Balance of Payments Account - Example

BALANCE OF PAYMENTS ACCOUNT BACKGROUND/INTRODUCTION The pocket of a country is managed like the budget of the people. The statistical summary that defines the transaction details of the economy for a specific period of time is known as balance of payment. Therefore, balance of payment is details of the transaction that an economy conducts with rest of the world detailed in an account known the balance of payment (Porcile, Dutra, & Meirelles, 2007). The transaction as referred in the balance of the payment takes into accounts different components which are as follows (Vera, 2006; McCombie, 2013): Transaction for goods and services Exchange of income which include financial and monetary claims Transfers and gifts Hence, every economic activity that results in the economic flow in terms of creation, transformation, transfer and exchange resulting from the ownership of the goods or services, financial capital and/ or assets or by servicing of the labor and capital (IMF, 2002). The balance of payment is a flow oriented document defining the transaction flow in the economy. Additionally, balance of payment can also be developed for defining the stock related balance of payment in which changes in the stock is determined for a given period of time. Balance of payment explains the economic links of the country with the rest of the world. For example, technically, a balance of payment shall be zero after accounting all inflows and outflows to the economy (Santos‐Paulino & Thirlwall, 2004). This condition is defined as an equilibrium; however, it such ideal condition does not exist in the real world. Furthermore, the countries continue constant efforts for the move close to the ideal condition of the balance of payment. This paper takes into account the components of the balance of payment (BoP) while shedding light on the disequilibrium reason. COMPONENTS OF BALANCE OF PAYMENT Balance of Payment carries critical insight for countries to understand. For example, countries determine their trade policy, exchange rate, and financing needs and abilities depending upon the BoP condition of the countries. A statistical summary of the country broadly has three components which are current account, capital account and the financial account. Each account further has other components that in detail determine the role of each factor in each county’s economy. The current account is the section of BoP in which the details pertaining to import, exports, investment inflows and outflows, and net inflow and outflow transfer of goods and services are considered in detail (Barbosa-Filho, 2012). List of items in the current account includes imports and exports of goods; service such as transportation, travel, construction, information and communication, business, culture and recreational related service; income exchange such as investment income, current transfers, and other sectors that have been exchanged between the two countries in relation are compiled in details (Calvo, 2000). According to the definition given by Cherunilam (2010), the current account consists of two categories of import and export which are merchandise and the invisible ones. For example, the sample current account balance is depicted below: (Hubbard and O’Brien, 2006) The current account can have a deficit or the surplus. The above situation in example has deficit where current account has more imports as compared to the value of goods (and other components) it has exported. This implies that income of the country components of current is less than expenditure on these components incurred by the country. According to Cherunilam (2010), the current account balance can also be defined as the sum of net foreign investment, net of national saving and domestic investment (S-Id) and the difference between the domestic product and national expenditure (Y-A). The second component of the BoP is the Capital Account. The capital account as the name implies includes the major changes in the capital of the country. These changes include the transfer of capital between the home country and the countries of relation. It also includes the acquisition or disposal of non-financial assets or non-produced assets (Araujo & Lima, 2007). Digging deep down, capital transfer in the capital account includes transfer in ownership of fixed assets, transfer of funds due to conditional, or any other reason related to fixed asset. On the basis of parties, current capital account is divided into capital transfer related to the government such as debt or the capital transfer related to the migrants etc. Other component of the capital account being acquisition or disposal or the non-produced and non-financial assets include components such as patents, goodwill etc (Rubaszek, 2004). The financial account in the balance of payment includes the components of direct investment, portfolio investment, other investment, and the reserve asset. The short term and long term assets, as well as liabilities of the countries, are accounted in the financial accounts (IMF, n.d.). Hence, sample of the capital accounts is as follows: (Cherunilam, 2010) Hence, collectively the three components determine the BoP of the country. However, these components of the balance of payment only appear to be simple but are complex in their dealing. Such as in contrast to the technical concept that requires balance of payment to conclude with zero as a result of the balance of capital and the current account; however, as the statement always ends up with credit or a balance figure. This is the difference in the number often arise due to the limited coverage to the transactions (Miller, 2002). Another reason that results in the difference, in the balancing of BoP is often reported to be the fact that prices of different reported components are found to be non-uniform. Furthermore, the difference is also attributed to the difference in the recording time which is affected by the difference in the policy, practices, and conversation practices. Hence, multiple implications are found responsible for the difference in the BoP. The difference amount is reported under net errors and omissions title with the reverse sign in order to formally balance the statement (Robinson, 2004). The concluding numbers of the balance of payment components are subject to debates in terms of their implications to the country. For example, the current account surplus means that a country has capital account deficit in accordance with the basic concept of the balance of all the components. However, the practical implication of current account deficit is that products from such country have greater demand in other countries due to competitive pricing or quality or any other factors etc (Kumhof, Li, & Yan, 2007). Furthermore, in the modern world the countries are under constant pressure arising from the comparative advantage and the specialization which often results in the widening gaps in the balance of payment. Hence, realities on the ground are usually different. Contrary to the technical meaning from the values of the surplus and the deficits, the impact of these terms is accounted on the basis of the policy implications and countries are more concerned for the policy implications of the balance of payment as compared to the technical implications (Johnson, 2014). CRITICAL REVIEW OF RELEVANT THEORIES OF INTERNATIONAL BUSINESS ECONOMICS The resulting difference in the balance of payment that is to be accounted in the net errors and omissions is caused by many factors. International business reports difference reasons explaining the main causes of difference. Broadly, the difference, is to be accounted under factor that result due to the economic reasons, social factors, or the political pressures (Rowthorn & Coutts, 2004). The social factors which account the difference in the preference of the society pose a considerable impact on the Balance of Payment statement. Some example of social factors to have an influence include the changes in fashion, trends, and tastes that in turn affect the level of imports and exports of the country create disequilibrium in BoP (Cherunilam, 2010). For example, cases of developing countries are increasingly dependent on the imported goods from the developed countries. Imports of the developing countries not only constitute the basic necessities but also the imports for the luxuries from developed countries as social preference (Berg, 1999). Political condition of the country results in producing positive and negative change in BoP statement. For example, countries offering free industrial zone for processing will receive greater investment while political instability in the country results in the capital flight from the country (Cherunilam, 2010). Similarly, impact of the political and the legal institutions have considerable impact on the level of openness of the economy. This openness has a direct impact on the foreign direct investment received in the country (Bussiere, 2013). Glick & Hutchison (2005) in a study have concluded that countries with less restriction on capitals that result in the liberalized economies are more able to resist the attack of potential crises from the speculative attacks on the currency. It is critical as the currency factors have considerable influence on the BoP. Economic factors most importantly affect the balance of payment. The impact of economic factors is also complimented with the pressures arising from the political and the social factors. Furthermore, there are large numbers of economic factors that result in the disequilibrium on the BoP (Chang, 2011). All these factors are categorized into four sections as follows: DISEQUILIBRIUM DUE TO DEVELOPMENT ISSUES: The development usually disequilibrium arises from the intense capital expenditure that results the huge imports. Hence, creates or expands the BoP gap (Cherunilam, 2010). For example, developing countries have high capital intensive imports against the export of the labor intensive products as their strategy (Balassa, 1984). DISEQUILIBRIUM DUE TO BUSINESS CYCLE ISSUES: Business Cycle not only have shrinking effect on the domestic economic instead it have considerable impact on the trade and relationship with other countries of the world (Cherunilam, 2010). For example, the recent global financial crises provide the best example on the impact of the business cycle. The impact of sub-mortgage crises was not only witnessed in the United States of America from where it started but also was witnessed in other countries. United Kingdom acknowledged the impact of the sub-prime mortgage crises only when the crises hit its own doorstep. This situation endorsed the Keynesian concept of interdependency of economies and its inability to revive itself on its own (Adair et al., 2009). Hence, the impact of financial crises affected the BoP’s section of investments considerably. DISEQUILIBRIUM DUE TO SECULAR FACTORS: The secular trends results in a certain situation of balance of payment for a longer period of time. For example, developed countries have higher disposable income. This positively affects the demand of the products and services in the economy. Alongside, on the other hand, high disposable income results in the higher wages demand by the labor. Both these factors cumulate the impact of the high cost of production. Comparatively, similar products in the developing countries with low labor cost and so low cost of production is made available at a lesser price. Hence, gives rise to the consistent trend of imports of the developed countries (Cherunilam, 2010). A secular trend needs analysis. As evident that economies running in deficit must take measures to reduce the level of dependency on factors for which it is not able to pay. However, for the surplus it is also important for the country to explore the factors that are fueling secular surplus trend. For example, surplus from the grant or aid does not reflect the strength of the economy. There is an ongoing debate not only on the causes of such disequilibrium but also on the fact that if such difference needs any corrective measures or shall be driven by self-corrective mechanism (Bobai, 2013). Cherunilam (2010) has graphically depicted potential measures for the improvement of the balance of payment as follows: (Cherunilam, 2010) Hence, by exploring the factor that is fueling the deficit or the surplus, the country can take measures for the improvement in the position either by corrective or the deliberate measures to close the gap of BoP. The analysis of the BoP considers different approaches for closing the gap of balance of payment. These approaches include: Monetary Approach: Under this approach the disequilibrium in the BoP is covered with adjusting the money supply in the country to the money demand. Hence, the difference in the demand and supply of the money in the country with respect to the rest of the world is adjusted by the adjusting the money quantity (Rehman & Rashid, 2006). According to this approach, the disequilibrium in the balance of payment is largely due to the monetary implications. According to Umer, et al., (2010) the monetary approach takes into account the primary role of the general price level as the value determinant of the nominal assets, debts and money while the role of relative prices to have a transitory effect on the balance of payment. Howard and Mamingi, (2002) criticized the approach for it only accounting for the monetary value of factors while ignoring the real value of the factors. Bobai (2013) refers, in order to account to the monetary imbalances; the policy solutions shall be implied in order to deal with the disequilibrium. For instance, the monetary policy to determine the interest rate which in turn controls the supply of money in the country and can be used to have an impact on the BoP (Rehman & Rashid, 2006). The Elasticity Approach: This approach was developed by Robinson in 1930s and takes into account the impact of exchange rate on the imports and exports of the country. Therefore, this approach does not take into account the capital account factors (Bobai, 2013). Therefore, it is accounted as the partial equilibrium. The Absorption Approach: This approach was developed to shed light on the importance of the changes in the income in the process of adjustment (Du Plessis et al., 1998). The system of the absorption method takes emphasizes that changes in the valuation can have an impact on the expenditure as well as the impact on the difference between the absorption and the income factors. Importantly, unlike the monetary approach that only takes accounts for the impact of the monetary value, this method takes into consideration the impact in real as well as nominal terms (Bobai, 2013). This approach or the devaluation often results in the inflationary pressures and measures are required to control the resulting inflationary pressures impact (Fleermuys, 2005). CONCLUSIONS The balance of payment is a reflection of the economic and financial strength of the economy. Contrary to the technical concept, the balance of payment of almost all countries either run in deficit or has surplus. Furthermore, BoP is a complex system where each component has its own relationship with the local and international factors; therefore, surplus or deficit dealing becomes a challenging job to deal with. Each component of the BoP statement requires complete designing of the inter-related policies that are able to produce the strength in the economy. Different economists have contributed in defining the different factors that have an impact on the BoP while the debate on the approach to be employed is still under constant evolution. Importantly it has identified that conditions of each economy is different and corrective measures to deal with the complex gaps of the BoP shall be accounted in their respective ways. List of References Adair, A., Berry, J., Haran, M., Lloyd, G., & McGreal, S. (2009). The global financial crisis: Impact on property markets in the UK and Ireland. Available from http://news.ulster.ac.uk/podcasts/ReiGlobalCrisis.pdf [Accessed 16 March 2014] Araujo, R. 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