Balance of Payment (BOP) - Concept & Definition
A statement that summarizes an economy’s transactions with the rest of
the world for a specified time period. The balance of payments, also
known as balance of international payments, encompasses all transactions
between a country’s residents and its non residents involving goods,
services and income; financial claims on and liabilities to the rest of the
world; and transfers such as gifts. The balance of payments classifies
these transactions in two accounts – the current account and the capital
account. The current account includes transactions in goods, services,
investment income and current transfers, while the capital account mainly
includes transactions in financial instruments. An economy’s balance of
payments transactions and international investment position (IIP)
together constitute its set of international accounts.
According to Kindle berger, "The balance of payments of a country is a
systematic record of all economic transactions between the residents of the
reporting country and residents of foreign countries during a given yeriod of
time".
The balance of payment record is maintained in a standard double-entry
book-keeping method.
International transactions enter in to the record as credit or debit. The payments
received from foreign countries enter as credit and payments made to other
countries as debit.
The debit side shows the use of total foreign exchange acquired in a
particular period.
The credit side shows the sources from which the foreign exchange is
acquired during a particular period.
Against every credit entry, there is an offsetting debit entry & vise-versa, so the
receipts and payments on these two sides must be equal. Hence the two sides
must necessary balance.
The individual items in the balance of payments may not balance. But the total
credits of the country must be equals to its total debits.
If there is any deficit in any individual account, it would be covered by a surplus
in other accounts, if there is any difference between total debits and total
credits, it would be settled under 'errors & omissions'. Hence in the
accounting sense, the balance of payments of a country always
balances.
Balance of Payment is a record pertaining to a period of time; usually it
is all annual statement. All the transactions entering the balance of
payments can be grouped under three broad accounts; (1) Current
Account, (2) Capital Account, and (3) Official International Reserve
Account. However, it can be vertically divided into many categories as
per the requirement.
Structure of Balance of Payment (BOP) ↓
1. Trade Account Balance
It is the difference between exports and imports of goods, usually referred as
visible or tangible items. Till recently goods dominated international trade. Trade
account balance tells as whether a country enjoys a surplus or deficit on that
account. An industrial country with its industrial products comprising consumer
and capital goods always had an advantageous position. Developing countries
with its export of primary goods had most of the time suffered from a deficit in
their balance of payments. Most of the OPEC countries are in better position on
trade account balance.
The Balance of Trade is also referred as the 'Balance of Visible Trade' or
'Balance of Merchandise Trade'.
Definition of 'Balance Of Trade - BOT'
The difference between a country's imports and its exports. Balance of trade is
the largest component of a country's balance of payments. Debit items include
imports, foreign aid, domestic spending abroad and domestic investments
abroad. Credit items include exports, foreign spending in the domestic economy
and foreign investments in the domestic economy. A country has a trade deficit
if it imports more than it exports; the opposite scenario is a trade surplus.
Also referred to as "trade balance" or "international trade balance."
2. Current Account Balance
It is difference between the receipts and payments on account of current
account which includes trade balance. The current account includes export of
services, interests, profits, dividends and unilateral receipts from abroad, and
the import of services, interests, profits, dividends and unilateral Payments to
abroad. There can be either surplus or deficit in current account. The deficit will
take place when the debits are more than credits or when payments are more
than receipts and the current account surplus will take place when the credits
are more than debits.
The difference between a nation’s savings and its investment. The current
account is an important indicator about an economy's health. It is defined
as the sum of the balance of trade (goods and services exports less
imports), net income from abroad and net current transfers. A positive
current account balance indicates that the nation is a net lender to the
rest of the world, while a negative current account balance indicates that
it is a net borrower from the rest of the world.
Definition of 'Current Account Deficit'
A measurement of a country’s trade in which the value of goods and
services it imports exceeds the value of goods and services it exports. The
current account also includes net income, such as interest and dividends,
as well as transfers, such as foreign aid, though these components tend to
make up a smaller percentage of the current account than exports and
imports. The current account is a calculation of a country’s foreign
transactions, and along with the capital account is a component of a
country’s balance of trade.
3. Capital Account Balance
It is difference between the receipts and payments on account of capital
account. The capital account involves inflows and outflows relating to
investments, short term borrowings/lending, and medium term to long term
borrowing/lending. There can be surplus or deficit in capital account. The surplus
will take place when the credits are more than debits and the deficit will take
place when the debits are more than credits.
A national account that shows the net change in asset ownership for a nation.
The capital account is the net result of public and private international
investments flowing in and out of a country. It may also refer to an account
showing the net worth of a business at a specific point in time. The capital
account includes foreign direct investment (FDI), portfolio and other
investments, plus changes in the reserve account. The capital account and the
current account together constitute a nation's balance of payments.
4. Foreign Exchange Reserves
Foreign exchange reserves (Check item No.9 in above figure) shows the
reserves which are held in the form of foreign currencies usually in hard
currencies like dollar, pound etc., gold and Special Drawing Rights (SDRs).
Foreign exchange reserves are analogous to an individual's holding of cash. They
increase when the individual has a surplus in his transactions and decrease when
he has a deficit. When a country enjoys a net surplus both in current account &
capital account, it increases foreign exchange reserves. Whenever current
account deficit exceeds the inflow in capital account, foreign exchange from the
reserve accounts is used to meet the deficit If a country's foreign exchange
reserves rise, that transaction is shown as minus in that country's balance of
payments accounts because money is been transferred to the foreign exchange
reserves.
Foreign exchange reserves (forex) are used to meet the deficit in the balance of
payments. The entry is in the receipt side as we receive the forex for the
particular year by reducing the balance from the reserves. When surplus is
transferred to the foreign exchange reserve, it is shown as minus in that
particular year's balance of payment account. The minus sign (-) indicates an
increase in forex and plus sign (+) shows the borrowing of foreign exchange
from the forex account to meet the deficit.
5. Errors and Omission
The errors may be due to statistical discrepancies & omission may be due to
certain transactions may not be recorded. For eg: A remittance by an Indian
working abroad to India may not yet recorded, or a payment of dividend abroad
by an MNC operating in India may not yet recorded or so on. The errors and
omissions amount equals to the amount necessary to balance both the sides.
The items 1 to 7 show the total receipts from all sources. These receipts amount
to Rs. 1000 Crores.
The items 1(a) to 7(a) Show the total payments on all accounts. These
payments amount to Rs. 990 Crores. When item 8 included, the total payment is
Rs. 1000 Crores, hence the total credit is equal to the total debit.
Thus the current account and capital account Balance each other. Thus surplus
in the current account is equal to the deficit in the capital account. A deficit in
the current account is equal to the surplus in the capital account.
In the above given table, the balance of current account shows a deficit of Rs.
200 crores But there is a corresponding surplus of Rs. 200 crores in the balance
of capital account.
Hence the credit and debit sides balance & the balance of payments is in
equilibrium.
The balance of trade of a country may not balance. For instance, if
exports exceed imports, there is a surplus and a favourable balance of
trade and vice-versa. Only if the value of exports is equal to the value of
imports, the balance of trade is said to be in equilibrium.
But the balance of payments always balances because every transaction must be
settled. Hence total debits must be equal to the total credits.
Monetary Measures for Correcting the BoP ↓
The monetary methods for correcting disequilibrium in the balance of payment
are as follows :1. Deflation
Deflation means falling prices. Deflation has been used as a measure to correct
deficit disequilibrium
Deflation is brought through monetary measures like bank rate policy, open
market operations, etc or through fiscal measures like higher taxation, reduction
in public expenditure, etc. Deflation would make our items cheaper in foreign
market resulting a rise in our exports. At the same time the demands for imports
fall due to higher taxation and reduced income. This would built a favourable
atmosphere in the balance of payment position. However Deflation can be
successful when the exchange rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline in the rate of exchange of domestic
currency in terms of foreign currency. This device implies that a country has
adopted a flexible exchange rate policy.
Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs.
40. If India experiences an adverse balance of payments with regard to U.S.A,
the Indian demand for US dollar will rise. The price of dollar in terms of rupee
will rise. Hence, dollar will appreciate in external value and rupee will depreciate
in external value. The new rate of exchange may be say $1 = Rs. 50. This
means 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because
exports will become cheaper and imports costlier. Hence, a favourable balance of
payments would emerge to pay off the deficit.
3. Devaluation
Devaluation refers to deliberate attempt made by monetary authorities to bring
down the value of home currency against foreign currency. While depreciation
is a spontaneous fall due to interactions of market forces, devaluation is
official act enforced by the monetary authority. Generally the international
monetary fund advocates the policy of devaluation as a corrective measure of
disequilibrium for the countries facing adverse balance of payment position.
When India's balance of payment worsened in 1991, IMF suggested devaluation.
Accordingly, the value of Indian currency has been reduced by 18 to 20% in
terms of various currencies. The 1991 devaluation brought the desired effect.
The very next year the import declined while exports picked up.
When devaluation is effected, the value of home currency goes down against
foreign currency, Let us suppose the exchange rate remains $1 = Rs. 10 before
devaluation. Let us suppose, devaluation takes place which reduces the value of
home currency and now the exchange rate becomes $1 = Rs. 20. After such a
change our goods becomes cheap in foreign market. This is because, after
devaluation, dollar is exchanged for more Indian currencies which push up the
demand for exports. At the same time, imports become costlier as Indians have
to pay more currencies to obtain one dollar. Thus demand for imports is
reduced.
Generally devaluation is resorted to where there is serious adverse balance of
payment problem.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy complete control
over the exchange dealings. Under such a measure, the central bank directs all
exporters to surrender their foreign exchange to the central authority. Thus it
leads to concentration of exchange reserves in the hands of central authority. At
the same time, the supply of foreign exchange is restricted only for essential
goods. It can only help controlling situation from turning worse. In short it is
only a temporary measure and not permanent remedy.
Non-Monetary Measures for Correcting the BoP ↓
A deficit country along with Monetary measures may adopt the following nonmonetary measures too which will either restrict imports or promote exports.
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the
prices of imports would increase to the extent of tariff. The increased prices will
reduced the demand for imported goods and at the same time induce domestic
producers to produce more of import substitutes. Non-essential imports can be
drastically reduced by imposing a very high rate of tariff.
2. Quotas
Under the quota system, the government may fix and permit the maximum
quantity or value of a commodity to be imported during a given period. By
restricting imports through the quota system, the deficit is reduced and the
balance of payments position is improved.
3. Export Promotion
The government can adopt export promotion measures to correct disequilibrium
in the balance of payments. This includes substitutes, tax concessions to
exporters, marketing facilities, credit and incentives to exporters, etc.
The government may also help to promote export through exhibition, trade fairs;
conducting marketing research & by providing the required administrative and
diplomatic help to tap the potential markets.
4. Import Substitution
A country may resort to import substitution to reduce the volume of imports and
make it self-reliant. Fiscal and monetary measures may be adopted to
encourage industries producing import substitutes. Industries which produce
import substitutes require special attention in the form of various concessions,
which include tax concession, technical assistance, subsidies, providing scarce
inputs, etc.
Non-monetary methods are more effective than monetary methods and are
normally applicable in correcting an adverse balance of payments.