A balance of payments is an internationally recognized representation of all transactions between an individual country and the rest of the world. According to the methodology, the net sum of debit and credit entries should be zero. This article explains the Great Britain’s double entry and sign convention system in the balance of payments. Such presentation is substantially an abstract framework: these are the various components of the balance of payments which provide economists with their tools for explanation of economic behavior.
PART A. What is a country’s balance of payments? Briefly explain its usefulness
The balance of payments (BOP) can be defined as the statistical accounting of the international operations of the country for a certain time, introduced in a mode of double-entry bookkeeping. The balance of payments of the country consists of a capital account, current account and the financial account. While the current account estimates international trade and a net profit on investments and also regulate payments, the financial account states the alteration in the international proprietorship of assets. The capital account consists of various financial transactions which do not influence economic indicators (Kearney, 2000).
Significance of the Balance of Payments
The balance of payments is significant as it will indicate whether an economy has sufficient financial holding and financial capabilities to pay for import’s consumption. It will also indicate if it is generating sufficient economic output for its development. Shortage in the balance of payments of the economy results in more imports than exports. It also seeks loans from other developed economies to pay for import transactions. For a certain time, it can be beneficial for a country so that it can promote its economic development. However, if it proceeds for many years, then an economy can be considered as the net consumer instead of net producer of the global economic production in the world. In such conditions the country may face a threat to dispose of its assets, for example, commodities and natural resources to compensate for its domestic consumption. Eventually, other economies can be surprised, if their investments would pay off (Collis, 1991).
An economy having a surplus in balance of payments is possibly exporting most part of its production. Besides, the government and inhabitants are savers, providing sufficient capital for financing the production and also financing other countries. It is the excellent scenario for stimulation of economic growth in a short-term prospect. Nevertheless, in the long-term prospect this country should encourage its inhabitants to increase their spending capacity for building strong domestic market. It will also restrict from too much dependency on the growth driven by exports. It will also initiate its domestic companies to improve the quality of goods, using the internal population as a test market. At last, the large domestic market also can impart the country from volatility of fluctuations of an exchange rate.
PART B. Explain the difference between the current account and the capital account
The most widespread and easy to understand approach to interpret the balance of payments is by a system of current account: a typical definition of the textbook states that it accounts international transactions in the sphere of money, goods and services, current transfers to and from other economies and net income from other economies. The current account data gives the main information for in-depth economic analysis (Kogut, 1985).
The capital account framework covers the dealings connected with capital transfers (i.e. debt forgiveness) and nonfinancial and non-produced assets. The purchases on a current account demand financing. When a country faces deficiency in a current account in comparison with countries then the need may arise for excess foreign currency for international requirements. Transactions are noted with other international activities of the capital market in the financial account as it simply characterizes international dealings in financial assets. The financial account, thus, offers detailed information on the international streams of financial assets and liabilities, and also enhanced globalization of the international financial system denote that there is a significant concern in it as a segregated set of financial operations does not influence economic indicators.
PART C. Explain the international product life cycle theory of FDI.
Product Life-Cycle Theory
International Product Life-Cycle Theory gives theoretical justification for trade and foreign direct investments. The theory, formulated by Raymond Vernon, describes why American producers switched from export to the direct foreign investments. Producers initially gain exclusive advantage of export from product development and innovations for domestic market of the USA. In the new product, the development stage and production activities continued to be focused in the USA, despite the fact that costs of production in some foreign countries can be lower. When the product attains its growth stage, the American producer has an opportunity for investments in other countries and also to find means for lower costs of production, thus chances of loosing export markets to local producers would be minimized. American manufacturers will prefer to invest in those industrial countries whose export sales are substantially high to support economic scale in local production. When a product reaches its maturity stage, the cost competitions, including imitation by foreign firms, are intensified. At this stage the American producer can switch over its production from the country of initial foreign direct investments to cheaper economies, sustaining old auxiliaries with new products. Vernon's theory holds more significance to producers’ for initial penetration into foreign markets than MNC that have already invested in foreign countries. Many multinational corporations have a possibility to design new products in other countries for ultimate sales in the America, thus, standing the product life-cycle model. To cite an example, Procter & Gamble’s workforce consisted of more than 8500 scientists and researchers in the year 2008 in 20 technical centers of ten different countries. P&G developed many products in health care and beauty segments in host countries and ultimately sold them in the USA market and other foreign markets. Multinationals can also shifts new products from the America directly to existing foreign subsidiaries, thereby passing over the export stage (Vernon, 1966).
PART D. Explain the eclectic theory, and identify the three advantages necessary for FDI to occur.
The eclectic paradigm provides general basis for explanation of international production. This theory incorporates three variables: ownership-specific (O), location-specific (L) and internalization (I); all revealed in previous theories of foreign direct investments and trades. This eclectic paradigm represents OLI framework that stands on crossing the macroeconomic theory, international trade (L) and microeconomic theory of the firm (O and I). The main contention is that all three factors (OLI) play a crucial role in scoping and structures of foreign direct investments. Ownership-specific variables are not only comprised of tangible assets; for example, capital, man power and natural endowments, but also contain intangible assets; for example, technology and information, organizational systems, marketing, managerial and entrepreneurial skills. FDI investments depend upon location-specific variables, as well as government legislation and policies, market structure, the political, cultural, legal and social environment (Rugman, 1981).
At last, internalization belongs to internal flexibility of the company and possibility to produce and sell through the internal subsidiaries. This is the inability of the market to obtain the satisfactory transactions between potential buyers and sellers of intermediate products. These crucial factors direct multinational corporations to choose internalizations for distinguishing comparative advantages between the countries. The eclectic theory differentiates between transactional and structural market failure. Structural market failure occurs due to external conditions leading to the emergence of exclusive advantages as a result of penetration barriers increased by operating firms or the government. Structural market failures thus distinguish between companies from the point of view of their ability to operate geographically dispersed valued-added activities or to gain control over the property rights. Transactional market failures are the inability of the intermediate commodity markets to make transactions of the goods and services at a lower price than sustained via internalization. As a whole, the eclectic paradigm gives a better understanding through explaining foreign direct investments than does the monopolistic advantage theory, the internalization theory or the product life-cycle theory. The eclectic paradigm integrates internalization, ownership-specific and country-specific factors in articulating the benefits and logic of international production (Kogut, 1985).
Statistics of the balance of payments portray the flow of money, goods and services into and from a country during a single period of fixed time. The balance sheet is an evaluation through stocks of financial assets and liabilities as a result of cumulative streams and any reassessment of existing stocks. It depicts the country’s financial relations with the rest of the world.
The product life-cycle theory states how a new multinational company develops a new product and then participates in foreign direct investments; however, it does not describe actions of existing multinational corporations with essential FDI to evade steps in the described model or even to turn back this process. The internalization perspective recommends that it is more effective for multinational corporations to acquire foreign operations through a uniform structure of governance than trade through the open markets.
Although international modern business environment and MNC’s behavior considerably differ from what it was earlier, when the eclectic theory was emerged, advantages of OLI still hold vital value for foreign direct investments and tell us how the superior profitability of MNC can be achieved.