Topic 1: The Balance of Payments

You already well understand that different countries have different currencies and that all exchanges of goods and assets between countries first involve exchanges of their respective currencies. The amounts of currencies exchanged depends on the size of the flow of transactions between the two countries.

The balance of payments is, first and foremost, an accounting statement that delineates the transactions between a country and the rest of the world. An illustrative summary is presented in Table 1.

TABLE 1.    BALANCE OF PAYMENTS (billions of $)

Debits (Payments)Credits (Receipts) Balance
   Goods (Merchandise)200 140 -60
   Services Excluding Capital Services  30  50  20
    (tourism, shipping, insurance, etc.)
   Gifts and Transfers 10   5  -5
______________________________ _______________
Trade Account Balance  240 195-45
   Interest and Dividends 30  10 -20
______________________________ _______________
Debt Service Balance   30  10-20
______________________________ _______________
Balance on Current Account  270 205-65
   Purchases of Assets from Foreign Residents   20 -20
   Sales of Assets to Foreign Residents  85  85
______________________________ _______________
Balance on Capital Account   20  85 65
______________________________ _______________
BALANCE  290 290  0

A country's transactions are of two types: payments and receipts. Payments (called debits) arise as a result of the purchase of goods and services and assets by domestic residents from foreign residents, and from gifts and other types of transfers to foreign residents. They necessarily involve exchanges of domestic currency for foreign currency on the international currency market. Receipts (called credits) arise from the sale of goods and services and assets by domestic residents to foreign residents, and from gifts and other transfers received from abroad. They involve exchanges of foreign currency for domestic currency on the foreign exchange market.

It is quite obvious what payments and receipts for goods involve. But what about services? Services are such things as tourism (foreigners visiting a country spend funds on hotel rooms, restaurants, sightseeing and entertainment), shipping (the use of foreign ships to transport a country's imports and exports), and insurance (as when an Italian company insures itself with Lloyds of London). Services also involve the direct use of labor and capital. For example, a U.S. resident working as a welder in pipe line construction in Saudi Arabia is exporting labour services. When domestic residents use their savings to purchase foreign assets they are in effect renting those savings to foreigners in return for ongoing interest and dividend payments. These interest and dividends thus represent payment for the services provided by the capital loaned abroad.

International transactions are also divided in to current and capital transactions. Current transactions are those that involve payments or receipts for the purchase of current goods and services---or, in other words, for the purchase and sale of claims against countries' current output. The excess of receipts over payments on account of these transactions is called the current account balance. Capital transactions involve payments or receipts for the purchase of assets---that is, of claims against countries' future output. The excess of receipts over payments on account of capital transactions is called the capital account balance.

Notice that receipts or payments of interest earnings on capital are current transactions while receipts or payments for the sale or purchase of assets are capital account transactions. This is because the interest earnings are a payment for capital's contribution to current output, while payments for the purchase of assets are payments for the right to receive a portion of future output. The interest payments on those assets will be current transactions in the year in which that future output is produced.

Notice also that the purchase and sale of capital goods such as trucks and bulldozers is a current and not a capital transaction. It is simply the purchase of part of the current output flow of the exporting country. If the purchaser borrows abroad the funds used to purchase the truck or bulldozer, then the promise to pay back the amount borrowed is an asset that becomes an item in the capital account. If the importer of equipment finances her purchase by borrowing from domestic residents, or uses her own savings, the capital account remains unaffected.

The capital account of the balance of payments is related to another important international account called the balance of indebtedness. The balance of indebtedness is equal to the stock of foreign assets owned by domestic residents minus the stock of domestic assets owned by residents abroad. A positive balance of indebtedness means that the country is a net international creditor and a negative balance means that it is a net debtor.

Note that the balance of indebtedness is a stock while the capital account balance is a flow. The capital account balance is the net flow of assets purchased by domestic residents from foreign residents and, as such, represents a flow of additions to the balance (net stock) of indebtedness. When domestic residents purchase assets from foreigners their balance of indebtedness increases---when they sell assets to foreigners, it decreases.

Indeed, all items in the balance of payments are flows. Current account items represent purchases or sales of current output flows, or of income flows produced in the course of producing current output. A positive balance on capital account indicates a net capital inflow and a negative balance a net outflow. Notice that purchases of securities represent a net outflow of capital (domestic accumulated savings is flowing abroad) and sales of securities to foreign residents represent an inflow of capital (foreign savings is flowing into the country). An outflow of capital is, in effect an import of securities (written promises to pay), while an inflow of capital is a a sale or export of securities to foreign residents.

The current account of the balance of payments can be subdivided into the balance of trade, which is the balance on account of transactions in goods or merchandise and in those services other than the direct services of capital, and the debt service balance, which is the excess of interest and dividend payments to domestic residents (for the services of capital they own abroad) over the payments of interest and dividends to foreigners by domestic residents. The component of the balance of trade that consists of transactions involving the purchase and sale of goods alone is called the merchandise balance.

The debt service balance is of special interest because it is an indication of the degree of indebtedness of domestic residents to foreign residents. Countries like Canada, which have made extensive use of foreign savings to develop their natural resources tend to have a negative balance of indebtedness and a negative debt service balance. To the extent that they are still using foreign savings to develop their resources, they will also be experiencing net capital inflows. Net inflows of capital this period will lead to a bigger negative (or smaller positive) debt service balance next year. Countries whose savings levels are high compared to investment opportunities within their borders will be net exporters of capital (importers or purchasers of securities) and will have negative capital account balances.

Since the balance of payments is an accounting statement it will always balance---that is, the sum of all debits or payments must equal the sum of all credits or receipts. This is guaranteed by the principles of double-entry bookkeeping. As a result, countries that are net importers of capital (exporters of securities) and have positive capital account balances will necessarily have equal negative balances on current account. A country with a current account deficit will necessarily have a capital account surplus, and one with a current account surplus will have a deficit in its capital account.

This double-entry feature of the balance of payments can be best understood by working through in detail the entry of a few transactions. Suppose that an Australian firm buys 10,000 Australian dollars worth of beer from the United States. We would enter a debit of 10,000 dollars in the Australian balance of payments under merchandise imports and a credit of 10,000 dollars under sales of assets to residents, assuming that the U.S. exporter gives the Australian importer 90 days to pay. The promise to pay is an asset which the exporter has purchased in return for the beer. Note that the overall balance of the balance of payments is unaffected because the transaction is entered in both the debit and payment columns.

In 90 days the Australian firm writes a cheque on its U.S. dollar account in the Commonwealth Bank of Australia for the $US equivalent of 10,000 Australian dollars payable to the U.S. beer exporter. The firm is, in effect, buying back the 90-day promise to pay from its trading partner in the U.S. and selling an equivalent amount of its US dollar reserves. The first part of this transaction enters as a negative item in the capital account and the second part enters as a positive item in the capital account. Again, the overall balance is unchanged.

At some point, the Australian firm may need to replenish its US dollar bank balance. It will have its bank sell some Australian dollars for US dollars. This purchase of $US will appear as a debit item in the capital account. The purchaser of those Australian dollars will, at least for a time, keep them in an Australian dollar account at his bank. This represents a sale of securities (Australian dollars) to a foreign resident and will appear as a credit item in the Australian balance of payments. Again, the overall balance is undisturbed.

It is time for a test. Be sure to think up your own answers before looking at the ones provided.

Question 1
Question 2
Question 3

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