Balance of Payment Nature, Components and Importance

Table of Contents:-

1. Meaning of Balance of Payment
2. Definition of Balance of Payment
3. Nature of Balance of Payment
4. Balance of Payment Account
5. Components of Balance of Payment
6. Factors Affecting Balance of Payment
7. Importance of Balance of Payment

Meaning of Balance of Payment

Balance of payment is a broader term which represents the balance of trade. When we refer to “services,” we are specifically alluding to the offerings provided by shipping lines, insurance companies banking concerns, and others. The term “balance of trade” refers to the merchandise account encompassing both exports and imports.

Balance of payment refers to the net results obtained by recording all the visible and invisible items that are imported and exported from one country to another. Balance of payment, such as provides a comprehensive statement of the net results of foreign trade and gives a true picture of where the country stands in international trade.

It exposes the economic viability, strength, and capability by correctly measuring its imports and exports, competency in goods and services as well as technical know-how. When we refer to services, we mean the services provided by shipping lines, insurance companies, banking concerns, and others. It also includes the foreign loan that is either provided by it or accepted from other countries.

Definition of Balance of Payment

According to Kindleberger, “Balance of payment is a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period”.

In other words, the balance of payments is a comprehensive record of the economic transactions of a nation’s residents with the rest of the world during a given period. The aim is to present an account of all receipts and payments on account of goods exported services rendered and capital by residents of a country, as well as goods imported, services received, and capital transferred by residents of the same country.

The balance of payments is an accounting statement that summarises all the economic transactions between residents of a particular country and residents of all other nations. It is a measure of all transactions between domestic country and international countries.

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Nature of Balance of Payment

The nature of the balance of payments is as follows:

1. Systematic Record
2. Fixed Period
3. Comprehensiveness
4. Double Entry System
5. Self-Balanced
6. Adjustment of Differences
7. All Government and Non-Government

1) Systematic Record

It is a systematic record of receipts and payments of a country to other countries.

2) Fixed Period

It is a statement of an account about a given period, usually a year.

3) Comprehensiveness

The balance of payments encompasses all three categories, i.e., visible, invisible and capital transfers. It serves as a comprehensive record of economic transactions of the residents of a country with the rest of the world during a given period. The aim is to present an account of all receipts and payments on account of goods exported services rendered and capital by residents of a country and goods imported, services received and capital transferred by citizens of the country.

4) Double Entry System

Receipts and payments are recorded based on a double entry system. In the construction of the balance of payments statement, a fundamental convention is followed, in which each recorded transaction is represented by two entries of equal value. One of these entries is designated a credit, denoted by a positive arithmetic sign, while the other is classified as a debit, indicated by a negative sign. In principle, the sum of all credit entries should be equal to the total of all debit entries, resulting in a net balance of zero for all entries in the statement. 

5) Self-Balanced

From the point of view of accounting, a double-entry system keeps automatically the debit and credit sides of the accounts in balance.

6) Adjustment of Differences

Whenever there are differences in actual total receipts and payments, the need is felt for necessary adjustment.

7) All Government and Non-Government

Balance of payments includes receipts and expenditures of all items, government and non-government.

Balance of Payment Account

The balance of payment statement records all types of international transactions that a country consummate over a certain period. The BOP statement is usually divided into three primary groups of accounts.

The balance of payments statement is prepared using a double-entry bookkeeping system, where all the entries are recorded in the form of debits and credits. When all entries are accurately recorded, the total debits must equal the total credits. The reason behind this phenomenon lies in the fact that two components, namely debits and credits, of each transaction, recorded are equal in amount and appear on opposite sides of the balance of payments account. From an accounting perspective, the balance of payments of a country must always be balanced.

In other words, the debit or payment side of the balance of payments accounts of a country represents the total amount of foreign exchange used by the country during a specific period. On the other hand, the credit or the receipt side represents the sources from which this foreign exchange was acquired by this country in the same period. The two sides as such must always balance each other out.

Components of Balance of Payment BOP

The accounting contents or components of the balance of payments are:

1. Current Account
2. Capital Account
3. Official Reserve Account
4. Other items in the Balance of Payments

1) Current Account

The current account is divided into three sub-categories;

1. The merchandise trade balance,
2. The services balance and
3. The balance on unilateral transfers.

Entries in this account are “current” in value as they do not give rise to future shares. In economics, a surplus in the current version represents an inflow of funds, while a deficit represents an outflow of funds. The capital account can be divided into three categories given as follows:

i) Merchandise

Balance of merchandise trade refers to the balance between exports and imports of tangible goods such as computers, automobiles, machinery and so on. A favourable balance of merchandise trade, also known as a surplus, occurs when the value of exports is greater in value than imports. An unfavourable merchandise trade (deficit) balance occurs when imports exceed exports. Merchandise exports and imports constitute the most significant element of total international payments for most countries.

ii) Invisibles

Services represent the 2nd category of the current account. This category includes a wide range of economic activities, such as interest payments, shipping and insurance fees, dividends, tourism, and military expenditures. These trades in services are sometimes called invisible trades.

iii) Unilateral Transfers

Unilateral transfers are gifts and donations by both private parties and governments. Private donations and grants include personal skills of all kinds and relief organisation shipments. For example, money sent by immigration workers to their families in their home country can be referred to as a private transfer of funds. Government transfers include money, goods and services extended as assistance to foreign nations. 

2) Capital Account

The capital account is an accounting measure of the total aggregate value of financial transactions between domestic residents and the rest of the world within a specific timeframe. This account consists of loans, investments, and other financial asset transfers, as well as the establishment of liabilities. International capital flows encompass financial transactions related to international trade, as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits.

The capital account can be divided into three main segments:

1. Direct investment,
2. Portfolio investment and
3. Other capital flows.

i) Direct Investment

Direct investment occurs when the investor acquires equity by purchasing stocks, developing entire firms, or establishing new subsidiaries. Foreign direct investment (FDI) generally occurs when firms take advantage of various market imperfections. Firms also undertake foreign direct investments when the expected returns from foreign investment surpass the cost of capital, allowing for political risks and foreign exchange. The expected returns from foreign profits can be higher than those from domestic projects due to lower material and labour costs, investment tax allowances, subsidised financing, exclusive access to local markets, etc.

ii) Portfolio Investment

Portfolio investments represent sales and purchases of foreign financial assets, such as bonds and stocks that do not involve a transfer of management control. The purpose of investment safety, returns, and liquidity in investments is the same for international and domestic portfolio investors. International portfolio investments have boomed explicitly in recent years due to investors’ desire to diversify risk globally. Investors generally believe that diversifying their portfolio holdings internationally, rather than solely domestically, can effectively reduce risk. In addition, investors may also benefit from increased expected returns from some foreign markets.

iii) Capital Flows

Capital flows define the third category of capital account and represent shares with a maturity of less than one year. Various types of financial assets are encompassed by these claims, including bank deposits, short-term loans, short-term securities, money market investments and so forth. These investments are sensitive to changes in relative interest rates between countries and the anticipated change in the exchange rate. For example, in the event of an increase in interest rates in India, with other variables remaining constant, the country will experience capital inflows. This is because investors would like to deposit or invest their funds in India, aiming to benefit from the higher interest rate. However, if the higher interest rate is accompanied by an anticipated depreciation of the Indian rupee, it is possible that capital inflows to India may not materialize.

3) Official Reserve Account

Official reserves refer to assets that are owned by the government.  The official reserve account represents only sales and purchases by the central bank of the country (for example, The Reserve Bank of India). The changes in official reserves are necessary to accurately reflect the deficit or surplus in the balance of payments. For example, if a country has a balance of payments (BOP) deficit, the central bank must take measures to address this situation. One possible course of action is to deplete its official reserve assets, such as gold, foreign exchange and Special Drawing Rights (SDRs) or borrow fresh from foreign central banks. However, if a country has a BOP surplus, its central bank will opt to either acquire supplementary reserve assets from foreign entities or reduce its foreign debts.

4) Additional Items in the Balance of Payment

The remaining items that cannot be categorised into the preceding categories constitute the other items in the balance of payments. They are included since the entire balance of payments account must be balanced. These items are as follows:

i) Errors and Omissions

These are to take into account the difficulty of accurately recording the wide variety of transactions that take place in the accounting period. These issues may occur as a result of sampling transactions instead of recording each transaction. (e.g, instead of recording each of a thousand exports of lemons, they may multiply an average lemon export figure by a thousand), due to dishonesty, i.e., businessmen underreporting sales abroad to avoid taxes, when smuggling occurs, etc.

ii) Official Reserve Transactions

All transactions except those in this category may be termed autonomous transactions. They are so-called because they are entered into with some independent motive, i.e., not to bring their consequences on the balance of payments or the exchange rate. In contrast to this, official reserve transactions are carried out by the government and the central banks in pursuit of some international economic policy objective; while keeping an eye on the effect of such transactions on the balance of payments (BOP) and the exchange rate.

As a result, such transactions are not autonomous. The first of these items is the change in the domestic country’s official reserve assets. These reserves of a country are held in the form of foreign currency or foreign currency securities, gold and Special Drawing Rights (SDR) with the IMF. SDR allows a country to avail of foreign exchange in proportion to the quantum of the country’s deposit of its currency with the IMF under the SDR scheme.

The changes in the country’s reserves must reflect the net value of all other items in the BOP. Reduction in these assets will be used to finance expenditures abroad. Reductions appear as a credit item in the BOP (because their sale causes foreign exchange inflow into the country). An increase in these reserves will appear as a debit because of purchasing assets.

Factors Affecting Balance of Payment BOP

The following factors affect the balance of payments in the country:

1) Cost of Production: The comparison of production costs, including labour, land, capital, taxes, incentives, and more, between the exporting economy vis-a-vis those in the importing economy.

2) Demand and Supply: The demand and supply trend defines the cost of domestic products sold in the international market.

3) Cost and Availability: The cost and availability of intermediate goods, raw materials and other inputs.

4) Exchange Rate Movements: For nations with low exchange rate values, the balance of trade tends to remain unfavourable.

5) Domestic Business: Sound domestic policies are needed to increase production and international trade. Some countries like the U.S. provide subsidies to local manufacturers for exported services and goods.

6) Trade Agreements: Bilateral agreements govern international trade and define the products with their prices in the global context.

7) External Pressures: Many countries export items that face heavy competition in the international market. This results in low pricing and market segmentation. Countries that are mostly oil exporters or IT hubs tend to generate favourable trade balances due to less competition in the international market. External pressures also function in the form of trade bans. These bans are implemented by individual countries or international organisations such as the IMF or World Trade Organisation.

8) Price: Prices of goods manufactured at home are influenced by the responsiveness of supply.

Importance of Balance of Payment BOP

BOP data may be important for various reasons some of which are as follows:

1) Forecasting: The BOP helps forecast a country’s market potential, especially in the short run. A country that is facing a significant balance of payments (BOP) deficit is not likely to import as much as it would if it were running a surplus.

2) Indicator of Pressure: The BOP is an important indicator of pressure on a country’s foreign exchange rate, and thus on the potential of a firm trading with or investing in that country to experience foreign exchange profits or losses. Changes in the BOP may presage the impositions (or removal) of foreign exchange controls.

3) Signal of Imposition: Changes in a country’s BOP may also indicate the implementation or removal of controls over the payment of dividends and interest, royalty fees, license fees, or other cash disbursements to foreign investors or companies.

4) Judging the Stability: Judging the stability of a floating exchange rate system is easier with BOP as the record of exchanges that take place between nations helps to track the accumulation of currencies in the hands of those individuals more willing to hold on to them and judging the stability of a fixed exchange rate system is also easier with the same record of international exchange. These recent exchanges once again highlight the extent to which a currency is accumulating in foreign hands, raising questions about the ease of defending the fixed exchange rate in a future crisis.

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