BALANCE OF PAYMENTS

Definition

An open economy deals with a great number of economic relations throughout the world, some are commercial relations and some others are financial relations. Thus, the balance of payments summarizes all the different transactions between a country and all other countries.

The balance of payments is an accounting record of all economic transactions between a country and other countries for a specific time period, usually a year or even a quarter. The balance of payments represents a systematic record of all payments and liabilities to foreigners and all payments and obligations received from foreigners, in dollars which is the currency commonly used for transactions.

The transactions that imply capital outflows or payments and liabilities to foreigners are called debits, which are represented by a minus sign in the balance of payments. For example: the imports, loans to other countries and the expenditures made by national tourists in other countries. On the other hand, credits are those payments and obligations received from foreigners, such credits are represented by a plus sign. For example, exports, foreign loans, and foreign investment.

 

Structure of the balance of Payments

The most common structure of the balance of payments is the one that divide it into four accounts, which correspond to the nature of their transactions.

1. Current Account: the current account of the balance of payments is subdivided into the following categories:

• Balance on Merchandise Trade: this balance reflects all the imports and exports. It is the difference in value between the total (FOB) exports and total (CIF) imports of a country. A positive balance of trade is known as a trade surplus and a negative one is known as a trade deficit.
• Balance on services: the difference in value over a period of time of a country's imports and exports of services and payments of property incomes. For example insurance, governmental services, travels and transportation.
• Unilateral Transfers: are those transfers in which one of the parties does not pay. In other words, gifts and shipments that the residents of a country send to another nation.
  The current account is the sum of the sub-accounts previously mentioned.

2. Capital Account: this account basically deals with the following transactions: foreign investments, short and long term loans, amortization of foreign debts, etc. These transactions can represent incomes or expenses as payments are made or received. This account is subdivided into two sub-accounts.

• Private capital: this account includes all the incomes and expenses of investments and loans carried out by the private sector.
• Official Capital: it includes external debt movements, in other words credits except amortization and interests. There are other incomes of official capital which correspond to investment in reserves and credits granted.

The sum f this account represents the net -indebtedness of a country.

3. Changes in Official Reserve: official reserves are the foreign assets held by central bank. Official reserves include:

Official Reserves play a relevant role. That’s why economic authorities seek to maintain an appropriate level of reserves. The main functions of official reserves are:

In other words, official reserves assure the stability and convertibility of national currency.

4. Errors and Omissions: this account deals with all the undetermined capital. In other words the errors and omissions account simply balances the balance of payments. Actually, the sum of the current account and the capital account should equal the changes in official reserve.