Concept OF BOT
• Balance of trade refers to the total volume of export and import of
visible goods of a country with rest of the countries in the world.
• Therefore, it shows the trade transaction in monetary term of visible
goods with the rest of the world during a year.
• Since it studies only about the visible trade, it is taken as a partial
study of the total economic transactions in the international trade.
• BOT has three different aspects:
• 1. Balance of trade: value of export is equal to value of import of
visible goods.
• 2. Deficit balance of trade: value of export is less than the value of
import of visible goods.
• 3. Surplus balance of trade: value of export is more than the value of
import of visible goods.
Concept of BOP
• Balance of payment is the sum of all the transactions that takes place
between its residents and the residents of foreign countries in the
world.
• In other words, it is a comprehensive record of economic transaction
of the residents of a country with the rest of the world during a given
period of time.
• Therefore it covers the transaction of all exports and imports of both
visible and invisible goods such as monetary value of all exported and
imported goods, services such as tourism service, interest and
dividend paid abroad or received etc
• BOP has three different aspects:
• 1. Balance of payment: value of export is equal to value of import of
all visible and invisible goods.
• 2. Deficit balance of payment: value of export is less than the value of
import of visible and invisible goods.
• 3. Surplus balance of payment: value of export is more than the value
of import of visible and invisible goods.
Balance of payments
• A country engaging in foreign trade will be making payments to
foreign countries and receiving payments.
• Each nation keeps account of its transactions with the rest of the
world, which is present in the form of balance of payments.
• IMF has recommended method for the presentation of nationals’
balance of payments accounts to enable international comparisons to
be made.
• BOP consists of three main headings:
1.The current account
• The current item is divided into four categories i.e.
• Trade in goods: It covers the exports and imports of visible goods.
• For example, the export of cooking oil from Nepal appears as a credit
item (+) as it involves money coming into the country where as the
imports of cars from India appears as a debit item.(-)
• Trade in services: It covers the exports and imports of services (invisible
trade).
• For example, foreign tourists spend time in Nepal is recorded as a credit item
and purchase of financial services from abroad by Nepali residents appears
as a debit item.
• Primary Income
• It covers income in the form of profits, interest and dividends earned on
direct investment abroad and foreign earning on investment in the country.
• For example, dividends paid on foreign shares to residents in the country
appear as credit items. While interest paid to foreigners on bank accounts
they hold in the country are debit items.
• Likewise, any dividend paid on foreign shares held by Nepali residents
are recorded as credit item where as interest paid to foreign deposit
holders in banks of Nepal is recorded as debit item.
• Current transfers/ secondary income
• It consists of payments and receipts where there is no corresponding
exchange of goods and services.
• So it includes government transfers such as payments to and receipts
from international organizations such as foreign aid, EU social fund,
social security payment abroad, military grants.
• Transfer by private individuals are also included in this part of current
account. One such transfer is workers’ remittances.
• This transfer of money from people working in a foreign country back
to their families at home forms a large credit item in the case of some
countries like Nepal.
2. The Capital Account
• The capital account records the transactions which involve the
transfer of ownership of fixed assets and disposal of non- financial
assets.
• This concept came into existence in 1998.
• It is relatively small section which is usually in surplus.
• It includes two categories:
i. Capital transfer: It includes for instance, money brought into and
taken out of the country by migrants, debt forgiveness by a
creditor through mutual agreement.
ii. Disposal of non-produced/ non-financial assets: It is concerned
with the purchase and sale of particular assets e.g. land purchased
or sold by a foreign embassy, purchase and sale of patents, copy
rights, trademarks.
3.The Financial Account:
The financial account is a significant of many countries’ BOP which
records large movements of funds into and out of the country. It has four
parts:
1. Direct investment: It concerns investments by residents of a country in
a broad and investments by non-residents in a country.
Foreign investment in a country involves money entering the country and
is recorded as a credit item whereas investment abroad, which involves
money leaving the country is recorded as a debit item.
For example: Building of a factory in another country and the takeover of
an existing firm in another country (debit item) or setting up of a new
plant or takeover of a firm in the country by a foreign firm(credit item)
• 2. Portfolio Investment: This includes the purchase and sale of
government bonds and shares that do not involve legal control.
• 3. Other Investments: this part covers shorter-term movements of
financial investment including bank loans and inter-government loans.
• 4. Reserve assets: These are made up of the government’s holding of
gold, foreign exchange reserves, special drawing rights and changes in
the country’s reserve position in the IMF.
• Of all the countries in the world, China had, by far, the largest
international reserves in August 2020, with 3.46 trillion U.S. dollars in
reserves and foreign currency liquidity.
• Reserves are kept to settle international debts and to influence the
value of the foreign exchange rate.
• Additions to the reserves are shown as debit items, while reductions
to the reserves are shown as credit items.
• Net errors and omissions:
As we know that balance of payment is a balance sheet. In this
balance sheet, the total outflow of money, debit items, must be equal
to the total inflow of money, credit items.
So when added together, the current, capital, financial account, net
transactions balances should be added up to zero.
However, in practice, because of mistakes and failure to record all
items, there is always a discrepancy.
The net errors and omissions (which is also known as the balancing
item) is the amount which is required to bring the recorded balance
of payments into balance.
• The inclusion of net errors and omissions makes the sum of the
credit & debit items equal to zero.
• A positive balancing item (net errors & omissions) means there has
been an unrecorded net inflow of foreign currency.
Summary of UK, BOP accounts for
2012
Category Credits Debits Balance
Current account
Trade in goods 299457 407350 -107893
Trade in services 193353 119361 73992
Net trade in goods and -33901
services
Income 161980 164234 -2254
Current transfers 17519 40574 -23055
Total current account 672309 731519 -59210
Capital account 6140 2352 3788
Financial account 75183 26970 48213
Reserve assets 7642
Total current, capital and 651479 658688
financial account
Net error and omissions -7209
Balance of payments problem
• Generally economists are concerned about BOP problem.
• So, it is necessary to know the condition of equilibrium and
disequilibrium in BOP.
• Equilibrium in BOP
• Equilibrium in BOP refers to a situation where manageable deficits are
cancelled out by modest( sufficient in size) surplus.
• Under such condition there is no particular tendency for the exchange
rate to change.
• So in short run, it doesn’t mean that a deficit is bad and a surplus is
good.
Two conditions of equilibrium
• 1. Imports of goods and services exceeds exports but the deficit is off
set by an inflow of foreign direct investment.
• It means that current account deficit is compensated by a financial
account surplus, then equilibrium occurs.
• 2. Export of goods and services exceeds import but there is
substantial investment abroad by companies and residents which
makes balance.
• It means that current account surplus is recorded but matched by a
deficit on financial account.
Disequilibrium in BOP
• This situation occurs when a country is recording persistent deficit or
surplus in its BOP over a particular period of time.
• As a result of this, the exchange rate is overvalued or undervalued on
foreign exchange market.
• In this situation, particularly in the case of deficit, correction action is
necessary to prevent the economy from draining its foreign currency
reserve.
The disequilibrium of BOP arises
due to the following conditions:
• 1. The imports of goods and services exceeds exports and the
financial account is in deficit.
• 2. Exports of goods and services may just exceeds import but there is
persistent deficit on the financial account.
• 3. Sometimes, if there is a large surplus on current account, and
overall BOP surplus, for e.g. in the case of Japan, this situation
occurred for many years.
Causes of BOP disequilibrium
• The main causes of disequilibrium can be identified as:
• 1. The economy has a high propensity to import of goods, as a result
substantial deficits are recorded annually on trading account ( current
account).
• Generally this is the problem of developing countries. These countries
have very limited domestic production and have to rely on imported
goods to meet the demand of their consumers.
• As far as exports are concerned, they often rely heavily for their export
revenue on sales of primary products.
• In such economies the terms of trade are often unfavorable.
• It means that they have to continuously export greater volume of goods
for the same export revenue due to devaluation of the currency.
• Therefore they have long term trading deficits on their current account.
• 2. There may be lack of confidence in a particular economy as a result
there will be few capital inflows.
• There may even be a situation of an outflow of capital from the
economy. Confidence may also be seriously affected by political
reason and this may discourage foreign investors.
• 3. At a period of expansion in the economy, consumers’ spending
power increases, it could produce a situation where more amount of
income is spent on imported goods. The number of importers are
increased which may create serious problems for the overall BOP.
Consequences of BOP disequilibrium
• For domestic economy
• 1. In domestic economy, industries suffer deindustrialization because
of increasing demand for imported goods.
• Therefore long term unemployment is an obvious consequence.
• 2. Because of low business confidence, foreign investors reluctant to
invest in that economy with a BOP disequilibrium.
• In this situation, economic prospects will be uncertain and there is a
possibility that currency will be devalued and the new investors are
hardly encouraged to invest in that economy.
• 3. Consumers can get only fewer stock of certain imported consumer
goods. The general range will be restricted because these products are not
produced domestically.
• A higher rate of tax is imposed on imports in order to restrict consumption.
• For external economy
• 1. Disequilibrium in BOP will put pressure on the government to introduce
the methods of protection.
• 2. Because of imported goods exceeding exports, the exchange rate has to
be devalued. It may create the situation that , citizens may lose their
confidence on their own currency.
• Activity 27.1
• 1 Balance of trade in goods: -$950bn.
• 2 Balance of trade in services: $270bn.
• 3 Balance of trade in goods and services: - $680bn,
• 4 Current account balance: - $554bn.
Activity 27.2 answers:
• 1 An increase in interest, profits and/or dividends received by domestic
economic agents.
• 2 An improvement in the balance of trade can occur for two reasons: a
country can either export more or import less in value terms. Output
and productivity had improved in the US leading to lower average costs
enabling US firms to become more price competitive, thus increasing
exports.
• Secondly, the ageing demographic of the US population means that the
nation’s propensity to import falls as older people tend to spend more
on services that are domestically produced and relatively less on goods
that are imported.
Activity 27.3 Answers
• 1. Credits: $2062m + $442m + $85m + $2215m = $4804m
• Debits: $4741m + $733m + $594m + $14m = $6082m
• Current balance = $4804m − $6082m = -$1278 deficit
• 2. Net of workers’ remittances: $2060m + $1278m = $3338m deficit
Activity 27.4
• 1 a The countries with the three highest inflation rates – Argentina,
Turkey and the UK – have current account deficits and the countries
with the lowest inflation rates, Australia, Germany and Singapore,
have current account surpluses.
• A higher inflation rate may reduce demand for the country’s exports
and increase demand for its imports as the country’s products are
likely to lose international price competitiveness. However, the UK’s
inflation rate was only slightly higher than those of Australia and
Germany but its current account balance differs to a greater extent.
• b Countries with a current account deficit might be expected to have
a low or negative economic growth rate. This is because a current
account deficit will reduce aggregate demand. The information
supports this to Argentina and Turkey, which both had deficits, had
negative economic growth rates. However, the UK had a relatively
high deficit but the second highest economic growth rate.
• A current account surplus will add to aggregate demand and might
be expected to add to economic growth. However, Singapore had a
large current account surplus but only a low economic growth rate.
Net exports is only one component of AD and economic growth is also
influenced by changes in AS.
