Balance of Payment: Definition, Components & Importance

 

What is Balance of Payment (BoP)

According to Prof.Kindle Berger, "Balance of payments is the systematic record of all the transactions of a nation's residents with the rest of the world during a particular period, usually a year."

It provides insights into the economic dealings of a country, including trade in goods and services, financial transfers, and capital flows. For this purpose, a country must maintain a record of all the import payments and export receipts, known as the balance of payments. 

In simpler terms, the BOP shows how much money is flowing into and out of a country. It helps policymakers, economists, and investors assess the country’s economic position, including its trade relationships and financial health.

   

Components of Balance of Payment

The balance of payment is divided into three parts,

1. Current Account

2. Capital Account 

3. Financial Account

1. Current Account 

• It is the difference between imports and exports of goods and services.
• Earnings from investments, like dividends and interest, or wages from abroad.
• Transfer of money where no exchange of goods and services like remittance, foreign aid, etc.
• Exports and imports of services like travel, transportation, insurance, and financial services.

2. Capital Account

The capital account consists of the inflow and outflow of short-term capital and long-term capital as direct foreign investment, portfolio investment, public investment, etc. Non-produced and non-financial assets with net capital transfers are presented in the capital account. It records the net change in ownership of national assets.

3. Financial Account

The financial account tracks investments that cross borders. This includes:

• Direct foreign Investments in real estate, businesses, or infrastructure.
• Loans, deposits, or other financial instruments that represent capital flows.
• Changes in a country's reserves of foreign currencies and gold held by its central bank.

The assets include direct investments, securities like stocks, bonds, gold, and hard currency commodities.

                         BoP =  current account +  financial account  

The capital account is assumed to be a subgroup of the financial account

How Balance of Payment is Balanced

When any country invests in another country, it's considered as money leaving the country. But if that investment is sold, the profit counts as money coming in; it is a balanced condition of balanced payment. For example, the United States' total imports are $2 trillion and exports are $1.5 trillion, meaning imports are more than exports, and the current account deficit is $500 billion. The U.S. finances this deficit by attracting foreign capital, the companies invest $500 billion in different sectors of the U.S. The capital account is in a surplus of $500 billion.

In this case, the capital and financial account surplus of $500 billion offset the current account deficit, balancing the BoP.

Balance of Payments' Relation to Economic Stability

The balance of payments is closely linked to economic stability. A balanced BoP supports stability by reflecting a sustainable economic structure and providing resources for growth. A healthy BOP often means that a country can build up its foreign exchange reserves. These reserves are essential for stabilizing the currency, managing international debt obligations, and mitigating the effects of economic shocks.

BoP Surplus or Deficit

Actually, every balance of payments should be zero; there are still what are known as balance of payment deficits and surpluses.

Deficit: A balance of payment is a deficit when the imports of a country are more than its exports; in this situation, currency appreciation decreases foreign exchange reserves, and it depends on borrowing from other countries.

Surplus: A country exports more than its imports is a situation in which the country does not depend on other countries because it produces enough capital. Surplus indicates a strong economy in which foreign exchange reserves increase, currency value, and investors' confidence are also increased.

Importance of BoP

The balance of payment provides a clear picture of the country's inflow and outflow of goods, services, and assets. A country with a current account surplus is likely to see its currency appreciate because there is a higher demand for its currency from foreign buyers of its goods and services.

A consistent BOP surplus (exports > imports) indicates a strong economy, while a deficit (imports > exports) can be a warning sign of economic instability. The BOP has a direct impact on a country’s currency value. 

Governments use BOP data to shape economic policies. For example, a persistent trade deficit may prompt a country to implement protectionist measures, like tariffs or subsidies, to reduce imports.

Causes of Deficit Balance of Payment

• The currency's depreciation causes the deficit because the cost of producing goods increases due to depreciation. Exports become cheaper, and imports become expensive, resulting in an unfavorable balance of trade.

• In underdeveloped countries, research and development have traditionally been a low priority,  due to a lack of innovation and technology, and imports are more than exports, which affects the whole economy.

• Frequent government changes have created uncertainty in the country. An unstable tax structure can lead to reduced foreign investment. The import duties on raw materials are so high that they raise the country's production cost. There are many taxes, and these taxes have high rates, which tend to decrease exports.

Measures to Improve Balance of Payment

• Cheaper exports and expensive imports should improve the current account, and the government should pay attention to producing import substitutes in the country.

• Devaluation is the lowering of the value of the home currency in terms of foreign currencies. When the value of the home currency is low, the import of goods and services becomes expensive. The exporting of goods becomes cheaper for other countries.

• The government should tighten the policies that will lead to a slowdown in consumer spending, reducing imports, and improving the current account.

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Related topic: What is a balance of trade