The basic balance

This is the current account balance plus the net balance of long-term capital flows.The basic balance was considered to be particularly important during the 1950s and 1960s period of fixed exchange rates because it was viewed as bringing together the stable elements in the balance of payments.It is argued that any significant change in the basic balance must be a sign of a fundamental change in the direction of the balance of payments.The more volatile elements such as short-term capital flows and changes in official reserves are regarded as below the line items.

Although worsening of the basic balance is supposed to be a sign of a deteriorating economic situation, having an overall basic balance deficit is not necessarily a bad thing.For example, a country may have a current account deficit that is reinforced by a large long-term capital outflow so that the basic balance is in a large deficit.However, the capital outflow will yield future profits, dividends and interest receipts that will help to generate future surpluses on the current account.Conversely, a surplus in the basic balance is not necessarily a good thing.A current account deficit which is more than covered by a net capital inflow so that the basic is in surplus could be open to two interpretations.It might be argued that because the country is able to borrow long run there is nothing to worry about since it is regarded as viable by those foreigners who are prepared to lend it money in the long run.Another interpretation could argue that the basic balance surplus is a problem because the long-term borrowing will lead to future interest, profits and dividend payments which will worsen the current account deficit.

Apart from interpretation, the principal problem with the basic balance concerns the classification of short-term and long-term capital flows.The usual means of classifying long-term loans or borrowing is that they are of at least 12 months to maturity.However, many long-term capital flows can be easily converted into short-term flows if need be.For example, the purchase of a five-year US treasury bond by a UK investor would be classified as a long-term capital outflow in the UK balance of payments and long-term capital inflow in the US balance of payments.However, the UK investor could very easily sell the bond back to US investors any time before its maturity date.Similarly, many short-term items with less than 12 months to maturity automatically get renewed so that they effectively become long-term assets.Another problem that blurs the distinction between short-term and long-term capital flows is that transactions in financial assets are classified in accordance with their original maturity date.Hence, if after four and a half years a UK investor sells his five-year US treasury bill to a US citizen it will be classified as a long-term capital flow even though the bond has only six months to maturity.