Balance of Payment (BOP) - Concept & Definition

A statement that summarizes an economy’s transactions with the rest of the world for a
specified time period. The balance of payments, also known as balance of international
payments, encompasses all transactions between a country’s residents and its non
residents involving goods, services and income; financial claims on and liabilities to the
rest of the world; and transfers such as gifts. The balance of payments classifies these
transactions in two accounts – the current account and the capital account. The current
account includes transactions in goods, services, investment income and current
transfers, while the capital account mainly includes transactions in financial instruments.
An economy’s balance of payments transactions and international investment position
(IIP) together constitute its set of international accounts.

According to Kindle berger, "The balance of payments of a country is a systematic record of all
economic transactions between the residents of the reporting country and residents of foreign
countries during a given yeriod of time".

The balance of payment record is maintained in a standard double-entry book-

keeping method.

International transactions enter in to the record as credit or debit. The payments received from
foreign countries enter as credit and payments made to other countries as debit.

The debit side shows the use of total foreign exchange acquired in a particular
period.

The credit side shows the sources from which the foreign exchange is acquired
during a particular period.

Against every credit entry, there is an offsetting debit entry & vise-versa, so the receipts and
payments on these two sides must be equal. Hence the two sides must necessary balance.

The individual items in the balance of payments may not balance. But the total credits of the
country must be equals to its total debits.

If there is any deficit in any individual account, it would be covered by a surplus in other
accounts, if there is any difference between total debits and total credits, it would be settled
under 'errors & omissions'. Hence in the accounting sense, the balance of payments of a
country always balances.

Balance of Payment is a record pertaining to a period of time; usually it is all annual

statement. All the transactions entering the balance of payments can be grouped
under three broad accounts; (1) Current Account, (2) Capital Account, and (3)
Official International Reserve Account. However, it can be vertically divided into
many categories as per the requirement.

Structure of Balance of Payment (BOP) ↓

1. Trade Account Balance

It is the difference between exports and imports of goods, usually referred as visible or
tangible items. Till recently goods dominated international trade. Trade account balance tells as
whether a country enjoys a surplus or deficit on that account. An industrial country with its
industrial products comprising consumer and capital goods always had an advantageous
position. Developing countries with its export of primary goods had most of the time suffered
from a deficit in their balance of payments. Most of the OPEC countries are in better position
on trade account balance.

The Balance of Trade is also referred as the 'Balance of Visible Trade' or 'Balance of
Merchandise Trade'.

Definition of 'Balance Of Trade - BOT'

The difference between a country's imports and its exports. Balance of trade is the largest
component of a country's balance of payments. Debit items include imports, foreign aid,
domestic spending abroad and domestic investments abroad. Credit items include exports,
foreign spending in the domestic economy and foreign investments in the domestic economy. A
country has a trade deficit if it imports more than it exports; the opposite scenario is a trade
surplus.

Also referred to as "trade balance" or "international trade balance."

2. Current Account Balance

It is difference between the receipts and payments on account of current account which
includes trade balance. The current account includes export of services, interests, profits,
dividends and unilateral receipts from abroad, and the import of services, interests, profits,
dividends and unilateral Payments to abroad. There can be either surplus or deficit in current
account. The deficit will take place when the debits are more than credits or when payments
are more than receipts and the current account surplus will take place when the credits are
more than debits.

The difference between a nation’s savings and its investment. The current account is an
important indicator about an economy's health. It is defined as the sum of the balance
of trade (goods and services exports less imports), net income from abroad and net
 current transfers. A positive current account balance indicates that the nation is a net
lender to the rest of the world, while a negative current account balance indicates that it
is a net borrower from the rest of the world.

Definition of 'Current Account Deficit'

A measurement of a country’s trade in which the value of goods and services it imports
exceeds the value of goods and services it exports. The current account also includes net
income, such as interest and dividends, as well as transfers, such as foreign aid, though
these components tend to make up a smaller percentage of the current account than
exports and imports. The current account is a calculation of a country’s foreign
transactions, and along with the capital account is a component of a country’s balance of
trade.

3. Capital Account Balance

It is difference between the receipts and payments on account of capital account. The capital
account involves inflows and outflows relating to investments, short term borrowings/lending,
and medium term to long term borrowing/lending. There can be surplus or deficit in capital
account. The surplus will take place when the credits are more than debits and the deficit will
take place when the debits are more than credits.

A national account that shows the net change in asset ownership for a nation. The capital
account is the net result of public and private international investments flowing in and out of a
country. It may also refer to an account showing the net worth of a business at a specific point
in time.  The capital account includes foreign direct investment (FDI), portfolio and other
investments, plus changes in the reserve account. The capital account and the current account
together constitute a nation's balance of payments. 

4. Foreign Exchange Reserves

Foreign exchange reserves (Check item No.9 in above figure) shows the reserves which are
held in the form of foreign currencies usually in hard currencies like dollar, pound etc., gold
and Special Drawing Rights (SDRs). Foreign exchange reserves are analogous to an individual's
holding of cash. They increase when the individual has a surplus in his transactions and
decrease when he has a deficit. When a country enjoys a net surplus both in current account &
capital account, it increases foreign exchange reserves. Whenever current account deficit
exceeds the inflow in capital account, foreign exchange from the reserve accounts is used to
meet the deficit If a country's foreign exchange reserves rise, that transaction is shown as
minus in that country's balance of payments accounts because money is been transferred to
the foreign exchange reserves.

Foreign exchange reserves (forex) are used to meet the deficit in the balance of payments. The
entry is in the receipt side as we receive the forex for the particular year by reducing the
balance from the reserves. When surplus is transferred to the foreign exchange reserve, it is
shown as minus in that particular year's balance of payment account. The minus sign (-)
indicates an increase in forex and plus sign (+) shows the borrowing of foreign exchange from
the forex account to meet the deficit.

5. Errors and Omission

The errors may be due to statistical discrepancies & omission may be due to certain
transactions may not be recorded. For eg: A remittance by an Indian working abroad to India
may not yet recorded, or a payment of dividend abroad by an MNC operating in India may not
yet recorded or so on. The errors and omissions amount equals to the amount necessary to
balance both the sides.
The items 1 to 7 show the total receipts from all sources. These receipts amount to Rs. 1000
Crores.

The items 1(a) to 7(a) Show the total payments on all accounts. These payments amount to
Rs. 990 Crores. When item 8 included, the total payment is Rs. 1000 Crores, hence the total
credit is equal to the total debit.

Thus the current account and capital account Balance each other. Thus surplus in the current
account is equal to the deficit in the capital account. A deficit in the current account is equal to
the surplus in the capital account.

In the above given table, the balance of current account shows a deficit of Rs. 200 crores But
there is a corresponding surplus of Rs. 200 crores in the balance of capital account.

Hence the credit and debit sides balance & the balance of payments is in equilibrium.

The balance of trade of a country may not balance. For instance, if exports exceed
imports, there is a surplus and a favourable balance of trade and vice-versa. Only if
the value of exports is equal to the value of imports, the balance of trade is said to be
in equilibrium.

But the balance of payments always balances because every transaction must be settled.
Hence total debits must be equal to the total credits.

Monetary Measures for Correcting the BoP ↓

The monetary methods for correcting disequilibrium in the balance of payment are as follows :-

1. Deflation

Deflation means falling prices. Deflation has been used as a measure to correct deficit
disequilibrium

Deflation is brought through monetary measures like bank rate policy, open market operations,
etc or through fiscal measures like higher taxation, reduction in public expenditure, etc.
Deflation would make our items cheaper in foreign market resulting a rise in our exports. At
the same time the demands for imports fall due to higher taxation and reduced income. This
would built a favourable atmosphere in the balance of payment position. However Deflation can
be successful when the exchange rate remains fixed.

2. Exchange Depreciation
Exchange depreciation means decline in the rate of exchange of domestic currency in terms of
foreign currency. This device implies that a country has adopted a flexible exchange rate
policy.

Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India
experiences an adverse balance of payments with regard to U.S.A, the Indian demand for US
dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in
external value and rupee will depreciate in external value. The new rate of exchange may be
say $1 = Rs. 50. This means 25% exchange depreciation of the Indian currency.

Exchange depreciation will stimulate exports and reduce imports because exports will become
cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay
off the deficit.

3. Devaluation

Devaluation refers to deliberate attempt made by monetary authorities to bring down the value
of home currency against foreign currency. While depreciation is a spontaneous fall due
to interactions of market forces, devaluation is official act enforced by the monetary
authority. Generally the international monetary fund advocates the policy of devaluation as a
corrective measure of disequilibrium for the countries facing adverse balance of payment
position. When India's balance of payment worsened in 1991, IMF suggested devaluation.
Accordingly, the value of Indian currency has been reduced by 18 to 20% in terms of various
currencies. The 1991 devaluation brought the desired effect. The very next year the import
declined while exports picked up.

When devaluation is effected, the value of home currency goes down against foreign currency,
Let us suppose the exchange rate remains $1 = Rs. 10 before devaluation. Let us suppose,
devaluation takes place which reduces the value of home currency and now the exchange rate
becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is
because, after devaluation, dollar is exchanged for more Indian currencies which push up the
demand for exports. At the same time, imports become costlier as Indians have to pay more
currencies to obtain one dollar. Thus demand for imports is reduced.

Generally devaluation is resorted to where there is serious adverse balance of payment

problem.

4. Exchange Control

It is an extreme step taken by the monetary authority to enjoy complete control over the
exchange dealings. Under such a measure, the central bank directs all exporters to surrender
their foreign exchange to the central authority. Thus it leads to concentration of exchange
reserves in the hands of central authority. At the same time, the supply of foreign exchange is
restricted only for essential goods. It can only help controlling situation from turning worse. In
short it is only a temporary measure and not permanent remedy.

Non-Monetary Measures for Correcting the BoP ↓

A deficit country along with Monetary measures may adopt the following non-monetary
measures too which will either restrict imports or promote exports.

1. Tariffs

Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports
would increase to the extent of tariff. The increased prices will reduced the demand for
imported goods and at the same time induce domestic producers to produce more of import
substitutes. Non-essential imports can be drastically reduced by imposing a very high rate of
tariff.

2. Quotas
Under the quota system, the government may fix and permit the maximum quantity or value
of a commodity to be imported during a given period. By restricting imports through the quota
system, the deficit is reduced and the balance of payments position is improved.

3. Export Promotion

The government can adopt export promotion measures to correct disequilibrium in the balance
of payments. This includes substitutes, tax concessions to exporters, marketing facilities, credit
and incentives to exporters, etc.

The government may also help to promote export through exhibition, trade fairs; conducting
marketing research & by providing the required administrative and diplomatic help to tap the
potential markets.

4. Import Substitution

A country may resort to import substitution to reduce the volume of imports and make it self-
reliant. Fiscal and monetary measures may be adopted to encourage industries producing
import substitutes. Industries which produce import substitutes require special attention in the
form of various concessions, which include tax concession, technical assistance, subsidies,
providing scarce inputs, etc.

Non-monetary methods are more effective than monetary methods and are normally applicable
in correcting an adverse balance of payments.