UNIT 47
THE STRUCTURE OF THE
BALANCE OF PAYMENTS
THE BALANCE OF PAYMENTS
All economic transactions between a country and the
rest of the world are recorded in its balance of
payments
Debits vs Credits
Would you prefer someone
to credit or debit your bank
account?
Credits: money received from overseas
Debits: money paid overseas
Money coming into the country is
recorded as credit items.(exports)
Money leaving the country is recorded as
debit items.(imports)
Sections of BOP
CAPITAL AND
FINANCIAL A/C
CURRENT
A/C
Trade in goods,
services,
investment
income & current
transfers
Capital A/c
(relatively small
amount)
Financial A/c
(involves a
substantial
sums and
overshadows
the Current
A/c)
Official Reserves
(also known as
Net Errors &
Omissions)
(involves an
estimate of any
mistakes made
while compiling
the BOP)
The 4 components of the Current Account:
1) Trade in goods
2) Trade in services
3) Income
4) Current Transfers
THE CURRENT ACCOUNT shows the income earned by the country and the
expenditure made by it in its dealings with other countries.
Imports and Exports
An export is a good or service sold to
overseas residents resulting in a flow of
income into the exporting country
An import is a good or service purchased from
overseas producers resulting in a flow of
money out of the importing country
VISIBLE EXPORT
A physical product
sold overseas
INVISIBLE EXPORT
A service sold to
overseas residents
VISIBLE IMPORT
A physical product
bought from overseas
INVISIBLE IMPORT
A service purchased
from overseas
residents
Deficits vs Surpluses
Total value of
Credits
Total value of
Credits
>
<
Total value of
Debits
Total value of
Debits
1. Trade in goods
• Covers exports and imports of goods
including cars, food and machinery.
• Referred to as visible exports and imports
or merchandise exports and imports.
• Expenditure on imports exceed revenue
from exports leads to trade in goods
deficit/visible trade deficit.
• Export revenue exceeds import
expenditure leads to trade in goods
surplus/ visible trade surplus.
2. Trade in services
• Records payments and expenditure for
services sold to and bought from abroad.
• Referred to as invisible balance
• include banking, construction services,
financial services, travel & transportation
of goods and passengers between
countries.
• Trade in service surplus means that service
receipts exceed payments for services
• Trade in service deficit means that service
payments exceed receipts
3. Income
Records 2 categories of income flow:
i. compensation of employees
ii. investment income
➢ Compensation of employees include wages, salaries and
other benefits earned by residents working abroad minus
earned by foreigners working in the home economy.
➢ Investment income covers profit, dividends and interest
receipts from abroad minus profit , dividends and interest
paid abroad.
– Investment income is earned on direct investment, portfolio
investment and loans.
– MNC sends profits back to its home country ( debit item in
this section)
– Receipt of dividends on shares in foreign companies and
interest on loans made to firms (credit items)
4. Current transfers
• These are transfers of money, goods or
services which are sent out of the country
or come into the country, not in return for
anything else.
• They can include:
– Donations
– Tax Payments
– Foreign Aid
– International Subsidies
– Gifts
– Money sent to or received from relatives abroad
• The balance of four sub-sections are
summed up to give a current account
balance/current balance
• Current account surplus = value of credit
items exceeds the value of debit items.
• Current account deficit = value of debit
items exceeds value of credit items
World Current Account Balances
The Capital and Financial Accounts
THE CAPITAL ACCOUNT includes :
▪ funds bought into the country by new
immigrants
▪ funds sent abroad by people emigrating
▪ transfer of funds associated with the acquisition
or disposal of fixed assets and
▪ the purchase and sale of patents
THE FINANCIAL ACCOUNT overshadows(dwarfs) the capital
account as it records transactions in assets and liabilities which can
involve substantial investment flows.
Made up of 3 main components :
i. direct investment (purchase of businesses or establishment of new
businesses)
ii. portfolio investment (purchase of shares and government bonds) and
iii. other investment (trade credit and loans)
• When countries citizens buy assets abroad, the transactions are
recorded as debit items as they involve money leaving the country.
• The interests, dividends and profits these assets generate will
appear in the credit items in the current account.
• When foreigners buy assets in the country - recorded in the credit
items but they are liabilities as they will later generate debit items
in the current account.
Official reserves/Reserve assets
▪ Last part of the capital and financial accounts
▪ Items held to settle debts with other countries
▪ Include :
• foreign exchange,
• special drawing rights (SDR) issued by the IMF
• reserve position (required quota of currency that each IMF
member country must provide to the IMF, but can designate for its
own use)at the IMF
• Gold
Note : SDR: This is a kind of reserve of foreign exchange assets
comprising leading currencies globally and created by the International
Monetary Fund. SDR is often regarded as a 'basket of national
currencies' comprising four major currencies of the world - US dollar,
Euro, British Pound and Yen (Japan). Countries can exchange SDRs for
hard currency at the IMF.
Net Errors and Omissions
• The balance of payments is a balance sheet (statement of
financial position of the financial balances of an individual or
organisation)
• If all items have been recorded accurately then the debit and
credit items should be equal.
• E.g. deficit in the current account should be matched equally
to a surplus in the capital and financial accounts.
• In practice, mistakes and failure to record the BOP does not
balance.
• Hence the balancing item/net errors and omission figure/
unrecorded transactions is included to ensure the debit and
credit items are equal
• Negative balancing item means that more money has left the
country than recorded.
CAUSES OF FINANCIAL DEFICITS
• Arises when the investment abroad in the
year is greater than the foreign investment
which has come into the country.
• Domestic firms may set up in foreign
countries because of lower tax rates, lower
costs of production, expanding markets,
good factors of production and
government subsidies.
• Domestic firms and individuals may buy
shares abroad if profit levels and dividends
are high.
• High interest rates may encourage them to
buy foreign government bonds.
Consequences of a Financial Account
Deficit
In the short run :
• Firms deciding to buy business abroad and
firms and individuals investing in foreign
firms and lending to them may mean
potential jobs and incomes are lost to a
foreign economy.
In the long run :
• investments abroad can generate incomes
at home if the businesses acquired and set
up and the investments made appear to be
profitable.