Table of Contents
- What is the balance of payments (BOP)?
- Components of the balance of payments
- The balancing act
- Importance of the balance of payments
- Balance on current account
- Balance of payment deficit and surplus
- Balance of payments crisis
- Balance of trade (BOT)
- Balance of trade vs balance of payments
- Frequently asked questions
What is the balance of payments (BOP)?
The balance of payments refers to a statement or record that provides information regarding all the transactions that took place between a country and the entire world over a definite period of time. This period of time can be quarterly or yearly. In other words, it is the method a country adopts in order to monitor every international monetary transaction over a definite period of time. A country accounts for every trade that both the private and public sectors conduct in the balance of payments to ascertain the amount of money that is going in and out of the country. If money enters the country (receipts), we refer to it as a credit. On the other hand, if the money goes out of the country (payments), we count the transaction as a debit.
In theoretical terms, the balance of payments should be equal to zero. This means that there should be a balance between assets (credits) and liabilities (debits) although this is rarely the case practically. The BOP can signify to the observer whether a country is facing a deficit or a surplus and the part of the economy from which discrepancies are stemming. For instance, if the export of a country exceeds its imports, then there is a surplus in the balance of payments. On the other hand, a balance of payment deficit can come about when the imports of a country exceed its total exports. So, every transaction recorded in the balance of payments account follows the same rule as that of a double-entry accounting system.
In essence, the BOP transactions comprise imports and exports of goods, services, and capital. It also includes transfer payments such as foreign aids and remittances. The balance of payments of a country alongside its net international investment position makes up its international accounts.
Practically, statistical discrepancies come about as a result of the difficulty that arises in counting every transaction that takes place between an economy and the rest of the world including discrepancies that foreign currency translations cause. This, therefore, makes it difficult to accurately count these international transactions.
From all indications, the balance of payments is a relevant metric that economies and nations are dependent upon in determining their economic status in the international markets. It tells whether a country saves sufficient funds to pay for its imports and whether it has the capacity to produce enough output to cover the costs that have to do with economic growth.
Components of the balance of payments
The BOP comprises three main components with subdivisions within these components that help to account for a different type of monetary transaction. The three major components are;
- Current account
- Capital account
- Financial account
A) The current account
Analysts use the current account to mark the goods and services that flow in and out of the country. This account also includes earnings on investments of both public and private sectors. Debits and credits on the trade merchandise are in the current account which includes raw materials and finished goods bought, sold, or given away probably in the form of aid. Services make reference to receipts from tourism, transportation, engineering, business service fees such as lawyers, and royalties from patents and copyrights.
Combining goods and services together makes up the balance of trade of a country. The balance of trade is typically the largest bulk of a country’s balance of payments because it makes up the total imports and exports. A country’s balance of trade deficit implies that its imports surpass its exports. On the other hand, surplus implies that exports surpass imports. Analysts record receipts from income-generating assets such as stocks in the form of dividends in the current account.
One component is the trade balance or balance of trade which measures the exports and imports of a country. In fact, this forms the largest component of the balance of payments. Most countries make efforts to avoid a trade deficit although this is a good thing for emerging market countries because it helps them to grow faster than they could if they maintained a surplus. Other components include trade in goods which are the visible balance, trade in services which are the invisible balance, investment incomes, and net transfers.
B) The capital account
The capital account records all international transfers. This makes reference to the acquisition or disposal of non-financial assets, that is physical assets such as land and non-produced assets which are necessary for production but are yet to be produced such as mines used for extracting diamonds.
The capital account is where all international capital transfers are recorded which includes transactions that involve non-financial assets or non-produced assets necessary for production but yet to be produced, e.g, a mine used for extracting gold.
The capital account is sub-divided into monetary flows that branch from debt forgiveness, goods transfer, and financial assets of migrants that are going in or out of the country, ownership transfer of fixed assets such as equipment in carrying out production for the generation of income, the transfer of funds received from the sale or acquisition of fixed assets, gifts, inheritance taxes, and damages to fixed assets that are uninsured.
C) The financial account
The financial account records changes in the domestic ownership of foreign assets and foreign ownership of domestic assets. This implies international flows that relate to business investments, special drawing rights (SDRs) a country holds with the International Monetary Fund (IMF), direct foreign investment, etc. If foreign ownership increases at a higher rate than domestic ownership, it brings about a deficit in the financial account. The increase signifies the country is selling its assets such as gold, commodities, and corporate stock faster than the nation’s acquisition of foreign assets.
The balancing act
A country should balance the current account against the combined capital and financial accounts. However, this is rare as we have seen above. It is also important to note that with fluctuations in exchange rates, the change in the value of money can add to the balance of payments discrepancies.
If a country has a fixed asset abroad, then it should mark this borrowed account as a capital account outflow. However, if the country sells that fixed asset, then it should be considered a current account inflow, which is earning from investments. Thus, it should fund the current account deficit.
When a country has a current account deficit that the capital account finances, it is actually foregoing capital assets for more goods and services. If a country borrows money to enable it to fund its current account deficit, it refers to a foreign inflow of capital in the BOP.
Importance of the balance of payments
The balance of payments and its components is relevant in the understanding of a nation’s financial and economic position. It helps to indicate whether there is depreciation or appreciation of the currency. Also, many financial professionals performing roles of investment management, government policy formulation, federal banking, etc., make use of a nation’s balance of payments to direct their research, analysis, and policy development as well as strategies that support the growth of a nation. These importance include;
- Developing trade policies
- Establishing fiscal objectives
- Implementing growth strategies
- Analyzing deficits
- Investing with surplus
The BOP can be of great importance in terms of decision-making at the national level. Professionals who include federal accountants, economists, policymakers, and others make use of the data from a national balance of payments to make decisions with regard to ways of adapting production and exportation to increasing and decreasing price levels, interest rates, inflation rates, and employment rates.
Developing trade policies
Government authorities make reference to the balance of payments to develop policies with regard to trade since the data gives information regarding economic transactions between one country and the rest of the world. The insights that economists can gain from the balance of payments help them in identifying trends that are beneficial and trends that are harmful. This provides room for them to create trade policies that help a nation in arriving at important objectives and support economic growth.
Establishing fiscal objectives
Governments depend on the data from the balance of payments to set important objectives that help their nations to attain positive economic development. For example, if a county is experiencing a deficit, it depends on its balance of payments to adopt strategies of getting out of its deficits. These objectives can include an increase in production on a gross domestic product in high demand, borrowing from another nation as well as making trade agreements with other nations. Fiscal objectives, therefore, help a country to have a better understanding of its economic and financial growth.
Implementing growth strategies
Through the balance of payments, governments can understand the areas of focus in order to attain their fiscal objectives as well as consistent economic growth. When governments analyze the balance of payments data, they have an insight into adopting strategies that help support the growth of their nations as well as their status in international markets. Also, it is important for a nation to understand whether it is in deficit or surplus because it is helpful in developing the most effective and beneficial growth strategies.
The balance of payments is essential for highlighting whether a country is in deficit or surplus. When economists analyze the data in the balance of payments, they have a better understanding of the reasons behind a nation’s deficit and then develop ways of solving it. To add to it, using the information from the balance of payments to analyze deficits helps economists to better allocate domestic funds to get out of its deficit and achieve growth. This metric helps nations to determine their economic relationships with other countries.
Investing with surplus
Just the way the balance of payments helps economists in analyzing deficits, it also helps them in determining how to invest surpluses into productive use. A nation with surpluses in gross domestic product and other assets can reinvest funds into its economy. This makes more jobs, resources, domestic goods and services, and other domestic assets to be available. Countries that have a balance of payments surpluses may decide to provide assistance to countries that are in deficit.
Balance on current account
The balance on the current account is the record of the international transactions that a country engaged in with the rest of the world. The current account includes every transaction that has to do with economic values and takes place between entities within the country and those outside the country. The metric also covers offsets to current economic values provided without receiving a reward or favor in return. In essence, the balance on the current account measures the inflow and outflow of goods, services, investment incomes, and transfer payments.
Balance of payment deficit and surplus
Balance of payments deficit refers to a situation whereby the residents of a country spend more on imports than they save. Here, other countries invest in the businesses of the deficit countries or lend money to them to enable them to fund their national deficit. In other words, a deficit means that the value of imports exceeds that of exports. Most times, the reason why the lender nation is always willing to pay for the deficits is the profits it generates from exports to the deficit country. However, the current account deficit is a win-win for both nations. But if this deficit persists for a prolonged period, then economic growth will slow down. This will make foreign investors start wondering if they will get an adequate return on their investment. The value of the currency of the borrowing country will fall correspondingly as demand falls off.
This implies that the current account deficit may bring about depreciation as a greater demand for imports and foreign currency is in place. By implication, foreign investors have a greater claim on assets and dividends. The fall in the value of the currency will then lead to inflation as import prices rise. Also, interest rates rise because the government must pay higher on its bonds. A current account deficit signifies that the economy is not competitive. In turn, consumers prefer to buy cheaper imports than domestic goods.
A current account deficit is beneficial at some point because it gives room for higher levels of domestic consumption than otherwise because the deficit country is buying from abroad.
- The balance of payment deficit becomes a problem when;
- It becomes persistent that does not correct itself over time.
- When it forms a larger share of the country’s gross domestic product.
- When compensating investment income inflows or inward capital outflows become absent.
The causes of the balance of payments deficit include;
- Excessive growth, where the economy grows too quickly and rises above its own trend rate.
- De-industrialization, where a country starts losing its manufacturing base.
- High export prices, when the country’s inflation exceeds that of its competitors.
- Non-price competitiveness can discourage exports which include poor marketing strategies, a poor reputation for reliability, poor product design.
- Poor productivity where a country may not be producing adequately from its scarce factor inputs.
- Political instability
- When the country does not invest adequately in human capital such as education and training. The levels of skills will decline in comparison to competitor countries and then countries are forced to produce exports of low value.
- Low investments in real capital, can come about as a result of long-term interest rates and poor research and development.
The balance of payments surplus occurs when a country exports goods and services more than it imports. In other words, the balance of payments surplus occurs when the current account plus capital current account receipts are greater than the current account plus capital account payments. When this happens, such countries will be able to generate capital to help in funding their domestic productions. When a country is in surplus, it lends to other countries especially those with deficits.
A surplus in the balance of payments can help in boosting the short-term growth in a country’s economy.
Balance of payments crisis
The balance of payments crisis also refers to a currency crisis. It occurs when there is an inability of a nation to pay for essential imports or service its external/public debt repayments. Typically, what follows is a rapid decline in the value of the currency of the affected nation. This crisis usually comes after large inflows of capital which at first have to do with rapid economic growth.
However, the country gets to a point whereby foreign investors become concerned about the level of debt their inbound capital is generating. In turn, this makes them pull out their funds. The outbound capital flows have to do with a rapid fall in the affected nation’s currency value. this brings about issues for the affected nation’s firms who have received the inbound investments and loans as those firms typically derive their revenue mostly domestically while their debts are usually dominated in a reserve currency.
The policy options of a nation become extremely limited as soon as it exhausts its foreign reserves trying to support the value of its domestic currency. It can then raise its interest rates in order to prevent further declines in its currency value. Although this action is helpful to those with debts dominated in foreign currencies, it further pushes the local economy into economic depression.
Balance of trade (BOT)
Balance of trade refers to the difference between the value of the goods a country exports and the value of the goods that it imports in a definite period of time. It forms the largest component of the balance of payments of a country. Sometimes, the balance of trade between a country’s goods and the balance of trade between its services fall into two separate figures. We can refer to the balance of trade as trade balance, commercial balance, net exports, or the international trade balance.
If a country imports more goods and services than it exports in terms of value, it has a trade deficit. On the other hand, if the country exports more goods and services than it imports, then it has a trade surplus.
Analysts calculate the balance of trade by simply subtracting the total value of imports from the total value of exports. They use this metric to measure a country’s economic relative strength. So, if a country exports more goods and services than it imports, then it has a surplus which is a positive balance of trade. On the other hand, if a country imports more goods and services than it exports, then it has a deficit which is a negative balance of trade.
Also, a country with a large trade deficit borrows funds to pay for its goods and services. On the other hand, a country with a large trade surplus lends money to countries that are experiencing deficits. There are cases whereby the balance of trade of a country may have a correlation with its political and economic stability because it reflects the amount of foreign investment in the country.
In the account, debit items include imports, foreign aids, domestic spending abroad, and domestic investments abroad while credit items include exports, foreign spending in the domestic economy, and foreign investments in the domestic economy. So, when economists subtract the debit items from the credit items, they will arrive at either a trade deficit or surplus for a particular country over a definite period of time either monthly, quarterly, or yearly.
Balance of trade vs balance of payments
Every country in the world tries to keep track of its economic activities with the help of the balance of trade and balance of payments. They both reflect the actual position or condition of a specific economy. The balance of trade only reveals a partial picture of an economy while the balance of payments reveals the complete view of the economy of a country.
The differences between the balance of trade and balance of payments are as follows;
The major difference between these two metrics lies in the records they keep. Balance of trade keeps a record of the country’s import and export of commodities with the rest of the world in a definite period of time. On the other hand, the balance of payments keeps a record of every economic transaction that a country engages in with the rest of the world in a definite period of time. In other words, the balance of trade does not include the import and export of services, it only deals with the transaction of tangible goods. The balance of payments is broader as it includes the balance of trade, the balance of services, the balance of unilateral transfers, and the balance of payments on capital account.
The balance of trade is the major component of the balance of payments in the section of the capital account.
Balance of trade deals with a country’s profit or loss from the import or export of goods. On the other hand, the balance of payments has to do with the proper accounting of transactions that a country conducts.
The balance of trade shows the differences between the imports and exports of goods. Balance of payments on the other hand is the difference between the inflow and outflow of a country’s foreign exchange.
In the balance of trade, the transactions only relate to goods while in the balance of payments, the transactions relate to goods, services, and transfer payments.
Capital transfers are not included in the balance of trade but they are included in the balance of payments.
The net effect of the balance of trade can either be positive, negative, or zero while the net effect of the balance of payments is usually zero.
Frequently asked questions
What is the formula for the balance of payments?
The mathematical expression of the balance of payments is;
BOP = Current account + Financial account + Capital account + Balancing item.
What is balance of payment and its importance?
The balance of payments refers to a statement or record that provides information regarding all the transactions that took place between a country and the entire world over a definite period of time. It is important in the following areas;
- It helps countries in decision-making.
- Countries can develop trade policies using the BOP data.
- Governments can set up important objectives using the BOP data thereby establishing fiscal objectives
- Aside from establishing fiscal objectives, countries can implement growth strategies
- Analyzing deficits
- Investing with surplus