What is Balance of Payments (BOP)?
Balance of Payments (BOP) is an accounting system that measures all economic transactions between residents (including government) of one country and residents of all other countries.
Economic transactions include exports and imports of goods and services, capital inflows and outflows, gifts and other transfer payments and changes in a country’s international reserves.
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Balance of Payments (BOP) Definition
Kindleberger defined balance of payments as “a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period of time“.
Normally the period is one year. These transactions are between residents of one country with those of other country.
We need to understand the difference between an economic transaction and a commercial transaction.
- An economic transaction is an exchange of value or transfer of a title to a good or an asset; whereas,
- A commercial transaction is an exchange of good or service for money that will result in payment in currency leading to financial flows.
For example, when we buy a share or property, it is transferred to our name but when we buy clothes or food items, we only pay money but there is no transfer of title.
Characteristics of Balance of Payments
Characteristics of a balance of payments are:
- BOP is the systematic record of all economic transactions with the rest of the world.
- BOP is related to period of time.
- BOP includes the Balance of Trade (BOT) in it.
- It includes all transactions current as well as capital.
- It includes the receipts and payments of the country.
- It is just like a balance sheet.
- Balance of Payments is based on double entry book keeping system.
- Is not balanced generally it contains some induced
Components of BOP
The three main components of BOP are:
The current account is typically divided into three sub-categories; the merchandise trade balance, the services balance and the balance on unilateral transfers. Entries in this account are “current” in value as they do not give rise to future claims. A surplus in the current account represents an inflow of funds while a deficit represents an outflow of funds.
- The balance of merchandise trade refers to the balance between exports and imports of tangible goods such as automobiles, computers, machinery and so on. A favourable balance of merchandise trade (surplus) occurs when exports are greater in value than imports
An unfavourable balance of merchandise trade (deficit) occurs when imports exceed exports. Merchandise exports and imports are the largest single component of total international payments for most countries.
- Services represent the second category of the current account. Services include interest payments, shipping and insurance fees, tourism, dividends and military expenditures. These trades in services are sometimes called invisible trade.
- Unilateral transfers are gifts and grants by both private parties and governments. Private gifts and grants include personal gifts of all kinds and also relief organisation shipments.
For example, money sent by immigration workers to their families in their native country represents private transfer. Government transfers include money, goods and services sent as aid to other countries.
For example, if the United States government provides relief to a developing country as part of its drought-relief programme, this would represent a unilateral government transfer.
Unlike other accounts in the BOP, unilateral transfers have only one-directional flow without offsetting flows. For double entry bookkeeping, unilateral transfers are regarded as an act of buying goodwill from the recipient.
The capital account is an accounting measure of the total domestic currency value of financial transactions between domestic residents and the rest of the world over a period of time. This account consists of loans, investments, other transfers of financial assets and the creation of liabilities.
It includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits.
The capital account can be divided into three categories: direct investment, portfolio investment and other capital flows.
- Direct investment occurs when the investor acquires equity such as purchases of stocks, the acquisition of entire firms, or the establishment of new subsidiaries.
- Foreign Direct Investment (FDI) generally takes place when firms tend to take advantage of various market imperfections. Firms also undertake foreign direct investments when the expected returns from foreign investment exceed the cost of capital, allowing for foreign exchange and political risks.
The expected returns from foreign profits can be higher than those from domestic projects due to lower material and labour costs, subsidised financing, investment tax allowances, exclusive access to local markets, etc.
For example, many US firms are engaged in direct investment in foreign countries. Coca-Cola has built bottling facilities all over the world. b.
- Portfolio investments represent sales and purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of management control. A desire for return, safety and liquidity in investments is the same for international and domestic portfolio investors.
International portfolio investments have specifically boomed in recent years due to investors’ desire to diversify risk globally. Investors generally feel that they can reduce risk more effectively if they diversify their portfolio holdings internationally rather than purely domestically. In addition, investors may also benefit from higher expected returns from some foreign markets.
- Capital flows represent the third category of capital account and represent claims with a maturity of less than one year. Such claims include bank deposits, shortterm loans, short-term securities, money market investments and so forth. These investments are quite sensitive to both changes in relative interest rates between countries and the anticipated change in the exchange rate.
For example, if the interest rates rise in India, with other variables remaining constant, India will experience capital inflows as investors would like to deposit or invest in India to take advantage of the higher interest rate.
But if the higher interest rate is accompanied by an expected depreciation of the Indian rupee, capital inflows to India may not materialise.
Short-term capital flows are of two types: non-liquid short-term capital and liquid short-term capital.
- Non-liquid short-term capital flows include bank loans and other short-term funds that are very difficult to liquidate quickly without loss.
- Liquid short-term capital flows represent claims such as demand deposits and short-term securities that are easy to liquidate with minimum or no loss.
Short-term capital accounts change for two specific reasons: compensating adjustments and autonomous adjustments.
- Compensating adjustments or accommodating adjustments are short-term capital movements induced by changes due to merchandise trade, services, unilateral transfers and investments. These compensating accounts change so as to finance other items in the balance of payments.
- Autonomous adjustments are short-term capital movements due to differences in interest rates and also expected changes in foreign exchange rate among nations. Autonomous changes take place for purely economic reasons.
Official Reserve Account
Official reserves are government owned assets. The official reserve account represents only purchases and sales by the central bank of the country (e.g., the Reserve Bank of India). The changes in official reserves are necessary to account for the deficit or surplus in the balance of payments.
For example, if a country has a BOP deficit, the central bank will have to either run down its official reserve assets such as gold, foreign exchange, and SDRs or borrow fresh from foreign central banks.
However, if a country has a BOP surplus, its central bank will either acquire additional reserve assets from foreigners or retire some of its foreign debts.
Debit and Credit Entries
BOP is kept on a double entry book-keeping system with credits and debits of equal size. For every transaction, there is a corresponding entry on both credit and debit sides. BOP is neither an income statement nor a balance sheet.
BOP accounting principles regarding debits and credits are as follows:
- Credit transactions (+) are those that involve the receipt of payment from foreigners.
The following are some of the important credit transactions:
- Exports of goods or services
- Unilateral transfers (gift) received from foreigners
- Capital inflows
- Debit transactions (–) are those involve the payment of foreign exchange, i.e., transactions that expend foreign exchange.
The following are some of the important debit transactions:
- Import of goods and services
- Unilateral transfers (gift) received from foreigners
- Capital inflows
Since the BOP statements is drawn up in terms of debits and credits based on a system of double-entry book-keeping, if all entries are made correctly, the total debits must equal total credits.
The debit or payment side of BOP accounts of a country represents the total of all the uses made out of the total foreign exchange acquired by a country during the given period, while the credit or the receipt side represents the sources from which this foreign exchange was acquired by the country in the same period. The sides as such necessary balance.