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why does the balance of payments always balance

A nation s BOP is a summary statement of all economic transactions between the residents of a country and the rest of the world during a given period of time. A BOP account is di]vided into current account and capital ac]count. Former is made up of trade in goods (i. e. , visibles) and trade in services (i. e. , invisibles) and unrequited transfers. The lat]ter account is made up of transaction in finan]cial assets. These two accounts comprise BOP. A BOP account is prepared according to the principle of double-entry book-keeping. This accounting procedure gives rise to two entriesa debit and a corresponding credit. Any transaction giving rise to a receipt from the rest of the world is a credit item in the BOP account. Any transaction giving rise to a pay]ment to the rest of the world is a debit item. The left hand side of the BOP account shows the receipts of the country. Such re]ceipts of external purchasing power arise from the commodity export, from the sale of invis]ible services, from the receipts of gift and grants from foreign governments, interna]tional lending institutions and foreign indi]viduals, from the borrowing of money from foreigners or from repayment of loans by for]eigners. The right hand side shows the payments made by the country on different items to for]eigners. It shows how the total of external purchasing power is used for acquiring im]ports of foreign goods and services as well as purchase of foreign assets. This is the account]ing procedure. However, no country publishes BOP ac]counts in this format. Rather, by convention, the BOP figures are published in a single col]umn with positive (credit) and negative (debit) signs. Since payments side of the account enu]merates all the uses which are made up of the total foreign purchasing power acquired by this country in a given period, and since the receipts of the accounts enumerate all the sources from which foreign purchasing power is acquired by the same country in the same period, the two sides must balance.

The en]tries in the account should, therefore, add up to zero. In reality, why should they add up to zero? In practice, this is difficult to achieve where receipts equal payments. In reality, total re]ceipts may diverge from total payments be]cause of: (i) the difficulty of collecting accu]rate trade information; (ii) the difference in the timing between the two sides of the balance; (iii) a change in the exchange rates. Because of such measurement problems, resource is made to balancing item that in]tends to eliminate errors in measurement. The purpose of incorporating this item in the BOP account is to adjust the difference between the sums of the credit and the sums of the debit items in the BOP accounts so that they add up to zero by construction. Hence the proposition: the BOP always balances. It is a truism. It only suggests that the two sides of the accounts must always show the same total. It implies only an equality. In this book-keeping sense, BOP always balances. Thus, by construction, BOP accounts do not matter. In fact, this is not so. The accounts have both economic and political implications. Mathematically, receipts equal payments but it need not balance in economic sense. This means that there cannot be disequilibrium in the BOP accounts. A combined deficit in the current and capital accounts is the most un]wanted macroeconomic goal of an economy. Again, a deficit in the current account is also undesirable. All these suggest that BOP is out of equilibrium. But can we know whether the BOP is in equilibrium or not? Tests are usu]ally three in number: (i) movements in foreign exchange reserves including gold, (ii) increase in borrowing from abroad, and (iii) move]ments in foreign exchange rates of the coun]try s currency in question.

Firstly, if foreign exchange reserves decline, a country s BOP is considered to be in disequi]librium or in deficit. If foreign exchange reserves are allowed to deplete rapidly it may shatter the confidence of people over domes]tic currency. This may, ultimately, lead to a run on the bank. Secondly, to cover the deficit a country may borrow from abroad. Thus, such borrowing occurs when imports exceed exports. This involves payment of interest on borrowed funds at a high rate of interest. Finally, the foreign exchange rate of a coun]try s currency may tumble when it suffers from BOP disequilibrium. A fall in exchange rate of a currency is a sign of BOP disequilib]rium. Thus, the above (mechanical) equality be]tween receipts and payments should not be interpreted to mean that a country never suf]fers from the BOP problem and the interna]tional economic transactions of a country are always in equilibrium.
fullpost{display:inline;} Balance of Payments (BOP) - Introduction Since the balance of payment is based upon system of double-entry book-keeping, the total debits must equal to total credits. This is because two aspects of each transaction recorded are equal in amount but appear on opposite sides of the balance of payments account. In this accounting sense, balances of payments for a country must always balance. The debit side shows the use of total foreign exchange acquired in a particular period. The credit side shows the sources from which the foreign exchange is acquired during a particular period. Against every credit entry, there is an offsetting debit entry vise-versa, so the receipts and payments on these two sides must be equal. Hence the two sides must necessary balance. If X imports from Y, Y would also import from X. Hence there would be a debit and credit entries in the balance of payments of both the countries X Y. The individual items in the balance of payments may not balance.

But the total credits of the country must be equals to its total debits. If there is any deficit in any individual account, it would be covered by a surplus in other accounts, if there is any difference between total debits and total credits, it would be settled under 'errors omissions'. Hence in the accounting sense, the balance of payments of a country always balances. Balance of Payments (BOP) Account of a Country The items 1 to 7 show the total receipts from all sources. These receipts amount to Rs. 1000 Crores. The items 1(a) to 7(a) Show the total payments on all accounts. These payments amount to Rs. 990 Crores. When item 8 included, the total payment is Rs. 1000 Crores, hence the total credit is equal to the total debit. Thus the current account and capital account Balance each other. Thus surplus in the current account is equal to the deficit in the capital account. A deficit in the current account is equal to the surplus in the capital account. In the above given table, the balance of current account shows a deficit of Rs. 200 crores But there is a corresponding surplus of Rs. 200 crores in the balance of capital account. Hence the credit and debit sides balance & the balance of payments is in equilibrium. The balance of trade of a country may not balance. For instance, if exports exceed imports, there is a surplus and a favourable balance of trade and vice-versa. Only if the value of exports is equal to the value of imports, the balance of trade is said to be in equilibrium. But the balance of payments always balances because every transaction must be settled. Hence total debits must be equal to the total credits.

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