Balance of payments (BoP) is an account of acquisitions and sales on the foreign market done by a country. Certain economists tend to exaggerate the meaning of this concept as a predictor of adverse economic issues in countries (Stein, 2008). Due to the existence of misunderstandings in this sphere, this paper will discuss the importance of the balance of payments and its components.
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The Importance of the Balance of Payments as an Accounting Measure
The balance of payments does not appear to be an effective accounting measure. If accounting is understood more broadly than simply a display of processed financial information about an entity within the economy, then the balance of payments cannot be viewed as a meaningful item. The reason for this is that BoP only shows that national currency was placed outside the country in exchange for goods, services, or other valuables and other nation’s currency in some form entered the border (Stein, 2008). It does not tell anything about the reasons why it occurred or is it a positive or a negative change.
BoP only registers transactions and is not suggestive of the processes that run within the country or in the world. In comparison to a more complex accounting measure such as the loss/profit statement that demonstrates the financial health of the company, BoP does not contain any such implications. For instance, if an American businessman buys a factory in France for 100 million dollars, the country seems to lose that sum of money in BoP, but in a few years that factory could bring the U.S. an equal sum of dollars in taxes, eliminating the deficit. Therefore, this measure cannot be used to draw any conclusions about the economic health of a country.
The Current Account and Its Components
Current account is an integral part of the balance of payments that represents imports and exports of goods and services, foreign investor fees, fees received for investments abroad, and one-way payments such as foreign aid (Freeman, Shoulders, Allison, & Smith, 2014). The deficit in current account means that a certain amount of currency exited the country in exchange for something. Surplus means that some goods or services were sold for the country’s currency and that currency is now within the country’s economy. The function of this concept is to demonstrate and account for all transactions made between the home country and foreign ones.
The current account consists of three components such as trade balance, foreign net income, and net current transfers. The first component represents only the transactions that resulted in an exchange of goods or services. The second part is the difference between the earnings of individuals received from abroad and earnings of foreigners in the country. The third part is the amount of money that citizens of the country transferred abroad. Together these variables provide an overview of the transactions and financial operations in a country and let the government exercise control and take actions if they deem it necessary.
Capital and Financial Accounts and Their Components
Capital account serves as a measure of investments made domestically by foreigners and abroad by residents. It includes direct investments, investments in shares, and capital reserves. If current account has a deficit, it means that capital account should have a surplus which in BoP equals zero. Capital account serves as a more valid accounting measure as it shows the interest of foreign investors in the acquisition of a country’s property, shares of its companies, or direct investing.
That means that the country’s economy demonstrates stable growth and enjoys the trust of foreigners as they lend a nation its finances. Financial account demonstrates “net acquisition and disposal of financial assets and liabilities” (International Monetary Fund [IMF], n.d.). In IMF terminology, it is also a part of the country’s BoP.
U.S. Deficit in Traded Goods and the Balance of Payments
According to Hellerstein and Tille (2008) trade deficit in the U.S. current account is representative of the weight of earnings from global assets and liabilities within the BoP structure. They argue that the more goods and services flows in and out of the country, the more significantly it influences globalization and the greater its impact is on the U.S. economy. The deficit in traded goods symbolizes that America produces and sells more goods than it imports.
It is one of the most important factors that explain the variations in the current account (Hellerstein & Tille, 2008). In addition, the constant flow of goods and services traded abroad and demonstrated through this variable insulates the domestic workers from risks in case of recession as the hazards are distributed among the countries with which the U.S. trades. This means that the more goods the U.S. produces and, most importantly, sells to the other countries, the more stable is the position of the domestic industries because there is a constant demand in what they have to offer. Thus, this factor is one of the most significant in analyses of BoP.
Thus, BoP is a complex and paramount concept that needs to be studied at all times as the global economy shifts constantly occur. As a whole, this concept is not very significant as an accounting measure. However, trade balance, as argued by researchers, appears to be representative of the country’s economic stability.
Freeman, R. J., Shoulders, C. D., Allison, G. S., & Smith, G. R. (2014). Governmental and nonprofit accounting. New York, NY: Pearson Education Limited.
Hellerstein, R., & Tille, C. (2008). The changing nature of the U.S. balance of payments. Current Issues in Economics and Finance, 14(4). Web.
International Monetary Fund. (n.d.). What is the financial account in the balance of payments statistics (BOPS)? Web.
Stein, H. (2008). Balance of payments. The concise encyclopedia of economics. Web.