer 17

To obtain the overall balance on the current account, the balance on goods and services is added to the income balance (primary plus secondary).

Question 18

What is the capital account comprised of?

What is the financial account comprised of?

Answer 18

The capital account comprises capital transfers and the acquisition and disposal of non-produced, non-financial assets.
E.g. Capital transfers include migrants’ funds. Non-produced, non-financial assets include copyrights and trademarks.

The financial account comprises transactions associated with changes in ownership of Australia’s foreign financial assets and liabilities.

Question 19

What do credit entries in the KAF represent?

Answer 19

Credit entries are net inflows resulting from a reduction in Australian investment abroad and/or an increase in foreign investment into Australia.

Question 20

When will the financial account record a surplus?

Answer 20

The financial account will record a surplus when the increase in foreign investment into Australia (capital inflow) exceeds the increase in Australia’s investment abroad (capital outflow).
A financial account surplus means that a country draws on the savings (foreign investment) from the rest of the world.

Question 21

What is direct investment?

Answer 21

Is undertaken with the objective of obtaining a lasting interest in a foreign enterprise and exercising a significant degree of influence in its management. It is direct investment if the investment is 10% or more, representing a significant shareholding.

Question 22

What is portfolio investment?

Answer 22

Portfolio investment consists of international equity and debt securities. It is more short term and speculative. The investor does not have any influence in the operating or decision making of the enterprise.

Question 23

What is other investment?

Answer 23

Other investment includes transactions not classified as direct or portfolio. It includes trade credits, loans, currency and deposits.

Question 24

What are reserve assets?

Answer 24

Reserves assets are those financial assets controlled by the monetary authority, such as the RBA. Include monetary gold and foreign exchange.

Question 25

What must the overall BoP always sum to? What does this mean?

Answer 25

The overall balance of payment must always sum to zero.
This means that if the current account is in deficit, then the capital and financial account will be in surplus and equal to the current account in absolute value.

Question 26

What does the balance of payments summarise and what does it provide information about?

Answer 26

The balance of payments is an important set of accounts that summarises a country’s transactions with the rest of the world.

The BoP is an important economic indicator providing information on a nation’s trade account and its financial position with the rest of the world.

Question 27

Give some examples of factors that will impact a nation’s balance of payments.

Answer 27

Changes in economic growth, inflation, the terms of trade, and exchange rates will all have an impact on a nation’s balance of payments.
This reflects that nation’s trading performance which directly impacts on GDP. (GDP= C+I+G+(X-M))

Changes in consumption, investment and government spending will also have an impact on the current account.
E.g. An increase in consumption and/or investment will increase imports.

Question 28

Does the current account reflect changes in the financial account? Explain using an example.

Answer 28

The current account not only summarises the net movement of goods and services but also reflects changes in the financial account through the net income category.
E.g. in increase in foreign investment into Australia will increase the financial account surplus which will cause in increase in the income deficit in the current account in terms of greater servicing costs, thereby increase the current account deficit.

Question 29

Using examples explain how the current account balance has fluctuated over time.

Answer 29

The current account has fluctuated over time (from a low of $43 billion in 2009 to a high of $73 billion in 2016). This is due to cyclical factors- e.g. the GFC in 2009.

Question 30

Explain the fluctuations in the net goods balance with reference to commodity prices and demand for resources.

Answer 30

The net goods balance fluctuates from year to year.
When our resources are in high demand (during the mining boom) our commodity prices increase and our goods balance can record a surplus (2011).

Question 31

Is the demand and supply of our commodities price elastic or inelastic?

Answer 31

Both the demand and supply of our commodities are price inelastic and subject to price fluctuations e.g. wool and wheat.

Question 32

How does world economic growth influence demand for our commodities? How does it effect the trade balance?

Answer 32

World economic growth can influence demand for our commodities (e.g. industrialization of China= more demand for our commodities).
In 2011, 2012, and 2014 Australia experiences large trade surpluses.
Economic shocks (e.g. rise in price of oil, drought) can lead to Australia's trade balance decreasing (the trade balance being at zero).

Question 33

Explain how an economic boom effects the current account balance via the goods balance. Provide examples of when this occurred.

Answer 33

In boom periods, there are larger deficits because more import goods are demanded. Also, an increase in investment means companies are importing capital equipment. Australia recorded large deficits in the net goods balance between 2005 and 2008 due to increased investment due to the mining boom.

Question 34

Is the services balance in surplus or deficit? Explain why.

Answer 34

The service balance has been in deficit for the past 12 years. This is due to Australia’s large imports of travel and freight services. Australia is an isolated nation which results in high freight costs and high numbers of outbound tourism.

Question 35

Which account makes up most of Australia’s CAD?

Why is this? When was this evident?

Answer 35

The primary income deficit always accounts for most of Australia’s current account deficit.
This is because the primary income balance parallels the build-up in Australia’s foreign liabilities. When the Australian economy grows, company profits and dividends will automatically increase which contributes to the increase in the primary income deficit.
This was evident in 2011 when the primary income deficit exceeded the overall current account deficit (?). The primary income deficit can be viewed as the servicing cost of foreign investment.

Question 36

Has the current account always been in deficit?

Answer 36

Yes, the current account has always been in deficit- only recording a surplus once in 50 years.

Question 37

When did Australia record a very large current account deficit? Why did this occur?

Answer 37

In 2008 Australia recorded a very large current account deficit of $79 billion, representing 6.9% of GDP- this was due to Australia’s strong economic growth that was fueled by the mining boom.
This resulted in strong domestic investment and consumption spending which increased import spending. At the same time, high profits in the resource sector increased the outflow of dividends to foreign investors increasing the net income deficit.

Question 38

When did Australia record a relatively small CAD? Why did this occur?

Answer 38

In 2014, Australia recorded a current account deficit of $47 billion, representing only 3% of GDP. This decrease in the deficit was partly due to the growth in export revenue associated with the completion of many mining projects. A second factor is that mining investment decreased which reduced the demand for capital goods imports.

Question 39

How is the size of the CAD measured? Why is this?

Answer 39

When comparing the size of the current account balance over time, it is more meaningful to measure the balance as a proportion of GDP, rather than in billions of dollars.
Measuring the balance as a proportion of GDP takes into account the size of the economy and more accurately reflects its relative size.
The gauge the importance of any variable, it should always be measured in relative terms.

Question 40

What happens to the CAD when the current account balance increases/decreases?

Answer 40

Note that when the balance of the current account increases, the deficit decreases (deficit is moving towards zero/getting smaller)
When the balance decrease, the deficit increases (deficit moves away from zero/gets larger).

Question 41

What is a cyclical factor?

Answer 41

A cyclical factor is something that is affected by changes in the business cycle. They are more temporary and subject to frequent changes.

Question 42

What is a structural factor?

Answer 42

A structural factor is more permanent and only changes gradually. They are to do with the actual structure of the economy.

Question 43

Explain the relationship between the goods and services balance and the current account balance.

Answer 43

Whenever there has been a decrease in the goods and services balance (e.g. between 2014 and 2015) the current account balance also decreases. Likewise, whenever there has been an increase in the goods and services balance (e.g. between 2012 and 2014) the current account balance has also increased.

Question 44

Is the trade balance volatile? What is it effected by?

Answer 44

The trade balance is relatively volatile and is very much influenced by both Australia’s business cycle and the world business cycle.

Question 45

What happens to the CAD when the economy expands at a rapid rate vs at a more sustainable pace.

Answer 45

Whenever the economy expands at a rapid rate, the current account deficit will increase due to increased spending on imports from both consumption and investment.
When the economy grows at a more sustainable pace, the relative size of the CAD declines and in years of very weak economic activity, such as in 2009 (GFC) the current account deficit fell to around 2% of GDP.

Question 46

How do changes in China’s business cycle impact Australia’s trade and current account balance?

Answer 46

Changes in China’s business cycle now have a major impact on Australia’s trade and current account balance. If the Chinese economy expands, world commodity prices (iron ore and coal) rise which will boost Australia’s export income and increase the trade and current account balance.

Question 47

What other factors cause cyclical changes in the current account balance?

Answer 47

Factors that affect Australia’s level of international competitiveness such as relative wage levels, inflation rates and exchange rates are also important in causing cyclical changes in the current account balance.

Question 48

List some cyclical factors.

Answer 48

• Domestic business cycle.
• World business cycle.
• Exchange rates.
• Commodity prices.
• Terms of trade

Question 49

List some structural factors.

Answer 49

• Investment-savings gap.
• Foreign investment
• Foreign debt

Question 50

Explain the structural cause of the CAD.

Answer 50

While the trade balance can change from surplus to deficit, the income balance is always a deficit. This is because Australia relies on foreign investment (net capital inflow) to fund Australia’s investment-savings gap.
Australia, throughout history, has been an importer of financial capital to develop its industries. This capital inflow is recorded in the financial account.
The tradeoff for this use of there country’s savings is the payment of interest and dividends to foreign investors which is recorded in the income account.
The result is that the income balance is always in deficit and is the structural cause of the current account deficit.

Question 51

Which is more stable, the income balance or the trade balance?

Answer 51

The income balance in the current account has been far more stable compared to the trade balance, fluctuating between -4% and -2% of GDP.

Question 52

When will a current account deficit occur- in terms of inflow and outflow of goods, services, and income?

Answer 52

A current account deficit will occur if a nation’s imports and income paid overseas exceeds the value of its exports plus income received from overseas.

Question 53

How will an increase in a country’s inflation rate effect the CAD?

Answer 53

An increase in a country’s inflation rate (ceteris paribus) will decrease net exports and increase a current account deficit.

Question 54

How will a rise in the terms of trade effect the CAD?

Answer 54

A rise in the terms of trade will increase a country’s net exports and lease to a rise in the current account balance (deficit will decrease).

Question 55

What is the current account balance equal to?

Answer 55

The current account balance is equal to the difference between exports and imports plus net income flows.

CAB= X-M+NI

Question 56

How is a nation’s level of savings obtained?

Answer 56

To obtain a nation’s level of savings, we subtract consumption and government spending from income. This means that a country’s savings is equal to its investment plus the current account balance.

Question 57

When will a country have a current account deficit- in terms of structure and domestic savings?

Answer 57

If a country’s investment is greater than its savings, then it will have a current account deficit.
A rise in investment will increase the CAD, while a rise in savings will reduce it.

The savings-investment gap will determine if a country has a CAD. Australia has insufficient domestic savings relative to its high capital investment requirements as it is a commodity driven economy.

Question 58

Why does Australia run a CAD?

Answer 58

By running a CAD, a country can fund a high rate of investment than if it had to rely on its domestic savings alone.
Australia, being small in terms of population, is not able to generate enough savings to finance the investment needed to develop its economy.
Drawing on foreign savings enables a country like Australia to achieve a higher rate of investment and economic growth, and to finance the development of the mining and energy sector.
Running a CAD means that Australia can import foreign savings to enable a higher rate of investment, boosting our rate of economic development.
A CAD can, however, be a bad thing if an economy is not continually growing.

Question 59

Is Australia’s level of savings or investment greater?

Answer 59

Australia’s gross national savings as a percentage of GDP has averaged 23%.
Australia has a very high investment rate, averaging 28% of GDP.

S < I
23 < 28

Question 60

Is there an optimal size for a current account balance?

What has Australia’s current account deficit averaged over the past 30 years?

Answer 60

There is no optimal or correct size for a current account balance.
Over the past 30 years, Australia’s CAD has averaged around 4.5% of GDP.

Question 61

When will a country have a current account surplus?

Answer 61

Some countries, such as Japan, have a current account surplus matched by a capital and financial account deficit.

• Countries that rely more on foreign investment will have a current account deficit.
• Countries that have excess savings to lend to other countries will have a current account surplus.

Question 62

List some factor that will contribute to an increase in a current account deficit. (6)

Answer 62

• A fall in the terms of trade.
• A higher rate of economic growth
• A decline in international competitiveness
• An increase in foreign investment
• A decline in national savings
• In increase in national investment

Question 63

Explain how a fall in the terms of trade could increase the CAD.

Answer 63

I export prices relative to import prices decline then (ceteris paribus) export receipts will fall, while import payments will rise. Normally, whenever then terms of trade fall, the balance on goods and services will also fall.

Question 64

Explain how a higher rate of economic growth could increase the CAD.

Answer 64

This will lead to an increase in national income and an increase in both consumption and investment spending -> boosting the demand for imports.

Question 65

Explain how a decline in international competitiveness could increase the CAD.

Answer 65

If productivity levels decline or if real wages rise more than productivity, then a country’s exports will be less competitive in an overseas market.
A rise in inflation will also reduce a nation’s competitiveness by increasing the prices of domestic goods relative to foreign goods.

Question 66

Explain how an increase in foreign investment could increase the CAD.

Answer 66

This will increase the financial account surplus (and the current account deficit). Australia is a country rich in natural resources which attracts a substantial flow of foreign investment from countries such as the United States, Japan and Europe. If the rate of return on investment is higher in Australia then the rest of the world, then there will be a large capital inflow into Australia. This will automatically increase the CAD.

Question 67

Explain how a decline in national savings could increase the CAD.

Answer 67

If savings by households, firms and the government fall, then (ceteris paribus) the current account deficit will increase. Savings may fall when an economy experiences a recession. Households will draw on savings to maintain consumption, firms’ profits will fall and the government’s budget balance will decrease.

Question 68

Explain how an increase in national investment could increase the CAD.

Answer 68

If investment increases by either the private or public sector, then the CAD will increase. An economy undergoing structural change may require a significant increase in physical and social over head capital. A mining boom that requires significant investment will initially increase the CAD.

Question 69

What changes does the CAD reflect?

Answer 69

The CAD reflects changes in spending savings, investment, productivity and external shocks.