The balance of payment is defined as a systematic record of all economic transactions between the residents of a country and residents of foreign countries during a certain period of time. Although the above definition of balance of payments is quite revealing certain terms used in the definition may require some clarification. The term’s systematic record does not refer to any particular system. However, the system generally adopted is double entry book-keeping system. Economic transactions include all such transactions that involve the transfer of title or ownership. While some transactions involve physical transfer of goods, services, assets and money along with the transfer of title while other transactions do not involve transfer of title. For example, suppose that a subsidiary company of a foreign undertaking is operating in India and making profit. This company may pay all its profits as dividend to the shareholders abroad, or it may, alternatively reinvest its profit in India instead of paying dividends to its parent company abroad. Both kinds of transactions are recorded in the balance of payments accounts. The time period for balance of payments is not specifically defined, it can be of any period. The generally period is one financial year of calendar.
Purpose of Balance of Payments
The balance of payment serves a very useful purpose as it yields necessary information for the future policy formulation in regard to domestic monetary and fiscal policies and foreign trade policy.
Following are the important uses of balance of payments:
- It provides useful data for the economic analysis of country’s weakness and strength as a partner in the international trade. By comparing the statements contained in the balance of payments for several successive years, one can find out whether international economic position of the country is improving or deteriorating. In case it is deteriorating, necessary corrective measures can be taken.
- It reveals the changes in the composition and magnitude of foreign trade. The changes that curb economic well-being of a country are taken care by the government.
- It also provides indications of future repercussions based on countries past trade performances. If balance of payments shows continuous and large deficits over time then it indicates growing international indebtedness, which ultimately leads to financial bankruptcy. Similarly. a continuous large-scale surplus in the balance of payments, particularly when its magnitude goes beyond the absorption capacity of the country indicates impending dangers of inflation.
- Detailed balance of payments accounts also reveal weak and strong points in the country’s foreign trade relations and thereby invite government attention to the need for corrective measures against the weak spots.
Balance of Payments Accounts
The economic transactions between a country and the rest of the world may be grouped under two broad categories:
- Current transactions: Current transactions pertain to export and import of goods and services that change the current level of consumption in the country or bring a change in the current level of national income.
- Capital transactions: Capital transactions arc those transactions, which increase or decrease country’s total stock of capital, instead of affecting the current level of consumption or national income. In other words, current transactions arc flow transactions. In accordance with the two kinds of transactions, balance of payments account is divided into two major accounts:
1. Current Account
The items, which are entered in the current account of balance of payments, are listed in the following Table, in the order of their importance. The categories of items presented in the table were published by the IMF and are currently followed in India. In the ‘credit’ column values receivable are entered and in ‘debt’ column values payable are entered. The net balance shows the excess of credit over the debit for each item, can be negative (-) or positive (+). The items listed in current account can be further grouped into visible and invisible items. Merchandise trade, i.e., export and imports of goods, fall under the visible items. Rest all other items in the current account payment and receipt for the services, such as banking, insurance and shipping are termed as invisible. Sometimes another category, i.e., un-required transfer, is created to give a separate treatment to the items like gifts, donations, military aid, and technical assistance. These are different from other invisible items since they involve unilateral transfers.
The net balance on the visible items, i.e., the excess of merchandise exports (Xg) over the merchandise imports (Mg) is called as balance of trade. If Xg < Mg it is unfavorable The overall balance on the Current Account is known as ‘Balance on Current Account.’ The ‘Balance on the Current Account’ either surplus or deficit is carried over to the Capital Account.
|2. Foreign travel|
|4. Insurance (premium)|
|6. Government (purchases and sales of goods and services)|
|Current Account Balance|
* Includes motion picture royalties, telephones and telegraph services, consultancy fees, etc.
2. Capital Account
As mentioned earlier, the items entered in the capital account of balance of payments are those items, which affect the existing stock of capital of the country. The broad categories of capital account items are: (a) short-term capital movements; (b) long-term capital movements; and (c) changes in the gold and exchange reserves.
- Short-term capital movements include (i) purchase of short-term securities such as treasury bills, commercial bills and acceptance bills, etc.; (ii) speculative purchase of foreign currency; and (iii) cash balances held by foreigners for such reasons as fear of war and political instability. An item of short-term capital results often from the net balances (positive or negative) in the Current Account.
- Long-term capital movements include: (i) direct investments in shares, bonds, real estate and physical assets such as plant, building and equipment’s in which investors hold a controlling power; (ii) portfolio investments including all other stocks and bonds such as government securities, securities of firms which do not entitle the holder with a controlling power; and (iii) amortization of capital, i.e., repurchase and resale of securities earlier sold to or purchased from the foreigners. Direct export or import of capital goods fall under the category of direct investment. It should be noted that export of capital is a debit item whereas export of merchandise is a credit item. Export of goods result in inflow of foreign currency, which is an addition to the circular flow of money income, whereas export of capital results in outflow of foreign exchange which, amounts to withdrawal from the foreign exchange reserves.
- Gold and foreign exchange reserves make the third major category of items in the capital account. Gold and foreign exchange reserves are maintained to stabilize the exchange rate of the home currency and to make payments to the creditors in case there exists payment deficits on all other accounts.
Balance of Payments always Balances
The balance of payments accounting is based on the double-entry book-keeping system in which both sides of a transaction, i.e., receipts and payments are recorded. For example, exports involve out-flow of goods and inflow of foreign currency. Similarly, imports involve inflow of goods and outflow of foreign currency. Both, inflow and outflow are recorded in this system. International borrowing and lending give rise to credit to the lender and debit to the borrower. Both are recorded in the balance of payments. However, donations, gifts, aids and assistance are unilateral transfers and do not involve transfer of an equivalent value. In regard to these items, there is only credit and no debit since they are nonrefundable. Yet, the receiving country is debited to keep the record of nonrefundable amounts and donator is credited for the record purposes. Such entries have information value for non-economic purposes. Besides, these transactions reduce the deficit in the current account of the reporting country. Since in this system of balance of payments accounting international transactions are entered on both debit and credit sides. Balance of payments always balances from the accounting point of view.