Balance of payments accounting system

Definition of Balance of payments accounting system: Each year, countries purchase trillions of dollars goods, services and assets from each other. The balance of payment accounting system is a double-entry bookkeeping system designed to measure and record all economic transactions between residents of one country and residents of all other countries during the particular time period. It helps policy makers understand the performance of each country’s economy in international markets. It also signals fundamental changes in the competitiveness of countries and assists policy makers in designing appropriate public policies to respond to these changes.

International business people also need to pay close attention to countries
BOP statistics for several reasons, including the following:

1. BOP statistics help identify emerging markets for goods and Services.
2. They can warn of possible new policies that may alter a country’s business climate, thereby affecting the profitability of a firm’s operations in that country For example. sharp rises in a country’s imports may signal an overheated economy and portend a tightening of the domestic money supply. In this case, attentive business people shrink their inventories in anticipation of a reduction in customer demand.
3. They can indicate reductions in a country’s foreign-exchange reserves, which may mean that the country’s currency will depreciate in the future. Exporters to country may find that domestic producers will become more price competitive.
4. As was true in the international debt crisis, BOP statistics can signal increased riskiness of lending to particular countries.

Four important aspects of the BOP accounting system need to be highlighted-

1. The BOP accounting system records international transactions made during some time period, for example, a year.
2. It records only economic transactions, those that involve something of monetary value.
3. It records transactions between residents of different countries. Residents can be individuals, businesses, government agencies, or nonprofit organizations, but defining residency is sometimes tricky Persons temporarily located in a country— tourists, students, and military or diplomatic personnel—are still considered
   residents of their home country for BOP purposes. Businesses are considered residents of the country in which they are incorporated. An unincorporated branch of an MNC is a resident of its home country, while an incorporated subsidiary is considered a resident of the host country.
4. It is a double entry system. Each transaction produces a credit entry and a debit entry of equal size. In most international business dealings, the first entry in a BOP transaction involves the purchase or sale of something—a good, a service, or an asset. The second entry records the payment or receipt of payment for the thing bought or sold. Figuring out which is the BOP debit entry and which is the BOP credit entry is not a skill that most people are horn with. Many experts compare a BOP accounting statement to a statement of sources and uses of hinds. Debit entries reflect us.-s of funds; credit entries measure sources of funds. Under this framework, buying things creates debits, and selling things produces credits.

The Major Components of  the BOP Accounting System:

The BOP accounting system can be divided conceptually into four major accounts. The first two accounts—the current account and the capital account—record purchases of goods, services, and assets by the private and public sectors. The official reserves account reflects the impact of central hank intervention in the foreign-exchange market. The last account—errors and omissions—captures mistakes made in recording BOP transactions.

Current Account. The current account records four types of’ transactions among residents of different countries:

1. Exports and imports of goods(or Merchandise)
2. Exports and imports of services
3. Investment income
4. Gifts

The following Table BOP#01 summarises debit and credit entries for transactions involving the current account.

For example, to Germany, the sales of a Mercedes- Benz automobile to a doctor in  Marseilles in a Merchandise export, and the purchase by a German resident of Dom Perignon from the France is a merchandise export.(The British use the term Trade visible to refer to merchandise trade). The difference between a country’s exports and imports of goods is called the balance of merchandise trade.For example, the United States, which has been importing more goods than it has been exporting, has merchandise trade deficit, Japan, which has been exporting more goods than it has been importing, has a merchandise trade surplus.

The services account records sales and purchases such services as transportation , tourism, medical care, telecommunications, advertising, financial services, and education. The sales of a service to another country is a service export, and the purchase of a service from another country  is a service import.( The British use the term trade in visible to denote trade in services.). For example, for Germany, a German student spending a year studying  at Sorbonne in Paris in a import of services, and the telephone call home that an Italian tourists make during the Oktoberfest in Munich represents a service export.The difference between a country’s export of services and its import of services is called balance of services trade.

The third type of transaction recorded in the current account is investment income. Income German residents earn from their foreign investment is viewed as export of the services of capital by Germany. This income takes the form of either interest and dividends earned by German residents on their investments in foreign stocks, bonds, and deposit accounts or profits that are repatriated back to Germany from incorporated subsidies in other countries that are owned by German firms.On other other hand, foreigners also make investments in Germany. Income earned by foreigners from their investments in Germany is viewed as an Import of the services of capital by Germany. This income includes interest

Table- BOP#01

	DEBIT	CREDIT
Goods	Buy	Sell
Services	Buy	Sell
Dividend and interest [investment income]	Pay	Receive
Gifts	Give	Receive

and dividends paid by firms in Germany on stocks, bonds, and deposit accounts owned by foreign residentsas well as profits that are repatriated by foreign -owned incorporated subsidiaries in Germany back to their corp rate parents.

The fourth type of transaction in the current account is unilateral transfers.or gifts between residents of one country and another. Unilateral transfers include private and public gifts. For example, a Pakistani-born resident of Kuwait who sends part of his earnings back home to feed his relatives is engaging in a private unilateral transfer. In contrast, governmental aid from the United Kingdom used for a flood control project in Bangladesh is a public unilateral transfer. In either case, the recipient need not provide any compensation to the donor.

The current account balance measures the net balance resulting from merchandise trade, service trade, investment income, and unilateral transfers. It is closely scrutinised by government officials and policymakers because it broadly reflects the country’s current competitiveness in international markets.

Capital Account. The second major account in the BOP accounting system is the capital account, which records capital transactions—purchases and sales of assets—between residents of one country and those of other countries. Capital account transactions (summarised in Table# 2), can be divided into two categories: foreign direct investment (FDI) and portfolio investment.

FDI is any investment made for purpose of controlling the organisation in which the investment is made, typically through ownership of significant blocks of common stock with voting privileges. Under U.S. BOP accounting standards,control is defined as ownership of at least 10 percent of a company’s voting stock.

A portfolio investment is any investment made for purposes other than control.
Portfolio investments are divided into two subcategories: short-term and long-
term. Short-term portfolio investments are financial instruments with maturities of one year or less. Included in this category are commercial paper; checking accounts, time deposits, and certificates of deposit held by residents of a country

Table- BOP#02

Capital Account Transactions

	MATURITY	MOTIVATION	TYPICAL INVESTMENTS
Portfolio (short-term)	One year or less	Investment income or facilitation of international commerce	Checking account balances Time deposits Commercial paper Bank loans
Portfolio (long-term)	More than one year	Investment income	Government bills, notes. and bonds Corporate stocks and bonds
Foreign direct investment	Indeterminate	Active control of organization (own at least 10 percent of voting stock)	Foreign subsidiaries Foreign factories international joint ventures

In foreign banks or by foreigners in domestic banks; trade deposits from international commercials customers; and banks short terms international lending activities, such as commercial loans, Long-terms portfolio investments are stocks. bonds, and other financial instruments issued by private and public organisation that have maturities greater than one year and that are held for purposes other than control. For example. when IBM invests excess cash balances overnight in a Paris bank to earn a higher Interest rate than it could earn in New York, it is making a short-term portfolio investment. When the California Public Employers Retirement System Pension Fund buys stock in British Airways it is making a long-term portfolio investment. When British Airways purchases 23
percent of the common stock of US Air. it is making an FDI.

Current account transactions invariably affect the short-term component of the capital account. Why? Well, as noted earlier in the chapter, the first entry in the double-entry BOP accounting system involves the purchase or sale of some thing—a good. a service, or an asset. The second entry typically records the payment or receipt of payment for the thing bought or sold. In most cases, this second entry involves a change in someone’s checking account balance, which in the BOP accounting system is a short-term capital account transaction. “Building
Global Skills” at the end of this articles  walks you through this linkage between the current account and the capital account in more detail.

Capital inflows are credits in the BOP accounting system. They can occur in two ways:

1. Foreign ownership of assets in a country increases. One highly publicized example of a  capital inflow into the United States was the Mitsubishi Estate Co.’s 1989 purchase of 51 percent of the Rockefeller Group, owner of Rockefeller Center, for $846 million. A capital inflow also occurs if a foreign firm deposits a check in a U.S. bank. In this case, the asset being purchased is a claim on a U.S. bank. which of course is all that a checking account balance represents.
2. Ownership of foreign assets by a country’s residents declines. When the now defunct Pan American World Airways sold its West Berlin operations to Lufthansa for $158 million in 1990, the United States experienced a capital inflow. Similarly, when IBM pays a Japanese disk drive supplier with a check drawn on IBM’s
   account at a Tokyo bank, IBM’s Japanese checking account balance declines and the United States experiences a capital inflow because IBM is partially liquidating its ownership of foreign assets.

Capital outflows are debits in the BOP accounting system. They also can occur in two ways:

1. Ownership of foreign assets by a country’s residents increases. Ford’s £1.5 billion purchase of the British firm Jaguar Motor Company in 1990 represented a capital outflow from the United States. A U.S. capital outflow also occurs when Delta Air Lines deposits a check from a London businessperson into an account it holds in
   an English bank.
2. Foreign ownership of assets in a country declines. A German mutual find that sells 100,000 shares of GM common stock from its portfolio causes a capital outflow from the United States. A U.S. capital outflow also occurs if japan Air Lines writes

Table- BOP#03

	DEBIT (OUTFLOW)	CREDIT (INFLOW)
Portfolio (short-term) .	Receiving a payment from a foreigner Buying a short-term foreign asset Buying back a short-term domestic asset from its foreign owner	Making a payment to a foreigner Selling a domestic short-term asset to a foreigner Selling a short-term foreign asset acquired previously
Portfolio (long-term)	Buying a long-term foreign asset (not for purposes of control)   Buying back a long-term domestic asset from its foreign owner (not for purposes of control)	Selling a domestic long-term asset to a foreigner (not for purposes of control) Selling a long-term foreign asset acquired previously (not for purposes of control)
Foreign direct investment	Buying a foreign asset for purposes of control Buying back from its foreign owner a domestic asset previously acquired for purpose of control	Selling a domestic asset to a foreigner for purposes of control Selling a foreign asset previously acquired for purposes of control

a check drawn on its account at a Hawaii bank to pay its fuel supplier at Honolulu Airport. In both cases, foreigners are liquidating a portion of their US. Assets.

Table BOP # 3 summarises the impact of various capital account transactions on the BOP.

Official Reserves Account. The third major account in the BOP accounting system is the official reserves account. The official reserves account records holdings of the official) reserves held by a national government. These reserves are used to intervene in the foreign-exchange market and in transactions with other central banks. Official reserves comprise four types of assets:

1. Gold
2. Convertible currencies
3. SDRs
4. Reserves position at the IMF

Official gold holdings are normally valued using prices determined in the London gold market. Convertible currencies are  currencies that are freely exchangeable in world currency markets. The convertible currencies most commonly used as official reserves are the U.S. dollar. the Deutsche mark, and the yen. The last two types of reserve-SDRs and reserve position (quotas minus IMF borrowings) at the IMF-were discussed earlier.

Errors and Omissions. The last account in the BOP accounting system is the Errors and Omissions account.One truism of the BOP accounting system is that BOP must balance. In theory the following equality should be observed.

Current Account + Capital Account + Official Reserves Account = 0.

However, the equality is never achieved in practice because of measurement errors. The account is called errors and omissions is used to make the BOP balance in accordance withe the following equation:

Current Account + Capital Account + Errors and Omissions + Official Reserves Account = 0.

The errors and omissions account can be quite large. In the chaotic year 1990, for example. the U.S. errors and omissions account totalled a record $73 billion, Experts suspect that a large portion of the errors and omissions account balance is due to under reporting of capital account transactions. Such innovations instantaneous, round-the-clock foreign_exchange trading. sophisticated monetary swaps and hedges. and international money-market funds have made it difficult for governmental statisticians to keep up with the growing volume of legal short-term
money flowing between countries in search of the highest interest rate. Sometimes, errors and omissions are due to deliberate actions by individuals who are engaged in illegal activities such as drug smuggling, money laundering, or evasion of currency and investment controls imposed by their home governments. Politically stable countries, such as the United States. are often the destination of flight capital money sent abroad by foreign residents seeking a safe haven for their assets hidden from the sticky fingers of their home governments. Given the often illegal nature of flight capital. persons sending it to the United States often try to avoid any official recognition of their transactions. For example. after Alberto Fujimori elected president of Peru in July 1990, an estimated $600 million of previously unreported flight capital was repatriated back ‘to Peru as citizens’ confidence in their economy was restored.Similarly, in the early l990s governmental statisticians estimated that as much as $15 billion worth of U.S. dollar bills were tucked under mattresses of Middle Easterners and Eastern Europeans distrustful of their own currencies. Much of this hoarding would go unreported in the U.S. BOP
accounts.Germany faced a similar problem in 1991. when the former Soviet Union and former Yugoslavia were breaking up politically. The Bundeshank became alarmed, fearing increased inflation, because cash in circulation was expanding at 8.5 percent annually. Yet much of the increased holdings o f Deutsche marks was later attributed to their use by Soviet and Yugoslavian citizens distrustful of their own currencies in politically chaotic times. Some errors may crop up in the current account as well. Statistics for merchandise imports arc generally thought to be reasonably accurate because most countries’ customs services scrutinise imports to ensure the all appropriate taxes arc collected. This scrutiny generates paper trails that facilitate the collection of accurate statistics. However, few countries tax exports, so customs services have less incentive to assess the accuracy of statistics concerning merchandise exports.

Statistics for trade in services also may contain inaccuracies. Many Services trade statistics are generated by surveys.For example, U.S. tourism exports are measured by surveying foreign tourists on how many days they spent in the United States and how many dollar they spent per day.If tourists underestimate their daily spending, then U.S. service exports are underestimated. To help the gain a better understanding of the BOP accounts.We next review the international transactions of the United States in 1993.

Balance of payments accounting system