2. Balance of payment as the monetary Peformance of Any Economy in International Markets

International business is facilitated by markets that allow for the flow of funds between countries. The transactions arising from international business cause money flows from one country to another. The balance of payments is a measure of international money flows.

Financial managers of MNCs monitor the balance of payments so that they can determine how the flow of international transactions is changing over time. The balance of payments can indicate the volume of transactions between specific countries and may even signal potential shifts in specific exchange rates.

The balance of payments is a summary of transactions between domestic and foreign residents for a specific country over a specified period of time. It represents an accounting of a country's international transactions for a period, usually a quarter or a year. It accounts for transactions by businesses, individuals, and the government.

Each year countries purchase trillions of dollars of goods, services, and assets from each other. The BOP accounting system is a double-entry bookkeeping system designed to measure and record all economic transactions between residents of one country and residents of all other countries during a particular time period. It helps policy makers understand the performance of each country's economy in international markets. It also signals fundamental changes in the competitiveness of countries and assists policy makers in designing appropriate public policies to respond to these changes.

International businesspeople need to pay close attention to countries' BOP statistics for several reasons, including the following:

1. BOP statistics help identify emerging markets for goods and services.

2. BOP statistics can warn of possible new policies that may alter a country's business climate, thereby affecting the profitability of a firm's operations in that country. For example, sharp rises in a country's imports may signal an overheated economy and portend a tightening of the domestic money supply. In this case attentive businesspeople will shrink their inventories in anticipation of a reduction in customer demand.

3. BOP statistics can indicate reductions in a country's foreign-exchange reserves, which may mean that the country's currency will depreciate in the future, as occurred in Thailand in 1997. Exporters to such a country may find that domestic producers will become more price competitive.

4. As was true in the international debt crisis, BOP statistics can signal increased riskiness of lending to particular countries.

The Major Components of the Balance of Payments Accounting System

The BOP accounting system can be divided conceptually into four major accounts. The first two accounts—the current account and the capital account—record purchases of goods, services, and assets by the private and public sectors. The official reserves account reflects the impact of central bank intervention in the foreign-exchange market. The last account—errors and omissions—captures mistakes made in recording BOP transactions.

Current account. The current account records four types of transactions among residents of different countries (table 1):

1. Exports and imports of goods (or merchandise)

2. Exports and imports of services

3. Investment income

4. Gifts

Table 1.1. Debit and credit entries for transactions involving the current account.

	Debit	Credit
Goods	Buy	Sell
Services	Buy	Sell
Dividends and interest (investment income)	Pay	Receive
Gifts	Give	Receive

For example, to Germany the sale of a Mercedes-Benz automobile to a doctor in Marseilles is a merchandise export, and the purchase by a German resident of Dom Perignon champagne from France is a merchandise import. (The British use the term trade in visible to refer to merchandise trade.) The difference between a country's exports and imports of goods is called the balance on merchandise trade. The United States, which has been importing more goods than it has been exporting, has a merchandise trade deficit; Japan, which has been exporting more goods than it has been importing, has a merchandise trade surplus.

The services account records sales and purchases of such services as transportation, tourism, medical care, telecommunications, advertising, financial services, and education. The sale of a service to a resident of another country is a service export, and the purchase by a resident of a service from another country is a service import. (The British use the term trade in invisibles to denote trade in services.)

For example, for Germany, a German student spending a year studying at the Sorbonne in Paris is an import of services, and the telephone call home that an Italian tourist makes during the Oktoberfest in Munich represents a service export.

The difference between a country's exports of services and its imports of services is called the balance on services trade.

The third type of transaction recorded in the current account is investment income. Income German residents earn from their foreign investments is viewed as an export of the services of capital by Germany. This income takes the form of either interest and dividends earned by German residents on tlieir investments in foreign stocks, bonds, and deposit accounts or profits that are repatriated back to Germany from incorporated subsidiaries in other countries that are owned by German firms. Of course, foreigners also make investments in Germany. Income earned by foreigners from their investments in Germany is viewed as an import of the services of capital by Germany. This income includes interest and dividends paid by firms in Germany on stocks, bonds, and deposit accounts owned by foreign residents, as well as profits that are repatriated by foreign-owned incorporated subsidiaries in Germany back to their corporate parents.

The fourth type of transaction in the current account is unilateral transfers, or gifts between residents of one country and another. Unilateral transfers include private and public gifts. For example, Pakistani-born residents of Kuwait who send part of their earnings back home to their relatives are engaging in private unilateral transfers. In contrast, governmental aid from the United Kingdom used for a flood control project in Bangladesh is a public unilateral transfer. In both cases, the recipients need not provide any compensation to the donors.

The current account balance measures the net balance resulting from merchandise trade, service trade, investment income, and unilateral transfers. It is closely scrutinized by government officials and policy makers because it broadly reflects the country's current competitiveness in international markets.

Examples of Payment Entries. Table 2 shows several examples of transactions that would be reflected in the current account. Notice in the exhibit that every transaction that generates a U.S. cash inflow (exports and income receipts by the United States) represents a credit to the current account, while every transaction that generates a U.S. cash outflow (imports and income payments by the United States) represents a debit to the current account. Therefore, a large current account deficit indicates that the United States is sending more cash abroad to buy goods and services or to pay income than it is receiving for those same reasons.

Table 2

International Trade Transaction J.C. Penney purchases stereos produced in Indonesia that it will sell in its U.S. retail stores. Individuals in the United States purchase CDs over the Internet from a firm based in China. The Mexican government pays a U.S. consulting firm for consulting services provided by the firm. IBM headquarters in the United States purchases computer chips from Singapore that it uses in assembling computers. A university bookstore in Ireland purchases textbooks produced by a U.S. publishing company. International Income Transaction A U.S. investor receives a dividend payment from a French firm in which she purchased stock. The U.S. Treasury sends an interest payment to a German insurance company that purchased U.S. Treasury bonds one year ago. A Mexican company that borrowed dollars from a bank based in the United States sends an interest payment to that bank. International Transfer Transaction The United States provides aid to Costa Rica in response to a flood in Costa Rica. Switzerland provides a grant to U.S, scientists to work on cancer research.

U.S. Cash Flow Position U.S. cash outflow U.S. cash outflow U.S. cash inflow U.S. cash outflow U.S. cash inflow U.S. Cash Flow Position U.S. cash inflow U.S. cash outflow U.S. cash inflow U.S. Cash Flow Position U.S. cash outflow U.S. cash inflow

Entry on U.S. Balance­ of-Payments Account Debit Debit Credit Debit Credit Entry on U.S. Balance-of-Payment Account Credit Debit Credit Entry on U.S. Balance-of-Payment Account Debit Credit

Actual Current Account Balance. The U.S. current account balance in the year 2006 is summarized in Table 3 Notice that the exports of merchandise were valued at $1,019 billion, while imports of merchandise by the United States were valued at $1,836 billion. Total U.S. exports of merchandise and services and income receipts amounted to $2,056 billion, while total U.S, imports amounted to $2,793 billion. The bottom of the exhibit shows that net transfers (which include grants and gifts provided to other countries) were -$54 billion. The negative number for net transfers represents a cash outflow from the United States.

Table 3 shows that the current account balance (line 10) can be derived as the difference between total U.S. exports and income receipts (line 4) and the total U.S. imports and income payments (line 8), with an adjustment for net transfer payments (line 9). This is logical, since the total U.S. exports and income receipts represent U.S. cash inflows while the total U.S. imports and income payments and the net transfers represent U.S. cash outflows. The negative current account balance means that the United States spent more on trade, income, and transfer payments than it received.

Table 3 Summary of U.S. Current Account in the Year 2006 (in billions of $)
(1)	U.S. exports of merchandise	+$1,019
+(2)	U.S. exports of services	411
+(3)	U.S. income receipts	+626
=( 4)	Total U.S. exports and income receipts	$2,056
(5)	U.S. imports of merchandise	- 1,836
+(6)	U.S. imports of services	-341
+(7)	U.S. income payments	- 616
= 8)	Total U.S. imports and income payments	$2,793
(9)	Net transfers by the U.S.	- $54
(10)	Current account balance = (4) - (8) - (9)	-$791

Capital Account.

The second major account in the BOP accounting system is the capital account, which records capital transactions—purchases and sales of assets— between residents of one country and those of other countries. Capital account transactions can be divided into two categories: foreign direct investment (FDI) and portfolio investment.

FDI is any investment made for the purpose of controlling the organization in which the investment is made, typically through ownership of significant blocks of common stock with voting privileges. Under U.S. BOP accounting standards control is defined as ownership of at least 10 percent of a company's voting stock. A portfolio investment is any investment made for purposes other than control. Portfolio investments are divided into two subcategories: short-term investments and long-term investments. Short-term portfolio investments are financial instruments with maturities of one year or less. Included in this category are commercial paper; checking accounts, time deposits, and certificates of deposit held by residents of a country in foreign banks or by foreigners in domestic banks; trade receivables and deposits from international commercial customers; and banks' short-term international lending activities, such as commercial loans. Long-term portfolio investments are stocks, bonds, and other financial instruments issued by private and public organizations that have maturities greater than one year and that are held for purposes other than control. For example, when IBM invests excess cash balances overnight in a Paris bank to earn a higher interest rate than it could earn in New York, it is making a short-term portfolio investment. When the California Public Employers Retirement System Pension Fund buys stock in British Airways, it is making a long-term portfolio investment. When Ford Motor Company purchases all of the common stock of Volvo, it is making an FDI.

Official Reserves Account. The third major account in the BOP accounting system, the official reserves account, records the level of official reserves held by a national government. These reserves are used to intervene in the foreign-exchange market and in transactions with other central banks. Official reserves comprise four types of assets:

1. Gold

2. Convertible currencies

3. SDRs

4. Reserve positions at the IMF

Errors and Omissions. The last account in the BOP accounting system is the errors and omissions account. One truism of the BOP accounting system is that the BOP must balance. In theory the following equation should be observed:

Current Account + Capital Account + Official Reserves Account = 0

However, this equality is never achieved in practice because of measurement errors. The errors and omissions account is used to make the BOP balance in accordance with the following equation:

Current Account + Capital Account + Official Reserves Account + Errors and Omissions =0

The errors and omissions account can be quite large. In 2002, for example, the U.S. errors and omissions account totaled $28.5 billion. Experts suspect that a large portion of the errors and omissions account balance is due to underreporting of capital account transactions. Such innovations as instantaneous, round-the-clock foreign-exchange trading, sophisticated monetary swaps and hedges, and international money market funds have made it difficult for government statisticians to keep up with the growing volume of legal short-term money flowing between countries in search of the highest interest rate.