What Is The Balance Of Payments?

The balance of payments (BOP) is the method countries use to monitor all international monetary
transactions at a specific period. Usually, the BOP is calculated every quarter and every calendar
year. All trades conducted by both the private and public sectors are accounted for in the BOP to
determine how much money is going in and out of a country. If a country has received money, this
is known as a credit, and if a country has paid or given money, the transaction is counted as a debit.
Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should
balance, but in practice, this is rarely the case. Thus, the BOP can tell the observer if a country has
a deficit or a surplus and from which part of the economy the discrepancies are stemming.

Importance of Balance of Payments

As pointed out above, Balance of Payments is a very important record of financial transactions
and status of any nation and its economy. It highlights the direction of economic growth or
otherwise of any country and is a ground on which many important policy decisions are based.The
balance of Payment’s importance can be gauged from the following points:

 It analyses the business transactions of any economy into exports and imports of goods and
services for a particular financial year. Here, the government can identify the areas that have
the potential for export-oriented growth and can formulate policies supporting those
domestic industries.
 The government can adopt some protective measures such as higher tariff and duties on
imports so as to discourage imports of non-essential items and encourage the domestic
industries to be self-sufficient.
 If the economy needs support in the form of imports, the government can formulate
appropriate policies to divert the funds and technology imported to the critical sectors of the
economy that can drive future growth.
 If the country has a flourishing export trade, the government can adopt measures such as
devaluation of its currency to make its goods and services available in the international
market at cheaper rates and bolster exports.
 The government can also use the indications from Balance of Payments to discern the state
of the economy and formulate its policies of inflation control, monetary and fiscal policies
based on that.

What does it mean to have a surplus or a deficit in the Balance of Payments?

 Ideally, a Balance of Payments should always balance or tally. That means the debit
(receipt) and payment (credit) side should be equal. But this scenario hardly materializes
with any country because there will always be some amount of imbalance between
international receipts and payments due to a country’s economic policies or fluctuations in
currency exchange rates.

 If the payments are more than the receipts, that shows a ‘Deficit’ in the Balance of
Payments. It signifies that the country is importing more goods and services than it is
 exporting. This leads to an imbalance in the Balance of Payments which is transferred to
the capital account.

 In the capital account is deficit is adjusted either against the reserves of foreign currency
or by taking loans from abroad. These loans, then, have to be used for creating and
developing infrastructural facilities that will boost production in the country. Increased
production will lead to increased exports and will bring in more revenues in foreign
exchange and the deficit can be nullified.

 If, on the other hand, a country fails to utilize the foreign loans and disbursements in order
to strengthen its economic growth, then it will continue to reply on imports for satisfying
its needs which will lead to the ever-increasing deficit in its Balance of Payments. Due to
this, this country will, in the end, be forced to liquidate some of its assets such as mines,
land and other precious natural resources to sustain its economy and repay the foreign
debts.

 Surplus, on the other hand, shows a country’s prosperity. It shows that the country is able
to satisfy its needs and is able to sell its products abroad earning huge reserves of foreign
currency. However, to maintain parity in international trade, the citizens of this country
will have to demand more goods and services in order to keep the monetary cycle flowing
and intact.

The Balance of Payments Divided

The BOP is divided into three main categories: the current account, the capital account, and the
financial account. Within these three categories are sub-divisions, each of which accounts for a
different type of international monetary transaction.

The Current Account: The current account is used to mark the inflow and outflow of goods and
services into a country. Earnings on investments, both public and private, are also put into the
current account. Within the current account are credits and debits on the trade of merchandise,
which includes goods such as raw materials and manufactured goods that are bought, sold or given
away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the
levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business
service fees (from lawyers or management consulting, for example) and royalties from patents and
copyrights. When combined, goods and services together make up a country's balance of
trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes
up total imports and exports. If a country has a balance of trade deficit, it imports more than it
exports, and if it has a balance of trade surplus, it exports more than it imports.

Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded
in the current account. The last component of the current account is unilateral transfers. These are
credits that are mostly worker's remittances, which are salaries sent back into the home country of
a national working abroad, as well as foreign aid that is directly received.
The Capital Account: The capital account is where all international capital transfers are recorded.
This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such
as land) and non-produced assets, which are needed for production but have not been produced,
like a mine used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from debt forgiveness, the
transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of
ownership on fixed assets (assets such as equipment used in the production process to generate
income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance
taxes, death levies and, finally, uninsured damage to fixed assets.

The Financial Account: In the financial account, international monetary flows related to
investment in business, real estate, bonds and stocks are documented. Also included are
government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with
the International Monetary Fund (IMF), private assets held abroad and direct foreign investment.
Assets owned by foreigners, private and official, are also recorded in the financial account.

The Balancing Act: The current account should be balanced against the combined-capital and
financial accounts; however, as mentioned above, this rarely happens. We should also note that,
with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies.
When there is a deficit in the current account, which is a balance of trade deficit, the difference
can be borrowed or funded by the capital account.

If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow.
However, the sale of that fixed asset would be considered a current account inflow (earnings from
investments). The current account deficit would thus be funded. When a country has a current
account deficit that is financed by the capital account, the country is actually foregoing capital
assets for more goods and services. If a country is borrowing money to fund its current account
deficit, this would appear as an inflow of foreign capital in the BOP.

IMBALANCES
While the BOP has to balance overall, surpluses or deficits on its individual elements can lead to
imbalances between countries. In general there is concern over deficits in the current account.
Countries with deficits in their current accounts will build up increasing debt and/or see increased
foreign ownership of their assets. The types of deficits that typically raise concern are:
1. A visible trade deficit where a nation is importing more physical goods than it exports
(even if this is balanced by the other components of the current account.)
2. An overall current account deficit
3. A basic deficit which is the current account plus foreign direct investment (but excluding
other elements of the capital account like short terms loans and the reserve account.)
Rebalancing by changing the exchange rate
An upwards shift in the value of a nation's currency relative to others will make a nation's
exports less competitive and make imports cheaper and so will tend to correct a current account
surplus. It also tends to make investment flows into the capital account less attractive so will
help with a surplus there too. Conversely a downward shift in the value of a nation's currency
makes it more expensive for its citizens to buy imports and increases the competitiveness of
their exports, thus helping to correct a deficit (though the solution often doesn't have a positive
impact immediately. Exchange rates can be adjusted by government in a rules based or
managed currency regime, and when left to float freely in the market they also tend to change
in the direction that will restore balance. When a country is selling more than it imports, the
demand for its currency will tend to increase as other countries ultimately need the selling
country's currency to make payments for the exports. The extra demand tends to cause a rise
of the currency's price relative to others. When a country is importing more than it exports, the
supply of its own currency on the international market tends to increase as it tries to exchange
it for foreign currency to pay for its imports, and this extra supply tends to cause the price to
fall. BOP effects are not the only market influence on exchange rates however, they are also
influenced by differences in national interest rates and by speculation.