The balance of payments (BOP) is a double-entry bookkeeping system that summarizes a country’s economic transactions with the rest of the world for a particular period of time. In simple terms, it is a record of all the country’s international transactions.
Analyzing the BOP is an important element in assessing a country’s macroeconomic environment, its monetary and fiscal policies, and its long-term growth potential. Investors use data on trade and capital flows to evaluate a country’s overall level of capital investment, profitability, and risk.
International receipts are credit items, while international payments are debit items.
|Balance of payment accounts|
|(Increase in assets, Decrease in liabilities)||(Decrease in assets, Increase in liabilities)|
|Value of imported goods and services.||Payments for imports of goods and services.|
|Purchases of foreign financial assets.||Payments for foreign financial assets.|
|Receipt of payments from foreigners.||Value of exported goods and services.|
|Increase in debt owed by foreigners.||Payment of debt by foreigners.|
|Payment of debt owed to foreigners.||Increase in debt owed to foreigners.|
Credit (+): This represents funds flowing into the country, and demand for domestic currency in the forex market.
Debit (-): This represents funds flowing out of the country, and supply of domestic currency in the forex market.
BOP is composed of the following three components:
The basic rule of BOP is that the sum of all its components must equal to zero.
Current account consists of the following four accounts:
Note: Patents related to the services sector go in the current account, the rest is accounted in the capital account. For example: selling the rights to exploration is a capital account.
The exhibit below is from example 10 in the curriculum. You may look at the various items under current account, capital account, and financial account and relate it to the ones we saw above.
|(Credits +, Debits -)||1970||1980||1985||1990||2000||2009|
|Exports of goods and services and income receipts||68,387||344,440||387,612||706,975||1,421,515||2,159,000|
|Exports of goods and services||56,640||271,834||289,070||535,233||1,070,597||1,570,797|
|Imports of goods and services and income payments||-59,901||-333,774||-483,769||-759,290||-1,779,241||-2,412,489|
|Imports of goods and services||-54,386||-291,241||-410,950||-616,097||-1,449,377||-1,945,705|
|Unilateral current transfers, net||-6,156||-8,349||-21,998||-26,654||-58,645||-124,943|
|Capital account transactions. net||…||…||…||-7,220||-1||-140|
|U.S. owned assets abroad , ex derivatives (increase/financial outflow (-))||-9,337||-86,967||-44,752||-81,234||-560,523||-140,465|
|Foreign-owned assets in the United States, ex derivatives (increase/financial inflow (+))||7,226||62,037||144,231||139,357||1,038,224||305,736|
|Financial derivatives, net||N/A||N/A||N/A||N/A||N/A||N/A|
|Statistical discrepancy (sum of above items with sign reversed)||-219||22,613||18,677||28,066||-61,329||162,497|
Note: This section is not highly testable. It cites various examples to illustrate how BOP bookkeeping entries are done.
Commercial exports: A company in Germany sells technology equipment to a South Korean auto manufacturer for a total price of EUR 50 million, including freight charges of EUR 1 million to be paid within 90 days. The merchandise will be shipped via a German cargo ship.
Let us look at how the transaction is recorded from Germany’s perspective.
Current account (under exports) credit entries:
Technology equipment: + €49 million
Freight services: + €1 million
Financial account (debit entry):
Money owed by foreigners to Germany: €50 million
Commercial imports: A German utility company imports gas from Russia valued at EUR 45 million, and agrees to pay the Russian company within three months.
Current account (under imports) debit entry:
Gas imported: €45 million
Financial account credit entry:
Money owed by Germany to Russia: €45 million
Loans to borrowers abroad: A German commercial bank purchases EUR 100 million in intermediate-term bonds issued by a Ukrainian steel company. The bonds are denominated in euros, so payment is made in euros.
Financial account – debit and credit entry:
German holdings of Ukrainian bonds (German investment in a foreign country, private long-term claims): €100 million
Deposits issued by the Ukrainian steel company (foreign private short-term claim): €100 million
Solution: Current account, Capital account, and Financial account.
a. Sell gas exploration rights to a Russian company.
Solution: Capital account
b. Sell software-related patents and services to a Canadian company.
Solution: Current account
c. Borrow $100 million euro from a German bank.
Solution: Financial account
d. Receive a $5 million dividend from an equity investment in the U.S.
Note: The curriculum describes this section in great detail. Most of the questions in this section are based on this equation.
The derivation of this relationship is shown in the curriculum. We will look at it briefly here.
In a closed economy, all goods and services are produced and consumed within the country i.e. nothing is traded.
GDP = National income of the country Y = C + I + G
C = Consumption
I = Investment
G = Government Expenditure
In an open economy, some of the produce is exported (X), while some money is spent on importing goods and services (M). For such an economy which is often the case, the GDP consists of four components: consumption, domestic investment, government spending, and net exports.
Now, Y = C + I + G + (X – M)
where: X – M = Net Exports = Current Account
Rearranging the above equation, we get current account CA = X – M = Y – (C + I + G)
If (C + I + G) represents expenditure, then the current account CA is the difference between what a country produces (Y) and what it spends (C + I + G).
CA Surplus → The country exports more than it imports; produces more than it spends, or net lending to other economies; CA > 0.
CA Deficit → The country imports more than it exports, or net borrowing from other economies; CA < 0.
Current account surplus results from:
Conversely, current account deficit results from:
What is the impact on the current account for each of the following?