Balance of payments

Introduction: The ‘balance-of- payment’s (BOP) accounts are an integral part of the national
income accounts for an open economy. They record (in principle) all transactions between
residents of the country concerned and those of other countries, where’ residents’ are broadly
interpreted as all individuals, businesses and governments and their agencies, international
organizations are also classified as ‘foreign’ residents for this purpose.

The BOP accounts however serve another purpose. The balance of a country’s foreign
transactions and the accompanying issues of the exchange rate and reserves (whether of
gold or of foreign currencies) has long been a focus of interest for policy makers. The way in
which policy makers view these foreign transactions and the policies they have adopted, have
of course varied overtime.
Whatever the objectives of policy makers however and regardless of the institutional
arrangements, the state of the balance of payments plays an essential role in providing
information to both governments and private individuals and firms. The traditional question
asked is whether the balance of payments is in equilibrium, since that may provoke
government action and / or lead to changes in exchange rates. As we shall see, however,
there have been disagreements about what is meant by ‘equilibrium’ and ‘disequilibrium’ in
the balance of payments.
The Balance of payments: book keeping
The BOP is essentially an application of double-entry book keeping, since it records both
transactions and the money flows associated with those transactions. If we do this in a
proper way, debits and credit will always be equal, so that in an accounting sense the balance
of payments will always be in balance. An accounting balance is however not synonymous
with equilibrium. An overall balance, with inflows of foreign currency equating outflows, may
conceal imbalances within it that will lead to changes. In such a case, we do not have
equilibrium in any meaningful sense. A major task will be to look into this apparent paradox
and understand in what way the balance of payments can be in disequilibrium and in what
sense it will always be in equilibrium.
It is important to keep it in mind that a balance of payments account records flows between
countries over a specified period of time (usually a year for the full accounts, but often less for
some components of the accounts). Some items in the balance of payments are readily

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identified as flows, such as exports. Other items, however are flows arising from changes in
stocks, and the appropriate handling of these is often a source of confusion.

In basic terms, the accounts usually gather together the transactions that give rise to the
balancing monetary flows under what are considered to be appropriate headings (e.g.
exports) and record them first. The net values of the monetary flows are then entered in the
same column, with their sign reversed. We thus have an account in a single column, which
must sum to zero.

Traditionally there are two basic elements in a perfectly compiled set of BOP account: the
current account and the capital account. Each of these is usually subdivided, the former into
visible and invisible trade and unrequited transfers, the latter into long-term and short-term
private transactions and changes in official reserves. The essential difference between the
two is that capital account transactions necessarily involve domestic residents either acquiring
or surrendering claims on foreign residents, whereas current account transactions do not. In
practice there is a third element, the ‘balancing item’ or ‘errors and omissions’, which reflects
our inability to record all international transactions accurately. We will follow the conventions
used in IMF statistics and by majority of countries regarding the ways in which accounts are
presented.
The current Account:
The current account records exports and imports of goods and services and unilateral
transfers. Exports, whether of goods or services, are by convention entered as positive items
in the account. Imports accordingly are entered as negative items. Exports are normally
calculated f.o.b. (free on board ), i.e. costs for transportation, insurance etc. are not included,
whereas imports are normally calculated c.i.f. (cost insurance freight), ie. transportation,
insurance costs etc. are included.
In many cases the payment for exports and imports will result in the transfer of money
between the trading countries. For example, a UK firm importing a good from the USA may
settle its debt by instructing its UK bank to make a payment to the US account of the US
exporter. This is not necessarily the case however. If the UK firm holds a bank account in
the US then it may make payment to the US exporter from that account. In the former case,
the financial side of the transaction will appear in the UK balance of payments as part of the

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net change in UK foreign-currency reserves. In the latter it will appear as part of the capital
account, since the UK firm has reduced its claims on the US bank.
Balance of payments accounts usually differentiate between trade in goods and trade in
services. The balance of exports and imports of the former is referred to in the UK accounts
as the balance of visible trade, in other countries it may be referred to as the balance of
merchandise trade or simply as the balance of trade. The net balance of exports and imports
of services is called the balance of invisible trade in the UK statistics.
Invisible trade is a much more heterogeneous category than is visible trade. It is often useful
for economic purposes to distinguish between factor and non-factor services. Trade in the
latter, of which shipping, banking and insurance services and payments by residents as
tourists a board are usually the most important, is in economic terms little different from trade
in goods. That is, exports and imports of such services are flows of outputs whose values will
be determined by the same variables that would affect the demand and supply for goods.
Factor services, which consist in the main of interest, profits and dividends, are on the other
hand payments for inputs. Exports and imports of such services will depend in large part on
the accumulated stock of past investment in and borrowing from foreign residents.
Unilateral transfers, or unrequited receipts’ are receipts which the residents of a country
receive ‘for free’, without having to make any present or future payments in return. Receipts
from abroad are entered as positive items, payments abroad as negative items. This kind of
receipt usually takes one of two forms. The first often referred to as private unrequited
transfers, most notably when migrant workers send money back to relatives living in the
country in question. The United States, many European countries and the Arab Gulf-States
are major sources of such remittances, while many Caribbean, Mediterranean and Muslim
non-oil exporting states are recipients. The second, official unrequited transfers is the
payment of ‘pure’ aid (as opposed to ‘tied’ aid) by governments in developed countries
(perhaps via an international agency) to government in LDCs. Historically, a third form of
unilateral transfer has been important i.e. reparation payments. Typically, such payments
occurred when a country came out of a war, morally and physically superior and was in a
position to make the foreign country (its former enemy) pay indemnities. Such payments
played an important part after the first world war but have since fallen into relative obscurity
except few occasions such as Iraq’s invasion of Kuwait and subsequent attack by the
United States under the UN flag.

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The net value of the balances of visible trade and of invisible trade and of unilateral transfers
defines the balance on current account. Table 5.1 shows the various components of the
current accounts of the United States, Japan, West Germany and the United Kingdom in
1989.
Table 1 current account summaries for four countries, 1989 ($US billion)

United Japan West United

States Germany Kingdom

A. Merchandise Exports 360.46 269.59 324.48 151.31

B. Merchandise Imports -475.33 -192.74 -247.77 -189.26
C. Visible trade balance -114.87 76.85 76.71 -37.96
(A+B)
D. Exports of Services 242.71 143.91 98.31 172.01
E. Imports of Services -223.14 -159.53 -101.13 -157.79
F. Invisible trade balance 19.57 -15.62 -2.82 14.22
(D+E)
G. Private unrequited -1.33 -0.99 -6.17 -0.49
Transfers (net)
H. Official unrequited - 13.43 - 3.30 -12.24 -6.93
Transfers (net)
I. Current account balance -110.06 56.94 55.48 -31.16

The capital Account:

The capital account records all international transactions that involve a resident of the country
concerned changing either his assets with or his liabilities to a resident of another country. As
we noted earlier, transactions in the capital account reflect a change in a stock-either assets
or liabilities.
It is often useful to make distinctions between various forms of capital account transactions.
The basic distinctions are between private and official transactions, between portfolio and
direct investment and by the terms of the investment (i.e. short or long-term). The distinction
between private and official transactions is fairly transparent and need not concern us too
much, except for noting that the bulk of foreign investment is private.
Direct investment is the act of purchasing an asset and at the same time acquiring control of it
(other than the ability to re-sell it). The acquisition of a firm resident in one country by a firm
resident in another is an example of such a transaction, as is the transfer of funds from the
‘parent’ company in order that the ‘subsidiary’ company may itself acquire assets in its own
country. Such business transactions form the major part of private direct investment in other

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countries, multinational corporations being especially important. There are of course some
examples of such transactions by individuals, the most obvious being the purchase of a
‘second-home’ in another country.
Portfolio investment by contrast is the acquisition of an asset that does not give the purchaser
control. An obvious example is the purchase of shares in a foreign company or of bonds
issued by a foreign government. Loans made to foreign firms or governments come into the
same broad category. Such portfolio investment is often also distinguished by the period of
the loan. The distinction between short-term and long-term investment is often confusing, but
usually relates to the specification of the asset rather than to the length of time for which it is
held. For example, a firm or individual that holds a bank account in another country and
increases its balance in that account will be engaging in short term investment, even if its
intention is to keep that money in that account for many years; On the other hand, an
individual buying a long term government bond in another country will be making a long term
investment, even if that bond has only one month to go before maturity. Portfolio investments
may also be identified as either private or official, according to the sector from which they
originate.
The purchase of an asset in another country, whether it is direct or portfolio investment, would
appear as a negative item in the capital account for the purchasing firm’s country, and as a
positive item in the capital account for the other country. That capital outflows appear as a
negative item in a country’s BOP and capital inflows as positive items, often causes
confusion. One way of avoiding this is to consider the direction in which the payment would
go (if made directly). The purchase of a foreign asset would then involve the transfer of
money to the foreign country, as would the purchase of an (imported ) good and so must
appear as a negative item in the balance of payments of the purchaser’s country (and as a
positive item in the accounts of the seller’s country).
The net value of the balances of direct and portfolio investment defines the balance on capital
account. Table 5.3 shows the various components of the capital accounts of the USA, Japan,
West Germany and the UK in 1989. Official long term transactions are subsumed in ‘Other
long term capital’.

The remaining items in the BOP: The balance of payments accounts are completed by the
entry of :other minor items that can be identified but do not fall comfortably into one of the
standard categories; errors and omissions, which reflect transactions that have not been

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recorded for various reasons and so cannot be entered under a standard heading, but which
we know must appear since the full balance of payments account must sum to zero, and
changes in official reserves and in official liabilities that are part of the reserves of other
countries.
Errors and omissions (or the balancing item) reflect the difficulties involved in recording
accurately, if at all, a wide variety of transactions that occur within a given period (usually 12
months). In some cases there is such a large number of transactions that a sample is taken
rather than recording each transaction, with the inevitable errors that occur, when samples
are used. In others problems may arise when one or other of the parts of a transaction takes
more than one year: for example with a large export contract covering several year some
payment may be received by the exporter before any deliveries are made, but: the last
payment will not be made until the contract has been completed. Dishonesty may also pay a
part, as when goods are smuggled in which case the merchandise side of the transactions
unreported although payment will be made somehow and will be reflected somewhere in the
accounts. Similarly, the desire to avoid taxes may lead to under-reporting of some items in
order to reduce taxable liabilities.
Finally, there are changes in the reserves of the country whose balance of payments we are
considering and changes in that part of the reserves of other countries that is held in the
country concerned. Reserves are held in three forms: in foreign currency, usually but not
always the US dollar, as gold and as special Deposit Receipts (SDRS) borrowed from the
IMF. Note that reserves do not have to be held within the country. Indeed most countries
hold a proportion of their reserves in accounts with foreign central banks.
The changes in the country’s reserves must of course reflect the net value of all the other
recorded items in the balance of payments. These changes will of course be recorded
accurately and it is the discrepancy between the changes in reserves and the net value of the
other recorded items allows us to identify the errors and omissions.

Table 3 records the full BOP for the United States, Japan, West Germany and the UK in
1989. The balances on current account on the long and short term capital accounts are
taken from tables 2 and.3.

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Table 2 : capital Account summaries for four countries, 1989 ($US billion)

United Japan West United

States Germany Kingdom

J. Direct Investment (net) 40.50 -45.22 - 6.99 - 0.23

K. Portfolio Investment (net) 44.79 -32.53 - 4.38 -43.17

L Other long term capital (net) 2.64 -15.86 -0.28 - 1.76

M Long term capital balance (J+K+L) 87.93 -93.61 -11.65 -34.98

N Short-term capital Balance)Net) 16.32 45.86 -56.75 27.53

Source: Based on Table 2.3 in Pilbeam (1992)

Table 3: Balance of payments summaries for four countries 1981 (US $ billion)
United Japan West United
States Germany Kingdom

I. Current Account Balance -110.06 56.94 55.48 -31.16

M. Long term capital balance 87.93 -93.61 -11.65 -34.98
N. Short term capital balance 16.32 45.86 -56.75 27.53
O Other recorded items 1.55 -0.01 0.12 -0.54
P Net errors and omissions 22.60 -21.95 2.33 24.55
Q Exceptional financing - - - -
R Liabilities constituting
other authorities’ reserves 8.48 - 13.43 7.19
S Total change in reserves -26.81 12.77 -2.95 9.34

Source : Based on Table 2.3 in pilbeam (1992)

Balance of Payments and Balance of Trade : The meaning of the concepts of balance of
trade (BOT) and BOP are often misunderstood. Balance of trade is a part of balance of
payments. A country exports and imports a vast assortment of tangible goods and invisible
services. Invisible service items include shipping, banking and insurance services for imports
& exports of which payments are made and received by a country. A country’s BOT refers to
the value of imports and exports of merchandise goods only. The exports and imports of
services-transport services, shipping, freights, passenger fares, harbour and canal dues,
postal, telephone and telegraph fees, banking and insurance services etc. – comprise the
balance of services but the BOP is more comprehensive which includes total debits and

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credits relating all the items for which a country makes payments to and receives payments
from rest of the world. Therefore, BOT is only a part of the BOP.
A favourable BOT may coexist with an adverse balance-of-payment and vice versa. For
example, until recently although England’s balance of trade was unfavourable but her balance
of payments was favourable because due to the exports of invisible services and receipts on
items being more from rest of the world than she paid to rest of the world.
Balance-of –payments: Surplus and deficits (Autonomous and Accommodating items)
The terms, ‘BOP deficit’ and ‘BOP surplus’ are familiar. These terms convey some implicit
judgment usually to the effect that a country with a BOP deficit is in some sense in trouble,
while one with a surplus is ‘strong’. The BOP of a country may be in balance in the sense of
equality between total payments and total receipts. More generally, however, it shows either
a surplus or a deficit. By a deficit or surplus in the BOP is usually meant gold movements
plus ‘accommodating’ capital movements – those capital movements which are induced by
the conditions of BOP and by loans that are given or taken for the explicit purpose of
equalizing the payments balance. The accommodating capital movements are a direct
consequence of the BOP situation. These capital flows are unforeseen and take place to
bring the country’s BOP into equilibrium. If a country has a deficit in her balance of current
account, there will always be an offsetting transaction on the capital account to bring the BOP
into equilibrium. For example, if a country had imported more than it had exported it will have
to borrow abroad to pay for its excess imports and this will be registered as an inflow of
capital on he capital account. In other words, the magnitude of accommodating capital flows
represents the extent or size of deficit in the country’s BOP. Conversely, the autonomous
capital flows are ordinary capital flows which take place regardless of the other items in the
BOP. The autonomous capital flows have no connection with the country’s BOP situation.
The autonomous capital flows may take many forms. For example, an autonomous capital
inflow may be due to a foreign corporation buying a domestic company thereby acquiring the
assets equal to the capital inflow in the country. It may also be due to a foreign firm or a
foreign resident paying an old loan to a firm or person in the country. In all these cases
private firms or persons have capital transactions conducted with the foreigners. Although
these capital transactions have their effect on the country’s BOP but these are in no way
caused by the BOP situation. On the other hand, accommodating capital flows arise due to
either a surplus or a deficit in a country’s BOP. These accommodating capital flows are the

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direct consequence of the BOP. A deficit in the Country’s BOP will cause accommodating
capital outflows while a surplus in the BOP will cause accommodating capital inflows.
While the autonomous capital movements can be regarded as planned capital movements
emerging from the decisions of individuals, firms or the government to engage in capital
transactions with rest of the world, accommodating capital flows are ex post in nature which
are discovered only at the end of the period whether such capital movements have occurred.
Autonomous capital flows should be regarded as planned or ex-ante flows as they result from
the different decision making units-individuals, firms or government for that matter-plan to
engage in these capital movements at the beginning of the relevant period.
Accommodating capital movements are politically of great significance. If a country has a
deficit in her BOP which is covered by an accommodating capital inflow, such inflow should
serve as a warning signal for the country. The deficit can be settled either by a short-term
loan or a depletion of the reserves. In either case, this situation cannot continue for long
because the foreign lenders will seldom be willing to extend short term loans for ever while
the foreign exchange or gold reserves of the country will become depleted after some time.
Thus, the government will have to change its economic policy- so as to eliminate causes of
BOP deficit causing the accommodating capital inflow. The government will have to adopt
appropriate economic or trade policy which may increase foreign exchange earnings and / or
reduce the foreign exchange payments.
In short, transactions are said to be autonomous if their values determined independently of
the BOP. Accommodating items on the other hand are determined by the net consequences
of the autonomous items.
Sum Up: The BOP accounts are constructed on a double entry basis, so that the BOP as a
whole must balance. Nevertheless we can identify various imbalances within the accounts
that are of use to the economic analyst and the policy maker, although they must be
interpreted with care. In particular, individual consideration should be given to the current
account and long-term capital account balances, the states of which have important
implications for the consequences of an overall surplus or deficit.

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