Balance of Payments

The world economy started with secluded sectors, with each country closely guarding all of its resources. But, with the passage of time and the building of bonds between nations, the world realised that the only way to move forward was with a global economy.

Today, the economy is akin to a living organism with different countries involved in all types of trades and business with each other. But with such high volumes of trade, it is imperative to track the changes that foreign trade creates in the national economy. Especially for a country like India, which is involved in multiple exports and imports, the effect of foreign trade is significant on the economy. One measure to track this change is through the ‘balance of payments’, which gives a record that can be used to trace foreign trade in a country.

What is the balance of payments?

A shopkeeper in a small grocery store and the general manager at a supermarket have one thing in common: they maintain a record of transactions in their respective institutions. Similarly, when a country is involved in foreign trade, it is essential to track transactions. This statement of all transactions relating to foreign companies, organisations and even foreign countries is called the ‘balance of payments’.

The balance of payments includes all transactions made by individuals or organisations to foreign institutions or countries, transactions made to individuals or organisations from foreign institutions or countries, and payments made to or by the country to foreign institutions or countries. The balance of payments also acts as a record of measuring the effect of the flow of funds in developing the economy. It has three components, which are measured separately and then combined to form the balance of payments.

Components of the balance of payments

The three components of the balance of payments are used to measure the total inflow and outflow of funds to and from a country’s total available funds. They are measured in parallel with each other. Economists use these three components to calculate the balance of payments every fiscal year:

1. Current accounts

The current account serves as the ledger for all transactions that involve the exchange of goods and services between countries. It provides a record of all the receipts and payments made for this exchange of goods and services between countries. The current account also records transactions that involve engineering, tourism, business services, stocks and royalties. 

The goods and services provided by a country make up its balance of trade (BOT). Trades and transfers are not as simple as they seem. In reality, there are different types of trades and transfers. All trade that involves some tangible items is called visible trade, whereas trade that involves intangible items like information is called invisible trade. Transfers made in the form of gifts, donations or personal transfers to foreign individuals are called unilateral transfers.

2. Financial Accounts

Financial accounts deal with the different types of ownership that can be seen in an economy. When talking about a country, there can be two types of ownership: foreign ownership of domestic assets and domestic ownership of foreign assets. Financial accounts provide a measure of the changes that occur in these ownerships. To do this, financial accounts record all transactions that involve investments in sectors like business ventures, real estate, etc., along with recording transactions that the country makes to acquire more assets.

3. Capital Accounts

Capital accounts provide a record of all transactions involving the purchase and sale of non-financial assets, like land and other properties, that occur between countries. These transactions are also called capital transactions. Three important sectors form the capital accounts, viz. loans and borrowings, investments and foreign exchange reserves.

Importance of balance of payments

The balance of payments, as stated above, gives an idea of the effect of funds on the country’s economy. To maintain a stable economy, an ideal condition of the balance of payments has to be achieved. This ideal condition stipulates that the inflow of funds in a country should be equal to the outflow of funds from the country. Thus, the balance of payments must be equal to zero. With the knowledge of the balance of payments and the three components that form a part of it, economic analysts can predict trends in the country’s economy and help the government take appropriate corrective measures.

Deficit vs Surplus

Achieving the ideal situation of the balance of payments is almost impossible for any country. Therefore, a country may usually find its balance of payments in two states, i.e. deficit or surplus. Both states have some short term and long term advantages. Let us have a look.

Deficit of the balance of payments

A balance of payments deficit happens when a country’s total imports are more than its exports. A deficit means that a country is acquiring more assets than it can pay for. In such a situation, the country also has to borrow funds from other countries to pay for its imports. In the short term, this fuels economic growth, as more imports mean more domestic trade. But in the long term, this also means that the country will go into debt when it has to pay back the borrowed funds.

Surplus of the balance of payments

A balance of payments surplus occurs when a country exports more services, goods and capital than it imports. A surplus means that the country has a higher inflow of funds too. While the situation looks good at first glance, it comes with a huge long term drawback. In the short term, a surplus in the balance of payments fuels economic growth as there are more foreign opportunities for domestic trade. But in the long term, a continued surplus of the balance of payments will cause the economy to become too dependent on exports for its growth, and an abrupt change in export will affect the country drastically.

Conclusion

The balance of payments of a country gives a record of all the transactions between the country and foreign institutions or other countries. It has three components: current accounts, capital accounts, and financial accounts. The balance of payments of a country can be either in deficit or in surplus, each having a short term and a long term effect. In an ideal situation, the balance of payments of a country should be equal to zero.