Balance of Payments Accounting

interest received by a U.S. saver who owns a French government bond. Another example is the profits earned by a U.S. company from its foreign subsidiary. In both examples, the income is recorded as income receipts from abroad.

The income payments flowing out of a country consist of compensation paid to foreign residents working in the country plus payments to foreign owners of assets in the country. For example, the wages paid by a U.S. company to a Swedish engineer who is temporarily residing in the United States, or the dividends paid by a U.S. automobile company to a Mexican owner of stock in the company, are both income payments to residents of other countries.

Net Unilateral Transfers. Unilateral transfers are payments from one country to another that do not correspond to the purchase of any good, service, or asset. Examples are official foreign aid (a payment from one government to another) or a remittance of money from a resident of one country to family members living in another country. A country's net unilateral transfers equal unilateral transfers received by the country minus unilateral transfers flowing out of the country. The negative value of net unilateral transfers in Table 5.1 shows that the United States is a net donor to other countries.

Current Account Balance. Adding net exports of goods and services, net income from abroad, and net unilateral transfers yields a number called the current account balance. If the current account balance is positive, the country has a current account surplus.

The Financial Account

International transactions involving assets, either real or financial, are recorded in the financial account. When a U.S. firm or resident sells an asset to another country, for example, if a U.S. hotel is sold to Italian investors, the transaction is recorded as an increase in foreign-owned assets in the United States, which is a financial inflow, because funds flow into the United States to pay for the asset. Similarly, when the home country buys an asset from abroad—say a U.S. resi­dent opens a Swiss bank account—the transaction involves a financial outflow from the United States and is recorded as an increase in U.S.-owned assets abroad.

The financial account balance equals the value of financial inflows minus the value of financial outflows plus the net increase in foreign-owned derivatives (which are financial assets whose value is based on, or "derived" from, the values of other assets) in the United States. When residents of a country sell more assets to foreigners than they buy from foreigners, the financial account balance is positive, creating a financial account surplus. When residents of the home country purchase more assets from foreigners than they sell, the financial account balance is negative, creating a financial account deficit. Table 5.1 shows that in 2021, U.S. residents increased their holdings of foreign assets (ignoring financial derivatives and unilaterally transferred assets) by $1213.3 billion while foreigners increased their holdings of U.S. assets by $1858.8 billion. Thus the United States had net financial flows of $645.5 billion in 2021 ($1858.8 billion minus $1213.3 billion).

The Balance of Payments. In Table 5.1 one set of financial flows—transactions in official reserve assets—has been broken out separately. These transactions differ from other financial account transactions in that they are conducted by central banks (such as the Federal Reserve in the United States), which are the official institutions that determine national money supplies. Held by central banks, official reserve assets are assets, other than domestic money or securities, that can be used in making international payments. Historically, gold was the primary official reserve asset, but now the official reserves of central banks also include govern­ment securities of major industrialized economies, foreign bank deposits, and spe­cial assets created by the International Monetary Fund.

Central banks can change the quantity of official reserve assets they hold by buying or selling reserve assets on open markets. For example, the Federal Reserve could increase its reserve assets by using dollars to buy gold. According to Table 5.1 (see the line "U.S. official reserve assets"), in 2021 the U.S. central bank acquired $114.0 billion of official reserve assets. In the same year foreign central banks increased their holdings of dollar-denominated reserve assets by $266.2 billion (see the line "Foreign official assets"). The balance of payments is the net increase (domestic less foreign) in a country's official reserve assets. A country that increases its net holdings of reserve assets during a year has a balance of payments surplus, and a country that reduces its net holdings of reserve assets has a balance of payments deficit. For the United States in 2021 the balance of payments was -$152.2 billion (equal to the $114.0 billion increase in U.S. reserve assets minus the $266.2 billion increase in foreign dollar-denominated reserve assets). Thus the United States had a balance of payments deficit of $152.2 billion in 2021.

For the issues we discuss in this chapter, the balances on current account and on financial account play a much larger role than the balance of payments. We explain the macroeconomic significance of the balance of payments in Chapter 13 when we discuss the determination of exchange rates.

The Relationship Between the Current Account and the Financial Account

The logic of balance of payments accounting implies a close relationship between the current account and the financial account. Except for errors arising from prob­lems of measurement, in each period the current account balance and the financial account balance must sum to zero. That is, if

CA = current account balance and

FA = financial account balance,

then

CA + FA = 0. (5.1)

The reason that Eq. (5.1) holds is that every international transaction involves a swap of goods, services, or assets between countries. The two sides of the swap always have offsetting effects on the sum of the current account and the financial account balances, CA + FA. Thus the sum of the current account and the finan­cial account balances must equal zero.

Table 5.2 helps clarify this point. Suppose that a U.S. consumer buys an imported British sweater, paying $75 for it. This transaction is an import of goods to the United States and thus reduces the U.S. current account balance by $75. However, the British exporter who sold the sweater now holds $75. What will he do with it? There are several possibilities, any of which will offset the effect of the purchase of the sweater on the sum of the current account and the financial account balances.

The Briton may use the $75 to buy a U.S. product—say, a computer game. This purchase is a $75 export for the United States. This U.S. export, together with the origi­nal import of the sweater into the United States, results in no net change in the U.S. current account balance CA. The U.S. financial account balance FA hasn't changed, as no assets have been traded. Thus the sum of CA and FA remains the same.

A second possibility is that the Briton will use the $75 to buy a U.S. asset—say, a bond issued by a U.S. corporation. The purchase of this bond is a financial inflow to the United States. This $75 increase in the U.S. financial account offsets the $75 reduction in the U.S. current account caused by the original import of the sweater. Again, the sum of the current account and the financial account balances, CA + FA, is unaffected by the combination of transactions.

TABLE 5.2

Why the Current Account Balance and the Financial Account Balance Sum to Zero: An Example (Balance of Payments Data Refer to the United States)

Finally, the Briton may decide to go to his bank and trade his dollars for British pounds. If the bank sells these dollars to another Briton for the purpose of buying U.S. exports or assets, or if it buys U.S. assets itself, one of the previous two cases is repeated. Alternatively, the bank may sell the dollars to the Federal Reserve in exchange for pounds. But in giving up $75 worth of British pounds, the Federal Reserve reduces its holdings of official reserve assets by $75, which counts as a finan­cial inflow. As in the previous case, the financial account balance rises by $75, offset­ting the decline in the current account balance caused by the import of the sweater.^[80]

This example shows why, conceptually, the current account balance and the finan­cial account balance must always sum to zero. In practice, problems in measuring international transactions prevent this relationship from holding exactly. The amount that would have to be added to the sum of the current account and the financial account balances for this sum to reach its theoretical value of zero is called the statistical discrepancy. As Table 5.1 shows, in 2017 the statistical discrepancy was $92.5 billion.

When you examine the data on the current account across countries, you see that for most of the past decade, the advanced economies of the world together ran a large current account deficit, while emerging and developing economies around the world ran a very large current account surplus. This means the emerg­ing and developing economies have invested some of their saving in developed countries. See the Application "Recent Trends in the U.S. Current Account Deficit," for some reasons why this may have occurred.

Net Foreign Assets and the Balance of Payments Accounts

In Chapter 2 we defined the net foreign assets of a country as the foreign assets held by the country's residents (including, for example, foreign stocks, bonds, or real estate) minus the country's foreign liabilities (domestic physical and financial assets owned by foreigners). Net foreign assets are part of a country's national wealth, along with the country's domestic physical assets, such as land and the capital stock. The total value of a country's net foreign assets can change in two ways: (1) the value of existing foreign assets and foreign liabilities can change, as when stock held by a U.S. citizen in a foreign corporation increases in value or the value of U.S. farmland owned by a foreigner declines; and (2) the country can acquire new foreign assets or incur new foreign liabilities.

What determines the quantity of new foreign assets that a country can acquire? In any period the net amount of new foreign assets that a country acquires equals its cur­rent account surplus. For example, suppose a country exports $10 billion more in goods and services than it imports and thus runs a $10 billion current account surplus (assuming that net factor payments from abroad, NFP, and net unilateral transfers both are zero). The country must then use this $10 billion to acquire for­eign assets or reduce foreign liabilities. In this case we say that the country has undertaken net foreign lending of $10 billion.

Similarly, if a country has a $10 billion current account deficit, it must cover this deficit either by selling assets to foreigners or by borrowing from foreigners. Either

SUMMARY 7____________________________________________________

Equivalent Measures of a Country's International Trade and Lending

Each Item Describes the Same Situation

A current account surplus of $10 billion

A financial account deficit of $10 billion

Net acquisition of foreign assets of $10 billion

Net foreign lending of $10 billion

Net exports of $10 billion (if net factor payments, NFP, and net unilateral transfers equal zero)

action reduces the country's net foreign assets by $10 billion. We describe this situa­tion by saying that the country has engaged in net foreign borrowing of $10 billion.

One important way in which a country borrows from foreigners occurs when a foreign business firm buys or builds capital goods; this is known as foreign direct investment. For example, when the Honda Motor Company from Japan builds a new auto production facility in Ohio, it engages in foreign direct investment. Because the facility is built in the United States but is financed by Japanese funds, foreign-owned assets in the United States increase, so the financial account balance increases. Foreign direct investment is different from portfolio investment, in which a foreigner acquires securities sold by a U.S. firm or investor. An example of portfo­lio investment occurs when a French investor buys shares of stock in Microsoft Corporation. This transaction also increases the financial account balance, as it rep­resents an increase in foreign-owned assets in the United States.

Equation (5.1) emphasizes the link between the current account and the acqui­sition of foreign assets. Because CA + FA = 0, if a country has a current account surplus, it must have an equal financial account deficit. In turn, a financial account deficit implies that the country is increasing its net holdings of foreign assets. Similarly, a current account deficit implies a financial account surplus and a decline in the country's net holdings of foreign assets. Summary table 7 presents some equivalent ways of describing a country's current account balance and its acquisition of foreign assets.

Application

The United States as International Debtor

From about World War I until the 1980s, the United States was a net creditor inter­nationally; that is, it had more foreign assets than liabilities. Since the early 1980s, however, the United States has consistently run large annual current account deficits. These current account deficits have had to be financed by net foreign bor­rowing (which we define broadly to include the sale of U.S.-owned assets to for­eigners as well as the incurring of new foreign debts).

The accumulation of foreign debts and the sale of U.S. assets to foreigners have, over time, changed the United States from a net creditor internationally to a net debtor. Figure 5.1 shows the U.S. ownership of foreign assets and foreign own­ership of U.S. assets, both measured as a percent of U.S. GDP, since 1982. As you can see, foreign ownership of U.S. assets overtook the U.S. ownership of foreign

FIGURE 5.1

International ownership of assets relative to U.S. GDP, 1982-2021

The chart shows annual values for ownership of foreign assets by U.S. res­idents and ownership of U.S. assets by foreigners, each as a percentage of U.S. GDP for the period 1982 to 2021.

Sources: International owner­ship of assets: Bureau of Economic Analysis, International Economic Accounts, International Investment Position, Table 1.1, available at ap-ps.bea.gov/iTable/ index_ita.cfm. GDP: Bureau of Economic Analysis, National Income and Product Accounts, available at fred.stlouisfed.org/ series/GDPA.

assets in the late 1980s and the gap between the two has grown substantially since then. According to estimates by the Bureau of Economic Analysis, at the end of 2021 the United States had net foreign assets of -$18.1 trillion, measured at cur­rent market prices. Equivalently, we could say that the United States had net for­eign debt of $18.1 trillion.^[81] This international obligation of more than $18 trillion is larger than that of any other country, making the United States the world's largest international debtor. This figure represents an increase of indebtedness of $4.1 tril­lion from yearend 2020. The U.S. current account deficit in 2021 was $824 billion. But the net debt of the United States increased by more because changes in the prices of stocks, bonds, and other assets caused increases in the value of foreign- owned assets in the United States relative to the value of U.S.-owned assets abroad.

Although the international debt of the United States is large, the numbers need to be put in perspective. First, the economic burden created by any debt depends not on the absolute size of the debt but on its size relative to the debtor's economic resources. Even at $18.1 trillion, the U.S. international debt is only about 79% of one year's GDP (U.S. GDP in 2021 was $20,894 billion). By contrast, some countries, especially certain developing countries, have ratios of net foreign debt to annual GDP that exceed 100%. Second, the large negative net foreign asset position of the United

States doesn't imply that it is being "bought up" or "controlled" by foreigners. If we focus on foreign direct investment, in which a resident of one country has owner­ship in a business in another country and has influence over the management of that business, it appears that the United States has a slightly smaller presence in other countries than they do in the United States. At the end of 2020, the market value of U.S. direct investment in foreign countries was $11,035 billion, and the market value of foreign direct investment in the United States was $14,840 billion.^[82]

In evaluating the economic significance of a country's foreign debt, keep in mind that net foreign assets are only part of a country's wealth; the much greater part of wealth is a country's physical capital stock and (though it isn't included in the official national income accounts) its "human capital"—the economically valuable skills of its population. Thus, if a country borrows abroad but uses the proceeds of that borrowing to increase its physical and human capital, the for­eign borrowing is of less concern than when a country borrows purely to finance current consumption spending. Unfortunately, the deterioration of the U.S. net foreign asset position doesn't appear to have been accompanied by any signifi­cant increase in the rates of physical investment or human capital formation in the United States. In that respect, the continued high rate of U.S. borrowing abroad is worrisome but unlikely to create a crisis in the near term.

⁵Incidentally, the largest direct investor in the United States is Japan. Japan is also the country that receives the most direct investment from the United States. For data on the distribution of U.S. direct investment abroad and foreign direct investment in the United States, see "Direct Investment by Country and Industry, 2020," Bureau of Economics Analysis website at WwwbeagpvlnewsIlOTlI direct-investment-country-and.-ind.ustry-2020, July 2021.

5.2