Balance of payments accounts record financial flows in a specific period such as one year.
Financial inflows (such as receipts for exports or when a foreigner invests in the stockmarket) are treated as credits or positive entries.
Outflows (such as payments for imports or the purchase of shares on a foreign stockmarket) are debits or negative entries.
When a foreigner invests in the country, there is a capital inflow which is a credit entry. Conversely, the acquisition of a claim on another country is a negative or debit entry.
Debits = Credits
The accounts are double entry, that is, every transaction is entered twice. For example, the export of goods involves the receipt of cash (the credit) which represents a claim on another country (the debit). By definition the balance of payments must balance. Debits must equal credits.
Current = Capital
One side of each transaction is treated as a current flow (such as a receipt of payment for an export). The other is a capital flow (such as the acquisition of a claim on another country).
Arithmetically current flows must exactly equal capital flows.
Let me now explain in detail the point mentioned above:
The foremost principle of BoP accouting is the use of the double entry bookkeeping system, i.e. every transaction has two aspects and hence enters the BoP account twice, once as a credit
and once as a debit.
Since for every credit there is a corresponding debit, the balance of payments account always balances.
The logic underlying every transaction being entered twice is that whenever there is a transaction, whether purchase of sale, there would be a corresponding payment – either immediately or deferred and giving rise to two entries.
Let us now see, the case of transfer payments.
Since there is no compensation involved in the case of transfer payments, they are treated as trade in goodwill to satisfy the principle of double entry.
An outflow on account of transfer payment is regarded as a purchase of goodwill, while an inflow is regarded as a sale.
There is a clear rule for determining the side of a BoP account on which a particular transaction should be entered.
Any transaction which is a source of foreign currency is a credit entry, and any transaction which is a use is a debit entry. In accordance with these definitions, credit transactions are recorded with a plus sign, and debit transactions with a minus sign.
Let us take a small example:
As a country exports goods to another country, the demand for the domestic currency goes up as the foreign importer would need to buy the domestic currency to pay for the imports.
This would appear as a credit item in the BoP account as it is a source of foreign currency.
On the other hand, imports increase the supply of the domestic currency, as foreign currency would need to be bought in exchange for the domestic currency in order to pay for the imports. Since it is a use of the foreign currency, it would appear as a debit item.
There is a clear rule for determining the side of a BoP account on which a particular transaction should be entered. The rule is that any transaction which creates demand for the domestic
currency in the forex markets enters the BoP account on the credit side, and any transaction increasing its supply enters the debit side.