The foundation of the balance of payments lies in the double entry bookkeeping system where each transaction is recorded twice, once as a credit, and again, as a debit.
This method guarantees at least in theory, that the balance of payments or BOP is always balanced, mirroring the concept that every monetary transaction is counted by an equal and opposite flow of finances.
What this means is that for a country's transactions with the rest of the world to balance, if money is spent on imports, it's must be counterbalanced by money earned through exports, by borrowing from other countries, attracting foreign investments, or by dipping into its own foreign reserves.
This intricate balancing act is played out across the three primary accounts, the current account, the capital account, and the financial account.
If there's a surplus or deficit in one account, it's inherently counteracted by a discrepancy of equal magnitude in another.
This is how we ensure that all international financial inflows and outflows are accounted for maintaining a state of equilibrium in the nation's finances on the global stage.
Let's break this down with some simplified examples.
Bearing in mind that real world transactions can be more complex and recorded in various ways based on the settlement of the transactions, consider an export transaction.
If a country exports goods amounting to $100 million, it logs a $100 million credit in the current account, signifying the influx of foreign currency.
Should the foreign purchaser make payment by transferring funds from their bank to the exporter's bank without converting to the local currency it boosts the exporting country's foreign exchange reserves marked as a debit in the financial account, signaling an uptick in foreign assets.
If, however, the exporters bank opts to sell these US dollars in the foreign exchange market, perhaps on the client's request, that would constitute a distinct transaction, which would be recorded in the BOP based on the buyer and the settlement method.
When a nation receives a non-refundable infrastructure grant of $50 million, its credited in the capital account.
This grant, when spent on importing goods and services for the infrastructure work is debited in the current accounts.
Alternatively, if the grant is given in foreign currency, it would bolster the nation's reserves reflected as a debit in the financial account.
Lastly, when a country takes out a $150 million loan from foreign entities, it is credited in the financial account as an influx of capital.
If this loan finances a current account deficit, such as importing goods, the import transaction is debited at $150 million in the current account signaling an outflow of funds for these imports.
Yet the process may involve intermediate steps.
Initially, the influx of foreign currency might augment foreign exchange reserves a debit on the financial account.
Subsequently, when imports are settled in foreign currency, there's a debit on the current account and a corresponding credit on the financial account as the reserves deplete.
