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BSc Financial Economics International
Finance Professor Anne Sibert
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International Finance
Lecture 1 Balance of Payments Accounting
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Learning Objectives

• To be able to explain the main and sub-accounts
  of the balance of payments and their relationship
  to each other.
• To understand the principles of double-entry
  bookkeeping.
• To be able to record transactions and present a
  balance of payments table.
• To understand the relationship between the
  balance of payments and a nations budget
  constraint.
• To understand the relationship between the
  balance of payments and the national income
  accounts.

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Definition The balance of payments is a record
of transactions between residents of a country
and residents of the rest of the world.

• The balance of payments is use to
• project exchange rates
• assess the health of the economy
• assess the credit worthiness of an economy

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Balance of payments accounting is based on the
principles of double-entry bookkeeping each
transaction is recorded twice, once as a debit
and once as a credit.
Definition. Assets are economic resources which
are expected to benefit future activities. Definit
ion. Liabilities are outsiders claims against
assets. Definition. Credit this means
right. Definition. Debit this means left.
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Georges Shoe Store
Account Name This account records
Inventory The purchase and sale of shoes
Accounts Payable Debts incurred and paid
Cash Cash acquired and disbursed
Accounts Receivable Loans made and repaid
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ASSET ACCOUNTS LIABILITY ACCOUNTS
Left-hand balances Right-hand balances
Increased by entries on the left Increased by entries on the right
Decreased by entries on the right Decreased by entries on the left
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George sells 500 of shoes. Payment is due in 30
days.
INVENTORY INVENTORY
Increases Decreases (1) 500

ACCOUNTS RECEIVABLE ACCOUNTS RECEIVABLE
Increases (1) 500 Decreases

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In 30 days, George receives payment in cash.
ACCOUNTS RECEIVABLE ACCOUNTS RECEIVABLE
Increases (1) 500 Decreases (2) 500

CASH CASH
Increases (2) 500 Decreases

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George buys new inventory for 800. Payment is
due in 30 days.
INVENTORY INVENTORY
Increases (3) 800 Decreases (1) 500

ACCOUNTS PAYABLE ACCOUNTS PAYABLE
Decreases Increases (3) 800

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Recalling our previous definitions, we now have
DEBITS CREDITS
Left-hand side entries Right-hand side entries
Increases in assets Decreases in assets
Decreases in liabilities Increases in liabilities
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Thus, we have

• Debit accounts receivable 500 Credit inventory
  500
• Debit cash 500 Credit Accounts Receivable 500
• Debit inventory 800 Credit Accounts Payable
  800
• Credits are entered as positive numbers Debits
  are entered as negative numbers.

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Georges Shoe Store
Inventory -300
Accounts Receivable 0
Cash -500
Accounts Payable 800
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A nations balance of payments is a record of
transactions between residents of that nation and
residents of the rest of the world.

• We are talking about residents not citizens.
  Tourists, military and diplomatic personnel and
  temporary migrants are not residents. A permanent
  migrant is a resident, even if not a citizen.

• Example A subsidiary of a Korean automobile firm
  located in the UK sells cars to Korea. This is a
  UK export and a Korean import.

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A Countrys Budget Constraint

• Net sales of goods and services Net Interest
  income Net gifts received from foreigners
  Change in home holdings of foreign assets
  Change in foreign holdings of home assets
• The left-hand side change in net worth
• The right-hand side change in asset holdings

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Current Account

• The Current Account is a record of transactions
  affecting the left-hand side of the budget
  constraint.
• It is a measure of the change in a countrys net
  worth.
• It is a record of trade in goods in services
  (including the services of capital and labour)
  and gifts.

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Current Account

• Merchandise Trade
• Services
• Income
• Current Transfers

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Merchandise Trade

• This is trade in physical goods such as computers
  and automobiles.
• It is often broken down into
• Merchandise exports
• Merchandise imports

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Services

• This is trade in invisible or intangible goods.
• Examples are shipping, travel, communications,
  financial services, insurance, tourism
• The sum of merchandise trade and services is
  called the trade balance

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Current Transfers

• These are one-sided transactions such as
  government grants, pension payments, and private
  gifts.

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The Capital Account

• A complication arose because debt forgiveness was
  distorting balance of payments numbers.
• It was decided to include only gifts that would
  be consumed within a year in the current account
  and to make up a new account called the Capital
  Account that would include long-term gifts such
  as debt forgiveness.
• Thus, the left-hand side of the budget constraint
  should actually be the Current Account plus the
  Capital Account.
• The Capital Account is unimportant for the UK or
  the US.

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Is this an increase or a decrease in an asset? Is this a debit or a credit? Is it entered as a positive or a negative number
A country buys a good or a service Increase (it has more goods and services) Debit Negative
A country sells a good or a service Decrease (it has fewer goods and services) Credit Positive
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Thus we have Exports Credits Positive
Entry Imports Debits Negative Entry A
positive balance on the current account means
that a country sold more than it bought A
negative balance on the current account means
that a country bought more than it sold
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The UK Current Account 2006
In millions, Pink Book
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G-7 Current Accounts as a Share of GDP 2007
Source IMF estimate
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Current Account Deficit as a Share of GDP
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The Financial Account

• This is the right-hand side of the governments
  budget constraint.
• The financial account is a record of capital
  flows between residents of a country and the rest
  of the world.

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• One way to break down capital flows is by the
  type of transaction.
• There are two main types of capital flows
• Direct investment When residents of a country
  acquire shares in a foreign business with the
  intent of exercising management control. This is
  typically defined as purchasing 10 percent of a
  firms stock.
• Portfolio investment Investment without the
  intention of exercising management control.
• Portfolio investment used to be further broken
  down between short- and long-term flows. But,
  secondary markets exist for many long-term
  financial assets and this has become increasingly
  meaningless. Once can also break it down between
  foreign claims on the home country and home
  claims on foreigners.

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Home purchase of a foreign asset Capital outflow Increase in an asset Debit Negative entry
Foreign sale of a home asset Capital outflow Decrease in a liability Debit Negative entry
Home sale of a foreign asset Capital inflow Decrease in an asset Credit Positive entry
Foreign purchase of a home asset Capital inflow Increase in a liability Credit Positive entry
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Reserve Account

• A special sub-account of the financial account is
  the reserve account.
• The reserve account is a record of changes in the
  home countrys official (government) assets.
• When fixed exchange rates were more prevalent
  this used to be separate from the financial
  account.

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Foreign Reserves

• For most countries the most important component
  is their foreign exchange reserves. This is the
  foreign currency held by the central bank.
• When a central bank intervenes in the exchange
  market to influence the value of its currency it
  uses its foreign exchange reserves.

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The central bank buys foreign exchange This is an increase in an asset debt Negative entry
The central bank sells foreign exchange This is a decrease in an asset credit Positive entry
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Reserve Account Balance

• Negative balance (debit, increase in an asset)
  Reserves rose.
• Positive balance (credit, decrease in an asset)
  Reserves fell.
• Another definition of the balance of payments is
  minus one times the reserve account balance.
• A positive (negative) balance of payments
  reserves rose (fell)

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Errors and Omissions

• Each transaction is entered once as a debit and
  once as a credit that is, once as a positive
  number and once as the same negative number.
• So, all of the transactions should sum to zero.
• In practice, it does not work out that way.

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Errors and Omissions

• Data on merchandise trade comes from customs
  declarations.
• Trade in services is typically estimated by
  various sampling techniques errors can be
  substantial.
• Reporting of capital flows and investment income
  is highly imperfect people try to hide these to
  evade taxes.
• The Statistical Discrepancy or Errors and
  Omissions is the amount we need to add or
  subtract to make things add up to zero.

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Balance of Payments Current Account Merchandise
Trade Exports Imports Services Income Curre
nt Transfers Capital Account Financial
Account Direct Investment Portfolio
Investment Home claims on Foreigners Foreign
Claims on the Home Country Reserves Errors and
Omissions
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Examples for the Mythical Country of Pongoland

• Which account is credited?
• Which account is debited?

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A European importer buys 3 million pongos worth
of equipment from a Pongoland firm. Payment is
made with a cheque drawn on a Pongoland bank.

• The equipment is a Merchandise Export.
• It is a decrease in an asset, so credit
  Merchandise Exports 3 million.
• The cheque is a Foreign Claim on Pongoland. It is
  a decrease in a liability so debit Foreign Claims
  3 million.

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Pongoland imports 1.2 million pongos of food from
Latin America. Payment is made with cheques drawn
on Pongoland banks.

• The food is a Merchandise Import.
• It is an increase in an asset so debit
  Merchandise Imports 1.2 million.
• The payment is a Foreign Claim on Pongoland.
• It is an increase in a liability so credit
  Foreign Claims 1.2 million.

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Pongoland tourists spend 400,000 pongos while
travelling in Europe. They pay with Pongoland
travellers cheques.

• The tourism is a Service.
• It is an increase in an asset so debit Services
  .4 million.
• The travellers cheques are a Foreign Claim on
  Pongoland.
• They are an increase in a liability, so credit
  Foreign Claims .4 million.

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A Pongoland company purchases 20 percent of a
European Company for 800,000 pongos. It pays with
cheques drawn on Pongoland banks.

• Debit Direct Investment .8 million.
• Credit Foreign Claims .8 million

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The government of Pongoland provides foreign aid
to a country in the form of 300,000 million of
agricultural products.

• Debit Current Transfers .3 million
• Credit Exports .3 million

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Pongoland investors receive 200,000 pongos from
their foreign investments. They are paid with
cheques drawn on foreign banks.

• The earnings are Income.
• They are no longer owed the income so this is a
  decrease in an asset. Or, view this as an export
  of the services of capital. Credit Income .2
  million.
• The cheques are Pongoland Claims on Foreigners.
• This is an increase in an asset debit Pongoland
  Claims.

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The Balance of Payments and the National Accounts

• Y C I G X where Y is output or income, C
  is private domestic consumption, I is private
  domestic investment, G is government spending
  (assumed to be consumption) and X is exports
  minus imports, or net exports or the current
  account.
• Y C G S I X, where S is income minus
  total private and government consumption, or
  savings.
• X S I the current account is domestic
  investment minus saving