As a child, you must have often seen your parents settling accounts and keeping tabs on small expenditures. You must have seen them set aside reserves, keep a record of all transactions and purchases, and tally their accounts and statements to ensure they are all set for the month or the quarter. Now apply this scenario to the country as a whole. And that’s Balance of Payments in layman terms.
Balance of Payments
The Balance of Payments or BoP is a statement or record of all monetary and economic transactions made between a country and the rest of the world within a defined period (every quarter or year). These records include transactions made by individuals, companies and the government. Keeping a record of these transactions helps the country to monitor the flow of money and develop policies that would help in building a strong economy.
In a perfect scenario, the Balance of Payments (BoP) should be zero. That is, the money coming in and the money going out should balance out. But that doesn’t happen in most cases. A country’s BoP statement correctly indicates whether the country has a surplus or a deficit of funds. A BoP surplus indicates that a country’s exports are more than its imports. A BoP deficit, on the other hand, indicates that a country’s imports are more than exports. Both scenarios have short-term and long-term effects on the country’s economy.
Components of BoP
Now let’s understand the different components of the BoP. The BoP consists of three main components—current account, capital account, and financial account. As mentioned earlier, the BoP should be zero. The current account must balance with the combined capital and financial accounts.
The current account monitors the flow of funds from goods and services trade (import and export) between countries. Now this includes money received or spent on manufactured goods and raw materials. It also includes revenue from tourism, transportation receipts, revenue from specialized services (medicine, law, engineering), and royalties from patents and copyrights. In addition, the current account includes revenue from stocks.
The capital account monitors the flow of international capital transactions. These transactions include the purchase or disposal of non-financial assets (for example, land) and non-produced assets. The capital account also includes money received from debt-forgiveness and gift taxes. In addition, the capital account records the flow of the financial assets by migrants leaving or entering a country and the transfer, sale, or purchase of fixed assets.
The financial account monitors the flow of funds pertaining to investments in businesses, real estate, and stocks. It also includes government-owned assets such as gold and Special Drawing Rights (SDRs) held with the International Monetary Fund (IMF). In addition, it includes foreign investments and assets held abroad by nationals. Similarly, the financial account includes a record of the assets owned by foreign nationals.
Why is BoP important?
The BoP statement provides a clear picture of the economic relations between different countries. It is an integral aspect of international financial management. Now that you have understood BoP and its components, let’s look at why it is important.
To begin with, the BoP statement provides information pertaining to the demand and supply of the country’s currency. The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries. Next, the country’s BoP determines its potential as a constructive economic partner. In addition, a country’s BoP indicates its position in international economic growth.
By studying its BoP statement and its components closely, a country would be able to identify trends that may be beneficial or harmful to the economy and take appropriate measures.