Essential definitions

Balance of payments

A record of transactions between residents of an economy and non-residents over a period.

Capital account

Capital transfers and transactions in non-produced, non-financial assets.

Financial account

Transactions in financial assets and liabilities, including direct investment, portfolio investment, borrowing and reserves.

Financial asset

A financial claim held by its owner, such as a bond or bank deposit.

Liability

An obligation owed to another party, such as a loan owed by a borrower.

Distinguish the transactions

The capital account includes capital transfers, such as qualifying debt forgiveness, and transactions in non-produced, non-financial assets, such as resource rights. Imported equipment remains a goods import, despite the everyday phrase capital goods.

The financial account records asset and liability transactions. Direct investment involves a lasting ownership interest and influence; portfolio investment includes securities without that relationship. A loan is an asset for its lender and a liability for its borrower. Official reserve assets are foreign assets held by the monetary authority. A future interest payment on a loan belongs to current primary income, not the original financing transaction.

State which sign convention is being used

For these teaching examples, F means net financial inflows: increases in foreign claims on domestic assets minus residents' acquisitions of foreign assets. Let CA be the current-account balance and KA the capital-account balance. Ignoring errors and omissions, CA + KA + F = 0. All are net flows in the same currency and period.

With CA = −20 and KA = +2 billion, solve −20 + 2 + F = 0 to get F = +18 billion. Some published tables instead define the financial account as net acquisition of assets minus net incurrence of liabilities. That reverses this teaching convention: current plus capital equals that financial balance, apart from errors. Read the convention before assigning a sign.

Follow reserves and later obligations

Buying foreign reserve assets increases residents' foreign assets, so it is an outflow under our F convention. Selling reserves to finance payments is an inflow. A new foreign loan also provides an inflow but creates an obligation; repayment later reduces that liability.

Double-entry accounting provides matching entries across the record. It does not require every account to be zero or make every funding source safe. The next HL lesson evaluates whether persistent deficits fund productive activity and whether the financing can continue.

Apply and evaluate

• The composition and maturity of financing matter: a long-lived investment differs from short-term debt.
• Errors, omissions and valuation changes must be treated carefully when comparing actual data.