Trade transaction that takes place between individuals gives rise to two things: first the exchange of physical goods or services and second, the exchange of money between the transactions. As it happens in the case of individuals so it is with international trade.
What is Balance of Payments? Balance of Payments is the exchange of commodities between one nation and her trading partners necessitates the payment by the nation to her trading partners.
Balance of Payments refers to the record of transactions between one country and her trading partners. In order to know what is happening to the course of international payments, governments keep track of the actual transactions among countries. Every transaction, whether of imports or exports is recorded and classified according to the payments or receipts that would typically arise from it.
Any item that gives rise to the purchase of foreign currency (e.g. paying for imports) is recorded as a debit on the balance of payment accounts and any item that gives rise to the sale of foreign currency (through exports) is recorded as a credit.
One feature of balance of payments account is that it always balances. While it is possible for holders of euro to want to purchase more dollars in exchange for euro, than holders of dollars want to sell in exchange for euro, it is not possible for holders of euro actually to buy more dollar than dollar holders wish to sell.
Every dollar that is bought must be sold by someone, and every dollar that is sold must be bought by someone. Since the dollars actually bought must be equal to the dollars actually sold, the payments made between countries must balance; even though, desired payments may not.
The Components Balance of Payments
These are the three components balance of payments:
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Current Account
This records all transactions in goods and services. Goods (visibles) are goods that can be seen when they cross international borders, e.g. cars, oil, cocoa, and groundnut.
Services (invisibles) are things that we cannot see, such as insurance and freight haulage, and tourist expenditures. Other items under invisibles are interest and dividends.
When the country receives dividends and interests on loans and investment in foreign countries, these are credited in her balance of payments and vice-versa.
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Capital Account
This records transaction related to movement of long and short term capital. Capital movements may be divided in several ways.
One important division is between direct and portfolio investment. Direct foreign investment occurs when firms transfer funds in order to create new capital in foreign countries.
Portfolio investment, however, occurs when equities or bonds are purchased. If for example, a Canadian saver buys a share issued by an American Company, this is a portfolio investment, and it represents a debit item on the Canadian balance of payments.
Capital movements may also be classified according to their term. Purchase of bonds in another country may be termed long term capital outflow. However, a deposit may be classified as short term since the foreign bank has the obligation to pay the deposit on demand.
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Official Financing
This represents transactions involving the Central Bank of the country whose balance of payments is being recorded.
There are three ways in which credit items may occur on the official financing account. First, the Central Bank may borrow from IMF.
This represents a capital inflow and is thus a credit item on the balance of payments. Second, the bank may borrow from other Central Banks. Third, the bank may run down its official reserves of gold and foreign exchange. This is a credit item because it gives rise to the selling of foreign exchange.
The fundamental relation among the three main divisions is that their sum must be equal to zero. That is the balances on the current, capital and official settlement account must be zero.
Why this it is possible and what happens in most cases is that a country might have surplus or deficit in the current account. A deficit occurs when the value of the country’s imports exceeds her exports. This deficit must however be matched by a net surplus on capital plus official settlement accounts which means borrowing abroad or running down exchange reserves.
