Balance of Payments Concepts - Components - Importance - Examples

Question: Discuss about the Introduction Balance of Payment. Answer: Introduction The balance of payment is the statement that briefs a countrys economy transactions with the rest of the globe for a particular period. On a general basis BOP of a country is calculated quarterly in every financial year. The Balance of Payment or in short BOP is also known as the balance of international payments, encloses all the business affairs between citizens of a country and the non-residents which include services, financial claims, liabilities, goods, income, and any transfers such as gifts (Alawattage, 2009). All the business transactions handled by either the public sector or a private sector are accounted for in the Balance of Payment to find out the amount of money going out and coming in the country. If money is coming in the country, then it is known as a credit, and when money goes out of the country then it is known as debit. These transactions are divided into three accounts by the BOP, and they are the Current account, the financial account, and the capital account. The current accounts consist of the business transactions in services, investment income, current transfers, and goods, while the capital account mostly consists of business transactions in financial instruments. A country economys BOP transactions, dealings, and international investment position are calculated together to establish its set of international accounts. In theory, the Balance of Payment of a country that includes the assets that are the credits of the country and the liabilities that is the debit of the country should be zero, but in reality, this rarely happens. Thus, the BOP of a country can tell clearly that from where the differences are emerging in the economy (Bussire, 2013). Breaking Down of the Balance of Payment The balance of payment is not actually includes the payment of money and receiving of money by an economy of a country. But, it is the data that includes the transactional details of a country with rest of the world. Many times the international collaborations get included in the BOP does not include money payment. Thus, the numbers here can be very much different from the actual payments made over a period to foreign entities. As mentioned before that BOP never actually balances. In theory, a deficit amount in a current account has to be financed with the help of net inflow coming in the financial and capital account, a surplus amount of current account need to be corresponded in the financial and capital account to an outflow to get a zero net figure (C., 2015). When the actual figure has calculated the data that is compiled with the help of multiple sources, increase the chances of measurement error up to some level. In the formulation of national and international economy policy, the data about the balance of payment and position of international investment is very critical. Various aspects of BOP data are the key issues that need to be addressed for a nations economic policies, and they are payment imbalances and foreign direct investment. The economic policies formed by a country are often designed to target some specific objectives and goals and which in turn leaves an impact on the BOP of the country. For example, policies that are specially created to attract foreign investment can be adopted by a nation to increase foreign investment in a particular sector. Another country can adopt a policy that keeps the currency of the country at an artificially depressed level to increase exports that will help in creating currency reserves for that country. The ultimate impact of these policies will be seen in the balance of payment (Chernyak, Khomiak and Chernyak, 2013). The Balance of Payment of a country is divided into three categories, and they are as follows:- The Current Account- to mark the outflow and inflow of goods and services into a nation the current account is used. Any type of earnings done on investments, both on private sector and public sector, are also added in the current account. The credits and debits on the transactions of products like raw materials, and the produced goods that are sold, bought, or given away many be in the form of an aid, comes in the current account. The services that are included in the current account are like receipts earn from tourism, business service fees, engineering, transportation, and royalties gained from copyrights and patents (Egger and Maria Radulescu, 2011). The combination of goods and services makes the nations balance of trade. Combining the total of imports and exports made up the BOT that is the maximum sum of a countrys BOP. If a countrys BOT is showing deficit, then the imports of the country are more than the exports, and if the country has a surplus BOT, then the exports of the country are more than its imports. Any type of receipts coming from income-generating assets like stocks is also added in the current account. The last part of BOP that is included in the current account is Unilateral Transfers. These unilateral transfers are generally the salaries credit in the accounts of workers working abroad and sending their salaries to the home country. Also all types of foreign aids directly received by the country come under the unilateral transfers (Eichengreen, 2013). The countrys current account is the best indicator of the economys health. Current account showing a positive balance displays that the country is the net lender to the other countries, while if the balance of the current account is negative than it makes the country a net borrower. A countrys net assets increase with the surplus current account balance and decreases if the account shows the deficit amount. A countrys current account balance gets affected by various factors like the trade policies of the country, its exchange rate, forex reserves, inflation rate, and competitiveness (Filipovic and Garic, 2014). The Capital Account- the capital account includes all the international capital transfers. Acquisition or disposal of any type of non-financial assets is included in the capital account such as physical assets like a land, assets that are not produced yet but needed for production, like a mine which is being used for extracting coal. The capital account could be divided into the financial flows that are branched into debt forgiveness, financial assets gained through the migrants leaving or entering a nation, the transfer of goods, transferring the ownership of fixed assets, all types of gifts and inheritance taxes, uninsured damage of fixed assets, death levies, and funds received from acquisition or sale of land (Freund, 2010). The net change in the financial and physical ownership of a country is shown in the capital account, along with the balance of current account, the balance of payment of a country is constituted. Foreign investment, changes in a reserve account, other investm ent, is included in the capital account. A capital account can also be referred as the account that can display the net worth of a business at a specified period. The economic activities of a country are calculated in the capital account of the nation. The amount that an investor pays an organization is recorded in the form of general ledger account which gives a cumulative amount of the earning company is doing. The balance of the capital account is reported in the form of partners equit, or owners equity section in the balance sheet (Ishikawa and Horiuchi, 2012). The Financial Account- in the financial account of the country the international monetary flows in relation to business investment; stocks, bonds, and real-estate are documented. Foreign reserves, special drawing rights, gold, and government-owned assets like foreign reserves are also included in the financial account of a nation. Along with them the assets owned by foreigners are also recorded in the financial accounts. A financial account is that part of a nations BOP which deals with the claims or liabilities to non-residential, specially related to the financial assets (Kalamova and Konrad, 2010). It includes the portfolio investment, reserve assets, direct investment and those who are broken down by the sector. Any claim made by the non-residents of the nation on the financial assets of the citizen of the country are considered as a liability, while any claim made against the non-resident by the countrys citizen are taken as assets. The financial account is further divided into two sub-accounts to provide a tracking mechanism for the ownership transfer of the international asset. The first sub-account is related to the domestic ownership of the foreign assets, like securities of a foreign company, or any foreign bank deposits. The second sub account includes the foreign ownership of domestic assets, like any type of purchase done by foreign entities of government bonds or loans given to a domestic bank by a foreign firm (Kristjansdottir, 2010). Other important parts of Balance of Payment Basic Balance- basic balance is an economic measure taken for the BOP which adds the current and capital account balances. The basic balance proves to be an alternative method to the deficit or surplus for the BOP due to the change in the exchange rate system. The basic balance is use by the economists to determine the trends of countrys BOP in a long-term. This measure is less helpful in short-term fluctuations that may occur in the exchange or interest rates. It incorporates the fluctuations of international investments from the capital account that gives a better response regarding long-term changes in a countrys productivity (Mathew, Vijaykumar and Jacob, 2013). Official Settlement Account- to keep track of the reserve asset transactions of central banks with each other in BOP an official settlement account is used. All types of transaction related to gold, bank deposits, foreign exchange reserves, and special drawing rights are tracked by the official settlement account. Official settlement account essentially keeps track of all the transactions including international assets (Odili, 2014). Average Balance- the average balance means the balance on a depositary or a loan account. The calculation of average balance is taken out by adding the beginning balance and ending balance together and dividing it by two. The time balance remained at a particular level at the calculating period that may be a month or a quarter of a year is taken into account by average balance account. It is commonly used to find out the average daily balance, especially when taking in account the interest on loans. As banks cannot charge interest, on interest all types of payments are applied to the due interest payment and then comes the principal amount. Average balance can be used by the investors who trade on margin accounts and wanted to determine margin requirements that the brokerage makes (Ojha, 2016). Account Balance- the amount of money at any point of time in a financial repository is known as an account balance. It can also be the money that a person owed to a third person like a credit card company, mortgage banker, utility company, or any other creditors. After factoring the debits and credits, the net amount is shown in the account balance. Unilateral Transfer- an economic transaction happening between the citizens of two different countries over a specified period is known as a unilateral transfer. It includes transactions like pension payment, gift exchanges, and other goods and services. Unilateral Transfers are added in the nations BOP through current account. Unilateral transfers are different from international trade, including things like humanitarian aid and payments coming from immigrants to their home country (Oladipupo, 2011). The Balancing Act- it is necessary that the current account should be balanced with the added balance of capital and financial accounts. But as told earlier this rarely happen in any country. The fluctuating exchange rates, the value of money changes and that can add discrepancies in BOP. If a deficit is found in the current account that is the balance of trade deficit, then that difference can be covered by borrowing the fund from the capital account. The borrowed amount is taken as an outflow of capital account if a country has a fixed asset abroad. But, if that fixed asset is sold then it will be added to the current account inflow. If a countrys balance of payment is showing a deficit in the current account then it means that for more goods and services the country is foregoing its capital assets. If the money is borrowed to balance the current account deficit then it would be taken as an entry of foreign capital in the balance of payment (Petrovic and Gligoric, 2010). Liberalizing the Accounts- the late 20th-century rise of global finance and trade urged the BOP and liberalization of macroeconomic in most of the developing countries. With the economic boom entering in the emerging market, the capital flows tripled in these markets. Until the 1980s when Asian crisis struck the world and spurred countries to release restrictions on financial and capital account transactions, to take the advantage of the capital inflows. Most of the developing countries have restrictive macroeconomic policies, which regulated the ownership of non-financial and financial assets by a foreigner (Rahman, 2016). These rules limit the transfer of funds abroad. With the linearization of capital and financial accounts, the growth of capital market increased, which not only initiated transparency and sophistication in the market for the investors, but also attracted foreign direct investment. Like an investment made in a new power station will be bringing a nation great expos ure to new technologies and growth, which will eventually be increasing the overall GDP of the nation allowing the prospects of increased volumes of production. A diversified market decreases the risk which will come due to liberalization (Stepanovic-Petrac, 2008). Balance of Payment Crisis When a country has a deficit of the balance of payment that is unsustainable, then it is known as the balance of payment crisis. When a large amount of money flows out of the country and the borrowing power of the country is less than the situation becomes a crisis for the country. A BOP crisis become serious when a situation comes where the budget of the country is exceptionally large and the finances of the country become deficits for a long period, and the debt of the country increases beyond the bound oh handling (Swenson, 2006). Many countries has faced severe crisis of balance of payment in the 290th century few examples of such balance of payment crisis are:- 1991 Indian Economic Crisis 1994 Economic Crisis in Mexico 1997 Asian Financial Crisis 1998 Russian Financial Crisis 1999-2002 Argentine Economic Crises Reason of balance of payment crisis It is necessary to understand the reasons due to which the balance of payment crisis occurs in a country. The balance of payment crisis is very harmful to the economy of the country. If the reasons are known to the government of the country for the balance of payment crisis, then measures could be taken to avoid it to happen (Yan, 2003). The reasons for the crisis of balance of payment are as follows: - Ever increasing trade gap- due to trade gap, trade deficit occurs that means a huge rise in imports but a substantial rise in exports of the nation for a long period. Import Liberalization- liberalization given in the rules and regulations of imports led to increasing of products imported. Increase in Import Intensity- the increase in national income popularizes and increases the demands of imported product. This led to the increase of imports in a country. Import of Oil- developing countries need a lot of oil products for their necessities and luxuries thus the demand for oil increases, which in result increased the import of oil (Ziying, 2014). Imports of essential items- when a scarcity of an essential product arise it becomes important for a country to import that product from other countries. Raise in the prises of Imports- the rise in the prices of the necessity products made country spend more on the imports that led to the balance of payment deficit (Khawar, 2005). Deterioration in the exchange rate of the currency- if the exchange rate of the currency deteriorates then the imports becomes expensive for a country. This increases the balance of payment deficit. All the above-given reason led a country towards balance of payment crisis. Thus, it becomes necessary for the economic department of the country to pay attention towards the number of imports a country is doing and the exchange rate of the currency of the nation should not deteriorate when the number of imports are more than the exports of the country (Williams, 2015). Conclusion A countrys smooth running depends on the condition of the economy of the country. A country decides a budget for itself as per the requirement of the nation. This budget includes all the expenses that a country will bear and all the finances that the government will be getting from various sources. The balance of payment is the condition when a countrys all the liabilities are equal to the assets of the country. These credits and debits are the transactions that take place between two countries. There are a number of factors that are used to have a balance of payment in a country like capital account, current account, and financial account. These accounts are further divided into various other parts that help in maintaining the countrys balance of payment. Like liberalization of account, average accounting etc. It is very necessary to control the balance of payment of a country because if the deficit of the balance of payment becomes larger than the borrowing power of the country and for a long period than it leads the country towards the balance of crisis. There are many examples of countries those who have faced this balance of crisis. 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