Balance of Payments

Balance of Payments

When countries trade financial transactions among businesses or consumers of different nations occur. Products and services are exported and imported, monetary gifts are exchanged, investments are made, cash payments are made and cash receipts received and vacation and foreign travel occurs. In short, over a period of time, there is a constant flow of money into and out of a country. The system of accounts that record as a nation’s international financial transactions is called its balance of payments.

A nation’s balance of payments statement records all financial transactions between its residents and those of the rest of world during a period of time usually one year. Because the balance of payments record is maintained on a double entry bookkeeping system, it must always be in balance. As on an individual’s financial statement the assets and liabilities or the credits and debits must offset each other. And like an individual’s statement, the fact that the balance does not mean a nation is in good or poor financial condition. Balance of payment is a record of condition and not a determinant of condition. Each of the nation’s financial transactions with other countries is reflected in its balance of payments.

A nation’s balance of payments presents an overall view of its international economic position and is an important economic measure used by treasuries, central banks, and other government agencies whose responsibility is to maintain external and internal economic stability. A balance of payments represents the difference between receipts from foreign countries on one side and payments to them on the other. On the plus side of the balance of payments are merchandize export sales, money spent by foreign tourists, payments to the foreign countries for insurance, transportation and similar services, payments of dividends and interest on investments abroad, return on capital invested abroad, new foreign investments in foreign countries and foreign government payments to the country.

On the minus side are costs of goods imported, spending by foreign tourists overseas, new overseas investments and the cost of foreign military and economic aid. A deficit results when international payments are greater than receipts. It can be reduced or eliminated by increasing a country’s international receipts (i.e. gain more exports to other countries or more tourists from other countries) and / or reducing expenditure in other countries. A balance of payments statement includes three accounts: the current account a record of all merchandize exports, and services plus unilateral transfers of funds; the capital account a record of direct investment, portfolio investment, and short term capital movements to and from countries; and the official reserves account – a record of exports and imports of gold, increases or decreases in foreign exchange, and increases or decreases in liabilities to foreign central banks. Of the three, the current account is of primary interest to international business.

The current account is important because it includes all international merchandise trade and service accounts, that is, accounts for the value of all merchandise and services imported and exported and all receipts and payments from investments.

Since 1971 the United States has had a favorable current account balance (as a percentage of GDP) in only a few years. The imbalances resulted primarily from US demand for oil, petroleum products, cars, consumer durables, and other merchandise. Indeed, the merchandise trade deficit for 2004 was $ 665 billion. Such imbalances have drastic effects on the balance of payments, and, therefore, the value of US currency in the world market place. Factors such as these eventually required an adjustment through a change in exchange rate, prices, and/or incomes. In short, once the wealth of a country whose expenditures exceed its income has been exhausted that country, like an individual, must reduce its standard of living. If its residents do not do so voluntarily, the rate of exchange of its money for foreign moneys declines, and through the medium of the foreign exchange market, the purchasing power of foreign goods is transferred from that country to another.

As the US trade deficit grows pressures should begin to push the value of the dollar to lower levels. And when foreign currencies can be traded for more dollars, US products (and companies) are less expensive for the foreign customer and exports increase, and foreign products are more expensive for the US customer and the demand for imported goods is dampened.