International Business - Balance of Payments

Balance of Payments

            Balance of Payments, according to Reserve Bank of India is a statistical statement that systematically summarizes for a specific period of time, the economic transactions of an economy with the rest of the world. International flow of goods, services and capital affect the balance of international payments and foreign exchange position of a country. The IMF describes BOP as a statistical statement for a given period showing:

• Transactions in goods and services and income between an economy and the rest of the world
• Changes of ownership and other changes in that country’s monetary gold, Special Drawing Rights (SDRs) and claims on liabilities to the rest of the world
• Unrequited transfers and counterpart entries that are needed to balance in the accounting sense, any entries for the foregoing transactions and changes which are not mutually offsetting

Importance of Balance of Payment:

• Reveals a country’s financial and economic status
• An indicator to determine whether the country’s currency value is appreciating or depreciating
• Helps the government to decide on fiscal and trade policies
• Provides information to analyze and understand the economic dealings of a country with other countries

Components of Balance of Payment:

            Balance of Payment transactions are recorded in standard double-entry book-keeping with credit and debit entries which are generally grouped under the following heads:

Current Account includes all transactions that give rise to or use of national income. This account covers all the receipts and payments made with respect to raw materials and manufactured goods; also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. It could be visible (trading in goods) or invisible trading (import/export of services such as banking, shipping, information technology, insurance), unilateral transfers or other payments/receipts.  It consists of:

• Merchandise exports and imports – Purchase and sale of goods
• Invisible exports and imports – Purchase and sale of services
• Unilateral Transfers Account – Private remittances, government grants, reparations and disaster relief
• Income receipts and Payments – Rent on property, interest on capital, and profits on investments

    When all the goods and services are combined, together they make a country’s Balance Of Trade (BOT). There is a trade deficit when imports are higher than exports and a trade surplus when exports are higher than imports.

Capital Account consists of short-term and long-term capital transactions.  The capital account is used to finance the deficit in the current account or absorb the surplus in the current account. Capital transactions include 

• loans and borrowings (both public and private sector),
• investments in the corporate stocks or real estates by non-residents,
• the purchase and sale of fixed assets,
• changes in foreign exchange reserves maintained by the central bank to control the exchange rate

Balance of Payments – Equilibrium and Disequilibrium:

            The balance of payments of a country is said to be in equilibrium when the demand for foreign exchange is exactly equivalent to the supply of it. If the demand is either surplus or deficit, the balance of payments is said to be in disequilibrium. There are a number of factors that may cause disequilibrium in the balance of payments.

• Economic factors: Large scale development expenditures, cyclical fluctuations of business activity, high aggregate demand, higher domestic prices, exhaustion of productive resources, changes in transport routes or cost, development of alternative sources of supply
• Political factors: Political instability, changes in world trade route due to war or trade agreements
• Sociological factors: Changes in tastes, preferences and fashions

            The balance of payments deficit can be corrected by adjusting the price, interest rates and income. Also, by monetary measures such as monetary expansion/contraction, devaluation and exchange control, trade measures such as export promotion and import control and by measures such as tourism development, incentives for foreign investments and remittances can be undertaken to correct the deficit in balance of payments.