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.
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.
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.
TABLE 1. BALANCE OF PAYMENTS (billions of $)
Debits (Payments) Credits (Receipts)
Balance CURRENT ACCOUNT 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
CAPITAL ACCOUNT 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