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Balance of Payments
Topic Thirty-Four

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 three 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.

1) Goods – this is the trade in tangible goods.

2) Services – services involve the trade in intangibles such as transportation, insurance, travel or tourism, investment services and banking.

3) Unilateral private transfers – unilateral transfers include gifts, donations, personal remittances and other ‘one-way’ transactions. These deal with those receipts and payments which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side.

4) Net property income – this account records income receipts from abroad and payments abroad. For example, if a French citizen goes to work in Sweden and sends money back to France, this will be considered to be a credit item in France’s current account. On the other hand, when foreigners invest in local companies, they earn incomes and when transferred to their home countries, this is a debit for the local country.

Capital Account – the capital account is the net result of public and private international investments flowing in and out of a country. It records the net changes in the country's international financial assets and liabilities –

The capital account comprises of the:

Borrowings to and from abroad which includes:

(i) transactions relating to borrowings from abroad by locals including private sector and government. Receipts of such loans and repayment of loans by foreigners are recorded as credits because money is entering the country.

(ii) 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:

(i) 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.

(ii) Investments by local residents in shares of foreign companies. Such investments in foreign companies 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 such as the current stock of foreign exchange reserves available for financing of international payment imbalances.

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.

Balance of payments Ratios

There are ratios associated with the balance of payments which are as follows:

The balance of trade is the difference between the value of a country’s exports and the value of its imports during a certain time.

A trade surplus is when there is a favorable balance of trade that occurs when a country exports exceed its imports.

A trade deficit occurs when a country imports exceeds its exports; it is also known as an unfavourable trade balance.

The terms- of- trade ratio is the ratio of a country’s export prices to import prices. If the terms of trade improve, we can say that the country has moved to an improved position.

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. It also makes it very difficult for exporters because they are relatively uncompetitive relative to other countries.

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. This can also be associated with a change in taste towards foreign products.

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 balance of payments deficit,

Decline in overseas visitors – when visitors to our country fall which can result from recession in their country, then 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. Therefore, the following will be measures that can be implemented in order to address a balance of payments deficit:

Deflationary Measures – if inflation is high in Denmark, this will mean that prices for its products will be unattractive on the international market even though Denmark can earn more for its goods and services internationally due to the high price for these goods and services. Thus, the response to a balance of payments problem by the financial authorities in Denmark will be to reduce prices or to create a deflationary situation so that foreigners will be more willing to buy Danish goods and services. This can be achieved by increasing the reserve requirement ratio, increasing the discount rate which is the rate at which commercial banks borrow from the Central Bank and by selling bonds to local citizens. These will have the effect of removing money from the system thereby causing less spending and thus reduced prices. This will therefore increase exports relative to imports and reduce the balance of payments deficit.

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 – when tariffs are imposed, the prices of imports would increase to the extent of the tariff. The increased prices will reduce the demand for imported goods and, at the same time, induce domestic producers to produce more of import substitutes. Non-essential imports can be drastically reduced by imposing a very high rate of tariff.

Quotas – with a quota system, the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the trade deficit is reduced and the balance of payments position is improved.