Study Notes on Balance Of Payments || Commerce || Management || Economics

Balance Of Payments

Introduction

• International Monetary Fund (IMF) defines the Balance of Payments (BoP) as a statistical statement that summarizes economic transactions between residents and non-residents during a specific time period.
• The BoP, thus, includes all transactions showing:
  (a) Transactions in goods, services, and income between an economy and the rest of the world,
  (b) Change of ownership and other changes in that economy’s monetary gold, special drawing rights (SDRs), and financial claims on and liabilities to the rest of the world
  (c) Unrequited transfers- transfer of money in which nothing is expected in return.
  Example- Foreign aid, debt forgiveness, etc.
• These transactions are categorized into
  (i) Current Account
  (ii) Capital Account and Financial Account (capital account is redesignated as capital and financial account)
• The balance of payments is, basically, the record of all international financial transactions made by a country's residents.
• The balance of payments tells us whether the country has a surplus or deficit. It also reveals whether the country produces enough economic output to pay for its growth.

When BoP is deficit it implies

• A balance of payments deficit means the country imports more goods, services, and capital than it exports.
• The country must borrow from other countries to pay for its imports.
• In the short-term, that fuels economic growth. But, in the long-term, the country becomes a net consumer, not a producer, of the world's economic output.
• The country goes into debt to pay for consumption instead of investing in future growth. If the deficit continues for long, the country gets into the debt trap and might end up selling its assets to pay off its debt.

When BoP is surplus it implies

• A balance of payments surplus means the country exports more than it imports.
• The country basically saves more than it earns. This boosts capital formation with its additional income. They might even lend outside the country.
• A surplus boosts economic growth in the short term.
• In the long run, the country becomes too dependent on export-driven growth. It must encourage its residents to spend more. A larger domestic market will protect the country from exchange rate fluctuations

BOP Components

• The BoP can be broadly divided into two accounts namely-
  (a) Current Account
  (b) Capital and financial account.

Current Account

• The current account measures the transfer of real resources (goods, services, income, and transfers) between an economy and the rest of the world.
• The current account is further subdivided into a merchandise account and an invisible account.
• The merchandise account consists of transactions relating to exports and imports of goods.
• In the invisible account, there are three broad categories namely-
  (a) non-factor services such as travel, transportation, insurance, and miscellaneous services;
  (b) transfers which do not involve any value in exchange, and
  (c) income which includes compensation for employees and investment income.

Current Account Deficit (CAD)

• Current Account Deficit (CAD) = Trade Deficit + Net Income From Abroad + Net transfers
  Note: Here Trade Deficit= Import-Export
  So we can see here that Trade Deficit and Current Account Deficit both are different and the Trade Deficit is one component of the Current Account Deficit.

Capital Account and Financial Account

• The capital and financial account reflect the net changes in financial claims on the rest of the world.
  Note-
  The former balance of payments capital account has been redesigned as the capital and financial account as per the fifth edition of Balance of Payments Manual (IMF).
• The capital account can be broadly broken up into two categories namely-
  (a) Non-debt flows such as direct and portfolio investments
  (b) Debt flows such as external assistance, commercial borrowings, non-resident deposits, etc.
• The financial account records an economy’s transaction in external financial assets and liabilities.
• All components are classified according to the type of investment or by functional subdivision
  (a) Direct investment
  (b) Portfolio investment
  (c) Other investment
  (d) Reserve assets
• The sum of the current account and capital account indicates the overall balance, which could either be in surplus or in deficit. The movement in overall balance is reflected in changes in the international reserves of the country.

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