How to define the payments among nations? - Chapter 16

Many international transactions are trades in financial assets. This can be deposits, loans, stocks and bonds. Almost all international transactions involve the exchange of money for something else: a good, a service or perhaps a different financial asset. This text looks at the framework that we use to summarize the international transactions of a country. The balance of payments what we use to keep score of all value flows between countries. But first, we need to obtain an understanding of basic accounting principles. 

What are the main accounting principles?

With balance of payment accounting, there are two directions the value flow can go in and out of a country: one direction out of the country and one direction into the country. A credit item is an item that the country gets a payment. This is measured with a positive sign (+). Credit items can be exports, but can also occur when you sell something to a foreigner in the country or a foreigner invests in the country. The opposite direction is a debit item. This is an item that the country has to pay for. This is measured with a negative sign (-). These items can be imports, but can also occur when you buy shares of a foreign country. Each transaction will have two items: either one positive and one negative, or sometimes two negatives or positives. This is the international approach of the fundamental accounting principle called double-entry bookkeeping. It is important to know that when you add all the debit and credit items of a country together, the total will always be zero. The interesting part of a balance of payment is when you look closer, into smaller categories of the balance: a sub-balance. This sub-balance (or just called a balance) actually can be positive or negative, unlike the whole balance of payment. A positive balance is a surplus and a negative balance is a deficit.

How to define a country's balance of payments?

There are three main parts of a country its balance of payment. These are the current account, the financial account and the official international reserves.

The current account (CA) records all credit and debit that comes in the form of exports and imports of goods and services (also called merchandise). These imports and exports are a balance within the CA called the goods and services balance. The goods and services balance is good for measuring the country its net exports. 
Receipts and payments of income are also part of the CA and are called the income flows. They are mainly the payments to holders of foreign financial assets. These include interest, dividends and other claims on the profits by the owners of businesses abroad. Payments to foreign workers are also included in the income flow. An example of this is a Dutch student works for a few months in the U.S. as an au pair. 
Lastly, unilateral transfers are added to the CA. These are items that keep track of gifts that a country receives or gives from and to other countries. These debit and credit items are necessary to sustain a double entry for each gift. An example here is the Netherlands donating Dutch trees to Portugal, to help regrow trees after a massive woods fire. 
All these flows of goods and services, income and gift transfers are the net value of the CA balance.

The financial account balance (FA) sums up the flows of financial assets. These are the net flows of financial assets or other similar claims. It is important to note that this does not include the official international reserve asset flows. Only principle amounts of these financial assets are taken into account. Earnings on foreign assets are recorded in the CA. But what is a debit or a credit is on the FA? For example, when you, a Dutch citizen, buy a stock in Australia, it is a debit. You make a payment to a foreigner, so the money is flowing out of the Netherlands into Australia. However, if you want to decrease or increase your holding of the Australian stock, it is a credit. This is because you receive payment from Australia.
When you bought the stock, this was the Netherlands importing financial assets to Australia. This is also called capital export. But when you increased or decreased your holding, it was the Netherlands exporting financial assets to Australia. This is called capital import. 
Also, foreign direct investment (FDI) and international portfolio investment is part of the FA.

The final part of balance of payments is the official international reserve assets (OR). As mentioned before this is actually part of the FA, however important enough to name as a part on the balance of payments on its own. These are money-like assets owned by the government. We say ‘money-like’ because they are accepted as payments between governments, but it is not actual money. Other monetary institutes hold them too. Centuries ago, gold was the OR. Now the major reserve assets are foreign exchange assets, assets that are ready to be accepted in international transactions.

What is the macro meaning of the current account balance?

What we did not tell you is that the current account (CA) balance can have multiple meanings. The first meaning is the double-entry bookkeeping. However, all the items except the CA are international financial investment flows (so the financial account and the official international reserve assets). Because of this, the balance of the country its current account has to be equal to the net foreign investment (If). This is the increase in foreign financial assets minus the increase of foreign financial liabilities of a country. When there is a surplus in the country its current account, its foreign assets are growing quicker than its foreign liabilities. This results in a positive net foreign investment for the country and means the country is a net lender to the rest of the world. However, if the current account is deficit, the foreign liabilities are growing faster. Thus, the net foreign investment is positive and the country is a net borrower to the rest of the world.

Every country has its national savings (S), which comes from a surplus in the financial account for example. With this S, a country could do two things: invest in net If abroad or invest in domestic capital formation (also called domestic real investment (Id)) at home.The S is the Id plus the If. And if we look at it another way, the If is the S minus the Id. As we mentioned, the CA showed us the S that is not invested at home. To calculate this, you do national savings minus Id.

The CA also shows the difference between domestic production of services and goods (Y) and the total expenditures on services and goods (E). The formula for this is Y is the domestic consumption (C) plus the Id plus the government spending on services and goods (G) plus the exports (X) minus the imports (M). E is calculated when you do the C plus the Id plus the G. Finally, the CA is equal to the net exports. This is CA is X minus MisYminusE. All these formulas might be confusing. In table 1, we provide you with overview of all the formulas mentioned above.

Table 1. Formulas.

What is the macro meaning of overall balance?

The overall balance depicts if a country has a balance of payments that developed a pattern that is relatively sustainable over time. However, it is difficult to show a perfect representation of the overall balance. To indicate this, the net foreign investment (If) is divided into two components: net private capital flows (which can be found on the financial account balance (FA)), and net official reserve assets flow (OR). The sum of CA and FA forms B, the official settlements balance (B). So B is CA plus FA. All items on the balance of payments have to sum up to zero. If there is an imbalance in the B, it should be financed through OR. This makes the sum B plus OR will be zero.

So if there is a deficit, the country’s official reserve assets will decrease (so, a credit in OR). If there is a surplus, they will increase (so, a debit in OR). In practice, that means that if there is a surplus in B, the country will sell its own currency in exchange for foreign currency.

Next to the balance of payments accounts, we have a balance sheet: the international investment position. This is not about flows, but about stocks of assets and liabilities at a given point (normally the end of the year). This sheet complements the balance of payments accounts (recall, stocks are accumulated flows). If there is a surplus on the balance of payments accounts, foreign currencies will be bought, and the international investment position will be better at the end of the year, which will be shown on the balance sheet of the international investment position. Recall that if the CA is in surplus, the country is a lender to the world, and with a deficit, it is a borrower. For the international investment position, we say that a country is a creditor (positive stock) or a debtor (negative stock).

BulletPoints

• With balance of payment accounting, there are two directions the value flow can go in and out of a country: one direction out of the country and one direction into the country. A credit item is an item that the country gets a payment. This is measured with a positive sign (+). Credit items can be exports, but can also occur when you sell something to a foreigner in the country or a foreigner invests in the country. The opposite direction is a debit item. This is an item that the country has to pay for. This is measured with a negative sign (-). These items can be imports, but can also occur when you buy shares of a foreign country. Each transaction will have two items: either one positive and one negative, or sometimes two negatives or positives. This is the international approach of the fundamental accounting principle called double-entry bookkeeping. It is important to know that when you add all the debit and credit items of a country together, the total will always be zero. The interesting part of a balance of payment is when you look closer, into smaller categories of the balance: a sub-balance. This sub-balance (or just called a balance) actually can be positive or negative, unlike the whole balance of payment. A positive balance is a surplus and a negative balance is a deficit.
• The current account (CA) records all credit and debit that comes in the form of exports and imports of goods and services (also called merchandise). These imports and exports are a balance within the CA called the goods and services balance. The goods and services balance is good for measuring the country its net exports. 
  Receipts and payments of income are also part of the CA and are called the income flows. They are mainly the payments to holders of foreign financial assets. These include interest, dividends and other claims on the profits by the owners of businesses abroad. Payments to foreign workers are also included in the income flow. An example of this is a Dutch student works for a few months in the U.S. as an au pair. 
  Lastly, unilateral transfers are added to the CA. These are items that keep track of gifts that a country receives or gives from and to other countries. These debit and credit items are necessary to sustain a double entry for each gift.
• The financial account balance (FA) sums up the flows of financial assets. These are the net flows of financial assets or other similar claims. It is important to note that this does not include the official international reserve asset flows. Only principle amounts of these financial assets are taken into account. Earnings on foreign assets are recorded in the CA. But what is a debit or a credit is on the FA? For example, when you, a Dutch citizen, buy a stock in Australia, it is a debit. You make a payment to a foreigner, so the money is flowing out of the Netherlands into Australia. However, if you want to decrease or increase your holding of the Australian stock, it is a credit. This is because you receive payment from Australia.
  When you bought the stock, this was the Netherlands importing financial assets to Australia. This is also called capital export. But when you increased or decreased your holding, it was the Netherlands exporting financial assets to Australia. This is called capital import. 
• The final part of balance of payments is the official international reserve assets (OR). As mentioned before this is actually part of the FA, however important enough to name as a part on the balance of payments on its own. These are money-like assets owned by the government. We say ‘money-like’ because they are accepted as payments between governments, but it is not actual money. Other monetary institutes hold them too. Centuries ago, gold was the OR. Now the major reserve assets are foreign exchange assets, assets that are ready to be accepted in international transactions.
• Every country has its national savings (S), which comes from a surplus in the financial account for example. With this S, a country could do two things: invest in net If abroad or invest in domestic capital formation (also called domestic real investment (Id)) at home.The S is the Id plus the If. And if we look at it another way, the If is the S minus the Id. As we mentioned, the CA showed us the S that is not invested at home. To calculate this, you do national savings minus Id.
• The overall balance depicts if a country has a balance of payments that developed a pattern that is relatively sustainable over time. However, it is difficult to show a perfect representation of the overall balance. To indicate this, the net foreign investment (If) is divided into two components: net private capital flows (which can be found on the financial account balance (FA)), and net official reserve assets flow (OR). The sum of CA and FA forms B, the official settlements balance (B). So B is CA plus FA. All items on the balance of payments have to sum up to zero. If there is an imbalance in the B, it should be financed through OR. This makes the sum B plus OR will be zero.

TentamenTickets

• In the book, official international reserves (OR) are described as a third part of the balance of payments. However, this is actually part of the second balance, the financial account (FA). It was mentioned in the lecture that this should not be mistaken.
• A question that could occur in the exam or midterm would be: Which one will improve the Dutch current account? 

1. The Netherlands reduces tariffs on imported goods. 
2. The Netherlands cuts back on Dutch military personnel stationed in Korea. 
3. Dutch tourists travel in large numbers to South America. 
4. Italian limoncello becomes increasingly popular in the Netherlands. 

• Which of the following transactions would be recorded as a debit item in the Swiss balance of payments? We ask you about the first booking. You can assume that the second booking would always involve the official reserves (OR) account. 

1. A Swiss resident transfers $200 from his account at Credit Aussie in Sydney (Australia) to his account at the Amsterdam branch of SNS Bank. 
2. A French resident transfers $200 from his account at SNS Bank in Amsterdam to his Credit Aussie account in Sydney. 
3. A Swiss resident sells his IBM stock to a French resident. 
4. A Swiss resident sells his Credit Aussie stock to a French resident.