Balance of Payments
The balance of payments is the set of accounts where trade transactions are recorded. Debit transactions involve payments by the local or domestic residents to foreign residents for imports of goods and services, purchases of local residents traveling abroad and foreign investment by home residents. Credit transactions are those where foreigners pay our country for goods and services sold to them and inflows of investments by foreign companies.
Composition of the Balance of Payments
The balance of payments is comprised of four main accounts which are the current account, the capital account and the official reserve account plus the errors and omissions. Within these three accounts are sub-divisions, each of which accounts for a different type of international monetary transaction.
Current Account – the current account on the balance of payments measures the inflow and outflow of goods, services, transfers and investment incomes. It comprises of the following:
Merchandise balance - records merchandise exports - merchandise imports.
- Goods - this is the trade in tangible goods.
- Services - services involve the trade in intangibles such as transportation, insurance, travel or tourism, investment services and banking.
- Unilateral private transfers - unilateral transfers include gifts, donations, personal remittances and other ‘one-way’ transactions.
- Net property income - this account records income receipts from abroad and payments abroad.
Capital Account - the capital account is the net result of public and private international investments flowing in and out of a country.
The capital account comprises of the:
Borrowings to and from abroad which includes:
- transactions relating to borrowings from abroad by locals and repayment of loans by foreigners. Receipts of such loans and repayment of loans by foreigners are recorded as credits because money is entering the country.
- transactions of lending to foreign companies by both the private sector and government. Lending abroad and repayment of loans to foreigners are recorded as debits because money is leaving the country.
Investments to and from abroad which includes:
- Investments by foreign companies and individuals in shares of local companies. Such investments from abroad are recorded as credits as these bring in foreign exchange.
- Investments by local residents in shares of foreign companies – these are recorded as debits as these are outflows of foreign exchange.
The Official Reserve or Change in Foreign Exchange or Capital Flows
The official reserve account records transactions of the central bank.
Errors and Omissions
This section of the capital account records errors and possible omissions. Just as in the case where companies’ financial status is recorded on a balance sheet which must balance, the same must be so with the balance of payments. The errors and omissions account attempts to provide for this balance.
Reasons for a Current Account and Balance of Payments Deficit
There are several reasons why a country’s current account and balance of payments can be in a deficit which are as follows:
Overvalued exchange rates – an overvalued currency or exchange rate means exports are more expensive, but imports are cheaper. This encourages domestic consumers to buy more imports which leads to a current account and balance of payments deficit.
High consumer spending - if there is rapid growth in consumer spending, then there tends to be an increase in imports causing a deterioration in the current account and balance of payments.
Increase in overseas investments - if there is a rise in overseas investments by local investors, there will be an outflow of foreign exchange and an increase in the current account and balance of payments deficit,
Decline in overseas visitors – when visitors to our country fall which can result from recession in their country, we can expect to see a decline in foreign exchange and a deficit in the balance of payments,
Measures to Correct for Balance of Payments Deficits
Balance of payment deficits are caused when a country’s imports exceed its export or when its outflow of money exceeds its inflow. The following will be measures that can be implemented in order to address a balance of payments deficit:
Deflationary Measures - if inflation is high, this will mean that prices for local products will be unattractive on the international market even though the local country can earn more for its goods and services internationally due to the high price for these goods and services. The response to correct for this will be to reduce prices or to create a deflationary situation so that foreigners will be more willing to buy local products.
Exchange Depreciation/Devaluation - in countries which have a flexible exchange rate system and have a balance of payments deficit, these countries currency can be depreciated. This will have the effect of making its exports more attractive and its imports more expensive. The effect of devaluation can be the same as with a depreciation.
Tariffs - tariffs can increase the price of imports causing imports to reduce which will correct for the current account and balance of payments deficit.
Quotas - by restricting imports through the quota system, the trade deficit is reduced and the balance of payments position is improved.
Balance of Payments Surplus
A balance of payments can arise due to the following:
Decline in demand for imports – when local residents demand less of foreign products and services, the country will be saving foreign reserves and this will have the effect of strengthening the country’s trade position and creating a surplus in its balance of payments.
Increase in demand for local goods by foreigners – when foreigners increase the demand for the local country’s goods and services, this will have the effect of increasing the local country’s incomes and this will result in a surplus in the balance of payments.
Increase in local investments by foreigners – if there is an increase in investments in the local economy or into local companies by foreign companies, this will have the effect of increasing the inflows of capital into the country and improving the surplus position in the balance of payment.
Decrease in foreign investments by local residents – when local residents decide to invest locally, this will have the effect of reducing the outflows of capital causing a surplus in the country’s balance of payments.