What it means
The balance of payments is a record of all economic dealings between a country and the rest of the world over a period. It is split into the current account, which covers trade in goods and services and income, and the capital and financial accounts, which cover investment and lending.
The official settlement account shows what the central bank and government had to do to make the totals balance. The idea is simple.
If a country runs a deficit on its current account and private investors do not send in enough funds to cover it, someone must supply foreign currency. The central bank does this by selling reserves, and that action is recorded in the official settlement account.
The reverse also happens. A country with a surplus, or with large inflows of foreign investment, ends up with extra foreign currency.
The central bank can buy it and add to its reserves, which is recorded as an increase in the account. Under a floating exchange rate, the central bank does not need to intervene, so the official settlement balance can be small.
Under a fixed or managed rate, however, the central bank has to buy or sell foreign currency to hold the rate steady, and the balance can be large. Persistent heavy use of reserves is a warning sign that the exchange rate may not be sustainable.
The term is also used more loosely in some places for settlement accounts that banks hold at a central bank to settle payments between themselves. The two ideas are related, since both involve the central bank as the final provider of settlement funds.
In this entry, the focus is on the balance of payments meaning, which is the one most often found in economics texts. For businesses, the account is a clue about currency risk.
A country steadily losing reserves may face pressure to devalue its currency, which would affect importers, exporters and anyone with overseas debts.
In practice
Real-world examples.
Example
A country imports far more than it exports, and foreign investors are unwilling to lend. Its central bank sells $15 billion of foreign currency reserves to pay for the shortfall. The sale is recorded in the official settlement account.
Example
An exporting country receives large inflows from foreign buyers and investors. Its central bank buys the extra foreign currency to prevent its own currency rising too fast. Reserves rise by $8 billion over the year.
Example
A multinational firm plans to lend $200,000,000 to a subsidiary in a country with falling reserves. Its treasury team reviews the official settlement balance as part of its risk assessment. The company decides to hedge the loan against a possible devaluation.
Formula
Calculation
Official settlements balance = -(current account + capital account + financial account excluding reserves)
This ignores statistical errors for simplicity. A country has a current account deficit of $50 billion, a capital account of $0 and net private inflows in the financial account of $35 billion. The sum of these items = -50 + 0 + 35 = -$15 billion. The official settlements balance is therefore +$15 billion of financing, which means the central bank must run down its reserves by $15 billion to cover the gap.Case study
Seen in the real world.
Zandria is a fictional country used to illustrate the official settlement account. In this illustrative story, it kept its currency fixed to the US dollar and ran a current account deficit of $12 billion a year. Private investment covered only $7 billion of the gap, so its central bank sold $5 billion of reserves each year.
After three years, reserves had fallen from $20 billion to $5 billion, enough to pay for only a few weeks of imports. Investors began to expect a devaluation and moved their money out, which made the problem worse. The government finally allowed the currency to float and arranged a loan from an international lender.
A fictional importer in Zandria, Kestrel Foods, had seen the falling reserves and bought dollars in advance for its next year of imports. When the currency lost a third of its value, it avoided a large rise in costs. Its finance director now includes reserve data in the company's currency risk reports.
Watch out
Common mistakes.
- Thinking a fall in official reserves is always a crisis. It can be a planned use of savings, though a steady decline is a warning.
- Confusing the official settlement account with a bank's settlement account at the central bank. The balance of payments account records changes in national reserves.
- Ignoring the account under a floating rate. Reserve changes tend to be small then, but other signals such as large capital flows still matter.
Questions
People also ask.
What does a negative official settlement balance mean?
It generally means the authorities are using reserves or borrowing to cover a gap in the balance of payments.
Why does it matter for currency risk?
A country that is losing reserves may be forced to devalue, which changes the cost of imports and foreign debt.
Which accounts make up the balance of payments?
The current account, the capital account and the financial account, with changes in official reserves shown in the financial account.
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