In this explainer, we will learn how to identify the characteristics of international economic relations and the components of a country’s balance of payment accounts.
In a nation’s economy, the households, firms, and governments work together to fulfill the needs of individuals. However, human needs are diverse and continually increasing, and the national economy is typically unable to satisfy these needs, especially if satisfying these needs requires resources that are not abundant in the country. For instance, many countries do not have resources within themselves to obtain petroleum, and countries in colder climates lack the ability to grow tropical fruits, like bananas. This lack of available resources within a country poses an economic problem, which motivates individuals from different countries to establish trades.
International trade refers to transactions of goods or services between countries. Countries with abundant resources can sell them to other countries in exchange for monetary compensation, just like we would conduct transactions in marketplaces. We recall that net exports, which refers to the difference between exports and imports, is a component of national income, more specifically, GDP and GNI. Hence, statistics of international trade are used to determine the overall health of the national economy. In newspapers, we can read reports on trade surplus or deficits in different years as well as editorials expressing concerns for these numbers.
International trade is not limited to governments and large firms, although they are responsible for a bulk of transactions in international trade. Economists consider transactions between individuals or firms in different countries to be trades between the economies of these countries rather than trades between individuals. No matter how small a transaction is, goods and services produced in one country’s economy enter a foreign economy, and money flows into the country’s economy in exchange. Residents or firms from different countries can establish trades in goods and services. Especially, thanks to the Internet, individuals can buy goods directly from foreign merchants and goods are delivered to the buyer’s doorstep. Also, in tourism, residents travel to different countries and purchase foreign goods and services. Hence, tourism also falls under the category of international trade.
In our first example, we will consider examples of international trade.
Example 1: Understanding International Trade
Which of the following is not an example of international trade?
- Hiring an engineer from another country
- Taking a vacation in another country
- Importing petroleum from another country
- Exporting cars to another country
- Investing in a foreign stock market
Recall that international trade refers to the transaction of goods or services between countries. Let us consider each given option and determine whether it is an example of international trade.
Option A: Hiring an engineer from another country may be necessary when a country lacks suitable human resources for production. This represents a transaction between two countries since one country is providing the service of an engineer, while the other country is compensating the service with wages. Hence, this is an example of international trade.
Option B: Taking a vacation in another country involves an individual enjoying the goods and services of another country that the individual pays for using money from the home country’s economy. In this sense, tourism involves transactions of goods and services between two countries and hence is an example of international trade.
Options C and D: Importing or exporting goods, such as cars or petroleum, clearly involves transactions between countries selling and buying these goods. Hence, both importing petroleum and exporting cars are examples of international trade.
Option E: Investing in the stock market can refer to purchasing stocks or bonds from firms in the foreign economy. Investing in stocks or bonds is a way to lend the firms capital, and it does not involve transactions of any goods or services. Hence, this is not an example of international trade.
Option E, investing in the stock market, is not an example of international trade.
In the previous example, we noted that economic activities, such as investment in the stock market, are not a part of international trade. However, investing in a foreign stock market does involve the movement of capital across borders, so such monetary movements should be considered together with international trades. The broader term used in this sense is international economic relations; these involve the different types of economic and financial interactions/inter-linkages across countries. International trade is an important part of international economic relations, and it is perhaps best understood by the public because of its inclusion in the national income. There are many components other than international trade that are included in international economic relations.
International investment, such as the one mentioned in the previous example, is a major component of international economic relations, which is often comparable in size of transactions to international trade. Here, investment covers more than trades of securities in foreign stock markets. Besides the exchange of securities, such as stocks and bonds, international investments include purchasing fixed capital (such as factory machinery) from abroad, buying foreign real estate, and playing a major role in entrepreneurship abroad. We will discuss this category in greater detail later in this explainer.
Let us consider a few other ways capital moves across borders. International economic aid from developed countries or international organizations also involves large sums of capital moving across borders and hence should be considered under international economic relations. Immigrants relocating to a country bring their wealth into the country’s economy and hence move it across borders. Workers in an economy may send money to families living abroad, which also moves capital across borders. These, and many more examples where money moves across borders, constitute international economic relations.
As we have discussed above, international economic relations encompass a wide range of economic activities between countries. We can note the characteristics of international economic relations as follows:
- Existence of political borders is an apparent and essential characteristic of international economic relations, which distinguishes them from other domestic economic activities. Any monetary movement across borders is considered to be a component of international economic relations.
- Difference in currencies is also a characteristic of international economic relations, although it is possible for some countries to share the same currencies. When currencies of two countries differ, money moving across borders needs to be converted using currency exchange rates. Currency exchange rates change frequently, which can cause discrepancies when keeping track of the total amount of transactions between countries.
- Differences in languages, customs, and values between countries are characteristics of international economic relations, particularly of international trade. On one hand, these differences are what drives international tourism as well as imports and exports of native goods and services. But on another hand, these differences also mean that consumers in different countries want different types of goods and services, which can cause challenges in trades.
- Cost of transportation is a characteristic of international trade, which is particularly relevant when the countries are far apart. Crossing oceans with a large quantity of goods can be quite expensive, in which case, transportation cost becomes a significant part of the trade.
A country’s international economic relations represent all of its financial dealings with other countries. Activities in this matter are recorded in a document known as balance of payment (BOP) accounts. A country’s BOP accounts are usually reported on a quarterly basis, and the annual figures are summarized based on the quarterly figures.
We can compare a country’s BOP accounts to its public budget. Recall that the public budget is a document containing projections of a government’s income and expenditure for the upcoming fiscal year. BOP accounts and public budgets are similar in the sense that they serve as budgets recording income and expenses, but they differ in several ways. The public budget contains estimated future activities, while BOP accounts record past fiscal activities. Another difference is that the public budget only records the government’s income and expenditure, while BOP accounts contain activities of all residents where money is moved across borders. Also, while the public budget does serve legal purposes in approving certain expenditure items, BOP accounts only function as a record and do not hold any legal power.
A country’s BOP accounts are useful in understanding economic trends especially in relation to other countries. BOP accounts of many different countries can be found on the websites of international economic organizations such as the IMF (International Monetary Fund) and World Bank. In particular, the IMF serves an important role in international economic relations, which we will discuss later. Through these BOP accounts, we can clearly see not only the net exports, which are the difference in value between exports and imports, but also how the trade deficit or surplus is materializing in the country’s economy.
To this end, BOP accounts aim to include all monetary movements across the country’s borders, including all unofficial private transactions as well as official public activities. However, since many private transactions are not officially documented, it is generally not possible to capture every activity. Instead, figures in the BOP accounts are a result of statistical analysis using smaller samples of transactions; hence, they are prone to small statistical errors. In addition, changes in currency exchange rates can cause discrepancies in these figures.
The movement of capital can be categorized as either credit or debit depending on the direction of monetary flow. Credit refers to monetary movement into a country’s economy, that is, money received by the country’s government or residents from foreign economies. Conversely, debit refers to capital going out of the economy, or money paid by the country’s residents or government to foreign entities. When credit exceeds debit in a certain category in BOP accounts, we say that the balance of the category is in surplus. Similarly, the balance is in deficit in the converse scenario.
Since BOP accounts contain all monetary movements in and out of a country’s economy, the net balance should, in principle, equal zero. To understand this principle, we can consider an analog in personal finance. If we spend more money than our income in a year, the balance containing income and expenditure will be in deficit. We will then need to borrow the amount of deficit so that we can cover the additional expenses. This loan, which counts as money received by us, is recorded as credit precisely equal to the deficit amount from the expenses. Hence, the net balance containing expenses and loans would precisely be equal to zero. While this should also be true in principle for a country’s BOP account, BOP accounts almost never carry the zero balance in practice. This is a discrepancy in BOP accounts as mentioned previously, as they consist of statistical errors and fluctuations in currency exchange rates. Due to these factors, a country’s BOP accounts generally carry some balance at the end. However, the net balance is usually a small fraction of the national economy, reflecting this principle.
In the next example, let us consider the characteristics of balance of payment accounts.
Example 2: Understanding the Role of a Country’s Balance of Payment Accounts
Which of the following is correct about a country’s balance of payment account?
- It contains a record of every economic activity with other countries.
- The net balance on the account is always equal to zero.
- It contains useful data for understanding trends in the national economy.
- It contains projections on inflows and outflows of the country in the international market.
- Any money going out of the country is recorded as credit, while any incoming money is recorded as debit.
Recall that a country’s balance of payment (BOP) accounts contain records of international economic relations, which encompass all monetary movement across borders. Let us consider the description of BOP given in each option and determine whether or not it correctly describes BOP accounts.
- In principle, all economic activities between countries should be included in the country’s BOP accounts. However, it is nearly impossible to track all international transactions, so the figures in a country’s BOP accounts are statistical estimates based on a smaller sample of transactions. This means that the BOP accounts do not have to contain every transaction between countries. Hence, this option incorrectly describes the characteristic of BOP accounts.
- Any money received from other countries is recorded as credit, while any outgoing money is recorded as debit in a country’s BOP. Large debits in trade can be balanced by credit items in trade or elsewhere in the BOP accounts, such as the sale of government or corporate bonds and the receipt of international aid. Hence, in principle, credit and debit items in a country’s BOP accounts should cancel out in the end. However, this is not the case in practice. Statistical errors as well as fluctuations in currency exchange rates cause BOP accounts to carry a small but nonzero balance. Hence, this option incorrectly describes the characteristic of BOP accounts.
- Since a country’s BOP accounts contain information on how money flows into and out of the national economy, they can be used to understand economic trends. For instance, the BOP accounts will show whether the country is running trade deficit or surplus in a certain year. Moreover, BOP accounts can indicate how trade deficit or surplus is affecting the country’s economy. Hence, BOP accounts contain useful data for understanding these types of trends.
- A country’s BOP accounts are records containing international economic relations over the past year (or quarter). Figures in BOP accounts are not projections for the future, but they are estimates of past transactions. Hence, this option incorrectly describes the characteristic of BOP accounts.
- As mentioned above, money received by a country’s residents, firms, and governments is recorded as credit in BOP accounts, while money paid by these entities is recorded as debit. Hence, this option incorrectly associates debit and credit in BOP accounts.
Option C, which states that BOP accounts contain useful data in understanding economic trends, is a correct description of a country’s balance of payment accounts.
While BOP accounts aim to record all activities falling within the scope of international economic relations, they do not list individual transactions, even if they are large. Instead, BOP accounts contain net figures in categories defined, or recommended, by the IMF. Largely, balance of payment accounts are divided into two sections: the current account and the capital account. More recently, the IMF recommended the capital account to be further split into two divisions: the capital account and the financial account, but we will consider the capital and financial accounts as one unit in this explainer. Current and capital accounts in BOP contain records of different types of economic activities, and surplus or deficit in one account is, in principle, balanced with deficit or surplus, respectively, of the other account. Let us first consider what type of activities are included in the BOP current account.
The current account in BOP summarizes the nation’s income from its international dealings. While this includes international trade, the scope of transactions included in the current account is broader than international trade. More specifically, the current account includes monetary flows resulting from the trade of goods and services, income from investment, and transfer payments (that is, payments made without expecting anything in return). The net balance of the current account can provide a comprehensive picture of the nation’s surplus or deficit from its international dealings. Current account surplus indicates that the nation has earned more money than it spent during the recorded period, and current account deficit indicates that the nation’s net income was negative. Since the current and capital accounts must have zero net balance in principle, large current account deficit is accompanied by capital account surplus of comparable size. In simplified terms, capital account surplus represents the nation’s liabilities (or debt) abroad.
Let us consider the categories in the current account. The first two categories of the current account are trade in goods and trade in services, which are separately recorded. The net balance of these two categories indicates whether a country has trade surplus or deficit during the accounting period. Exported goods and services are recorded as credit since money is received by the country’s residents, firms, or governments in the case of exporting. Similarly, imports are recorded as debit in the current account. The current account distinguishes between trade in goods and trade in services. Transactions of physical products, such as petroleum and cars, are included in trade in goods, while transactions of intangible services, such as tourism, are included in trade in services.
For instance, consider the diagram below, which represents a transaction in which country A imports petroleum from country B.
We can see that the payment goes out of country A’s economy, so it is recorded as debit in country A’s current account under trade of goods. At the same time, the payment is coming into country B’s economy, so this same amount is recorded as credit in country B’s current account. In this way, a credit item in one country’s BOP is reflected as a debit item of comparable amount in another country’s BOP.
Besides these two categories, which constitute international trade, the current account includes categories known as primary income and secondary income. Primary income, also known as investment income, refers to payments for investments such as stock dividends or bond coupon payments made to a foreign investor who owns these stocks or bonds. For instance, consider the diagram below.
In the transaction represented above, no goods or services were exchanged. An investor from country A already owns an asset or a loan issued by a firm in country B. As agreed by the terms of the security, the firm owes the investor either dividends (for stocks) or coupon (for bonds) payments, which count as primary income. Since this payment is entering country A’s economy, it is recorded as credit in country A’s current account and as debit in country B’s current account under primary income.
Secondary income refers to transfer payments, which are payments made without expecting anything in return. In the context of BOP, transfer payments are called current transfers. Current transfers from governments or international organizations are called international grants (or subsidies), while current transfers from individuals are worker remittances, where workers send money to families living abroad. For instance, we consider the diagram below.
The transaction represented above is worker remittance, which is a type of current transfer; hence, it is recorded under secondary income. The worker in country A is sending money to the family in country B. Again, we can follow the direction of money to determine that this payment is recorded as debit in country A and as credit in country B. The BOP of many developing countries shows large credit under secondary income due to worker remittances.
We have discussed the categories of the current account, which are trade in goods, trade in services, primary income, and secondary income. Each of these categories is split into credit and debit. We can see the organization of the current account in the diagram below.
Credit and debit in each category are recorded separately so that the overall size of economic activities can be seen before cancelation. The balance of each category can be computed by taking the difference between credit and debit within the category. To understand these categories in the real world, we can consider Egypt’s BOP current account from 2019 as given below, which is available on the IMF website. The monetary unit used in this table is one billion US dollars.
|Trade in goods||28.5||57.8|
|Trade in services||25.1||21.2||3.9|
|Current account balance|
Let us observe different elements of this current account. For instance, we see that residents, firms, and the government in Egypt have sold goods abroad worth approximately in 2019, while they purchased goods totaling . The balance for the category of trade in goods is given by
This tells us that Egypt ran a deficit of in trade in goods during 2019. Similarly, we can see that the balance for trade in services has a surplus of . Adding these figures, we can calculate the balance of international trade:
Hence, in 2019, Egypt experienced a trade deficit of . Additionally, the primary income shows a deficit of , which together with the trade deficit leads to a deficit. However, the balance of secondary income, which consists of current transfers such as international grants and worker remittances, shows a large surplus of , offsetting much of the deficit due to the other categories. Adding these figures together,
This tells us that the net current account balance is in a deficit of . This deficit should be further offset by the capital account balance as we will see later in this explainer.
In our next example, we will consider the characteristics of the BOP current account.
Example 3: Balance of Payments on the Current Account
Which of the following is recorded as credit under the balance of payments on the current accounts?
- Stock dividends received from a foreign share
- Imported cars
- Exported petroleum
- International tourism in the country
Recall that a country’s balance of payment (BOP) accounts contain records of the economic activities of the country in relation to other countries. Transactions resulting in money entering the country’s economy are recorded as credit, while transactions where money goes out of the national economy are recorded as debit. In particular, the BOP current account contains records of a country’s international dealings. More specifically, categories of the current accounts are trade in goods, trade in services, primary income, and secondary income.
Let us consider the options given here and determine which items are recorded as credit under the current account.
- Primary income in the BOP current account refers to income resulting from foreign investments. In particular, the stock dividend payment is included under primary income and is recorded in the current account. Let us determine whether this transaction would be recorded as credit or debit. In this option, we are given that this dividend is received from a foreign stock share. This means that money would enter the country’s economy through this payment. Hence, this activity would be recorded as credit in the current account.
- Importing cars is a trade in goods, which is a category under the current account. Let us determine whether this transaction would be recorded as credit or debit. When importing cars, money is paid to a foreign entity selling the cars, which means that money goes out of the nation’s economy through this transaction. Hence, this activity is recorded as debit in the current account.
- Exported petroleum is also a trade in goods; hence, it is recorded in the BOP current account. Let us determine whether this transaction would be recorded as credit or debit. When exporting petroleum, money is received by a domestic entity selling petroleum, which means that money is entering into the nation’s economy through this transaction. Hence, this activity is recorded as credit in the current account.
- When foreign tourists visit the country, they purchase goods and services within the country, which is recorded under the BOP current account. Since money is received by the country from the tourists, this activity is recorded as credit in the current account.
Options I, foreign stock dividends, III, exported petroleum, and IV, international tourism in the country, are recorded as credit under the balance of payments on the current account.
Next, we will consider what activities are recorded in the capital account. Transactions recorded in the capital account involve a change in ownership (that is, assets) or debts (that is, liabilities). These transactions are known as capital transfers. Capital transfers differ from current transfers, which are recorded under the current account, because no ownership or debt changes as a result of current transfers. While the current account reflects a nation’s income from its international dealings, the capital account reflects its accumulated wealth in the form of change in its ownership and liabilities abroad.
Compared to the current account, which mostly contains straightforward transactions, transactions in the capital account often involve complicated financial claims. These claims include securities such as stocks and bonds, which contain legal contracts between involved parties. Additional types of complex financial claims included in the capital account are certain insurance claims, real estate transactions, debt forgiveness, sales or purchases of fixed capital, and money brought in by immigrants. Since there is a wide range of capital transfers, the capital account holds more categories compared to the current account. In this explainer, we will focus on the three main categories, which generally contain the largest figures. The three main categories of the capital account are direct investment, portfolio investment, and other investments. Let us consider the distinctions between these categories.
The distinction between direct investment and portfolio investment is in the “degree of interest” in the firm by foreign investors. Direct investment includes large-scale investments, typically involving the transfer of large stakes on firms abroad. On the other hand, portfolio investment includes smaller trades compared to direct investment, which most regular investors conduct through the secondary market. Lastly, other investments contain capital transfers that do not belong to other categories such as direct or portfolio investments like loans from international banks.
Adding to the complexity of the capital account is the distinction between assets and liabilities. In the capital account, assets refer to transactions by a national in buying or selling investment products in foreign markets, changing the country’s total ownership (hence, assets) status abroad. On the other hand, liabilities refer to foreigners’ investment activities in the home country, which create or dissolve the country’s future obligations (hence, liabilities). Within each category, transactions can be further broken down into credit versus debit, as was the case in the current account. Often, abbreviated reports on the capital account omit credit and debit subcategories and simply show the net figure within the assets and liabilities categories. A positive sign indicates surplus; that is, credit exceeds debit in the category, while a negative sign indicates that the category is in deficit.
For instance, consider a transaction where an investor from country A buys stock from country B’s secondary market. This is represented in the diagram below.
We note that this transaction differs from that of primary income since the ownership of stock is changed as a result, while no ownership is changed during the transaction shown in primary income. Since trades in secondary markets are generally small, we can assume that this transaction belongs under portfolio investment. This transaction increases the asset (or ownership) of country A’s economy in country B, and it increases the responsibilities (or liability) of the stock-issuing firm in country B for this shareholder. Hence, this is recorded in the capital account under assets for country A and under liabilities for country B. More specifically, let us see whether this item would be considered credit or debit. Since the investor’s money is flowing out of country A’s economy, this payment is considered to be a debit item for country A, while it would be considered credit for country B. In summary, this item would be recorded as credit (respectively, as debit) under country A’s (respectively, under country B’s) capital account under portfolio investment and assets.
We can summarize the organization of the capital account in the diagram below.
With these categories in mind, let us return to Egypt’s BOP capital account from 2019, measured in units of one billion US dollars.
|Assets||Liabilities||Balance (Assets + Liabilities)|
|Capital account balance||13.0|
Let us observe a few items in this table. The figure under direct investment of assets tells us that this money is going out of the Egyptian economy. In other words, the net transactions of Egyptian investors in foreign markets resulted in spending in excess of corresponding sales. This negative figure indicates that the ownership of Egyptian economy has increased abroad. On the other hand, we can see that the net balance of foreign investors, given under direct investment in liabilities, is positive: , which means that Egypt’s international liability has increased by this amount. The net balance in the direct investment is given by summing these two figures:
Hence, the Egyptian economy received from transactions in direct investment. Similarly, Egypt received from net transactions in portfolio investment, while it spent in other investment items. Finally, we can see that the capital account shows the balance of in surplus. On one hand, this surplus means that this sum of money has entered the Egyptian economy during 2019. On the other hand, it also means that Egyptian liabilities (or debts) have increased by this amount.
We recall that the current account in the same year displayed a deficit of . This deficit should cancel with the capital account surplus. We can see this in the following computation:
Thus, the current account deficit is more than offset by the capital account surplus. We recall that this balance should be equal to zero in principle because the current account balance represents a country’s income, while the capital account balance represents its loan from the international marketplace. Rather than equaling zero, the BOP carries a balance of . This nonzero figure is due to statistical errors and fluctuations in current exchange rates. While it is not precisely equal to zero, we can see that the final balance is relatively small in comparison to the size of individual items in BOP accounts.
In the next example, we will consider what is included in the BOP capital account.
Example 4: Balance of Payments on the Capital Account
Which of the following are recorded as a debit transaction in the balance of payments on the capital accounts?
- Stock purchased from a foreign market
- Bond sold to a foreign investor
- Exported petroleum
- Real estate sale to a foreign national
Recall that a country’s balance of payment (BOP) accounts contain records of international economic relations. In particular, the capital account in BOP contains records of capital transfers, which are monetary movements resulting in a change of ownership (assets) or debt (liabilities). Credit means that the money is received by the country’s economy, while debit means that the money is going out of the country’s economy.
Let us consider the options given here and determine which items are recorded as debit under BOP capital account.
- Transactions involving securities, such as stocks and bonds, are recorded in the capital account. Let us determine whether this transaction falls under credit or debit. When stock is purchased from a foreign market, an investor from the country is spending money in the foreign country so that money is flowing out of the country’s economy. Hence, this transaction is recorded as debit in the capital account.
- Similar to the first option, transactions involving securities, such as stocks and bonds, are recorded in the capital account. Let us determine whether this transaction falls under credit or debit. Since a foreign investor is purchasing a bond from the domestic stock market, the foreign investor’s money is flowing into the country’s economy. Hence, this transaction is recorded as credit in the capital account.
- Exported petroleum falls under trade in goods, which is recorded in the current account rather than the capital account.
- Real estate is considered to be an investment property, so it is recorded under the capital account. Since a foreign national is purchasing a domestic property, money is flowing into the country’s economy. Hence, this transaction is recorded as credit in the capital account.
Option I, stock purchased from a foreign market, is the only option that is recorded as debit under the balance of payments capital account.
As we have discussed, capital transfers can be considered to be loans between countries. In general terms, we can say that assets in the capital accounts are loans given to foreign countries, while liabilities are loans received by the country. Here, the term loan carries a broader meaning compared to its regular usage, which refers to borrowing money from another entity. For instance, purchasing a real estate property abroad, which falls under the asset category of the capital account, can be thought of as loaning money to that country since the owner of the land can sell it back in the future to recover the property’s value. In this sense, capital transfers can be perceived as loans even when they do not directly involve debt obligations.
Recall that commercial banks’ loans increase the firm’s ability to produce more goods and services, which leads to economic growth. Similarly, capital transfers, which serve similar functions to loans, can benefit the international economy. We can better understand how capital transfers help the international economy when we divide them into the following categories:
- Short-term loans (or financing) are capital transfers that need to be settled within 1 year. Generally, short-term loans are used to settle the difference (surplus or deficit) in international trade. For instance, a country can make a loan to another country that wants to import goods and services from it. This benefits both economies because country A can gain revenue by exporting, while country B is able to import goods and services quickly. This process is similar to credit card transactions in personal finance, where the consumer pays for the goods and services by creating a debt. Since short-term loans allow countries to import goods and services in exchange for liabilities, more countries are encouraged to participate in the trade. Hence, short-term loans cause the volume of international trade to increase, benefiting the international economy overall.
- Medium- to long-term loans (or investments) refer to capital transfers with terms longer than 1 year. Unlike short-term loans that are used to pay for goods and services for consumption, medium- and long-term loans are capital transfers intended for investment. In other words, these loans provide capital to the firms, which can be used to develop new projects or increase the scale of current projects. Capital transfers in this category include the trading of securities such as stocks and bonds, which are used for the firms to raise long-term capital as well as bank loans. They also include more direct forms of investment, such as purchasing land or production equipment abroad, where the investor functions as the firm’s owner rather than a creditor. In this case, the investor fully takes on the firm’s risk and participates directly in the management of the firm abroad. These loans, or international investments, help in the development of firms internationally and hence are beneficial to the international economy overall.
- Economic aid includes current transfers, that is, payments without
creating liabilities and capital transfers that create new liabilities. International grants and subsidies are examples of current transfers recorded in
the current account in BOP, and these are generally used to help countries in need
of emergency assistance. Since these do not lead to a change in ownership or
liabilities abroad, they do not fall under capital transfers.
On the other hand, loans from international organizations, such as the IMF, exist with the intention to help developing countries achieve economic growth. Hence, such loans fall under the capital transfer’s category of economic aid for development. Since these loans need to be repaid in the future, often with low interest rates in comparison to loans between countries, they create new liabilities and hence fall under capital transfers. Like medium- to long-term loans, these loans are used as investments for the firms to develop new productive capabilities, which can lead to economic growth. However, these loans accompany much lower costs (or interest rates) in comparison to similar debt instruments in the previous category. Hence, economic aid benefits the international economy by improving the quality and quantity of goods and services produced by developing countries.
In our final example, we will consider different types of capital transfers.
Example 5: Understanding Short-Term Loans
Which of the following best describes the motives for issuing short-term loans in capital transfers?
- Helping developing countries to achieve economic growth
- Protecting major businesses from bankruptcy
- Financing new projects to encourage production
- Increasing the volume of trade exchange between countries
Recall that capital transfers are monetary movements resulting in a change in ownership of assets and liabilities. Capital transfers can be divided into short-term loans, medium- to long-term loans, and economic aid for development. Let us recall the functions of these loans within the relevant options and determine which option describes the motive for short-term loans.
- Economic aid in the form of loans is a type of capital transfer since it creates new liabilities for the recipient country. International organizations, such as the IMF, have special funds available to make loans to developing countries with the intent of helping them achieve economic growth. Hence, this option describes the motives of economic aid rather than short-term loans.
- Firms declare bankruptcy when they are unable to meet their liabilities. Since loans increase a firm’s liabilities, they cannot be used to prevent firms from bankruptcy. Hence, this option is not an accurate description for the role of capital transfers.
- Medium- to long-term loans carry terms longer than 1 year. These loans are ideal for financing the development of new projects, since it generally takes a long time before new projects can create profit. These loans can take the form of bank loans that create debts for the firms abroad, or they can take the form of a more direct involvement in foreign firms, such as purchasing land and equipment abroad. Hence, this option describes the motives of medium- to long-term loans rather than short-term loans.
- Short-term loans are loans between countries with terms less than 1 year. To settle the net difference in international trade, the exporting country can make a short-term loan to the importing country. Such loans help importing countries and hence cause the volume of international trade to increase. Hence, this option describes the motives of short-term loans.
Option D, increasing the volume of trade exchange between countries, is the motive of short-term loans.
Let us finish by recapping a few important concepts from this explainer.
- The scope of international trade is limited to transactions of goods or services between countries, while international economic relations encompass any movement of capital across borders.
- Activities of international economic relations are recorded in a document known as balance of payment (BOP) accounts on an annual basis.
- In BOP accounts, any money received by a country’s economy is recorded as credit, and any outgoing money is recorded as debit.
- Balance of payment accounts are divided into two sections: current account and capital account. In a simplified picture, the current account represents the income and the capital account represents the debt of the country from international markets.
- In principle, surplus and deficit in the current and capital accounts should cancel out, resulting in zero net BOP balance. However, this is rarely the case due to factors such as statistical errors and fluctuations in currency exchange rates.
- The BOP current account is a summary of the country’s income in
transactions with other nations. These consist of the following categories:
- trade in goods,
- trade in services,
- primary income (investment income): stock dividends, interest payments, and so on,
- secondary income (current transfers): worker remittance, international grants, and subsidies.
- The net amount, which is computed as the difference of credit and debit, of each category of BOP accounts is called the category’s balance. The balance is in deficit if total debit exceeds credit and is in surplus otherwise.
- The capital account of a country’s BOP consists of capital transfers,
which are monetary movements involving a change in ownership (assets) or
obligations (liabilities). These include the following categories:
- direct investment: investors take a major (larger than ) stake in a foreign firm,
- portfolio investment: investors take a minor stake in a foreign firm,
- other investments: these include bank loans as well as complex transactions.
- Capital transfers are divided into the following categories:
- short-term loans: under a one-year term, used to settle deficit and surplus in international trade,
- medium- to long-term loans: over a one-year term, used to finance developments of firms abroad,
- economic aid for development: loans from international organizations to help developing countries achieve economic growth.