The Balance of Payments Accounts

Introduction:
The balance of payments reflects a record of all economic transactions between
country citizens and the rest of the world for a given period of time.
Individuals , companies, and government entities conduct these transactions.
Therefore, the balance of payments includes both visible and non-visible
external transactions of the country in question. This is an important issue that
needs to be studied, particularly in the field of international financial
management, for a number of reasons. Next, the balance of payments offers
quantitative information of the demand and supply of the country's currency.
Secondly, data on a country's balance of payments can signal to the rest of the
world its potential as a business partner. If a nation is dealing with big balance
of payments problems, it may not be able to increase imports from outside the
world. Alternatively, it may be tempted to introduce steps to limit imports and
deter capital outflows, in order to boost the balance of payments situation. At
the other hand, a nation with a significant balance of payments surplus will be
more likely to increase imports, provide marketing incentives for foreign firms
and less likely to place restrictions on foreign currencies. Third, data regarding
balance of payments can be used to determine the country's performance in
international economic competition. Assume a country's trade deficits are
constant. These trade data then indicate a lack of international competitiveness
for domestic industries in the region. While the overall BoP accounts will
always be balanced when all forms of payments are included, imbalances that
occur with respect to the individual elements of the BoP, such as the current
account, the capital account excluding the reserve account of the central bank,
or the amounts of the two. The imbalances in the latter sum will result in
wealth-accumulating countries with surpluses while deficit countries are
increasingly indebted.

1
The Balance of Payments Accounts Definition:
To carry out many transactions involved in international trade money is
obviously necessary, but international transactions are also complicated by the
fact that different countries use different currencies. So foreign exchange
market is needed to convert one country's currency into another.
International transaction includes payments outward from the country for its
import, gift, and investments abroad and payments inward for exports, gifts, and
investments by foreigners.
The international transactions that are recorded in a country’s balance of
payments reflect the size of that country’s activities with the rest of the world
that take place in any given year.
The balance of payment account maintains a systematic record of all economic
transactions between the home country and the rest of the world for a specific
time period usually a year.
Credits and Debits in Balance of Payment Account:
Credit items reflect transactions that give rise to payment inward to the home
country such as exports, foreign investment inflows to the home country, and
receipts of interest and dividends by home country from earlier investments
abroad.
Debit items reflect transactions that give rise to payments out ward from the
home country such as imports, investments made in foreign countries, and
payments of interest and dividends by the home country on earlier investment
made in the home country foreign investors.

The Balance of Payments Accounts (Four Major Categories):

Our presentation of credit and debit items generally uses the analytic framework
followed by the International Monetary Fund in its annual assemblage of

2
balance of payments statistics for its 182 member countries and certain
terminology employed by the U.S. Department of Commerce in its presentation
of U.S. data. Items are grouped into the four major categories discussed below.
Category I: Current account. Credit items (+sign) consist of exports of goods
and services, income (such as interest and dividends) received from investments
abroad as well as other factor income (e.g. Wages)earned abroad, and unilateral
transfer item representing gifts received from abroad. Debit items (-sign) are
imports of goods and services, income paid to other countries’ residents from
foreign investments and foreign factor services in the home country, and
unilateral transfers representing gifts sent abroad.
Category II: Direct investment and other long-term financial flows. This
category and the next two constitute the financial account in a country\'s balance
of payments. Category II is concerned with changes in holdings of long-term
real physical assets and financial assets, where long-term refers to assets with a
maturity of one year or longer. If there is an increase in long-term assets in the
home country held by foreign citizens, corporations, and governments (financial
inflow to the home country), a credit entry (+sign) is made; if a sale of these
holdings by foreigners causes a decrease, a debit entry (-sign)is made (financial
outflow from the home country). Alternatively, if domestic citizens,
corporations, and governments increase their holdings of long-term assets
abroad, a debit entry is made （ financial outflow from the home country);if a
sale of these assets decreases holdings abroad by the home country, a credit
entry is made(financial inflow to the home country as the sale proceeds are
brought home).An easy way to remember this treatment is to note that credits
represent a net increase in holdings of assets in the home country by the foreign
country and debits represent a net increase in holdings of assets in foreign
countries by the home country.
Category IIl: Short-term nonofficial financial flows: This category records
transaction in short-term assets (maturity of less than one year).The transactions

3
are basically private; that is, they are carried out by parties other than central
banks or monetary authorities.
As in category II, an increase in foreign holdings of these assets in the home
country is a credit item and a decrease is a debit item. Alternatively, if the home
country's private sector increases its holdings of these assets in foreign
countries, the entry is a debit; a decrease is a credit.
Category IV: Changes in reserve assets of official monetary authorities. (central
banks). If foreign central banks acquire assets (e.g. Bank accounts)in the home
country, this is a credit item; a decrease is a debit. On the other hand, if the
home country's central bank acquires international reserve assets or assets of
other countries (e.g. foreign bank deposits), this is treated as a debit item in
balance of payments accounting: a sale of or decrease in such assets is a credit.
SAMPLE ENTRIES IN THE BALANCE-OF-PAYMENTS ACCOUNTS
To obtain a better grasp of balance-of-payments (BOP) accounting, it is helpful
to use hypothetical transactions. In this example and in all discussions of the
balance of payments, it is crucial to recognize that the principle of double-entry
bookkeeping is employed. This means that any transaction involves two sides to
the transaction, so the monetary amount is recorded twice-once as a debit and
once as a credit. It follows that the sum of all the debits must be equal to the
sum of all the credits; that is, the total BOP account statement must always be in
balance. (Remember that the debits are recorded with a minus sign and the
credits with a plus sign. The equality of the sums really means equality of the
absolute values of the debits and the credits.) Let us now turn to our
hypothetical examples. We designate the home country as country A (e.g.
United States) and treat all foreign countries as one country-country B (e.g.,
Britain).We will describe seven different transactions and indicate at each step
the manner in which the transaction is recorded.
Transaction 1. Exporters of country A send$6,000 of goods to country B,
receiving in exchange a short-term bank deposit (e.g., checking account deposit)

4
of $6,000 in country B. In this transaction, the balance-of-payments accountant
records the two sides of the transaction as follows:
Credit: Category I, Exports of goods,+$6,000
Debit: Category III, Increase in short-term private assets abroad,-$6,000
The credit entry is obvious. This particular debit entry occurs because country
A’s exporters now have checking account deposits in country B. These deposits
are classified as short-term assets.
Transaction 2. Suppose that country A’s consumers purchase$12,000 of goods
from country B firms and that payment is made by citizens of country A by
transferring $12,000 to the bank accounts of country B firms in country A (e.g.,
in New York).For this transaction, the entries made by the balance-of-payments
accountant are:
Debit: Category I, Imports of goods, -$12,000
Credit: Category III, Increase in foreign short-term private assets in country A,
＋＄12,000
We list the debit entry first, using the practice in these examples of first
recording the initial part of the transaction or the initiating entry, followed by
the financing part of the transaction. Imports have gone up in this instance, but
remember that imports constitute debit items; thus, a minus sign is affixed to the
entry. In paying for the imports, home country citizens have increased the bank
accounts of country B firms in country A; this entry for the financing of the
imports has a positive sign.
Transaction 3. Residents of country A send $1,000 of goods to country B’s
citizens as a gift. This is a special type of entry in the balance-of-payments
accounts, and it differs from our previous entries because no purchase or sale is
involved. Nevertheless, there has been economic interaction with foreigners, so
it must be recorded somewhere. In this case, since goods have been sent from
the home country, the credit entry is exports. However, since double-entry
bookkeeping is involved a debit entry is mandated even though no payment has

5
taken place. The balance-of-payments accountant creates a debit entry in this
instance, much like goodwill or contributions entry in an individual firm’s
balance sheet when there is no payment entry because a gift has been made. The
entries for ＂transaction”3 are:
Credit: Category I, Exports of goods,+$1,000
Debit: Category I, Unilateral transfers made,-$1,000
Transaction 4. Country A firms provide $2,000 of shipping services to country
B firms. Country B firms pay for these services by transferring some of their
checking account deposits in country A banks to the accounts of country A
shipping firms in country A banks. The transaction is recorded as:
Credit: Category I, Exports of services,+$2,000
Debit: Category III, Decrease in foreign short-term private assets in country A,
－＄2.000
The debit entry is explained by the fact that the foreign firms have reduced their
bank accounts in home country banks and thus have fewer assets in country A.
Transaction 5. A country B firm sends $2,500 of dividends to its country A
stockholders. Payment is made by the country B firm writing checks on its bank
account in a country A bank. This transaction is recorded as follows:
Credit: Category I, Investment (or factor)income receipts from abroad,+$2,500
Debit: Category III, Decrease in foreign short-term private assets in country A,
－＄2,500
The debit entry occurs because the foreign firm now has reduced assets in the
home country.
Transaction 6. A citizen of country A purchases a$5,000 long-term corporate
bond is sued by a country B company. Payment is made by the A citizen by
deducting this amount from his or her bank account in country A and
transferring the funds to the country A bank account of the country B firm. This
transaction is an exchange of assets, and no goods are involved. The
bookkeeping entries recognize that a long-term financial asset (the bond) is

6
acquired by the home country citizen in exchange for a short-term asset (the
checking account deposit).
Debit: Category II, Increase in long-term assets abroad,-$5,000
Credit: Category III, Increase in foreign short-term private assets in country A,+
$5,000
Transaction 7. This transaction previews the operation of a foreign exchange
market when a country\'s central bank participates in the market. Suppose that
commercial banks（which are regarded as private citizens)in country B wish to
decrease their A-currency balances (e.g., U.S. dollars)in country A banks by
converting some of them into their own country’s currency(e.g., British
pounds).This desire to shift out of dollars may reflect, for example, the
anticipation by the commercial banks of a lower future value of the dollar. One
method of reducing dollar holdings is to sell them(for pounds)to the Bank of
England, and the Bank of England is willing to buy dollars if it is committed, as
in a system of fixed exchange rates, to keep the dollar from falling in value
against other currencies.
Transaction 7 consists of the sale of $800 to country B’s central bank by B’s
commercial banks. The foreign central bank\'s dollar accounts in country A
banks are increased, and the foreign commercial banks have reduced their dollar
balances in country A banks. This exchange of dollar account holdings in
country A banks can and does occur if country A is the United States, since
foreign commercial banks as well as central banks maintain balances in New
York banks. The balance-of-payments accountant for country A records this
change in ownership of dollar assets as follows:
Debit: Category III, decrease in foreign short-term private assets in country A, -
$800
Credit: Category IV, increase in foreign short-term official assets in country A,
+$800

7
There is no change in the total foreign holdings of dollar assets, but the
distribution of such holdings has between the foreign private and public sectors.

The Relationship between Current Account balance and

Aggregate income and Expenditure:
Equilibrium in the goods market is achieved when aggregate output is equal to
total expenditures by all sectors in the economy.
Y = C + I + G + (X – M), where
Y = aggregate income or GDP or GNP.
C = consumption spending.
I = investment spending on plant, equipment and so on.
G = government spending on goods and services.
X= exports, but in reality it consists of all the credit items in the current
account.
M = imports, but in reality it consists of all the debit items in the current
account.
SO, (X-M) represent the current account balance.
The 1st equation can be rearranged as follows:
Y – (C + I + G) = (X–M)
This rearrangement indicates that the current account balance (X – M) is the
difference between income of the country (Y) and (C+I+G) which represents
spending by the country's residents during a given time period.
Then we have two cases:
If the country has a current account deficit, means (X-M) is negative, this means
that (C+I+G) is greater than Y and the country is spending more than its income
and this has been the case in the United States since 1982.

8
If the country has a current account surplus, means (X-M) is positive, this
means that (C+I+G) is less than Y and the country is spending less than its
income and this has been the case in Japan since 1981.
Income can also be written as follows:
Y=C+S+T
Means that income can be used only for the purpose of consumption (C), saving
(S), and paying taxes (T).
From equation above we will get the following equation:
C + I + G + (X–M) = C + S + T
Or: (X–M) = [ S + (T-G) ] – I
Where:
S: private saving
(T–G): Government saving.
[S + (T–G)]: the country's saving.
I: The country's investment.
Then we have two cases:
If the country has current account deficit or (X-M) is negative, this means that
[S + (T–G)] is less than ( I ) and the country is saving less than it invests means,
the country is not saving enough.
If the country has a current account surplus or (X–M) is positive, this means
that [S + (T – G)] is more than ( I ) and the country is saving more than it
invests.

9
Conclusion:
The balance of payments provides a list of all international exchange and
financial transactions made by the country's citizens.
There are three main balance of payments: the current account, the financial
account, and the capital account. International trade, net capital gains, and tax
transfers are calculated by current accounts. The financial statement points out
the transition in asset ownership on an international basis. The capital account
shall include all other financial transactions which have no impact on the
nation's economic performance.
A country's trade balance refers to the disparity in how much one nation imports
and exports.
The current budget, the budget and the account of capital are the three elements
of the balance of payments.
Dependence on imports and low prices of the US economy has generated a
large balance of payments deficit.
Unchecked, increasing long-term deficits will result in inflation, and lower
living standards.
The country's balance of payments tells you it's saving enough to pay for its
imports. This also reveals whether a country generates sufficient economic
production to pay for its growth. The BOP is recorded for a quarter to a year.
The balance of payments deficit means that more goods, services and resources
are imported by the country than are exported. To order to pay for its imports it
must borrow from other nations.
A surplus in the balance of payments means the country exports more than it
imports. It is giving enough money to pay for any domestic demand. The nation
was also able to lend off its borders.

10
References:
International Economics Appleyard & Field

https://en.wikipedia.org/wiki/Balance_of_payments

https://www.thebalance.com/what-is-balance-of-payments-components-and-
deficit-3306278

11