Balance of Payments

Balance of Payments (BoP) is a record of transactions between people of a country and the rest of the world in commodities, services, and assets over a specific time period, generally a year.

The current account and the capital account are the two primary accounts kept by BoP.

Current Account

• It is a record of trade in products and services, as well as financial transfers
• The current account is composed of three major components: commerce in products, trade in services, and transfer payments
• Trade-in products encompass both exports and imports
• Trade-in services encompass transactions including both factor income and non-factor revenue
• Transfer payments are receipts that people of a country receive ‘for free,’ without supplying any products or services in exchange
• They may be presented by the government or by individual citizens who live overseas
• Current Account Balance: A current account is in balance when its receipts match its payments
• A current account surplus indicates that the country is a lender to other countries
• A current account deficit indicates that the country is a borrower from other countries
• The current account balance is composed of two components: the balance of trade and the balance of invisible

• Balance of Trade (BoT): It is the difference between a country’s exports and imports of goods during a specified time period
• Exports are recorded as credit items in the balance of trade, whereas imports are recorded as debit items
• A surplus balance of trade or trade surplus occurs when a country exports more goods than it imports
• Whereas a trade imbalance or balance of trade deficit occurs when a country imports more goods than it exports
• Balance of Invisibles (BoI): It is also used to refer to net invisible
• It is the difference between a country’s exports and imports over a specified time period
• Invisibles include services, transfers, and income movements between countries
• Income from services trade is composed of both factor and non-factor income
• Income from factors of production is net international earnings on factors of production (like labour, land and capital)
• Non-factor revenue is derived from the net sales of service products such as shipping, banking, tourism, and software development

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Capital Account

• It keeps track of all overseas asset transactions
• An asset is any of the several ways in which wealth can be held, such as cash, stocks, bonds, or government debt
• A capital account is composed of three major components: investment, external borrowings, and external aid
• The acquisition of assets is recorded as a debit item on the capital account
• If an Indian acquires a UK automobile company, the acquisition is recorded as a debit item in the capital account (as foreign exchange is flowing out of India)
• A credit item on the capital account is the sale of assets, such as shares in an Indian company to a Chinese consumer
• Balance on Capital Account: When capital inflows (such as loans from abroad, the sale of assets or shares in foreign enterprises) equal capital outflows, the capital account is balanced (like repayment of loans, purchase of assets or shares in foreign countries)
• Capital account surpluses occur when capital inflows exceed capital outflows
• Capital account deficits occur when capital inflows exceed capital outflows

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Surplus and Deficits in Balance of Payments

• A country with a current account deficit (spending more than it obtains from exports) must finance it through asset sales or borrowing from overseas
• Thus, any current account deficit must be repaid by a capital account surplus, i.e., a net inflow of capital

Current account + Capital account = 0

• When a country achieves the balance of payments equilibrium, the current account deficit is totally funded through international financing, with no reserve movements
• Alternatively, the country might use its foreign exchange reserves to close any balance of payments deficits
• When there is a shortfall, the reserve bank sells foreign currency
• This is referred to as a reserve sale
• The fundamental concept is that monetary authorities are the ultimate financiers of any balance of payments imbalance (or the recipients of any surplus)
• We note that official reserve transactions are more significant under a fixed exchange rate regime than under a floating exchange rate regime

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Autonomous Transactions

• In BoP, these are also referred to as “above the line” objects
• International economic transactions are said to be autonomous when they are made for a reason other than to close a balance of payments gap, or when they are unrelated to the state of the balance of payments
• If autonomous receipts exceed (or are less than) autonomous payments, the balance of payments is said to be in excess (deficit)

Accommodating Transactions 

• In BoP, these are also referred to as “below the line” items
• It depends on whether the balance of payments is in deficit or surplus
• They are determined by the balance of payments deficit
• Additionally, they are decided by the net effects of autonomous transactions
• Because official reserve transactions are used to close gaps in the balance of payments, they are viewed as the accommodating item in the balance of payments (all others being autonomous)

Conclusion 

If a country’s current account is in deficit (it spends more abroad than it receives from exports), it must fund it through foreign borrowing or asset sales. As a result, any current account deficit must be covered by net capital inflows. A country is said to be in a balance of payments equilibrium when the total of its current account and non-reserve capital account equals zero, implying that the current account balance is wholly supported through international lending without the need for reserves.