Managerial Economics

Assignment on
Balance of payments

Submitted To : Mr. Puneet Mittal

Submitted By:

P.ThaneeshKumar

Roll no : 10231

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Table Of Contents

1 Introduction 3

2 Balance of payments deficit 4

3 Composition of the balance of payments sheet 5

4 Imbalances 6

5 Balance of payments crisis 7

6 Balancing Mechanisms 8

7 The balance of payments divided 11

8 Balance of payments deficit and surplus 15

9 Structure and characteristics of the current account 17

10 Structure and characteristics of the capital and financial account 21

11 References 27

Introduction

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 A balance of payments (BOP) sheet is 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, and financial capital,
as well as financial transfers. The BOP summarizes international transactions for a
specific period, usually a year, and is 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 a
negative or deficit item. When all components of the BOP sheet are included it must
balance – that is, it must sum to zero – there can be 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 counter balanced in other ways – such as by funds earned
from its foreign investments, by running down reserves or by receiving loans from other
countries. While the overall BOP sheet will always balance when all types of payments
are included, imbalances are possible on individual elements of the BOP, such as the
current account. This can result in surplus countries accumulating hoards of wealth, while
deficit nations become increasingly indebted. Historically there have been different
approaches to the question of how to correct imbalances and debate on whether they are
something governments should be concerned about. With record imbalances held up as
one of the contributing factors to the financial crisis of 2007–2010, plans to address
global imbalances have been high on the agenda of policy makers since 2009.

Every transaction that is made between a country and one of its trading
partners is recorded in the balance of payments. A country’s balance of payments is
composed of two separate accounts, the capital and current account. The current account
records transactions involving the import and export of goods and services in to and out
of a country. The capital account records transactions involving the inflow and outflow
of assets to and from a country. The balance of payments is the sum of these two
accounts, which, by definition, is zero. What this means is that for every entry (credit (+)
or debit (-)) on a country’s balance of payments sheet, there will be an offsetting entry in

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one of the two accounts. This method of recording transactions is known as “double-
entry bookkeeping”.

The current account is made up of several components. The first and most
significant component is the balance of merchandise trade, or the import and export
“visible” goods. The second entry on the current account balance is net trade in services,
which consists of trade in intangible commodities between countries. Service trade
includes tourist expenditures abroad, shipping and receiving expenses, and a variety of
other internationally tradable services. The third type of transaction recorded on the
current account balance is net investment income; this includes payments to foreign
investors and receipts from overseas investments in the form of profits, dividends and
interest payments. The last item recorded on the current account balance is net unilateral
transfers. A unilateral transfer includes the transfer of goods, services, or finances from
one country to another with no expectations of repayment to the donating country from
the beneficiary. Provision of foreign aid is the most easily recognized type of unilateral
transfer.

The capital account records transactions involving the purchase or sale of

assets and liabilities. When a country purchases a foreign asset (such as a private bank
deposit, stock in a company, or a government bond), or lends overseas, the transaction is
recorded as a capital outflow on the capital account. Similarly, when a country sells a
domestic asset to a foreign country, or borrows abroad, the transaction is recorded as a
capital inflow.

Balance Of Payments Deficit

A country is said to be running a balance of payments deficit when the non-
reserve portion of the capital account and the current account are not in balance. This
payments gap can be the result of excessive overseas investment, or a current account
deficit that is not financed entirely by non-reserve capital inflows. The latter of the two
types of balance of payments deficits is more common, particularly in the case of
developing countries. In order to finance a balance of payments deficit, a country’s
central bank must use its international reserves. Such payments are known as official
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reserve transactions, and involve the transfer of international reserves between central
banks.International reserve transfers are particularly important for two reasons: 1.) They
change a country’s money supply, thus effecting interest rates, exchange rates, and a host
of other economic factors; and 2.) in the case that a country is running a chronic balance
of payments deficit, the supply of international reserves can be depleted in its financing,
thus reducing the country’s capacity to fund imports and obtain credit. Both of these
factors can be particularly significant in the case of developing countries, whose reserve
positions tend to be smaller and more vulnerable to short term economic shocks.

Composition of the balance of payments sheet

Since 1974, the two principal divisions on the BOP have been the current account and the
capital account. The current account shows the net amount a country is earning if it is in
surplus, or spending if it is in deficit. It is the sum of the balance of trade (net earnings on
exports – payments for imports), factor income (earnings on foreign investments –
payments made to foreign investors) and cash transfers. Its called the current account as it
covers transactions in the "here and now" - those that don't give rise to future claims. The
capital account records the net change in ownership of foreign assets. It includes the
reserve account (the international operations of a nation's central bank), along with loans
and investments between the country and the rest of world (but not the future regular
repayments / dividends that the loans and investments yield, those are earnings and will
be recorded in the current account). Expressed with the standard meaning for the capital
account, the BOP identity is:

The balancing item is simply an amount that accounts for any statistical errors and
assures that the current and capital accounts sum to zero. At high level, by the principles
of double entry accounting, an entry in the current account gives rise to an entry in the
capital account, and in aggregate the two accounts should balance. A balance isn't always
reflected in reported figures, which might, for example, report a surplus for both
accounts, but when this happens it always means something has been missed—most

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commonly, the operations of the country's central bank. An actual balance sheet will
typically have numerous sub headings under the principal divisions. For example, entries
under Current account might include:

• Trade – buying and selling of goods and services

• Exports – a credit entry
• Imports – a debit entry
• Trade balance – the sum of Exports and Imports
• Factor income – repayments and dividends from loans and investments
• Factor earnings – a credit entry
• Factor payments – a debit entry
• Factor income balance – the sum of earnings and payments.

Especially in older balance sheets, a common division was between visible and invisible
entries. Visible trade recorded imports and exports of physical goods (entries for trade in
physical goods excluding services is now often called the merchandise balance). Invisible
trade would record international buying and selling of services, and sometimes would be
grouped with transfer and factor income as invisible earnings.

Imbalances
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.)

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Causes of BOP imbalances

There are conflicting views as to the primary cause of BOP imbalances, with much
attention on the US which currently has by far the biggest deficit. The conventional view
is that current account factors are the primary cause these include the exchange rate, the
government's fiscal deficit, business competitiveness , and private behaviour such as the
willingness of consumers to go into debt to finance extra consumption. An alternative
view, argued at length in a 2005 paper by Ben Bernanke , is that the primary driver is the
capital account, where a global savings glut caused by savers in surplus countries, runs
ahead of the available investment opportunities, and is pushed into the US resulting in
excess consumption and asset price inflation.

Balance of payments 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 mechanisms

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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 Marshall–Lerner
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

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When exchange rates are fixed by a rigid gold standard, or when imbalances exist
between members of a currency union such as the Euro zone, 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 (sterilizing 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 its 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. That is:

where CA = current account, NS = national savings (private plus government sector), NI

= national 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
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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 euro zone. 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. 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 with out the downside risk of other rebalancing methods. History of
balance of payments issues historically, accurate balance of payments figures were not
generally available. However, this did not prevent a number of switches in opinion on
questions relating to whether or not a nations government should use policy to encourage
a favourable balance.

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The Balance of Payments Divided

The BOP is divided into three main categories: the current account, the capital account
and the financial account. Within these three categories are sub-divisions, each of which
accounts for a different type of international monetary transaction.

The Current Account

The current account is used to mark the inflow and outflow of goods and services into a
country. Earnings on investments, both public and private, are also put into the current
account. Within the current account are credits and debits on the trade of merchandise,
which includes goods such as raw materials and manufactured goods that are bought, sold
or given away (possibly in the form of aid). Services refer to receipts from tourism,
transportation (like the levy that must be paid in Egypt when a ship passes through the
Suez Canal), engineering, business service fees (from lawyers or management consulting,
for example), and royalties from patents and copyrights. When combined, goods and
services together make up a country's balance of trade (BOT). The BOT is typically the
biggest bulk of a country's balance of payments as it makes up total imports and exports.
If a country has a balance of trade deficit, it imports more than it exports, and if it has a
balance of trade surplus, it exports more than it imports. Receipts from income-
generating assets such as stocks (in the form of dividends) are also recorded in the current
account. The last component of the current account is unilateral transfers. These are
credits that are mostly worker's remittances, which are salaries sent back into the home
country of a national working abroad, as well as foreign aid that is directly received.

The Capital Account

The capital account is where all international capital transfers are recorded. This refers to
the acquisition or disposal of non-financial assets (for example, a physical asset such as
land) and non-produced assets, which are needed for production but have not been
produced, like a mine used for the extraction of diamonds. The capital account is broken

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down into the monetary flows branching from debt forgiveness, the transfer of goods, and
financial assets by migrants leaving or entering a country, the transfer of ownership on
fixed assets (assets such as equipment used in the production process to generate
income), the transfer of funds received to the sale or acquisition of fixed assets, gift and
inheritance taxes, death levies, and, finally, uninsured damage to fixed assets.

The Financial Account

In the financial account, international monetary flows related to investment in business,
real estate, bonds and stocks are documented. Also included are government-owned
assets such as foreign reserves, gold, special drawing rights (SDRs) held with the
International Monetary Fund, private assets held abroad, and direct foreign investment.
Assets owned by foreigners, private and official, are also recorded in the financial
account.

The Balancing Act

The current account should be balanced against the combined-capital and financial
accounts. However, as mentioned above, this rarely happens. We should also note that,
with fluctuating exchange rates, the change in the value of money can add to BOP
discrepancies. When there is a deficit in the current account, which is a balance of trade
deficit, the difference can be borrowed or funded by the capital account. If a country has
a fixed asset abroad, this borrowed amount is marked as a capital account outflow.
However, the sale of that fixed asset would be considered a current account inflow
(earnings from investments). The current account deficit would thus be funded. When a
country has a current account deficit that is financed by the capital account, the country is
actually foregoing capital assets for more goods and services. If a country is borrowing
money to fund its current account deficit, this would appear as an inflow of foreign
capital in the BOP.

Liberalizing the Accounts

The rise of global financial transactions and trade in the late-20th century spurred BOP

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and macroeconomic liberalization in many developing nations. With the advent of the
emerging market economic boom - in which capital flows into these markets tripled from
USD 50 million to USD 150 million from the late 1980s until the Asian crisis -
developing countries were urged to lift restrictions on capital and financial-account
transactions in order to take advantage of these capital inflows. Many of these countries
had restrictive macroeconomic policies, by which regulations prevented foreign
ownership of financial and non-financial assets. The regulations also limited the transfer
of funds abroad. But with capital and financial account liberalization, capital markets
began to grow, not only allowing a more transparent and sophisticated market for
investors, but also giving rise to foreign direct investment. For example, investments in
the form of a new power station would bring a country greater exposure to new
technologies and efficiency, eventually increasing the nation's overall gross domestic
product by allowing for greater volumes of production. Liberalization can also facilitate
less risk by allowing greater diversification in various markets

The Current Account

When a trade deficit or surplus is reported, this is usually the account that is being
referred to. It is an indication of the desirability of a country's products and services by
the rest of the world, and therefore, its competitiveness in the world marketplace. The
current account is composed of 4 sub-accounts:

1. Merchandise trade consists of all raw materials and manufactured goods bought,
sold, or given away. Until mid-1993, this was the figure that was used when the
balance of trade was reported in the media. Since then, the merchandise trade
account has been combined with a second sub-account, services, to determine the
total for the balance of trade.
2. Services include tourism, transportation, engineering, and business services, such
as law, management consulting, and accounting. Fees from patents and copyrights
on new technology, software, books, and movies also are recorded in the service
category. Most outsourcing of labor is a debit to the services account.

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 3. Income receipts include income derived from ownership of assets, such as
dividends on holdings of stock and interest on securities.
4. Unilateral transfers represent one-way transfers of assets, such as worker
remittances from abroad and direct foreign aid. In the case of aid or gifts, a debit
is assigned to the capital account of the donor nation.

The amount of goods and services imported compared to the amount exported is known
as the balance of trade. A trade surplus exists when exports exceeds imports over a
measured period and a trade deficit exists when imports exceeds exports.

The Capital Account

The capital account is equal to capital transfers, and the sale of natural and intangible
assets to foreigners minus the capital transfers, and the purchase of foreign natural and
intangible assets by U.S. residents.

1. Capital transfers include debt forgiveness and migrants’ transfers (goods and
financial assets accompanying migrants as they leave or enter the country). In
addition, capital transfers include the transfer of title to fixed assets and the
transfer of funds linked to the sale or acquisition of fixed assets, gift and
inheritance taxes, death duties, uninsured damage to fixed assets, and legacies.
2. Acquisition and disposal of non-produced, non-financial assets represent the
sales and purchases of non-produced assets, such as the rights to natural
resources, and the sales and purchases of intangible assets, such as patents,
copyrights, trademarks, franchises, and leases.

The Financial Account

The financial account, a subdivision of the capital account, consists of 2 categories,

which lists trade in assets such as business firms, bonds, stocks, and real estate:

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 1. U.S.-owned assets abroad are divided into official reserve assets, government
assets, and private assets. These assets include gold, foreign currencies, foreign
securities, reserve position in the International Monetary Fund, U.S. credits and
other long-term assets, direct foreign investment, and U.S. claims reported by
U.S. banks.
2. Foreign-owned assets in the United States are divided into foreign official
assets and other foreign assets in the United States. These assets include U.S.
government, agency, and corporate securities, direct investment, U.S. currency,
and U.S. liabilities reported by U.S. banks.

Balance of Payments Deficit and Surplus

The current account should balance with the capital account, because every transaction is
recorded as both a credit and a debit (double-entry accounting), and since credits must
equal debits and the balance of payments is equal to credits minus debits, the sum of the
balance of payments statements should be zero. For practical reasons, however, it
deviates slightly from zero.

BOP = Current Account + Capital Account = Credits - Debits ≈ 0

For example, when the United States buys more goods and services than it sells—a
current account deficit—it must finance the difference by borrowing, or by selling more
capital assets than it buys—a capital account surplus. A country with a persistent current
account deficit is, therefore, effectively exchanging capital assets for goods and services.
Large trade deficits mean that the country is borrowing from abroad or selling assets to
foreigners. In the balance of payments, this appears as an inflow of foreign capital. In
reality, the accounts do not exactly offset each other, because of statistical discrepancies,
accounting conventions, and exchange rate movements that change the recorded value of
transactions. However, the specific accounts can, and almost always do, have surpluses
and deficits. Surpluses in 1 account are counterbalanced by deficits in the other.

Structure and Classification

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The standard components of both sets of accounts and contains discussions and
elaboration of the current account, the capital and financial account, selected
supplementary information, and the international investment position . Balance of
payments statistics must be arranged within a coherent structure to facilitate their
utilization and adaptation for multiple purposes—policy formulation, analytical studies,
projections, bilateral comparisons of particular components or total transactions, regional
and global aggregations, etc. The structure and classification of balance of payments
standard components reflect conceptual and practical considerations, take into account
views expressed by national balance of payments experts, and are in general concordance
with the SNA and with harmonization of the expanded classification of international
transactions in services with the Central Product Classification (CPC). The classification
system also reflects efforts to link the structure of the financial account to that of the
income accounts and that of the international investment position. The scheme is
designed as a flexible framework to be used by many countries in the long-term
development of external statistics. Some countries may not be able to provide data for
many items; other countries may be able to provide additional data.
Furthermore, several components may be available only in combination, or a minor
component may be grouped with one that is more significant. The standard components
should nevertheless be reported to the IMF as completely and accurately as possible.
National compilers are in better positions than IMF staff to make estimates and
adjustments for components that do not exactly correspond to the basic series of the
compiling economy.

Net Errors and Omissions

Application of the principles presented in this Manual should result in a consistent body
of positive and negative entries with a net (conceptual) total of zero. In practice, however,
when all actual entries are totaled, the resulting balance will almost inevitably show a net
credit or a net debit. That balance is the result of errors and omissions in the compilation

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of statements. Some errors and omissions may be related to recommendations for
practical applications approximating principles. In balance of payments statements, the
standard practice is to show a separate item for net errors and omissions. Labeled by
some compilers as a balancing item or statistical discrepancy, that item is intended as an
offset to the overstatement or understatement of their corded components. Thus, if the
balance of those components is a credit, the item for net errors and omissions will be
shown as a debit of equal value, and vice versa. Sometimes the errors and omissions that
occur in the course of compilation offset one another. Therefore, the size of the residual
item does not necessarily provide any indication of the overall accuracy of the statement.
Nonetheless, interpretation of the statement is hampered by a large net residual.

Structure and Characteristics of the Current Account

It does not cover the carriage, within an economy, of nonresident passengers by resident
carriers.) There is a close interrelationship between freight services and goods and, in
some instances; such services may not be subject to clear distinctions from goods. There
may be analytical interest in both separate and inclusive treatment of the two for purposes
of various domestic and international comparisons. Passenger transportation is closely
linked with travel, in which some related services are included. Transportation subsumes,
with the exception of freight insurance, the shipment and other transportation items as
presented in the fourth edition of the Manual. Freight insurance is now included with
insurance services. The new grouping should facilitate international comparisons and is
in accord with other statistical systems. Travel differs from other components of services
in that it is a demand-oriented activity. The traveler (consumer) moves to the location of
the economy that provides the goods and services desired. Travel is subdivided into two
major components: business and personal. Treated as part of a residual item in the fourth
edition of the Manual, other services are accorded increased prominence in the fifth
edition. Both the structure and classification of the specific other services are related to
the importance attached to these items by international bodies [e.g. in the General
Agreement on Tariffs and Trade (GATT) ] as a basis for negotiations and by analysts

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involved with domestic and international aspects of trade, production, and related issues.
Although the significance of these services varies widely in the international accounts of
countries, the structure provides a ready reference for items likely to assume increasing
importance in international transactions.
Income comprises compensation of employees and investment income (covering direct
investment income and other dividends and interest). This treatment of income as a
separate component of the current account accords with that in the SNA; tightens the
links between income and financial account flows and between the balance of payments
and the international investment position; and increases the analytical usefulness of the
international accounts.
Current transfers are grouped separately from goods, services, and income because the
former are generally conceived as showing distinctive characteristics. The distinction
between real resources and transfers, however, may sometimes be rather arbitrary. For
example, receipts by an economy from certain individuals working abroad are classified
either as current transfers or as compensation of employees; the classification depends on
how long the individuals have stayed in the countries where they are working. The
Manual and the SNA define a current transfer in the same way, and the disaggregation of
transfers into current transfers and capital transfers—a departure from previous editions
—aligns with SNA treatment and with various analytical presentations. This change
removes inconsistencies in the use and meaning of the term current as it concerns
transactions and balancing items in the Manual and the SNA.

Gross Recording, Valuation, and Time of Recording

In the current account, gross outflows from and gross inflows to the economy should, in
principle, be recorded as credits and debits, respectively. Individual components are
defined in such a way that entries would be made on a gross basis. This emphasis on
gross recording in the current account stems from the fact that credit and debit entries for
many specific types of current transactions are seldom related in a causal way. For
example, even though provision and acquisition of travel services are included in the
single component for travel, provision of travel services has, from an economic

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standpoint, little connection with the acquisition by the same economy of such services.
Moreover, gross figures are utilized in contexts other than the analysis of balance of
payments developments. In general, gross transactions recorded in the current account are
often indicators of the relative importance of particular items within an economy and of
the relative importance of various economies in international transactions. Gross
transactions recorded in the current account are therefore used to compare economies and
to provide weights for aggregation. Also, gross figures provide a better basis for analysis
of changes in net balances. Two specific applications important for the IMF represent the
use of gross figures: (i) Valuation of the SDR is based on a basket of currencies selected
in consideration of the issuing countries’ shares in world exports of goods and services
and weighted in broad proportion to those shares. (ii) The relative size of an IMF
member’s gross transactions in the current account is one factor used to determine the
relative quota of a Fund member.

STRUCTURE AND CLASSIFICATION

Exceptions to the general rule of gross recording are sometimes made because of the
practical difficulty of collecting certain information on a gross basis (e.g., some
transportation services) or because of netting procedures used to derive certain estimates.
Nonetheless, gross recording remains the principle for recording transactions in the
current account and, in general, is more useful than net recording for balance of payments
accounts of the SNA external accumulation accounts. However, in the balance of
payments, the primary basis for classification of the financial account is functional
category (i.e., direct investment, portfolio investment, other investment, and reserve
assets) while the SNA classification is primarily by type of instrument: monetary gold,
currency and deposits, loans, etc. The structure of the capital and financial account also is
generally compatible with other statistical systems of the IMF and is consistent with the
classification of related income components of the current account and with the
international investment position. The capital and financial account of the balance of
payments is divided into two main categories: the capital account and the financial
account. The capital account covers all transactions that involve the receipt or payment of

19
capital transfers and acquisition or disposal of non produced, nonfinancial assets. The
financial account covers all transactions associated with changes of ownership in the
foreign financial assets and liabilities of an economy. Such changes include the creation
and liquidation of claims on, or by, the rest of the world. All changes that do not reflect
transactions are excluded from the capital and financial account. The following changes
are among those specifically excluded: valuation changes in, or reclassifications of,
reserves; changes resulting from territorial or other changes in classification of existing
assets (for example, portfolio investment to direct investment); allocation or cancellation
of SDRs; monetization or demonetization of gold; write-offs (that is, changes resulting
from the unwillingness or inability of a debtor who resides in one economy to make full
or partial repayment including expropriation without compensation—in settlement of a
claim to a creditor who resides in another economy and regards part or all of the claim as
unrecoverable); and valuation changes, which reflect exchange rate or price changes, in
assets for which there are no changes in ownership. When there is a change in ownership
and an asset acquired at one price is disposed of at a different price, both assets are
recorded at respective market values and the difference in value—holding (capital) gain
or loss—is included in the balance of payments.

Capital Account

The capital account consists of two categories: (i) capital transfers and (ii) acquisition or
disposal of non produced, nonfinancial assets. In previous editions of the Manual, capital
transfers were included indistinguishably with current transfers in the current account.
Capital transfers are classified primarily by sector (i.e., general government and other
sectors). Within each, debt forgiveness is specified as category while migrants’ transfers
comprise a category under other sectors. In concept, acquisition or disposal of non
produced, nonfinancial assets comprises transactions associated with tangible assets that
may be used or necessary for production of goods and services but are not actually
produced (e.g., land and subsoil assets) and transactions associated with non produced,
intangible assets (e.g., patents, copyrights, trademarks, franchises, etc. and leases or other
transferable contracts). However, in the case of resident-nonresident transactions in land

20
(including subsoil assets), all acquisition or disposal is deemed to occur between resident
units, and the nonresident acquires a financial claim on a notional resident unit. The only
exception concerns land purchased or sold by a foreign embassy when the purchase or
sale involves a shift of the land

Structure and Characteristics of the Capital and Financial

Account

From one economic territory to another. In such instances, a transaction in land between
residents and nonresidents is recorded under acquisition or disposal of non produced,
nonfinancial assets. The changes recorded for all of the assets described in this paragraph
consist of the total values of assets acquired during the accounting period by residents of
the reporting economy less the total values of the assets disposed of by residents to
nonresidents.

Financial Account

The foreign financial assets of an economy consist of holdings of monetary gold, SDRs,
and claims on nonresidents. The foreign liabilities of an economy consist of indebtedness
to nonresidents. To determine whether financial items constitute claims on, or liabilities
to, nonresidents, the creditor and debtor must be identified as residents of different
economies. The unit in which the claim or liability is denominated—whether the national
currency, a foreign currency, or a unit such as the SDR—is not relevant. Furthermore,
assets must represent actual claims that are legally in existence. The authorization,
commitment, or extension of an unutilized line of credit or the incurrence of a contingent
obligation does not establish such a claim, and the pledging or setting aside of an asset
(as in a sinking fund) does not settle a claim or alter the ownership of the asset. However,
options and other financial derivatives are included among financial items, in accordance
with the treatment of these items in the SNA. These instruments can be valued by
reference to the market prices of the derivatives or to the market prices of the

21
commitments underlying the derivatives. Thus, both parties to a derivative contract
recognize a financial instrument; one party recognizes a liability and the other recognizes
a claim. Alternatively, this value could be viewed as the amount that one party must pay
to the other party in order to extinguish the contract. As a result, derivatives satisfy the
definition of foreign financial assets and liabilities.
The conventions stated in this Manual result in ownership of some nonfinancial assets
being construed as ownership of financial assets (claims). The following specific cases
are examples. The ownership of immovable assets, such as land and structures, is always
attributed to residents of the economies in which the assets are located. Therefore, when
the owner of such assets is a nonresident, he has, in effect, a financial claim on a resident
entity that is considered the owner. An unincorporated enterprise operating in a different
economy from the one in which the owner of the enterprise resides is considered a
separate entity; that entity is a resident of the economy in which it operates rather than a
resident of the economy of the owner. All nonfinancial as well as financial assets
attributed to such an enterprise are regarded as foreign financial assets for the owner of
the enterprise. Any goods transferred under a financial leasing arrangement are presumed
to have changed ownership. This change in ownership is financed by a financial claim
(i.e., an asset of the lessor and a liability of the lessee). At the time the imputed change in
ownership occurs, the market value of the good is recorded under goods in the current
account, and an offsetting entry is made in the financial account. In subsequent periods,
the actual leasing payment must be divided into interest, which is recorded in the current
account as investment income payable or receivable, and debt repayment, which is
recorded in the financial account and reduces the value of the lessor‘s asset and the
lessee’s liability. The financial asset should be classified as a loan.
Transactions in assets Transactions in assets (specifically, changes of ownership,
including the creation and liquidation of claims) most often reflect exchanges of
economic values. Financial items may be exchanged for other financial items or for real
resources. However, one party to a transaction may provide a financial item and not
receive any economic value in exchange. The offset to this latter type of provision of an
asset is a transfer. To establish whether a transaction involving a foreign asset is a
transaction between a resident and a nonresident, the compiler must know the identities

22
of both parties. The information available on transferable claims constituting foreign
assets may not, however, permit identification of the two parties to the transaction.

STRUCTURE AND CLASSIFICATION

Ascertain whether a resident, who acquired or relinquished a transferable claim on a

nonresident, conducted the transaction with another resident or with a nonresident, or
whether a nonresident dealt with another nonresident or with a resident. Thus, a
recommendation that the balance of payments be confined solely to asset transactions
between residents and nonresidents would be difficult or impossible to implement. Also,
the introduction, in this Manual, of a domestic sect oral breakdown for the portfolio
investment and other investment components of the financial account makes it necessary
to record certain transactions between resident sectors within the economy—although
such transactions cancel each other for the total economy. As a result, recorded
transactions may include not only those that involve assets and liabilities and take place
between residents and nonresidents but also those that involve transferable assets of
economies and take place between two residents and, to a lesser extent, transactions that
take place between non residents. Because the credit and debit entries for most
components of the financial account are according to the rules of this Manual generally
net, many transactions between residents and between nonresidents will offset each other
and thus will not actually appear as entries in the balance of payments statement. The
most prevalent types of transactions that do not cancel each other are, for assets, those
transactions between resident creditors classified in different functional categories or
domestic sectors. For liabilities, the identity of the nonresident creditor is a factor only in
a few instances (for example, in differentiating between direct investment and other types
of capital and in determining regional allocation). Net recording can also result in a
transaction between a resident and a nonresident being offset by a transaction between
residents or by a transaction between nonresidents. For instance, a resident may acquire a
claim against a nonresident and, during the same recording period, transfer the claim to
another resident classified in a different sector. The first resident’s transaction with a
nonresident is canceled by the same resident’s subsequent transaction with another
resident (if the value of the claim does not change). So, in the balance of payments, only

23
the increase in the second resident’s holdings, which are actually acquired through a
transaction with the first resident, are recorded. The effect is the same as if the second
resident dealt directly with the nonresident.

Reinvested earnings
The reinvested earnings of a direct investment enterprise (which accrue to a direct
investor in proportion to participation in the equity of the enterprise) are recorded in the
current account of the balance of payments as being paid to the direct investor as
investment income-income on equity and in the financial account as being reinvested in
the enterprise. Thus, these reinvested earnings increase the value of the stock of foreign
assets of the direct investor’s economy. In a similar way, the distribution to direct
investors of earnings (in the form of stock dividends) included in investment income-
income on equity results in an increase, shown in the financial account, in the investors’
equity.
Borderline cases
In some cases, questions may arise as to whether transactions have taken place; for
example—when the maturity of a debt instrument is extended (and thereby changed from
a nominally short-term claim to a nominally long-term claim) or when a government
takes over an obligation for liabilities incurred by the private sector and the sector of the
domestic debtor is altered. As a change in the original terms of a contract requires the
assent of both parties, the existing claim is considered to be satisfied by the creation of a
new one. (That is, a pair of transactions between a resident and a nonresident has
occurred.) Changes in contractual terms for existing assets are thus construed as
constituting transactions to be included in the balance of payments statement. Another
borderline case arises when a transactor intends to dispose of a certain asset at virtually
the same moment that ownership of the asset is acquired. (Examples are arbitrage and
certain other dealings in financial assets.) The issue may be viewed two ways. (i) If two
changes of asset ownership have occurred, any profit or loss could be regarded as the
realization of a holding (capital) gain or loss and could be entered, like any other
realization of a holding gain or loss, in the appropriate component of the financial
account. (ii) If no change of ownership has effectively taken place, the profit or loss

24
could be seen as a fee for a service. It is recommended that the treatment described in (i)
be used because entries in the financial account may reflect, without regard to the fact
that some items may have been owned only briefly, the holding gain or loss realized on
the purchase and sale of financial items at different market prices.
Net recording
Two or more changes in a specific asset, or changes in two or more different assets
classified in the same standard component, are consolidated in a single entry. This entry
reflects the net effect of all the increases and decreases that occur during the recording
period in holdings of that type of asset. For example, purchases (by nonresidents) of
securities issued by resident enterprises of an economy are consolidated with sales (by
nonresidents) of such securities, and the net change is recorded for that item. Net
decreases in claims or other assets and net increases in liabilities are recorded as credits;
net increases in assets and net decreases in liabilities are recorded as debits. Net recording
for standard components distinguished in the capital and financial account is specified
partly because gross data for transactions often are not available. Changes derived from
records showing amounts outstanding at the beginnings and ends of reporting periods, for
example, always represent net changes. In addition, net recording generally is of more
interest than gross recording, which would give added prominence to the transactions—
between residents and between nonresidents—that are covered in the statement.
Nonetheless, gross entries may be a relevant factor in analyzing aspects of the payments
positions or financial markets (e.g., securities transactions) of economies, and such data
can be utilized in supplementary presentations when appropriate. For direct investment,
particularly for reasons of analytic usefulness, it is suggested in this Manual that separate
totals for liabilities to, and claims on, direct investors on the part of affiliated enterprises
(and vice versa) be recorded for the appropriate components of direct investment (i.e.,
equity capital and other capital) in addition to the net figures for each. In the totaling of
net credits and debits for two or more separate components, the net approach is always
favored. For instance, if equity securities and debt securities are combined to show a net
figure for these two components, the net for each should be totaled not net credits and
debits separately.

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Classification
The primary purpose of the classification of items in the financial account is to facilitate
analysis by distinguishing categories that exhibit different patterns of behavior. Changes
in financial items recorded in the balance of payments occur for a wide variety of
reasons. Such changes may occur to settle actual imbalances or to deal with prospective
imbalances; to influence or react to exchange rate movements; to make holding (capital)
gains (or avoid losses) on past or future valuation changes, including those resulting from
exchange rate changes; to take advantage of interest rate differentials; to establish,
acquire, or expand enterprises; to obtain or provide additional real resources in
connection with commercial and financial activities; and to diversify investments. In the
collection of data, it is usually not feasible to inquire into the underlying causes and
motivations for changes in holdings. However, behavior is also associated to a
considerable degree with such attributes as type of asset and sector of holder.
Characteristics of this kind are readily observable and can thus be used as a basis for
developing a classification scheme. In this Manual, several bases are utilized for
classifying financial items: functional type; assets and liabilities; type of instrument;
domestic sector; original contractual maturity; and, in the case of direct investment,
direction of investment (i.e., inward or outward). The primary basis for the classification
of components of the financial account is functional type. Further classification levels in
these categories are based upon factors relating to general analytical usefulness and
compatibility with other statistical systems. The components can, of course, be
rearranged to meet specific analytic requirements and to include, when appropriate,
subordinate and supplementary classification.

References

• Economics 8th Edition by David Begg, Stanley Fischer and Rudiger Dornbusch,
McGraw-Hill

26
 • Economics Third Edition by Alain Anderton, Causeway Press
• Business Environment - Shaikh Saleem

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