THE BALANCE OF PAYMENTS is based on a double entry system, which provides for each debit to be matched by a credit. How, then, can there be “a deficit in the balance of payments”? Yet this phrase, along with its reciprocal, “a surplus in the balance of payments,” is constantly used in public discussion. Is it a contradiction in terms?
In economic usage, it is not, and the reason is quite simple: a so-called over-all surplus or deficit does not—according to this usage—represent the balance of all items in the balance of payments (which is necessarily zero when the entry for net errors and omissions is included), but only the balance of a certain selection of transactions. The other transactions are, as it were, excluded from the balance of payments proper and regarded as “financing” it. In the jargon of the balance of payments technicians, all the items of the balance of payments are divided into those “above the line” which make up the surplus or deficit, and those “below the line” which represent the financing of the positive or negative over-all balance. Transactions recorded below the line thus characteristically represent the reaction of the financial authorities to a number of (as it were) spontaneous movements; the authorities responsible for providing the financing are not, in general, thinking in terms of individual transactions, but rather of “financing” or balancing them in the mass. Why is such a division made, and where should the line be drawn?
The purpose of this division is sometimes said to be that of showing whether the international transactions of a country are in balance or whether they are in surplus or deficit by some amount. Such an explanation, however, gives the false impression that the classification of the balance of payments from this standpoint is somehow an objective, scientific analysis, and it can ultimately lead only to tautological or circular definitions. In fact, the determination of balance of payments surplus or deficit is far from being a fully objective exercise. It has the clearly normative aspect of providing a guide for economic policy. To bring this normative aspect into the open we may define a surplus or deficit in terms of the need for action. A deficit, then, is a negative balance (or an excess of debits over credits) on account of certain transactions (the items above the line), which will cause trouble if it becomes large and persistent; to prevent this, some adjustment of the balance of payments is called for—and usually some adjustment in the domestic economy as well. A surplus is a positive balance on account of the same transactions. While in a statistical sense a surplus (when used in relation to a given country) is simply the reciprocal of a deficit, it is not a simple reciprocal in terms of the importance attached to it by financial authorities or in terms of policies of adjustment to which it gives rise. This is because the urgency to adjust the balance of payments is much greater when the balance of payments is in deficit than when it is in surplus by a similar amount. Although the international community may, in principle, consider surplus and deficit countries equally responsible for adjusting their payments positions, in practice the greater part of the burden of adjustment tends to rest on those that are in deficit.
When the concept of surplus or deficit is defined in these terms it is readily understood why there can be conflicting views about where the line should be drawn. This implies a judgment as to whether the situation revealed by the balance of payments figures is good or bad, and raises questions as to whether policies of adjustment are required. These questions, like others in the area of economic policy, are prone to give rise to vigorous disagreement. It is not surprising, therefore, that the definition of surplus or deficit is by far the most controversial question in balance of payments methodology. This has been evident at meetings of balance of payments experts which the Fund has held. When these meetings have taken up the concept of surplus or deficit, somehow the discussion has become much livelier or even emotional. At the same time it has usually been inconclusive, being concerned with something about which reasonable men can forever hold different views. And those who, like the author of this article, have been concerned with balance of payments questions for a long time, may not even be reasonable any more. Indeed, it has recently been suggested to me by a friend in the academic world that dealing with balance of payments questions over a long period can be dangerous to mental health and may inspire a certain fanaticism. Be that as it may, the failure of experts to agree on the definition of surplus or deficit is understandable.
Current Account Balance
If a deficit (or surplus) in the balance of payments is composed of selected transactions only, it is important to know what the selection comprises. Sometimes, and in particular in Europe, surplus or deficit in the balance of payments is identified with the balance on current account (i.e., of current transactions) or the balance on account of goods, services, and transfer payments (other than those transfer payments considered to be “capital transfers”). However, current transactions cannot universally be expected to be in balance over the long run since some countries are exporters or importers of capital. It seems natural for a developing country to have a deficit on current account in its balance of payments to the extent that it can provide for the financing of this deficit through an inflow of economic aid or capital. Conversely, a country which grants economic aid to other countries or is an exporter of capital must have a surplus on current account if its balance of payments is not to become troublesome.1 When we speak of “export” and “inflow” of capital in this context, following common usage, we do not mean, of course, all the capital transactions entering the balance of payments but only those that are included “above the line.” But how do we distinguish the line between the capital movements included above the line and those regarded as “financing” below the line?
Which Capital Movements Represent “Financing”?
In the first place we exclude the movement in official gold and foreign exchange reserves from capital inflows and outflows above the line because countries cannot go on forever drawing down their reserves without running into difficulties. The same applies to drawings on the Fund, whether representing use of Fund reserve positions or credit tranches, and for related reasons all other financial transactions (repurchases, subscriptions, use of a country’s currency by other countries) are also entered below the line. For many and perhaps most countries, changes in gold and foreign exchange reserves, together with financing through the Fund, constitute the main, or even the only, component of what can reasonably be regarded as the financing of the balance of payments below the line.
However, where a country exercises strict control over the foreign operations of its commercial banks a case can be made for including the change in the foreign exchange holdings of these institutions along with that in official reserves. In these circumstances the commercial banks are, of course, usually permitted to hold only relatively small working balances, and it makes little difference whether or not changes in them are included in the measure of surplus or deficit.
In the balance of payments of a number of countries there are some other important transactions which clearly function in the same way as reserves in financing surpluses or deficits and which can similarly not be counted upon as a source of financing over the long run. In recent years, the most conspicuous case of such financing has been perhaps the bilateral assistance extended to the United Kingdom under swap or similar arrangements during periods of crisis. Creditor and debtor positions arising from such arrangements, whose only raison d’être is to finance short-term imbalances in international transactions, also belong below the line.
It is possible to go further in this direction by including other transactions that are also brought into play only by a surplus or deficit in the rest of the balance of payments, but this soon leads onto slippery ground, and in Fund analysis such other transactions are now rarely included. However, it is at least easier now than it used to be to distinguish between above the line transactions and below the line financing. In the early postwar period much economic aid was extended by the United States ostensibly to finance deficits in the balance of payments of the recipient countries, and was interpreted in the Fund and elsewhere as belonging below the line. A number of difficult borderline cases arose in that connection. These do not apply to present-day aid to developing countries. For, unlike the postwar economic aid received by the European countries, aid to developing countries constitutes a continuous source of financing. In general, therefore, the recipient countries are not expected to adjust their balances of payments to do without the aid as were the European countries during the immediate postwar period.
Over-All and Basic Balance
In defining over-all surplus or deficit (i.e., the total surplus or deficit above the line) the purpose is to determine the selection of transactions that should be in balance over the long run. However, surplus or deficit so defined may not always be the most useful guide for policy over the short run—and it must never be forgotten that guidance on policy is what the financial authorities in a country expect from the balance of payments. A number of the items above the line (e.g., movements of private short-term capital) may be quite volatile, or even on occasion so abnormal as to exaggerate, or conceal, positions of strength or weakness in the balance of payments. While a full appraisal of the balance of payments must always be a matter of careful analysis, it may sometimes be useful to draw a balance which excludes some of the more volatile or extraordinary items and is, therefore, a better expression of the trends in the balance of payments—and so a better guide to policy in the short run than the over-all surplus or deficit.
In the Fund’s analysis of developments in world payments, such a “partial” balance is frequently drawn under the name “basic” balance. The basic balance in this context covers usually current and long-term capital transactions, from which certain transactions may be eliminated on an ad hoc basis. But it is often difficult, as a practical matter, to know which items to eliminate, and one cannot go very far in that direction without making the analysis cumbersome.
Another difficulty with this approach is that even the items excluded from the “basic” balance may have a long-term trend which must be taken into account in the ultimate appraisal of the balance of payments. In a developing country, for instance, there may be a tendency toward an inflow of foreign short-term capital in connection with the financing of a rising volume of imports; or a troubled political situation may cause a persistent (even if somewhat volatile) outflow of domestic short-term capital. In the advanced countries these tendencies may be reversed; there may be a rather steady outflow of short-term capital in connection with the financing of exports (or of trade between foreign countries) or a volatile but persistent inflow of foreign private short-term capital. This has been the usual pattern in the United States. In spite of the inherent difficulties of this approach, a balance of the more basic transactions will often be illuminating. Many of the differences of view as to how surplus or deficit should be defined have to do with the failure to distinguish clearly between a balance of the more basic transactions and the ultimate balance that should be in equilibrium over the long run.
Special Problems of the Reserve Centers
The problems of defining over-all surplus or deficit are compounded in the two main reserve centers, the United Kingdom and the United States, whose currencies are used widely in settling transactions, not only between the reserve center itself and the rest of the world, but also between third-party countries. Changes in the amounts of reserve currencies that are held by foreign monetary authorities clearly represent financing of surplus or deficit from the standpoint of the country holding them. Can they be similarly regarded from the standpoint of the reserve center concerned?
Most people, including the authorities of the two reserve centers, would undoubtedly answer this question in the affirmative. However, even this simple proposition is by no means self-evident. There have been long periods when foreign central banks or governments have been content to accumulate substantial holdings of the reserve currencies without claiming conversion into gold or other currencies. If so, does the increase in the liabilities of the reserve center that is involved make it appropriate for it to adjust its balance of payments? The answer to this question may vary with circumstances. At this time, however, there appears to be a consensus that the reserve centers should not add, or at least not add substantially, to their total liabilities to foreign reserve holders, except to the extent that they increase their own reserves.
But what about the reserve currency holdings of private parties, including commercial banks? Should changes in these holdings also not be included below the line? This has for a long time been the practice of the two reserve currency countries in presenting their official balance of payments statistics. However, this practice does not provide a complete view, and it is being supplemented in the United States by an alternative new form of presentation, recently introduced at the recommendation of a committee of independent experts, which treats changes in foreign private dollar balances as belonging above the line. One argument for including changes in such holdings of reserve currencies below the line is that these holdings can be sold by the private party to the central bank of his country, in which case the reserve currency country may be called upon to convert the balances. Against this theoretical argument, there has been a clear long-term trend toward a substantial increase in foreign private holdings of U.S. dollars, in particular after the introduction of convertibility by the major European countries and the consequent freeing of exchange markets. From that standpoint, a calculation of surplus or deficit, in accordance with the more traditional approach in the United States, that excludes the inflow of foreign short-term capital in the form of dollar holdings, therefore tends somewhat to overstate the U.S. deficit over a longer period. On the other hand, since changes in foreign private dollar holdings are volatile, their exclusion from a balance of the more basic transactions (however defined) may facilitate the analysis of the balance of payments over the short run.
The position of foreign private sterling balances is similar, except that the outstanding movements have been withdrawals in periods of crisis. A surplus or deficit which excludes changes in private sterling balances (from above the line) may for this reason be unsuitable as an indication of the balance of payments problem facing the U.K. monetary authorities in such periods. However, the calculation of a balance of the more basic transactions, excluding changes in pound sterling balances, has advantages for the purpose of analyzing underlying trends.
The table on page 177 (which covers the years 1960-62 and thus includes the 1961 sterling crisis) illustrates the problem of defining surplus or deficit in the U.K.’s balance of payments. (Item G is “backwards”; that is to say, improvements are shown as minuses.)
In 1960, the balance of payments position of the United Kingdom was basically quite weak, as shown by the deficit on current and long-term capital account in line C. The overall balance of payments, as measured in line F, however, was in surplus as a result of a substantial inflow of private short-term capital (probably related to the 1960 U.S. dollar crisis), some of which may be reflected in the large credit entry for errors and omissions. In 1961, however, in spite of a considerable strengthening of the basic position, the overall balance went into deficit as movements of short-term capital were reversed (much of the outflow being associated with the wave of speculation that followed the appreciation of the deutsche mark in March). A quite severe crisis for sterling developed in the first half of 1961, as was evident from the large-scale support given to it by a number of central banks; their assistance was repaid out of a Fund drawing in the second half of the year and appears as a change in the Fund position. After mid-1961 the U.K. balance of payments again eased, and in 1962 there was an over-all surplus, in part attributable to inflows of short-term capital.
Should Persistent Surpluses Be Avoided?
The common sense notion is that surpluses and deficits are symmetrical concepts, and that if some country is in deficit then some other country must necessarily be in surplus. This is generally true when the concepts applied to individual countries’ balance of payments are mutually consistent as in Fund analyses. Even so, there is asymmetry between surpluses and deficits in one respect, i.e., gold production (less use of gold in industry and hoarding) added to the world’s monetary reserves creates an excess of balance of payments surpluses over deficits. However, the practices followed by countries in estimating their balance of payments surpluses and deficits are, in fact, not mutually consistent, with some tendency to err on the side of caution. Even though the amount of gold added to monetary reserves has averaged some $600 million in recent years, there has been an annual excess of deficits over surpluses, as viewed by national monetary authorities, averaging about the same amount, during the first half of the 1960’s.
|A. Goods, services, and transfer payments|
|Trade balance||- 1,131||-417||-275|
|Other current items||367||377||536|
|B. Long-term capital, n.i.e.1||- 151||- 149||-260|
|C. Basic balance (A + B)||-915||-189||1|
|D. Errors and Omissions||839||-67||249|
|E. Short-term capital movements, n.i.e.1|
|Foreign private sterling balances||653||-753||160|
|F. Over-all balance (C + D + E)||806||-984||843|
|G. Official monetary movements|
|Foreign official sterling balances||106||25||-297|
|Official gold and foreign exchange||-490||-87||515|
Not included elsewhere.
Not included elsewhere.
It is generally agreed that persistent balance of payments deficits should be avoided. It is true that countries with ample reserves can permit themselves to be in persistent deficit over quite a long period, the outstanding example being that of the United States, which, in addition to ample reserves, has had the special facility of financing deficits through an accumulation of foreign dollar liabilities. There are now, however, very few countries in the world, if any, which consider themselves in a position to incur deficits over a protracted period. But is there a similar limitation to the accumulation of surpluses? Can countries not permit themselves to be in long-run surplus?
Under existing monetary arrangements and conditions, if surpluses and deficits are defined as in Fund analyses, there are very narrow limits (set by increases in monetary gold holdings) to the surpluses which some countries can accumulate over the long run without persistent deficits elsewhere. The redistribution of gold reserves and the creation of dollar reserves that have been associated with the U.S. deficits have enabled countries other than the United States to incur an appreciable collective balance of payments surplus over the postwar period, but if the U.S. balance of payments is brought into balance, as is widely expected, the scope for surpluses outside the United States will be greatly narrowed. It is the anticipation of that situation that has recently led to an intensification of the international discussion of the problem of international liquidity.
INTERNATIONAL MONETARY FUND
ANNUAL REPORT, 1966
The Annual Report of the Fund is published on September 6. The Report is presented by the Executive Directors to the Board of Governors and covers the fiscal year 1965/66. It contains detailed analyses of economic developments during the year, with special reference to balances of payments and international financial affairs. A chapter on international liquidity summarizes the progress made during the year. Another chapter reviews some problems in developing countries seeking to ensure steady economic growth, dealing with the fiscal and financial measures that are called for, and with the role of the central bank.
The Report is available without charge. Applications should be sent to:
International Monetary Fund 19th and H Streets, N.W., Washington, D.C. 20431, U.S.A.
In the following exposition economic aid is for simplicity associated with “capital,” this concept being used in the broader sense of “flow of financial resources.”