- International Finance Tutorial
- International Finance - Home
- International Capital Markets
- The Interest Rate Parity Model
- Monetary Assets
- Exchange Rates
- Interest Rates
- Forex Intervention
- International Money Market
- International Bond Markets
- International Equity Markets
- Hedging & Risk Management
- Exchange Rate Forecasts
- Exchange Rate Fluctuations
- Foreign Currency Futures & Options
- Transaction Exposure
- Translation Exposure
- Economic Exposure
- Strategic Decision Making
- Foreign Direct Investment
- Long-Term and Short-Term Financing
- Working Capital Management
- International Trade Finance
- International Finance Resources
- International Finance - Quick Guide
- International Finance - Resources
- International Finance - Discussion
Balance of Payments
It is important to measure the performance of an economy. Balance of Payment (BOP) is one way to do so. It shows the big picture of the total transactions of an economy with other economies. It takes the net inflows and outflows of money into account and then differentiates them into sections. It is important to balance all accounts of BOP in case of an imbalance so that the economic transactions can be measured and taken into account in a systematic and prudent manner.
Balance of Payment is a statement that shows an economy’s transactions with the remaining world in a given duration. Sometimes also called the balance of international payments, BOP includes each and every transaction between a nation’s residents and its nonresidents.
Current Account and Capital Account
All the transactions in BOP are classified into two accounts: the current account and the capital account.
Current account − It denotes the final net payment a nation is earning when it is in surplus, or spending when it is in deficit. It is obtained by adding the balance of trade (exports earnings minus imports expenses), factor income (foreign investment earning minus expenses for investment in a foreign country) and other cash transfers. The current word denotes that it covers transactions that are happening "here and now".
Capital account − It shows net change in foreign-asset-ownership of a nation. The capital account consists the reserve account (the net change of foreign exchange of a nation's central bank in market operations), loans and investments made by the nation (excluding the future interest payments and dividends yielded by loans and investments). If net foreign exchange is negative, the capital account is said to be in deficit.
BOP data does not include the real payments. Rather, it is involved with the transactions. This means that the figure of BOP may differ significantly from net payments made to an entity over a period of time.
BOP data is crucial in deciding the national and international economic policy. Part of the BOP, such as current account imbalances and foreign direct investment (FDI), are very important issues which are addressed in the economic policies of a nation. Economic policies with specific objectives impact the BOP.
The Tweak in Case of IMF
The IMF's BOP terminology uses the term "financial account" to include the transactions that would under alternative definitions be included in the general capital account. The IMF uses the term capital account for a subset of transactions that form a small part of the overall capital account. The IMF calculates the transactions in an additional top level division of the BOP accounts.
The BOP identity, according to IMF terminology, can be written as −
Current account + Financial account + Capital account + Balancing item = 0
According to IMF, the term current account has its own three leading sub-divisions, which are: the goods and services account (the overall trade balance), the primary income account (factor income), and the secondary income account (transfer payments).
Points to Note
BOP is an account to show the expenses made by consumers and firms on imported goods and services.
BOP is also a pointer to how much the successful firms of a country are exporting to foreign countries.
The money or the foreign currency entering a nation is taken as a positive entry (e.g. exports sold to foreign countries)
The money going out or expenses of foreign currency is adjusted as a negative entry (e.g. imports such as goods and services)
BOP Table for a Hypothetical Country
The following table shows the BOP for a hypothetical country.
|Item of the BoP||Net Balance ($ billion)||Comment|
|(A) Balance of trade in goods||-20||There is a trade deficit in goods.|
|(B) Balance of trade in services||+10||There is a trade surplus in services.|
|(C) Net investment income||-12||Net outflow of income, i.e., due to profits of international corporations|
|(D) Net overseas transfers||+8||Net inflow of transfers, say, from remittances from non-resident citizens|
|Adding A+B+C+D = Current account balance||-14||Overall, the nation runs a current account deficit|
|Net balance of FDI flows||+5||Positive FDI net inflow|
|Net balance of portfolio investment flows||+2||Positive net inflow into equity markets, property etc.|
|Net balance of short term banking flows||-2||Small net outflow of currency from nation’s banking system|
|Balancing item||+2||There to reflect errors and omissions in data calculations|
|Changes to reserves of gold and foreign currency||+7||(Means that gold and foreign currency reserves have been reduced|
|Overall balance of payments||0|
BOP has to balance, however surpluses or deficits on its individual elements may create imbalances. There are concerns about deficits in the current account. The types of deficits that typically raise concerns are −
A visible trade deficit in case of a nation that is importing significantly more goods than it exports.
An overall current account deficit.
A basic deficit which is the current account plus FDI, excluding short-term loans and the reserve account.
Reasons behind BOP Imbalances
Conventionally, current account’s factors are thought to be the primary cause behind BOP imbalances – these include the exchange rate, the fiscal deficit, business competitiveness, and private behavior.
Alternatively, it is believed that the capital account is the major driver of imbalances where a global savings satiation created by the savers in surplus countries goes ahead of the present investment opportunities.
BOP defines the reserve asset as the currency or other standard value that is used for their foreign reserves. The reserve asset can either be gold or the US Dollar.
According to IMF, between 2000 to mid-2009, official reserves increased from $1,900 billion to $6,800 billion. Global reserves were at the top, about $7,500 billion in mid-2008, then the reserves declined by about $430 billion during the financial crisis. From Feb 2009, global reserves increased again to reach $9,200 billion by the end of 2010.
A BOP crisis, or currency crisis, is the inability of a nation to pay for the necessary imports and/or return the pending debts. Such a crisis occurs with a very quick decline of the nation's currency value. Crises are generally preceded by large capital inflows.
How to Correct BOP Imbalances
There are three possible processes to correct BOP imbalances −
- Adjustments of exchange rates,
- Adjustment of nation’s internal prices along with its levels of demand, and
- Rules-based adjustment.
Rebalancing by Changing the Exchange Rate
If a nation's currency price is increased, it will make exports less competitive and imports cheaper.
When a country is exporting more than what it imports, the demand for its currency will increase in foreign countries because other countries ultimately seek the country's currency to pay for the exports. Therefore, if the country is earning more, it will change (increase) the exchange rate to contain the current account surplus.
Rebalancing by Adjusting Internal Prices and Demand
A possible policy is to increase its level of internal demand (i.e. the nation’s expenditure on goods). An alternative expression for current account is that it is the excess of savings over investment. That is,
Current Account = National Savings – National Investment
When the Savings are in surplus, the nation can increase its investments. For example, in 2009, Germany amended its constitution to reduce its surplus by increasing demand.
Rules-based rebalancing mechanisms
Nations can also agree to determine the exchange rates against each other, and then try to correct the imbalances by rules-based and mutually negotiated exchange-rate changes.
The Bretton Woods system of fixed but adjustable exchange rates is an example of a rules-based system.
Keynesian Idea for Rules-based Rebalancing
John Maynard Keynes believed that surpluses impose negative effects on the global economy. He suggested that traditional balancing mechanisms should add the threat of possession of a section of excess revenue if the surplus country chooses not to spend it on additional imports.
Kickstart Your Career
Get certified by completing the courseGet Started