Balance of Payments
In our everyday lives, we keep a track of our money outflows and inflows. This helps us in optimizing our expenditure and realizing our gains and losses. Similarly, governments like to keep a track of the money that flows in and out of their countries over a period of time. This record of all the economic transactions of goods, services, investment, assets, etc. of a country with the rest of the world over a specified period of time is called a balance of payments. A balance of payments account has a credit and debit side, which are money inflow and money outflow respectively. Trades from both the public and private sectors are included.
It's fairly simple, the value of the volume of trade that takes place between a country and the rest of the world is accounted for in BOP, all the outflows are on the debit side and inflows on the credit side.
Before delving deeper into the components of BOP and various transactions it accounts for, it's imperative to know why BOP is so important for the government and what it signifies.
Significance of BoP
Highlights the international standing of a country’s economy, if the economy requires support in the form of exports then the government should focus on policies which the government can recognize the areas that have the possibility for export-oriented growth and can prepare policies supporting those domestic industries.
Analysis of BOP can help identify the dependence of a nation on another.
The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries.
A balance of payments deficit per se is not proof of the competitive weakness of a nation in foreign markets. However, the longer the balance of payments deficit continues, the more it would imply some fundamental problems in that economy.
Now, BoP has three major components or what we call accounts, namely- Current account, Capital account, and Financial account
Current Account
The current account measures imports and exports of goods and services, payments to foreign holders of a country's investments, payments received from investments abroad, and transfers such as foreign aid and remittances. Exports are recorded as credits in the balance of payments, while imports are recorded as debits. The current account may be positive (a surplus) or negative (a deficit); positive means the country is a net exporter and negative means it is a net importer of goods and services.
Components of a current account
Trade-in goods (visible balance of imported and exported goods)
Trade-in services (invisible balance), e.g. flow of services in and out of a country
Investment incomes; e.g. dividends, interest.
Net /Unilateral transfers – Money transferred from one person or group to another (e.g. from the government to individuals) without production taking place. eg - Migrants remittances from/to abroad.
Factors affecting current account
Since the trade balance (exports minus imports) is generally the biggest determinant of the current account surplus or deficit, the current account balance often displays a cyclical trend. During a strong economic expansion, import volumes typically surge; if exports are unable to grow at the same rate, the current account deficit will widen. During a recession, the current account deficit will shrink if imports decline and exports increase to stronger economies.
The exchange rate exerts a significant influence on the trade balance, and by extension, on the current account. An overvalued currency makes imports cheaper and exports less competitive, thereby widening the current account deficit or narrowing the surplus. An undervalued currency, on the other hand, boosts exports and makes imports more expensive, thus increasing the current account surplus or narrowing the deficit.
Capital account
The capital account of BoP records all those transactions, between the residents of a country and the rest of the world, which cause a change in the assets or liabilities of the residents of the country or its government. It is related to claims and liabilities of financial nature. The capital account indicates whether a country is importing or exporting capital. Big changes in the capital account can indicate how attractive a country is to foreign investors and can have a substantial impact on exchange rates.
Components of capital account
Borrowings and lendings to and from abroad
All transactions relating to borrowings from abroad by the private sector, government, etc. Receipts of such loans and repayment of loans by foreigners are recorded on the positive (credit) side.
All transactions of lending abroad by the private sector and government. Lending abroad and repayment of loans abroad is recorded as a negative or debit item.
Investments to and from abroad:
Investments by the rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange.
Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments abroad are recorded on the negative (debit) side as they lead to the outflow of foreign exchange.
Change in Foreign Exchange Reserves:
The foreign exchange reserves are the financial assets of the government-held in the central bank. A change in reserves serves as the financing item in India’s BOP. So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side. It must be noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’.
Balance of Capital Account:
When the net value of credit and debit is equal, then the account is balanced
A surplus in a capital account arises when credit items are more than debit items. It indicates the net inflow of capital.
A deficit in a capital account arises when debit items are more than credit items. It indicates the net outflow of capital.
Disequilibrium of BoP
When a country’s current account is at a deficit or surplus, its balance of payments (BOP) is said to be in disequilibrium.
Disequilibrium in the balance of payment means its condition of Surplus Or deficit.
A Surplus in the BOP occurs when Total Receipts exceed Total Payments. Thus, BOP= CREDIT>DEBIT.
A Deficit in the BOP occurs when Total Payments exceed Total Receipts. Thus, BOP= CREDIT<DEBIT.
Disequilibrium is a result of a mismatch between the market forces of supply and demand. The mismatch is generally resolved through market forces or government intervention
Current account deficit and financial/capital account surplus:
When there is a current account deficit and capital account surplus, this would mean that while more capital/money is flowing out than is flowing in, thus putting the current account in deficit, the assets in the country increase. Note here that “money flowing out” doesn’t just mean importing goods from other countries. For example, it could be a situation where a foreign investment company produces machinery locally that is then being bought in the same country-this would still count as money flowing out because the profit of the company is being sent back to its domestic country, not staying in the country it is based in.
Consequences:
a deficit in the current account can be unsustainable if the consumption of imports is funded through foreign borrowing and foreign debt will grow
a surplus in the financial account means that a lot of the assets in your economy are controlled by foreign companies, causing dependency.
A current account deficit and financial account surplus may be due to foreign investments in an economy (if for example, it is due to the transfer of payments to a foreign country of the firm's origin). This means that foreign firms will have an increasing claim on assets in your country.
Oftentimes when there is a current account deficit, this may mean that the economy is uncompetitive in the global market, as it means that there is a low demand for exported goods.
If imports are much higher than exports, there may be depreciation, which means that your currency gets weaker, causing exports to become cheaper but imports to become more expensive. More expensive imports mean that it becomes more expensive for firms to buy imported capital, and for consumers to buy goods internationally.
Import inflation can be caused where prices in an economy rise because imports become much more expensive due to the exchange rate becoming weaker.
Consequences in detail:
Although disequilibrium due to current account deficit (and capital surplus) is often seen as bad for the economy, it doesn’t necessarily have to be. The effect can either be positive or negative depending on the case.
Let’s see how current account deficit can affect 2 different economies:
- If an economy is growing at a rapid pace, it will likely attract foreign investments and the benefits that come with it (e.g capital, new technology, education) and/or start importing capital from other countries themselves. This may put it in a current account deficit, however, by doing so the economy has the resources to develop at a higher rate. It is an investment into the future that will eventually pay off when the country starts seeing rises in GDP, exporting more, and sees a rise in living standards.
- However, take a developing economy that is inefficient and a current account deficit will have a severe impact on it. Having fewer exports than imports can mean that the country has used foreign borrowing to sustain its level of consumption, which can lead to higher and higher levels of debt. Foreign investments in this country may lead to exploitation of land and labour, and will only worsen the deficit in the current account as the firm's profits will be sent back to its country of origin.
A surplus in the balance of payments and deficit in capital/financial account:
This is a disequilibrium situation where the more money is flowing into the economy the more assets are flowing out. For example, if the surplus in the current account is due to exports > imports, this means that there are more net exports, which are assets flowing out of the country, which lead to money from those exports flowing in. Thus, there is a surplus in the current account (as more money is injected into the economy than is withdrawn) and a deficit in the capital account (as more assets are being withdrawn than are being injected through import).
Consequences:
Note that the consequences of this type of disequilibrium are often very subjective depending on the economy and the magnitude of the surplus, so beware.
Higher economic growth. A surplus in the current account means will cause higher economic growth, as the net exports (exports-imports) are higher which means the aggregate demand of the economy’s goods and services is higher. This leads to an increase in GDP as the higher the aggregate demand, the more profit firms get. They can then use this money to expand and output more products, leading to a higher GDP. A higher GDP will then lead to a multitude of other effects, some of which are:
Lower unemployment
Higher inflation
Higher standards of living
More taxes
More government investment in infrastructure and merit goods.
A surplus in the current account may also be due to low imports, which is good because if there are few imports, that means the goods and services are being bought domestically, which is good for the economy as less money is flowing out.
More exports than imports mean that the exchange rate will likely strengthen, which means the goods and services from that economy become more expensive for the rest of the world. This will mean that exports of that economy will decrease. At the same time, imports become cheaper, so more goods will be imported. This means that while a surplus can have positive effects on the economy, it is often unsustainable.
A current account surplus may mean that there are growing foreign investments in other countries. For the country of investment origin, this is good news because they receive the money from these investments and have more assets around the world. However, this can be bad for the country into which the economy invests (see above in the last paragraph of consequences in detail)
Policies to adjust the balance of payments:
To change the balance of payments, the government can impose different policies. Most often, they will target the balance of trade in order to improve the current account, and thus, the balance of payments. Most commonly these measures are taken whenever the economy is in a deficit, as that is the undesirable circumstance when it comes to a balance of payments disequilibrium. Some measures:
decreasing imports: the government can impose trade restrictions on imports in order to decrease their quantity:
Tariffs are a tax on imported goods which make them more expensive, thereby decreasing the amount demanded
A quota is a restriction on the supply of imports, which causes the price of the product to go up, making the demand for it smaller.
An embargo prevents certain, and sometimes all, goods from a particular country from being imported.
More restrictions can be put on imported goods, for example increasing the health and safety standards in order to prevent some goods from being imported.
Increasing exports: the government can use policies to stimulate the economy’s exports:
Increasing availability of credit. When credit becomes cheaper and more available, more firms will take credit in order to expand and invest, causing their goods to become cheaper and increasing their international level of competitiveness.
Restrictions can be simplified. By doing so, it will become cheaper for firms to export, increasing the exports.
Supply subsidies. By giving subsidies, the government makes the production process cheaper, allowing firms to export goods at lower prices.
Depreciating currency. By artificially depreciating the currency, an economy can make its exports cheaper to other countries, increasing the demand for them.
These policies can be used in order to influence the current account. They are often targeted towards keeping the balance of payments in equilibrium
