The BOP is an accounting method that tracks transactions between a country and its international trading partners. It accounts for government, consumer and business transactions. Similar to a balance sheet of a corporation, the BOP reflects payments and liabilities, however, it tracks payments and liabilities in 2 accounts, to the trading partner and from the trading partner.
The current account tracks the exchange of gods, services investment income and unilateral transfers. A surplus indicates we are selling more goods and services then we are buying, and vice versa for a deficit.
Current account deficits lead to a depreciating currency through the following channels:
supply/demand mechanism. Current account deficits in a country
increase the supply of that currency in the markets (as exporters to that
country convert their revenues into their own local currency). This puts
downward pressure on the exchange value of that currency. The decrease in
the value of the currency may restore the current account
deficit to a balance—depending on the following factors:
- The initial deficit. The larger the initial deficit, the larger the depreciation of domestic currency needed to restore current account balance.
- The influence of exchange rates on domestic import and export prices. As a country’s currency depreciates, the cost of imported goods increases. However, some of the increase in cost may not be passed on to consumers.
- Price elasticity of demand of the traded goods. If the most important imports are relatively price inelastic, the quantity imported will not change.
- Portfolio balance mechanism. Countries with current account surpluses usually have capital account deficits, which typically take the form of investments in countries with current account deficits. As a result of these flows of capital, investor countries may find their portfolios’ composition being dominated by few investee currencies. When investor countries decide to rebalance their investment portfolios, it can have a significant negative impact on the value of those investee country currencies.
- Debt sustainability mechanism. A country running a current account deficit may be running a capital account surplus by borrowing from abroad. When the level of debt gets too high relative to GDP, investors may question the sustainability of this level of debt, leading to a rapid depreciation of the borrower’s currency.
The financial or capital account tracks the flow of investment in debt and equity in and out of a country.
Capital accounts is heavily influenced by differences in real rates between countries, as investors seek higher rates to work their capital. Inflows are important for countries that lack high savings rates, however excess flows can pose economic problems, particularly in emerging countries. These can be countered by imposing capital controls or directly intervening in currency markets. Excess capital flows can lead to:
- Excessive real appreciation of the domestic currency.
- Financial asset and/or real estate bubbles.
- Increases in external debt by businesses or government.
- Excessive consumption in the domestic market fueled by credit.