What is Balance of Payments?
The Balance of Payments is a statement that contains the transactions made by residents of a particular country with the rest of the world for a specific time period. It is also known as the balance of international payments and if often abbreviated as BOP. It summarizes all payments and receipts by firms, individuals, and the government. The transactions can be both factor payments and transfer payments.
There are two accounts in the BOP statement: Current Account and Capital Account. Current account records all transactions involving goods, services, investment income and current transfer payment. Capital account shows the net change in ownership of foreign assets and transactions in financial instruments. The balance of payments account follows a double entry system. All receipts are entered on the credit whereas all payments are entered on the debit side. Theoretically, a balance of payments accounts is always zero with the total on the debit side equaling the total on the credit side. Practically, however, there might be an error of some degree due to the different sources of data and fluctuation of currency exchange rates.
Components of BOP
The BOP comprises of two accounts: Current and Capital.
The four major components of current account are as follows:
- Visible trade – This is the net of export and imports of goods (visible items). The balance of this visible trade is known as the trade balance. There is a trade deficit when imports are higher than exports and a trade surplus when exports are higher than imports.
- Invisible trade – This is the net of exports and imports of services (invisible items). Transactions mainly constitute of shipping, IT, banking and insurance services.
- Unilateral transfers to and from abroad – These refer to payments that are not factor payments. These are ‘one-way’ transactions. For examples, gifts or donations sent to the resident of a country by a non-resident relative.
- Income receipts and payments – These include factor payments and receipts. These are generally rent on the property, interest on capital and profits on investments.
The capital account is used to finance the deficit in the current account or absorb the surplus in the current account. The three major components of capital account:
- Loans to and borrowings from abroad – These consist of all loans and borrowings given to or received from abroad. It includes both private sector loans as well as the public sector loans.
- Investments to/from abroad – These are investments made by nonresidents in shares in the home country or investment in real estate in any other country.
- Changes in foreign exchange reserves – Foreign exchange reserves are maintained by the central bank to control the exchange rate and ultimately balance the BOP if it is not.
Current account deficit is financed by a surplus in the capital account and vice versa. This can be done by borrowing more money from abroad or lending more money to non-residents.
Significance of BOP
The balance of payments data is important to a lot of users. Investment managers, government policymakers, the central bank, businessmen, etc. all make use of the BOP data to make important decisions. The BOP data is affected by vital macroeconomic variables such as exchange rate, price levels, interest rates, employment, and GDP.
Monetary and fiscal policies are formed in a way to achieve very specific objectives, which generally exert a significant impact on the balance of payments. Policies can be formed with the objectives to induce or curb foreign inflows or outflows.
Businesses use BOP to analyze the market potential of a country, especially in the short term. A country with a large trade deficit is not as likely to import as much as a country with a trade surplus. If there is a large trade deficit, the government may adopt a policy of trade restrictions such as quote or tariffs.
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