Understanding The Balance Of Payments: Meaning, Classification etc

Understanding-the-concept

 

Ever wondered as to how the recording is being done for the transactions that takes place in and around countries having a different system, currency, and economic status. In this article, we will discuss such recording.

 

Meaning

The balance of payments or BOP is a statement or summary of all transactions that take place between entities ofonecountry with the rest of the worldover a specified period.

The transactions specified above consists of import, export of goods or services or both, capital, transfer payments, i.e., remittances made by the resident of a country from outside of the country and foreign aid, the relief provided to a nation.

When the Company imports more than the exports of Goods,Services and Capital then such a situation is termed as a Deficit of BoP.

Moreover, the situation where the imports are less than the exports is termed as the Surplus of BoP. This implies that the government and residents are savers. They provide enough capital to meet the requirement of domestic production which is a good situation for boosting the economic condition.

 

 

Classification of the Balance of Payments (BoP)

Majorly the BoP is classified in two accounts which are as follows:

  1. TheCurrent Accountand
  2. TheCapital Account.

The Capital Account can also be termed as the financial account and can be listed separately as a different account. So the third classification is:

  1. Finance Account

BoP on Current Account refers to the inclusion of three balances of:

  1. Merchandise balance, i.e., Goods,
  2. Services balance and
  3. Unilateral Transfer balance

The current account is the summary of the trade balance that a country has along with the net of Income and payments. In other words, it reflects the net flow of goods, services, and unilateral transfers. The net value of the balances of visible, invisible trade and unilateral transfers defines the balance on the current account.

The Current Account deficit is a situation in which the residents of a country spend more on the imports.

Current Account Trade Deficit is a situation in which the countries import are more than the companies exports. The imports of any goods or services that are produced in a foreign country, even if the domestic company is producing these goods or services overseas.

The transactions and their treatment in the Current Account

Credit

Debit

Visible

  • Merchandise Exports
  • Sell of goods

Visible

  • Merchandise Imports
  • Purchase of Goods

Invisible

  • Transfer and Insurance services rendered abroad
  • Foreign tourist expenditure in the country
  • Interest received on loans and investment abroad

Invisible

  • Transfer and Insurance services bought from abroad
  • Indian tourist expenditure out of the country
  • Interest paid on loans and investment abroad

 

 

BoP on Capital Account

The capital account reflects the transactions that generally do notaffect the country’s income, expenditure, production, or savings. This account considers the details of the acquisition or disposal of non-financial assets such as land, machinery, etc. and non-produced assets. Usually, the capital account is the smallestconstituentof the balance of payments.

 

 

BoP on Financial Account

The financial account consists of details such as:

  • Changes related to the domestic ownership of foreign assetsand
  • Foreign ownership of assets held locally.

The deficit is created in the financial account when foreign ownership increases more than domestic ownership. This implies that the country is acquiring assets such as gold, commodities, stocks, and shares at relatively less pace than selling off foreign assets.

 

 

 

Importance of BoP

BoP is used by the Businesses to ascertain whether a market of a country has a potential or it can be a prospective market for the business. As a country having a very large trade deficit is less likely to import goods and services in comparison to a country with a trade surplus. The trade deficit with large quantum may even lead to the restriction on the imports in the form of Trade restrictions such as Tariff rates, Quotas, etc.

Monetary policies and fiscal policies are formed keeping in mind the Balance of Payment as these policies decide the flow of foreign currency in a nation and ultimately results in checking the Balance of payments.

 

Example

To understand the balance of payments, lets consider a small fictional example: not a country, but a family farm.

Lets say that we know the following about how last year went financially for Mr. Hari, who owns a small farm in Rajasthan:

  • They made ?1,00,000 by selling Chana Dal.
  • They spent ?70,000 on operating expenses of the farm, including purchases of new machinery, and another ?40,000 for buying food, paying bills, replacing their worn-out tractor.
  • Their interest income from bank deposits is ?500 but paid ?10,000 for interest on their mortgage.
  • They took out a new farm loan of ?25,000 to help pay for farm irrigation system but did not use the complete loan amount immediately. So they deposited the extra amount in the bank.

Particulars

Sources of Cash

Uses of Cash

Net

Purchase or sale of goods and services

Chana Dal sales:

?100,000

Farm Operation and Living expenses: (70,000+40,000)

?110,000

?10,000

Interest Payments

Interest Received on Bank Account:

?500

Interest Paid on their mortgage:

?10,000

?9,500

Loans and Deposits

Funds Received from new Loan:

?25,000

Funds Deposited in Bank:

?5,500

+?19,500

Total

?125,500

?125,500

?0

The last row shows all the inflows of cash coming in from all sources and outflow of the cash used. These sums are equal, by definition: every unit of money has a source, and every money received gets used somewhere.

A countrys balance of payments accounts is a table which summarizes the countrys transactions with the rest of the world for a given year in a manner very similar to the way we just summarized Mr. Haris financial year.

A countrys balance of payments accounts show payments from foreignerssources of cash for the Country as a wholeand payments to foreignersuses of cash for the Country as a whole.

Particulars

Payments from Foreigners

Payments to Foreigners

Net

Sales and Purchases of Goods and Services

1,646

2,346

-700

Factor Income

818

736

82

Transfers

-113

Current Account

-731

Official Asset Sales and Purchases

411

22

389

Private Sale and Purchases of assets

1653

1267

386

Financial Account

775

Total

44

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