Balance of payments is a statement of economic transactions one country does with the rest of the world within a year of period. BOP is a yardstick to judge the strength of economy of the given country in relation to other countries in the world. So, in detail, explaining balance of payments is utmost important to know the economic state of a country in compare to outside world.
Meaning and definition of balance of payments
Logically, in the today’s globalizing world, no country ever be isolated from the positive and negative economic impacts of the world affairs.
In order to reap and harness comparative advantage, one must depends on others, outside the political borders to satisfy its demands and realise full potential.
For example, trade in goods and services with other nations, demands for capital from foreign players, technology, and expertise requirements, loans, assistance etc.
Simply speaking, all the transactions whether it is done by public or private players of a given country with the rest of the world including trade, investment, loan, dividends, remittance, assistance etc.
In other words, the systematic statement about the account of debit or credit one country does with rest of the world in a year is termed as Balance of payments.
Purpose behind balance of payments
As I mentioned earlier that BOP is a yardstick to judge the true nature of a country’s economic state or health in relations with the rest of the world.
More clearly, it helps any country to analyze the country’s losses and benefits by the international economic relations one country have in the specific period of time (one year).
Explaining Balance of payments Components
To monitor better, BOP is categorized in the following three parts or components. These are :-
A.Current Account
B. Capital Account
C. Financial Account
Current account includes given country’s export and import in goods and services with the rest of the world in a year.
Technically, it is also called visible and invisible account. Visible includes goods like consumer goods, capital goods, and durable goods. And, invisible means trade in services including expertise, services and income. Let’s understand in detail current account of balance of payments.
A.Understanding current account of balance of payments
Basically, thete are two types of accounts in balance of payments – current account and capital account. Current account balance includes goods and services, investment income, and current transfers; while, capital account balance includes investment, borrowing and others.
Meaning of current account balance
Exports minus imports in a year is called trade balance. If we add investment income and net transfers, it is called current account balance.
If the current account balance is deficit, the given economy is debitor to the outside world as it imports more than that of its exports. Conversely, if the same nation’s current account balance is surplus, it is creditor to the outside world.
In simple terms, current account deficit and surplus indicates whether the given economy has productive capabilities or it is overlay depends on others. Unlike balance of payments, it doesn’t mean that the health of economy is poor.
Components of current account
1.Goods and services
Goods and services are the major component of the current account. Goods includes movable and physical. Business services, tourism, royalties, insurance are the services part of current account. It is also called visible and invisible balance.
2.Investment income
Investment income includes dividends, investment income, interests, migrants remittance. When a economy invest its surplus in the other economy as investment, it receives investment income in future on current account.
3.Current transfers
Actually, current or net transfers are the transfers without repayment obligations. These includes donations, aids and grants, official assistance, and pensions.
Impacts of Current account surplus
Suppose, if the current account is surplus means economy is creditor to the outside world, it transfers fund outside of country to invest in other countries.
If such fund is invested in portfolio investment to purchase stocks bonds etc. It is debited on financial account. But, if it is invested as direct investment, in is debited on the capital account.
Impacts of Current account deficit
Any economy termed as current account deficit can finance its deficit account by direct investment, borrowing, and portfolio investment. Direct investment is the best means by which any country would enjoy to finance current account as it helps to fuel productive activities. Once the productive activities increase, exports will rise and so the deficit Will decline automatically.
But, portfolio investment and borrowing are not best means to finance deficit. Borrowing might make the capital account more vulnerable by the flight of investment in case of adversity. And, borrowing may increase burden of interest payments.
So, it is too difficult to concludes that whether a country having current account deficit in trouble or in a rapidly growing stage and it is attracting investment for productive activities.
B. Explaining Balance of payments Components-Capital account
Second, capital account deals with the transactions in terms of foreign investment like foreign direct investment and foreign institutional investment, government’s external commercial borrowing, loans and NRI transfers.
Balance of payments that is the summary statement of international transactions in a year, is divided in the current account balance and capital account balance. Current account deals with exports and imports in goods and services, interest, dividends, profit, remittance, donations and gifts received in a year.
Understanding capital account balance
Capital account balance shows the summary statement of net capital inflow and out flow in the country in a specific time. Capital means nothing but the country’s international assets and liabilities.
In short, capital account balance indicates that how much domestic assets is owned by foreigners and how much international assets is owned by domestic players.
Capital account deals with the financial or capital transfer so there is no relations with country’s production, saving, employment, etc.
Main components of capital account
1.Foreign loans or external commercial borrowing, foreign portfolio investment,
2.Foreign direct investment. NRI deposits, banking capital, trade credit, SDRs etc.
If the country has more inflow of capital or surplus capital account, it is debitor to the outside world. Conversely, if the country has more outflow of capital, it is creditor to the outside world.
As I explained before that surplus capital account means more domestic assets is owned by foreign players. And, in return, country has to pay investment income to the outside world.
On the other side, deficit capital account means domestic players have more ownership of outside assets. So, in future, country will receive investment income on the current account balance.
Impacts of capital account
Usually, capital account surplus is used to fund current account deficit. If there is current account deficit, it is essential to have capital account surplus.
But, it is not good sign to have portfolio investment, commercial borrowing as credit to the capital account as they are more riskier than that of the direct investment. Direct investment is a good sign as it fuels the productive activities and doesn’t imply liabilities on the country.
Finally, if the country has more liabilities or inflow to the capital account, it will definitely affect the exchange rate as well as foreign exchange reserve.
Finally, capital account helps to measure the net changes in a country’s assets and liabilities, and helps to assess nation’s economic state. It also signals the degree of country’s competitive atmosphere in terms of openness.
C.Financial account of balance of payments
In the today’s open economies, financial transactions are growing so fast. Financial transactions between nations or economies are recorded in account called financial account of balance of payments.
In most of the economies, financial account is part of capital account. Financial account includes investment in businesses, real estate, bonds, and stocks.
Financial account includes three components. They are direct investment, portfolio investment and short term capital flow in search of better return.
Final thought on explaining Balance of Payments
In the process of explaining balance of payments, you might have realized that it is a systematic account of transactions one country does with the rest of the world in terms of trade, capital, income etc.
Suppose, if a country’s export is more than that of the import of goods and services, its balance of trade in specific and current account in general will be surplus. Consequently, the economic state of a country in question is more resilient than other. In opposite case, capital account surplus need to be diverted to balance the current account.
Understandably, all the three accounts are interrelated to balance the deficit and surplus in case of such conditions.
After all, state of BOP has strong bearing on the depreciation and appreciation, as well as country’s economic credibility in the global economy.
Summary of Explaining Balance of payments
Economic transactions one country does with the rest of the world within a year of period is known as balance of payments.
Here, the transactions whether it is done by public or private players of a given country with the rest of the world including trade, investment, loan, dividends, remittance, assistance etc.
In layman’s terms, balance of payments is the systematic statement about the account of debit or credit one country does with rest of the world in a year.
Balance of payments highlights the true state of economic health of any nation.
Current account, capital account and financial account are the major components of the balance of payments.
In detail, Current account is classified as visible and invisible account or account of records of international trade in goods and services. In addition, investment income and current transfers are also part of the current account.
Next, capital account deals with the transactions in terms of foreign investment like foreign direct investment and foreign institutional investment, government’s external commercial borrowing, loans and NRI transfers
In simple terms, capital account is divided as external loans and investments.
Financial transactions between nations or economies are recorded in account called financial account
Financial account includes investment in businesses, real estate, bonds, and stocks.
Solved Questions on explaining Balance of payments
For more simplification of topic, let’s have a look of the following solved questions.
Q. 1. What is the definition of balance of payments?
Ans: Balance of payments is a account of records of economic transactions one country does with the rest of the world within a year. It has three components- current account, capital account, and financial account.
Q. 2. What is the importance of balance of payments?
Ans: Balance of payments provides a better insight of the country’s true economic health. Also, it is a window to observe whether economic relations with rest of the world are beneficial or not to the given country.
Q. 3. What does current account means?
Ans: current account is a record of international trade in goods and services of a country with rest of the world in a year. Besides, it also covers investment income, current transfers.
Q. 4. Write down the components of current transfers?
Ans: Current or net transfers are the transfers without repayment obligations. Donations, aids and grants, official assistance, and pensions are the main components of current transfers.
Q. 5. What do you know by investment income?
Ans: When a economy invest its surplus in the other economy as investment, it receives investment income in future on current account. It includes dividends, investment income, interests, migrants remittance.
In short, this is an overview of the economic term balance of payments.
Understanding capital formation
Visible and invisible trade balance
Currency market and convertibility