Introduction to Balance of Payment, Accounting Principles in Balance of Payment

The balance of payments (also known as balance of international payments and abbreviated BOP or BoP) of a country is the difference between all money flowing into the country in a particular period of time (e.g., a quarter or a year) and the outflow of money to the rest of the world. These financial transactions are made by individuals, firms and government bodies to compare receipts and payments arising out of trade of goods and services.

The balance of payments consists of two components: the current account and the capital account. The current account reflects a country’s net income, while the capital account reflects the net change in ownership of national assets.

Important

The BoP statement provides a clear picture of the economic relations between different countries. It is an integral aspect of international financial management. Now that you have understood BoP and its components, let’s look at why it is important.

To begin with, the BoP statement provides information pertaining to the demand and supply of the country’s currency. The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries. Next, the country’s BoP determines its potential as a constructive economic partner. In addition, a country’s BoP indicates its position in international economic growth.

By studying its BoP statement and its components closely, a country would be able to identify trends that may be beneficial or harmful to the economy and take appropriate measures.

The International Monetary Fund (IMF) use a particular set of definitions for the BoP accounts, which is also used by the Organisation for Economic Co-operation and Development (OECD), and the United Nations System of National Accounts (SNA).

The main difference in the IMF’s terminology is that it uses the term “financial account” to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, previously formed a small part of the overall current account. The IMF separates these transactions out to form an additional top-level division of the BoP accounts. Expressed with the IMF definition, the BoP identity can be written:

Current account + Financial account + Capital account + Balancing item =0

The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading sub-divisions, which are:

• The goods and services account (the overall trade balance)
• The primary income account (factor income such as from loans and investments)
• The secondary income account (transfer payments)

Imbalances

While the BoP has to balance overall, surpluses or deficits on its individual elements can lead to imbalances between countries. In general there is concern over deficits in the current account. Countries with deficits in their current accounts will build up increasing debt or see increased foreign ownership of their assets. The types of deficits that typically raise concern are

• A visible trade deficit where a nation is importing more physical goods than it exports (even if this is balanced by the other components of the current account.)
• An overall current account deficit.
• A basic deficit which is the current account plus foreign direct investment (but excluding other elements of the capital account like short terms loans and the reserve account.)

Accounting Principles in Balance of Payment

The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. But balance of payments accounting differs from business accounting in one respect.

In business accounting, debits (-) are shown on the left side and credits (+) on the right side of the balance sheet. But in balance of payments accounting, the practice is to show credits on the left side and debits on the right side of the balance sheet.

When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit transaction. The principal items shown on the credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, borrowings from abroad, investments by foreigners in the country and official sale of reserve assets including gold to foreign countries and international agencies.

The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and international agencies.

These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry book-keeping. Horizontally, they are divided into three categories: the current account, the capital account and the official settlements account or the official reserve assets account.

Three main elements of actual process of measuring international economic activity are:

• Identifying what is/is not an international economic transaction,
• Understanding how the flow of goods, services, assets, money create debits and credits, and
• Understanding the bookkeeping procedures for BoP accounting.

The following some simple rules of thumb help to the reader to understand the application of accounting principles for balance of payments accounting.

• Any individual or corporate transaction that leads to increase in demand for foreign currency (exchange) is to be recorded as debit, because if is cash outflow, while a transaction which results in increase the supply of foreign currency (exchange) is to be recorded as a credit entry.
• All transactions, which result an immediate or prospective payment from the rest of the world (RoW) to the country should be recorded as credit entry. On the other hand, the transactions, which result in an actual or prospective payment from the country to the RoW should be recorded as debits.

Current Account:

The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation, insurance, income and payments of foreign investments, etc. Transfer payments relate to gifts, foreign aid, pensions, private remittances, charitable donations, etc. received from foreign individuals and governments to foreigners.

In the current account, merchandise exports and imports are the most important items. Exports are shown as a positive item and are calculated f.o.b. (free on board) which means that costs of transportation, insurance, etc. are excluded. On the other side, imports are shown as a negative item and are calculated c.i.f. (costs, insurance and freight) and included.

The difference between exports and imports of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is favourable. In the opposite case when imports exceed exports, it is unfavourable.

It is, however, services and transfer payments or invisible items of the current account that reflect the true picture of the balance of payments account. The balance of exports and imports of services and transfer payments is called the balance of invisible trade.

The invisible items along with the visible items determine the actual current account position. If exports of goods and services exceed imports of goods and services, the balance of payments is said to be favourable. In the opposite case, it is unfavourable.

In the current account, the exports of goods and services arid the receipts of transfer payments (unrequited receipts) are entered as credits (+) because they represent receipts from foreigners. On the other hand, the imports of goods and services and grant of transfer payments to foreigners are entered as debits (-) because they represent payments to foreigners. The net value of these visible and invisible trade balances is the balance on current account.

Capital Account:

The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lending’s and borrowings and private and official investments. In other words, the capital account shows international flows of loans and investments, and represents a change in the country’s foreign assets and liabilities.

Long-term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investment like the purchase of foreign bonds and stocks and international loans. On the other hand, short- term international capital transactions are for a period ranging between three months and less than one year.

There are two types of transactions in the capital account; private and government. Private transactions include all types of investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.

In the capital account, borrowings from foreign countries and direct investment by foreign countries represent capital inflows. They are positive items or credits because these are receipts from foreigners. On the other hand, lending to foreign countries and direct investments in foreign countries represent capital outflows.

They are negative items or debits because they are payments to foreigners. The net value of the balances of short-term and long-term direct and portfolio investments is the balance on capital account. The sum of current account and capital account is known as the basic balance.

The Official Settlements Account:

The official settlements account or official reserve assets account is, in fact, a part of the capital account. But the U.K. and U.S. balance of payments accounts show it as a separate account. “The official settlements account measures the change in nations’ liquidity and non-liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year.

The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF”. It shows transactions in a country’s net official reserve assets.

Errors and Omissions:

Errors and omissions is a balancing item so that total credits and debits of the three accounts must equal in accordance with the principles of double entry book-keeping so that the balance of payments of a country always balances in the accounting sense.