INSTITUTE OF BUSINESS MANAGEMENT

Introduction
Authorization:

We have been authorized by Mr. Mirza Aqeel Baig to make a long formal
report on the topic of our own choice. The topic that has been selected by our
team members is “Balance of Payment”, which is duly approved and
registered by our instructor.

Plan of Presentation:

The plan of our report is that we first start by explaining Balance of Payments
and then smoothly moved on to its sub concepts.

Subject Matter in Concern:

The issue or matter in consideration, in this report, is the Balance of Payment

and Its importance to succeed in today’s dynamic environment.

Purpose:

This report summarizes the facts and figures we have discovered during our
research on the topic. This report will enable us to understand that why
Balance of Payment is considered as a most important factor of success of a
Country’s Economy.

Methodology:

The methodology used by the team members to collect data and information
regarding the topic is as follows:
1) Seminar on Economy of Pakistan.
2) Polling/consensus.
3) Book and Internet Research.

Sources:

The sources of information that make us enable to complete our report on the
topic, Balance of Payment and Its Importance, are as follows:

1) Primary Sources:
 Attended a seminar on Economic Problems conducted by
Egalitarian Economics Society of IoBM.
 Polling or voting by students on the ADVERSE EFFECTS of Deficit
in Balance of Payment in Pakistan

2) Secondary Sources:

 www.google.com.pk
 www.wikipedia.com

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INTRODUCTION:

Foreign exchange is involved in the transaction of good where a country

exports its product to the rest of the world, it receives foreign exchange
otherwise when it imports goods and services, it makes payment in terms of
foreign exchange. Generally all forms of payment are made in U.S. Dollars
($). For this matter a country must maintain a record for all the import
payments and export receipts and such a record is known as the BALANCE
OF PAYMENTS…..

DEFINITION:

As defined:

“It is a systematic record of all economic transactions of a country with the

rest of the world in a given period of time.”

Professor Kindleberger

The economic transaction includes all visible and invisible goods imported
and exported by a country. Visible or tangible goods are the goods such as
Wheat, Rice, Jute, Cotton and Machinery e.t.c. and Invisible or Intangible
goods include the services of Transport Companies, Insurance Companies,
Banks e.t.c...

HISTORY:

Historically these flows simply were not carefully measured due to difficulty in
measurement, and the flow proceeded in many commodities and currencies
without restriction, clearing being a matter of judgment by individual private
banks and the governments that licensed them to operate. Mercantilism was a
theory that took special notice of the balance of payments and sought simply
to monopolize gold, in part to keep it out of the hands of potential military
opponents (a large "war chest" being a prerequisite to start a war, whereupon
much trade would be embargoed) but mostly upon the theory that large
domestic gold supplies will provide lower interest rates. This theory has not
withstood the test of facts.

As mercantilism gave way to classical economics, and private currencies

were taxed out of existence, the market systems were later regulated in the
19th century by the gold standard which linked central banks by a convention
to redeem "hard currency" in gold. After World War II this system was
replaced by the Breton Woods institutions (the International Monetary Fund
and Bank for International Settlements) which pegged currency of
participating nations to the US dollar and German mark, which was
redeemable nominally in gold. In the 1970s this redemption ceased, leaving
the system with respect to the United States without a formal base, yet the
peg to the Mark somewhat remained. Strangely, since leaving the gold
standard and abandoning interference with Dollar foreign exchange, the

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surplus in the Income Account has decayed exponentially, and has remained
negligible as a percentage of total debits or credits for decades. Some
consider the system today to be based on oil, a universally desirable
commodity due to the dependence of so much infrastructural capital on oil
supply; however, no central bank stocks reserves of crude oil. Since OPEC oil
transacts in US dollars, and most major currencies are subject to sudden
large changes in price due to unstable central banks, the US dollar remains a
reserve currency, but is increasingly challenged by the euro, and to a small
degree the pound.

The United States has been running a current account deficit since the early
1980s. The U.S. current account deficit has grown considerably in recent
years, reaching record high levels in 2006 both in absolute terms ($758
billion) and as a fraction of GDP (6%). Milton Friedman (Balance of Trade)
has tried to explain that cheaper, riskier, foreign capital is exchanged for
"riskless", expensive, US capital and that the difference is made up with extra
goods and services. Nevertheless, Friedman's interpretation is incomplete
with respect to countries that interfere with the market prices of their
currencies through the changes in their reserves so only applies to Canada
and, to a lesser extent, the United States.

BALANCE OF TRADE:

Balance of Trade includes all the records of Receipts for Visible EXPORTS
and Payments on Visible Imports. The Balance of Trade records may show
the accounts of Exports and Imports which are Merchandised in Nature. By
comparing the exports receipts and import payments of such goods we can
see whether the Balance of Trade of a Country is Favourable or
Unfavourable. A country’s Balance of Trade is Favourable when its Balance of
Receipts is in excess of its balance of Payments.

The Balance of Trade does not show the true receipts and payments of a
country as it does not include the payments and receipts of Invisible Goods
i.e. Services.

The true condition of a country’s Economy can only be seen through

BALANCE OF PAYMENT as it includes both the records of transactions of
Invisible and Visible goods.

BALANCE OF PAYMENTS:

Balance of Payment is a systematic record of all economic transactions of

visible and invisible goods.

--- SERVICES:

i. SERVICES OF COMPANIES: If a country supplies Export Services

for another Country in Shipping, Airlines, Banks e.t.c. Through

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these Export services a country receives Foreign Exchange which

constitutes the Export receipts.

Supposing if the same country obtains the same services from a

foreign country and this would be known as the Import of services
of the Country and thus this would give Foreign Exchange as
Payments and this constitutes Import Payments.

ii. EXPENDITURE ON POLITICAL, CULTURAL AND TRADE

DELEGATIONS: From a view of a country whatever expenditure is
incurred by our trade delegates in a foreign country is considered to
be the payments for the import of political, economic Services.
Similarly, if a delegation of foreign country in our country makes any
expenditure it would be regarded as Receipts on exports of our
services to them.

iii. EXPENITURE ON TOURISM: If a tourist from our Country spends

a certain amount while visiting a foreign country, in terms of foreign
exchange it would be considered as payment on import of services
of foreign country and vice versa.

iv. EXPENDITURE ON EDUCATION AND TRAINNING: If students

from our country go abroad for purpose of studies, the expenditure
made by the student in foreign country will be considered as
payment on import of Foreign services and vice versa.

v. EXPENDITURE ON EMBASSIES: The expenditure made by our

Foreign Missions with the rest of world constitutes the import
payment for diplomatic services. Similarly, the expenditure made by
foreign embassies in our country would amount to receipts on the
export of diplomatic services by us to the rest of the world.

vi. INTEREST ON FOREIGN LOANS: If a country such as America

gives Loan to another country like Pakistan and receive its Interest
than the entire loan as well as the interest would add up to its
receipts and vice versa.

vii. PROFIT ON INVESTMENT: When a firm of a home country or the

government makes an investment in foreign country, the profit
which is remitted back to the home country is the receipt for the
home country and vice versa.

viii. UNREQUIRED PRIVATE AND OFFICIAL TRANSFERS: These

are only one way transactions. There is no reciprocation. Un-
required private transfer comes from those individuals of a country
who are working abroad, know as transfer payments. Some rich
government also gives AID to a poor country, these are also one
way. These transfer amounts will be omitted from the GNP of the
Donner and will be added to the DONNE.

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Thus by adding the visible and invisible transactions we will get a

statement of BALANCE OF PAYMENT.

PRESENTATION OF BALANCE OF PAYMENT:

The Statement of Balance of Payment is divided into three parts,

namely;

• Current Account
• Capital Account
• A Change in Gold and Reserve Assets.

1. CURRENT ACCCOUNT: Contains the record of all the transactions

which does not create any future liability e.g. Exports Receipts and
Import Payments of all the goods and services (Tangible and
Intangible). Un-required transfers are also included in this account.
Current Account is also divided into three parts, namely;

• Balance of Trade
• Services (NET)
• Un-required Private/Official Transfers

If the total of net values on the balance of trade, services (net) and un-
required transfers will give us the current account on the balance of payment.
If Current account is Positive i.e. there is surplus balance of payment then the
situation is favorable or vice versa...

2. CAPITAL ACCOUNT: Contains the record of all the transactions which

creates future liability e.g. Investment made from surplus will earn
Interest e.t.c

Capital in Balance of Payment contains four items i.e.

• Long term foreign Investment: The long term capital inflow or

outflow can be divided in to two parts;

I. Private Investment (Net)

II. Government/Private Investment (Net)

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• Allocation of Special Drawn Rights (SDRs): commonly known as

Paper Gold. It is specifically issued by IMF to the member
countries for use as International currency. It is given respectively
according to ability of a country to repay the loan.

• Official Borrowings: It is of tow types;

I. Short term Net Foreign Public Investment

II. Balance of Payment Borrowings

• Errors and Omissions (net): is the difference between the error

and omissions of the total receipts and total payments in a country’s
capital account and are adjusted accordingly so that the account is
balanced.

By adding these four items we get the whole capital account.

3. CHANGES IN THE GOLD AND FOREIGN EXCHANGE RESERVES:

If by comparison of Capital account and Current account, it is found that
the receipts in the capital account are greater than the deficit of the current
account, this excess Capital will increase the Gold and Foreign exchange
Reserves of the Country.

ITEMS Amounts (Billion US $)

CURRENT ACCOUNT:

(a) Balance of Trade: - 30

(i) Exports 100

(ii) Imports -130

(b) Services (Net) - 50

(i) Receipts 150

(ii) Payments -200

(c) Un-Required Transfers (Net) 20

Balance on the Current Account - 60

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ITEMS Amounts (Billion US $)

CAPITAL ACCOUNT:

(a) Long Term Foreign Investment: 25

(i) Private Investment (Net) 10

(ii) Public Investment (Net) 15

(b) Allocation of SDRs: 8

(c) Official Borrowings: 15

(i) Short Term Net Foreign Investment 4

(ii) Balance of Payment Borrowing 11

(d) Errors and omissions (Net) 2

Balance on Capital Account 50

CHANGES IN GOLD AND FOREIGN

EXCHANGE RESERVES: -10

DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS:

This means that the total Receipts and the total Payments on the Current
account of the balance of payments are not equal to each other.

When the total receipts exceed the total payments then the there is Surplus
on the Balance of Payments otherwise Vice Versa.

CAUSES OF PRESISTENT DEFICIT IN THE BALANCE OF

PAYMENTS:

There are certain reasons, following are some;

i. HIGH RATE OF INFLATION: Less developed country’s market is

relatively expensive than developed, so it diverts other countries from
purchasing goods from its markets. And from that country’s point of
view, local products are expensive which influences the local people to
Import and problem rises.

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ii. TRADE RESTRICTIONS BY OTHER COUNTRIES: There are certain

developed countries which place tight restrictions on Import of goods;
such measures have adverse effect on countries with adverse balance
of payments. Restrictions such as Import Taxes, Quota restrictions and
restrictions on export of capital e.t.c.

iii. DETORIATION OF TERMS OF TRADE: This happens when there is

inelastic demand for foreign goods and Imports are made in large
amounts, this raises not only the prices but also has adverse effect on
the balance of payment.

iv. DEMAND FOR MACHINERY, OIL AND INDUSTRIAL GOODS:

Demand for these goods is simply inelastic.

v. DEPRESSION IN THE INTERNATIONAL MARKET: When a

depression occurs in developed countries, there per capita income falls
down thus there production is lowered and casing acute shortage for
exports thus causing adverse balance of payments. E.g. Current US
Depression.

vi. FOREIGHN LOANS: There is deficit in balance of payments for less

developed countries as they acquire loans and thus having adverse
effect on balance of payment. E.g. Pakistan.

vii. SLOW INCREASE IN FACTOR OF PRODUCTION: The factor of

production can only be increased with the passage of time.

viii. INTRODUCTION OF A SUBSTITITE: Supposing that a cheaper and

arguably better quality product is introduced in the international market
to replace a major export of the country. It will result in lower demand
of the latter product thus reducing the export receipt.

ix. CHANGE IN THE PRODUCTION TECHNOLOGY: With advance

technology, production can be optimized and at a lower cost. Thus a
country using old technology will produce goods at a high cost yielding
low demand effecting export receipt.

x. CHANGE IN CAPITAL MOVEMENT, TASTE AND FASHION: When a

country exports more capital than its surplus in the current account or
import less capital than usual, that country’s balance of payment is
likely to be in deficit. Than a country either uses its reserves or sells its
assets.

MEASURES TO RECTIFY ADVERSE BALANCE OF PAYMENTS:

There are certain steps that can help a country with adverse balance of
payments, such as;

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Stringent Monetary and Fiscal Policy, Protection of Local Products policy,

Reduction in Capital Export, Exchange Control, Devaluation of Currency,
Export Subsidies, Encouraging Import of Capital or Help from IMF.
MEASUREMENT OF BALANCE OF PAYMENT:

Where:

• X = exports
• M = imports
• Ki = capital inflows
• Ko = capital outflows

Rearranging, we have:

Quotes
If a currency is to become a growing, an increasing reserve currency, there
has to be not only a demand for it there has to be a supply of it.
Robert C. Solomon

A flexible exchange rate will help to improve the international balance of

payments, but large-scale fluctuations will harm the stable development of
the economy.

If political tension cannot be resolved, it could lead to an alarming imbalance

in the trade account, the current account and the balance of payments.

If your interest rate is relatively low then there is only really one way of getting
the balance of payments to balance in the medium to long term, which is to
offer more of your currency at each time of asking for foreign capital.

It's still a fast pace and that's partly to do with the difficulty in managing this
very large balance of payments surplus because part of it is spilling over into
the money supply.

We continue to believe that inflation is currently the least worrisome among

the key macroeconomic policy goals such as growth, inflation and balance of
payments.

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SUMMARY
A country’s balance of payments is commonly defined as the record
Of transactions between its residents and foreign residents over a specified
period. Each transaction is recorded in accordance with the principles of
double-entry bookkeeping, meaning that the amount involved is entered on
each of the two sides of the balance-of-payments accounts. Consequently,
the sums of the two sides of the complete balance-of-payments accounts
should always be the same, and in this sense the balance of payments
always balances. However, there is no bookkeeping requirement that the
sums of the two sides of a selected number of balance of payments accounts
should be the same, and it happens that the (im) balances shown by certain
combinations of accounts are of considerable interest to analysts and
government Officials. It is these balances that are often referred to as
“Surpluses” or “Deficits” in the balance of payments.

Balance of payments equilibrium is defined as a condition where the sum of

debits and credits from the current account and the capital and financial
accounts equal to zero.

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Specimen:

Table: The U.S. Balance of Payments, 2004

*. Includes statistical discrepancy.
Goods −665.4
Services +48.8
Investment income +30.4
Balance on goods, services, and income −587.2
Unilateral transfers −80.9
Balance on current account −668.1
Nonofficial capital* +270.6
Official reserve assets +397.5
Balance on capital account +668.1
Total balance 0
Source: U.S. Department of Commerce, Survey of Current Business.
Notes: Dollar amounts are in billions; += surplus; − = deficit.

REFERENCES
1) www.referenceforbusiness.com
2) www.google.com
3) www.books.google.com.pk
4) www.wikipedia.com
5) www.jstor.com
6) www.altavista.com
7) www.answers.com
8) www.ask.com
9) www.lycos.com
10) Economics by Abdul Haleem Khawaja

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