What is Balance of Payments ?

All the countries in the world trade with each other. Each country maintains a record of its trade and other economic transactions with other country in its balance of payments accounts.

For example, the balance of payments account) f India measures the economic transactions of India with other countries. These transactions include the sale of Indian goods and services abroad and the purchase of foreign made goods and services by India, as well as inflow and outflow of capital.

Balance of Payments:

“The balance of payments of a country is a systematic record of all economic transactions between the residents of one country and residents of foreign countries during a given period of time”.

” The balance of payments is an account of all payments made by a country to other countries and all receipts by it from abroad during the period of one year.”

Components of Balance of Payments:

Items included in the balance of payments are called components of balance of payments.

Balance of payments (BoP) account of a country has two sides – credit or receipt side and debit or Payment side.

Payments received from the foreigners are called credits and payments made by a country’s residents to foreigner are called debits.

Any item that enables a country to acquire foreign currency is recorded as credit and any item that gives rise to use or spending of the foreign currency is recorded as debit item in the balance of payments.

BoP is a way of listing these items on the credit and debit side.

BoP is not a balance sheet showing a country’s foreign assets and liabilities at any given period of time. But it shows for a given period of time, the flow of total receipt from abroad and its total payments made to abroad.

Various items in the balance of payments are categorised in two groups:

1. Current Account

2. Capital Account

1. Current Account:

Current account records all international transactions relating to export and import of goods and services, unilateral transfers and international incomes.

Current account transactions do not cause any change in the assets or liabilities of the residents of the country or its government.

The balance on current account is the value of exports minus the value of imports, adjusted for international incomes and net transfers.

Current account transactions are of flow nature.

2. Capital Account :

The capital account records all international economic transactions relating to change in assets – both financial and physical, or liabilities of the residents and its government.

These transactions are of stock nature. Capital account transactions change the capital stock of the country.

Capital account is a record of short – term and long term capital transactions both private and official.

Components of current account :

1. Visible trade or merchandise transactions

2. Invisible trade

3. Unilateral transfers

4. Income

1. Visible trade or Merchandise Transactions :

This category includes all types of physical goods exported and imported.

In foreign trade there will be inflow and outflow of foreign exchange on account of export and import of visible items.

The items by exporting of which, foreign currency is acquired are shown as credit items.

The items, by importing of which, the foreign currency is used or spend are shown as debit items.

2. Invisible trade :

There will be receipts and payments of foreign exchange for services sold to and purchased by the residents of a country from the rest of the world.

The payments received for the selling of service or export of service is put on credit side.

Example: shipping services, banking and insurance services etc. Income through tourism is another example of income from services.

The payments made by the residents for hiring or importing a foreign service is put on the debit side.

Example, shipping, banking and insurance and payments the residents made as tourists abroad.

They are items on debit side.

3. Unilateral Transfers:

Unilateral transfers are those receipts and payments which take place without any service in return in the current period.

There is no quid pro quo in return.

Unilateral transfers includes both at the private and official (government ) level.

These are the receipts which the residents of a country receive ‘for free’ without any payment in return. Example, payments received by the residents as gifts, donation etc., from their friends and family – abroad.

Receipt of foreign currency as unilateral transfer is put on credit side.

The payments made by the residents of a country to abroad as gift, donation etc, which causes spending of foreign exchange is put on the debit side.

4. Incomes:

Incomes are classified into investment income and compensation of employees.

Investment income comprises interest and dividends, profits etc, which the residents of a country made abroad.

Interests and dividends on foreign loan and investments respectively provide foreign currency, so these items are entered on the credit side.

Similarly, payments for capital services like interest and dividends made by residents of a country to the foreign countries because of the use of foreign currency is entered on debit side.

Compensation of employees including wages and salaries, received by the residents of a country from non residents. These earnings are entered on the credit side because the country acquires foreign exchange thereby.

Similarly, the payments made by the residents of a country to the non residents for labour services in the form of wages and salaries are entered on the debit side.

Components of Capital Account of Balance of Payment:

Capital account is related to assets and liabilities of the residents of the country or its government and its components are:

1. Foreign Direct investment

2.Portfolio investment

3. Private transactions

4. Official transactions

1. Foreign Direct investment :

It refers to purchase of an asset in abroad which gives full control to buyer over the asset.

Purchase of an asset abroad, involves with export of capital (foreign exchange). This is recorded on debit side.

Sale of asset to any foreigner which receives capital or import of capital, is recorded on credit side.

2. Portfolio Investment :

It refers to purchase of an asset in abroad which does not give full control over asset. Purchase of shares of a foreign firm gives only partial control over the asset.

Purchase of shares of firms abroad involves with export of capital hence is recorded on debit side.

Purchase of shares of firm by foreigners and sale of shares of firms abroad is recorded on credit side of BoP.

3. Private Transactions:

Private sectors of the country receives short term and long term foreign loans.

Receipt of such foreign loans, import capital hence is recorded on credit side.

The repayment of loans to foreign country involves export of capital hence, is recorded on debit side.

4. Official Transactions:

Government borrows loans from foreign government and foreign organisations to finance the deficit in the balance of payments.

Receipt of such loans are recoded on credit side and repayment of loans is recorded on the debit side.

Categories of Balance of Payments:

Balance means difference between the sum total of the credit items and the sum total of the debit items, i.e., net credit.

There are three main categories of BoP:

1. Balance of Trade

2. Balance of Current Account

3. Balance of Capital Account

1. Balance of Trade:

Balance of trade shows the balance of export and imports of visible goods in a given year.

It refers to the merchandise (tangible goods) portion of balance of payment, meaning that it is the difference between the value of goods exported and the value of goods imported during a year.

Balance of trade need not balance.

If a country exports more goods than it imports, it has a favourable balance or surplus in the balance of trade.

On the other hand, if a country imports more goods than it exports, it has unfavourable balance of trade or deficit in the balance of trade.

It refers to the difference between export of goods and import of goods.

Balance of Trade = (Export of goods) – (Import of goods)

2. Balance of Current Account:

Balance of current account is made up of visible, invisibles and transfers.

It is the measure of all the international transactions made for goods, services plus non trade – flow of funds.

Non trade flow refers to flow of factor income (interests, profits, wages etc.)and unilateral international transfers (gifts etc).

This, balance of current account refers to balance of imports and export of goods and services, including factor services.

Balance of Current account = (balance of trade) + (balance of invisibles)+ (balance of transfers)

Balance of current account shows the flow aspect of country’s international economic transactions.

The items included in the current account respond quickly to change in the exchange rate.

3. Balance of Capital Account :

Balance of capital account refers to the valance of capital transfers – by borrowing and lending from abroad and sales and purchase of assets (export and import of capital), gold!and foreign exchange from other countries.

Balance of capital account shows the difference between the inflow and outflow of capital.

There are two types of capital floes included in the capital account:

1. Autonomous capital flow

2. Accommodating capital flow.

1. Autonomous capital flow:

These are ordinary capital flow. They take place because of normal economic motives like earning profits, dividends, interests and other income from international investment and lending.

2. Accommodating capital flow:

These flow have to be made specifically to bring the balance of payments into equilibrium.

Question : State the relationship between balance of current account and balance of capital account.

Answer:

Balance of current account and balance of capital account are interrelated.

A deficit on current account must be settled by a net surplus on capital account.

The foreign currency necessary to finance the excess imports must be either borrowed from some other country or be provided by the government out of its reserve of gold and foreign exchange .

Similarly a surplus in current account must be matched by a deficit in the capital account.

Question : Distinguish between

1. The balance of trade and balance of payment

2. Current account and Capital account

3. Autonomous items and Accommodating items

Answer:

1.Difference between Balance of Trade and Balance of Payment:

SN	Balance of Trade	Balance of Payments
1.	Balance of Trade is the systematic record of the value of visible goods (exports and imports) in a country.	Balance if Payments is the systematic records of all economic transactions of a country.
2.	It is a narrow concept.	It is a wider concept.
3.	It is an incomplete record of economic transactions with rest of the world.	It is a complete record of economic transaction with rest of the world and present a true picture of economic relation with other countries.

2. Difference between Current Account and Capital Account:

SN	Current Account	Capital Account
1.	Current account of BoP records all those transactions between the residents of a country with rest of the world, which do not cause a change in the assets or liabilities of the residents or its government.	Capital account of BoP records all those transactions between the residents of a country with rest of the world which cause a change in the assets or liabilities of the residents or its government.
2.	It is a flow concept.	It is a stock concept.
3.	Current Account = (balance of visible trade) + (balance of invisibles) + (unilateral transfers) + (Incomes from investment and work)	Capital account = (Borrowing and Lending) + (Foreign direct investment and Portfolio investment) + (change in foreign exchange reserve).

3. Difference between Autonomous Items and Accommodating Items:

S N	Autonomous Items	Accommodating Items
1.	These refer to those economic transactions which take place due to economic motives I.e., they are transactions which are determined by profit maximization.	These are not related to those transactions which are determined by profit maximization.
2.	These transactions do not maintain BoP identity i.e., these are not conditioned by positive or negative BoP status.	They maintain BoP identity i.e., these are conditioned by positive or negative status of a country.
3.	These transactions take place on both current and capital account.	These transactions take place on capital account only.
4.	These transactions are undertaken by Private sector and also by government sector.	These transactions are undertaken by government sector only.
5.	These are known as above the line items.	These are known as below the line items.

Balance of Payments : Economics Notes Class 12 : Ecogradeshelp

What is Balance of Payments ?

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