BALANCE OF PAYMENT

INTRODUCTION

This chapter covers; balance of trade, the invisible trade, the capital account and BOP
accounting.

The BOP shows the relationship between the country`s total expenditure abroad with its total
income from abroad. Payments from one country to another arise out of the following;

1. The sale or purchase of goods i.e. exports and imports respectively, which forms a
balance of trade
2. Provision /acceptance of services i.e. providing services to or accepting services from
other country. This is known as the invisible balance of trade
3. The transfer of capital from abroad or other countries i.e. balance of payment on capital
account.

The first plus the second equals to balance of payments on current account and the third
equals to BOP on capital account. 1+2+3 equals BOP on current and capital accounts also
known as the autonomous or above the line of transaction. None of the above items singly
(independently) need to balance exactly but the full BOP must always balance. If there is a
deficit in the full BOP, it must be settled in some way and this is one of the reasons why
countries keep foreign expenditure reserves.

CAPITAL ACCOUNT

The capital account reflects net change in national ownership of assets.

A surplus in the capital account means money is flowing into the country, but unlike a surplus in
the current account, the inbound flows will effectively be borrowings or sales of assets rather
than earnings. A deficit in the capital account means money is flowing out the country, but it also
suggests the nation is increasing its claims on foreign assets.

The term "capital account" is used with a narrower meaning by the IMF and affiliated sources.
The IMF splits what the rest of the world call the capital account into two top level divisions:
financial account and capital account, with by far the bulk of the transactions being recorded in
its financial account.

At high level:

Breaking this down:

The term BOP may be more misleading than helpful. Eg it gives no hint on the fact that the
statement is mainly concerned with international transactions. Moreover, it stresses the word
balance and payment. If balance is taken in the accounting sense of balance sheet, the analogy is
not incorrect but emphasizes only a technical aspect of a way in which a statement is presented.
It is intended to mean “net balance” of some sort. The word “payment” is inaccurate since
important categories of international transactions are carried out without any expectation that
payment in any form will even be made or received.

BOP is a systematic record of economic transactions during a given period between a country`s
resident and residents of the rest of the world. The systematic record takes the form of a double
entry in the accounting statement in which each transaction is reflected in both as a credit and
debit entry. Thus, an export of a good is shown as a credit and the payment received for this
export what form it may take is entered as a debit. In practice, the two offsetting entries are
derived from separate statistical sources e.g. exports may be taken from the trade returns while
the payments may show as an increase in foreign exchange holding in the balance sheet of the
central bank. The sources on which the entries are based may be incomplete or inaccurate and
may not be entirely consistent as to timing or evaluation. To bring the statement to balance,
therefore, a balancing item representing “net errors and omissions” is needed. The word “net” is
important since missing entries on one side of the account will cancel an equal amount of
missing entries on the other side. Only to the extent that any errors have not been offsetting will
the whole statement is out of balance. The net errors therefore throw little light on the general
quality of the statistics in the statement although they do help to provide some control over gross
mistakes that affect only one side of the accounts. The economic transactions measured in the
BOP occur when an economic value is provided by one economic want to another. Economic
values are goods and services and financial items including monetary gold. These values may be
exchanged against each other or sometimes they may be provided or acquired free of charge i.e.
without quid-pro-quo in the jargon of BOP.

Five basic types of economic transactions can be distinguished;

1. Purchases and sales of goods and services against financial items

A SIMPLE HYPOTHETICAL BALANCE OF INTERNATIONAL PAYMENT

Item Credit Debit NIE +/-

I. Current Account
a. Goods and services
 Merchandise
 Services
 Other transportation travel
 Investment income
 Government transactions (NIE)
b. Transfer payments
 Private
 Government
II. Capital accounts
 Net export(+) or import(-)
 Private
 Official
c. Errors and omission
III. Monetary movements
 Central monetary institutions
 Other monetary institutions

A country`s residents whose transactions with foreigners are recorded in the BOP comprise both
individuals and institutions. Broadly speaking, individuals are residents of the country where
their centre of interest is located i.e. this being taken as the country where they concentrate their
earning activities and the investment. Resident institutions always include the domestic
government and its agency and personnel, wherever they may be located. Business enterprises
are treated as residents of the country in which they operate since they are considered to form an
integral part of that country`s economy.

BALANCE ON CURRENT ACCOUNT

This is an important magnitude in that it summaries the difference between total export and
imports of goods and services. The current account is the sum of the balance of trade (exports
minus imports of goods and services), net factor income (such as interest and dividends) and net
transfer payments (such as foreign aid). You may refer to the list of countries by current account
balance.
The current account balance is one of two major measures of the nature of a country's foreign
trade (the other being the net capital outflow). A current account surplus increases a country's net
foreign assets by the corresponding amount, and a current account deficit does the reverse. Both
government and private payments are included in the calculation. It is called the current account
because goods and services are generally consumed in the current period.

CAPITAL MOVEMENTS

These are divided in the hypothetical table into only 2 broad groups namely private and official.
Changes in foreign assets and liabilities are recorded in the sector of the domestic creditor in case
of foreign assets or debtor in case of foreign liabilities. If an individual purchases foreign
securities, he/she is the domestic transaction of such a purchase, thus he/she is also a domestic
creditor since he/she possess claims on foreigners. For liabilities, the domestic debtor, like the
borrower, will also be the domestic transaction.

MONETARY MOVEMENTS

The monetary sector usually consists of two parts ice the central monetary institutions and other
monetary institutions. The former consists of such institutions as a central bank and an exchange
stabilization fund, which hold the official gold and convertible foreign exchange assets and
intervene in the local foreign exchange market. The later consists primarily of the commercial
banks.

RESERVES

These are a country`s defence against non synchronization of international receipts and
payments. They consist of a supply of gold or balances generally accepted as international
medium of payment. If a country`s inflow of those means of payment were exactly equal to its
outflow and if it were certain that this happy equality will continue, there would be need to keep
a supply of reserves at all. Funds flowing in would immediately allocated to proper channel of
outflow and international transaction will be settled by book keeping entries alone. Since this
synchronization is far from the case in this complex economic society, countries must have
reserves on which to draw when payment to the rest of the world exceeds their current receipts.

Causes of BOP imbalances

There are conflicting views as to the primary cause of BOP imbalances, with much attention on
the US which currently has by far the biggest deficit. The conventional view is that current
account factors are the primary cause - these include the exchange rate, the government's fiscal
deficit, business competitiveness, and private behaviour such as the willingness of consumers to
go into debt to finance extra consumption. An alternative view, argued at length in a 2005 paper
by Ben Bernanke , is that the primary driver is the capital account, where a global savings glut
caused by savers in surplus countries, runs ahead of the available investment opportunities, and
is pushed into the US resulting in excess consumption and asset price inflation.
AUTONOMOUS AND ACCOMODATING TRANSACTIONS

All transactions in current and capital accounts are called autonomous or above the line
transactions. Accommodating items are those below the line, transactions in official reserves
assets are needed to balance the international transactions. If total debit and credit on the
autonomous items exceeds total credit/debit, the nation has a deficit/surplus in its balance of
payments equal to the net debit/credit. The deficit/surplus is then settled by an equal net credit
/debit balance from/to accommodating or below the line item. Since all transactions in full
statement cancel out zero, it follows that transactions above the line must equal to transactions
below the line with the sign reversed. The balance of payment surplus/deficit can therefore be
measured from above the line or below the line. This fact is sometimes of considerable practical
importance from the statistical stand point, since information on transaction below the line may
be more accurate or more promptly available than those above the line and therefore permit more
current measurement of a country`s position than would be possible if the full BOP where
needed for the purpose.

IMPORTANCE OF SURPLUS AND DEFICT

Since the measurement of surplus or deficit requires the selection of items, it obviously cannot be
a fully scientific objectives exercise. Rather it is a matter for analytical judgment influenced and
tampered by the purpose for which the measurement is to be used. However, an important use
which the concept can be made to serve is as a guide to policy. The surplus/deficit that concerns
a country`s authorities is the one that they must do something about i.e. that leads to a need for
policy action. It is evident that the deficit on goods and services is not a cause for concern when
it can be reasonably matched by an inflow of aid or capital. On the other hand, a deficit that
results in the sustained loss of reserves will eventually compel the authorities to take measures to
contain it. Similarly, the surplus which threatens future prospects of exporting may lead to
changes in national policies as it happened in respect to countries such as Japan and Germany.
One can argue that a persistent surplus in BOP like a persistent deficit, spell a fundamental
disequilibrium which has to be dealt with. Given this kind of problem, the answer is basically
revaluation, but, like devaluation, this is often done reluctantly. One of the causes of this
reluctance is the general elasticity of demand in the export and import markets, and possible
effects of foreign revenues/export revenues.