ACM-903

TERM PAPER
TOPIC-

BALANCE OF PAYMENT ACCOUNTING- MEANING, PRINCIPLES AND ACCOUNTING

SUBMITTED TO: Dr. P.D.SAINI

SUBMITTED BY: SHIVANJALI SINGH 112528

BALANCE OF PAYMENT ACCOUNTING- MEANING, PRINCIPLES AND ACCOUNTING

MEANING OF BALANCE OF PAYMENT
Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. The BoP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items. When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries. While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted. The term "balance of payments" often refers to this sum: a country's balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a certain amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter. Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country's currency and other currencies. Then the net change per year in the central bank's foreign exchange reserves is sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a managed float where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange rate). With a pure float the central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the central bank's foreign exchange reserves do not change.

DEFINITION OF BALANCE OF PAYMENT

In general, the balance of payments is a statistical statement that systematically records all economic transactions between residents of an economy (General Government, Monetary Authority, Banks and Other Sectors) and nonresidents for a specific time period. Economic transactions consist of those involving; goods, services and income, transactions of financial claims and liabilities, transfers between residents and non-residents for the provision of real and financial resources without quid pro quo.

There are two basic concepts in the balance of payments definition: economic territory and residence. The concept of economic territory corresponds to a geographic territory administered by a government while the concept of residence refers to an institutional unit or an individual who regularly resides and engages in economic activities in an economic territory for more than one year. The balance of payments statistics measure all economic flows between residents and nonresidents for a specific time period, such as a month, a quarter or a year. The unit of account for compiling these statistics may be the domestic currency or other foreign currencies which are convertible in international markets. However, it is preferable that the unit of account be a stable currency.

PRINCIPLES OF BALANCE OF PAYMENT 1.Double-entry

The basic principle applied in the balance of payments statistics in accordance with the double-entry accounting system is that every recorded transaction is represented by two entries with equal values. One of these entries is designated a credit with a positive (+) sign and the other is designated a debit with a negative sign (-). In other words, double-entry accounting system requires every transaction to be recorded with two entries as Credit and Debit. In the balance of payments statistics; a credit (+) entry indicates; in the current account, exports of real resources (goods and services) in the capital and financial account, an increase in liabilities or a decrease in assets

while a debit (-) entry indicates; in the current account, imports of real resources (goods and services)

in the capital and financial account, a decrease in liabilities or an increase in assets

Some examples of the double-entry transactions are given below: a). In return for exported goods, 100 units are deposited by a nonresident importer to the resident exporters account in a domestic bank. This transaction is recorded as follows: Credit Debit Current Account: Exports 100 Capital and Financial Account: Other Investment/Assets/ Currency and Deposits 100 b). A syndicated loan in the amount of 100 units provided by nonresident banks to a resident bank is recorded as follows: Credit Debit Capital and Financial Account: Other Investment/Assets/ Currency and Deposits 100 Other Investment /Liabilities/Loans 100 Non-cash transactions are also recorded in the balance of payments. For example, a resident importer imports 100 units worth of goods, which will be repaid in a future date after the delivery is realized. The recording of this transaction is as follows: During the delivery of the goods: Credit Current Account: Goods Capital and Financial Account: Other Investment /Liabilities /Trade Credits Debit 100 100

2. Change of Ownership
Within the framework of double-entry accounting principle, credit and debit entries of all economic transactions are recorded at the time of change of ownership.

3. Market Value
Economic transactions are valued at market prices. Market price may be defined as the exchange price agreed upon by transactors and the current price at which an asset or service can be bought or sold.

BALANCE OF PAYMENT ACCOUNTING

The balance of payments statistics are classified under two major categories as set forth in the BPM5: Current Account and Capital and Financial Account. In summary, while the current account covers all transactions that involve real sources (goods, services, income)

and current transfers; the capital and financial account shows how these transactions are financed (generally through transactions in financial instruments or capital transfers).

1. Current Account
The current account is subdivided into three broad items: a) Goods and Services b) Income c) Current Transfers (Unrequited Transfers) a) Goods and Services i) Goods Goods item covers general merchandise, goods for processing, repairs on goods, goods procured in ports by carriers and nonmonetary gold (commodity gold). Foreign trade flows are measured in terms of either the Special Trade or the General Trade system and the choice may differ among countries. The special trade system is based on the physical movement of goods across customs excluding the movement of goods to or from the free trade zones located within countrys national borders, whereas the general trade system covers all goods crossing the national borders. ii) Services Services item covers transportation (including freight), travel, communication services, construction services, insurance services, financial services, computer and information services, royalties and license fees, merchanting and other trade-related services, operational leasing services, miscellaneous technical services, personal, cultural and recreational services and government services. b) Income Income item covers, compensation of employees and receipts and payments on direct investment, portfolio investment and other investment. Direct investment income includes income on equity, dividends, reinvested earnings and other intercompany investment income. Portfolio investment income refers to income on equity securities (dividends) and income on bonds and other debt securities (interest). Finally, other investment income refers to interest receipts and payments on all other resident claims on and liabilities to nonresidents, respectively. c) Current transfers Transfers are defined as offsetting entries for real resources or financial items provided, without a quid pro quo, by one economy to another. This item is divided into two subitems, according to the related sector: General Government ( such as grants) Other Sectors ( workers remittances and other transfers)

2. Capital And Financial Account

This item is divided into two main categories: The capital account and the financial account: a) Capital Account Capital account consists of two items i) Capital transfers (such as debt forgiveness, migrants transfers)

ii) Acquisition or disposal of non-produced and nonfinancial assets (intangible assets like land and tangible assets like franchise, copyright, trademarks and leases and other transferable contracts) b) Financial Account Transactions in the external assets and liabilities of an economy constitutes another significant category of the balance of payments statistics. Short and long-term international financial flows of the private and public sector are followed under this account. The financial flows, which are an integral part of the international economic transactions, basically cover all transactions associated with the change of ownership in external financial assets and liabilities of an economy. According to the type of the financial flows, the Financial Account is classified as follows; i) Direct Investment ii) Portfolio Investment iii) Financial Derivatives iv) Other Investment v) Reserve Assets. The above items, except for the Reserve Assets, are classified as follows on an asset/ liability basis; Direct Investment, according to direction of the investment; Portfolio Investment, according to sector and instrument; Financial Derivatives, according to sector; Other Investment, according to instrument, sector and maturity; Sectors are classified as; Monetary authority (Central Bank) General Government (Government and subordinate bodies, local administrations etc.) Banks (Public and private banks) Other sectors (Public and private enterprises and real persons)

Maturity is described as; short-term referring to a maturity of less than or equal to 1 year long-term referring to a maturity of more than 1 year

i) Direct investment Direct investment is the category of international investment that reflects the objective of a resident entity in one economy obtaining a lasting interest in an enterprise resident in another economy. Direct investment definition requires that direct investor should have an

ownership of 10 percent or more of the ordinary shares or the voting power in the management of an enterprise. Being recorded on a directional basis (residents direct investment abroad and nonresidents direct investment in the reporting economy), the major components of the direct investment item are Equity Capital, Reinvested Earnings, and Other Capital: Equity Capital refers to the investment of a direct investor for the establishment of a new enterprise outside the economy in which the investor is located or the acquisition of the share of ownership in an existing enterprise, Reinvested Earnings refers to direct investors share of earnings not distributed as dividends and added to the equity capital, Other Capital refers to investment associated with the borrowing and lending of funds between direct investors and their subsidiaries, branches and associates.

ii) Portfolio Investment The portfolio investment, which is briefly defined as investment on securities, generally includes equity securities and debt securities in the form of bills and bonds issued by public and private institutions as well as money market instruments. There are significant differences between direct investment and portfolio investment, the most important being the issue of management and control. In the case of direct investment, investors expect to have an effective voice in the management and control of the enterprise. However, portfolio investors provide funds for the resident enterprise from international capital markets without having an effective voice in management. Also in addition to the investment capital, direct investors may provide production technology and management skills to the direct investment enterprise. On the other hand, the portfolio investor provides only capital to the enterprise. The portfolio investment subitems, classified under assets and liabilities, are equity securities and debt securities. iii) Financial Derivatives Financial derivatives are financial instruments that are linked to an underlying asset that may be purchased or sold in their own right. Derivatives are conducted by binding contracts in which the terms of future transactions are determined at present. There are two main types of financial derivative contracts: forward-type and options-type. iv) Other Investment All the other financial transactions, not covered by direct investment, portfolio investment, financial derivatives and reserves are included in this category. Similar to the portfolio investment, it is classified on an asset/liability basis according to the type and institutional sector as follows: Trade credits (credits extended for exports or imports) Loans

Currency and deposits Other assets and liabilities.

v) Reserve Assets Reserve Assets include; Monetary Gold Special Drawing Rights (SDRs) Reserve Position in the Fund Foreign Exchange Holdings Other claims

Monetary Gold: Monetary gold refers to the gold owned by the monetary authority of the country. Special Drawing Rights (SDR): SDRs are international reserve assets created by the IMF to supplement other reserve assets that have been allocated to IMF members in proportion to their respective quotas. Reserve Position in the Fund: The members reserve positions in the IMF are the sum of members reserve tranche purchases that are readily repayable to them. The purchases from the Fund are recorded as an increase in foreign exchange holdings and a decrease in the reserve position. Foreign Exchange Holdings: Foreign exchange holdings cover monetary authorities claims on nonresidents in the forms of currency, bank deposits, securities, other bond and notes, money market instruments and claims arising from arrangements between central banks or governments. Other Claims: Other claims is a residual category including the items that are not classified above. For instance, reserve assets of banks that are subject to the control of the monetary authority are classified under this category. 3. Net Errors And Omissions The balance of payments is constructed as an accounting system, in which each transaction is recorded twice with two opposite signs (credit and debit entries). That is, the Current Account and the Capital and Financial Account should always be equal in absolute values since each transaction is recorded as credit and debit entries with equal values. In practice, however, this theoretical consequence occurs rarely. The collection of data from different sources leads to differences in valuation, measurement and time of recording; as a result, these differences are reflected in Net Errors and Omissions item as residual. Here are two examples: The physical movement of goods is recorded on the basis of customs documents, while records regarding the payments are provided from banks reports. The value of these records may differ causing unequal entries to the related items.

Assuming that the exported goods are invoiced as 100 units in custom documents, and 70 units of this total amount are deposited to the exporters account in a resident bank, while the remaining 30 units are kept in a deposit account abroad; the remaining 30 units is recorded under Net Errors and Omissions item since it will not be reflected in resident banks records. However, the change in resident nonbank sectors deposit accounts abroad is obtained from the Bank for International Settlements (BIS) statistics and reflected under the Other Investment/Assets/Currency and Deposits/Other Sectors item beginning with 2008 data. If the 100 units of tourism revenues or expenditures derived from survey results do not match with a corresponding 100 units increase or decrease in foreign currency holdings of the banks, the difference is reflected in Net Errors and Omissions item.

IMBALANCES
While the BOP has to balance overall, surpluses or deficits on its individual elements can lead to imbalances between countries. In general there is concern over deficits in the current account. Countries with deficits in their current accounts will build up increasing debt and/or see increased foreign ownership of their assets. The types of deficits that typically raise concern are: A visible trade deficit where a nation is importing more physical goods than it exports (even if this is balanced by the other components of the current account.) An overall current account deficit. A basic deficit which is the current account plus foreign direct investment (but excluding other elements of the capital account like short terms loans and the reserve account.)

BALANCE OF PAYMENT CRISIS

A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential imports and/or service its debt repayments. Typically, this is accompanied by a rapid decline in the value of the affected nation's currency. Crises are generally preceded by large capital inflows, which are associated at first with rapid economic growth. However a point is reached where overseas investors become concerned about the level of debt their inbound capital is generating, and decide to pull out their funds. The resulting outbound capital flows are associated with a rapid drop in the value of the affected nation's currency. This causes issues for firms of the affected nation who have received the inbound investments and loans, as the revenue of those firms is typically mostly derived domestically but their debts are often denominated in a reserve currency. Once the nation's government has exhausted its foreign reserves trying to support the value of the domestic currency, its policy options are very limited. It can raise its interest rates to try to prevent further declines in the value of its currency, but while this can help those with debts in denominated in foreign currencies, it generally further depresses the local economy.

BALANCING MECHANISM
One of the three fundamental functions of an international monetary system is to provide mechanisms to correct imbalances.

Broadly speaking, there are three possible methods to correct BOP imbalances, though in practice a mixture including some degree of at least the first two methods tends to be used. These methods are adjustments of exchange rates; adjustment of a nations internal prices along with its levels of demand; and rules based adjustment. Improving productivity and hence competitiveness can also help, as can increasing the desirability of exports through other means, though it is generally assumed a nation is always trying to develop and sell its products to the best of its abilities.

Rebalancing by changing the exchange rate

An upwards shift in the value of a nation's currency relative to others will make a nation's exports less competitive and make imports cheaper and so will tend to correct a current account surplus. It also tends to make investment flows into the capital account less attractive so will help with a surplus there too. Conversely a downward shift in the value of a nation's currency makes it more expensive for its citizens to buy imports and increases the competitiveness of their exports, thus helping to correct a deficit (though the solution often doesn't have a positive impact immediately due to the MarshallLerner condition). Exchange rates can be adjusted by government in a rules based or managed currency regime, and when left to float freely in the market they also tend to change in the direction that will restore balance. When a country is selling more than it imports, the demand for its currency will tend to increase as other countries ultimately need the selling country's currency to make payments for the exports. The extra demand tends to cause a rise of the currency's price relative to others. When a country is importing more than it exports, the supply of its own currency on the international market tends to increase as it tries to exchange it for foreign currency to pay for its imports, and this extra supply tends to cause the price to fall. BOP effects are not the only market influence on exchange rates however, they are also influenced by differences in national interest rates and by speculation.

Rebalancing by adjusting internal prices and demand

When exchange rates are fixed by a rigid gold standard, or when imbalances exist between members of a currency union such as the Eurozone, the standard approach to correct imbalances is by making changes to the domestic economy. To a large degree, the change is optional for the surplus country, but compulsory for the deficit country. In the case of a gold standard, the mechanism is largely automatic. When a country has a favourable trade balance, as a consequence of selling more than it buys it will experience a net inflow of gold. The natural effect of this will be to increase the money supply, which leads to inflation and an increase in prices, which then tends to make its goods less competitive and so will decrease its trade surplus. However the nation has the option of taking the gold out of economy (sterilising the inflationary effect) thus building up a hoard of gold and retaining its favourable balance of payments. On the other hand, if a country has an adverse BOP it will experience a net loss of gold, which will automatically have a deflationary effect, unless it chooses to leave the gold standard. Prices will be reduced, making its exports more competitive, and thus correcting the imbalance. While the gold standard is generally considered to have been successful up until 1914, correction by deflation to the degree required by the large imbalances that arose after WWI proved painful, with deflationary policies contributing to prolonged unemployment but not re-establishing balance. Apart from the US most former members had left the gold standard by the mid 1930s.

A possible method for surplus countries such as Germany to contribute to re-balancing efforts when exchange rate adjustment is not suitable, is to increase its level of internal demand (i.e. its spending on goods). While a current account surplus is commonly understood as the excess of earnings over spending, an alternative expression is that it is the excess of savings over investment. If a nation is earning more than it spends the net effect will be to build up savings, except to the extent that those savings are being used for investment. If consumers can be encouraged to spend more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if the corporate sector divert more of their profits to investment, then any current account surplus will tend to be reduced. However in 2009 Germany amended its constitution to prohibit running a deficit greater than 0.35% of its GDP and calls to reduce its surplus by increasing demand have not been welcome by officials, adding to fears that the 2010s will not be an easy decade for the eurozone. In their April 2010 world economic outlook report, the IMF presented a study showing how with the right choice of policy options governments can transition out of a sustained current account surplus with no negative effect on growth and with a positive impact on unemployment.

Rules based rebalancing mechanisms

Nations can agree to fix their exchange rates against each other, and then correct any imbalances that arise by rules based and negotiated exchange rate changes and other methods. The Bretton Woods system of fixed but adjustable exchange rates was an example of a rules based system, though it still relied primarily on the two traditional mechanisms. John Maynard Keynes, one of the architects of the Bretton Woods system had wanted additional rules to encourage surplus countries to share the burden of rebalancing, as he argued that they were in a stronger position to do so and as he regarded their surpluses as negative externalities imposed on the global economy. Keynes suggested that traditional balancing mechanisms should be supplemented by the threat of confiscation of a portion of excess revenue if the surplus country did not choose to spend it on additional imports. However his ideas were not accepted by the Americans at the time. In 2008 and 2009, American economist Paul Davidson had been promoting his revamped form of Keynes's plan as a possible solution to global imbalances which in his opinion would expand growth all round without the downside risk of other rebalancing methods.

REFERENCES
http://en.wikipedia.org http://www.investopedia.com http://www.rbi.org.in