BSc Financial Economics
International Finance
Professor Anne Sibert
International Finance
Lecture 1
Balance of Payments Accounting
Revised Autumn 2013
Learning Objectives
• To be able to explain the main and sub-accounts of the
balance of payments and their relationship to each
other.
• To understand the principles of double-entry
bookkeeping.
• To be able to record transactions and present a
balance of payments table.
• To understand the relationship between the balance of
payments and a nation’s budget constraint.
• To understand the relationship between the balance of
payments and the national income accounts.
Definition: The balance of payments is a record of
transactions between residents of a country and
residents of the rest of the world.
The balance of payments is use to:
• project exchange rates
• assess the health of the economy
• assess the credit worthiness of an
economy
Balance of payments accounting is based on the
principles of double-entry bookkeeping : each
transaction is recorded twice, once as a debit and once as
a credit.
Definition. Assets are economic resources which are
expected to benefit future activities.
Definition. Liabilities are outsiders claims against
assets.
Definition. Credit : this means “right”.
Definition. Debit : this means “left”.
George’s Shoe Store
Account Name
Inventory
Accounts Payable
Cash
Accounts Receivable
This account records
The purchase and sale
of shoes
Debts incurred and
paid
Cash acquired and
disbursed
Loans made and repaid
ASSET ACCOUNTS
LIABILITY
ACCOUNTS
Left-hand balances
Right-hand balances
Increased by entries on Increased by entries on
the left
the right
Decreased by entries on Decreased by entries on
the right
the left
George sells £500 of shoes.
Payment is due in 30 days.
INVENTORY
Increases Decreases
(1) £500
ACCOUNTS
RECEIVABLE
Increases Decreases
(1) £500
In 30 days, George receives
payment in cash.
ACCOUNTS
RECEIVABLE
Increases Decreases
(1) £500
(2) £500
CASH
Increases
(2) £500
Decreases
George buys new inventory for £800.
Payment is due in 30 days.
INVENTORY
Increases Decreases
(3) £800
(1) £500
ACCOUNTS PAYABLE
Decreases Increases
(3) £800
Recalling our previous
definitions, we now have
DEBITS
CREDITS
Left-hand side entries
Right-hand side entries
Increases in assets
Decreases in assets
Decreases in liabilities
Increases in liabilities
Thus, we have
1. Debit accounts receivable £500; Credit
inventory £500
2. Debit cash £500; Credit Accounts
Receivable £500
3. Debit inventory £800; Credit Accounts
Payable £800
Credits are entered as positive numbers;
Debits are entered as negative
numbers.
George’s Shoe Store
Inventory
-£300
Accounts
0
Receivable
Cash
-£500
Accounts
Payable
+£800
A nation’s balance of payments is a record of
transactions between residents of that nation and
residents of the rest of the world.
We are talking about
residents – not
citizens. Tourists,
military and
diplomatic personnel
and temporary
migrants are not
residents. A
permanent migrant
is a resident, even if
not a citizen.
Example: A subsidiary
of a Korean
automobile firm
located in the UK
sells cars to Korea.
This is a UK export
and a Korean
import.
A Country’s Budget
Constraint
Net sales of goods and services + Net
Interest income + Net gifts received
from foreigners = Change in home
holdings of foreign assets – Change in
foreign holdings of home assets
The left-hand side: change in net worth
The right-hand side: change in asset
holdings
Current Account
• The Current Account is a record of
transactions affecting the left-hand side
of the budget constraint.
• It is a measure of the change in a
country’s net worth.
• It is a record of trade in goods in services
(including the services of capital and
labour) and gifts.
Current Account
• Merchandise Trade
• Services
• Income
• Current Transfers
Merchandise Trade
This is trade in physical goods such as
computers and automobiles.
It is often broken down into
Merchandise exports
Merchandise imports
Services
• This is trade in invisible or intangible
goods.
• Examples are: shipping, travel,
communications, financial services,
insurance, tourism
• The sum of merchandise trade and
services is called the trade balance
Income
• This account includes investment
income, such as interest income and
dividends, and labour income, say from
consulting.
• For countries such as the US and the
UK, investment income is by far the
more important.
Current Transfers
These are one-sided transactions such as
government grants, pension payments,
and private gifts.
The Capital Account
• A complication arose because debt forgiveness was
distorting balance of payments numbers.
• It was decided to include only gifts that would be
consumed within a year in the current account and to
make up a new account called the Capital Account
that would include long-term gifts such as debt
forgiveness.
• Thus, the left-hand side of the budget constraint
should actually be the Current Account plus the
Capital Account.
• The Capital Account is unimportant for the UK or the
US.
Is this an
increase or
a decrease Is this a
in an
debit or a
asset?
credit?
A country
buys a
good or a
service
Increase (it
A country
sells a
good or a
service
Decrease
(it has fewer Credit
has more
goods and
services)
goods and
services)
Debit
Is it
entered as
a positive
or a
negative
number
Negative
Positive
Thus we have:
Exports – Credits – Positive Entry
Imports – Debits – Negative Entry
A positive balance on the current account means
that a country sold more than it bought
A negative balance on the current account means
that a country bought more than it sold
The UK Current Account 2011
400000
350000
300000
250000
200000
Credits
Debits
150000
100000
50000
0
Merchandise Services
Trade
In millions, Pink Book, 2012
Income
Transfers
Current Account Balances
as a percent of GDP, 2013
Source: IMF staff projections, World Economic Outlook
Database, April 2013
Current Account Deficit as a
Share of GDP
The Financial Account
• This is the right-hand side of the
country’s budget constraint.
• The financial account is a record of
capital flows between residents of a
country and the rest of the world.
One way to break down capital flows is by the type of
transaction.
There are two main types of capital flows
1. Direct investment: When residents of a country acquire
shares in a foreign business with the intent of exercising
management control. This is typically defined as
purchasing 10 percent of a firm’s stock.
2. Portfolio investment: Investment without the intention
of exercising management control.
Portfolio investment used to be further broken down
between short- and long-term flows. But, secondary
markets exist for many long-term financial assets and
this has become increasingly meaningless. Once can also
break it down between foreign claims on the home
country and home claims on foreigners.
Home
purchase of
a foreign
asset
Foreign sale
of a home
asset
Home sale
of a foreign
asset
Foreign
purchase of
a home
asset
Capital
outflow
Increase
in an
asset
Capital
outflow
Decrease
in a
liability
Capital
inflow
Decrease
in an
asset
Capital
inflow
Increase
in a
liability
Debit
Negative
entry
Debit
Negative
entry
Credit
Positive
entry
Credit
Positive
entry
Reserve Account
• A special sub-account of the financial
account is the reserve account.
• The reserve account is a record of
changes in the home country’s official
(government) assets.
• When fixed exchange rates were more
prevalent this used to be separate from
the financial account.
Foreign Reserves
• For most countries the most important
component is their foreign exchange
reserves. This is the foreign currency
held by the central bank.
• When a central bank intervenes in the
exchange market to influence the value
of its currency it uses its foreign
exchange reserves.
The
central
bank buys
foreign
exchange
The
central
bank sells
foreign
exchange
This is an
increase in
an asset
debt
Negative
entry
This is a
decrease in
an asset
credit
Positive
entry
Reserve Account Balance
• Negative balance (debit, increase in an
asset): Reserves rose.
• Positive balance (credit, decrease in an
asset): Reserves fell.
• Another definition of the balance of
payments is minus one times the reserve
account balance.
• A positive (negative) balance of
payments: reserves rose (fell)
Errors and Omissions
• Each transaction is entered once as a
debit and once as a credit; that is, once
as a positive number and once as the
same negative number.
• So, all of the transactions should sum to
zero.
• In practice, it does not work out that
way.
Errors and Omissions
• Data on merchandise trade comes from
customs declarations.
• Trade in services is typically estimated by
various sampling techniques; errors can be
substantial.
• Reporting of capital flows and investment
income is highly imperfect; people try to hide
these to evade taxes.
• The Statistical Discrepancy or Errors and
Omissions is the amount we need to add or
subtract to make things add up to zero.
Balance of Payments
Current Account
Merchandise Trade
Exports
Imports
Services
Income
Current Transfers
Capital Account
Financial Account
Direct Investment
Portfolio Investment
Home claims on Foreigners
Foreign Claims on the Home Country
Reserves
Errors and Omissions
Examples for the Mythical
Country of Pongoland
Which account is credited?
Which account is debited?
A European importer buys 3 million pongos worth of
equipment from a Pongoland firm. Payment is made
with a cheque drawn on a Pongoland bank.
• The equipment is a Merchandise Export.
• It is a decrease in an asset, so credit
Merchandise Exports 3 million.
• The cheque is a Foreign Claim on
Pongoland. It is a decrease in a liability
so debit Foreign Claims 3 million.
Pongoland imports 1.2 million pongos of food
from Latin America. Payment is made with
cheques drawn on Pongoland banks.
• The food is a Merchandise Import.
• It is an increase in an asset so debit
Merchandise Imports 1.2 million.
• The payment is a Foreign Claim on
Pongoland.
• It is an increase in a liability so credit
Foreign Claims 1.2 million.
Pongoland tourists spend 400,000 pongos while
travelling in Europe. They pay with Pongoland
travellers’ cheques.
• The tourism is a Service.
• It is an increase in an asset so debit
Services .4 million.
• The travellers’ cheques are a Foreign
Claim on Pongoland.
• They are an increase in a liability, so
credit Foreign Claims .4 million.
A Pongoland company purchases 20 percent of a
European Company for 800,000 pongos. It pays
with cheques drawn on Pongoland banks.
• Debit Direct Investment .8 million.
• Credit Foreign Claims .8 million
The government of Pongoland provides
foreign aid to a country in the form of
300,000 million of agricultural products.
• Debit Current Transfers .3 million
• Credit Exports .3 million
Pongoland investors receive 200,000 pongos
from their foreign investments. They are paid
with cheques drawn on foreign banks.
• The earnings are Income.
• They are no longer owed the income so
this is a decrease in an asset. Or, view
this as an export of the services of
capital. Credit Income .2 million.
• The cheques are Pongoland Claims on
Foreigners.
• This is an increase in an asset; debit
Pongoland Claims.
The Balance of Payments and the
National Accounts
• Y = C + I + G + X where Y is output or income,
C is private domestic consumption, I is private
domestic investment, G is government
spending (assumed to be consumption) and X
is exports minus imports, or net exports or the
current account.
• Y – C – G = S = I + X, where S is income
minus total private and government
consumption, or savings.
• X = S – I : the current account is domestic
investment minus saving