Balance of Payment and Its Components : 

 Balance of Payments (BoP) statistics systematically summaries the economic transactions of an economy with the rest of the World (i.e.transactions between resident & non resident entities) during a given period. It comprises of current and capital & financial accounts . It can be better appreciated in terms of the national income accounting identity: GDP = C+G+I+X-M. In other words, domestic output (GDP) is equal to private consumption(C), plus government consumption (G), plus domestic investment (I), plus net exports (X-M). If net exports of goods and services (X-M) are negative (i.e. Balance of Trade is negative or there is a trade(including services) deficit,), the domestic economy is absorbing more than it can produce. In other words, absorption (C+G+I) by the domestic economy is greater than domestic output (GDP). This adverse trade balance (or trade deficit) is also reflected in Current Account of BOP, which besides covering goods and services, also covers income (investment income & compensation of employees) and current transfers (remittances, grants etc). In case the combined net effect of trade balance, income and current transfers is also negative, the same results in Current Account Deficit . The deficit needs to be financed by external borrowings and/or investments which are constituents of Financial Accounts.

The balance of payment is a comprehensive and systematic records of all economic transaction between normal residents of a country and rest of the world during an accounting year.

In a country’s’ international economic transactions, there is not only visible merchandise only, there are invisible merchandise as well which are commonly known as services e.g., freights and fare of ships and planes, insurance and banking charges, foreign tours and education in foreign countries, payments of interest and dividend on foreigners’ investments etc. — both individual and Governments.

Needless to mention that if a complete picture is wanted, these invisible transactions are also to be taken into consideration which is called Balance of payments. In short, the balance of payments is a comprehensive record of economic transactions of the residents of a country with the rest of the world during a given period of time i.e., it is defined as the systematic records of all economic transactions between the residents of foreign countries and the residents of the reporting countries during a given period of time.

Why balance of payment is vital for a country?

A country’s BOP is vital for the following reasons:

• BOP of a country reveals its financial and economic status.
• BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
• BOP statement helps the Government to decide on fiscal and trade policies.

It provides important information to analyze and understand the economic dealings of a country with other countries.

India’s Balance of Payment – Historical Perspective

 India’s BoP evolved reflecting both the changes in our development paradigm and exogenous shocks from time to time. In the 60 year span, 1951-52 to 2011-12, six events had a lasting impact on our BoP:

(i) the devaluation in 1966; 

(ii) first and second oil shocks of 1973 and 1980; 

(iii) external payments crisis of 1991; 

(iv) the East Asian crisis of 1997;

(v) the Y2K event of 2000; and 

(vi) the global financial crisis of 2008 and subsequent Euro zone crisis . 

The first phase can be considered from the 1950s through mid-1960s. In the early 1950s, India was reasonably open. For example, in 1951-52, merchandise trade, exports plus imports, accounted for 16 per cent of GDP. Overall current receipts plus payments were nearly 19 per cent of GDP. Subsequently, the share of external sector in India’s GDP gradually declined with the inward looking policy of import substitution. Moreover, Indian export basket comprised mainly traditional items like tea, cotton textile and jute manufactures. Not only the scope of world trade expansion in these commodities was less but additionally India had to face competition from new emerging suppliers, such as Pakistan in jute manufactures and Sri Lanka and East Africa in tea. 

During this period, policy emphasis was on import saving rather than export promotion, and priority was given to basic goods and capital goods sector. It was argued that investment in heavy industries would bring in saving in foreign exchange, as output from such industries would replace their imports in the long-run. Importsubstituting strategies were expected to gradually increase export competitiveness through efficiency-gains achieved in the domestic economy. But this did not happen. Hence, exports remained modest. In fact our external sector contracted in relation to GDP from the level observed in the early 1950s. By 1965-66,merchandise trade was under 8 per cent of GDP and overall current receipts and payments were below 10 per cent of GDP.

Elements of balance of payment:

There are three components of balance of payment viz current account, capital account, and financial account. The total of the current account must balance with the total of capital and financial accounts in ideal situations.

Current Account

The current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with respect to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they make up to a country’s Balance Of Trade (BOT).

There are various categories of trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries are referred to as visible items and import/export of services (banking, information technology etc) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This can also be personal transfers like –  money sent by relatives to their family located in another country.

Capital Account

All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc by migrants moving out/in to a different country. The deficit or surplus in the current account is managed through the finance from capital account and vice versa.

There are 3 major elements of capital account:

• Loans & borrowings – It includes all types of loans from both the private and public sectors located in foreign countries.
• Investments – These are funds invested in the corporate stocks by non-residents.
• Foreign exchange reserves – Foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account.

Financial Account

The flow of funds from and to foreign countries through various investments in real estates, business ventures, foreign direct investments etc is monitored through the financial account. This account measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign assets. On analyzing these changes, it can be understood if the country is selling or acquiring more assets (like gold, stocks, equity etc).

Accounts of Balance of Payments:

1. Current Account: The current account records export and import of goods and services and unilateral transfers.

2. Capital Account: It records of all such transactions between normal residents of a country and rest of the world which relates to sale and purchase of foreign assets and liabilities during an accounting year.

Types of Balance Payment:

Balance of payments is divided into two following ways:

(i) Vertically into credit and debit (according to the principals of double entry systems of book-keeping)

(ii) Horizontally into two major categories (according to the nature of transactions).

It is interesting to note that the current account consists of all transactions which relate to the current national income and current expenditure of the home country. It includes imports and exports of goods and services, expenses on travel, transportation, insurance, investment incomes and unilateral transfers.

Similarly, capital account relates to capital transactions i.e., transactions in financial assets which directly affect wealth and debt and as such, it includes only future income and not the current one. It includes borrowings and lending of capital including repayments of capital, purchase and sale of securities and other assets to and from foreigners, individuals as well as governments.

It is called overall balance of payments when both current and capital account are taken into consideration.

Balance of payments is like the Balance Sheet of a company i.e., the left side of the accounts shows receipts of the country during a particular period and right hand side shows the payments made by the country on various items to other countries for the same period. The balance of payments must always balance.

In short, the left hand side must be equal to right hand sight (at least in principle) although, in reality, the two sides may not be exactly equal and as such, balance of payments may be adverse one or in deficit or it may be favorable or surplus in the opposite case.

We know that an economic transaction relates to a receipt as well as a payment of money in exchange for the economic goods and services or the assets. As such, in each case, an international economic transaction exists and it becomes necessary to make appropriate entry in the balance of payments.

The following table will make the principle clear:

Structure and Classification: Balance of Payments

The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. But balance of payments accounting differs from business accounting in one respect.

In business accounting, debits (-) are shown on the left side and credits (+) on the right side of the balance sheet. But in balance of payments accounting, the practice is to show credits on the left side and debits on the right side of the balance sheet.

When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit transaction. The principal items shown on the credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, borrowings from abroad, investments by foreigners in the country and official sale of reserve assets including gold to foreign countries and international agencies.

The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and international agencies.

These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry book-keeping. Horizontally, they are divided into three categories: the current account, the capital account and the official settlements account or the official reserve assets account.

The balance of payments account of a country is constructed in Table 10.

In the current account, the exports of goods and services arid the receipts of transfer payments (unrequited receipts) are entered as credits (+) because they represent receipts from foreigners. On the other hand, the imports of goods and services and grant of transfer payments to foreigners are entered as debits (-) because they represent payments to foreigners. The net value of these visible and invisible trade balances is the balance on current account.

In the capital account, borrowings from foreign countries and direct investment by foreign countries represent capital inflows. They are positive items or credits because these are receipts from foreigners. On the other hand, lending to foreign countries and direct investments in foreign countries represent capital outflows.

They are negative items or debits because they are payments to foreigners. The net value of the balances of short-term and long-term direct and portfolio investments is the balance on capital account. The sum of current account and capital account is known as the basic balance. 

The official settlements account or official reserve assets account is, in fact, a part of the capital account. But the U.K. and U.S. balance of payments accounts show it as a separate account. “The official settlements account measures the change in nations’ liquidity and non-liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year. The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF”. It shows transactions in a country’s net official reserve assets.

Errors and omissions is a balancing item so that total credits and debits of the three accounts must equal in accordance with the principles of double entry book-keeping so that the balance of payments of a country always balances in the accounting sense.