Balance of Payments

By : Neha Dhyani

Updated : May 17, 2022, 8:59

Balance of Payments refers to the statement of financial transactions between a nation and the rest of the world. All transactions between individuals, companies, or Governments are included in this statement. There should be matching inflows for every outflow and vice-versa, so in an ideal situation, the sum of all elements in the BOP should equal zero. In reality, however, this is rarely the case.

There is a positive Balance of Payments or a surplus when a country's exports exceed its imports. In the opposite situation, when the imports exceed exports, there is a deficit. Monitoring transactions in BOP is like a double-entry method of accounting; every debit has a corresponding credit.

Balance of Payments Importance

Here are some reasons why the Balance of Payments is important for a nation -

  • The financial and economic status of a nation can be determined through the Balance of Payments
  • You can check whether there is depreciation or appreciation of your nation's currency
  • The fiscal and trade policies of a Government depend on the Balance of Payments
  • You can analyze your country's economic status versus other nations (trade deficit/surplus) based on this information

Balance of Payments is an indicator of the economic health of a nation and based on the trends, corrective measures can be taken.

Important Components of Balance of Payments

Balance of Payments has three important components -

  • Current Account: Transactions in goods and services
  • Capital Account: Asset-based transactions
  • Financial Account: Transactions in intangibles and investments

Current Account -

All financial transactions in raw materials and manufactured goods pass through this account. Income generated from tourism, royalty, stocks, business, and transportation come into the current account. All this combined income forms the Balance of Trade.

Trading can be visible or invisible. There are unilateral transfers and other receipts. Goods traded between two countries are visible items, and services like banking or IT are considered invisible.

Gifts or donations are considered unilateral transfers and include money remitted to relatives abroad.

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Capital Account -

Transactions in non-financial assets like land and property take place in this account. The flow of taxes is also included in this account. The three key parts of a capital account include:

  • Loans and Borrowings: Public and Private sector loans between countries come under this head
  • Investments: Funds invested by non-residents in corporate stocks are part of this.
  • Foreign Exchange Reserves: These are used by the Central Bank to regulate the exchange rate in a country

Financial Account -

Liabilities to or claims on non-residents are routed through the Financial Account of the Balance of Payments. These include direct investments in companies or projects, investments in portfolios, and reserve assets such as gold.

The Balance of Payments is an essential indicator of the economic health of a nation. It helps the Government set tariffs for international trade so that a nation can be financially independent.

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FAQs on Balance of Payments

Q1. Why is Balance of Payments Important in India?

Balance of Payments is important in India for the following reasons -

  • Exports and imports of all products and services for a specific period are monitored through it
  • The export potential of a particular sector can be analyzed by the Government and policies can be formulated accordingly
  • The Government gets a comprehensive view of the different export and import tariffs. It tries to modify taxes to encourage exports and discourage exports so that the nation can be self-sufficient.

Q2. How are the Balance of Trade and the Balance of Payments different?

While the balance of trade considers only exports and imports of visible items, the Balance of Payments considers both visible items and services along with unilateral services under the current account. So the balance of trade is part of the Balance of Payments.

Q3. What are the Different Sources of Foreign Exchange?

Our nation gets foreign exchange through foreign direct investment, NRI inflows, and speculative home currency purchases by foreigners.

Q4. What is a Balance of Payments Deficit?

When the imports during a particular period exceed the exports, there is a Balance of Payments deficit.