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BALANCE OF PAYMENTSBALANCE OF PAYMENTSModule 3Module 3

Topic 3: Balance of Payments & Exchange Rates Topic 3: Balance of Payments & Exchange Rates

Objectives

Explanation of the balance of payments.Distinguish between the current account

and capital account.Causes and consequences of balance of

payments disequilibria.Policy measures for correcting balance of

payments disequilibria

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Defining Balance of Payments

The The balance of paymentsbalance of payments is a record of all is a record of all economic transactions conducted between economic transactions conducted between a country and the rest of the world for a a country and the rest of the world for a given time period, usually one year.given time period, usually one year.

An economic transaction is an exchange of value. It involves a receipt and a payment of money in exchange for economic goods and services.

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Accounting Treatment of Items

In standard accounting double entry book-keeping, each transaction will result in a debit and a credit entry of equal size or amount.

Thus in that sense, a country’s balance of payments accounts for any given year always balances.

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Accounting Treatment of Items

In terms of actual receipts and payments, a country may be faced in any given year with one of two situations.

(a) A surplus or favourable balance on the

BOP accounts.

(b) A deficit or unfavourable balance on the

BOP accounts.

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Accounting Treatment of Items (Debit and Credit Items)

Any item which gives rise to a sale of foreign exchange (an inflow) is recorded as a credit item (+) in the accounts e.g. export of goods and services

Any item which gives rise to the purchase of foreign exchange (an outflow) is recorded as a debit item (-) in the accounts e.g imports of goods and services.

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The Components of the BOP Account

The Balance of Payments Account consists of two parts:

(i) A current accountcurrent account

(ii) A capitalcapital (and financial) accountaccount

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The Components of the BOP Account

The CURRENT ACCOUNTCURRENT ACCOUNT records all items relating to imports and exports of goods and services, net property income and current transfers between a country and the rest of the world.

The CAPITAL ACCOUNTCAPITAL ACCOUNT records all movement from private sources and official sources between a country and the rest of the world.

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The Components of the BOP Account

The Current Account generally comprises two sections: (a) Visible balance (balance of visible trade): primarily the

import and export of merchandise or goods)

(b) Invisible balance (Balance of invisible trade): primarily

the import and export of services.

N.B. The sum of the two balances is referred to as the balance balance on the current accounton the current account.

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The Components of the BOP Account

The Current Account generally comprises four main items: (a) Merchandise Trade Balance

(b) Services Balance

(c) Net Property Income Balance

(d) Current Transfers Balance

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The Components of the BOP Account

The capital account records all movement of capital from both private sources as well as official government sources between a country and the rest of the world.

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The Components of the BOP Account

The Capital Account deals primarily with short term and long term flows/movements of capital, that is, it is concerned with international loans and investments.

It may consist of borrowing/repayment, transfer of It may consist of borrowing/repayment, transfer of ownership of a fixed asset; foreign direct ownership of a fixed asset; foreign direct investments, financial portfolio investments, investments, financial portfolio investments, foreign aid transactions, other investments and foreign aid transactions, other investments and reserve assets. reserve assets.

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The Components of the BOP Account

It must be noted that when the balances of both sections are added there can be a surplus or a deficit.

The account must therefore show the treatments of any of these two situations as well as the item to “balance off” the account. This is strictly for accounting purposes. All surplus or deficits must be dealt with.

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Balance of Payments Disequilibrium

A deficit or an unfavourable balancedeficit or an unfavourable balance exists when the value of autonomous debit items exceeds the value of autonomous credit items.

A surplus or a favourable balancesurplus or a favourable balance exists when the value of autonomous credit items exceeds the value of autonomous debit items.

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