• What Is the Balance of Payments (BOP)?
• The balance of payments (BOP), also known as the balance of international
payments, is a statement of all transactions made between entities
in one country and the rest of the world over a defined period, such as a quarter
or a year. It summarizes all transactions that a country's individuals, companies,
and government bodies complete with individuals, companies, and government
bodies outside the country.
Balance of Payment (BOP) always
Balances.
• A nation’s BOP is a summary statement of all economic transactions between the residents of a
country and the rest of the world during a given period of time.
• A BOP account is divided into current account and capital account. Former is made up of trade in goods
(i.e., visibles) and trade in services (i.e., invisibles) and unrequited transfers. Latter account is made up
of transaction in financial assets. These two accounts comprise BOP.
• A BOP account is prepared according to the principle of double-entry book keeping. This accounting
procedure gives rise to two entries—a debit and a corresponding credit. Any transaction giving rise to a
receipt from the rest of the world is a credit item in the BOP account. Any transaction giving rise to a
payment to the rest of the world is a debit item.
• The left hand side of the BOP account shows the receipts of the country. Such receipts of external
purchasing power arise from the commodity export, from the sale of invisible services, from the
receipts of gift and grants from foreign governments, international lending institutions and foreign
individuals, from the borrowing of money from foreigners or from repayment of loans by foreigners.
• The right hand side shows the payments made by the country on different items to foreigners. It shows
how the total of external purchasing power is used for acquiring imports of foreign goods and services
as well as purchase of foreign assets. This is the accounting procedure.
• However, no country publishes BOP accounts in this format. Rather, by convention, the BOP figures are
published in a single column with positive (credit) and negative (debit) signs.
• Since payments side of the account enumerates all the uses which are made up
of the total foreign purchasing power acquired by this country in a given period,
and since the receipts of the accounts enumerate all the sources from which
foreign purchasing power is acquired by the same country in the same period, the
two sides must balance. The entries in the account should, therefore, add up to
zero.
• In reality, why should they add up to zero? In practice, this is difficult to achieve
where receipts equal payments.
• In reality, total receipts may diverge from total payments because of:
• (i) The difficulty of collecting accurate trade information
• (ii) The difference in the timing between the two sides of the balance
• (iii) A change in the exchange rates, etc.
• Because of such measurement problems, resource is made to ‘balancing item’ that intends to
eliminate errors in measurement. The purpose of incorporating this item in the BOP account is to
adjust the difference between the sums of the credit and the sums of the debit items in the BOP
accounts so that they add up to zero by construction.
• Hence the proposition ‘the BOP always balances’. It is a truism. It only suggests that the two
sides of the accounts must always show the same total. It implies only an equality. In this book-
keeping sense, BOP always balances.
• Thus, by construction, BOP accounts do not matter, In fact, this is not so. The accounts have both
economic and political implications. Mathematically, receipts equal payments but it need not
balance in economic sense. This means that there cannot be disequilibrium in the BOP accounts.
• A combined deficit in the current and capital accounts is the most unwanted macroeconomic
goal of an economy. Again, a deficit in the current account is also undesirable. All these suggest
that BOP is out of equilibrium.
• But can we know whether the BOP is in equilibrium or not? Tests are usually three in number:
• (i) Movements in foreign exchange reserves including gold
• (ii) Increase in borrowing from abroad
• (iii) Movements in foreign exchange rates of the country’s currency in question.
• Firstly, if foreign exchange reserves decline, a country’s BOP is considered to be in
disequilibrium or in deficit. If foreign exchange reserves are allowed to deplete
rapidly it may shatter the confidence of people over the domestic currency. This
may ultimately lead to a run on the bank.
• Secondly, to cover the deficit a country may borrow from abroad. Thus, such
borrowing occurs when imports exceed exports. This involves payment of interest
on borrowed funds at a high rate of interest.
• Finally, the foreign exchange rate of a country’s currency may tumble when it
suffers from BOP disequilibrium. A fall in the exchange rate of a currency is a sign
of BOP disequilibrium.
• Thus, the above (mechanical) equality between receipts and
payments should not be interpreted to mean that a country never
suffers from the BOP problems and the international economic
transactions of a country are always in equilibrium.
Current Account Definition
• The current account is a record of businesses in commodities, transfer
payments, and services. Trade-in commodities comprise the exports
and imports of commodities. Trade-in services comprise factor
income and non-factor income transactions or undertakings.
• Transfer payments are the receipts that the citizens of a nation get for
free’, without having to provide any commodities or services in
return. They consist of remittances, grants, and gifts. They could be
provided by the government or by private residents living abroad.
• Capital Account Definition
• The capital account records all the international undertakings of assets. An asset
is any one of the types in which wealth can be held. For instance, stocks, bonds,
government debt, money, etc. The purchase of assets is a debit on the capital
account. If an Indian purchases a UK car company, it enters the capital account
undertakings as a debit (as foreign exchange is going out of India).
• On the other hand, the sale of assets, like the sale of the share of an Indian
company to a Japanese customer, is a credit on the capital account. These items
are foreign direct investments (FDIs), foreign institutional investments (FIIs),
assistance, and external borrowings.
• What Is an Official Settlement Account?
• An official settlement account is a special type of account used in
international balance of payments (BoP) accounting to keep track of
central banks' reserve asset transactions with one other. The official
settlement account keeps track of transactions involving gold, foreign
exchange reserves, bank deposits and special drawing rights (SDRs).
• Essentially, this type of account keeps track of transactions related to
international reserves and central bank assets that are transferred
among nations to settle either a balance of payment deficit or
surplus.
• The Equilibrium and Disequilibrium in the Balance of Payments!
• Before we analyse the causes of disequilibrium in the balance of payments, we
would like to explain what is meant by equilibrium in the balance of
payments.When we add up all the demand for foreign, currency and all the sources
from which it comes, these two amounts are necessarily equal and thus the overall
account of the balance of payments necessarily balance or must always be in
equilibrium.
• What then do we mean by when we say that the balance of payments of a country
is ‘in equilibrium or disequilibrium’. As a matter of fact, when we speak of
equilibrium or disequilibrium in the balance of payments we refer to the balance
on those parts of the account which do not include the accommodating items such
as borrowing from the IMF, use of SDRs, drawing from the reserves of foreign
currencies held by the Central Bank, etc.
• When excluding these accommodating items there is neither deficit nor surplus
in the overall balance of payments, it is said to be in equilibrium. When in this
sense, there is either deficit or surplus, the balance of payments is said to be in
disequilibrium.
• The deficit in balance of payments can be financed by drawings from the IMF,
use of SDRs, drawings from the reserves of foreign currencies and loan and aid
received from abroad. For example in 2001-02, we added to our foreign
exchange reserves to the tune of 11757 million US dollars.
• However for previous several years India’s balance of payment on current
account was in deficit. To finance the deficits India borrowed from IMF or from
other countries or even resorted to commercial borrowing from abroad. But
India’s balance of payments for the year 2001-02 was favourable.
