Balance of Payments

Updated on 2023-08-29T11:55:16.659523Z

What is meant by Balance of Payments or BOP?

Balance of Payments refers to the record of transactions maintained by a country with the rest of the world. It is a detailed list of international transactions that a country has with its trading partners. These transactions can be made by the residents, domestic businesses or by the government.

In an ideal situation, the sum of all the elements of BOP should be zero. However, this is rarely witnessed as most countries do not have the exact same amount of inflow as that of outflow.

The inflow and outflow from the rest of the world, can be with respect to goods, services, assets, investments, etc. Notably, a deflection from the ideal zero BOP state may not always be harmful.

A surplus (positive BOP) might indicate a strong economy as it means exports are greater than imports. While, a deficit (negative BOP) might point to an increased debt on the home country.

The Balance of Payments is highly reflective of the economic strength of a country. Most of the impacts of BOP are indirectly observed on various macroeconomic indicators.

What are the Components of BOP?

BOP comprises of two broad components, namely, Current Account and Capital Account. Sometimes the Capital Account is referred to as the Financial Account, along with a separate capital account. The Financial Account includes transactions in financial instruments and central bank reserves. While the capital account includes transactions in capital assets.

A balance in inflow and outflow of all these accounts makes for a BOP equal to 0.

• CURRENT ACCOUNT: In technical terms, Current Account is the sum of Balance of Trade, Factor Income (net income from foreign investments) and unilateral transfers (net gifts and grants received). Put simply, current account records the transactions done in goods and services, investments and the net transfer payments or unilateral payments. Exports are maintained as credits, while imports are maintained as debits in the balance of payments.

A positive current account balance means that the domestic country is a net lender, while a negative current account balance indicates that the home country is a net debtor.

According to the double-entry accounting method, any entry on the export side would be adjusted with an appropriate entry on the import side. For example, for a good exported by the home country to a foreign country, the corresponding import transaction would be the inflow of foreign currency received in exchange for the good exported.

• CAPITAL ACCOUNT: The capital account involves all transactions relating to international asset It involves transactions made in the reserve account as well as loan payments and investment made across nations. These loans, however, do not include the future stream of interest or dividend payments as they are a part of current account. This is so because they form a part of nation’s spending or income, depending on the type of flow.

A capital account is said to be in deficit when a country purchases more assets than the assets it sells to the rest of the world. An increase in assets is followed by a corresponding decrease in cash and vice versa.

In some countries, the capital account is known as the financial account and has separate component called the capital account. This capital account records the transactions that do not affect the income, production or savings like international transfer of trademarks and rights, etc.

What do BOP deficit and surplus mean for the home country?

In layman’s language, BOP tells us whether the country is earning enough to meet its expenditure. If there is a deficit, then it can point towards the country’s growing expenses which are not sufficed by the income generated. Thus, there is a need to generate debt in order to fund the current requirements. Many a times the need to repay current debt gives rise to more debt. Therefore, an endless cycle of financing previous debt with current period loans takes place.

The credit received from the rest of the world is generated either by taking a loan, which adds as a liability in the accounts or by selling off the assets currently possessed by the country. These assets can be natural resources, land, commodities, etc.

A surplus on the other hand means that a country is exporting more than it is importing in all its existing BOP accounts. This can be a positive sign in most instances as it points towards stronger economic movements.

A surplus can encourage the home country to invest in production of goods and services and in turn promote GDP growth. However, an export-driven growth in the long run could point to lack of sufficient demand in the home country. In such a case, the government should boost consumer spending in home country in order to become more self- reliant.  

What are the factors affecting BOP?

BOP depends on various factors. These include:

• The domestic exchange rate: Exchange rate is a measure of foreign currency with respect to the domestic currency. Governments can revalue or devalue the exchange rate with the help of appropriate policies. This affects the BOP by making exports cheaper as the exchange rate falls and making imports cheaper when the exchange rate rises.
• The spending capacity of domestic consumers: As businesses and households are left with greater disposable income, they can spend more on imports and this can affect the BOP.
• Price competitiveness offered by domestic goods: For a country that is going through higher rates of inflation than its trading partner, the goods and services offered by it would be relatively more expensive. Thus, the country becomes less competitive in terms of price competitiveness. The country with lower inflation would thus have cheaper exports. In such a case, domestic consumers would prefer foreign goods and services causing increased imports and eventually a BOP deficit.

• Domestic policies: Trade based taxes and tariffs are a huge influencer on the BOP. Policies boosting exports are always beneficial to a country. It is important to pay attention to imports by imposing restrictions using tariffs or quotas. Apart from trade centric policies, domestic policies aimed at economic growth may cause changes in BOP. For instance, increased interest rates can promote FDI in the home country, which would affect the Current Account in BOP.