THE BALANCE OF PAYMENTS

Definitions and Concepts

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 have forced countries to resort to corrective measures like currency devaluation, imposition of tariffs, exchange controls, contractionary monetary and fiscal policies .Even the so called developed

countries 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 receipts of 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 the balance 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 include six major accounts which are as follows: Goods Account Services Account Unilateral Transfers Account Long Term Capital Account Short Term Capital Account International Liquidity Account.
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1. 2. 3. 4.

5.
6.

GOODS ACCOUNT
It includes the value of the merchandise exports and the 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 negative goods 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. Unlike goods 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 and payments 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 ACCOUNT
The service transactions take various forms. They basically include (a) transportation, banking and insurance receipts and payments from and to the foreign countries, (b) tourism, travel services and tourist purchases of goods and services received from foreign visitors to home country and paid out in foreign countries by home country citizens, (c) expenses of students studying abroad and receipts from foreign students studying in the home country, (d) expenses of diplomatic and military personnel's stationed overseas as well as the receipts from similar personnel from overseas 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 Unilateral Transfer 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. A Malaysian 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 or into the country in a year. Any capital that has moved in or out of the country for a period of one year or more is regarded as long-term capital movement. The long-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 by home country citizens and firms in foreign countries (debit) and by foreigners in the home country (credit). This type of capital movement is induced by difference in profit rate between the home country 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 the

home 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 by foreign governments (credit).
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If the foreign multinational corporations are investing 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 our service 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 than one year, as opposed to long term capital flows which have maturity after one year or thereafter. The vast majority of Short-Term Capital transactions basically represents bank transfers that finance trade and commerce.
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Short-Term Capital Account

It is also interesting to note that it is often hard to keep track 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 not exist. In some countries Short-Term Capital transactions are included in the Unrecorded Transactions as a separate BOP account in its own right. This Unrecorded Transactions Account or Errors and Omissions Account Includes,
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Short-Term Capital Account

Beside short term capital movements, the following items as well. Statistical and recording errors Smuggling Illegal and secret capital movements Imperfect 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 internationally acceptable means of settling international obligations. International Liquidity Account is best understood as follows:
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Table 1:Surplus Case ($) MILLION

Credit
Goods Account 1,500 500 Service Account 2 Unilateral Transfers Accounts 100 Long Term Capital Account 900 Errors & Omissions (including short term capital) A/C 500

Debit 800 1400 120 400 630

International Liquidity Account

Balance of Payment 3,500

150
3,500
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Surplus Case
The total receipts are $3,500 million and total payments 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 accounting for this sum of $150 million 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

Credit
Goods Account 800 1400 Service Account 2 Unilateral Transfers Accounts 120 Long Term Capital Account 400 Errors & Omissions (including short term capital) A/C 630

Debit 1500 500 100 900 500

International Liquidity Account

Balance of Payment

150
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 of the 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 $150 million; or Borrowing capital in the sum of $150 million on short term or long term basis from friendly countries or international institutions like IMF
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Balance of Trade
Balance of trade may be defined as the difference between 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 unilateral transfers 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 of production do not move across international boundaries: the classical economists built models of trade assuming that only goods and services move across international boundaries. International capital movements 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 are included 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 capital account 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 is not 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 put together. It includes all international monetary transactions of the reporting country vis--vis the rest of the world.

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Accounting Balance of Payments

The 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 following ways (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 foreign income earning short term assets. There may be some combinations of (a), (b) and (c) as well.
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