BALANCE OF PAYMENTS Any transaction resulting in a payment to other countries is entered in the Balance of Payments account as a debit.

Any transaction resulting in a receipt from other countries is entered as a credit. Balance of Payments Approach The BOP approach to forecasting exchange rates looks at current account balances, portfolio investment, foreign direct investment, exchange rate regimes, and official monetary reserves to determine the direction of the exchange rate.
Current Account Balance + Capital Account Balance + Financial Account Balance + Reserve Balance = BOP (X M) + (CI CO) + (FI FO) + FXB = Balance of Payments

X = exports of goods and services M = imports of goods and services CI = capital inflows CO = capital outflows FI = financial inflows FO = financial outflows FXB = official monetary reserves Note: Whether or not the country has a fixed exchange rate is an important determinate when forecasting exchange rate movements using the balance of payments approach. Q: Suppose a country has a fixed exchange rate. What are the potential effects on a countrys foreign exchange reserves of a balance of payments deficit? A: A deficit in either the basic balance or the official settlements balance will cause an initial decrease in the countrys foreign exchange reserves caused by increased flight from the local currency to stronger foreign currencies if this continues the country will have to devalue its currency. Remember: Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. To ensure a fixed exchange rate, the government must intervene in the foreign exchange market and buy or sell domestic currencies to bring the BOP back to near zero. Thus, it is very important for a government to maintain significant foreign exchange reserve balances to allow it to intervene in the foreign exchange market effectively.

Q: Suppose a country has a floating exchange rate. What are the potential effects on a countrys foreign exchange reserves of a balance of payments deficit? A: An account deficit will cause private parties to judge the economy as being weak, and the currency will probably drop in value in the free exchange markets. This drop might be self-correcting because a cheaper local currency will encourage more exports and make imports more expensive. No specific reason exists to expect foreign exchange reserves to change. The Balance of Payments accounts are divided into two main sections: 1. The current account records transactions that pertain to four categories a. Goods Trade (Merchandise) the export or import of physical goods (autos, computers, chemicals) b. Services Trade intangible products such as banking service, insurance services, and travel services. c. (Investment) Income income from foreign investments and payments made to foreign investors. d. Current Transfers financial settlements associated with the change in ownership of real resources and financial items such as one-way gifts or grants. Example: U.S. citizen owns a share of a Finnish company and receives a dividend of $5, the payment shows up on the U.S. balance of payments as a credit on the current account (investment income). 2. The capital/financial account records transactions that involve the purchase and sale of assets. There are two main categories. e. Capital Account f. Financial Account i. Direct Investment 10% or more of the voting shares. ii. Portfolio Investment investment of less than 10%. iii. Other Asset Investment financial institutions, currency deposits and bank deposits, and other accounts receivable and payable related to cross-border trade. Example: A firm in Peru purchases stock (less than 10%) in a U.S. company, the transaction enters the U.S. balance of payments as a credit on the capital/financial account (portfolio investment).

Here is an additional example: Q. When a German consumer purchases a Canadian chain saw, this transaction is recorded as a: A. debit on the German capital account B. credit on the Canadian current account C. debit on the German current account D. credit on the Canadian capital account Why? Every international transaction enters the balance of payments twice (once as a credit and once as a debit). One side of the transaction is a debit to the German current account, because it has to do with the import of merchandise. Additionally, the other side of the transaction will eventually result in a credit to the German balance of payments (either the capital or current account) depending on the action of the Canadian company. Since we arent sure what the Canadian company will do with the euros, the only side of the transaction that is certain and listed above is C - debit the German current account.

Facts behind the figures

A quick guide to the balance of payments A country's balance of payments gives a snapshot of all transactions with foreigners. It has two main parts. The current account mainly measures trade in goods and services (known as the trade balance). It also includes interest paid on foreign borrowing (or received on foreign investments), as well as unilateral transfers abroad, such as official foreign aid and remittances by foreign workers. The second part of the balance of payments is the capital account. It measures all asset transactions with foreigners. The private capital account is made up of private investments, whether foreign direct investment, stocks, bonds, or bank loans. All official transactions (such as the central bank building up reserves) are dubbed official reserve transactions. The sum of the current account, the private capital account, and the official reserve transactions is always zero. Thus net capital inflows, whether private or official, imply a current-account deficit. Net capital outflows, in contrast, mean the current account will be in surplus. But what do these balances mean in economic terms? A country that runs a currentaccount deficit is spending more than it produces, making up the difference by borrowing from abroad. Put another way, the current account is the difference between how much a country saves and how much it invests. A rising currentaccount deficit could imply rising investment or falling saving, or both. To reduce a current-account deficit, a country must save more and/or invest less. Higher saving can come from the private sector (companies or households) or from the government through a smaller budget deficit. The current-account balance shows the pace at which debt is being incurred (or, for a surplus country, the pace at which assets are being accumulated). The basic balance of payments (the current account plus long-term private capital inflows) gives a sense of how much a country is borrowing and how willing private investors are to fund that borrowing by providing long-term capital.

One last example:

1. U.S. citizen purchases a rug from India for $1000. (payment to another country for goods = debit U.S. current account) U.S. + 1 rug India + $1000

The U.S. has 1 more rug and India has an additional $1000. Now the Indian rug maker has two options: 1. Deposit the $1000 into a U.S. bank 2. Convert the $1000 to rupees Option 1: Credit U.S. Capital account Option 2:
Indian bank + $1000 - x rupees

Under option 1, the U.S. asset (a bank deposit) will show up as a credit to the U.S. capital account. Under option 2, the Indian bank also has options: 1. Lend the $1000 to a customer for the purchase of U.S. goods (export of merchandise = credit U.S. current account) 2. Purchase U.S. government bonds (sale of assets i.e. bonds = credit U.S. capital account)