The Balance of Payments: A Tool of Economic Analysis

The balance of payments, in its modern sense, may be defined as a system of accounts in which the accounting entity is a country or region and the entries refer to all economic transactions between residents of the country or region and residents of the rest of the world. The term “economic transactions” is used here in a broad sense to include transfers of goods, the rendering of services, and transfers of capital items, whether or not a quid pro quo is given. The quid pro quo may take the form either of payment in money or another capital item (including a promise to pay) or of payment in kind, that is in the form of goods and services. Transactions in which there is a quid pro quo may be described as two-way transactions, and those in which there is not, as one-way transactions. Two-way transactions are recorded by means of equal credit and debit entries to indicate the two sides of the transaction. For one-way transactions, the one side is recorded in the usual way and the double-entry system is preserved by offsetting this entry by a contra-entry under a heading described as “donations” or “unilateral transfers.”

Abstract

The balance of payments, in its modern sense, may be defined as a system of accounts in which the accounting entity is a country or region and the entries refer to all economic transactions between residents of the country or region and residents of the rest of the world. The term “economic transactions” is used here in a broad sense to include transfers of goods, the rendering of services, and transfers of capital items, whether or not a quid pro quo is given. The quid pro quo may take the form either of payment in money or another capital item (including a promise to pay) or of payment in kind, that is in the form of goods and services. Transactions in which there is a quid pro quo may be described as two-way transactions, and those in which there is not, as one-way transactions. Two-way transactions are recorded by means of equal credit and debit entries to indicate the two sides of the transaction. For one-way transactions, the one side is recorded in the usual way and the double-entry system is preserved by offsetting this entry by a contra-entry under a heading described as “donations” or “unilateral transfers.”

I. Introduction

The balance of payments, in its modern sense, may be defined as a system of accounts in which the accounting entity is a country or region and the entries refer to all economic transactions between residents of the country or region and residents of the rest of the world. The term “economic transactions” is used here in a broad sense to include transfers of goods, the rendering of services, and transfers of capital items, whether or not a quid pro quo is given. The quid pro quo may take the form either of payment in money or another capital item (including a promise to pay) or of payment in kind, that is in the form of goods and services. Transactions in which there is a quid pro quo may be described as two-way transactions, and those in which there is not, as one-way transactions. Two-way transactions are recorded by means of equal credit and debit entries to indicate the two sides of the transaction. For one-way transactions, the one side is recorded in the usual way and the double-entry system is preserved by offsetting this entry by a contra-entry under a heading described as “donations” or “unilateral transfers.”

The balance of payments is customarily divided into two major sections: a current account and a capital account. The standard schedule adopted by the International Monetary Fund, which is shown in Table 1, provides a typical example of this form of presentation. Apart from differences of opinion on the treatment of certain types of donation or unilateral transfer, it is fairly generally agreed that the line between the current and the capital accounts should be drawn, as in this example, between those entries which represent changes in the country’s international creditor-debtor position or in its monetary gold holdings and those which do not. Within this broad framework there is considerable diversity, both in the type of classification used and in the method of presentation, as may readily be seen by comparing the official balance of payments statements published in different countries.

Table 1.

International Monetary Fund Standard Schedule

A. CURRENT TRANSACTIONS

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Table 1.

International Monetary Fund Standard Schedule

B. MOVEMENT OF CAPITAL AND MONETARY GOLD

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Historical Review

Origin of the concept

While the precise formulation of the balance of payments in accordance with accounting principles is of recent origin, the underlying concept is one of the oldest tools of economic analysis. Its origin can be traced back as far as the earliest period of mercantilist thought in the latter part of the fourteenth century. The term was first used in its modern sense, according to Viner, by Sir James Steuart in 1767,1 but the general idea had been familiar for centuries. In these early forms, the most prominence was given to merchandise trade and movements of precious metals, but the existence of “invisibles” was also recognized.2 The term “balance of trade” was ordinarily used interchangeably to mean the commodity balance of trade or the total balance of commodity and non-commodity items. Other terms, such as “balance of accounts,” “temporal balance of remittance,” “state of debt and credit,” were also used 3 but the concept was fundamentally the same.

First statistical computation

In spite of the early development of the concept, statistical computation of the balance of payments is of quite recent origin. The commodity balance of trade was first computed for England in 1615,4 but it was not until the latter part of the nineteenth century that attempts were made to measure the “invisible” items and to construct a statement resembling the balance of payments in its modern sense. In England, interest in the subject was aroused by a desire to explain the increasing import surplus which had been developing since about 1825 in spite of the continuing outflow of capital.5 In 1903, Shaw-Lefevre brought together a number of these estimates and established a rough balance of payments for the period 1865-1902.6 His estimates indicated a net capital outflow of £1,290 million during this period. Further unofficial estimates were made by Sir George Paish 7 and C. K. Hobson.8 The first official estimates were made by the Board of Trade for the years 1907, 1910, and 1913; after World War I, official estimates were published regularly. Developments were similar in the United States, except that the capital movement and the flow of investment income which attracted attention were in the opposite direction. A number of early estimates are quoted by Taussig,9 the first being that of D. A. Wells for 1868-69 in a report submitted as Special Commissioner of the Revenue. The most interesting feature of this estimate is the large figure of $200 million for new loans received by the United States. Later estimates by Sir George Paish in 1908-0910 and Kent in 1911-12 11 show a falling off in new loans and an expansion in interest and dividend payments. They also show a spectacular increase in immigrants’ remittances. A comprehensive historical survey was made by Bullock, Williams, and Tucker in 1919.12 Most of this ground was again covered later by Graham and Dickens, with important differences.13

The economic readjustments made necessary by World War I and the growing interest in trade and foreign exchange policies led to the preparation of balance of payments estimates in many countries, particularly in Europe and the British Dominions. The League of Nations published the first of a series of volumes on Balances of Payments in 1924,14 incorporating statements for thirteen countries comprising the United States, the United Kingdom, seven other European countries, three British Dominions,15 and Argentina. Ten more European countries, another British Dominion, Japan, and Siam were added in the second and third volumes. While some of these statements were nothing more than very rough approximations, they at least give an indication of the growing interest in the balance of payments.

At the same time, economists began to make historical studies of the balance of payments for a number of countries in an effort to test the theoretical conclusions of the classical doctrine against actual experience in a period of balance of payments adjustment. A number of these studies were made by students of Professor Taussig, at his suggestion. The best known are those of Viner, White, and Williams.16

Interval between origin of concept and systematic computation

The explanation of the long interval between the original development of the concept and the first systematic attempts to measure its components is to be found in part in the fact that the tool fell into disuse during the period of the ascendancy of the international gold standard and the classical theory of international trade. When the mercantilist preoccupation with the balance of payments as the criterion of the success of trade policy gave way to the classical doctrine of the automatic price specie-flow mechanism, the concept disappeared almost completely from economic literature. Not until the emergence of neo-mercantilism in the latter part of the nineteenth century was interest in the balance of payments revived. Many of the early estimates were made by free traders in an attempt to refute the arguments of the protectionists.17 Taussig, the greatest pioneer of all, describes in the following passage how his attempt to verify the classical theory of comparative cost led to his interest in empirical studies to verify other aspects of the classical theory:

For my own part, it is prolonged inquiry on the working of protective duties in the United States which has confirmed my conviction that the actual course of industrial development and of trade between nations affords a striking verification of essential features in the theory of international trade; and it is this conviction which in turn has led me to reflect on the importance of the general problem of verification, and to search for possibilities of similar verification in other directions also.18

The revival of interest in the balance of payments has been most intense during and since World War II. Many factors have contributed toward this development. In the first place, the sheer force of economic events has thrust balance of payments problems upon the attention of economists and policy-makers as never before. At the same time, economic theory has been especially active in the fields most closely connected with the balance of payments. The Keynesian theory of employment, for example, has focused attention on the relationship of the foreign balance to national income and employment. As a result of these developments, interest in the balance of payments, which had previously been largely academic, has now become extremely practical. In the 1920’s and early 1930’s the balance of payments was looked upon primarily as a means of testing the theories of the classical economists regarding the mechanism of adjustment and the “transfer problem” associated with the initiation of a stream of reparations payments or large-scale capital movements. Partly through the force of circumstances and partly in response to the new economic theories, the balance of payments has now become a matter of day-to-day concern to those responsible for shaping economic policy.

Parallel with this revival of interest in the balance of payments has been a rapid development in the study of national income, resulting in its extension into the broader field of social accounting. To an increasing extent, economic discussions revolve around these two concepts and economic policy is determined in the light of their evidence.

Task of Standardization

The League of Nations

The growing interest in balance of payments data in the interwar period led to a steady improvement in techniques and in the accuracy and comprehensiveness of the data. It soon became apparent, however, that there was considerable diversity both in the definitions and general principles underlying the various estimates and in the method of presentation. The League of Nations, therefore, took steps to ensure a greater degree of uniformity and achieved a certain amount of success. A further step was taken by the League’s Committee of Statistical Experts in 1938 when it appointed a subcommittee to prepare a report on balance of payments statistics. The subcommittee reached preliminary decisions on certain points, but arrangements for a technical inquiry to be carried out by experts chosen by the Secretariat had to be cancelled on the outbreak of World War II. The war years witnessed a further development in balance of payments techniques in many countries. Exchange control provided a new and fertile source of information on a number of items for which little had previously been known. Serious attention was paid for the first time to such questions as the regional classification of the balance of payments. The League’s subcommittee was reconstituted in 1945, and its decisions were communicated to governments in January 1946 and published by the United Nations in the following year.19 The report, although brief, was a noteworthy contribution to the methodology of the subject.

The International Monetary Fund

The work of collecting and publishing balance of payments estimates and of standardizing their compilation has been taken over by the International Monetary Fund. The very establishment of the Fund, with the object of promoting international monetary cooperation in the maintenance of orderly exchange arrangements and the correction of maladjustments in the balance of payments, is reason enough for pressing on with this task. The obligation of members of the Fund to supply balance of payments data, in accordance with Article VIII, Section 5, of the Articles of Agreement, places the Fund in a much stronger position than the League to bring about the necessary extension and standardization of available data. The publication of the Fund’s Balance of Payments Manual20 and Balance of Payments Year books21 is a notable step in this direction.

Purpose of This Study

The major purpose of this study is to examine the present status of the balance of payments as a tool of economic analysis, with a view to suggesting ways in which it can be made a more effective instrument. In view of the major contribution of the Manual to this field, the first task will be to consider the methodological foundations on which this document has been based. Attention will then be turned to the aspects in which it is felt that further development is needed. These aspects may be described briefly as (1) the relationship of the balance of payments to social accounting, (2) the financing of deficits or surpluses in the balance of payments, (3) the regional classification of the balance of payments, and (4) the analysis of long-period equilibrium.

II. The Fund’s Balance of Payments Manual

As indicated in the Introduction, the Fund’s Balance of Payments Manual is a notable landmark in the development of the balance of payments as a tool of economic analysis. It was first published in January 1948 after extensive consultations with economists and technicians from many countries. A revised version, issued in January 1950, was described as having profited greatly from experience gained by the staff of the Fund in collecting the data published in the first Balance of Payments Yearbook. In this chapter, attention will be focused on the statement of underlying principles with which the Manual begins and in which the basic definitions and concepts are discussed.

The balance of payments for a given period is defined as “a systematic record of all economic transactions during the period between residents of the reporting country and residents of other countries, referred to for convenience as foreigners.” Certain essential concepts in this definition are then selected for elucidation. The first of these is the concept of economic transactions, which is defined as broadly as possible to include all transactions, both in cash and in kind, regardless of whether or not they involve a quid pro quo. In discussing the nature of these transactions, reference is also made to the double-entry accounting system, by means of which they are recorded.

Concept of “Resident”

Resident individuals

The next concept selected for discussion is the term “resident.” The balance of payments, like other forms of social accounting, records the transactions not of a single person or institution but of the group of persons and institutions that is considered as being identified with the country concerned. The way in which the persons and institutions identified with one country are distinguished from those identified with another country is by means of this concept of “resident.” In order to ensure uniform treatment by different countries, the term has to be so defined that there is no overlapping and no one is overlooked. Nationality is not a satisfactory criterion for this purpose, since many migrants who have severed all economic ties with their homeland retain their original nationality. The Fund’s staff has adopted the criterion of “center of interest” and has laid down a few general rules for the interpretation of this principle. Citizens of a country who live there permanently are obviously residents of that country, but whenever the country’s citizens are abroad for one reason or another, an attempt must be made to determine their center of interest. The Manual provides that diplomatic representatives and members of armed forces stationed abroad and citizens studying or undergoing medical treatment abroad are to be treated as residents of their own country rather than of the country where they are staying. The extent to which other citizens living abroad are to be treated as residents (travelers) or as foreigners (emigrants) is left flexible, the criterion of their “center of interest” being interpreted in the light of such factors as the length of their stay abroad and the extent to which they concentrate abroad their earning activities and their investments.

Resident institutions

In addition to persons, the term “resident” applies to governments, business enterprises, and nonprofit organizations. International agencies are not considered residents of the country in which they are located, but rather as international areas outside national boundaries. These international agencies are confined to political, administrative, or financial organizations in which the members are governments or official institutions. They do not include intergovernmental organizations conducting ordinary business undertakings. Branches and subsidiaries of business enterprises in another country are treated as residents of the country in which they operate on the ground that they are an integral part of that country’s economy. Agencies, however, are not considered separate enterprises, and transactions with them are regarded as transactions with the principal for whom they are acting.

Distinction between “branch” and “agency”

The distinction between “branch” and “agency,” as it is drawn in the Manual, is made to rest on whether the local office acts as a principal for its own account or whether it acts for account of principals abroad.22 This does not seem to be in harmony with the preceding sentence in the Manual which states that the reason for treating branches and subsidiaries as residents of the country in which they operate is that they are considered an integral part of that country’s economy. The important question is not whether the local office has books of its own and a manager who has authority to make decisions on his own responsibility, but whether the local office plays a significant role in the economic activity in which the undertaking as a whole is engaged. If the function performed is a minor one, the office should be regarded as an agency regardless of its legal or accounting status. Even though it may legally be the head office, an office which plays no more than a nominal role in a productive process which is centered in another country should, for this purpose, be regarded as an agency of an enterprise in the country where the operations are in fact carried out.23 For example, when a British-owned tea plantation in Ceylon ships its produce to the home office in London and the home office as its contribution merely puts the tea up for sale at the regular tea auctions, it seems reasonable to regard the enterprise as being located in Ceylon and the home office as being a mere agent in disposing of the tea. Only when the home office makes a significant contribution to the final value of the product would it be reasonable to regard it as a parent and the plantation in Ceylon as a branch. It should be emphasized, however, that this criticism is directed at the manner in which the distinction has been drawn, and not at the validity of the distinction itself. The distinction is highly significant, as will be seen in the discussion of the relationship of the balance of payments to social accounting. The main point being made is merely that the distinction should be couched in economic, rather than legal or accounting, terms.

Application of Resident-Foreigner Principle

In the application of the principle that the balance of payments should record all transactions between residents and foreigners (the “resident-foreigner principle”), there are some borderline cases that have been singled out for special comment.

Undistributed profits of branches and subsidiaries

The first of these concerns the extent to which the profits of branches and subsidiaries (direct investments) should be regarded as resident-foreigner transactions and, therefore, included in the balance of payments. The case of branches is quite straightforward. Whether the profits are remitted or not, they accrue to the parent concern and should be entered in the balance of payments. For a subsidiary (i.e., a directly-controlled company), the position normally taken is that only the income distributed in the form of dividends and interest constitutes an economic transaction. After first taking the view that the inclusion of undistributed profits of subsidiaries would create statistical and theoretical difficulties, the Fund’s staff decided, in issuing the second edition of the Manual, to waive these objections and to include the undistributed profits of subsidiaries as well as branches. The reasons for this decision were that “the total earnings of a subsidiary, whether or not paid out, are subject to the disposition of the parent in much the same way as those of a branch” and that “such earnings are often an important source of new investment and their exclusion might seriously understate the influence of direct investment on the international economic situation of many countries.” These are convincing reasons and the decision seems to be completely justified.

Migrants’ transfers

In view of the crucial significance of the distinction between residents and foreigners, a problem arises when a person migrates, that is, when his status changes from resident to foreigner (or vice versa). When this change occurs, the property which he owns becomes the property of a foreigner instead of that of a resident (or vice versa). The Manual’s solution of this problem is to envisage an automatic transfer from the person in his capacity as a resident to himself in his capacity as a foreigner (or vice versa). This “transaction” embraces all his property whether or not it accompanies him abroad.

Uniform valuation of merchandise

Another borderline case in the application of the resident-foreigner principle concerns the basis of valuation of merchandise transactions. The difficulty arises from the fact that transportation services are continuously being embodied in the value of merchandise and, consequently, merchandise entering into international trade is valued on a number of different bases, e.g., f.o.b. factory, f.o.b. frontier of exporting country, or c.i.f. frontier of importing country, depending on the point at which ownership passes. It is obviously desirable that merchandise transactions should be valued on a uniform basis, and the Fund has adopted the principle of valuing both exports and imports f.o.b. the frontier of the exporting country. This procedure has a number of advantages over the widespread practice of valuing exports f.o.b. and imports c.i.f. in that exports and imports are treated symmetrically and international transportation and insurance are treated as distinct services. It also avoids the necessity of including fictitious entries in the transportation and insurance accounts to offset freight and insurance on imports paid to residents. The point of immediate concern from the standpoint of methodology is that the adoption of this uniform valuation basis appears to conflict with the resident-foreigner principle. The Fund solves this problem by assuming that, when goods are sold on a c.i.f. basis, the exporter acts merely as an agent for the importer in arranging for the transportation and insurance of the goods.

Gold transactions

In addition to these borderline cases, there have been some deliberate departures from the strict application of the resident-foreigner principle. The first of these arises from the unique position of gold in international transactions. On the one hand, gold is produced and consumed like other commodities and, on the other hand, it is used by monetary authorities throughout the world as a means of settlement of outstanding balances and as a major component of international reserves. Net gold transactions with foreigners are, therefore, divided into two movements: a nonmonetary movement representing the net of gold production and consumption, and a monetary movement representing the change in the monetary gold holdings of the country. While the two gold movements combined reflect only transactions between residents and foreigners, the division between monetary and nonmonetary movements involves the inclusion of some domestic transactions. These domestic transactions have been included because “domestic sales of gold to the monetary authorities increase their international monetary reserves in the same way as sales of merchandise to foreigners; and domestic purchases of gold from the monetary authorities decrease international monetary reserves in the same way as purchases of merchandise from foreigners.”

Short-term capital movements

A similar exception has been made in the case of short-term capital movements. A distinction is made in the capital account between transactions of official and banking institutions (the official sector), and those of private persons and institutions (the private sector). The transfer of a foreign deposit from the official sector to the private sector, like a similar transfer of gold, affects the international monetary reserves of the country and is, therefore, significant from a balance of payments point of view even though no resident-foreigner transaction is involved. These transactions are automatically taken into account by recording short-term capital movements on the basis of changes in outstanding amounts rather than on a transactions basis.

Comparison of Balance of Payments and Exchange Record

Deficiencies of exchange record

The balance of payments, as defined in the Manual, is far more comprehensive in its coverage than its early predecessors. The modern counterpart of the earlier concept would be a record of money transfers between residents and foreigners rather than a balance of payments as it is now understood. To the extent that such transfers pass through the domestic banking system, a record of this kind is readily available in countries with exchange control. The Manual gives a fairly detailed account of the differences between the balance of payments and such an exchange record. This comparison brings out clearly the deficiencies of an exchange record of this type as a tool of analysis. It is deficient in coverage, since it covers only transactions which give rise to recorded money transfers. Barter transactions and gifts in kind are excluded entirely, and other transactions are covered only partially to the extent that they are settled through the exchange market. As examples of other transactions which are excluded, the Manual refers to the use of export proceeds to build up private foreign exchange balances or to purchase goods abroad, the reinvestment of income from investments abroad, and the granting or receipt of trade credits. There are also differences in valuation arising from such causes as the recording of exports and imports on different valuation bases (f.o.b., c.i.f., c. and f., etc.) depending on the terms of the actual transactions. Finally, there are differences in timing owing to the interval that frequently occurs between the transaction itself and ultimate settlement through the exchange market.

Advantages of exchange record when adequately supplemented

There is a danger that this account of the deficiencies of the exchange record may give rise to an erroneous impression that exchange control data, especially those relating to merchandise trade, are of little value in the compilation of a balance of payments. This impression is reinforced by the fact that the merchandise tables in the Manual refer only to customs data.24 The fact is, however, that the customs data themselves are defective in many respects. The Manual lays down the rule that the balance of payments should record transactions as they occur and accepts the transfer of ownership as the criterion for the correct timing of merchandise transactions. It is then taken for granted that, in the typical case, the time at which exports and imports are entered in the customs statistics coincides approximately with the transfer of ownership. This assumption is at best a very rough approximation and has the additional disadvantage of introducing a lack of symmetry into the system because of the time interval between the recording of a transaction in the exporting and importing countries. The time of transfer of ownership may, in fact, differ from the date of the customs entry by a period of a month or more even when there are no delays in transportation. On the other hand, as long as there are no prepayments or postpayments, the exchange record shows the transaction at precisely the time when the transfer of ownership occurs. Therefore, provided the necessary information is available for transactions involving prepayments and postpayments, the exchange record is preferable to the customs returns from the point of view of timing. The customs statistics are also deficient from the point of view of valuation. The use of actual transaction values is far from being a universal practice in the customs records, and it is extremely difficult to obtain the necessary data to correct for differences between recorded values and transaction values. A further point is that exchange control authorities are far more likely to check the declared value carefully than are customs authorities, especially when the goods concerned are duty free or subject to a specific duty. The one point at which customs statistics are definitely superior to exchange control data is in coverage. It is at this point that considerable additional information is necessary if the exchange control figures are to be used as the basic source for the merchandise item.

In view of the many respects in which exchange control statistics are superior to customs statistics, there are strong grounds for preferring them as a basis for the merchandise item, provided the necessary supplementary data are available. However, since the adjustments to the exchange control data are likely to be numerous and since there is always the possibility that some transactions outside the exchange record might have been overlooked, the figures used should be reconciled with the customs data.

The Standard Schedule

Description

The schedule itself comprises a series of detailed tables and a summary table (Table I) in which the data from the subsidiary tables are brought together to give the story as a whole. As shown above, this table follows the traditional form in its retention of the distinction between the current account and the capital account. The current account includes two distinct types of transactions: items 1 through 8 which refer to transfers of goods and services, and item 9 which covers donations. The capital account is divided into a private sector (items 11 and 12) and an official sector (items 13 to 15), depending on the status of the party to the transaction in the reporting country. In order to present a maximum of information compactly, the capital items are shown in terms of net changes in assets and liabilities, and not, as in the current account, in terms of gross transactions on a credit-debit basis. Increases in assets and decreases in liabilities indicate an outflow of capital (a debit); decreases in assets and increases in liabilities indicate an inflow of capital (a credit). Valuation changes (e.g., changes in the market values of securities or revaluations of assets and liabilities because of exchange rate adjustments) are excluded since they are not transactions.

Problems of classification

In the preparation of the schedule, a number of problems of classification arose. One problem was whether transactions should be reported on a gross or a net basis. This question is of particular significance for transactions in goods and services, as will appear below when the relationship of the balance of payments to social accounting is discussed. For the most part, the schedule provides for the reporting of gross figures, both because of their inherent interest and because they are necessary to permit classification of the balance of payments by countries. The decision to show the capital account on an assets-liabilities rather than a credit-debit basis prevented these transactions from being shown on a gross basis in the summary table. In the subsidiary tables, however, provision is made for the reporting of long-term transactions on a gross basis. Short-term capital movements, on the other hand, are calculated on the basis of changes in outstanding amounts rather than on a transactions basis and, therefore, show only net changes.

Another problem of classification which arose was whether to classify data by type of transaction (e.g., travel) or by the agency responsible (e.g., government, if the travel is official). For goods and services, the type of transaction was considered more significant, but for capital movements, more significance was attached to the agency concerned. The reasons for these decisions are fairly obvious. Merchandise transactions, for example, have common characteristics, whether they are undertaken by private or official agencies, and are most conveniently studied in a distinct group. Similar considerations apply to international transportation, travel, insurance, and other services. For capital movements, on the other hand, the motive behind the transactions is an important consideration since the motivation for private capital movements is normally quite different from that for official transactions. This matter will be considered in detail later when the financing of the balance of payments is discussed.

It should be emphasized that this review by no means exhausts the Manual’s contributions to our subject. Significant contributions have also been made to each of the aspects that have been selected for special study in the next three sections. These contributions will be considered in detail at the appropriate points in the discussion.

III. Relationship of the Balance of Payments to Social Accounting

The extension of national income analysis into a system of social accounts has presented a new field for the use of the balance of payments. The approach is described in considerable detail by J. R. N. Stone in the appendix to the Report of the Sub-Committee on National Income Statistics of the League of Nations Committee of Statistical Experts.25 A simplified system of national accounts has recently been prepared for the Organization for European Economic Cooperation under Stone’s directorship.26

Like the balance of payments, the social accounts are based on a double-entry system of accounting. In this system of accounts, a country’s economy is classified into a number of broad sectors—such as productive enterprises, government and households—and one or more accounts are set up for each of these sectors. Separate entries are made for economically distinct categories of transactions. In this way, economic activity is represented as a series of flows between the various sectors. Since national economic systems in the modern world are not closed but have transactions with each other, the rest of the world has to be introduced as one of the sectors. The “rest of the world” account is identical with a balance of payments except for a rearrangement of the items and the recording of credits as debits and vice versa. The latter difference is due to the fact that the balance of payments records the transactions of the country with the rest of the world, whereas the “rest of the world” account records the transactions of the rest of the world with the various sectors of the given country’s economy.27

In view of the fact that the balance of payments is an integral part of the social accounts, it is essential that the basic concepts and definitions in the two systems should be consistent. This point has frequently received insufficient attention in the past. Social accounts have generally been drawn up by national income statisticians, many of whom are not particularly familiar with balance of payments concepts and definitions. Balance of payments statisticians have likewise often been unfamiliar with national income and social accounting concepts. Considerable progress in harmonizing the two approaches has been made in the postwar years. The desire for consistency with social accounting concepts was always in the minds of the Fund’s staff in preparing its Manual. The system of national accounts prepared for OEEC also shows evidence of a desire for greater consistency. A number of inconsistencies remain, however, between the practices of national income and balance of payments statisticians. In the following discussion, the main comparison will be between the League Report and the Manual, but reference will be made to subsequent changes in social accounting practice as, for example, in the scheme prepared for OEEC.

Definition of “Resident” and “Domestic Territory”

Since the balance of payments and the “rest of the world” account refer to transactions between “residents” and “foreigners,” it is important first of all that “resident” should be defined consistently. There is substantial agreement in this respect. The League Report speaks of normal residents without defining what it means by “normal.”28 As pointed out above, the Manual is more precise and gives a few specific instructions for the interpretation of its principle of “center of interest.”29 There are many cases in which any hard and fast rule would be quite arbitrary, and to attempt to formulate a set of rules for all circumstances would undoubtedly lead to some incongruous situations. For ordinary circumstances, however, a great deal may be said for the rule adopted in the United States that citizens going abroad for a longer period than twelve months are migrants.

Concept of extraterritoriality

The League Report’s concept of normal residents is elaborated in the OEEC Report along lines similar to the Manual definition. The definition of “resident” is made to depend on the definition of “domestic territory,” normal residents being defined as individuals whose principal residence is situated on domestic territory. Official representatives and armed forces stationed abroad are brought within the definition of “resident” by attributing extraterritoriality to them. The concept of extraterritoriality is also applied to ships and aircraft. Thus, ships sailing and aircraft flying under the national flag of a given country are considered as part of the domestic territory of that country. It is not clear, however, whether this extraterritoriality is intended to carry with it the attribute of residence. A possible interpretation of these definitions is that those permanently engaged in manning ships and aircraft are to be treated as normal residents of the countries under whose flags the carriers are operating. The Manual does not deal with this question explicitly in defining residents, but the instructions to the relevant tables reveal a rather different viewpoint. The Manual is concerned with the operator of the carrier rather than the flag it flies, although it provides that, if necessary, the flag may be taken as indicating the country of the operator. Moreover, the country of residence of the crew is determined independently of the flag or operator of the carrier by their “center of interest.” A hypothetical example will clarify the differences between the two viewpoints. Assume that a vessel flying the U.S. flag and carrying a cargo to the United States is chartered by a British operator employing British and Norwegian seamen. If the seamen are permanently engaged on this vessel, the above interpretation of the OEEC Report would involve their treatment as U.S. residents contributing to the U.S. national income. The carriage of U.S. imports in this vessel would then be a domestic transaction and the only balance of payments entries involved would be the profit due to the British operator (unless he, too, resided permanently on the ship and thus was regarded as a U.S. resident) and any cash remittances to the United Kingdom or Norway by the seamen. If the seamen were hired only for the voyage and were regarded as residents of their own countries, the whole of their wages would be entered as a debit in the U.S. balance of payments (workers’ earnings), with offsetting credit entries for their living expenses (travel) and the unremitted portion of their savings (inflow of private capital). The Manual treatment would be to regard the transportation as a British service, subject to the importation by the United Kingdom of the services of the ship (charter hire) and of the Norwegian seamen (workers’ earnings).

The determination of the territorial status of vessels and the concept of extraterritoriality raise questions which will be considered later, in connection with the concept of domestic production. For the time being, the discussion will be confined to whether the territorial status of a vessel should be regarded as influencing the residential status of its crew. It would seem to be unrealistic to allow it to do so. The center of interest of a seaman cannot be regarded as having changed merely because he accepts employment, even on a permanent basis, on a vessel operated by a resident of another country. It would seem more reasonable to require further evidence of a transfer in his center of interest before regarding him as a migrant. A Norwegian seaman employed on a British-operated vessel, for example, should continue to be treated as a Norwegian resident until he gives other evidence of a change in his center of interest, e.g., naturalization as a British citizen or the transfer of his family or property to the United Kingdom.

Resident institutions

The terms “resident” and “foreigner” apply to business enterprises and nonprofit organizations as well as to persons. Here again the Manual is more precise than the League Report. In defining resident institutions, the Manual includes branches and subsidiaries, but not agencies, of foreign institutions as residents of the country in which they are located. Branches and subsidiaries are included in a distinct category of “direct investment,” to distinguish them from foreign investment in enterprises which are controlled by residents of the home country. Agencies are not considered separate enterprises, and transactions with them are regarded as transactions with the principal for whom they are acting. The League Report offers two alternatives for the classification of enterprises: the first on the basis of geographical location, the second on the basis of control.30 The OEEC Report adopts the first of these alternatives. By adopting the category of direct investment, the Manual has been able to retain the geographical basis and, at the same time, introduce the distinction at which the League Report’s second alternative aims.

The Manual’s distinction between “branch” and “agency” also helps to clarify an obscure point in the League Report, which does not deal explicitly with the question as to what constitutes an “enterprise operating abroad.” This distinction is highly significant from the social accounting point of view. If an establishment is regarded as a branch and therefore as a resident of the country in which it is located, the goods it receives from abroad must be included immediately in imports, and changes in its stocks must be included in domestic investment. If it is regarded as an agency, the goods it receives from abroad are regarded as being outside the economy until they are sold to residents. Similarly, export goods should be included in exports immediately when they are acquired by an agency, but not until they are sold to a foreigner or transferred to a foreign parent when they pass through a branch. The suggestion was made in Section II that the distinction should be drawn in economic terms on the basis of whether or not the establishment constitutes an integral part of the economy of the country in which it is located. The problem is most likely to arise when the function of an establishment is that of selling goods or services produced elsewhere by, or under the control of, the parent or principal. The solution suggested in this case is that the distinction should depend on whether or not the establishment makes a significant contribution to the final value of the product. Thus it is felt reasonable to regard the home office of a tea plantation in Ceylon as an agent rather than a parent if it does no more than put the tea up for auction at the regular tea sales. On the other hand, a parent company in the United States engaged in the distribution of bananas produced by branches and subsidiaries in Central America may reasonably be regarded as an integral part of the U.S. economy. These examples illustrate the difficulty of drawing a precise line between “branch” and “agency.” Each particular case must be considered on its merits.

It seems desirable on both the above grounds that, subject to the minor modification suggested, the Manual’s definition of resident institutions should be adopted for social accounting purposes.

International agencies

A further point which is not covered explicitly in the League Report is the treatment of international agencies. The Manual’s proposal to treat them as international areas outside national boundaries is accepted by the OEEC Report, and seems to be the best solution, for social accounting as well as for balance of payments purposes. The employees of international agencies who are not citizens of the country in which the agency is located are treated differently, however. No specific reference to these employees is made in the Manual, but since there is no suggestion that these international areas have their own residents, the implication is that they are to be regarded as residents either of the countries in which they are employed or of the countries of which they are citizens. The OEEC Report treats them as residents of the international area, which is thus regarded as having a national income of its own. The choice between these alternatives is obviously of little practical importance, particularly when the agencies are located in the United States where the effect on national income aggregates is negligible. However, since the “center of interest” of these employees is more likely to be the international agency itself than the country in which it is located, and since they are likely to be away from their home countries for many years, the OEEC treatment seems preferable.31

Major Categories in Balance of Payments

Donations as a distinct category

In addition to differences in the definition of “resident,” there are differences in the treatment of various types of international transaction. Before the treatment of individual items is considered, attention must be given to the major groups into which these items may be divided. Although the Fund adheres to the traditional classification into current and capital account, it makes a clear distinction between two types of item in the current account: “goods and services” and “donations.” The Fund may therefore be regarded as adopting a threefold classification, “goods and services,” “donations,” and “capital movements.” In social accounting, however, the practice in a number of countries has been to ignore the existence of donations and to identify the balance on current account with the net exports of goods and services. Net foreign purchases of goods and services are then taken to equal net capital outflow. Morris A. Copeland has protested vigorously against this practice in a paper presented to the International Association for Research in Income and Wealth.32 He points out that this practice “requires one to force all balance of payments items into an arbitrary two-way classification, and different countries have sometimes done the forcing differently.” As an example, he quotes ERP aid which appears in the U.S. income and product accounts as GNP purchases by government, and in the U.K. accounts as a capital inflow. Both treatments are obviously unsatisfactory. The League and OEEC Reports both recognize the need for distinguishing between the export surplus and the balance on current account. They adopt slightly different solutions of the problem. The League Report makes national expenditure equal to national product, and includes “net expenditure by the rest of the world on goods and services” as a component of national expenditure. The OEEC Report makes national expenditure equal to national revenue, defined as national product, plus net transfers from abroad, and includes “net lending to the rest of the world” in national expenditure.33 While recognizing the advantage of having net foreign lending as one of the components of the national expenditure account, the League Report preferred to exclude net unilateral payments abroad from the national aggregates.34 The solution it has adopted has the disadvantage that it includes receipts from the sale of goods and services in an aggregate of national expenditure.

Treatment of investment income

The recognition that international transfers should be given a place in the social accounts as well as in the balance of payments removes a major obstacle to the reconciliation of the two approaches. A more complicated problem concerning the treatment of investment income remains, however. A number of questions suggest themselves as to the most appropriate classification of this item. Is investment income a service payment or a transfer payment? If it is a service payment, should it be distinguished from “real” services? Should a distinction be made between investment income accruing in respect of productive processes and interest payments on the “national” debt? Different answers have been given to these questions at different times; they have to be reconsidered from both the balance of payments and the social accounting points of view.

The League of Nations Sub-Committee on Balance of Payments Statistics took the view that investment income occupies an intermediate position between services proper and transfer payments. The Manual, on the other hand, follows the classical tradition of regarding investment income as the reward for the services of saving and risk-taking, and includes the item without qualification in the category “goods and services.” While this procedure can undoubtedly be justified from some points of view, it creates difficulties for the concept of production. This is particularly the case where investment income represents interest on national debt which has been raised, for example, to finance a past war and cannot be identified in any way with production.

A similar divergence of opinion has been shown in respect to the treatment of investment income in social accounting. The League Report treats interest and dividends in general as payments to factors of production, but it treats interest on national debt in a separate category.35 Two alternatives are suggested. The first is to treat interest on the national debt as a transfer payment. It is argued that commercial interest can be paid, generally speaking, because the money borrowed is put to a use that yields a measurable return, whereas in the case of the national debt, almost no assets yielding a measurable return exist. It is, therefore, thought to be less misleading to treat interest on the national debt as a transfer payment than to force the analogy with commercial interest payments. An advantage claimed for this procedure is that it makes national income and national product independent of the measures adopted to finance past wars. The alternative procedure, which does not require the treatment of national debt interest as a transfer, but at the same time excludes it from national income, is to treat the national debt as a loan for consumption purposes. As such, it gives rise only to an increase in financial claims and not to an increase in national capital. Since there is no current production against which to charge the interest on such loans, the positive interest from the positive claim of the lender must be offset by negative interest from the negative claim of the borrower. National debt interest must therefore be entered as a negative item under income from property. Under these alternatives, interest paid abroad would be treated differently in the calculation of national income. If national debt interest is treated as a transfer payment, it is omitted from national income, irrespective of whether it is paid at home or abroad. If it is treated as income from property, it appears as a negative item in its entirety; but it is treated as a positive item only to the extent that it is received within the economy concerned.

The view that all investment income should be treated as a transfer payment has been taken by Earl R. Rolph and Odd Aukrust. Rolph argues that to regard loan interest as a payment for a service is to confuse a capital transaction with an income transaction.36 The gist of the argument is that, at the time of the contract, “one asset, cash, is exchanged for another asset, a promise to pay. As of this moment of exchange, no income or service feature is present.” To treat the payment of interest to the creditor as the purchase of a service is to deny that a firm debt contract exists. “Debtors do not have the right to refuse to pay interest to creditors on the ground that they no longer desire the service provided by the creditors. Depending upon the type of debt contract, they may have the right to extinguish the debt by repayment or by simply offering to buy back their own liabilities. Such an exchange is again a capital, not an income, transaction.” This argument is not very convincing. The interest payments are quite distinct from these capital transactions, and the mere fact that they are also stipulated in the contract does not prove that they are not payment for a service. Other payments for services (e.g., for rent or wages) are frequently stipulated in contracts which are just as binding as loan contracts. Rolph meets this point by arguing that under certain conditions wages and rental payments should be regarded as transfers. “For example, payments in connection with a ninety-year lease of land and buildings should be regarded as transfers, because the lessor is currently obtaining income without currently selling any services in return.”37 But surely the crucial question is whether a service is currently being performed, not whether a new contract is signed every year. The fundamental flaw in Rolph’s position seems to be in his concept of an economic transaction. This example makes it clear that he regards the transaction as taking place when the contract is signed. The more realistic point of view seems to be to regard the transaction as taking place when the service is performed.

Rolph then attacks the common practice of distinguishing between public debt incurred for productive and for nonproductive purposes, and of treating interest on the former as nontransfer income and that on the latter as a transfer. In this argument he is on firmer ground. It is clear that the issue as to whether or not bondholders are performing services in return for their income is an entirely different question from the use to which the money obtained by the sale of the debt was put. While this argument can be used effectively against the first alternative of the League Report, it does not apply to the second alternative.

A somewhat more convincing case is made by Aukrust, who argues for a sharper distinction between real and monetary phenomena.38 He defines a real transaction to include the performance of a service by one sector for another or the transfer of a real asset from the balance sheet of one sector to the balance sheet of another. A financial transaction is defined as an act influencing the financial assets of the two sectors concerned. Transactions between two sectors in the same type of objects are grouped together as flows: flows of coal, postal services, etc., as real flows; and flows of notes, consols, shares, etc., as financial flows. These flows are then subdivided into required flows, where a flow from one sector to another is accompanied by a simultaneous flow in the opposite direction, and transfer flows, where some objects (real or financial) pass from one sector to another without any objects moving in the opposite direction. In accordance with this terminology, payments of interest and dividends are always treated as transfers on the ground that they are not payments for services passing simultaneously in the opposite direction. Aukrust does not recognize the objection that it is possible to envisage a service passing in the opposite direction, the service of waiting. This objection could be met readily enough by incorporating a category of financial services and distinguishing these from the category of transfers. Transfers would then be confined to those transactions for which there is no quid pro quo whatever.

Aukrust claims as a further advantage of his system that it leads to the adoption of “geographical product” and “disposable national income,” both valued at market prices, as the basic national aggregates. He argues very convincingly that these aggregates lead to more meaningful classifications than does the concept of national income, as defined in the League Report and adopted in official publications of the United Kingdom and the United States. This suggestion brings us to the crux of the problem which seems to reside in the distinction between “production” and “income” rather than in the distinction between real and financial flows. Production is most readily identified with a geographic area, i.e., the domestic territory of a particular country, whereas income is most readily identified with either real or legal persons, i.e., residents of a particular country. In order to preserve this distinction in the balance of payments it is desirable to group with goods only those services which would be included in an aggregate of production in the domestic territory of the exporting country, and to group separately investment income and other payments to the owners of factors of production, in respect of contributions to production outside the domestic territory of the country of which they are residents. This procedure would be quite consistent with Aukrust’s proposal that “geographical product” and “disposable national income” be adopted as the basic national aggregates, but would avoid the necessity of making the extremely difficult distinction between real and financial flows.

Flows of distributive shares as a separate category

Morris A. Copeland has proposed a solution of the problem along the following lines.39 He suggests that four kinds of items should be recognized in the balance of payments—purchases of one country’s products by other countries, international flows of distributive shares, transfer payments, and capital movements. The country’s products would include all goods and services produced within the domestic territory, regardless of whether foreign-owned factors contributed to their production. International flows of distributive shares would refer to income accruing to residents of one country in respect of factoral services rendered outside the domestic territory of that country. The Manual has already taken a step in this direction in its decision to treat branches and subsidiaries as residents of the country in which they are located. Acceptance of Copeland’s suggestion would involve the inclusion of certain other items, such as payments for services rendered abroad, film rentals, patent royalties, etc., as well as investment income, in the category “flows of distributive shares.” In the case of direct investment, for example, it matters little from the economic point of view whether the parent withdraws the earnings of a subsidiary in the form of dividends or in the form of royalties. To classify both payments as flows of distributive shares seems reasonable.

This procedure is followed in the OEEC Report with minor modifications.40 In accordance with the second alternative of the League Report, interest on public debt is included with other income from property as a positive item for the recipients and a negative item for the government. In the rest of the world account, compensation of employees and income from property and entrepreneurship are shown separately from purchases of goods and services.

To adapt the Fund’s standard schedule to this suggestion, “investment income” would have to be shown after the total of goods and services, and a further category would have to be added for “other factor income,” to which would be transferred such items as workers’ earnings, profits or losses on business activity abroad, copyrights, film rentals, patent royalties, etc. The schedule would then fall into four major categories as suggested by Copeland.

If this proposal were adopted, the concept of “domestic territory” would assume significance for the balance of payments as well as for the social accounts, since the distinction between “services” and “factor income” would be based on whether the production occurred within or outside domestic territory. The concepts of “extraterritoriality” and “agency” discussed above raise a number of difficulties in this connection.

The main reason for introducing the concept of “extraterritoriality” is to avoid a no-man’s land to ensure that the aggregate of domestic production for all countries gives a complete and unduplicated coverage of world production of goods and services. With respect to ships and aircraft, a number of alternatives are available for solving this problem. One is to regard the vessel as part of the domestic territory of the country under whose flag it is sailing and to regard the full value of the services involved in its operation as part of the domestic product of that country. Another possibility is to regard the vessel as part of the domestic territory of the country of the operator and to include the full value of the services in the domestic product of that country. A third alternative would be to attribute extraterritoriality separately to each factor of production and to include the value of its services in the domestic product of the country to which it is attached. This third alternative seems to be the most reasonable. In the hypothetical example considered above of a U. S. ship chartered to a British operator employing British and Norwegian seamen, this would mean that the charter hire of the vessel would be included in the domestic product of the United States, the wages of the British seamen and the net earnings of the operator in the domestic product of the United Kingdom, and the wages of the Norwegian seamen in the domestic product of Norway.41

If this solution is adopted, the question still remains as to the countries to which the different factors should be attached. While the flag of the vessel may generally be taken as a reasonable indication of the country with whose economy the vessel is most closely associated, there are some circumstances in which it is an inappropriate test. For example, it seems quite unrealistic to attribute services rendered by the Panamanian fleet to Panama, since the part played by Panama in the process of production is negligible. In this case it is more satisfactory to ignore the flag and to regard the vessels as being part of the domestic territory of the country of residence of the owners. On the other hand, when a vessel is closely related to the economy of the country whose flag it flies, there is a strong case for treating it as part of the domestic territory of that country even though it may be owned by a parent concern elsewhere. In this case the income accruing to the parent would be treated as income from investment.

When extraterritoriality is attributed to vessels, an interesting point is raised concerning the treatment of fish caught in the territorial waters of one country by a vessel operated by a resident of another country. Whether the production should be attributed to the one country or the other is arguable. The exploitation of the resources of a country’s territorial waters by foreign ships differs little from the exploitation of its mineral resources by foreign capital. There would be considerable difficulty, however, in distinguishing between fish caught in territorial waters and those caught on the high seas, and in attempting to record as exports the fish caught by foreign vessels in territorial waters and taken to foreign ports. The simpler procedure, which has been adopted implicitly by the Fund, is to attribute the production to the country of residence of the operator of the vessel. No account need then be taken of the waters in which the fish were caught. The only adjustment which is necessary is to include in exports fish caught by domestic vessels and sold directly in foreign ports. Charges for the use of fishing grounds would, of course, be treated as an export by the country receiving payment.

The treatment of ships and aircraft might give rise to a question as to whether extraterritoriality should also be attributed to railways and other carriers. There is no possibility of a no-man’s land in this case, and there is, therefore, no a priori reason for introducing the concept of extraterritoriality. There would, however, be some advantages in adopting a definition of “international carriers,” and attributing extraterritoriality to all carriers coming within that definition. It would then be possible to value exports and imports f.o.b. an international carrier instead of f.o.b. the frontier of the exporting country. The implications of this procedure will be discussed below.

The difficulty involved in the “agency” concept concerns the part of the production which is attributable to the country in which the agency is located. Even though the agent’s function in the productive process with which it is associated is a minor one, the value of the service it performs may be significant. Assume, for example, that a shipping line operated between London and New York is wholly owned in the United Kingdom, and that its New York office is concerned solely with selling tickets and cargo space and with facilitating the movement of the ships into and out of New York harbor. In the performance of these services, the New York office should logically be regarded as a U.S. resident since, to this extent at least, it is part of the U.S. economy. The rental value of premises used, the salaries paid to employees, and similar items should therefore be regarded as U.S. production. The reason for the treatment of the New York office as an agent in the balance of payments is to avoid regarding the productive services of the ships as part of U.S. production. When the productive services of premises occupied and personnel employed by an agency are significant, they should be entered in the balance of payments even though no resident-foreigner transaction may be involved. For example, if the premises are owned by the foreign company, the rental value should be recorded as the purchase of a service with an offsetting entry under investment income.

Goods and Services

Significance of gross credit and debit figures

After the removal of investment income and other factor income from “goods and services,” the items remaining in this category can readily be related to the production and disposition of the domestic product. Goods and services supplied by residents to foreigners are entered as credits in the balance of payments and as debits in the rest of the world account, and goods and services supplied by foreigners to residents are entered as debits in the balance of payments and as credits in the rest of the world account. When defined in this way the totals of credits and debits, as well as the net figure, are significant. The credit entries in the balance of payments represent exports of goods and services, and the debit entries represent imports of goods and services. Great care has been taken in the preparation of the Manual to safeguard the significance of the credit and debit totals. One of the reasons for preferring f.o.b. to c.i.f. values for imports was that, if c.i.f. figures were used, freight on imports paid to domestic carriers would have to be offset by a credit entry under transportation, thus causing an overstatement of the credit and debit totals by this amount. Returned exports and increases in domestically-owned stocks of exported goods are treated as negative credits, and returned imports and increases in foreign-owned stocks of imported goods as negative debits for a similar reason. The Manual’s treatment of a number of other items, however, can be challenged, as will be seen below.

Like the Manual, the League Report enters goods and services on a gross basis. It does not, however, take the same care to ensure that the credit and debit totals measure the aggregates of goods and services supplied by foreigners and those supplied to foreigners. For goods purchased on a c.i.f. basis and transported in the home country’s ships, for example, it states that an offsetting entry showing the rest of the world’s purchases of these services will appear on the opposite side of the account.42 The Manual takes the view that in arranging this transportation the foreign exporter is acting as agent for the domestic importer, and that no service to foreigners is involved. By recording all imports on an f.o.b. basis, the overstatement involved in including on both sides freight on imports carried in domestically-operated ships is avoided.

Entrepôt trade

The Manual records merchandise transactions abroad on a gross basis, the proceeds of sales in foreign countries of commodities bought abroad being entered as a credit and the cost of acquiring these commodities as a debit. This procedure means that the acquisition of commodities abroad for resale is treated in the same way as an import, and the resale of these commodities is treated in the same way as an export, although the goods do not at any time enter into the economy of the country. An alternative procedure would be to record the profit on merchandise transactions abroad as a service rendered to foreigners or possibly as the receipt of factor income from abroad. Since there is no essential difference between entrepôt trade in which the commodities remain abroad and entrepôt trade in which the commodities are imported and re-exported in the same form, alternatives will be considered in relation to entrepôt trade of either type. From the balance of payments point of view, when attention is concentrated on transactions between residents and foreigners, the former procedure is obviously preferable. From the social accounting point of view, however, when attention is focused on the transactions occurring within a given economy, it would seem preferable, at first sight, to record only the profit on entrepôt trade. As long as the goods concerned are purchased and sold in the same period, no serious difficulties result from this procedure. To the extent that stocks are carried over from one period to the next, however, a complication arises. Since the goods concerned in entrepôt trade would not be included in imports and exports if they were bought and sold in the same period, it would not be logical to include them in imports if they happened to remain unsold at the end of the period. This means that the stocks could not be regarded as domestic investment and would, therefore, have to be regarded as foreign investment. They would not, however, be included as domestic investment in the social accounts of any other country, and a lack of symmetry would thus be introduced into the system. Moreover, there would not be any foreign country to which they could logically be allocated in a regional classification of the balance of payments. It would be possible but quite arbitrary to regard them as foreign investment in the country in which they are located, but even this arbitrary solution could not be applied to stocks in bonded warehouses at home.

A further practical difficulty is that it might not be possible to distinguish between stocks abroad and in bonded warehouses which are destined for the entrepôt trade and those which will ultimately be consumed domestically. While there is some justification for treating stocks of the former class as foreign investment, there is no good reason why stocks of the latter type should not be included in domestic investment. A procedure which would be particularly appropriate in this case and which, though not entirely logical, might perhaps be the best solution in practice in all cases, would be to show entrepôt trade on a net basis but, at the same time, to treat the changes in stocks as domestic investment.

One of the reasons given in the Manual for entering entrepôt trade on a gross basis is that this procedure is necessary to permit a regional classification of these transactions. It will be shown later, however, that a regional classification would still be possible if entrepôt trade were recorded on a net basis.

In view of the many possibilities for the treatment of these transactions, the standard schedule might well be presented in such a way that those favoring the different methods could obtain the information needed as easily as possible. A comparatively minor rearrangement of the Fund’s standard schedule would make it possible to follow any of the alternative procedures depending on which was considered the more appropriate in the circumstances of the particular case. This would involve amending the sub-items of item 1 (Table 1) as follows:

  • 1.1 Special trade (f.o.b.)

  • 1.2 Entrepôt trade

  • 1.3 Changes in stocks.

This rearrangement would involve the transfer of the re-export trade from item 1.1 to item 1.2, and the subdivision of item 1.2 into entrepôt trade and changes in stocks. If changes in entrepôt stocks could be distinguished from changes in other stocks, it would be desirable to confine item 1.3 to the former and to include the latter with special trade. This would involve expressing special trade on a transaction rather than a customs basis. Entrepfôt trade would comprise the re-export trade as well as merchandise transactions abroad, and changes in stocks would include changes in domestically owned stocks in bonded warehouses, as well as those held abroad. The totals for the three sub-items would remain the same as for the present two sub-items. The figures would be used as they stand if it were desired to enter entrepôt trade on a gross basis. If it were desired to enter only the profit on entrepôt trade as a service, item 1.2 would be shown on a net basis; and, if it were desired to treat changes in stocks as foreign investment, item 1.3 would be transferred to the capital account.

Nonmonetary gold movement

Another objection that might be raised against the Manual’s treatment of goods and services is the entry of the nonmonetary gold movement on a net basis and the treatment of movements into and out of private hoards as consumption and negative consumption, respectively. It is desirable to consider the question of whether this item should take account of movements in private gold hoards before considering whether a gross or a net basis should be used, since the nature of the gross entries depends on the answer to the former question.

The decision as to whether gold hoards should be regarded as monetary or nonmonetary depends on whether they are regarded as being more like stocks of other commodities or like holdings of foreign exchange. The form which the hoard takes has some bearing on this decision. Thus a hoard of sovereigns is obviously of a monetary nature, whereas a hoard of gold ornaments is in a rather different category. Under present circumstances, however, when the fabrication of simple gold ornaments is being resorted to as a means of evading the Fund’s prohibition of premium sales, it does not seem unreasonable to treat all hoarding as monetary. This would involve the transfer of movements in private gold hoards to the capital account.

If this proposal were adopted, the principal components of the nonmonetary gold movement would be production and consumption in industry and the arts. To show the item on a gross basis would then involve entering production as a credit and consumption as a debit. The choice between a net and a gross basis depends, to some extent, on the nature of the transactions involved. If a country exports all its newly-produced gold and imports its requirements for industry and the arts, there is a clear case for showing the item on a gross basis. Again, if all current production must be sold to the monetary authorities and consumption is permitted only under license, it would seem reasonable to enter the gross figures. If, on the other hand, the monetary authorities rarely enter the market and current production is sold locally or exported in accordance with the demand, there is a case for entering the item on a net basis. Even in this case, however, the gross basis can be justified. The credit entry would be interpreted as implying that the production of gold is equivalent to an export in that it creates a foreign asset, and the debit entry would imply that the consumption of gold is equivalent to an import in that it involves the using up of a foreign asset. This suggestion takes no account of entrepôt trade in gold, for which provision must be made in this item or elsewhere in the current account. It seems preferable to keep the gold transactions together in this item rather than to split them and to include the entrepôt trade in gold with other entrepôt trade and the remaining transactions in the nonmonetary gold item. In accordance with the suggestion in the preceding section, it would also be desirable to show entrepôt trade in gold on a net basis. The nonmonetary gold item would then comprise two elements—production and consumption on a gross basis and entrepôt trade in gold on a net basis. While the Manual’s treatment of nonmonetary gold is not entirely satisfactory, the treatment of this item in the League Report is much less so. The latter adopts the rule that gold is to be treated at all times as a commodity, and that gold added to the reserves of the central bank forms part of domestic capital formation in the same way as the accumulation of industrial equipment. The principal reason for adopting this procedure is a desire to avoid the treatment of newly-mined gold in one way and existing gold in a different way. The argument is that in considering a complete international system in which the other end of the transaction must be integrated into a unified accounting system, it is desirable to regard gold as a commodity and not as a financial claim.43 To be sure, the Manual’s distinction between monetary and nonmonetary gold transactions introduces a lack of symmetry into the system. This is not due, however, to a faulty accounting system, but to a lack of symmetry in the economic reality of the situation. The fact is that when newly-mined gold is exported and added to the monetary reserves of the importing country, the transaction has an entirely different nature for the two participants. Under these circumstances it does not seem unreasonable to treat these two aspects differently. In preparing a matrix of transactions in goods and services, an “unallocated” column must be shown, to cover entries for nonmonetary gold movements which are not matched by a corresponding movement in another country. The net nonmonetary gold movement is matched by an equal and opposite net monetary gold movement in the capital account.

It might be argued that it is desirable to keep this asymmetry to a minimum, and, therefore, to confine monetary gold movements to movements in the holdings of official and banking institutions. If this argument were accepted, it would imply the acceptance of the Manual’s present practice and the rejection of the suggestion that private gold hoarding be transferred to the capital account, since this suggestion would normally increase the degree of asymmetry. Under present circumstances, new production is offset to a significant extent by private hoarding. However, once the necessity for asymmetry is recognized, there is no particular reason for seeking to keep it to a minimum at the expense of a more realistic presentation. The advantages from the balance of payments point of view of transferring private gold hoarding to the capital account would seem to outweigh the disadvantage of increasing the degree of asymmetry in the international system.44

Travel and transportation

The treatment of tourist expenditures and passenger fares in the OEEC Report is rather confusing, and also inconsistent with the rule that international transactions should refer only to transactions between residents and foreigners. Instead of basing its treatment on the nature of the underlying transaction, the OEEC Report bases its classification on where payment is made. Payments by residents in the rest of the world are included as tourism in the rest of the world account even if they cover passage in a domestically operated carrier. Likewise, payments by foreigners on domestic territory are included as tourism in the rest of the world account even if they cover passage in a foreign-operated carrier. Payments by persons of any nationality in the rest of the world for passage in domestically-operated carriers, and payments by persons of any nationality on domestic territory for passage in foreign-operated carriers, are then included as transportation in the rest of the world account. This procedure means that, when a resident pays for a passage in a domestically-operated carrier in the rest of the world, both sides of the rest of the world account are overstated by this amount. Similarly, when a foreigner pays for a passage on a foreign-operated carrier on domestic territory, both sides are overstated.

This procedure has been adopted through a failure to distinguish between local (intranational) and international transport services. The Fund’s distinction between these two types of transport service is justified by the fact that travelers’ expenditures for local transport services cannot readily be distinguished from other travel expenditures, whereas expenditures for international transport can be so distinguished. A further justification for the distinction is that local transport services are almost invariably provided by residents of the country concerned, while international transport services are of a more truly international character. Once this distinction has been drawn there is no reason why passenger fares in international transportation should not be allocated on the basis of the country of the operator rather than on the basis of where payment is made. Travel expenditures are then confined to expenditures within national boundaries.

Full consideration of the implications of the concept of extraterritoriality of vessels on the transportation account seems desirable at this point. The view has been expressed above that the concept of extraterritoriality of vessels should be confined to international transportation, and that carriers primarily engaged in international transportation should be designated “international carriers.” If this view is accepted, the method of allocation proposed above would be followed for international carriers but not for other carriers. In all cases of extraterritoriality, the services of each factor would be attributed to the country to which it is regarded as being attached. The final product would, of course, be attributed to the country of the operator of the vessel. The other factor services (charter hire and seamen’s earnings) would then be similar to the services rendered to the country’s residents traveling abroad, and would be regarded as imports by the country of the operator.

Problems also arise in the treatment of transportation services by an international carrier in the domestic territory of another country, and in the treatment of international transport services by a domestic carrier. The best solution seems to be to regard domestic transportation within a country’s economy as part of that country’s domestic product even when it is undertaken by an international carrier or a domestic carrier attached to another country. International transportation by a domestic carrier should be included in the domestic product of the country in whose waters its operations are mainly centered. Whenever the production is attributed to a country different from that of which the factor concerned is regarded as a resident, payments to factors should be treated as factor income. When the country to which the production is attributed and the country of residence of the factor are the same, payments received from foreigners should be treated as services.

In discussing the concept of domestic territory, the question was raised as to whether extraterritoriality should be attributed to railways and other carriers as well as to ships and aircraft. The suggestion was made that a definition of “international carriers” might be adopted, and that extraterritoriality might be attributed to all carriers falling within that definition.45 Exports and imports could then be valued f.o.b. an international carrier instead of f.o.b. the frontier of the exporting country. The advantage of this procedure would be that the services of international carriers would then be treated as part of the geographical product of the country of the operator rather than of the country in which the service is performed. Perhaps the best illustration of the way in which the procedure would operate is the case of trade between the United States and Canada via the Great Lakes. In theory, if exports are valued f.o.b. the frontier of the exporting country and extraterritoriality of carriers is limited to the no-man’s land between countries, the freight would have to be divided into that earned in the United States and that earned in Canada. The freight earned in the United States would be added to the value of U.S. exports to Canada, and would be treated as part of the domestic product of the United States, even if the goods were carried in a Canadian vessel. The earnings of the Canadian vessel in U.S. waters would then be regarded as factor income in the balance of payments rather than as a service item. An obviously simpler and more reasonable procedure is to value exports f.o.b. the Great Lakes port and to attribute extraterritoriality to the vessels carrying them. The earnings of the vessels would then be regarded as part of the domestic product of the country of the operator, and the transportation services would be regarded as a service item in the balance of payments.

Transportation on other international waterways, such as the Rhine and the Danube, should obviously be treated in the same way as transportation on the Great Lakes. The case of land transportation is not quite so clear. There is no difference in principle, however, between the case of trade between the United States and Canada via the Great Lakes, discussed above, and the case of a railway solely engaged, for example, in carrying ore from a mine in Canada to a blast furnace in the United States. There is, therefore, a very strong case for valuing such exports f.o.b. the international carrier, and for regarding the transportation as a service rather than factor income in the balance of payments An objection that may be raised against this procedure is that a foreign-operated railway in a country is similar to a foreign-owned enterprise. Since foreign-owned enterprises have been regarded as residents of the country in which they are located, it might be argued that a foreign-owned or operated railway or pipeline should be treated similarly. The reason for treating foreign-owned enterprises as residents of the country in which they are located is that they form an integral part of that country’s economy. The same cannot always be said of foreign-operated railways and pipelines. The railway from Beira in Mozambique to Umtali in Southern Rhodesia is operated by Rhodesia Railways and is much more closely integrated with the economy of Southern Rhodesia than with the economy of Mozambique. It would, therefore, be reasonable to attribute extraterritoriality to the operations of the railway in Mozambique. Similarly, various oil pipelines in the Middle East are in no way integrated with the economies of the countries through which they pass, and the concept of extraterritoriality should therefore be applied to their operation. The services rendered by the fixed equipment involved would, of course, be attributed to the country in which it is located.

In all of the cases considered up to this point, there would be no difficulty in distinguishing international transportation from domestic transportation. In some cases, however, there is no such clear line of demarcation. Road transportation is an example. The carriers must use the roads of the country through which they are passing, and may compete with purely domestic carriers over considerable parts of the route. There is, therefore, a less convincing case for attributing extraterritoriality to road transport carriers than to those of the types considered above. Even in this case, however, it may be reasonable to do so. In the immediate postwar period, for example, Germany was in effect a no-man’s land in international road transportation. A heavy transit trade developed which was in no way related to the German economy. To regard the transportation services as a product of Germany does not seem reasonable in these circumstances. When the German economy has recovered and domestic carriers compete with foreigners to provide these services, the case for attributing extraterritoriality to foreign carriers will be less clear.

Insurance

The Manual’s treatment of insurance transactions may be criticized on two scores. In the first place, it would be more appropriate to treat claims payments as negative premiums than as positive entries. Assume, for example, that a Frenchman insures his house with Lloyds in London and the house burns down. The Manual requires the United Kingdom to enter the premium received as a credit and the claim paid as a debit. The latter entry implies that a service has been rendered by the Frenchman to a British resident, which is certainly not the case. The net of premiums received and claims paid, while still no more than a rough approximation, would approach more closely the measure of the service involved.

The other criticism, which is anticipated as far as life insurance is concerned, is that no allowance is made for the capital element in insurance transactions. Only in very rare cases is the capital element sufficiently important to warrant its separation. Most international life insurance business is conducted through branches or subsidiaries in the countries concerned, and is, therefore, excluded from the insurance account. It is conceivable, however, that for a country like the United Kingdom, which undertakes a very large volume of insurance business, the capital element of other insurance transactions might be sufficiently important to warrant separation. The value of the insurance services rendered by a country during a given period may be defined as the earnings accruing to residents of the country in respect of risks borne on behalf of foreigners during the period. These earnings may be measured by the premiums received or receivable, less the claims paid or payable in respect of these risks. At a time when business is expanding, the premiums received against unexpired risks and the claims payable against expired risks will probably also be increasing. Premiums received less claims paid will, therefore, overstate earnings on both these counts. Thus, if the entries in the insurance account are to measure the value of insurance services rendered during the given period, claims should be treated as negative premiums and the movement in liabilities in respect both of premiums received against unexpired risks and of claims payable against expired risks should be transferred to the capital account.

Government transactions

One issue which arises also in connection with investment income and other factor income, namely the treatment of taxes, is best considered under this heading. The Manual provides that taxes paid to the country in which income is earned should be netted against the gross income in recording investment income, workers’ earnings, profits on business activity abroad, etc., and that certain other taxes or tax refunds should be entered as service transactions in the government account. There is a strong case, however, for recording income on a gross basis and for showing taxes as transfer payments. This is the procedure adopted in both the League and the OEEC Reports. Transfers, or donations as they are called in the Manual, are the contra-entries for all transactions that do not involve a quid pro quo. It would be extremely difficult to argue that a specific quid pro quo is given in exchange for direct taxes even though it might often be true that the taxpayer receives certain free benefits from the state.

The point should be made, however, that only when the tax is paid by a foreigner should it be treated in this way. In the case of direct investment, a decision must be made as to whether taxes paid to the government of the country in which the branch or subsidiary is located are to be regarded as being paid by the parent out of its earnings in the country or by the branch or subsidiary as part of its local costs. If the tax is assessed on the branch or subsidiary as such, the latter treatment seems preferable; but if the tax is levied on dividends as they are paid, the conclusion that the tax is paid by the parent seems inescapable. An export tax would, of course, be regarded as being paid by the local company and therefore as being part of its local costs.

The treatment of government pensions as service transactions is subject to the same criticism. In theory, they should be entered as donations if they are noncontributory and as capital movements if they are contributory. Their treatment in practice as service payments is sometimes defended on the ground that they are a recurring item and that current pension payments afford an approximate measure of the liability that is currently accruing in respect of future pension payments. The reply to this argument depends on whether the persons in respect of whom the government is incurring a liability to pay future pensions are regarded as residents or foreigners. If they are regarded as residents, no liability to foreigners is involved until they migrate. If they are regarded as foreigners, the accruing liability of the government to pay them pensions is only part, and a very small part, of their gross earnings which should be entered in the item “other factor income.” There are some circumstances, however, in which neither of these possibilities seems completely satisfactory. Government employees in various colonial administrations, for example, may quite reasonably be regarded as residents of the colony while they continue working, but there may be no doubt whatever that they will emigrate on retirement and receive their pensions abroad. In these circumstances, it does not seem unrealistic from the point of view of the colony to regard the pensions as service payments. A strict application of the resident-foreigner principle, however, would involve the entry of the capital value of a pension as an increase in government liabilities to foreigners as each foreign employee retired, offset by a donation in accordance with the procedure for dealing with migrants. Current pension payments would then be treated as a reduction in government liabilities.

The most important instance of government pensions in actual balance of payments statements at the present time is that of pensions to war veterans. It can be argued that these should be treated as a supplement to wages but, since they are not normally paid until the war in question is over, current payments cannot be offset against accruing liabilities. If it were desired to treat the government’s liability to pay pensions as a supplement to wages, it would be necessary to add the amount to the wages paid while the war was on and to treat the accruing liability as a capital item. The effect on the balance of payments would depend on whether the persons concerned were treated as residents or foreigners at the time this liability was being incurred. Two distinct cases must be considered. First, residents of another country may have enlisted in the armed forces of the country concerned. For example, large numbers of Philippine residents enlisted in the U.S. Army during World War II. To regard this act as an indication of a change in their “center of interest” does not seem reasonable. They may, therefore, be regarded as continuing to be residents of their own country. The pay of these foreigners would then be treated as factor income and would include a supplement corresponding to the pension liability incurred. The latter would be entered in the capital account as an increase in liabilities. After the war, when these foreigners have returned to their own country, the payment of pensions to them would be regarded as a reduction in liabilities. Secondly, veterans who were residents during the war may have migrated to other countries after the war was over. In theory, the capital value of the pension should be entered in the capital account with an offsetting donation as each veteran migrates. In practice, however, this method would be quite unworkable, and the only reasonable procedure would seem to be to treat the pensions as government donations as they are paid.

Another problem under this heading concerns the treatment of the acquisition and disposal of surplus property. In the Manual, the acquisition of foreign surplus property in the form of merchandise is included in the merchandise account, and all other surplus property transactions are covered in the “government” item. Transactions of the former type present no problem, since they may be regarded as similar to other current merchandise imports. Transactions of the latter type are the ones that cause difficulty. The Fund put the disposal of war-accumulated property in the form of merchandise on a different footing from its acquisition on the ground that it could not, like the acquisition, be regarded as similar to current merchandise trade. The fundamental difficulty is that, in social accounting practice, military purchases are treated as being consumed at the time of purchase by the government. In order to be treated as exports in the current period, they must be regarded at the same time as negative consumption by the government. There does not seem to be any objection to this procedure, which is similar to that of regarding the recovery of gold from industry and the arts as negative consumption. This case is not specifically covered in the League Report, but the above solution is consistent with the treatment of sales of second-hand goods by persons.46 The lack of symmetry introduced into the Fund’s schedule in the treatment of this item is unnecessary. A neater solution would be to provide a separate sub-item under item 1 for surplus property in the form of merchandise.

The problem of the treatment of surplus property other than merchandise (e.g., military installations) is closely related to the treatment of the acquisition of fixed assets by military establishments and diplomatic missions. The Manual makes an exception of property of this type in its definition of investments. While there are, admittedly, serious objections to treating such property as foreign investment, there are even more serious objections to including the real estate component of it in the goods and services account. In order to be consistent with the social accounting approach, every credit entry in the goods and services account must either be part of current production or represent domestic disinvestment or negative consumption. To regard a transaction as disinvestment or negative consumption does not seem realistic unless it formed part of past production. The real estate component involves neither current nor past production, and its disposal should not be regarded as negative consumption. The only alternative seems to be to regard it as foreign investment. Expenditure incurred in building fortifications, airfields, etc., is in a different category, and since such expenditure is normally included in consumption, it is reasonable enough to regard the disposal of all except the real estate component as negative consumption. In the majority of cases, the real estate component will be negligible and may be ignored, but where it is significant it should preferably be treated as foreign investment.

There is a superficial similarity between the item “leases of naval and strategic bases,” which is included with government transactions in the Manual, and the items for film rentals, patent royalties, etc., which it has been proposed should be transferred to the item “other factor income.” The difference is that a rental of the former type refers to a payment for a service rendered in one country to residents of another country stationed within the borders of the first country, whereas a rental of the latter type is a charge against current production in one country accruing to factors of production owned by residents of another country. Payments of the former type can legitimately be regarded as forming part of current production in the country receiving the payment, while payments of the latter type are charged against current production of the paying country.

Miscellaneous services

A number of items listed in the Manual as miscellaneous services have already been discussed in connection with the treatment of factor income. If the suggestion made at that time is accepted, the category “miscellaneous services” would be confined to services produced on domestic territory for the benefit of foreigners (credits) and services produced abroad for the benefit of residents (debits). The actual items that would need to be transferred to the category “other factor income” will be discussed later. Two further items, however, call for special comment, namely pensions and lottery tickets and prizes. Pensions can be disposed of briefly since the issue involved has already been discussed in relation to government pensions. If the persons in respect of whom a liability to pay pensions is accruing are regarded as foreigners, this liability should be regarded as a supplement to their earnings and included in “other factor income” with an offsetting entry in the capital account. If they are regarded as residents, no international transaction is involved until they migrate. Strictly speaking, the capital value of the pension should be regarded as an automatic donation at the time of migration. A more practical procedure would be to treat the pensions as donations as they are paid.

The question of lottery tickets and prizes presents an issue somewhat similar to that involved in the case of insurance. Clearly, to enter gross receipts and payments is to exaggerate the amount of services rendered. For practical purposes, a reasonable assumption is that the net amount measures roughly the service involved.

As with insurance, a capital element may be involved to the extent that there is a change in the value of tickets held in lotteries which have not yet been drawn or in the prizes payable but not yet paid. This possibility is unlikely to be significant, however, and can be ignored. Also, prizes (claims) may exceed payments for tickets (premiums), but this is similar to a loss incurred in business operations.

Flows of Distributive Shares

Investment income

The question of whether or not investment income should be included in the goods and services account has already been discussed. It remains now merely to compare the way in which the item is calculated for balance of payments and social accounting purposes.

As pointed out in the discussion of government transactions, the Manual records investment income net of direct taxes, whereas both the League and the OEEC Report record it on a gross basis and show taxes as transfer payments. A preference has been expressed for the latter procedure.

Another difference between the Manual, on the one hand, and the League and the OEEC Report, on the other, is in the treatment of income from direct investment. The Manual includes undistributed profits of branches and subsidiaries, whereas the League and the OEEC Report include only income actually distributed. No specific reference is made in the League Report to the particular case of undistributed income of branches and subsidiaries. The OEEC Report, however, explicitly excludes undistributed income of branches and subsidiaries, but does not state the reason for this decision.47 There would appear to be no reason whatever for excluding undistributed profits of branches. All transactions between the head office and the branch take place in inter-company accounts, and profits are credited to the head office as they accrue. When new investment is taking place in the branch it is quite immaterial whether the profits are withdrawn from the branch and new funds transferred to it or whether the profits are retained in the branch and reinvested. The case is not so clear for a subsidiary, but the argument in the Manual is quite convincing.48

Other factor income

The reasons for excluding other factor income from the goods and services account have already been discussed, and the treatment of direct taxes on such income has also been considered. The items to be included in this category must now be decided.

The criterion that has been suggested for distinguishing between services and factor income is the territory on which the production takes place. If the production takes place on the territory of the country receiving payment, the item is regarded as a service; if it takes place elsewhere, the item is regarded as factor income. Thus the wages of a frontier worker are regarded as factor income, whereas the earnings of a lawyer representing a foreign client in the courts of his own country are regarded as a service. The decision is fairly simple for such items as workers’ earnings, but for others it is more difficult. In the case of profits or losses on business activity abroad, it must be decided whether the service was rendered at home or abroad. The simplest solution is to base the decision on the location of the person earning the profit: if he has remained at home, the item would be regarded as a service; if he made the profit abroad, the item would be regarded as factor income.

An even more complicated problem arises in connection with copyrights, royalties, and similar payments. If an author writes a book in one country and the book is published in another, it is reasonable enough to take the view that part of the value of the book published in the second country was produced in the first country. If, however, after an interval of several years, the book is reprinted it is more difficult to claim that this involves current production in the first country to the value of the royalties received. To take an extreme case, it would be absurd to claim that the performance of a Gilbert and Sullivan opera in the United States involves current production in the United Kingdom because the owner of the copyright resides there. The most practical solution seems to be to regard all copyrights, patent royalties, film rentals, etc., as factor income rather than service payments. In the borderline case, such as that of the author mentioned above, where royalties are received in respect of a service performed currently, it would be more correct from a theoretical point of view to treat the royalties (or better still the capital value of all expected royalties) as payment for a service.

Neither the League nor the OEEC Report deals satisfactorily with this question. The League Report recognizes rent as factor income, but, in view of the difficulty of separating it as a distinct factor share, takes the view that it is better handled as a service.49 The discussion is entirely in terms of rent from real estate, but it is apparently intended to apply equally to other types of rentals. When an attempt is made to identify the production of such a service with the country which is allegedly rendering the service, the weakness in this approach is immediately apparent. The rent accruing to a foreigner in respect of his investment in real estate is just as surely factor income as dividends on his equity holdings. The approach of the League Report can be reconciled with the position taken here by regarding foreign holders of property rights as enterprises. The rentals would then be regarded as service payments to domestic enterprises, and the entries in the rest of the world account would appear as withdrawals of operating surpluses. This procedure is unnecessarily cumbersome from a balance of payments point of view.

The OEEC Report treats rent in respect of land and buildings as factor income but treats royalties as service payments.50 This seems to be inconsistent with its own principle that production should be ascribed to the territory on which the production takes place.51

Gross versus net presentation

The question must now be raised whether investment income and other factor income should be entered in the balance of payments on a gross or a net basis. To ensure consistency with social accounting, the resulting totals should harmonize with the concept of “national income” just as the totals for goods and services are intended to harmonize with the concept of “national product.” Subject to a qualification for exports arising from disinvestment or negative consumption, the credit entries for goods and services are associated with the generation of income, thus contributing to national income except when the income accrues to foreigners. The debit entries, on the other hand, are associated with national expenditure. This suggests that factor income accruing to foreigners should be entered as a negative entry in the credit column rather than as a positive entry in the debit column. Factor income accruing to residents from abroad should then be added as a positive entry in the credit column to indicate the extent to which current income arises from sources other than current domestic production. The net entry for factor income then indicates the extent to which national income exceeds (if positive) or falls short of (if negative) the income arising from current domestic production.

Donations and Capital Movements

Public debt interest

As mentioned above, the category of “donations” or “unilateral transfers” has generally received insufficient attention in social accounting. This defect has been remedied to a large extent, but not entirely, by the League and the OEEC Report. The League Report does not deal specifically with public debt interest payable abroad, but the implication is that it should be treated as a transfer. From the point of view of the lender, it is obviously unsatisfactory to treat interest on the public debt differently from interest on loans for business purposes. The “service” provided by the foreigner is the, same in each case. The OEEC Report adopts the more acceptable procedure of regarding public debt interest as positive property income of the recipient, and as negative property income of the government.

Migrants’ transfers

The question of migrants’ transfers is covered by the League Report, but not by the OEEC Report. The League Report’s treatment of this item52 differs from that of the Manual, however, in that it is confined to capital accompanying migrants, while the Manual includes all property belonging to migrants. The League Report’s exclusion of personal and household effects can be explained by the practice in social accounting of regarding durable consumers’ goods as being consumed at the time of purchase. If this practice is adopted, the inclusion in exports and imports of such goods owned by migrants is obviously incorrect unless they are included at the same time in negative consumption, which is equally unacceptable. The Manual’s treatment would be consistent with the social accounting approach only if stocks of durable consumers’ goods were included in domestic investment. Since this is quite impractical, there is a strong case for amending the Manual to exclude migrants’ personal and household effects from items 1 and 9. On the other hand, the Manual’s procedure of including all other assets and liabilities of the migrant is preferable to the League Report’s procedure of including merely the capital accompanying him.

Occupation costs

The Manual, as well as the League and the OEEC Report, is deficient in its treatment of donations. Reference has already been made to the questions of direct taxes and pensions. Another item which is not dealt with explicitly in the Manual, but which must obviously be faced in the social accounts, is occupation costs. In practice, these costs have generally been excluded from balance of payments statements, but they cannot be excluded from the social accounts and a decision must be made as to their most appropriate treatment. An occupied country has a natural inclination to regard all expenditures made at the direction of the occupying authorities as occupation costs, and to enter them in the balance of payments as services rendered to the occupying power, offset by donations. To the extent that the services concerned are rendered exclusively for the occupying troops, this treatment is unquestionably correct. The situation is different, however, when the services benefit the occupied country, either directly or indirectly. The occupying authorities in Germany and Japan, for example, have been engaged in the relief of the civilian population as well as in the enforcement of disarmament and the punishment of war criminals. Expenditures incurred by the occupied country in facilitating the relief program are obviously not a donation to the occupying country. More doubtful cases arise when the service is of immediate benefit to the occupying troops but may ultimately benefit the local population. Airfields, roads, housing, etc., built at the command of the occupying authorities, will presumably remain when the occupation ends, and will probably be at least of some benefit to the local population. Any solution of this problem is likely to be rather arbitrary. Perhaps the most satisfactory alternative would be to exclude that part of occupation costs which is predominantly of benefit to the local population, and to enter the remainder as a service to the occupying powers, offset by a donation. Then, when the occupation ends, the facilities left behind should be entered as a reverse donation at their value for domestic purposes.

Gross versus net presentation

Just as an attempt has been made to integrate the totals for goods and services and factor income with social accounting concepts, the same must be done with the remaining category of current transactions, donations. The most satisfactory procedure seems to be to regard all donations as elements of national expenditure. Donations received would then be recorded as negative entries in the debit column, indicating the extent to which imports and outflows of capital did not involve expenditure from current income. Donations extended would be recorded as positive entries in the debit column, indicating the extent to which current income was expended abroad for purposes other than imports and outflows of capital.

Capital account

Little attention is paid to the capital account of the balance of payments in social accounting. Net foreign investment appears as a single figure and its definition follows from the definition of the current account items. Special attention will be given to the capital account later, when the foreign exchange aspects of the balance of payments are discussed.

Social Accounts in General

National product and national income

Some of the points raised in the above discussion have a bearing not only on the rest of the world account as an element of the social accounts but also on the social accounts as a whole. It has been suggested53 that the concept of “production” should be related to the place where it occurs and that the concept of “income” should be related to the person to whom it accrues. A strict application of this principle would involve the definition of “national product” in terms of the production occuring within the “domestic territory” of a country, and of “national income” in terms of the income accruing to the “residents” of the country.

Acceptance of this suggestion would require the rejection of the commonly-accepted practice in social accounting of defining national income, net national product, and net national expenditure as identical magnitudes. The separation of “product” aggregates from “income” aggregates involves the recognition of two distinct concepts of “expenditure,” one related to the disposition of the national product and the other to the expenditure of the national income.

Gross national turnover

Further analysis of the disposition of the national product would be facilitated by the adoption of a new concept which might be described as “gross national turnover.” This concept would include the gross national product and imports of goods and services together with disinvestment and negative consumption to the extent that these are significant for the analysis of the disposition of the available flow of goods and services into broad categories, such as consumption, investment, and exports.54 Assume, for example, that a country is engaged solely in making bread from imported wheat which is paid for by exporting part of the product. In one year it imports wheat worth $1 million and produces bread worth $2 million, half of which is consumed locally and half exported. The gross national product would then be $1 million representing the value added in making bread. The disposition of the gross national product would be personal consumption $1 million and net exports nil. The $1 million of production, however, is not identical with the $1 million of personal consumption. In order to show the disposition of the total output, imports must be added to the gross national product, and exports added to domestic consumption. This would give an aggregate gross national turnover of $2 million, representing the total value of the output of bread. The disposition of the gross national turnover would then be shown as $1 million of bread consumed and $1 million of bread exported. In a similar manner, disinvestment and negative consumption should be included in gross national turnover to the extent necessary for the analysis of the disposition of the aggregate by type. For example, if the country in the above illustration obtained half of the wheat from its own stocks and imported the remainder in exchange for $0.5 million of bread, the gross national turnover would be $2 million of bread, of which $1.5 million would be entered as personal consumption and $0.5 million as exports. Again, if the wheat imports were paid for with surplus military property instead of with bread, the gross national turnover would be $2.5 million comprising $2 million of bread and $0.5 million of surplus property. The disposition of this aggregate would be shown as personal consumption of $2 million of bread and exports of $0.5 million of surplus property.

The examples of disinvestment and negative consumption in the above illustrations have been chosen deliberately to show the way in which these items may affect the recording of consumption and exports by types. The extent to which disinvestment and negative consumption that do not affect a broad classification of this type would need to be included in gross national turnover depends on the extent to which it is desired to subdivide these broad types. For example, a reduction in stocks of one type of consumers’ goods may be offset against an increase in stocks of another type as long as it is not desired to subdivide consumption and investment in such a way as to distinguish between these types. In the extreme case it might be found desirable to include all negative consumption by individuals and the government and all disinvestment by individual firms even though their actions might be offset by consumption and investment of other individuals and firms. For our present purpose, all that is necessary is to include disinvestment and negative consumption to the extent necessary to permit a broad classification of the gross national turnover between consumption, investment, and exports.

This brief description of “gross national turnover” shows clearly that the credit and debit totals for goods and services as defined above are entirely consistent with this concept. Each of the categories of consumption, investment, and exports in a country’s economy is comprised of elements of production, disinvestment, negative consumption, and imports. These imports consist, in turn, of elements of production, disinvestment, negative consumption, and imports in other countries’ economies.

IV. Financing OF International Transactions

As shown in Section III, social accounting is concerned primarily with those international transactions which relate to the acquisition and disposal of goods and services and the distribution of factor incomes. Transfers or donations between countries are brought into the picture as a subsidiary element of national revenue or expenditure, and capital transactions appear as a residual described as “net foreign investment.”

From the foreign exchange point of view, the way in which these flows are financed must be studied. For this purpose, attention should be focused on the elements in the balance of payments which have been discussed the least so far, namely, donations and capital movements. The objective will be to determine what it is that makes the balance of payments balance.

Since the balance of payments is a double entry system of accounting in which every credit is offset by a corresponding debit of equal magnitude, the fact that it must balance is obvious. This is an ex post relationship, similar to the identity of savings and investment. In neither this case nor that of savings and investment does this formal balance give any indication as to whether or not the system is in equilibrium. No judgment can be given on this issue until some evidence is available regarding the ex ante relationships of the supply and demand schedules concerned. These ex ante relationships cannot be determined statistically, however, and the question arises whether the ex post relationships as revealed in the balance of payments can be used to throw light on the ex ante situation. This question will be discussed in more detail below. At this stage, it is sufficient to point out that there is an important difference in this respect between the savings-investment relationship and the balance of payments. In the case of savings and investment, price movements ordinarily play a significant role in the balancing process, both in the short run and the long run.55 In the foreign exchange market, however, price movements have customarily played a much more indirect part. Under gold standard conditions, fluctuations in the exchange rate were limited by the gold points while, under modern conditions, the rate is generally held at a level determined by the monetary authorities instead of being allowed to fluctuate freely with changes in market conditions. Under these circumstances, any gap between supply and demand must be filled by elements which are not part of normal supply and demand. The question whether these elements can be isolated in the ex post balance of payments leads to a consideration of the various concepts of surplus and deficit in the balance of payments.

Various Concepts of Surplus and Deficit

Mercantilist concept

The concept of a surplus or deficit in the balance of payments has existed from the earliest mercantilist times. While its significance has, of course, been recognized only gradually, it has long been regarded as a means of indicating strength or weakness in the balance of payments of the country concerned. Frequently at first, and sometimes even today, attention has been confined to the balance of “visible” trade. Some writers, however, recognized at a very early stage that concentration on the trade balance alone might be extremely misleading. A wide variety of “invisible” items was recognized long before an attempt was made to measure them statistically. One of the primary motives of the compilers of the earliest balance of payments estimates was to demonstrate that, in spite of a growing trade deficit, England had a large surplus on current account which was available for reinvestment.56 Even when the terms import or export surplus continued to be used, they were implicitly intended to cover “invisible” transactions as well as trade. The balance on current account thus emerged as a measure of surplus or deficit in the balance of payments. In this balance no attempt was made to distinguish donations from other current items. Donations were simply treated as one category of invisibles. Not until recently has this item acquired sufficient quantitative importance to justify the recognition of its distinct character.

Just as there was a tendency to simplify the current account of the balance of payments, there was a similar tendency to simplify the capital account. The mercantilist writers ignored the possibility of capital movements and envisaged the import or export surplus as payable in specie. In view of the comparatively insignificant volume of international capital movements at that time, the simplification was justified.57 It was a matter of indifference to them whether the surplus or deficit was measured by means of the balance on current account or by means of the actual movement of specie.

Classical and neo-classical concept

When the place of international capital movements was recognized, a distinction was drawn between “autonomous” capital movements on the one hand and “equilibrating” or “induced” capital movements on the other. Movements of the former kind were regarded as part of the market supply and demand, and movements of the latter kind were regarded as part of the balancing item. This development arose naturally out of practical experience of the working of the gold standard.

It was found that gold movements were small and infrequent relatively to the gaps which continually arose in the international accounts. The explanation is simple. To a large extent the gaps were filled by equilibrating movements of private short-term funds in response to interest differentials or slight exchange variations within the gold points. More particularly, they could be filled by sales or purchases of foreign bills and balances held as reserves—instead of or in addition to gold—by commercial banks as well as central monetary authorities… .58

The concept of “equilibrating” capital movements involves the introduction of a new principle of classification. Up to this point the distinction between the transactions entering into the supply and demand for foreign exchange and those intended to fill the gap between supply and demand was based on the outward characteristics of the transactions. In this case, however, the classification of a transaction became dependent on the underlying motive. A distinction then became necessary between transactions which had the same outward characteristics, since short-term capital movements that were outwardly similar frequently arose from entirely different motives. For example, an “equilibrating” capital movement in response to international differences in interest rates might be outwardly indistinguishable from a movement due to increased requirements for working capital.

It is understandable, therefore, that considerable differences of opinion have existed as to where the line of demarcation between “autonomous” and “induced” movements should be drawn. Some writers have tended to classify all long-term capital movements as autonomous and short-term movements as induced.59 A number of objections to this procedure may be raised, however. In the first place, long-term assets for which there is a ready market are frequently more liquid than short-term assets of nonmarketable types. Assets of the former category are therefore a convenient vehicle for induced movements, while certain types of short-term movement rarely come within this category. This fact has led Frisch to put emphasis on the degree of liquidity rather than on the term of the asset or liability involved.60 This criterion, however, is also unsatisfactory, since some movements in liquid assets arise independently of the over-all balance of payments situation and some items which are not in the least liquid are, nevertheless, of an equilibrating nature. The Anglo-American loan, for example, was clearly equilibrating even though the long period of amortization and the absence of a marketable security of any kind made it highly illiquid.61

The concept of “induced” capital movements as a balancing item was associated in the writings of most of the classical and neo-classical economists with a belief in “the efficacy of the Bank discount rate, if employed skillfully and forcibly enough, as a regulator of specie movements through its influence on the international movement of short-term funds and, to a less extent, on the commodity trade balance.”62 Viner points out, however, that some writers took a skeptical view of the effect of an increase in the discount rate in attracting short-term funds from abroad. They pointed out that “a rise in the discount rate might be interpreted as a signal of impending financial stress” and therefore lead to an outflow rather than an inflow of capital.63

A more recent criticism of the formula based on gold flows plus equilibrating capital movements is that of Nurkse.64 As a standard for the discussion of the equilibrium rate of exchange, Nurkse urges that dis-equilibrating short-term capital movements, as well as transfers of gold or foreign exchange reserves and equilibrating capital movements, should be excluded from the balance of payments. This suggestion was prompted by the phenomena of capital flight and “hot money” which were particularly apparent during the nineteen thirties, mainly because of fear of exchange depreciation and war. There is no suggestion on Nurkse’s part that a flight of capital does not exert pressure on the balance of payments. The suggestion is merely that such pressure is not an indication of a departure from the equilibrium rate of exchange. As stated above, the concept of surplus and deficit has generally been used to indicate the presence or absence of balance of payments pressures,65 and it is in this sense that the concept will be used here. From this point of view, disequilibrating capital movements are clearly components of market supply and demand and should, therefore, be included in calculating the balance. It is, of course, true that under these circumstances the absence of a surplus or deficit cannot be taken as an indication of long-term balance of payments equilibrium.66

The disruption of the world balance of payments situation brought about by World War II, and the development of a wide range of techniques for financing the resulting surpluses and deficits, have made even the best of the earlier concepts inadequate. In an effort to cope with this situation, the staff of the International Monetary Fund has developed a new concept, compensatory official financing, which is presented as a realistic approach to the question of surplus or deficit in the balance of payments under present-day conditions.

Concept of Compensatory Official Financing

A detailed description of the concept of compensatory official financing was given in the 1938-47 Yearbook. The concept is defined as “the financing undertaken by the monetary authorities to provide exchange to cover a surplus or deficit in the rest of the balance of payments.”67 An appendix to the second edition of the Manual gave a brief description of the concept, and this description was published in a slightly expanded form in the 1948-49 Yearbook. Although the concept is still in the experimental stage, it has been used widely for the presentation of balance of payments data, not only in the Fund’s publications but also in the official publications of certain countries. Slightly different terminology has been used in some of the latter cases, but the underlying concept is the same.

Reasons for concentration on official financing

The first point that should be noted about this new concept is that it is confined to official financing, i.e., financing undertaken by the monetary authorities.68 The earlier concept of gold flows plus equilibrating capital movements was not limited in this way. Neither the gold flows nor the capital movements need necessarily have involved the monetary authorities. It has been argued in the 1938-47 Yearbook, however, that gold flows may be interpreted as the equivalent of official fiancing when, as under the gold standard, gold may be exported and imported without restriction and may be converted freely into domestic currency, and vice versa. Under such circumstances, there is no essential difference between private exports of gold out of circulation or domestic hoards and the conversion by the central bank of domestic currency into gold for the purpose of export. When such a policy is officially adopted, all gold movements, except new production and consumption in industry and the arts, may be regarded as the equivalent of official financing.69 A similar situation applies in the case of equilibrating capital movements if the currency is fully convertible and the central bank is willing to buy and sell foreign exchange freely. Under these circumstances, there is no essential difference between a decrease in foreign exchange holdings of the central bank and an inflow of private short-term capital induced by an increase in the central bank’s discount rate. Thus, although the older formula of gold flows plus equilibrating capital movements covers a broader field than purely official financing, it is reasonable enough to regard such movements as the equivalent of compensatory official financing under the conditions of the gold standard and free foreign exchange markets. As long as the monetary authorities possess the confidence of the public and can rely on inducing equilibrating capital movements by varying the discount rate, there is no particular significance in distinguishing between private and official holdings of gold and foreign exchange.70

When the public no longer has full confidence in the currency or the monetary authorities have abandoned the gold standard and free exchange markets, the distinction between private and official holdings becomes imperative. Without public confidence in the currency, the monetary authorities can no longer rely on being able to induce equilibrating capital movements by varying the discount rate. Without the gold standard and free exchange markets, they can no longer rely on a small movement in the exchange rate to the gold export point to bring gold out of private hands. The Fund’s decision to concentrate on official financing may therefore be justified on the ground that, under present conditions in which the gold standard has been almost universally abandoned and differences between interest rates in the money markets of different countries are a minor factor influencing private short-term capital movements, the theory which fitted nineteenth century conditions is no longer applicable.

Movements in international reserves

When allowance is made for the exclusion of private capital movements, it will be seen that compensatory official financing covers all the remaining elements of the concept of gold flows plus equilibrating capital movements. In theory there are two ways in which these elements may be estimated. In the first place, an attempt may be made to isolate each transaction that is clearly of an equilibrating nature. This would involve the exclusion of official transactions undertaken for other reasons, e.g., a shift in the form in which international reserves are held. The other alternative, which is the only practicable one, is to assume that, in the absence of evidence to the contrary, the net movement in the various items that make up international reserves is compensatory. To this movement must be added, then, only those other transactions that are clearly of an equilibrating nature. The Fund’s staff has followed this method and has defined international reserves to include monetary gold, short-term official assets abroad, long-term assets which are readily marketable abroad and are at the disposition of the monetary authorities, and short-term liabilities to foreign official and banking institutions.71 The last category is included since it is the “counterpart of foreign exchange assets of foreign monetary authorities except to the extent that the liabilities are to banks not members of the official family abroad”.72 Among the other transactions of a clearly equilibrating character, the Fund’s staff has included grants as well as capital movements whenever these are intended to meet a deficit in the balance of payments of the recipient country.

The assumption that the net movement in international reserves as defined above is compensatory is valid only if all official transactions in these items are either equilibrating or of the nature of a shift in the form in which the international reserves are held. It is possible, however, to envisage circumstances in which the movement in a country’s international reserves would actually have a disequilibrating effect on its balance of payments. The monetary authorities might, for example, be anxious to replenish reserves and might enter the market as a purchaser of foreign exchange, allowing the exchange rate to depreciate to whatever level was necessary to equate supply and demand. Under these circumstances the movement in reserves would be a determinant of the exchange rate, rather than the exchange rate and the other conditions imposed on the market by the monetary authorities being a determinant of the movement of reserves. In these circumstances, there would be no point in talking of a surplus or deficit. However, although such a situation is conceivable in theory and may have actually occurred in practice in a period when less attention was paid to the establishment and maintenance of a par value, it is of little practical significance today.

When a shift in the form in which a country’s international reserves are held involves the shifting of balances from one financial center to another, there is no error in the global balance of payments in treating the net movement in reserves as compensatory. A difficulty arises, however, in a regional classification. The decrease in reserves shown in the balance of payments with the country from which balances have been withdrawn would appear to indicate a deficit with that country; and conversely, the increase in reserves with the country to which they have been transferred would appear to indicate a surplus with that country. In order to remove this implication, both the multilateral settlement and the movement in reserves should be regarded as noncompensatory. The logic of this procedure becomes apparent when attention is focused on the balance of payments of the financial centers affected by the transfer. Shifts of this kind are usually disequilibrating from the standpoint of the financial centers themselves. The movement is unlikely to take place unless there is evidence of weakness in the balance of payments of the center losing the reserves and of strength in that of the center gaining the reserves. The movement accentuates both tendencies. The British crisis in 1931 was aggravated by movements of this kind between London and New York. The effect of the transfer on each of the countries concerned can be shown most clearly by treating both the multilateral settlement and the movement in reserves as noncompensatory.

Another difficult practical problem arises when a voluntary decision by the government, resulting in a movement in reserves, is prompted primarily by the existence of excessive reserves or of reserves which are not available for ordinary balance of payments financing. Examples of such transactions are the extraordinary transactions of the United Kingdom with India and Pakistan after these countries attained independence. The pensions annuities would not have been purchased by India and Pakistan if they had not had large holdings of blocked sterling which would not have become available for other uses for many years. Movements in reserves under these circumstances can hardly be regarded as “equilibrating”. For this reason, the 1948-49 Yearbook showed the purchase of the annuities and the corresponding movement in reserves together in a separate group of extraordinary noncompensatory transactions.73

It may be objected that these transactions are similar to the planned deficits discussed in the 1938-47 Yearbook.74 In the case of planned deficits, however, there is a genuine market deficit which is partly held in check by controls and partly financed out of reserves. To the extent that a deficit is allowed to appear, the movement in reserves can be said to reflect the financial pressures on the monetary authorities, given the level of controls in effect. In the case of government transactions whose primary motivation is the existence of excess reserves, however, it does not seem realistic to speak of a market deficit at all. Therefore, whenever a government transaction is motivated primarily by the size or the availability of the international reserves which are to be used to finance it, both the transaction itself and the corresponding movement in reserves should be excluded from compensatory official financing.

Apart from the comparatively infrequent exceptions to which reference has been made, a reasonable assumption is that all other movements in reserves are either equilibrating or of the nature of a shift in the form in which the reserves are held.

Other components of compensatory official financing

In addition to movements in international reserves, a number of other transactions of an equilibrating nature are included in the concept of compensatory official financing. The most obvious example is the use of the Fund’s resources. One of the objects of the establishment of the Fund was that its resources should be made available, under adequate safeguards, to members to provide them with an “opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.”75 In presenting the outline of the proposed Fund to the House of Lords, Keynes described the Fund as being, “in effect, a great addition to the world’s stock of monetary reserves.”76 There can be no doubt whatever that the use of these resources is compensatory.

A further category of transactions that is classed as compensatory comprises certain transactions in the country’s outstanding long-term obligations. The country concerned may play either an active or a passive role. In the former case, the monetary authorities finance a surplus through voluntary prepayment of public or other debt owed to foreigners. In the latter case, the country’s long-term obligations are purchased or sold by the monetary authorities of a foreign country to finance a surplus or deficit in its balance of payments.

Repayment of foreign debt before final maturity is treated as voluntary except when, for the purpose of orderly handling, final maturity is anticipated by a short period. In certain special cases (e.g., Australian Government bonds maturing in London) where the credit of the debtor country in the money market concerned is so strongly established that a maturing loan can be readily refunded, redemption on maturity has been treated by the Fund as, in effect, voluntary.77 The monetary authorities are regarded as being free to exercise their discretion as to whether or not to make repayment. The difficulty remains, however, that in a given situation the terms on which the loan could be refunded might be so unfavorable that the government might decide to make repayment, not because of its balance of payments situation but because of the added interest burden involved in refunding. Thus, although the most realistic procedure seems to be to treat repayments by a country in this situation as compensatory, there is always the possibility that other considerations may outweigh the balance of payments aspect. The decision as to whether or not a particular repayment is compensatory is probably, therefore, best made on an ad hoc basis.

Another problem which arises in connection with the repayment of loans concerns the treatment of loans issued for a short period. Clearly, a loan issued and repaid during the same year can be omitted entirely without distorting the picture for the year as a whole. This means that, if the transactions are included, the issue of the loan and its repayment must be classified under the same heading. When the end of a year happens to fall between the issue of the loan and its repayment, there is no reason for altering this procedure. Thus, if a short-term loan raised in one year is classified as compensatory, its repayment in the following year should also be classified as compensatory. Otherwise, the deficit originally financed by the loan would be counted twice, once when it first occurred and again in the following year when the loan was repaid. A reasonable assumption is that, when a choice is being made as to the manner in which a deficit is to be financed, the monetary authorities take account of the fact that a short-term loan will have to be repaid in the following year. When a short-term loan is chosen rather than another means of financing, the presumption is that the monetary authorities expect the situation to be better in the following year. If their expectations are not realized and there is no surplus with which to make repayment, it is more reasonable to regard the repayment of the loan as the substitution of one form of financing for another than as the financing of a further deficit. This solution raises the problem as to where to draw the line between loans whose repayment is of this nature and those whose repayment presents a financing problem. The answer would seem to be in terms of the period over which the monetary authorities of the country concerned can be regarded as planning their international financing. When the authorities raise a loan and undertake to repay it in the same “planning period,” the transaction is best regarded not as borrowing which will impose a burden of repayment in the future but as an attempt to arrange liquidities over the entire period. What, then, should be regarded as the length of this “planning period”? The Manual defines short-term loans as those maturing on demand or within 12 months after the obligation was incurred. It would seem reasonable, however, to go beyond that point in this case and to treat medium-term loans of 2 or 3 years in a similar manner. It would be difficult to justify an extension to loans of longer periods but exceptions might be made when the circumstances warrant it.78

The next category included in the description of compensatory official financing is that of long-term official loans extended or received for the purpose of balancing international transactions. A distinction is made between such loans and those intended to finance specific projects. Loans of the latter type are treated as noncompensatory and are classified as special official financing. The reason for this distinction is that project loans are regarded as being similar to the financing of development projects by private interests. They are treated as part of the normal phenomenon of the flow of investment money from capital-abundant to capital-scarce countries. The development of the project rather than the development of balance of payments deficits governs disbursements under the loan. Such loans may even be extended to a country which is experiencing a balance of payments surplus. It cannot be taken for granted, however, that “project” loans are necessarily noncompensatory. Even though the borrowing may be linked to a specific development project, the main concern of the government, when arranging the loan, may have been to fill a gap in the balance of payments. This possibility has become of increasing importance with the emergence of governmental borrowing on a large scale through such institutions as the Export-Import Bank and the International Bank for Reconstruction and Development.79

In discussing the significance of the concept of dollar shortage, R. F. Kahn has adopted a classification of loans somewhat different from that used by the Fund’s staff. He draws a distinction between “distress” borrowing and “acceptable” borrowing. “Distress” borrowing is described as being “onerous and objectionable on account of the capital charges involved, or of a threat to the country’s liquidity, or on political grounds, or because it is precarious.”80 “Acceptable” borrowing is described as borrowing which is “normal in the sense that it can be expected to continue for a considerable time and that it is matched by investment in the borrowing country which, directly or indirectly, provides for interest payments”.81 This distinction is designed to go further than merely indicate whether or not a balance of payments deficit exists. It deals with the problem of whether or not the balance of payments is in long-term equilibrium. This is the reason for the emphasis on the continuing nature of the borrowing and on the extent to which the capital charges involved are onerous. A volume of borrowing which might be quite acceptable for a short period to finance urgently needed development projects might be quite unacceptable for a longer period in view of the mounting capital charges it would involve. It is preferable, therefore, to postpone consideration of this suggestion of Kahn’s until a later chapter when the question of long-term equilibrium will be considered.

The remaining category of compensatory official financing in the outline published by the Fund’s staff comprises official grants whose primary purpose is the balancing of international transactions. Here again the problem arises of distinguishing between compensatory and special official financing. Detailed consideration of the problem is presented in a later section.

Machlup’s Criticism of Compensatory Official Financing

Machlup’s three concepts

In a recent article,82 Fritz Machlup has argued that a good deal of confusion has arisen concerning the meaning of a deficit or a disequilibrium in the balance of payments because three fundamentally different concepts—the market balance, the program balance, and the accounting balance—have been called by the same name. Machlup defines a deficit in the market balance of payments as “an excess of [foreign exchange] effectively demanded at the given exchange rate by would-be purchasers (who are not restricted by specially adopted or discretionary government control measures) over the [foreign exchange] supplied at that exchange rate by would-be sellers (who are not motivated by a desire to support the exchange rate).”83 He defines a deficit in the program balance as “an excess of [foreign exchange] needed or desired for some specified purposes (assumed to be important with reference to some accepted standards) over the [foreign exchange] expected to become available from regular sources”;84 and a deficit in the accounting balance, as “an excess of [foreign exchange] entered on the debit side of certain accounts in the annual record of international transactions over the [foreign exchange] entered on the credit side of the same accounts, the accounts being selected from the full, necessarily balancing statement in order to throw light upon problems connected with market or program balances of payments.” 85

It will be seen that the first two of these concepts are ex ante and the last ex post. As pointed out above, our interest in the ex post concept arises from the light that it throws on the ex ante situation. Machlup’s chief criticism of the concept of compensatory official financing appears to be that there are two distinct ex ante concepts and that compensatory official financing refers sometimes to one and sometimes to the other. As he expresses it, “the balance of payments pressures which compensatory official financing is supposed to relieve are, in one place, taken to refer to the market balance and, in another place, to the program balance of payments.”86

The reason for this criticism is that Machlup attaches a number of unnecessary limitations to his concept of the market balance. In particular, he is prepared to extend his definition to cover the effects of tariffs, quotas, and prohibitions of a protective nature, but he is not willing to extend it to cover the effects of controls introduced for balance of payments purposes. The program balance is introduced to deal with the situation where controls of this nature are employed, but it is further differentiated from the market balance by being defined in terms of “hopes and desires” rather than “effective demand.” This ignores the fact that once a government program is adopted and the necessary steps to implement it have been taken, the demand becomes effective and, consequently, part of the market.

Machlup’s exclusion of exchange and trade controls from his definition of the market balance seems to be due to a desire to measure something more than the actual gap between effective demand and market supply which has to be filled by official financing. He seems to be trying to define the market balance in such a way that the absence of a surplus or deficit will indicate that the balance of payments is in equilibrium.87 No such claim has been made for the concept of compensatory official financing. All that is indicated by the absence of a surplus or deficit, in the sense in which the terms are used by the Fund’s staff, is that, given the actual conditions affecting the exchange market in the period under review, there has been no need for supplementary financing by the monetary authorities on either side of the market.

Extension of market balance to cover discretionary controls

As Machlup has explained, a given demand curve for foreign exchange assumes a large number of “underlying conditions.”88 His refusal to extend his concept of the market balance to include the effect of discretionary controls arises from the fact that he is unwilling to subsume them in the “underlying conditions.” This attitude seems to be due, in part at least, to the unrealistic manner in which he apparently envisages such controls as operating. From his point of view there would appear to be no such thing as a given severity of exchange controls. He appears rather to assume that the actual severity differs from day to day or week to week as the available supply of foreign exchange increases or declines. If this were so, the international reserves of the countries applying discretionary controls could be expected to vary little, if at all. The assumption that will be made here is that these controls can be administered at a certain level of severity over a period long enough to be taken into account as part of the underlying conditions. The fact that the reserves of countries which have applied discretionary controls have shown wide fluctuations would seem to provide justification for this assumption. If this assumption is accepted, there is no reason why the controls which Machlup describes as “discretionary” should not be dealt with in the same way that Machlup suggests for “non-discretionary” measures; that is, by means of two demand curves, one including and the other excluding the effects of the controls. Instead of following Machlup and speaking of a market balance and a program balance, it is then possible to speak of a “realized market balance,” defined to include the effects of discretionary controls, and a “pure market balance,” defined to exclude such effects. No one will deny that the market balance in Machlup’s sense has considerable theoretical importance, but his contention that a market balance in which the demand curve includes the effects of exchange controls is meaningless is far from acceptable. For some problems it is not necessary to know the balance in Machlup’s sense, as for example in the case he cites of the possible effect of depreciation without a change in the controls.89 If the controls are to remain in effect, there is no need to know what the deficit would have been if they had not existed. Even if the intention is to vary the controls, without eliminating them, it is just as convenient to start from the demand curve which includes the effects of the existing controls as from that which excludes them altogether.

The various demand curves involved may be illustrated diagrammatically. In Chart 1 (in which the vertical axis refers to the exchange rate, expressed in terms of the amount of domestic currency exchanged per unit of foreign currency, and the horizontal axis to the amount of foreign exchange), SS′ represents the market supply curve and DD′ the demand curve as it would have been if there had been no exchange controls. The effect of exchange control of a given severity on the demand curve may be either one of two types or a combination of the two. The exchange control may result in a demand curve which is more or less perpendicular over a certain range of exchange rates, and which coincides with DD′ above a certain level. This type is represented by the curve DAB. On the other hand, the effect of exchange control may be to shift the curve to the left throughout its length, as in curve D1D′1. A combination of the two types is illustrated by the curve D1CB.

Chart 1.
Chart 1.

Effect of Exchange Control on Demand Curve for Foreign Exchange

Citation: IMF Staff Papers 1951, 002; 10.5089/9781451971460.024.A004

As the exchange control becomes more severe, the line AB or the curve D1D′1, or both, move to the left. As the control becomes less severe, they move to the right.

Assume that the problem under consideration is the effect of a change in the exchange rate from OE to OJ without a change in the severity of the exchange control. If the effect of the exchange control on the demand curve is of the first type discussed above, the depreciation would result in the reduction of the deficit from FG to KM, whereas if it were of the second type the deficit would be reduced from FH to KL. If the exchange control were of a composite type, the deficit would be reduced from FG to KL. The effect of the depreciation on the deficit as defined by Machlup, from FI to KN, while of interest from the point of view of the effect of the elimination of exchange control, may be of only minor concern from the point of view of the immediate problem. To be sure, these deficits are of more relevance than the others in connection with the question of long-period equilibrium in the balance of payments. Even if they could be measured, however, other factors would have to be taken into consideration before it could be stated whether or not a position of equilibrium existed.90

Machlup’s rejection of the accounting balance

A second criticism of Machlup’s is that the light thrown by the accounting balance “is more often deceptive then helpful, particularly in the analysis of the market balance of payments.”91 It is true, of course, that a great number of qualifications must be borne in mind when an accounting balance is being used in this way. The “underlying conditions” must be carefully examined, and allowance must be made for the effect of changes in any of them during the period under review. As shown above, Machlup has listed a number of these conditions, and our extension of the concept of the market to cover the effects of discretionary controls adds further to this list. An additional condition that should be mentioned is the state of expectations. When, for example, a change in the exchange rate is anticipated, the conditions are different from those that prevail when the expectation is that the rate will be maintained. As long as the changes that may have occurred in the underlying conditions during the period have not been pronounced, a reasonably satisfactory allowance for their effects should be possible when the surplus or deficit for the whole period is being interpreted. When the changes have been pronounced, however, it is desirable to subdivide the period and to measure the surpluses or deficits before and after the changes occurred.92

Machlup’s main reason for rejecting the accounting balance as an indication of the market balance of payments is that “even the most careful selection of items in an accounting statement cannot indicate whether the particular transactions were ‘autonomous’ or ‘induced,’ which is the significant thing in market analysis.” He elaborates this argument as follows:

In an analysis of the foreign-exchange market it is essential to distinguish, for example, between imports which give rise to additional demand for foreign exchange, and imports which are induced by additional supply of foreign exchange. The accounting balance of payments, regardless of the way the accounts are selected, cannot say anything about such problems. AH imports are considered as representing a demand for foreign exchange.93

This argument is not so serious as it might seem. In the first place, our concern is only in measuring the surplus or deficit and not in obtaining separate totals of market demand and market supply. As long as the supply which gives rise to induced demand (and the demand that gives rise to induced supply) is not motivated by a desire to support the exchange rate, no problem arises. The totals of both market supply and market demand would have to be reduced by the same amount to obtain independent aggregates, but the balance would be unchanged. The real difficulty arises when government actions taken in the light of the over-all balance of payments position influence market supply and demand in a manner that is not offsetting.

The various possibilities of this kind can be divided broadly into two classes—those which may be regarded as involving a change in the underlying conditions and those which may be regarded as instances of direct interdependence of supply and demand. These two classes overlap to some extent, but most cases fall without much difficulty into one class or the other.

Machlup has referred to a number of cases that would fall into the first group. These involve action by the government to change the exchange rate, to adjust domestic income levels by means of fiscal and monetary policies, to adjust tariffs, subsidies and prohibitions, and to introduce discriminatory controls.94 These actions clearly involve changes in the underlying conditions. In accordance with the suggestion made above, it is desirable that the period be subdivided when changes occur, if the changes are sufficiently pronounced. For example, if an increased supply of foreign exchange leads to a pronounced relaxation of exchange controls, a marked expansion of credit, or a significant appreciation in the exchange rate, it is desirable that the surplus or deficit be measured both before and after the change. Given the new supply and the new conditions, the new demand is “autonomous,” not “induced.”

The second group comprises cases where official financing is related directly to a particular item or items of market demand or supply. Under these circumstances, a theoretically perfect solution to the problem is not possible. The best compromise seems to be to take account of the interdependence of supply and demand only when the relationship is so direct that it would be clearly misleading to regard the financing as evidence of strength or weakness in the balance of payments.

Interdependence as an ex ante phenomenon

In elaborating his reasons for rejecting the accounting balance as an indication of the market balance, Machlup implies that the difficulty of distinguishing between autonomous and induced items arises solely from the fact that the transactions in the accounting balance are recorded ex post instead of ex ante.

The difficulty is, however, more deep-rooted and is due to the interdependence of the supply and demand in the foreign exchange market which arises from the fact that government actions affecting the balance of payments are normally taken in the light of the over-all balance of payments situation. The following hypothetical example shows that the difficulty applies to ex ante magnitudes as well as to ex post. Assume that the government has planned an investment project which requires imports, and that it anticipates a deficit in its balance of payments next year. If it continues with the project in spite of the anticipated deficit, the financing provided by the monetary authorities on the foreign exchange market is, to some degree, financing required so that the investment project may be undertaken, and is not just passive financing to keep the exchange rate constant. In this example, supply and demand have been deliberately defined as ex ante (expected) magnitudes, in order to illustrate the point that interdependence of supply and demand is not only an ex post phenomenon.95

This discussion suggests that, while the accounting balance may be seriously inadequate for some purposes, it does, when properly interpreted, throw considerable light on the market balance of payments. In the typical case today, when the country’s exchange rate has been stable and the other underlying conditions have been reasonably constant, the surplus or deficit may be taken as a reasonable indication of the gap between market demand and market supply under those conditions. Where the exchange rate has changed during the period or the other underlying conditions have changed substantially, the device of subdividing the period may be adopted. The difficulty caused by the interdependence of demand and supply remains, but, as pointed out above, the difficulty is not peculiar to the accounting balance. Moreover, by a careful ad hoc evaluation of the motives of the parties, a reasonable decision can usually be made. Finally, it should be emphasized that the accounting balance, despite its defects, is the only available objective measure and that, if it is rejected, resort must be had entirely to mere qualitative statements.

Machlup’s criticisms of judgment

Machlup’s final criticism of the concept of compensatory official financing is that the Fund’s staff has shown poor judgment in its classification of certain transactions, principally loans and grants. In discussing market supply he makes a bald statement that “there is no reason why the market supply should not also include the foreign exchange derived from official (governmental or institutional) loans for relief, rehabilitation, reconstruction and development.”96 There seem, however, to be a number of reasons why this should not be done. The motives on which loans of this kind are based are usually quite different from those influencing private capital movements. The government of the lending country is usually influenced by much broader considerations than the private lender. Also the degree of interdependence between the supply and the associated demand is generally much greater than for private loans. A strong case can therefore be made for keeping all such loans outside of the market supply.

The loans which Machlup has grouped together in a single category seem to fall into two distinct classes. Borrowing by countries suffering from the effects of a national calamity, such as a disastrous crop failure or devastation and disruption caused by war, differs considerably from borrowing by underdeveloped countries to finance specific development projects. Emergencies of the former kind generally, but not necessarily always, involve pressure on the balance of payments. Even though the catastrophe may also involve a decline in the level of incomes, demand—generally in domestic currency—is actually greater than can be met from the current market supply of foreign exchange. To the extent that there are such pressures, the monetary authorities are faced with the immediate responsibility of meeting them out of their reserves or taking other action to cope with the situation. Because of the possibility of such emergencies arising, countries normally hold international reserves. Borrowing is undertaken only when reserves are inadequate to cope with the deficit. Under such circumstances, borrowing may reasonably be regarded just as compensatory as the use of reserves. The monetary authorities of the underdeveloped countries, on the other hand, are not usually under such immediate pressure. In the typical case, no domestic capital is available to finance the project and, even apart from the foreign exchange aspect, the project would not have been undertaken if external finance had not been available. Supply and demand then are directly interdependent and it seems desirable to set them off against each other.

Anglo-American loan

The Anglo-American loan may be taken as an example of a loan for the purpose of relief and rehabilitation which the Fund has classified as compensatory but which Machlup would apparently regard as part of market supply and therefore as noncompensatory. It is quite true that the loan can be treated as a genuine investment from both the British and the American point of view. The British were short of real resources and would have been willing to borrow to make up for this deficiency, even if there had been no monetary pressure on the balance of payments. The Americans were interested, in Keynes’ words, in “the future benefits which were expected as a result of financial aid to Britain.” To them the loan was an investment with the objective of “a strong Britain endowed with renewed strength.”97 From this point of view, there is a case for regarding the loan as similar to project loans to underdeveloped countries. It might be argued that, although the project is of a much broader nature than a particular steel mill or hydroelectric plant, it is nevertheless an investment which may be expected to yield a return for both parties.

To take this view would seem to be missing the point of the distinction between project loans and compensatory financing. As pointed out in the 1938-47 Yearbook, for project loans “the development of the project, rather than the development of balance of payments deficits, governs disbursements under the loan. A project loan may in fact be extended to a country that is enjoying a balance of payments surplus.”98 The Anglo-American loan, however, was to be drawn upon only as necessary to meet the current balance of payments situation. The loan was drawn upon much more quickly than had been anticipated, not because the project was completed more quickly but because the balance of payments deficits were larger than expected. The heavy drawings during the brief period of convertibility were clear evidence of weakness in the British balance of payments. Under these circumstances, classification of the loan as compensatory, rather than noncompensatory, seems more realistic.

Classification of ERP and UNRRA aid

Machlup also appears to have oversimplified the problem of ERP aid. He argues that ERP aid should not be classified as compensatory because it was “not the pressures in the foreign exchange markets but the potentials for improvement in the productive use of domestic resources” which were “fundamental guides in the allocation of loans and grants under the ERP program.”99 It is quite true that the “project” element has always been important in the ERP program. It is also true that the supply and demand associated with the program are highly interdependent. In the absence of the program, the policies of the government would have had to be different. Under these circumstances, two alternative courses are available. In the first place, the aid can be classified as compensatory and the government policies actually followed (the level of controls, fiscal-credit policy, investment program, etc.) can be regarded as part of the underlying conditions. In interpreting the figures shown on this basis, it is necessary to bear in mind that these policies would have been different if the aid had not been received. The alternative is to regard the supply and demand associated with the program as being completely interdependent and to classify the aid as noncompensatory. The demand schedule would then have to be envisaged as referring not to the total demand but to the demand other than that related to the ERP program. The underlying conditions would have to be envisaged not as the policies actually followed but as the policies which, in the absence of ERP aid, would have led to a demand for foreign exchange less than the existing demand by the amount of the aid. The effect of these alternatives may be illustrated by considering Europe’s balance of payments in 1949. Table 2, which summarizes a statement given in the 1948-49 Yearbook, shows the effect of the first alternative. This statement should be interpreted as indicating that, within the framework of the government policies and controls in force during 1949, Europe’s transactions with the rest of the world resulted in a deficit of $4.1 billion, financed primarily by ERP aid. Obviously, if there had been no ERP aid, government policies would have had to be different and the deficit would have been smaller.

Table 2.

Europe’s Balance of Payments in 1949

alternative i: erp aid classified as compensatory financing 1

(In billions of U.S. dollars)

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Adapted from Table 1 in Balance of Payments Yearbook 1948-49 (International Monetary Fund, 1950), p. 34.

If the currency approach recommended in the following section were adopted here, the dollar deficit would appear as $5.0 billion and there would be a surplus in other currencies of $0.9 billion.

The second alternative presents an entirely different picture. If ERP aid were to be classified as noncompensatory, it would be reasonable to class other grants to European countries, such as civilian supplies for Germany, in the same category. Europe’s balance of payments in 1949 would then appear as shown in Table 3. This statement should be interpreted as indicating that, given the existing amount of ERP aid and the accompanying demand for foreign exchange, the rest of Europe’s balance of payments showed a surplus of $0.7 billion. This figure would be relevant to a consideration of the balance of payments problem that would confront Europe in the event of a curtailment of ERP aid only if the assumption could be made that the reduction in aid would be offset for the most part by appropriate changes in government policies so that the rest of the balance of payments would remain comparatively unaffected. This is most likely to be the case if the aid should take the form of finance for long-range projects which would not be undertaken in the absence of ERP. On the other hand, it would be quite irrelevant if the aid should take the form of goods for which the demand would continue even if ERP aid were curtailed. In the latter case, the aid received would have to be added to the residual demand in estimating Europe’s balance. This is the result that is shown when ERP aid is classified as compensatory. Obviously, the true situation lies somewhere between these extremes. To some extent, the aid is of a project nature and it may be assumed that a reduction in aid would be offset by appropriate changes in government policies without involving a substantial change in the underlying conditions in the rest of the economy. On the other hand, a substantial proportion, at least for some countries, takes the form of goods for which the demand would continue even if ERP aid were curtailed. As long as the assumed underlying conditions are described fully, no error is involved in classifying ERP aid either way. The choice must depend on which set of assumptions is regarded as the more realistic.

Table 3.

Europe’s Balance of Payments in 1949

alternative ii: erp aid classified as “project” financing

(In billions of U.S. dollars)

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If the currency approach recommended in the following section were adopted here, there would be a dollar deficit of $0.2 billion and a surplus in other currencies of $0.9 billion.

Machlup’s criticism would have been justified if he had merely claimed that the classification of ERP aid as compensatory tends to overstate the deficit that would in fact be realized if the aid were curtailed. However, to imply as he does that the whole program was noncompensatory is surely most unrealistic. The importance of balance of payments considerations is well illustrated by the decision to discontinue aid to the United Kingdom because of the spectacular recovery in British gold and dollar reserves. It is probably true in this case that effective demand has continued for the great bulk of the goods that were received under the program. It would seem, therefore, that for the United Kingdom at any rate, and probably also for most of the OEEC countries, it is more realistic to classify ERP aid as compensatory than as noncompensatory. The Fund’s staff is subject to criticism only for not stating explicitly the assumptions on which the classification was based.

Machlup’s criticism of the Fund’s treatment of UNRRA grants is perhaps more justified. The claim that “UNRRA was all compensatory financing for the recipient countries”100 is undoubtedly too sweeping. The reason given for this statement is that “it was directed to needy countries that could not make international payment for it out of their own resources.” Machlup is right in rejecting this argument. If compensatory official financing is to indicate whether or not there was pressure on the balance of payments, it is necessary to establish not only that need existed in the recipient country but also that it is not unrealistic to assume that there would have been local currency demand for the goods if the aid had not been received. A decision on this point would need to be based on an examination of the market conditions in the countries concerned. If it were found that the program played a significant part in relieving balance of payments pressures in a particular country, the Fund’s procedure would appear to have been justified. If, on the other hand, it were found that the program merely made possible the import of goods for which there would have been no local currency demand in the absence of the program, it would probably have been more realistic to have treated the program as “project” financing. Whatever the decision, it is essential that a clear statement be given of the underlying conditions that are implied in the classification adopted.

Reconsideration of Compensatory Official Financing

In the following discussion, the assumption will be made that the purpose of the concept of compensatory official financing is to cast light on the strength of a country’s exchange position within the framework of certain “given” conditions (including controls and other government policies). The problem of “induced” demand and supply will be met as far as possible by regarding such changes in the supply and demand schedules as being due to changes in the underlying conditions rather than to direct interdependence of a particular item of supply and a particular item of demand. When, for example, controls are relaxed in response to increased supply, this change will be regarded as a change in the underlying conditions. Under these new conditions, supply and demand may be regarded as independent. Similarly, if the initiation of ERP aid leads to the adoption of a fiscal-credit policy that differs from that which was previously followed, a change in the underlying conditions has occurred.

The problem of “induced” demand will be regarded as one of interdependence only when the relationship is so direct that the underlying conditions can be regarded as being unchanged. Even with this limitation, it will be necessary to take account of interdependence in some cases where it has been ignored by the Fund.

Fund’s recognition of interdependence

In at least one case, the Fund has taken account of the interdependence of supply and demand and classified an item that would otherwise have been compensatory as special official financing. This is the series of extraordinary transactions between the United Kingdom and the dominions of India and Pakistan following the granting of independence to those countries. These transactions, involving the purchase by India and Pakistan of annuities to cover their liabilities for pensions to former employees of the Indian Civil Service and the purchase by India of defense stores and installations taken over from the British, were financed by a reduction in blocked sterling balances that would not have been available for other purposes for many years. In these circumstances it would have been extremely misleading to treat the reduction in these sterling balances as evidence of balance of payments pressure. The two sides of these transactions were, therefore, set off against each other and shown in a separate group, thus cancelling each other out without effect on the deficit or on compensatory official financing.101

Fund’s failure to recognize interdependence

In other similar cases of direct interdependence, however, this precedent was not followed. One of these is the case of gold subscriptions to the Fund. A reasonable assumption is that the monetary authorities of the different countries, when deciding whether or not to join the Fund, weighed the fact that part of the subscription was payable in gold against the fact that the payment of the gold subscription carried with it the right to use the Fund’s resources should the need arise. This right is not automatic, it is true, but there is a reasonable presumption that a country joining the Fund will abide by the provisions of the Agreement and that it will therefore have this right when the current balance of payments situation requires the provision of compensatory financing. Under these circumstances, it is rather misleading to suggest that the payment of the subscription has imposed pressure on the country’s balance of payments. It would be more reasonable to treat the transaction as being similar to a switch in the form of the country’s reserves. An objection that may be raised to this suggestion is that there is no direct connection between the rights acquired in this way and the amount of the gold subscription. Under certain circumstances, a country may use the Fund’s resources to an extent far beyond its gold subscription. In this connection, reference has already been made to Keynes’ description of the Fund as being, in effect, a great addition to the world’s stock of monetary reserves. It is true that a transaction which improves a country’s reserve position is not the same as a switch in its reserves, but it is unquestionably preferable to treat it as such rather than to treat it as involving a worsening in the reserve position.

Another instance in which the precedent of the extraordinary transactions with India and Pakistan might have been followed is that of gifts by Australia and New Zealand to the United Kingdom in 1947. These gifts took the form of partial cancellation of accumulated war balances and represented voluntary contributions toward the settlement of a long-term postwar problem of the United Kingdom. The Fund’s staff rightly decided to classify the gifts as special rather than compensatory financing since they were not related to the balance of payments situation in the year in which they were made. The corresponding movements in sterling balances, however, were allowed to remain in the compensatory category.102 This implies that the reduction in sterling balances as a consequence of these gifts was evidence of pressure on the balance of payments. This seems to be a misleading implication. It would have been more realistic to have cancelled the gifts against the corresponding movement in sterling balances.

Degree of interdependence versus “project” concept

For official loans, the degree of direct interdependence would seem to be a better basis for the distinction between special and compensatory financing than whether the loan is for a specific project. Although the question of interdependence is not referred to in the discussion in the 1938-47 Yearbook, it seems to be partly responsible for the attitude taken by the Fund’s staff toward project loans. The reference to the fact that “the funds are made available as equipment for the project is purchased or delivered” may be regarded as a recognition of the interdependence of the loan and the demand for the equipment on which it is spent. To a large extent, the belief that the demand would not have existed if it had not been for the supply is responsible for the feeling that it would be misleading to regard the supply as compensatory. In the case described above as typical, i.e., when there is no domestic capital available for the purpose and the project would not have been undertaken if external finance had not been obtained, supply and demand are completely interdependent. There are numerous cases, however, when these conditions are not fulfilled, and the arguments for treating the loan as noncompensatory are far less convincing. When, for example, the government is merely acting as an intermediary in importing capital equipment under a project loan and the purchasers are required to make immediate cash payment, there is clear evidence that the demand would have existed even if the loan had not been received. This may be taken as an indication that the loan is compensatory. On the other hand, if the government resells the equipment on terms similar to those on which it borrows, or if it merely guarantees an obligation on the part of the private purchaser, there is a presumption that the loan is noncompensatory, provided that the terms are at least as favorable as those which could have been obtained on the local investment market. If the government requires the equipment itself, another test must be found since the government can always obtain the financing domestically, by credit expansion, if it is not available otherwise. The matter can be decided only on the basis of priorities. If in the government’s import program the project in question has a higher priority than other imports which are being admitted, the loan may be assumed to be compensatory. On the other hand, if the project is known to be marginal and contingent on the availability of external finance, the loan should be classified as noncompensatory.

Symmetry versus asymmetry

Another aspect of the Fund’s classification of loans which requires re-examination in the light of the above discussion is the treatment of a loan raised for compensatory purposes by the government of one country in the private market of another country. The case described in the 1938-47 Yearbook was that of a loan obtained by the Netherlands Government in 1946 from commercial banks in the United States. The solution adopted was to enter the transaction as compensatory official financing in the Dutch balance of payments but as a private capital movement in the U.S. balance of payments.103 This is a case, however, in which it is misleading to ignore the interdependence of supply and demand. If it could be assumed that the U.S. private capital market would have lent this amount abroad even if it had not been required by the Dutch Government, it would be quite reasonable to treat it as part of U.S. market demand for foreign exchange. Under the circumstances, however, it is probably correct to say that this amount would not have been lent at all if it had not been required to finance a Dutch deficit. The transaction is, therefore, similar to the equilibrating short-term capital movements of the classical theory, which, it has been argued above, are equivalent to compensatory official financing. In the same way, it may be argued that the fact that the private capital movement occurred in response to a deficit in the Dutch balance of payments is evidence of strength in the U.S. balance of payments. If the only two countries in the world were the Netherlands and the United States, this argument would be difficult to refute. But in the actual world, it is possible to reply that the transaction is evidence of strength in the balance of payments of the rest of the world (including the United States) with the Netherlands, but not necessarily of strength in the U.S. balance of payments. In the case at issue, however, the fact remains that the Dutch deficit was with the dollar area, particularly the United States. In these circumstances, the grounds for treating the transaction as compensatory in the U.S. balance of payments are quite strong.

The same principle of the degree of interdependence should be adopted in classifying official grants. If it is believed that, given the general policies of the government actually in force, the demand for the goods received would continue if the aid were discontinued, the aid should be classified as compensatory. If, on the other hand, the demand for the goods received can be regarded as directly dependent on the receipt of the grant and if it can be assumed that the discontinuance of the aid would leave the demand in the rest of the balance of payments unchanged, the aid should be classified as noncompensatory. In intermediate cases it is generally impractical to attempt a subdivision and the only practical course is to classify the entire program in the way that seems most reasonable for the bulk of it. At any rate, the underlying conditions implied in the classification adopted should be stated clearly.

At the beginning of this section, a brief reference was made to the question of equilibrium in the balance of payments. While the subsequent discussion has been highly relevant to this question, it has been concerned solely with short-run considerations. No judgment is possible as to whether or not the balance of payments of a particular country is in equilibrium until attention has been paid to the long-run elements in the situation. Before attention is given to this question, however, it is necessary to consider certain problems of regional classification since these are also relevant to the issue.

V. Problems of Regional Classification

One of the new features incorporated in the revised version of the Fund’s Balance of Payments Manual was an appendix on the methodological problems involved in a regional classification of the balance of payments with detailed instructions for the preparation of such a classification. Before adopting a classification of this kind, it is necessary to decide whether to base it on a geographic or a currency criterion. Each of these possibilities is subject to a number of different interpretations,104 but for the purpose at this stage of the discussion, the question may be posed as a simple choice between two broad alternatives.

Geographic versus Currency Classification

Social accounting aspect

In the section dealing with the relationship of the balance of payments to social accounting, considerable emphasis has been placed on defining the category of goods and services on a strictly territorial basis. The suggestion was made that exports of goods and services should be confined to goods sold and services rendered to foreigners out of the gross national turnover of the country concerned, and that imports should be confined to goods sold and services rendered to the country’s residents out of the gross national turnover of foreign countries. The logical extension of this principle is to subdivide exports and imports on a similar territorial basis. Exports would then be allocated to the countries or regions into whose gross national turnover they went, and imports to the countries or regions from whose gross national turnover they came.

A classification of this kind would facilitate the study of the relationship between the economy of the country concerned and the economies of the various foreign countries or areas with which it exchanges goods and services. If a uniform classification were used by a large group of countries with multilateral trading relations, a matrix of transactions in goods and services could be constructed, and when groups of countries form important economic units their balance of payments statements could be consolidated. In this way the balance of payments, when classified on a geographic basis, becomes the connecting link between the social accounting systems of the various countries.

Financing aspect

When attention is focused on financing problems rather than on social accounting relationships, the currency classification assumes greater significance. Under present conditions of inconvertible currencies and of exchange arrangements which discriminate between “hard” and “soft” currencies, it is necessary to know the strength or weakness of a country’s balance of payments in relation to each of the currencies in which its transactions are financed. Even under conditions of complete inter-convertibility of currencies, a currency classification would contribute to an understanding of the network of international payments.

In view of the advantages of each type of classification, it might appear at first sight that the geographic classification is to be preferred when attention is being focused on social accounting relationships and that the currency classification is preferable for the study of financing problems. The fact is, however, that the two types of study cannot be separated in that way. For example, when a country’s financing problems in respect of particular currencies are being studied, it is necessary to have not only a currency classification of its balance of payments but also a geographic classification to throw light on the underlying economic relations with particular countries or areas which have contributed to the development of the financing problems. A pure geographic classification would be unsatisfactory for analyzing financing problems unless all transactions were carried out in the currency of either of the partner countries concerned. A pure currency classification would likewise be unsatisfactory for determining the underlying causes of a surplus or deficit in a particular currency unless that currency was used for all transactions with a particular country or group of countries and not for any transactions with other countries. Even when the latter condition is fulfilled, a currency classification becomes of progressively less value, the larger the area with which a particular currency is used. The ideal solution would be a balance of payments cross-classified by both countries and currencies, but such a classification would be too complicated to be statistically feasible on a uniform basis.

The gap between the pure geographic and the pure currency classifications can be bridged, to a large extent, by introducing an item for multilateral settlements, that is settlements of transactions between two countries in the currency of a third. For a geographic classification, the multilateral settlement item would show the necessary adjustment to convert the regional totals to a currency basis. For a currency classification, the multilateral settlement item would show the necessary adjustment to convert the currency figures to a geographic basis.

The Fund’s regional schedule

Faced with the necessity of choosing between a standard form based primarily on a geographic classification and one based primarily on a currency classification, the Fund’s staff chose a classification of the former type for a number of reasons. Trade statistics and certain other basic data are classified by countries rather than by currencies, except when they are based on exchange control records, in which case they could be tabulated on either basis. Even when trade statistics are available on a currency basis, they are less useful for the purpose of analysis and for the determination of economic policy than figures on a geographic basis. The foregoing discussion of the social accounting and financing aspects of the balance of payments suggests that it would be more logical to classify transactions in goods and services and other noncompensatory transactions on a geographic basis, and to use the multilateral settlements item to bring the regional totals to a currency basis, than to classify the noncompensatory items on a currency basis and convert the totals to a geographic basis. A currency classification, moreover, is of little value for the analysis of the balance of payments of countries settling virtually all international transactions in their own currency or in a single foreign currency, such as U.S. dollars. Moreover, at a time when payments agreements and similar arrangements are the subject of almost continuous negotiation, the currency pattern is probably subject to greater variation than the geographic pattern.

The Manual’s uniform geographic classification

In adopting a uniform geographic classification as a basis for subdivision, the Fund’s staff, nevertheless, paid particular attention to the existing payment pattern. In one case, that of the sterling area, a currency grouping has been adopted directly as one of the regional subdivisions. Although the sterling area cuts right across the normal geographic groupings, there can be little objection to this decision. It has been estimated that almost 40 per cent of the world’s merchandise trade is conducted in terms of sterling, and that the percentage is even higher for service transactions.105 The bulk of these transactions take place either within the sterling area or between sterling area countries and other countries with which the United Kingdom has payments agreements on behalf of the sterling area. The fact that the sterling area has a legally precise form and is not subject to varying interpretations also facilitates its use in a uniform classification.106 In this respect, the sterling area may be contrasted with the “dollar area” which varies from country to country and from time to time, depending on the payments arrangements in force at the time. For this reason the Fund’s staff contented itself with taking the United States (including its dependencies), Canada, and Latin America as separate groups, instead of trying to define a “dollar area” which would be a reasonable approximation to the actual area with which different countries conduct their transactions in dollars. While this grouping does not permit a precise separation of the dollar area for any country, it gives a satisfactory picture of the dollar problem for all countries.

No further allowance is made in the Manual’s classification for currency relationships; the remaining categories are of a purely geographic character. In some respects this is unfortunate. The dependencies of the European countries are shown in the appropriate geographic subdivisions in spite of the fact that they form part of the currency areas of their mother countries. In the case of the OEEC countries, separate figures are obtainable for the metropolitan areas but not for the dependent overseas territories which also participate in the ERP program. Again, for Latin America it can be argued that the Latin American Republics comprise a more homogeneous region, from an economic point of view, than does the geographic region which includes the Western Hemisphere dependencies of France and the Netherlands. In view of the fact that a number of the Latin American Republics themselves have payments agreements with various countries, even this group is far from being a homogeneous unit from a currency point of view. Furthermore, individual “hard” currency countries scattered elsewhere in the world are included in regional groups in which “soft” currency countries predominate. In spite of these deficiencies, however, the Fund’s classification is probably the most satisfactory possible without a considerable expansion in the number of subdivisions.

The Social Accounting Aspect

Origin-destination versus purchase-sale

In classifying transactions geographically, the general principle followed in the Manual is that they should be allocated in accordance with the residence of the foreign participant, i.e., the transferor or transferee. For merchandise, this involves the classification of transactions on a purchase-sale basis rather than on the basis of origin and destination. It is recognized, however, that the origin-destination basis is more significant from the point of view of “real” flows, and therefore provision is made for recording merchandise transactions on an origin-destination basis and then converting them to a purchase-sale basis by means of a “purchase-sale adjustment.” For service transactions, it is implicitly assumed that the two bases coincide. This may be inferred from the explicit assumption that when goods are sold on a c.i.f. basis the exporter acts merely as an agent for the importer in arranging transportation and insurance on the goods. These assumptions do not fit the facts very well, especially when goods are exported on consignment. When the Manual’s procedure is adopted and goods sold on a c.i.f. basis are carried in another country’s ship, an adjustment must be made for a fictitious “multilateral settlement” unless the two transactions (the c.i.f. payment and the payment for freight) are carried out in the same currency.

Entrepôt trade

One of the reasons given in the Manual for entering entrepôt trade on a gross basis is that this is necessary to permit the classification of the transactions by countries. While it is true that gross data on a purchase-sale basis are necessary to make a regional classification balance, this does not prevent the adoption of an alternative classification of the merchandise items in which entrepôt trade is shown on a net basis. In fact, if a genuine origin-destination classification is to be given for merchandise transactions, entrepôt trade must be entered on a net basis. The problem may be illustrated by a simple example. Suppose a resident of country A purchases goods from country B for 100, pays freight of 10 to a resident of country C and sells the goods in country D for 120. Let us assume that A’s currency is used for the first two transactions and D’s for the last. The way in which the transactions would be entered in the balance of payments of each of the countries in accordance with the instructions in the Manual is shown in Table 4. It will be seen that the origin-destination classification of the transactions in A’s balance of payments is necessarily inconsistent with that in the statements for the other countries. Country A shows an import originating in country B and an export destined for country D, but there are no corresponding entries in the statements of these countries. The necessity for introducing a fictitious multilateral settlement is also apparent.

Table 4.

Classification of Entrepôt Trade on a Gross Basis

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In accordance with the Balance of Payments Manual (International Monetary Fund, 2nd ed., January 1950) these transactions would be classified under “general trade” if the goods were brought to country A before being taken to country D. If they were taken directly to D, the transactions would be shown under “merchandise transactions abroad.”

The difficulty can readily be overcome by converting all the entries for goods and services to a gross purchase-sale basis by means of the purchase-sale adjustment. In A’s balance of payments the merchanting profit would be allocated to D, since it may reasonably be regarded as a service to the ultimate consumer. The purchase-sale adjustment would then indicate the payments to B and C and the amount to be added to obtain the gross receipts from D. Country B’s statement would remain unchanged, and C’s would simply show a purchase-sale adjustment in place of the fictitious multilateral settlement. Country D would show the f.o.b. value of the goods as a transaction with B, and the merchanting profit as a transaction with A.107 The entries would then appear as shown in Table 5. This method makes possible symmetrical treatment in each country and gives a more realistic picture of the actual flows of goods and services between the different economies. In spite of the net entry for entrepôt trade, the purchase-sale adjustment converts the totals for goods and services to a gross basis. The fictitious multilateral settlement is also eliminated.

Table 5.

Classification of Entrepôt Trade on a Net Basis

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The perfect symmetry of the above picture holds only as long as the goods are bought and sold in the same period. As pointed out above (section III), difficulties arise when there is a change in merchanting stocks. These changes should logically be regarded as changes in foreign investment. This would give rise to a lack of symmetry since there would be no other country which would regard the stocks as its liability. There would be no asymmetry if the entrepôt country treated the changes in stocks as domestic investment and if the exporting country showed the entrepôt country, rather than the ultimate consumer, as the destination of the goods. It is most unlikely, however, that the asymmetry could in fact be avoided in this way. In any event, the asymmetry should be confined to the cases of movement in entrepôt stocks.

Limit to origin-destination classification

If this procedure is adopted, the question then remains of how far to go in allocating imports and exports on an origin-destination basis. If attention were being paid solely to the social accounting aspect, it might be argued that the goal should be to allocate all purchases of goods and services to the country in which the production (or negative consumption or disinvestment) actually occurred and all sales to the country by whose residents the goods are ultimately consumed or invested. This would involve eliminating from exports the value of imported materials incorporated in them, and from imports that portion which is to be incorporated in exports. Exports not wholly consumed (or invested) in the country of destination would have to be allocated to the various countries in which their consumption (or investment) ultimately occurs; and imports not wholly produced in the country of origin would have to be allocated to the various countries which have contributed to their production. While theoretically conceivable, this solution would involve insuperable statistical difficulties. Moreover, it is unrealistic since it would involve the elimination of an essential part of the pattern of the movement of goods and services.

A more realistic procedure would be to include in the gross national turnover all imports that play a significant role in the country’s economy even though they may ultimately be consumed (or invested) elsewhere. Only when the transformation of imported merchandise is relatively minor would it be reasonable to exclude it from the gross national turnover and confine the entry in the goods and services account to the net value added. For example, if Ceylon tea were imported into the United Kingdom in bulk and then packaged and re-exported, the entry under goods and services in the British balance of payments could be confined to the value added in packaging together with the profit on the transaction. In practice even this solution might involve statistical difficulties. Even though the value added may be minor, the process may involve the combination of goods from different sources. The British merchant may import tea from China and India as well as from Ceylon and blend it before re-exporting it. Similarly, when unrefined metals are imported from a number of different countries and re-exported after refinement, it would probably be impossible to say from which country a particular re-export shipment came. There is little prospect, therefore, of going beyond the point where the goods are re-exported in substantially the same form as that in which they are imported.

From the foregoing discussion, a series of rules for the classification of goods and services transactions may be suggested. As long as attention is focused on “real” flows, the allocation of these transactions on an origin-destination basis is desirable. But when attention is focused on money flows, the purchase-sale basis becomes more relevant. This situation may be met by recording the individual items according to origin and destination and by converting the regional totals for goods and services to a purchase-sale basis by means of the purchase-sale adjustment described above. In following this rule, “origin” should be interpreted as the country from whose gross national turnover the item has come, and “destination” as the country into whose gross national turnover the item has gone. The imports included in the gross national turnover should refer only to those entering the domestic economy and should exclude goods re-exported in substantially the same form as that in which they are imported.

Factor income

For the most part, no difficult questions of principle are involved in classifying investment income and other factor income on a regional basis. Income receivable should be allocated to the country in which the income is earned, and income payable to the country to whose residents the income accrues. When one of the parties to the transaction does not fit these categories, he may be regarded as the agent of a principal in the country concerned.

The only instance in which a problem is involved is when a branch or subsidiary itself has branches or subsidiaries, or holds investments in other branches or subsidiaries of the foreign parent, or when the parent company itself is controlled by residents of another country. The question then arises whether the earnings of a subsidiary should be allocated to the country of which the subsidiary is a resident or to the country of the ultimate parent. The Manual’s answer to this question is that it depends on whether the office in the intermediate country has significant functions in its own right.108 If this condition is fulfilled, the Manual provides that allocation should be made to the country to which payment is made or from which payment is received. If not, the office may be regarded as an agency and the transaction may be attributed to the principal for which it is acting. While this rule is satisfactory for the majority of cases, it is not always so. If, for instance, the profits of one subsidiary are reinvested in another subsidiary which operates independently, the first subsidiary may have significant functions in its own right but it may not play a significant part in the particular transaction under review. It should then be treated as an agent for the purpose of that transaction.

The Financing Aspect

As pointed out above, social accounting is at present concerned primarily with transactions in goods and services. Interest in capital movements and donations is therefore confined mainly to the financing aspect. For this reason, long-term capital movements and donations are allocated in the Manual on a transferor-transferee basis. Thus the transfer of a U.S. long-term security from a British resident to a Canadian resident is classified in the British balance of payments as a transaction with Canada, not with the United States. If the capital account had been approached from the point of view of the effect of capital transactions on the country’s geographic creditor-debtor position, the transaction would have been allocated to the United States column.109

Short-term capital movements have been treated differently partly on account of statistical necessity but also because they are a clue to the currency problem. In this case, transactions are recorded on a creditor-debtor basis, all transactions in U.S. dollars, for example, being allocated to the U.S. column. The extent to which this classification differs from that on a transferor-transferee basis is then indicated in the multilateral settlement item. It should be pointed out that, when multilateral settlements are defined in this way, they cover only the transfer of existing assets or liabilities to a third party and not transactions in which one of the parties incurs a liability in the currency of a third country. In the latter case, no multilateral settlement occurs until the liability is discharged in that currency. While it might be argued that the negotiation of a credit expressed in terms of U.S. dollars is evidence of a dollar problem even though the other party may not be a resident of the United States, there is a strong case for regarding such a transaction as involving pressure in the market for U.S. dollars only when payment is actually made in that currency. If the second view is taken, multilateral settlements, as defined in the Manual, are the bridge between the regional deficit and the currency deficit.

Convertible currencies

The question must now be decided whether it is preferable to analyze compensatory official financing on a currency or on a regional basis. The problem may be illustrated by an example in which it is assumed that country A has regional deficits of 50 with country B and 50 with country C and that both are settled in B’s currency. Assume, first, that all currencies are convertible and that the particular currency in which settlement is made is a matter of indifference. Then currency deficits are not particularly significant, and if compensatory official financing is to be subdivided at all it might as well be done on a regional basis. The statements for the countries concerned would then be presented as shown in Table 6.

Table 6.

Compensatory Official Financing: Regional Aspect1

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In this and the subsequent tables the entries are shown on a net basis. No sign indicates a credit; a minus sign indicates a debit.

Currencies of varying “hardness”

As soon as the currency in which settlement is made ceases to be a matter of indifference for either party, the currency aspect comes to the fore. In examining the analysis of compensatory official financing under these circumstances, the treatment of a shift in the location of a country’s reserves from one financial center to another will be considered first.110 The fact that a shift occurs may in itself be taken as evidence that the currency in which reserves are held is no longer a matter of indifference. This in turn suggests that compensatory official financing should be considered from the currency rather than the regional aspect. It was suggested in section IV that the effect of the transfer on each of the countries concerned could be most clearly shown by treating both the multilateral settlement and the movement in reserves as noncompensatory. The effect of this suggestion is illustrated in Table 7, in which the assumption is made that the only transaction affecting the international reserves of countries A, B, and C is that A shifts reserves of 100 from B to C. This form of presentation seems to describe what has happened far more accurately than any possible alternative. From A’s point of view neither the transfer of reserves nor the multilateral settlement is compensatory since neither is in response to balance of payments pressures. From B’s point of view neither the movement in liabilities nor the multilateral settlement is compensatory for the same reason, but the movement in C’s reserves is compensatory since it indicates pressure in the exchange market with C. From C’s point of view neither the movement in liabilities to A nor the multilateral settlement is compensatory, but the movement in liabilities to B is compensatory since it is evidence of a surplus in the exchange market with B.

Table 7.

Noncompensatory Movements in Reserves1

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See note to Table 6.

The next situation to be considered is that in which reserves of a convertible currency are used to finance transactions with another country. Assume, as in the case above, that country A has deficits of 50 with country B and 50 with country C, but also assume that B’s currency is convertible, that A’s is used for international transactions but is inconvertible, and that all C’s international transactions are undertaken in B’s currency. There are then only two effective exchange markets, those of A with B and B with C, and compensatory official financing is confined to these markets. The statements for the three countries concerned may be presented as shown in Table 8, in order to emphasize the currency aspect.

Table 8.

Compensatory Official Financing: Currency Aspect I1

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See note to Table 6.

The situation becomes somewhat more complicated if transactions between A and C are conducted through a payments agreement and only amounts in excess of an agreed limit are payable in B’s currency. There is then an effective exchange market between A and C up to this limit. Any excess spills over into the markets of A and C with B. As an example of this situation assume that 30 is financed through the payments agreement and that the remaining 20 is settled in B’s currency. The statements for the three countries would then appear as shown in Table 9.

Table 9.

Compensatory Official Financing: Currency Aspect II1

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See note to Table 6.

The situation may be complicated further if gold is used instead of B’s currency. When currencies differ in hardness, gold reserves may be regarded, for practical purposes, as being on a par with reserves of the hardest currency. The use of gold reserves in settlements with countries whose currencies are less hard would then be regarded as involving pressure in the market for the hardest currency. This involves allocating movements in gold reserves as financing in the hardest currency and treating such transactions with other countries as multilateral settlements, just as if the hardest currency had been used. This is the solution adopted in the presentation of the British balance of payments. Another possibility would be to regard gold as a separate currency and to show a column for gold transactions. Assume that, in the above example, the remaining 20 was settled in gold rather than in B’s currency. The statements for the three countries would then be presented as shown in Table 10. This method has the advantage of distinguishing between gold and the hardest currency. There may be times when gold is preferred even to the hardest currency. Under these circumstances a shift in reserves from the hardest currency to gold would involve pressure on the hardest currency. This pressure may be shown by recording the transaction as a noncompensatory movement in reserves in the same way as suggested for a shift in reserves from one financial center to another.

Table 10.

Treatment of Gold as Separate Currency1

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See note to Table 6.