CETS Reading-2

An Overview of Balance of Payment

 An Overview of Balance of Payment

Balance of payment is one of the important parts of macroeconomic statistics. The balance of
payments (BOP) is an accounting system for the external sector of the economy. It is a summary
of the economic transactions of a country with the rest of the world, for a specific time period.
According to the Balance of Payments Manual, the balance of payments is “a statistical
statement that systematically summarizes, for a specific time period, the economic transactions
of an economy with the rest of the world. Despite the connotation, the balance of payments is not
concerned with payments, as that term is generally understood, but with transactions. A number
of international transactions that are of interest in a balance of payments context may not involve
the payment of money, and some are not paid for in any sense. The inclusion of these
transactions, in addition to those matched by actual payments, constitutes a principal difference
between a balance of payments statement and a record of foreign payments. The main purpose of
keeping these records is to inform government authorities of the overall international economic
position of the country in order to assist them in arriving at decisions on monetary and fiscal
policy, on the one hand, and trade and payments policy on the other. Balance of payments
statistics are therefore helpful to government authorities charged with maintaining
macroeconomic stability. The accounts keep track of international movements
 Goods
 Services
 Assets (Government bonds, stocks, etc.)
 Money

2.1 Basic principles of Balance of Payments Accounting

Balance of payments accounting is governed by a set of principles and conventions that ensures
the systematic and coherent recording of transactions, which are consistent across countries and
over time. Some basic principles of balance of payment accounting consider
 Double Entry System
 Residency
 Time periods and the Timing of Recording
 Valuation of Transactions
 Unit of Account

2.1.1 Double Entry System

The balance of payments is constructed according to the principles of double-entry bookkeeping.
Under this system a transaction is represented in the balance of payment by two entries with
equal values but opposite sign. One of these entries is designated a credit with a positive
arithmetic sign; the other is designated a debit with a negative sign. In principle, the sum of all
credit entries is identical to the sum of all debit entries, and the net balance of all entries in the
statement is zero.
There are some basic rules governing how entries are recorded in the balance of payments. A
credit entry is recorded when the transaction gives rise to a receipt by a domestic resident from a
foreign resident. The receipt itself may take the form of an increase in the resident's foreign
assets or balances of foreign currencies. Whatever its form, the receipt is recorded as a debit
entry. Conversely, any transaction that gives rise to a payment by a resident to a foreign resident
is recorded as a debit entry. The payment that results from this transaction is recorded as a credit
entry.
Under the conventions of the system, a compiling economy records credit entries (i) for real
resources denoting exports and (ii) for financial items reflecting reductions in an economy’s
foreign assets or increases in an economy’s foreign liabilities. Conversely, a compiling economy
records debit entries (i) for real resources denoting imports and (ii) for financial items reflecting
increases in assets or decreases in liabilities.
By convention, certain items are recorded as debits and others as credits, as follows in table 1:

Table 1: Recording of Double Entry System

Exports of goods and services Credit (+)
Imports of goods and services Debit (−)
Increase in financial liabilities Credit (+)
Increase in financial assets Debit (−)
Decrease in liabilities Debit (−)
Decrease in assets Credit (+)

The double entry approach can be demonstrated with some hypothetical examples. Example 1:
Let us assume Alcoa, a textile company in Bangladesh exports US$2.0 mn worth of bauxite to
Jimpex a company in the USA and Jimpex pays for the textile by depositing US$2.0 mn to
Alcoa's Bank account. Table 1 shows the entries that would be made in Bangladesh’s balance of
payments:

Table 2: Accounting of Balance of Payment

Credit Debit
Exports (Transaction that gives rise to a receipt) $ 2.0 million
Financial Account (Receipt from exports or increase on $2.0 million
claims on foreigners)

If all the principles of the BOP manual are adhered to then the sum of all the credit entries should
be identical to the sum of all the debit entries and the net balance of all entries in the BOP
statement, including changes in the reserves of the Central Bank, should be zero. In practice,
however, when all the actual entries are summed the resulting balance will invariably show a net
credit or a net debit. That balance is the result of incomplete coverage of transactions, use of
non-uniform prices and inconsistent times of recording and conversion practices. The custom in
BOP accounting is to show the net balance of all the actual transactions as "net errors and
omissions". This entry is equal to the difference in the credit and debit entries, but with the sign
reversed. Thus if the balance of the recorded components is a credit, the item for net errors and
omissions would be shown as a debit of equal value and vice versa. The custom in BOP
accounting is to show the net balance of all the actual transactions as "net errors and omissions".
This entry is equal to the difference in the credit and debit entries, but with the sign reversed.
Thus if the balance of the recorded components is a credit, the item for net errors and omissions
would be shown as a debit of equal value and vice versa. Relatively large and persistent net
errors and omissions are cause for concern as they are indicative of statistical error, major
discrepancies or improperly recorded information.

2.1.2 Residency
The concept of residency in the balance of payments is based on the transactor’s location, not on
the transactor’s nationality. The main considerations relating to economic territory are as
follows:
 Individuals in a country are generally considered residents if they have lived there for at
least 12 months. Nonresidents include visitors (tourists, crews of ships or aircraft, and
seasonal workers); border workers (who are considered to be residents of the country in
which they live); and diplomats and consular representatives and members of armed
forces stationed in a foreign country, who are nonresidents irrespective of the duration of
their stay. But this consideration may depend on country’s own regulations.
 Enterprises are considered residents of the economy where they are engaged in business
provided they have at least one productive establishment there and plan to operate it over
a long period of time. Subsidiaries of foreign-owned companies are considered to be
resident in the country in which they are located.
 General government, including all agencies of central, regional, and local governments,
together with embassies, consulates, and military establishments located abroad, are
considered to be resident of the home country, not of the foreign country in which they
are located. Treatment of officials thus differs from treatment of enterprises and of
individuals not employed as government officials.

2.1.3 Time periods and the Timing of Recording

The time period for recording balance of payments flows may be of any length. However, this
aspect is usually dictated by practical considerations, especially the frequency of data collection.
Many countries prepare balance of payments data annually because firm estimates for some
balance of payments transactions are available only once each year. However, since other data
(for example, for exports and imports) are often available quarterly and sometimes monthly,
some countries prepare quarterly balance of payments data consistent with quarterly estimates of
the national accounts. By convention, both parties to an international transaction record it at the
time at which there is a legal change of ownership. In principle, they record it according to the
principles of accrual accounting (when transactions such as interest payments are due, not when
cash settlements are made). In practice, however, trade, service, and financial transactions may
be recorded at different times by the two parties.

2.1.4 Valuation of Transactions

A balance of payments transaction should be valued at market price, which means it should
“reflect the terms of an exchange between a willing buyer and a willing seller.” Besides ruling
out coercive terms, this definition is also intended to give guidance to statistical compilers
especially in three difficult cases:
 Barter transactions, which involve a direct exchange of goods for other goods rather than
for money;
 Transactions between affiliated enterprises (for example, sales of intermediate goods
between a subsidiary and the parent company at imputed prices that could affect the
apparent location of the source of profits and thus cause the company to benefit from a
lower rate of taxation in one of the countries); and Transfers, which may not have a
market price.
 Exports and imports are shown f.o.b. (“free on board”), which means that the reported
value excludes the cost of transportation beyond national borders. Imports are usually
recorded in customs procedures on a c.i.f. basis, including the cost of international
insurance and freight. However, in the balance of payments accounts, the insurance and
freight components are recorded under services.
2.1.5 Unit of Account
Since transactions may be settled in various currencies, an appropriate unit of account is required
for recording balance of payments transactions. For the sake of comparison with other
developments in the domestic economy, use of the national currency is clearly advantageous.
However, the higher is the domestic rate of inflation, the less meaningful are year-to-year
comparisons of values of foreign transactions measured in units of domestic currency. In such
cases, one might consider deflating BOP items by a domestic price index, to obtain figures that
approximate quantity changes. Against this procedure it may be argued that the foreign prices of
items in the BOP accounts may change independently of the domestic price level, and in fact it is
not clear what sense it makes to deflate financial flows by a price index. Perhaps for this reason,
the unit of account most often used as an alternative to the domestic currency is the U.S. dollar or
some other major currency. While recording a country’s BOP in terms of dollars or marks
instead of the national currency may yield an advantage from the point of view of interpreting
period-to-period changes, it does not provide an ideal measure since the resulting data will be in
value terms—price changes as well as quantity changes will influence the published figures.
Besides that, any single currency, no matter how important in global transactions, is subject to
fluctuations relative to other currencies; BOP accounts for a country measured in dollars will
include the effects of fluctuations of the dollar as well as quantity and price changes in the
recording country’s external sector. The SDR would be a superior unit of account from this point
of view since its value is based on a basket of major currencies. However, it is possibly less
familiar to the residents of countries who may be expected to read the official reports of BOP
developments, and so the dollar and other major currencies are used more often than the SDR.
The appropriate exchange rate (the market rate prevailing on the transaction date) is used to
convert data from the currency of the reporting country into the accounting currency.
2.2 Standard Classification of the BOP
The BOP Manual’s standard classification system has two accounts:
 The current account(CA) and
 The capital(KA) and financial account(FA)
Generally speaking, the CA keeps track of the export and import of goods and services, and the
international movement of income. The KA and FA keep track of changes in the stock of foreign
financial assets. These accounts are the mirror image of the CA since any international
movement in goods and services or income, recorded by the CA, must be accompanied by some
form of payment which is typically recorded in the KA and FA. This leads to the basic BOP
identity:
Current Account + Capital Account + Financial Account = 0
Each transaction is recorded in one of the accounts as either a debit or a credit. The rule is that
inflows of real resources (i.e. imports of goods and services), increases in financial assets, and
decreases in liabilities should all be recorded as debits in the BOP (i.e. entered with a minus
sign). Similarly, outflows of real resources (i.e. exports of goods and services), decreases in
financial assets, and increases in liabilities should all be recorded as credits in the BOP (i.e.
entered with a plus sign). In short, any transaction that requires a payment to the rest of the world
is recorded as a debit (imports for example), and any transaction in which the country receives a
payment is recorded as a credit (selling financial assets for example).

2.2.1 Current Account

The current account keeps track of the international movement of goods and services, income,
and unilateral current transfers. The current account has four main sub accounts:
 Merchandise trade: this is a record of trade in physical goods such as automobiles and
computers. It is typically broken down into exports and imports.
 Services: this is a record of trade in intangible or invisible goods such as insurance,
shipping, consulting, fees from patents and copyrights and tourism.
 Income: Income payments are labor and investment income. Labor income includes
wages, salaries, and other benefits. Investment income includes dividends, profits, and
interest payments. When residents of the home country receive income from foreigners,
that income is recorded as a credit, while income payments to foreigners are recorded as
debits.
  Current transfers: These are one-sided transactions such as government grants, pension
payments, private transfers (gifts), and worker remittances from abroad, direct foreign
aid. So, unilateral current transfers are transfers that do not result in a change in the stock
of assets; that is all transfers that are not transfers of capital. These may include gifts in
food, clothing, and other consumer goods, military equipment, regular contributions to
international organizations or other countries, cash transfers for the purpose of financing
current expenditure, etc. Typically we classify a gift as a current transfer if it is aimed at
increasing current consumption in the recipient country. Current transfers are recorded as
credits when the country receives them and as debits when the country provides them.
The sum of these components is known as the current account balance. A negative number is
called a current account deficit and a positive number called a current account surplus. If the
CAB is in surplus, the country is a “net lender” to the rest of the world in the amount of the
surplus or the excess in the current account transactions. Net lending occurs when the national
saving is more than the country’s investment in real assets. If in deficit, the country is said to be
a “user of funds” and thus, is considered as net borrower from abroad in order to fill in the
shortage. In this case, the country invested more than what its national saving can finance.

2.2.2 Capital and Financial Account

The Capital and Financial Account record transactions that directly affect the wealth and debt of
the country. The account is sub-divided into two main categories:
a. The Capital Account, and
b. The Financial Account
a. The Capital Account covers (i) capital transfers and (ii) the acquisition/disposal of non-
produced, non-financial assets. Capital transfers include the transfer of ownership of fixed assets,
the transfer of funds linked to disposal/acquisition of fixed assets and the cancellation of debt by
creditors. Acquisition/disposal of non-produced, non-financial assets mainly involves intangibles
such as patents and leases. It also includes purchases and sales of land by foreign embassies.

b. The Financial Account covers (i) direct investment, (ii) portfolio investment, (iii) other
investments (trade credits, loans, currencies and deposits) and (iv) changes in reserves.
i. Direct investment is the category of international investment in which a
resident entity in one economy acquires or disposes of 10 per cent or more
of the ordinary shares or voting power of an enterprise located in another
economy and has an effective voice in management. The resident entity is
referred to as the direct investor and the enterprise is the direct investment
enterprise. The components of direct investment are: equity capital,
reinvested earnings and intercompany debt transactions.
ii. Portfolio Investment covers transactions in equity securities and debt
securities. With respect to equity a portfolio investment would imply less
than 10 per cent ownership of the voting power of an enterprise located in
 another country. Debt securities include bonds and notes, money market
instruments and financial derivatives. The essential characteristic of these
instruments is that they are tradable. This means these instruments offer
investors the flexibility to shift invested capital from one instrument to
another.
iii. Other investment is a residual category that includes all financial
transactions not covered in direct investment, portfolio investment or
reserve assets. It includes trade credits, (the direct extension of credit by
suppliers to buyers of goods and services), loans to finance trade, other
loans and advances and financial leases.
iv. The Reserves represent the foreign exchange which the country has
available for financing an imbalance of payments with the rest of the
world. An increase in the reserves of a country (a debit) indicates that
there was a surplus from there remanding non-reserve transactions,
indicating an overall surplus for the balance of payments and vice versa.

Students are required to go through (Detailed) for Bangladesh Balance of Payment

Review of Bangladesh Balance of Payments, 2016-17 (Specially Page No. i-ix)

Reference: Madura, Jeff. International Financial Management. 12th ed. Cincinnati: South-
Western College Pub., 2014