How to Record Transactions in the Balance of Payments (BOP)

So my last post, Why are the Net Exports of a Country = its Net Capital Outflow?, sets up this post really well. In this post, I will explain how transactions are recorded in a country’s Balance of Payments (BOP) account and why the Current Account Balance is always = - (Capital Account Balance) i.e. a deficit in the Current Account is always balanced out by a Surplus (of the same magnitude) in the Capital Account and vice versa. Don’t freak out if you don’t/only vaguely understand what these terms mean....

“Patience you must have, my young padawan."

....we’ll go through everything. 

Balance of Payments (BOP) and its Sub-Accounts 

The Balance of Payments account of country X records all international transactions undertaken between the residents of country X and the residents of the Rest of the World (ROW) during a given period of time, usually a year.

The BOP is divided into 2 sub-accounts: 1) Current Account, and 2) Capital Account. 

1. Current Account 

The Current Account records all trade (export/import) transactions of country X in goods and services, income receipts/payments on investments made abroad/investments made by foreigners in country X, as well as current transfers. Transfers are transactions where money or goods/services are transferred but nothing is received in return. For e.g. foreign aid, remittances by citizens working abroad, charitable contributions/gifts from foreign residents etc. 

The Net Balance on the Current Account (credit entries - debit entries) is called the “Current Account Balance”. If credits are more than the debits, the Current Account is said to be in “surplus”; if credits are less that the debits, it is said to be in “deficit”. 

The Current Account includes:

• Merchandise Trade Account: This records all international trade transactions (export/imports) for goods. The balance on this account is called the “Merchandise Trade Balance”.

• Services Account: This records all export/import transactions for services. The balance on this account is called the “Services Balance”. 

• Goods and Services Account: It is the record of all international trade transactions for goods and services. Goods and Services Account = Merchandise Trade Account + Services Account.

Note: The balance on the Goods and Services Account called the “Goods & Services Balance” is more commonly referred to as the “Balance of Trade” or “Trade Balance”. So, when you hear that country X has a Trade deficit, it means that the country’s net export of goods and services is negative i.e. it is a net importer of goods and services. If it has a Trade Surplus, it is a net exporter of goods/services. 

2. Capital Account

The Capital Account (of country X) records all international transactions involving a change in the ownership of foreign physical or financial assets held by residents of country X as well as the change in the ownership of domestic physical or financial assets held by residents of foreign nations. Foreign Direct Investment or FDI (investment in the form of a “controlling interest” defined as 10% or more of outstanding stock of a foreign business), Foreign Portfolio Investment or FPI (investment in foreign stocks, bonds and other financial instruments), foreign currency deposits, foreign real estate purchases etc. are all recorded in the Capital Account. 

A Capital Account Surplus means that the credit entries in the account are greater than the debits. This means that foreign capital is flowing into the country. A Capital Account Deficit means that domestic capital is flowing out of the country, to the ROW. 

Now that I’ve provided a brief overview of the BOP and its sub-accounts, lets get to the important part - how to record transactions in the BOP. Once you understand this, everything else will make sense automatically. 

Rules for making BOP Entries 

There are 3 basic rules one needs to remember while recording transactions in the BOP. These are the same rules that are applied for recording transaction in double entry accounting.

• Each transaction is entered twice, once as Credit and once as a Debit because each transaction has two sides - you give up something, and you receive something in return. These credit and debit entries can be in the same or in different accounts, depending on the type of transaction.

• A transaction is recorded as a Credit if it: 1) increases revenues 2) decreases expenses, 3) decreases assets, or 4) increases liabilities. 

• A transaction is recorded as a Debit if it: 1) decreases revenues, 2) increases expenses, 3) increases assets, or 4) decreases liabilities. 

Keeping these basic rules in mind, I will now make entries for some credible looking transactions, so that the mechanism becomes clear. 

1. Exchange of Currency (for trade) 

Suppose you’re me. You live in India, and want to order a great dress that you saw online on the White House Black Market (WHBM) website. White House Black Market is an American women’s clothing retailer. It’s one of my favourite stores - but I digress. What I wanted to say was....let’s make the BOP entries for this transaction. 

This is an import (of goods) transaction. I (a resident of India) am going to buy a good from a US retailer who will ship it to me in India. 

I will need to pay WHBM in USD. When I use my credit card to make this transaction, my credit card company will perform the currency exchange for me. Supposing the cost of the dress is $100 or Rs 6,600 (I’m assuming an exchange rate of $1= Rs 66), my credit card company will exchange my INR (Rupees) for USD on the forex market. 

This is how the exchange of currency (INR for USD) will be recorded in the Indian BOP:

	Debit	Credit
Capital Account	Rs 6,600 (currency - USD)	Rs 6,600 (currency -INR)

Remember currency is an asset. When the credit card company exchanges INR for USD, INR (Indian currency asset) leaves India, and USD (foreign currency asset) is purchased by India. So, in India’s BOP, the decrease of Rs 6,600 (which is what I have to pay to get $100) = decrease in an asset = Credit entry in the Capital Account (where changes in financial assets are recorded). The $100 that I get in return = increase in an asset = Debit entry in the Capital Account. 

Bottom-line: For the exchange of currency, both entries are made in the Capital Account, so net impact on the Capital Account Balance is = 0. 

2. Import of Goods

Now that I have the $100 I need to buy the dress I want from WHBM, lets see how this import transaction is recorded in the Indian BOP. 

	Debit	Credit
Current Account	Rs 6,600 (Import of dress)
Capital Account		Rs 6,600 (currency - USD)

The import transaction is recorded in the Current Account as a Debit since it increases expenses (importing the dress costs Rs 6,600) for the nation. 

How did we pay for the dress import? With the USD that we got through the currency exchange. As a result of this payment, our foreign currency assets are reduced (by $100), which is why we record a credit worth Rs 6,600 in the Capital Account. Note: all the entries in the Indian BOP are made in INR, even when the asset being depleted/accumulated is foreign currency. 

Bottom-line: A debit of Rs 6,600 in the Current Account is counter-balanced by a Rs 6,600 credit in the Capital Account. This is how a deficit on the Current Account is always balanced out by a Surplus on the Capital Account, and vice versa. 

3. Purchase of Foreign Assets (stock of a company, government bonds, real estate etc.) 

Let’s assume that instead of buying a dress, I want to invest the $100 that I received through the currency exchange to buy Apple stock. Let’s assume that the share price of Apple is $100, so I can buy one Apple share. 

Here’s how this transaction is recorded in the Indian BOP:

	Debit	Credit
Capital Account	Rs 6,600 (Apple stock)	Rs 6,600 (currency - USD)

Both entries are made in the Capital Account because both sides of this transaction involve financial assets. Since I’ve bought a share of an American company, there is an increase in assets i.e. a Debit worth Rs 6,600 is recorded. How did I pay for this transaction? I used the $100 received in the currency exchange. This means that there is a decrease in foreign current assets i.e. a Credit worth Rs 6,600 is recorded. 

Even if the foreign asset purchased is a US government bond or a rental property in the US, the entries in the Indian BOP would be the same (of course the debit in the Capital Account would now reflect an increase in the purchased asset instead of Apple stock). 

I could give more examples, but hopefully you get the picture. 

Because each international transaction (export, import, purchase/sale of asset, exchange of currencies etc.) involves 2 sides: what you receive (a good/service or an asset) and what you give up (currency/other asset or a good/service), and because of the way transactions are recorded in the double entry accounting system, the deficit on the Current Account will always be = to the surplus on the Capital Account and vice versa.

Another way of stating this truism is:

The Balance of Payments will always balance

Or 

The Net Exports of a country are always = its Net Capital Outflow

In my post Why are the Net Exports of a Country = its Net Capital Outflow?, I explained this inevitability using the same underlying logic. Let’s connect the dots...i mean the posts....here.

In Why are the Net Exports of a Country = its Net Capital Outflow?, I explained how when India exports goods, we get paid in foreign currency and end up holding foreign assets - foreign currency assets. Whether we simply hold this foreign currency, or we use it to buy foreign stock, bonds or any other assets - we are making an investment abroad i.e. capital is flowing out of India to the ROW (capital outflow). So, net exports imply a net capital outflow from the country. 

A net capital outflow means that the Capital Account is in deficit (you’re investing more abroad than what foreigners are investing in India). So when the country has positive net exports (i.e. when the Current Account is in Surplus), the Capital Account is always in Deficit (there’s a net capital outflow). That’s what I’ve discussed and illustrated in the current post as well. 

Signing off.