What is the Balance of Payments?
Balance of Payments is the record of the transaction of goods and services, assets between the residents of the country with the rest of the world for a specified period of time typically one year.
A payment is received from a foreign nation is credit and similarly, payment is paid to a foreign country is called a debit transaction.
A credit transaction is the Export of goods and services, FDI (Foreign Direct Investment), official sale of reserves such as gold to another nation or foreign agencies.
Similarly, Debit transactions are imports, payments to foreign nations, investment by residents in foreign, and purchase of gold reserves from foreign agencies and nations.
Components of Balance of payment
The Components of the balance of payment are as follows:
- Current Account
- Capital Account
- Official Reserve Assets Account or official settlements account.
The current account is the record of trade in goods and services and transfer payments. Trade-in goods include exports and imports of goods.
Trade-in services include factor income and non-factor income transactions.Net factor income is two types of Net income from Compensation of Employees and Net investment income.
Net Non-Factor income is Shipping, Banking, Insurance, Tourism, Software Services, etc. Transfer payments are the receipts which the residents of a country get for ‘Free’, without providing any goods and services in return.
Examples of transfer payments are grants, remittances, and gifts from government or private citizens living abroad. When buying goods from foreign countries money from our country becomes the income of another country.
Thereby the purchase of foreign goods and imports reduces the demand for local goods and services. Similarly, selling foreign goods or exports gets income to the country and adds aggregate domestic demand for goods and services in our country.
The balance on Current Account
The Current account is in balance when receipts on the current account are equal to the payments on the current account.
Receipts = Payments
A surplus current account means that the nation is a lender to other countries.
Receipts > Payments
A deficit current account means that the nation is a borrower from other countries.
Receipts < Payments
Balance of Current Account has two components
- Balance of Trade or Trade Balance
- Balance of Invisibles
Disequilibrium in the balance of payment
A disequilibrium in BOP is a condition of Surplus or Deficit. A surplus in the Balance of Payment happens when the Total Receipt exceeds the Total Payment. Thus BOP = Credit > Debit.
A Deficit in the BOP happens when the Total Payments exceeds, the Total Receipts. Thus BOP = Credit < Debit
Causes of disequilibrium in balance of payment
- Cyclical Fluctuations
- Increase in Population
- International Capital Movements
- Unfavourable balance of trade
- Demonstration Effect
- Huge External Borrowing
- Political Conditions
Balance of Trade(BOT)
In a given time, it is the difference between the value of exports and the value of imports of goods in a country. Export of goods is credit in BOT, import of goods is debit in BOT. It is called the Trade Balance.
BOT is said to be in balance when exports of goods are equal to the imports of goods. Surplus BOT or Trade Surplus – It is a condition that arises when the country exports more goods than imports.
Deficit BOT or Trade Deficit – It is the condition when imports are more than exports.
Net Invisibles- It is the difference between the value of exports and the value of imports of Invisibles of a country in a given period of time.
Invisibles include Services, transfers, and income flow between different countries. Services trade includes both factor and non-factor income.
Factor income includes net international earnings on factors of production such as labour, land, and capital. Non-factor income is the net sale of services such as shipping, banking, tourism, software services, etc.
A capital account is a record of all international transactions of assets. Examples of assets are stocks, bonds, money, Government debt, etc. The purchase of assets is a debit item on the capital account.
For example, When a person from India buys a mobile from China, it goes into capital account transactions as a debit object (Foreign exchange is flowing out of India).
Similarly, the Sale of a share of Indian companies to a UK person is a credit item on the capital account.
Capital is divided into three:
- External Borrowings
- External Assistance
Investments are divided into two:
- Direct Investments- FDI(Foreign Direct Investment), Equity Capital, Reinvested Earnings, and other Direct Capital Flows.
- Portfolio Investments- FII(Foreign Institutional Investments), Offshore Funds.
External Borrowings– Short-term debt, External Commercial Borrowings.
External Assistance– Government Aid, Inter-Governmental, Multilateral and Bilateral Loans.
The balance on Capital Account
The capital account is said to be balanced if the capital inflows are equal to capital outflows.
Loans from the foreign, sale of assets or shares in foreign companies.
Repayment of loans, purchase of assets, or shares in foreign countries.
Capital Account Surplus arises when capital inflows are more than capital outflows. Capital Account Deficit arises when capital inflows are less than capital outflows.
Balance of Payments Surplus and Deficit
If a country is in a deficit in its current account, it must sell its assets or by borrowing from foreign. Thus any current account must be financed by capital account surplus that is net capital flow.
Current account + capital account = 0
In the case, in which a country is said to be in a balance of payments equilibrium, the current account deficit is financed fully by abroad lending without any movement of reserves.
Alternatively, the nation can use its foreign exchange reserves to balance the deficit in the balance of payments. This is called Official Reserve Sale.
The decrease in official reserves of the nation is called the overall balance of payments deficit (Surplus)
The basic assumption is monetary authorities are the utmost financiers of any deficit in the balance of payments or recipients of any surplus.
The official reserve transactions are more closely connected under a system of fixed exchange rates than when exchange rates are floating.
Autonomous and Accommodating Transactions
It is termed ‘below the line items’, it is determined by the space in the balance of payments, that is whether there is a deficit or surplus in the balance of payments.
In other words, they are determined by the net outcomes of autonomous transactions. Since the official reserve transaction are made to bridge the gap in the BoP, they are seen as a versatile item in the BoP.
Errors and Omissions
As there is difficulty in recording all the international transactions accurately, there is another element of Balance of Payments (BoP), apart from the current and capital that is errors and omissions.