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What does it really mean?—Balance of Payments

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1966
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Poul Høst-Madsen

IN THE COURSE of the postwar period the term “balance of payments” has become thoroughly familiar to readers of newspapers in all countries. Even in the United States, where ten years ago the balance of payments, outside the circle of economists and financial experts, was either an unknown concept or associated with something distant and foreign, the public has since become painfully conscious of its existence.

In articles in the press the balance of payments is often defined in a very simple manner. It may be described, for instance, as a record of a country’s money receipts and payments from and to abroad, the difference between receipts and payments being the surplus or deficit. Such simple explanations are useful in that they immediately provide a common-sense notion of what the balance of payments is all about, and even though it is in fact something much more complex, such language provides a good starting point for defining it in more precise terms.

What is a “Country”?

Leaving aside for the time being what is meant by receipts and payments, we may first discuss what is meant by a country. For purposes of the balance of payments, as for most other economic statistics, a country means those individuals and business enterprises, including financial institutions, that have a permanent association with a country’s territory, together with that country’s governmental authorities at all levels. All these in balance of payments terminology are called the country’s “residents.” Residents include all those economic units whose economic activity is subject to direction and control by the national authorities. By the same token, everybody else is nonresident. This is an immensely practical definition, and a good deal of what follows flows from it naturally.

Thus, all enterprises that are engaged in production in the domestic territory are regarded as residents even if they are owned by foreigners. It is the transactions of such an enterprise with other countries, including its transactions with its own home office, that are recorded in the balance of payments, and not those between the foreign-owned enterprise and the rest of the economy of the host country. The balance of payments records the exports and imports of such enterprises, the profits accruing to their foreign owners, and the net movement of foreign capital invested in them—rather than their domestic expenditures, including the taxes and royalties they pay. This is so even though it is their local transactions that directly result in foreign exchange receipts by the country in which they operate. However, as can readily be shown, the balance of such a company’s international transactions is equivalent to that of its local transactions.

In drawing the line of the national economy so as to include foreign-controlled enterprises, the balance of payments concepts are in accordance with those of the national accounts; both are founded upon political and economic reality. Foreign-controlled enterprises—for example, oil companies—have, of course, sometimes been able to exercise a great deal of autonomy in the country where they have operated. They may even have been geographically isolated from the rest of that country’s economy. Nevertheless, the fact that any enterprise is operating on the territory of a given country implies that it is, like other local enterprises, subject to that country’s authority in carrying out its productive activity, and the ultimate demonstration of this has been on occasion expropriation of the foreign owner. This subjection to government authority makes it an integral part of the host country’s economy.

This is obviously not so with embassies or military units and personnel of governments stationed in foreign countries. Their economic activity is not subject to the direction of the government of the country in which they are located; they can best be regarded as part of the home country’s economy, and therefore as nonresidents of the country in which they happen to dwell. The transactions of foreign embassies and military installations, and of their personnel, with the country in which they are located, are therefore recorded in the balance of payments of their home country. Remittances by a government to an embassy or a military agency abroad are not per se part of the home country’s balance of payments. It is the amounts spent abroad by the embassy or military agency that enter it. Thus, the salary paid to the Danish Ambassador in Washington is not an item in Denmark’s balance of payments; but when he pays a bill in a local restaurant, that is an item.

With respect to individuals it is sometimes less obvious where the line should be drawn between residents and nonresidents. Fortunately it is usually much less important also, although in recent years the question has assumed somewhat greater importance with the large migrations of workers in Europe. The tendency has been to treat all those who work in a given country as residents of that country unless they are “border workers,” moving back and forth every day. Tourists and other travelers are, of course, residents of their home country.

Receipts and Payments

We return now to the question of what is meant by receipts and payments. This side of the popular notion represents an oversimplification. The balance of payments in the first place includes all transactions which at some stage (whether sooner or later) give rise to a monetary settlement, such as exports and imports against credits of varying duration. The common sense of this is readily apparent since the financial position of a country, like that of a business, depends not only on its cash holdings but also on what it owes and what others owe to it.

But the balance of payments has an even broader coverage. It includes economic transactions even if they will never give rise to monetary settlements. Although most resident-nonresident transactions give rise to such settlements, there are some important categories that do not. These include, for instance, goods granted under a foreign aid program and the shipment by a parent company of equipment for investment in its foreign subsidiaries and branches. Such transactions are included as exports or imports with a matching entry for the foreign aid or capital movement involved. Similarly, if a company does not repatriate all the proceeds of its exports but invests part of them abroad, there will be an entry in the capital account partly offsetting the entry for exports. This is because the balance of payments is intended to record systematically all the flows of real resources between a country (i.e., residents) and the rest of the world, and all the changes in its foreign assets and liabilities.

This wide coverage relates the balance of payments systematically to the economic activity in the domestic economy, and it does not make it any less suited for the assessment of international payments problems. On the contrary, it permits the analysis of these problems to be carried out in a broader economic context than if the balance of payments had been confined to a mere statement of money receipts and payments.

Accounting Conventions

The balance of payments is a double entry accounting statement based on rules of debit and credit similar to those of business accounting. For instance, exports (like the sales of a business) are credits, and imports (like the purchases of a business) are debits. In one rather superficial respect, the accounting procedures of the balance of payments are different: by tradition credit entries are made in the left-hand column and debit entries in the right-hand column. This is a tradition that appears almost as difficult to change as it is to change traffic from the left side to the right side of the road in a country. A fairly common alternative convention is to give debits a minus sign and credits no sign. This permits entering the balance of payments in a single column—which can be practical, for instance, when a time series covering many years is to be presented.

As in business accounting the balance of payments records increases in assets (say, direct investment abroad) and decreases in liabilities (say, repayment of debt) as debits, and decreases in assets (say, a sale of foreign securities) and increases in liabilities (say, the utilization of foreign loans) as credits. An elementary rule that may assist in understanding these conventions is that in such transactions it is the movement of a document, not of the money, that is recorded. An investment made abroad involves the import of a documentary acknowledgment of the investment; it is therefore a debit. The balance of payments has one important category that has no counterpart, or at least no significant counterpart, in business accounting, i.e., international gifts and grants and other so-called transfer payments. Transfer payments refer to transactions which have no quid pro quo. Transfer payments received from abroad are credits, and transfer payments made abroad are debits.

In general, credits may be conceived as receipts and debits as payments. However, this is not always possible. In particular, the change in a country’s international reserves in gold and foreign exchange is treated as a debit if it is an increase and a credit if it is a decrease. This is merely a convention, or accounting device, perfectly familiar to professionals, but undoubtedly puzzling, because seemingly anomalous, to others. This procedure is to offset changes in reserves against changes in the other items in the table so that the grand total is always zero (except for errors and omissions).

The transactions entering the balance of payments fall into three broad categories: transactions in goods and services, transfer payments, and capital transactions, or in more precise language transactions in capital and monetary gold. Capital transactions are transactions representing a change in a country’s foreign assets and liabilities, and gold entering a country’s reserves is treated like a foreign asset.

In fact, a transaction entering the balance of payments usually has two aspects, as have transactions entered in business accounting, and invariably gives rise to two entries, one a debit and the other a credit. Often the two aspects fall into different categories. For instance, an export against cash payment may result in an increase in the exporting country’s official foreign exchange holdings. Such a transaction is entered in the balance of payments as a credit for exports and as a debit in the capital account. Both aspects of a transaction may sometimes be appropriate to the same account. For instance, the purchase of a foreign security (recorded as a debit in the capital account) may have as its counterpart a reduction in official foreign exchange holdings (a credit also in the capital account). For barter (not a common phenomenon in free enterprise economies) both entries are in the goods and services account. In the case of a foreign grant one entry will be for a transfer payment and the other in the goods and services account (grants in kind) or in the capital account (cash grants).

Recording the Balance of Payments

The Fund collects balance of payments statistics from its member countries in accordance with its Balance of Payments Manual (available in French and Spanish as well as in English), which is a systematic guide for the compilation of such statistics and contains a comprehensive discussion of their basic concepts and their relation to the other social accounts. The statistics themselves are published in its Balance of Payments Yearbook. The following table for Colombia is drawn from the most recent volume (Volume 16) of that publication. In the classification by main categories (items 1 through 19), although not in the selection of subitems, it follows a standard form from which the data can be rearranged in accordance with varying analytic purposes; it is not a form that is specially adapted to the needs of the Fund. Because it is designed for general use, the standard form of presentation gives, however, a reasonably complete catalog of the transactions entering the balance of payments.

Goods and Services

A brief review of this table will add concreteness to the definition of the balance of payments. In Group A, the first item, merchandise, covers essentially exports and imports as shown in external trade statistics, although these statistics may be adjusted in various ways for balance of payments purposes. In this case (as generally recommended) both exports and imports are shown at f.o.b. (free on board) values, i.e., as excluding costs of international freight and insurance. Exports are valued free on board in a Colombian port and imports free on board in a port in the exporting country. (When goods are sent by land to and from neighboring countries, both exports and imports are valued at the frontier.) The freight on imports that are carried in Colombian ships or aircraft does not enter the balance of payments, but import freight paid on foreign carriers is included in item 3 as a debit (in the same way that the imports themselves are recorded as a debit). Freight on exports earned by Colombian ships and aircraft is recorded as a credit in the same item.

The second item, nonmonetary gold, is difficult to explain briefly; indeed this item is one of the most complex in the balance of payments. Gold is sometimes treated as merchandise (nonmonetary gold) and sometimes as a financial asset (monetary gold, see item 19.4 in the table). The entries in the Colombian statement for nonmonetary gold represent exports of newly mined gold; those for monetary gold cover changes in official gold holdings. However, if newly mined gold is purchased by the monetary authorities and added to reserves, it is treated as if it had been exported by the mines as nonmonetary gold (credit in item 2) and subsequently purchased abroad by the monetary authorities (debit in item 19.4). This is done because from an economic standpoint it makes no difference whether newly mined gold is exported and the proceeds of the exported gold added to the country’s international reserves, or whether the newly mined gold is actually added directly to these reserves. The point is that by either means an addition has been made to the country’s international reserves. Changes in a country’s international reserves are an essential feature of a balance of payments record.

The other items in Group A are relatively easy to understand. The main components of item 4 (other transportation) are port expenditures in Colombia by foreign ships and aircraft (credit) and abroad by Colombian ships and aircraft (debit), and international passenger fares paid by foreigners to Colombian ships and aircraft (credit) and by Colombia to foreign ships and aircraft (debit). Travel covers expenditures by foreigners traveling in Colombia as tourists or for business or other purposes (credit), and similar expenditures by Colombians traveling abroad (debit). Income from direct investment covers the earnings of foreign-controlled enterprises in Colombia accruing to their foreign parents. Other investment income covers interest and dividends received (credit) and paid (debit). Government, n.i.e. (meaning, not included elsewhere) covers diplomatic and consular expenditures by foreign governments (credit) and by the Colombian Government abroad (debit). This item would also include military expenditures, if such transactions had taken place (i.e., if foreign troops had been stationed in Colombia or Colombian troops abroad); overseas military expenditures by the U.S. Government are a significant item in the balance of payments of the United States and several other countries. Finally, the last item covers all transactions in goods and services that are not appropriate to the preceding items.

Balance of Payments: Colombia Basic Global Statement, 1959-63(In millions of U.S. dollars)
19591960196119621963
CreditDebitCreditDebitCreditDebitCreditDebitCreditDebit
A. Goods and Services610.4550.1591.5676.4578.1720.7571.4747.0590.1736.1
1. Merchandise f.o.b514.2402.5480.2496.4462.5530.8461.9536.9474.0497.5
2. Nonmonetary gold13.715.114.013.911.3
3. Freight24.517.627.820.929.623.633.429.732.726.4
4. Other transportation9.635.811.348.813.249.414.749.816.234.4
5. Travel17.322.522.728.322.624.112.622.819.325.0
6. Investment income1.437.82.442.00.450.857.380.6
6.1. Direct investment18.727.136.034.739.4
6.2. Other1.419.12.414.90.414.822.641.2
7. Government, n.i.e4.06.94.09.24.09.44.013.74.57.5
8. Other services25.727.028.030.831.832.630.936.832.164.7
8.1. Nonmerchandise insurance6.810.49.112.89.612.19.514.310.814.2
8.2. Other18.916.618.918.022.220.521.422.521.350.5
Net goods and services60.384.9142.6175.6146.0
Trade balance (1 and 2)125.41.154.361.112.2
Net services (3 through 8)65.183.888.3114.5133.8
B. Transfer Payments4.11.78.42.711.42.817.43.522.74.4
9. Private1.71.22.62.23.12.37.52.311.83.0
10. Central government2.40.55.80.58.30.59.91.210.91.4
Net transfer payments2.45.78.613.918.3
Net total (1 through 9)60.884.5141.8170.4137.2
Net total (1 through 10)62.779.2134.0161.7127.7
C. Capital and Monetary Gold58.535.2116.8109.9164.9
Nonmonetary sectors30.126.16.534.489.0
11. Direct investment0.92.51.10.40.8
12. Other private long-term33.448.74.144.1125.7
12.1. Loans received15.48.124.35.538.57.036.712.252.111.9
12.2. Other26.129.935.619.685.5
13. Other private short-term4.411.77.122.645.5
14. Local government3.24.66.46.82.4
14.1. Bonds issued and retired1.11.31.41.41.4
14.2. Loans received4.06.12.96.22.37.312.54.37.53.7
15. Central government5.48.84.25.75.6
15.1. Bonds issued and retired2.42.22.12.12.2
15.2. Loans received4.411.57.78.812.77.922.17.920.58.3
15.3. U.S. Government peso holdings4.11.01.70.13.7
15.4. Subscriptions to IBRD, IDA, and IDB6.58.66.30.7
Monetary sectors88.69.1123.375.575.9
16. Private institutions: liabilities0.66.60.27.02.5
16.1. Loans received2.42.42.41.41.4
16.2. Other3.09.02.68.43.9
17. Private institutions: assets1.52.46.65.80.4
18. Central institutions: liabilities16.237.1125.820.784.7
18.1. IMF peso holdings3.83.865.07.548.5
18.2. IBRD, IDA, and IDB peso holdings4.24.71.32.3
18.3. Payments agreements0.51.30.30.10.6
18.4. Loans and credits received by Bank of the64.884.343.891.435.6190.9178.9182.1144.2
19. Central institutions: assets74.537.23.953.610.9
19.1. IMF subscriptions25.025.0
19.2. Payments agreements3.11.50.51.39.3
19.3. Other claims47.270.914.624.12.7
19.4. Monetary gold0.87.210.230.84.3
Net errors and omissions4.244.017.251.837.2

Why is it that all these items have been classified under the common heading goods and services? The significance of this total category can best be understood when related to the activity in the national economy by means of a very simple arithmetical equation. The national income arises in part from exports of good and services (E) and in part from sales of goods and services for domestic investment (I) and consumption (C), while part of the expenditure of the national economy is directed toward imports of goods and services (M). Since the total inflow of goods and services into an economy—whether arising from production (Y) or from imports (M)—is equal to the total outflow, or use, of goods and services (E + C + I), we can establish the following equation:

Y + M = E + C + I

from which follows

Y—C—I = E—M

In words, this equation says that the excess of the national product over consumption and investment is equal to the export surplus on goods and services account, or conversely that an excess of consumption and investment over the national product implies an equivalent deficit on the goods and services account of the balance of payments.

Transfer Payments

All transfer payments, i.e., receipts and payments without a quid pro quo, are entered in Group B. They may be in cash or in kind and are divided into private and government transactions. Private transfer payments cover such transactions as charitable contributions and remittances to relatives in other countries. The main component of government transfer payments is economic aid in the form of grants. Official economic aid can take several forms and in a standard table such as that employed here these may be spread over several items. If it is at some stage repayable, it is entered in the capital account; if it is a grant, which is not repayable, it is, by contrast, entered as a transfer payment because it does not (as does repayable aid) represent a change in a country’s foreign assets and liabilities.

All transactions representing changes in a country’s foreign assets and liabilities are entered in the capital account, the net balance of which (except for errors and omissions) measures the change in a country’s debtor-creditor position that results from transactions (rather than from mere valuation changes, or windfall gains and losses). Alternatively, the change in a country’s debtor-creditor position resulting from transactions can be gauged from the balance of goods, services, and transfer payments (Groups A and B), which, in principle, should be equivalent to the balance of capital transactions.

The balance of goods, services, and transfer payments is sometimes referred to as the current balance or the balance on current transactions, but this term is not used consistently from country to country. Many countries divide transfer payments into some they consider to be “current transfers” and some they consider to be “capital transfers.” No criterion that is applicable to international transactions has been formulated for this distinction and this is why it has not been introduced in the Fund’s balance of payments schedule. Nevertheless, the expression “current balance” or “balance of payments on current account” is widely used. It implies a common-sense idea that a country which can avoid a deficit on current account can somehow “stand on its own feet,” but it has not been given terminological precision. The current balance includes all transactions in goods and services and a varying element of transfer payments. “Current” transfers are included in the disposable (rather than the produced) income of a country (see next paragraph); “capital” transfers are regarded as part of the financing of foreign or domestic investment and not as an element of income. Foreign aid grants are usually regarded as “capital” transfers.

If we disregard this complication and regard all transfer payments as “current” we can establish another important relationship between the balance of payments and the domestic economy. The balance on account of goods, services, and (current) transfer payments is equivalent to the balance of domestic investment (I) and saving (S). This relationship can be derived as follows. The total disposable income of a country is its produced income (Y) plus the net transfer payments it receives from abroad (T). i.e., Y + T. Saving (S) is the portion of this income that is not used for consumption, i.e., Y + T—C. We can establish the following equation:

S = Y + T—C

and since

Y—C = E—M + I

we can derive the following equation:

S = T + E—M + I

or S—I = E—M + T

which say that the balance of saving and investment in the economy is equivalent to the balance on account of goods, services, and (current) transfer payments, or the balance on “current account.” This is an important relationship in the planning of economic policy. It says that a country cannot invest more than it saves without running a deficit on the current account of its balance of payments. It follows that unless it can find appropriate financing for its current deficit, and thus for the excess of domestic investment over saving, it will have a balance of payments problem to cope with.

Capital Account

Within the capital account (Group C of the table) there are two or three important distinctions, only one of which is readily apparent from the table. The one that is apparent is that by sector of the economy. The sector distinction separates, in the first place, the nonmonetary sector from the monetary one, that is to say, the trading or ordinary private business element in the economy together with the ordinary institutions of central or local government, from the central bank and the commercial banks, which are directly involved in framing or implementing monetary policy. In addition, it separates altogether five sub-sectors within these two broad sectors (within the nonmonetary sector, a private sector covering private enterprises other than banks as well as individuals, together with sectors for local government and central government, and within the monetary sector central and other monetary institutions).

The second major distinction, which is not readily apparent, is one by assets (domestic capital) and liabilities (foreign capital). This distinction can be seen clearly only under the monetary sectors. Elsewhere it is made implicitly only in the description of the items (“loans received,” for instance, indicates that the entries refer to liabilities or foreign capital), or not at all in the table itself; extensive notes are published with the table and must be consulted to determine whether the entries refer to assets or liabilities. This method of presentation is necessary in a compact presentation to permit the maximum detail of transactions by type.

A third important distinction for most types of capital transactions is that into long-term and short-term capital. The difference between the two is simple and arbitrary: long-term capital covers obligations without a maturity or with an original maturity of one year or more, and short-term capital obligations with a maturity of less than one year. This distinction is similarly sometimes made implicitly through the item description or in the notes to the table. It is not made with respect to direct investment, which covers investment in enterprises controlled by the investor, usually branches and subsidiaries of a parent company, whether of a long-term or a short-term character (the former usually predominates).

The capital transactions of the nonmonetary sector, to use the economists’ description, means the ordinary run of business and governmental transactions on capital account. It includes not only direct investment, i.e., in enterprises controlled by the investors, other investment in securities, and changes in open bank accounts of private traders, but also, for example, loans for development. They cover the bulk of what is commonly referred to in newspaper and other reports as inflows or outflows of capital. The transactions of the monetary sector, or at any rate those of the central bank, are essentially different. They are the response of the monetary authorities to the rest of the balance of payments, that is to say that they finance the over-all surplus or deficit as it arises from autonomous transactions. The capital transactions of the central bank are usually limited to the financing of surplus or deficit; the transactions of commercial banks can have this character if they are subject to control by the monetary authorities, but may otherwise be autonomous; all the capital transactions of the nonmonetary sectors can usually best be regarded as autonomous.

The last item in the table, entitled net errors and omissions, is a statistical residual. It is used to balance the statement because in practice it is not possible to have complete and accurate data for reported items and because these cannot, therefore, ordinarily have equal entries for debits and credits. The entry for net errors and omissions can often be interpreted as an indication of unreported flows of private capital, although the conclusions to be drawn from them vary a great deal from country to country, and even in the same country at different times, depending on the reliability of the reported information. Developing countries in particular may experience great difficulty in providing reliable information.

Summarizing, balance of payments statistics are a tool for economic analysis which relates the economic activity in a country to its transactions with the rest of the world. The transactions summarized in the balance of payments are the mechanism through which economic impulses are transmitted between a country and the rest of the world. They constitute, therefore, a limiting factor that must be considered in framing policies aimed at stimulating domestic production and growth. Such policies express themselves in added demands for foreign goods and services, and hence may, if carried too far, give rise to a loss of reserves, or more precisely a deficit in the balance of payments, calling for corrective action. A surplus or deficit in the balance of payments may provisionally be defined as the balance of the autonomous transactions for which financing is provided by the monetary authorities; but since it is difficult to distinguish between autonomous transactions and such compensatory financing, and because more than one significant balance can be drawn in the balance of payments, the definition of surplus or deficit is a complex matter. A second article will, therefore, be devoted to it.

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