Question

The sum of the current, capital and financial, and official settlements accounts must always be zero (hence the name “balances of payments”). Why?

Answer 1

Balance of Payments (BOP) records all the transactions that takes place between the residents of a country with the rest of the world during an year. The economic transactions include both the real transaction of trade in goods and services as well as the financial transactions that deals with financial flows.

The principle on which the BOP is prepared is the double-entry book-keeping in which for every debit entry is followed by a credit entry. In terms of the BOP any receipt from the rest of the world is entered as a credit item, while any payment to the rest of the world is entered as debit item.

Reason why the BOP must balance is that the while payment side of the BOP relates to the uses to which total foreign purchasing power is acquired by the country, the receipt side relates to the sources through which the country has acquired the mentioned foreign purchasing power. So, the two sides should balance in theory, and add up to zero.

However, due to several practical issues like problem in collecting correct trade data and fluctuations in the exchange rates, the perfect balance in the BOP is hard to achieve in reality.

For this reason only, a balancing item is included in the BOP so that the difference between the credit and debit can be reconciled.