Balance of Payments

What Is the Balance of Payments (BOP)?

The balance of payments (BoP) records the economic transactions of a nation with the rest of the world in commodities, services, and assets during a specific period, generally a year. 

In basic terms, it is the country's systematic accounting balance sheet, which contains both debit and credit activities. In addition, the BoP is used to keep track of all foreign monetary transactions. 

The BoP accounts for all trades made by both the public and private sectors to establish how much money enters and exits the country.

The primary goal of BoP accounting is to identify the economy's strengths and shortcomings. You may learn about the losses and profits of the previous year's BoP accounts. The BoP has two primary accounts: the current and capital accounts. 

The current account keeps track of exports and imports of goods, trade in services, and transfer payments. In addition, all overseas acquisitions and sales of assets such as money, stocks, bonds, and so on are recorded in the capital account. Foreign investments and loans are also included.

The country is considered to be in a balance of payments equilibrium when the sum of the country's current account and the non-reserve capital account is zero, and the current account balance is wholly financed by foreign lending. 

After combining the current and capital account balances, the BoP deficit or surplus is calculated. The total BoP deficit is the loss in official reserves, whereas the growth in reserves is the increase in reserves.

Current-account deficit countries may face issues. For example, the country's currency reserves diminish if the deficit is significant and the economy cannot attract sufficient foreign investment inflows.

Components of BOP

The account is separated into three parts: the current account, the capital account, and the financial account. In addition, there are sub-categories within these three categories, each of which accounts for a particular form of foreign monetary transaction.

1. Current account

The current account measures the entrance and outflow of commodities and services into and out of a country. In addition, earnings from governmental and private investments are credited to the current account.

The trade of products, which includes items like raw materials and manufactured goods purchased, sold, or given away, is reflected in the current account as credits and debits (possibly in the form of aid). 

Services include tourism, transportation, engineering, business service fees (such as attorneys or management consulting), and royalties from patents and copyrights.

When products and services are combined, they constitute a country's trade balance (BOT). The BOT accounts for most of a country's BoP since it includes all imports and exports. 

A country with a trade deficit imports more than what it exports, whereas a country with a trade surplus exports more than it imports.

Dividend payments from income-producing assets like stocks are likewise reflected in the current account. Unilateral transfers are the final component of the current account. 

These are mostly worker remittances, which are salaries paid back to the home country of a person working abroad and direct foreign aid.

 2. Capital Accounts 

The capital account includes all forms of short-term and long-term foreign capital transfers, the movement of gold and other precious metals, receipts and payments to and from government and private accounts, institutional and private loans, grants, etc.

Because the capital account is concerned with financial flows, they have no direct impact on the country's revenue, output, and employment.

Changes in ownership of fixed assets (assets like machinery used to produce revenue) and the transfer of cash received to the sale or acquisition of such assets are included in the capital account. 

Gifts and inheritance taxes, and death levies, among other things, also affect the amount of money in the bank account.

3. Financial Accounts

International monetary flows are recorded in the financial account of the Republic of Ireland. 

Government-owned assets such as exchange reserves, gold, and special drawing rights (SDRs) are kept with the International Monetary Fund (IMF), overseas-held private assets, and foreign direct investment. 

Foreigners' private and government assets are also reflected in the country's financial statement.

Significance of BOP

This account is an important document or transaction in the finance department since it indicates the state of a country and its economy. The following indicators demonstrate the significance of the BoP account: 

• A financial record, such as the BoP, examines all transactions in a country's economy concerning the export and import of goods and services and other finances for a fiscal year. 
• The BoP assists the government in identifying the various areas of the economy that have the potential for export-oriented growth. 
• The government can use the BoP to impose higher tariffs and tax rates on foreign exchange inflows to encourage local industries to become more self-sufficient and to reduce non-essential item imports.

• Suppose a country has a thriving export trade. In that case, its BoP can offer reliable information to the government, allowing it to take policies such as currency depreciation to make its goods and services more inexpensive, increasing foreign exchange outflow tremendously. 
• Another fundamental reason a BoP account is crucial for an economy is that it serves as a significant signal for a government in developing its criteria for monetary and fiscal policy, inflation management, etc.

Surplus and Deficit in Balance of payments

A BoPs imbalance is shown when the central bank purchases domestic currency and sells foreign reserve currency. Alternatively, a BoP surplus is shown when the central bank sells local currency and buys foreign currency.

Official reserve transactions are the account in which central bank transactions are documented. It is contained in the balance of payments financial account. The nation's balance of payments is in surplus if this account shows an increase in official reserves over time. 

If the official reserve balance falls over time, the government has a BoP deficit. The terms deficit and excess are derived from the following conditions.

Assume a country has a trade deficit under a fixed-currency system. A trade deficit occurs when import demand surpasses overseas demand for our exports. This means that domestic demand for foreign currency (to purchase imports) outnumbers foreign demand for domestic currency (to buy our exports). 

The central bank would need to interfere by selling foreign money for domestic currency to maintain the exchange rate. This would result in a decrease in foreign reserves, leading to a BoP deficit. 

In the absence of financial account activities, having a trade deficit and a stable exchange rate entails having a BoP deficit.

A BoP deficit (surplus) occurs anytime there is an excess demand for (supply of) foreign currency in the market at the official fixed exchange rate. 

To meet excess demand (supply), the central bank will automatically act in the market and sell (purchase) foreign reserves. 

Thus, we may ascertain if a nation's balance of payments is in deficit or surplus by keeping track of sales and buying foreign reserves in the official reserve account.

How the BOP Is Balanced

There are differing opinions on the major origin of BoP imbalances, with a significant focus on the United States, which now has, by far, the most significant deficit. 

The common wisdom is that current account variables, such as the currency rate, the government's budget deficit, company competitiveness, and private behavior, such as consumers' propensity to borrow to finance excess spending, are the fundamental causes.

The top measures to rectify the BoP deficit are highlighted in the following sections. The measurements are as follows:

1. Adjustment through exchange depreciation

Under flexible exchange rates, the forces of demand and supply for foreign exchange naturally correct the imbalance in the balance of payments. 

An exchange rate is a currency's price governed by demand and supply, just like any other commodity.

"The exchange rate changes with changing supply and demand situations, but an equilibrium exchange rate that clears the foreign exchange market and promotes external equilibrium can always be found."

In the event of a balance-of-payments deficit, a country's currency depreciates automatically. When a currency depreciates, its relative value falls. The impact of depreciation is to encourage exports while discouraging imports.

When the currency's value falls, international prices are converted into local prices. For example, assume the dollar falls in value compared to the pound. It signifies that the dollar's value to the pound lowers in the foreign exchange market.

2. Adjustment via Capital Movements

Capital inflows can help fund a deficit when capital is fully mobile within countries—a little increase in the local interest rate results in a significant inflow of money.

When the local interest rate reaches parity with the global rate, the balance of payments is considered to be in equilibrium. Conversely, capital inflows will occur if the local interest rate exceeds the global rate, and the BoP imbalance will be repaired.

3. Export Stimulation and Import Substitutes  

Exports may be encouraged through manufacturing high-quality goods, boosting exports through greater productivity and production, and improving marketing. In addition, they can be boosted via an import substitution scheme.

It signifies that the country manufactures the commodities that it imports. Imports are reduced at first, but exports of such commodities begin in the long term. 

An increase in exports causes the national income to grow multiple times due to the operation of the international trade multiplier.

4. Adjustment via Income Changes

Given a country's foreign exchange rate and prices, a rise in the value of exports raises the earnings of all people involved in the export industry. As a result, demand for other goods and services inside the country increases. 

This will increase the earnings of those working in the latter businesses and services. This process will continue, and the national revenue will rise by the multiplier value.

5. Direct Controls

To remedy imbalances in the balance of payments, the government also implements direct regulations to reduce the volume of imports. The government controls the import of undesired or minor commodities by imposing high import charges, quotas, and so on.

In addition, it may set generous import quotas or provide duty-free or reduced import tariffs for imports of necessities.

For example, the government may permit the unfettered entrance of capital items while imposing high import charges on luxury. Import quotas are also set, and importers must get permits from the government to import certain critical items in predetermined quantities.

Imports are lowered in this manner to rectify a negative balance of payments. In addition, the government implements exchange restrictions. Exchange controls have two functions. 

They limit imports while also controlling and regulating foreign exchange. As a result, visible and invisible imports are lowered as imports are reduced, and foreign exchange is controlled. As a result, an incorrect payment balance is adjusted.

Researched and authored by Kavya Sharma | Linkedin

Reviewed and edited by Parul Gupta | LinkedIn

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