13.the Balance of Payment

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THE BALANCE OF

PAYMENTS

Definitions

and Concepts


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Definitions

We often hear that the less developed countries

(LDCs) suffer from adverse balance of payment

and consequently experience chronic foreign

exchange gap. Continuous BOP deficits haveforced countries to resort to corrective measures

like currency devaluation, imposition of tariffs,

exchange controls, contractionary monetary and

fiscal policies .Even the so called developedcountries have been no exception to this

tendency.


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Concepts of BOP

Policies of import substitution and export

promotion to achieve external balance have led to

serious problems of growth and trade for the

countries of the world.The BOP is one of the oldest and the most

important statistical statement for any country.

The BOP of a country is a systematic record of

all economic transactions between the residents of

a given country and of the resident of the rest of

the world in an accounting period.


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ACCOUNTING METHOD AND FORMAT

The BOP transactions include all the foreign receiptsof and payment by a country during a given year.

The receipts include all the earning and borrowing of

foreign exchange, and they are recorded as credit

items. The payment include all the spending and

lending's of foreign exchange, and they are recorded

as debit items.

In the purely accounting or book keeping sense thebalance of payment must always balance, because

the BOP is a schedule of debit and credit transactions

which must necessarily be equal.


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BOP accounts

The BOP statements basically includesix major accounts which are as follows:

1. Goods Account

2. Services Account

3. Unilateral Transfers Account

4. Long Term Capital Account

5. Short Term Capital Account

6. International Liquidity Account.


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GOODS ACCOUNT

It includes the value of the merchandise exports andthe value of the merchandise imports. These items of

foreign exchange earnings & spendings are called as

visible items in the BOP. If the receipts from

exports of goods happen to be equal to the payments

for the imports of goods, we describe the situation as

one of zero" goods balance.

Otherwise there would be either a positive or negativegoods balance depending on whether we have

receipts exceeding payments (positive) or payments

exceeding receipts (negative).


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SERVICE ACCOUNT

Just as a country exports goods and import goods a

country also exports and imports what are called as

services. The Service Account records all the service

exported and imported by a country in a year. Unlikegoods which are tangible or visible, services are

intangible. Accordingly, services transactions are

regarded as invisible items in the BOP. They are

invisible in the sense that service receipts andpayments are not recorded at the port of entry or exit

as is the case with the merchandise imports and

exports receipts.


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SERVICE ACCOUNTThe service transactions take various forms. They basicallyinclude

(a) transportation, banking and insurance receipts andpayments from and to the foreign countries,

(b) tourism, travel services and tourist purchases of goods andservices received from foreign visitors to home country andpaid out in foreign countries by home country citizens,

(c) expenses of students studying abroad and receipts fromforeign students studying in the home country,

(d) expenses of diplomatic and military personnel's stationedoverseas as well as the receipts from similar personnel fromoverseas who are stationed in the home country, and


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SERVICE ACCOUNT

(e) interest, profits, dividends and royalties received

from foreign countries and paid out to foreign

countries.These items are generally termed as investment

income or receipts and payment arising out of what

are called as capital services

A positive sum is regarded as favorable to a

country and a negative sum is considered as

unfavourable.


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Unilateral Transfer Account

The third account in the BOP schedule is the UnilateralTransfer Account . This account includes all gifts, grants and

reparation receipts and payments to foreign countries.

Unilateral transfer consist of two types of transfers: (a)

government transfers and (b) private transfers.

Foreign economic aid or assistance and foreign military aid or

assistance received by the home countrys government

constitute government to government transfers.

Private transfers, on the other hand, are funds received from or

remitted to foreign countries on person-to-person basis. AMalaysian settled in the United States remitting $100 a month

to his aged parents in Malaysia , is a private transfer inflow

item in the Malaysian BOP.


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Long-Term Capital Accounts

It includes the amount of capital that has moved out orinto the country in a year. Any capital that has movedin or out of the country for a period of one year ormore is regarded as long-term capital movement. Thelong-term capital account includes the following

categories.

Private Direct Investment

Private Portfolio Investment

Government loans to Foreign Governments.


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Private Direct Investment

These investments are done byhome country citizens and firms inforeign countries (debit) and byforeigners in the home country(credit). This type of capitalmovement is induced by differencein profit rate between the homecountry and the rest of the world.


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Private Portfolio Investment

These investments are done by home

country citizens and firms in foreign securities or

stocks or bonds or shares (debit) and by foreigners

in home country securities, stocks, bonds ,shares,etc. (credit)

This type of movement in and out of a

country is induced by differences in interest rates,

dividends or rate of return on capital between thehome countrys financial assets and those of

the foreign nations.


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Government loans to Foreign

Governments

These loans are given by

home countrys government(debit) and to the home

countrys government byforeign governments (credit).


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If the foreign multinational corporations areinvesting heavily in our country, we receive

capital inflow in the form of direct private

investment. It has a favorable effect on our

BOP. But when the foreign investors in our

country starts repatriating profits to their home

country, there will be a capital outflow from our

country to foreign countries. This goes in to ourservice account as investment income outflow

(debit).


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Short-Term Capital Account

The Fifth main account in the BOP, is the Short-Term

Capital Account. Bank deposits and other short

term payments fall into this category. Short term

capital items fall due on demand or in less thanone year, as opposed to long term capital flows

which have maturity after one year or thereafter.

The vast majority of Short-Term Capitaltransactions basically represents bank transfers

that finance trade and commerce.


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It is also interesting to note that it is often hard to keeptrack of all the Short-Term Capital movements in and

out of the country. They can at best be rough

estimates. Indeed in some countries the separate

category of Short-Term Capital account does notexist.

In some countries Short-Term Capital transactions are

included in the Unrecorded Transactions as aseparate BOP account in its own right. This

Unrecorded Transactions Account or Errors and

Omissions Account Includes,


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Beside short term capital movements, the

following items as well.

Statistical and recording errors

Smuggling

Illegal and secret capital movementsImperfect estimation procedures.


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International Liquidity Account

The sixth and final BOP account is the

International Liquidity Account which simply

record net changes in foreign reserves.

Essentially this account lists internationallyacceptable means of settling international

obligations.

International Liquidity Account is bestunderstood as follows:


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Table 1:Surplus Case ($) MILLION

DebitCredit

2

Goods Account 1,500 800

Service Account500 1400

Unilateral Transfers Accounts 100 120Long Term Capital Account 900 400

Errors & Omissions(including short term capital) A/C 500 630

International Liquidity Account 150

Balance of Payment 3,500 3,500


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Surplus Case

The total receipts are $3,500 million and totalpayments are $3,350 millions. There is a net BPO

surplus amounting to $150 million. This sum of $150

million is entered into International Liquidity Account

as debit. The logic of accountingfor this sum of $150million as debit is that , this sum represents either

Purchase or import of gold worth $150 million

Net addition to accumulation of foreign reserves of$150 million

Capital lending in the sum of $150 million to other

countries on short term or long term basis.


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Table 2:Deficit Case ($) MILLION

DebitCredit

2

Goods Account 800 1500

Service Account1400 500

Unilateral Transfers Accounts 120 100Long Term Capital Account 400 900

Errors & Omissions(including short term capital) A/C 630 500

International Liquidity Account 150

Balance of Payment 3,500 3,500


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Deficit Case

The above table has the exact opposite picture. The

sum of debit payments exceeds the sum of credit

receipts by $150 million which represents the net

deficit in the BOP due to the first five accounts.

The question is, how was this deficit of $150 million

financed? The answer is that it was financed in one ofthe following three ways:


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Deficit Case

Selling or exporting gold worth $150

million; or

Drawing down upon the past accumulated

foreign reserves equal to the sum of $150million; or

Borrowing capital in the sum of $150

million on short term or long term basisfrom friendly countries or international

institutions like IMF


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Balance of Trade

Balance of trade may be defined as the differencebetween the value of goods and services sold to

foreigners by the residents and firms of the home

country and the value of goods and services purchased

by them from foreigners. In others words, the

difference between the value of goods and services

exported and imported by a country is the measure of

balance of trade..In Table there is a balance of trade deficit equal to $130

million.


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Balance of Payment on Current Account

This is a broader concept than the concept of

balance of trade. Balance of payment on current

account includes the sum of three balances,

Merchandise balance, service balance and unilateraltransfers balance.

in other words, it comprises of trade balance and

transfer balance. In table the positive unilateral

transfers balance of $180 million is added on to the

negative trade balance of $130 million which will give

us a current account BOP surplus of $50 million.


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Balance of Payment on Capital Account

For a long time, economist had assumed that factors ofproduction do not move across international

boundaries: the classical economists built models of

trade assuming that only goods and services move

across international boundaries. International capitalmovements viewed in that light, were an impossibility.

Perhaps, for this reason, we do not have a well

developed theory of international capital movement.

Theory or no theory, international capital movements

in and out of countries are a fact of life and very much

a reality in todays world.


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Balance of Payment on Capital Account

Returning to the question of BOP accounting

procedure, all the transactions involving inward or

outward movement of capital and investment areincluded in the capital account of the BOP of the

reporting country. In simple terms, the BOP

capital account comprises of the Long-Term and

Short-Term Capital Accounts. In table the capitalaccount balance shows a net surplus of $40

million.


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Basic Balance

This is a relatively straightforward and simple

concept. Basic balance in the BOP comprises of the

BOP on current account plus Long-Term Capital

Account. The Short-Term capital account balance isnot included in the basic balance. This is perhaps for

two main reasons

Due to short term

Many countries do not have a short term capital

account.


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Overall Balance of Payment

This is a sum of balance on current

account and on capital account puttogether. It includes all international

monetary transactions of the reporting

country vis--vis the rest of the world.


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Accounting Balance of PaymentsThe overall BOP entries in our table show a net surplus of $90

million. This sum of $90 million surplus is entered into the

International Liquidity (debit) Account. The rationale behind

this entry in the debit column is that, this sum of $90 million

constitutes disposal of that BOP surplus in any of the followingways (a) purchase or import of gold worth $90 million; or (b)

adding to the countrys stock of foreign exchange reserves of

$90 million for future use; or (c) extending short term loan of

$90 million to other needy countries or buying some foreignincome earning short term assets. There may be some

combinations of (a), (b) and (c) as well.

13.the Balance of Payment

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