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BALANCE OF PAYMENTS

Balance of payments is a statistical statement that systematically summarizes, for a specific time
period, the economic transactions of an economy with the rest of the world.
The BALANCE OF PAYMENTS helps in monitoring the flow of money and developing the
economy.

Components of Balance of payments

The balance of payments has three components:

 The current account


 The capital account
 The financial account. 
Current account

Current account covers the transactions other than those in financial items that involve economic
values and occur between resident and nonresident entities. The current account is divided into
four main components, which record the transactions of a country's capital markets, industries,
services, and governments. The four components are:

1. Balance of trade in goods. Tangible items are recorded here.


2. Balance of trade in services. Intangible items like tourism are recorded here.
3. Net income flows (primary income flows). Wages and investment income are examples
of what would be included in this section.
4. Net current account transfers (secondary income flows).Government transfers to the
United Nations (UN) or European Union (EU) would be recorded here.

The current account balance is calculated using this formula:

Current Account = Balance in trade + Balance in services + Net income flows + Net current
transfers

The current account can either be in a surplus or deficit.

Current account surplus

When the country’s outflow is more than the inflow, meaning that the rest of the world owes
more to it than what is owed by said country, it is said to have a Current Account Surplus. The
surplus shows a growth in the net assets of the country (Net assets = Assets-Liabilities).
If the current account balance is positive, it shows a current account surplus. Generally, Net
exports (X-M) is the main determinant of the current account balance.

Current Account Deficit

A current account deficit is when a country's residents spend more on imports than they save.
Other countries lend funds or invest in the deficit country's businesses to fund that national
deficit. The lender country is usually willing to pay for the deficit because its businesses profit
from exports to the deficit country. In the short run, the current account deficit is a win-win for
both nations.

But if the current account deficit continues for a long time, it will slow economic growth.
Foreign lenders will begin to wonder whether they will get an adequate return on their
investment. If demand falls off, the value of the borrowing country's currency may also decline.
This fall in currency value leads to inflation as import prices rise. It also creates higher interest
rates as the government must pay higher yields on its bonds

Capital account

The capital account determines the position of a country whether it is a borrower or lender. 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.

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 financial account is split into three main parts:

1. Direct investment. This records the net investments from abroad.


2. Portfolio investment. This records financial flows such as the purchasing of bonds.
3. Other investments. This records other financial investments such as loans.

Importance of balance of payments for a Country


The balance of payments of the country is important for the following reasons:
 The balance of payments of the country reflects its financial and economic status.
 The balance of payments statement can be used as an indicator to determine whether the
value of a country's currency is rising or falling.
 The balance of payments statement helps the government to decide on financial and trade
policies.
 It provides valuable information for the analysis and understanding of international
economic cooperation.

What does a Country’s Balance of Payments Statement Indicate?

The Balance of Payments statement of a country indicates whether it has a deficit or surplus of
funds. For instance, if a country’s export is higher than its import, then there is a surplus in the
balance of payments. 

However, a Balance of Payments deficit can arise if a country’s imports amount to more than its
total exports. The transactions recorded in a Balance of Payments statement follow the same
rules as that of a double-entry accounting system. That is, every transaction has debit, and credit
entries made corresponding to each other.

Balance of Payment Deficit

A balance of payment deficit in a country can arise if said country imports more capital, goods
and services than it exports. 

Balance of payment deficit is given by – (Current account + capital account receipts) < (current
account + capital account payments)

This Balance of Payments deficit can be balanced by utilizing the country’s foreign exchange
reserves to meet the Balance of Payments shortfall. 

Following are a few crucial points to remember about the Balance of Payments deficit in a
country

1. A Balance of Payments deficit can be corrected through an official reserve sale which
denotes the sale of foreign exchange by the Reserve Bank.
2. The monetary authorities of a country are the financiers when any deficit arises in the
country’s balance of payment. Conversely, they are also the recipients when there is a
surplus in the country’s Balance of Payments.
3. An overall decrease in a country’s official reserves signifies a deficit in balance of
payments.
4. Official reserve transactions can be accounted for only under the regime of fixed
exchange rates. They cannot be considered when exchange rates are floating.
What is Balance of Payment Surplus?

Balance of payments surplus occurs when a country’s total exports are higher than its imports.
This helps to generate capital to fund its domestic productions. With a surplus in its Balance of
Payments, a country can also lend funds outside its borders.

Balance of payment surplus occurs when – 

(Current account + capital account receipts) > (current account + capital account payments)

A surplus in Balance of Payments can help to boost the short term economic growth of a country
Balance of trade Balance of payments

                                                                Definition

Balance of trade is a financial statement Balance of payment is a financial


that captures the nation’s import and statement that keeps track of all the
export of commodities with the rest of the economic transactions by the nation
world. with the rest of the world.

                                                            What does it deal with?

It deals with the net profit or loss that a It deals with the proper accounting of
country incurs from the import and export the transactions conducted by the
of goods. nation.

                                                        Fundamental Difference

Balance of trade is the difference that is Balance of payments (Balance of


obtained from the export and import of Payments) is the difference between
goods. the inflow and outflow of foreign
exchange.

                                                          Type of transactions included

Transactions related to goods are included Transactions related to transfers,


in Balance of trade. goods, and services are included in
Balance of Payments.

                                                          Are capital transfers included?

No Yes

                                                            What is its net effect?

The net effect of Balance of trade can be The net effect of Balance of Payments
either positive, negative, or zero. is always zero.

 Balance of payments problems


Trade in goods and services typically forms the largest part of an economy’s current account.
The current account also includes primary and secondary income flows.

Primary income refers to international payments to factors of production, such as investment


income and compensation to employees. Secondary income includes transfer payments flowing
between countries, such as personal remittances, pension payments and overseas aid.

Is a current account deficit a problem?

A deficit can be a problem under certain circumstances, including the following:

1. It is a persistent deficit that does not self-correct over time.


2. The deficit forms a large share of GDP.
3. There are no compensating inflows of investment income or inward capital account
flows.
4. The central bank has low reserves.
5. The economy has a poor record of repaying debt.

Causes of a current account deficit

There are several possible causes of a persistent current account deficit, including the following:

Excessive growth

When national income rises above its trend rate it is likely that income elasticity of demand for
luxury imports such as motor cars is relatively high, so that imports rise relative to exports.

DE-industrialization

An increasing trade deficit may be a symptom of long-term DE-industrialization. 

High export prices

High export prices will occur if a country’s inflation is higher than its competitors, or if its
currency is over-valued which will reduce its price competitiveness.

Non-price competitiveness

Non-price factors can discourage exports, such as poorly designed products, poor marketing or a
worsening reputation for reliability.

Low levels of investment in human capital

This involves a lack of investment in education and training, which reduces skill levels relative
to competitor countries and forces countries to produce low value exports.
Poor productivity

An economy might not be producing enough from its scarce factors of production. Labour
productivity, which is defined as output per worker, plays an important role in a
country’s competitiveness and trade performance

Low levels of investment in real capital

This could be caused by excessive long-term interest rates, or low levels of research and
development.

Low levels of investment in human capital

This involves a lack of investment in education and training, which reduce skill levels relative to
competitor countries and force countries to produce low value exports.

Policies to reduce a deficit

There are four basic strategies for dealing with a persistent deficit.

1. Deflating demand

Deflating demand means deliberately reducing consumer spending, or reducing its rate of


growth, through fiscal contraction, such as raising direct taxes,  or by monetary contraction, such
as raising interest rates or reducing the availability of credit.

As a by-product of this, imports are also likely to fall, hence deflating demand is said to work by
a process called expenditure reduction
The cross diagram

The cross diagram can be used to illustrate how deflation works. The cross diagram shows the
relationship between injections and withdrawals and national income, Y.

The export line is horizontal because it is determined by overseas GDP and not domestic GDP.

2. Devaluation

The second policy option to improve the current account is devaluation, which involves the
deliberate reduction in the value of a country’s currency. It works by expenditure switching,
which means that the policy encourages consumers to alter the distribution of their spending,
rather than the total level of spending.
Devaluation will stimulate export revenue and reduce import spending, hence closing the trade
gap.

3. Direct controls

A third option to help reduce a current account deficit is to impose direct controls on imports by
erecting barriers against imports or by providing assistance to exporters.

Specific measures include:

 Tariffs
 Non-tariff barriers, such as quotas, subsidies to domestic firms and discrimination against
imports and in favour of domestic firms.

4. Supply-side policy

Finally, supply-side policy could be used to help improve an economy’s ability to produce. There


are several actions that a government can take to improve supply-side performance. These
measures include improving labour productivity and labour market flexibility.

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