Balance of payments is a systematic record of all economic transactions.

Visible as well as
invisible, in a period, between one country and the rest of the world. It shows the
relationship between one country's total payments to all other countries and its total
receipts from them. Balance of payments thus is statement of payments and receipts on
international transactions.

Payments and receipts on international account are of three lands:

(a) the visible balance of trade;

(b) the invisible items; and

(c) capital transfers.

Kindleberger defines balance of payments as "a systematic record of all economic

transactions between the residents of the reporting country and the residents of foreign
countries during a given period of time."

In the words of Benham, "Balance of payments of a country is a record of the monetary

transactions over a period with the rest of the world."
Features of Balance of Payments

Balance of Payments has the following features:

(i) It is a systematic record of all economic transactions between one country and the rest
of the world.

(ii) It includes all transactions, visible as well as invisible.

(iii) It relates to a period of time. Generally, it is an annual statement.

(iv) It adopts a double-entry book-keeping system. It has two sides: credit side and debit
side. Receipts are recorded on the credit side and payments on the debit side.

(v) When receipts are equal to payments, the balance of payments is in equilibrium; when
receipts are greater than payments, there is surplus in the balance of payments; when
payments are greater than receipts, there is deficit in the balance of payments.

(vi) In the accounting sense, total credits and debits in the balance of payments statement
always balance each other.

Structure of Balance of Payments Accounts

The balance of payments account of a country is constructed on the principle of double-

entry bookkeeping. 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 offcial settlements account or the
Official reserve assets account.

The balance of payments account of a country is constructed in Table 1.

1. Current Accounting:
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, and 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. which means that costs,
insurance and freight are 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 and 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.

2. 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 flow 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.
Sodersten and Reed refer to the external wealth account of a country which shows the
stocks of foreign assets held by the country (positive item) and of domestic assets held
by foreign investors (liabilities or negative item). The net value of a country’s assets and
liabilities is its balance of indebtedness. If its assets are more than its liabilities, then it
is a net creditor. If its liabilities are more than its assets, then it is a net debtor.

Basic Balance:
The sum of current account and capital account is known as the basic balance.

3. 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 nation’s
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.

3. Is Balance of Payments Always in Equilibrium?

Balance of payments always balances means that the algebraic sum of the net credit and
debit balances of current account, capital account and official settlements account must
equal zero. Balance of payments is written as.

B = Rf -Pf
B =where, В represents balance of payments,

Rf receipts from foreigners,

Pf payments made to foreigners.
When В = Rf-– Pf = 0, the balance of payments is in equilibrium.
When Rf – Rf > 0, it implies receipts from foreigners exceed payments made to
foreigners and there is surplus in the balance of payments. On the other hand, when Rf –
Pf < 0 or Rf < Pf – there is deficit in the balance of payments as the payments made to
foreigners exceed receipts from foreigners.
If net foreign lending and investment abroad are taken, a flexible exchange rate creates
an excess of exports over imports. The domestic currency depreciates in terms of other
currencies.

The export becomes cheaper relatively to imports. It can be shown in

equation form:
X + В = M + If
Where X represents exports, M imports, 1, foreign investment, В foreign borrowing

or X-M= If -B
or (X-M)-(If -B) = 0
The equation shows the balance of payments in equilibrium. Any positive balance in its
current account is exactly offset by negative balance on its capital account and vice
versa. In the accounting sense, the balance of payments always balances. This can be
shown with the help of the following equation:

C + S + T= C + I + G + (X-M)

or Y=C + I + G + (X — M) [‘.’ Y = С + S + T]

where С represents consumption expenditure, S domestic saving, T tax receipts, I

investment expenditures, G government expenditures, X exports of goods and services,
and M imports of goods and services.

In the above equation

С + S + T is GNI or national income (Y), and

С + I + G =A,

where A is called ‘absorption’.

In the accounting sense, total domestic expenditures (С + I + G) must equal current

income (C + S + T) that is A = Y. Moreover, domestic saving (Sd) must equal domestic
investment (7d). Similarly, an export surplus on current account (X > M) must be offset
by an excess of domestic savings over investment (Sd > Id). Thus the balance of
payments always balances in the accounting sense, according to the basic principle of
accounting.
In the accounting system, the inflow and outflow of a transaction are recorded on the
credit and debit sides respectively. Therefore, credit and debit sides always balance. If
there is a deficit in the current account, it is offset by a matching surplus in the capital
account by borrowings from abroad or/and withdrawing out of its gold and foreign
exchange reserves, and vice versa. Thus, the balance of payments always balances in this
sense also.

1) Impact of Inflation:
If a country’s inflation rate increases relative to the countries with which it trades, its
current account will be expected to decrease, other things being equal. Consumers and
corporations in that country will most likely purchases more goods overseas (due to high
local inflations), while the country’s exports to other countries will decline.

2) Impact of National Income:

If a country’s income level (national income) increases by a higher percentage than
those of other countries, its current account is expected to decrease, other things being
equal. As the real income level (adjusted for inflation) rises, so does consumption of
goods. A percentage of that increase in consumption will most likely reflect an increased
demand for foreign goods.

3) Impact of Government Policies:

A country’s government can have a major effect on its balance of trade due to its policies
on subsidizing exporters, restrictions on imports, or lack of enforcement on piracy.

4) Subsidies for Exporters:

Some governments offer subsidies to their domestic firms, so that those firms can
produce products at a lower cost than their global competitors. Thus, the demand for
the exports produced by those firms is higher as a result of subsidies.

Many firms in China commonly receive free loans or free land from the government.
These firms incur a lower cost of operations and are able to price their products lower as
a result, which enables them to capture a larger share of the global market.
5) Restrictions on Imports:
If a country’s government imposes a tax on imported goods (often referred to as a tariff),
the prices of foreign goods to consumers are effectively increased. Tariffs imposed by the
U.S. government are on average lower than those imposed by other governments. Some
industries, however, are more highly protected by tariffs than others. American apparel
products and farm products have historically received more protection against foreign
competition through high tariffs on related imports.

In addition to tariffs, a government can reduce its country’s imports by enforcing a

quota, or a maximum limit that can be imported. Quotas have been commonly applied
to a variety of goods imported by the United States and other countries.

6) Lack of Restrictions on Piracy:

In some cases, a government can affect international trade flows by its lack of
restrictions on piracy. In China, piracy is very common; individuals (called pirates)
manufacture CDs and DVDs that look almost exactly like the original product produced
in the United States and other countries. They sell the CDs and DVDs on the street at a
price that is lower than the original product. They even sell the CDs and DVDs to retail
stores. It has been estimated that U.S. producers of film, music, and software lose $2
billion in sales per year due to piracy in China.

As a result of piracy, China’s demand for imports is lower. Piracy is one reason why the
United States has a large balance-of-trade deficit with China. However, even if piracy
were eliminated, the U.S. trade deficit with China would still be large.

7) Impact of Exchange Rates:

Each country’s currency is valued in terms of other currencies through the use of
exchange rates, so that currencies can be exchanged to facilitate international
transactions.

International flow of finances if facilitated by these agencies;

1. International Monetary Fund (IMF); Its operations involve surveillance,

and financial and technical assistance. In particular, its compensatory
financing facility attempts to reduce the impact of export instability on
country economies. The IMF uses a quota system, and its unit of account is
the SDR (special drawing right).
2. World Bank Group; The world bank was Established in 1944, the Group
assists development with the primary focus of helping the poorest people
and the poorest countries. It has 183 member countries, and is composed of
five organizations – IBRD, IDA, IFC, MIGA and ICSID.
3. IBRD: International Bank for Reconstruction and Development; Better
known as the World Bank, the IBRD provides loans and development
assistance to middle-income countries and creditworthy poorer
countries. In particular, its structural adjustment loans are intended to
enhance a country’s long-term economic growth. The IBRD is not a profit-
maximizing organization. Nevertheless, it has earned a net income every
year since 1948. It may spread its funds by entering into co-financing
agreements with official aid agencies, export credit agencies, as well as
commercial banks.
4. IDA: International Development Association; IDA was set up in 1960 as
an agency that lends to the very poor developing nations on highly
concessional terms. IDA lends only to those countries that lack the financial
ability to borrow from IBRD. IBRD and IDA are run on the same lines,
sharing the same staff, headquarters and project evaluation standards.
5. IFC: International Finance Corporation; The IFC was set up in 1956 to
promote sustainable private sector investment in developing countries
by; financing private sector projects, helping to mobilize financing in the
international financial markets and providing advice and technical
assistance to businesses and governments.
6. MIGA: Multilateral Investment Guarantee Agency; The MIGA was
created in 1988 to promote FDI in emerging economies by offering political
risk insurance to investors and lenders and helping developing countries
attract and retain private investment.
7. ICSID: International Centre for Settlement of Investment
Disputes; The ICSID was created in 1966 to facilitate the settlement of
investment disputes between governments and foreign investors, thereby
helping to promote increased flows of international investment.
8. World Trade Organization (WTO); It was Created in 1995, the WTO is the
successor to the General Agreement on Tariffs and Trade (GATT). It deals
with the global rules of trade between nations to ensure that trade flows
smoothly, predictably and freely.At the heart of the WTO’s multilateral
trading system are its trade agreements. The functions of the World Trade
Organisation (WTO) administering WTO trade agreements, serving as a
forum for trade negotiations, handling trade disputes, monitoring national
 trading policies, providing technical assistance and training for developing
countries and cooperating with other international groups.
9. Bank for International Settlements (BIS); It was Set up in 1930, the BIS is
an international organization that fosters cooperation among central banks
and other agencies in pursuit of monetary and financial stability.It is the
“central banks’ central bank” and “lender of last resort.” The functions of
the Bank of International settlements are; a forum for international
monetary and financial cooperation, a bank for central banks, a center for
monetary and economic research and act as an agent or trustee in
connection with international financial operations.
10. Regional Development Agencies; These are Agencies with more
regional objectives relating to economic development and they include; the
Inter-American Development Bank, the Asian Development Bank, the
African Development Bank and the European Bank for Reconstruction and
Development.