Managerial Economics Assignment on Balance of payments

Submitted To : Mr. Puneet Mittal

Submitted By: P.ThaneeshKumar Roll no : 10231

Table Of Contents

1 2 3 4 5 6 7 8 9

Introduction Balance of payments deficit Composition of the balance of payments sheet Imbalances Balance of payments crisis Balancing Mechanisms The balance of payments divided Balance of payments deficit and surplus Structure and characteristics of the current account

3 4 5 6 7 8 11 15 17 21 27

10 Structure and characteristics of the capital and financial account 11 References

Introduction
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A balance of payments (BOP) sheet is an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of goods, services, and financial capital, as well as financial transfers. The BOP summarizes international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit item. When all components of the BOP sheet are included it must balance that is, it must sum to zero there can be no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counter balanced in other ways such as by funds earned from its foreign investments, by running down reserves or by receiving loans from other countries. While the overall BOP sheet will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account. This can result in surplus countries accumulating hoards of wealth, while deficit nations become increasingly indebted. Historically there have been different approaches to the question of how to correct imbalances and debate on whether they are something governments should be concerned about. With record imbalances held up as one of the contributing factors to the financial crisis of 20072010, plans to address global imbalances have been high on the agenda of policy makers since 2009. Every transaction that is made between a country and one of its trading partners is recorded in the balance of payments. A countrys balance of payments is composed of two separate accounts, the capital and current account. The current account records transactions involving the import and export of goods and services in to and out of a country. The capital account records transactions involving the inflow and outflow of assets to and from a country. The balance of payments is the sum of these two accounts, which, by definition, is zero. What this means is that for every entry (credit (+) or debit (-)) on a countrys balance of payments sheet, there will be an offsetting entry in

one of the two accounts. This method of recording transactions is known as doubleentry bookkeeping. The current account is made up of several components. The first and most significant component is the balance of merchandise trade, or the import and export visible goods. The second entry on the current account balance is net trade in services, which consists of trade in intangible commodities between countries. Service trade includes tourist expenditures abroad, shipping and receiving expenses, and a variety of other internationally tradable services. The third type of transaction recorded on the current account balance is net investment income; this includes payments to foreign investors and receipts from overseas investments in the form of profits, dividends and interest payments. The last item recorded on the current account balance is net unilateral transfers. A unilateral transfer includes the transfer of goods, services, or finances from one country to another with no expectations of repayment to the donating country from the beneficiary. Provision of foreign aid is the most easily recognized type of unilateral transfer. The capital account records transactions involving the purchase or sale of assets and liabilities. When a country purchases a foreign asset (such as a private bank deposit, stock in a company, or a government bond), or lends overseas, the transaction is recorded as a capital outflow on the capital account. Similarly, when a country sells a domestic asset to a foreign country, or borrows abroad, the transaction is recorded as a capital inflow.

Balance Of Payments Deficit

A country is said to be running a balance of payments deficit when the nonreserve portion of the capital account and the current account are not in balance. This payments gap can be the result of excessive overseas investment, or a current account deficit that is not financed entirely by non-reserve capital inflows. The latter of the two types of balance of payments deficits is more common, particularly in the case of developing countries. In order to finance a balance of payments deficit, a countrys central bank must use its international reserves. Such payments are known as official 4

reserve transactions, and involve the transfer of international reserves between central banks.International reserve transfers are particularly important for two reasons: 1.) They change a countrys money supply, thus effecting interest rates, exchange rates, and a host of other economic factors; and 2.) in the case that a country is running a chronic balance of payments deficit, the supply of international reserves can be depleted in its financing, thus reducing the countrys capacity to fund imports and obtain credit. Both of these factors can be particularly significant in the case of developing countries, whose reserve positions tend to be smaller and more vulnerable to short term economic shocks.

Composition of the balance of payments sheet

Since 1974, the two principal divisions on the BOP have been the current account and the capital account. The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports payments for imports), factor income (earnings on foreign investments payments made to foreign investors) and cash transfers. Its called the current account as it covers transactions in the "here and now" - those that don't give rise to future claims. The capital account records the net change in ownership of foreign assets. It includes the reserve account (the international operations of a nation's central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments / dividends that the loans and investments yield, those are earnings and will be recorded in the current account). Expressed with the standard meaning for the capital account, the BOP identity is:

The balancing item is simply an amount that accounts for any statistical errors and assures that the current and capital accounts sum to zero. At high level, by the principles of double entry accounting, an entry in the current account gives rise to an entry in the capital account, and in aggregate the two accounts should balance. A balance isn't always reflected in reported figures, which might, for example, report a surplus for both accounts, but when this happens it always means something has been missedmost 5

commonly, the operations of the country's central bank. An actual balance sheet will typically have numerous sub headings under the principal divisions. For example, entries under Current account might include:

Trade buying and selling of goods and services

Exports a credit entry Imports a debit entry Trade balance the sum of Exports and Imports Factor earnings a credit entry Factor payments a debit entry Factor income balance the sum of earnings and payments.

Factor income repayments and dividends from loans and investments

Especially in older balance sheets, a common division was between visible and invisible entries. Visible trade recorded imports and exports of physical goods (entries for trade in physical goods excluding services is now often called the merchandise balance). Invisible trade would record international buying and selling of services, and sometimes would be grouped with transfer and factor income as invisible earnings.

Imbalances
The BOP has to balance overall, surpluses or deficits on its individual elements can lead to imbalances between countries. In general there is concern over deficits in the current account. Countries with deficits in their current accounts will build up increasing debt and/or see increased foreign ownership of their assets. The types of deficits that typically raise concern are

A visible trade deficit where a nation is importing more physical goods than it exports (even if this is balanced by the other components of the current account.) An overall current account deficit. A basic deficit which is the current account plus foreign direct investment (but excluding other elements of the capital account like short terms loans and the reserve account.) 6

Causes of BOP imbalances There are conflicting views as to the primary cause of BOP imbalances, with much attention on the US which currently has by far the biggest deficit. The conventional view is that current account factors are the primary cause these include the exchange rate, the government's fiscal deficit, business competitiveness , and private behaviour such as the willingness of consumers to go into debt to finance extra consumption. An alternative view, argued at length in a 2005 paper by Ben Bernanke , is that the primary driver is the capital account, where a global savings glut caused by savers in surplus countries, runs ahead of the available investment opportunities, and is pushed into the US resulting in excess consumption and asset price inflation.

Balance of payments crisis

A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential imports and/or service its debt repayments. Typically, this is accompanied by a rapid decline in the value of the affected nation's currency. Crises are generally preceded by large capital inflows, which are associated at first with rapid economic growth. However a point is reached where overseas investors become concerned about the level of debt their inbound capital is generating, and decide to pull out their funds. The resulting outbound capital flows are associated with a rapid drop in the value of the affected nation's currency. This causes issues for firms of the affected nation who have received the inbound investments and loans, as the revenue of those firms is typically mostly derived domestically but their debts are often denominated in a reserve currency. Once the nation's government has exhausted its foreign reserves trying to support the value of the domestic currency, its policy options are very limited. It can raise its interest rates to try to prevent further declines in the value of its currency, but while this can help those with debts in denominated in foreign currencies, it generally further depresses the local economy.

Balancing mechanisms
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One of the three fundamental functions of an international monetary system is to provide mechanisms to correct imbalances. Broadly speaking, there are three possible methods to correct BOP imbalances, though in practice a mixture including some degree of at least the first two methods tends to be used. These methods are adjustments of exchange rates; adjustment of a nations internal prices along with its levels of demand; and rules based adjustment. Improving productivity and hence competitiveness can also help, as can increasing the desirability of exports through other means, though it is generally assumed a nation is always trying to develop and sell its products to the best of its abilities. Rebalancing by changing the exchange rate An upwards shift in the value of a nation's currency relative to others will make a nation's exports less competitive and make imports cheaper and so will tend to correct a current account surplus. It also tends to make investment flows into the capital account less attractive so will help with a surplus there too. Conversely a downward shift in the value of a nation's currency makes it more expensive for its citizens to buy imports and increases the competitiveness of their exports, thus helping to correct a deficit (though the solution often doesn't have a positive impact immediately due to the MarshallLerner condition. Exchange rates can be adjusted by government in a rules based or managed currency regime, and when left to float freely in the market they also tend to change in the direction that will restore balance. When a country is selling more than it imports, the demand for its currency will tend to increase as other countries ultimately need the selling country's currency to make payments for the exports. The extra demand tends to cause a rise of the currency's price relative to others. When a country is importing more than it exports, the supply of its own currency on the international market tends to increase as it tries to exchange it for foreign currency to pay for its imports, and this extra supply tends to cause the price to fall. BOP effects are not the only market influence on exchange rates however, they are also influenced by differences in national interest rates and by speculation. Rebalancing by adjusting internal prices and demand

When exchange rates are fixed by a rigid gold standard, or when imbalances exist between members of a currency union such as the Euro zone, the standard approach to correct imbalances is by making changes to the domestic economy. To a large degree, the change is optional for the surplus country, but compulsory for the deficit country. In the case of a gold standard, the mechanism is largely automatic. When a country has a favourable trade balance, as a consequence of selling more than it buys it will experience a net inflow of gold. The natural effect of this will be to increase the money supply, which leads to inflation and an increase in prices, which then tends to make its goods less competitive and so will decrease its trade surplus. However the nation has the option of taking the gold out of economy (sterilizing the inflationary effect) thus building up a hoard of gold and retaining its favourable balance of payments. On the other hand, if a country has an adverse BOP its will experience a net loss of gold, which will automatically have a deflationary effect, unless it chooses to leave the gold standard. Prices will be reduced, making its exports more competitive, and thus correcting the imbalance. While the gold standard is generally considered to have been successful up until 1914, correction by deflation to the degree required by the large imbalances that arose after WWI proved painful, with deflationary policies contributing to prolonged unemployment but not re-establishing balance. Apart from the US most former members had left the gold standard by the mid 1930s. A possible method for surplus countries such as Germany to contribute to re-balancing efforts when exchange rate adjustment is not suitable, is to increase its level of internal demand (i.e. its spending on goods). While a current account surplus is commonly understood as the excess of earnings over spending, an alternative expression is that it is the excess of savings over investment. That is:

where CA = current account, NS = national savings (private plus government sector), NI = national investment. If a nation is earning more than it spends the net effect will be to build up savings, except to the extent that those savings are being used for investment. If consumers can be 9

encouraged to spend more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if the corporate sector divert more of their profits to investment, then any current account surplus will tend to be reduced. However in 2009 Germany amended its constitution to prohibit running a deficit greater than 0.35% of its GDP and calls to reduce its surplus by increasing demand have not been welcome by officials, adding to fears that the 2010s will not be an easy decade for the euro zone. In their April 2010 world economic outlook report, the IMF presented a study showing how with the right choice of policy options governments can transition out of a sustained current account surplus with no negative effect on growth and with a positive impact on unemployment. Rules based rebalancing mechanisms Nations can agree to fix their exchange rates against each other, and then correct any imbalances that arise by rules based and negotiated exchange rate changes and other methods. The Bretton Woods system of fixed but adjustable exchange rates was an example of a rules based system, though it still relied primarily on the two traditional mechanisms. Keynes, one of the architects of the Bretton Woods system had wanted additional rules to encourage surplus countries to share the burden of rebalancing, as he argued that they were in a stronger position to do so and as he regarded their surpluses as negative externalities imposed on the global economy. Keynes suggested that traditional balancing mechanisms should be supplemented by the threat of confiscation of a portion of excess revenue if the surplus country did not choose to spend it on additional imports. However his ideas were not accepted by the Americans at the time. In 2008 and 2009, American economist Paul Davidson had been promoting his revamped form of Keynes's plan as a possible solution to global imbalances which in his opinion would expand growth all round with out the downside risk of other rebalancing methods. History of balance of payments issues historically, accurate balance of payments figures were not generally available. However, this did not prevent a number of switches in opinion on questions relating to whether or not a nations government should use policy to encourage a favourable balance.

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The Balance of Payments Divided

The BOP is divided into three main categories: the current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction. The Current Account The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account. Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports. Receipts from incomegenerating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received.

The Capital Account The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds. The capital account is broken 11

down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets (assets such as equipment used in the production process to generate income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to fixed assets.

The Financial Account In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented. Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account. The Balancing Act The current account should be balanced against the combined-capital and financial accounts. However, as mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies. When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account. If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded. When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP. Liberalizing the Accounts The rise of global financial transactions and trade in the late-20th century spurred BOP 12

and macroeconomic liberalization in many developing nations. With the advent of the emerging market economic boom - in which capital flows into these markets tripled from USD 50 million to USD 150 million from the late 1980s until the Asian crisis developing countries were urged to lift restrictions on capital and financial-account transactions in order to take advantage of these capital inflows. Many of these countries had restrictive macroeconomic policies, by which regulations prevented foreign ownership of financial and non-financial assets. The regulations also limited the transfer of funds abroad. But with capital and financial account liberalization, capital markets began to grow, not only allowing a more transparent and sophisticated market for investors, but also giving rise to foreign direct investment. For example, investments in the form of a new power station would bring a country greater exposure to new technologies and efficiency, eventually increasing the nation's overall gross domestic product by allowing for greater volumes of production. Liberalization can also facilitate less risk by allowing greater diversification in various markets

The Current Account When a trade deficit or surplus is reported, this is usually the account that is being referred to. It is an indication of the desirability of a country's products and services by the rest of the world, and therefore, its competitiveness in the world marketplace. The current account is composed of 4 sub-accounts: 1. Merchandise trade consists of all raw materials and manufactured goods bought, sold, or given away. Until mid-1993, this was the figure that was used when the balance of trade was reported in the media. Since then, the merchandise trade account has been combined with a second sub-account, services, to determine the total for the balance of trade. 2. Services include tourism, transportation, engineering, and business services, such as law, management consulting, and accounting. Fees from patents and copyrights on new technology, software, books, and movies also are recorded in the service category. Most outsourcing of labor is a debit to the services account. 13

3. Income receipts include income derived from ownership of assets, such as dividends on holdings of stock and interest on securities. 4. Unilateral transfers represent one-way transfers of assets, such as worker remittances from abroad and direct foreign aid. In the case of aid or gifts, a debit is assigned to the capital account of the donor nation. The amount of goods and services imported compared to the amount exported is known as the balance of trade. A trade surplus exists when exports exceeds imports over a measured period and a trade deficit exists when imports exceeds exports. The Capital Account The capital account is equal to capital transfers, and the sale of natural and intangible assets to foreigners minus the capital transfers, and the purchase of foreign natural and intangible assets by U.S. residents. 1. Capital transfers include debt forgiveness and migrants transfers (goods and financial assets accompanying migrants as they leave or enter the country). In addition, capital transfers include the transfer of title to fixed assets and the transfer of funds linked to the sale or acquisition of fixed assets, gift and inheritance taxes, death duties, uninsured damage to fixed assets, and legacies. 2. Acquisition and disposal of non-produced, non-financial assets represent the sales and purchases of non-produced assets, such as the rights to natural resources, and the sales and purchases of intangible assets, such as patents, copyrights, trademarks, franchises, and leases.

The Financial Account The financial account, a subdivision of the capital account, consists of 2 categories, which lists trade in assets such as business firms, bonds, stocks, and real estate: 14

1. U.S.-owned assets abroad are divided into official reserve assets, government assets, and private assets. These assets include gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, U.S. credits and other long-term assets, direct foreign investment, and U.S. claims reported by U.S. banks. 2. Foreign-owned assets in the United States are divided into foreign official assets and other foreign assets in the United States. These assets include U.S. government, agency, and corporate securities, direct investment, U.S. currency, and U.S. liabilities reported by U.S. banks.

Balance of Payments Deficit and Surplus

The current account should balance with the capital account, because every transaction is recorded as both a credit and a debit (double-entry accounting), and since credits must equal debits and the balance of payments is equal to credits minus debits, the sum of the balance of payments statements should be zero. For practical reasons, however, it deviates slightly from zero. BOP = Current Account + Capital Account = Credits - Debits 0 For example, when the United States buys more goods and services than it sellsa current account deficitit must finance the difference by borrowing, or by selling more capital assets than it buysa capital account surplus. A country with a persistent current account deficit is, therefore, effectively exchanging capital assets for goods and services. Large trade deficits mean that the country is borrowing from abroad or selling assets to foreigners. In the balance of payments, this appears as an inflow of foreign capital. In reality, the accounts do not exactly offset each other, because of statistical discrepancies, accounting conventions, and exchange rate movements that change the recorded value of transactions. However, the specific accounts can, and almost always do, have surpluses and deficits. Surpluses in 1 account are counterbalanced by deficits in the other. Structure and Classification

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The standard components of both sets of accounts and contains discussions and elaboration of the current account, the capital and financial account, selected supplementary information, and the international investment position . Balance of payments statistics must be arranged within a coherent structure to facilitate their utilization and adaptation for multiple purposespolicy formulation, analytical studies, projections, bilateral comparisons of particular components or total transactions, regional and global aggregations, etc. The structure and classification of balance of payments standard components reflect conceptual and practical considerations, take into account views expressed by national balance of payments experts, and are in general concordance with the SNA and with harmonization of the expanded classification of international transactions in services with the Central Product Classification (CPC). The classification system also reflects efforts to link the structure of the financial account to that of the income accounts and that of the international investment position. The scheme is designed as a flexible framework to be used by many countries in the long-term development of external statistics. Some countries may not be able to provide data for many items; other countries may be able to provide additional data. Furthermore, several components may be available only in combination, or a minor component may be grouped with one that is more significant. The standard components should nevertheless be reported to the IMF as completely and accurately as possible. National compilers are in better positions than IMF staff to make estimates and adjustments for components that do not exactly correspond to the basic series of the compiling economy.

Net Errors and Omissions Application of the principles presented in this Manual should result in a consistent body of positive and negative entries with a net (conceptual) total of zero. In practice, however, when all actual entries are totaled, the resulting balance will almost inevitably show a net credit or a net debit. That balance is the result of errors and omissions in the compilation 16

of statements. Some errors and omissions may be related to recommendations for practical applications approximating principles. In balance of payments statements, the standard practice is to show a separate item for net errors and omissions. Labeled by some compilers as a balancing item or statistical discrepancy, that item is intended as an offset to the overstatement or understatement of their corded components. Thus, if the balance of those components is a credit, the item for net errors and omissions will be shown as a debit of equal value, and vice versa. Sometimes the errors and omissions that occur in the course of compilation offset one another. Therefore, the size of the residual item does not necessarily provide any indication of the overall accuracy of the statement. Nonetheless, interpretation of the statement is hampered by a large net residual.

Structure and Characteristics of the Current Account

It does not cover the carriage, within an economy, of nonresident passengers by resident carriers.) There is a close interrelationship between freight services and goods and, in some instances; such services may not be subject to clear distinctions from goods. There may be analytical interest in both separate and inclusive treatment of the two for purposes of various domestic and international comparisons. Passenger transportation is closely linked with travel, in which some related services are included. Transportation subsumes, with the exception of freight insurance, the shipment and other transportation items as presented in the fourth edition of the Manual. Freight insurance is now included with insurance services. The new grouping should facilitate international comparisons and is in accord with other statistical systems. Travel differs from other components of services in that it is a demand-oriented activity. The traveler (consumer) moves to the location of the economy that provides the goods and services desired. Travel is subdivided into two major components: business and personal. Treated as part of a residual item in the fourth edition of the Manual, other services are accorded increased prominence in the fifth edition. Both the structure and classification of the specific other services are related to the importance attached to these items by international bodies [e.g. in the General Agreement on Tariffs and Trade (GATT) ] as a basis for negotiations and by analysts 17

involved with domestic and international aspects of trade, production, and related issues. Although the significance of these services varies widely in the international accounts of countries, the structure provides a ready reference for items likely to assume increasing importance in international transactions. Income comprises compensation of employees and investment income (covering direct investment income and other dividends and interest). This treatment of income as a separate component of the current account accords with that in the SNA; tightens the links between income and financial account flows and between the balance of payments and the international investment position; and increases the analytical usefulness of the international accounts. Current transfers are grouped separately from goods, services, and income because the former are generally conceived as showing distinctive characteristics. The distinction between real resources and transfers, however, may sometimes be rather arbitrary. For example, receipts by an economy from certain individuals working abroad are classified either as current transfers or as compensation of employees; the classification depends on how long the individuals have stayed in the countries where they are working. The Manual and the SNA define a current transfer in the same way, and the disaggregation of transfers into current transfers and capital transfersa departure from previous editions aligns with SNA treatment and with various analytical presentations. This change removes inconsistencies in the use and meaning of the term current as it concerns transactions and balancing items in the Manual and the SNA. Gross Recording, Valuation, and Time of Recording In the current account, gross outflows from and gross inflows to the economy should, in principle, be recorded as credits and debits, respectively. Individual components are defined in such a way that entries would be made on a gross basis. This emphasis on gross recording in the current account stems from the fact that credit and debit entries for many specific types of current transactions are seldom related in a causal way. For example, even though provision and acquisition of travel services are included in the single component for travel, provision of travel services has, from an economic 18

standpoint, little connection with the acquisition by the same economy of such services. Moreover, gross figures are utilized in contexts other than the analysis of balance of payments developments. In general, gross transactions recorded in the current account are often indicators of the relative importance of particular items within an economy and of the relative importance of various economies in international transactions. Gross transactions recorded in the current account are therefore used to compare economies and to provide weights for aggregation. Also, gross figures provide a better basis for analysis of changes in net balances. Two specific applications important for the IMF represent the use of gross figures: (i) Valuation of the SDR is based on a basket of currencies selected in consideration of the issuing countries shares in world exports of goods and services and weighted in broad proportion to those shares. (ii) The relative size of an IMF members gross transactions in the current account is one factor used to determine the relative quota of a Fund member. STRUCTURE AND CLASSIFICATION Exceptions to the general rule of gross recording are sometimes made because of the practical difficulty of collecting certain information on a gross basis (e.g., some transportation services) or because of netting procedures used to derive certain estimates. Nonetheless, gross recording remains the principle for recording transactions in the current account and, in general, is more useful than net recording for balance of payments accounts of the SNA external accumulation accounts. However, in the balance of payments, the primary basis for classification of the financial account is functional category (i.e., direct investment, portfolio investment, other investment, and reserve assets) while the SNA classification is primarily by type of instrument: monetary gold, currency and deposits, loans, etc. The structure of the capital and financial account also is generally compatible with other statistical systems of the IMF and is consistent with the classification of related income components of the current account and with the international investment position. The capital and financial account of the balance of payments is divided into two main categories: the capital account and the financial account. The capital account covers all transactions that involve the receipt or payment of 19

capital transfers and acquisition or disposal of non produced, nonfinancial assets. The financial account covers all transactions associated with changes of ownership in the foreign financial assets and liabilities of an economy. Such changes include the creation and liquidation of claims on, or by, the rest of the world. All changes that do not reflect transactions are excluded from the capital and financial account. The following changes are among those specifically excluded: valuation changes in, or reclassifications of, reserves; changes resulting from territorial or other changes in classification of existing assets (for example, portfolio investment to direct investment); allocation or cancellation of SDRs; monetization or demonetization of gold; write-offs (that is, changes resulting from the unwillingness or inability of a debtor who resides in one economy to make full or partial repayment including expropriation without compensationin settlement of a claim to a creditor who resides in another economy and regards part or all of the claim as unrecoverable); and valuation changes, which reflect exchange rate or price changes, in assets for which there are no changes in ownership. When there is a change in ownership and an asset acquired at one price is disposed of at a different price, both assets are recorded at respective market values and the difference in valueholding (capital) gain or lossis included in the balance of payments. Capital Account The capital account consists of two categories: (i) capital transfers and (ii) acquisition or disposal of non produced, nonfinancial assets. In previous editions of the Manual, capital transfers were included indistinguishably with current transfers in the current account. Capital transfers are classified primarily by sector (i.e., general government and other sectors). Within each, debt forgiveness is specified as category while migrants transfers comprise a category under other sectors. In concept, acquisition or disposal of non produced, nonfinancial assets comprises transactions associated with tangible assets that may be used or necessary for production of goods and services but are not actually produced (e.g., land and subsoil assets) and transactions associated with non produced, intangible assets (e.g., patents, copyrights, trademarks, franchises, etc. and leases or other transferable contracts). However, in the case of resident-nonresident transactions in land 20

(including subsoil assets), all acquisition or disposal is deemed to occur between resident units, and the nonresident acquires a financial claim on a notional resident unit. The only exception concerns land purchased or sold by a foreign embassy when the purchase or sale involves a shift of the land

Structure and Characteristics of the Capital and Financial Account

From one economic territory to another. In such instances, a transaction in land between residents and nonresidents is recorded under acquisition or disposal of non produced, nonfinancial assets. The changes recorded for all of the assets described in this paragraph consist of the total values of assets acquired during the accounting period by residents of the reporting economy less the total values of the assets disposed of by residents to nonresidents. Financial Account The foreign financial assets of an economy consist of holdings of monetary gold, SDRs, and claims on nonresidents. The foreign liabilities of an economy consist of indebtedness to nonresidents. To determine whether financial items constitute claims on, or liabilities to, nonresidents, the creditor and debtor must be identified as residents of different economies. The unit in which the claim or liability is denominatedwhether the national currency, a foreign currency, or a unit such as the SDRis not relevant. Furthermore, assets must represent actual claims that are legally in existence. The authorization, commitment, or extension of an unutilized line of credit or the incurrence of a contingent obligation does not establish such a claim, and the pledging or setting aside of an asset (as in a sinking fund) does not settle a claim or alter the ownership of the asset. However, options and other financial derivatives are included among financial items, in accordance with the treatment of these items in the SNA. These instruments can be valued by reference to the market prices of the derivatives or to the market prices of the 21

commitments underlying the derivatives. Thus, both parties to a derivative contract recognize a financial instrument; one party recognizes a liability and the other recognizes a claim. Alternatively, this value could be viewed as the amount that one party must pay to the other party in order to extinguish the contract. As a result, derivatives satisfy the definition of foreign financial assets and liabilities. The conventions stated in this Manual result in ownership of some nonfinancial assets being construed as ownership of financial assets (claims). The following specific cases are examples. The ownership of immovable assets, such as land and structures, is always attributed to residents of the economies in which the assets are located. Therefore, when the owner of such assets is a nonresident, he has, in effect, a financial claim on a resident entity that is considered the owner. An unincorporated enterprise operating in a different economy from the one in which the owner of the enterprise resides is considered a separate entity; that entity is a resident of the economy in which it operates rather than a resident of the economy of the owner. All nonfinancial as well as financial assets attributed to such an enterprise are regarded as foreign financial assets for the owner of the enterprise. Any goods transferred under a financial leasing arrangement are presumed to have changed ownership. This change in ownership is financed by a financial claim (i.e., an asset of the lessor and a liability of the lessee). At the time the imputed change in ownership occurs, the market value of the good is recorded under goods in the current account, and an offsetting entry is made in the financial account. In subsequent periods, the actual leasing payment must be divided into interest, which is recorded in the current account as investment income payable or receivable, and debt repayment, which is recorded in the financial account and reduces the value of the lessors asset and the lessees liability. The financial asset should be classified as a loan. Transactions in assets Transactions in assets (specifically, changes of ownership, including the creation and liquidation of claims) most often reflect exchanges of economic values. Financial items may be exchanged for other financial items or for real resources. However, one party to a transaction may provide a financial item and not receive any economic value in exchange. The offset to this latter type of provision of an asset is a transfer. To establish whether a transaction involving a foreign asset is a transaction between a resident and a nonresident, the compiler must know the identities 22

of both parties. The information available on transferable claims constituting foreign assets may not, however, permit identification of the two parties to the transaction. STRUCTURE AND CLASSIFICATION Ascertain whether a resident, who acquired or relinquished a transferable claim on a nonresident, conducted the transaction with another resident or with a nonresident, or whether a nonresident dealt with another nonresident or with a resident. Thus, a recommendation that the balance of payments be confined solely to asset transactions between residents and nonresidents would be difficult or impossible to implement. Also, the introduction, in this Manual, of a domestic sect oral breakdown for the portfolio investment and other investment components of the financial account makes it necessary to record certain transactions between resident sectors within the economyalthough such transactions cancel each other for the total economy. As a result, recorded transactions may include not only those that involve assets and liabilities and take place between residents and nonresidents but also those that involve transferable assets of economies and take place between two residents and, to a lesser extent, transactions that take place between non residents. Because the credit and debit entries for most components of the financial account are according to the rules of this Manual generally net, many transactions between residents and between nonresidents will offset each other and thus will not actually appear as entries in the balance of payments statement. The most prevalent types of transactions that do not cancel each other are, for assets, those transactions between resident creditors classified in different functional categories or domestic sectors. For liabilities, the identity of the nonresident creditor is a factor only in a few instances (for example, in differentiating between direct investment and other types of capital and in determining regional allocation). Net recording can also result in a transaction between a resident and a nonresident being offset by a transaction between residents or by a transaction between nonresidents. For instance, a resident may acquire a claim against a nonresident and, during the same recording period, transfer the claim to another resident classified in a different sector. The first residents transaction with a nonresident is canceled by the same residents subsequent transaction with another resident (if the value of the claim does not change). So, in the balance of payments, only 23

the increase in the second residents holdings, which are actually acquired through a transaction with the first resident, are recorded. The effect is the same as if the second resident dealt directly with the nonresident. Reinvested earnings The reinvested earnings of a direct investment enterprise (which accrue to a direct investor in proportion to participation in the equity of the enterprise) are recorded in the current account of the balance of payments as being paid to the direct investor as investment income-income on equity and in the financial account as being reinvested in the enterprise. Thus, these reinvested earnings increase the value of the stock of foreign assets of the direct investors economy. In a similar way, the distribution to direct investors of earnings (in the form of stock dividends) included in investment incomeincome on equity results in an increase, shown in the financial account, in the investors equity. Borderline cases In some cases, questions may arise as to whether transactions have taken place; for examplewhen the maturity of a debt instrument is extended (and thereby changed from a nominally short-term claim to a nominally long-term claim) or when a government takes over an obligation for liabilities incurred by the private sector and the sector of the domestic debtor is altered. As a change in the original terms of a contract requires the assent of both parties, the existing claim is considered to be satisfied by the creation of a new one. (That is, a pair of transactions between a resident and a nonresident has occurred.) Changes in contractual terms for existing assets are thus construed as constituting transactions to be included in the balance of payments statement. Another borderline case arises when a transactor intends to dispose of a certain asset at virtually the same moment that ownership of the asset is acquired. (Examples are arbitrage and certain other dealings in financial assets.) The issue may be viewed two ways. (i) If two changes of asset ownership have occurred, any profit or loss could be regarded as the realization of a holding (capital) gain or loss and could be entered, like any other realization of a holding gain or loss, in the appropriate component of the financial account. (ii) If no change of ownership has effectively taken place, the profit or loss 24

could be seen as a fee for a service. It is recommended that the treatment described in (i) be used because entries in the financial account may reflect, without regard to the fact that some items may have been owned only briefly, the holding gain or loss realized on the purchase and sale of financial items at different market prices. Net recording Two or more changes in a specific asset, or changes in two or more different assets classified in the same standard component, are consolidated in a single entry. This entry reflects the net effect of all the increases and decreases that occur during the recording period in holdings of that type of asset. For example, purchases (by nonresidents) of securities issued by resident enterprises of an economy are consolidated with sales (by nonresidents) of such securities, and the net change is recorded for that item. Net decreases in claims or other assets and net increases in liabilities are recorded as credits; net increases in assets and net decreases in liabilities are recorded as debits. Net recording for standard components distinguished in the capital and financial account is specified partly because gross data for transactions often are not available. Changes derived from records showing amounts outstanding at the beginnings and ends of reporting periods, for example, always represent net changes. In addition, net recording generally is of more interest than gross recording, which would give added prominence to the transactions between residents and between nonresidentsthat are covered in the statement. Nonetheless, gross entries may be a relevant factor in analyzing aspects of the payments positions or financial markets (e.g., securities transactions) of economies, and such data can be utilized in supplementary presentations when appropriate. For direct investment, particularly for reasons of analytic usefulness, it is suggested in this Manual that separate totals for liabilities to, and claims on, direct investors on the part of affiliated enterprises (and vice versa) be recorded for the appropriate components of direct investment (i.e., equity capital and other capital) in addition to the net figures for each. In the totaling of net credits and debits for two or more separate components, the net approach is always favored. For instance, if equity securities and debt securities are combined to show a net figure for these two components, the net for each should be totaled not net credits and debits separately.

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Classification The primary purpose of the classification of items in the financial account is to facilitate analysis by distinguishing categories that exhibit different patterns of behavior. Changes in financial items recorded in the balance of payments occur for a wide variety of reasons. Such changes may occur to settle actual imbalances or to deal with prospective imbalances; to influence or react to exchange rate movements; to make holding (capital) gains (or avoid losses) on past or future valuation changes, including those resulting from exchange rate changes; to take advantage of interest rate differentials; to establish, acquire, or expand enterprises; to obtain or provide additional real resources in connection with commercial and financial activities; and to diversify investments. In the collection of data, it is usually not feasible to inquire into the underlying causes and motivations for changes in holdings. However, behavior is also associated to a considerable degree with such attributes as type of asset and sector of holder. Characteristics of this kind are readily observable and can thus be used as a basis for developing a classification scheme. In this Manual, several bases are utilized for classifying financial items: functional type; assets and liabilities; type of instrument; domestic sector; original contractual maturity; and, in the case of direct investment, direction of investment (i.e., inward or outward). The primary basis for the classification of components of the financial account is functional type. Further classification levels in these categories are based upon factors relating to general analytical usefulness and compatibility with other statistical systems. The components can, of course, be rearranged to meet specific analytic requirements and to include, when appropriate, subordinate and supplementary classification.

References

Economics 8th Edition by David Begg, Stanley Fischer and Rudiger Dornbusch, McGraw-Hill 26

Economics Third Edition by Alain Anderton, Causeway Press Business Environment - Shaikh Saleem

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