Every country import from other countries the goods that cannot be produced at all in the country or can be produced only at an unduly high cost as compared to the foreign supplies. Similarly, a country exports to other countries the commodities which those countries prefer to buy from abroad rather than produce at home.
“The balance of payments is a systematic record of economic transactions of the residents of a country with the rest of the world during a given period of time.” The record is so prepared as to provide meaning and measure to the various components of a country’s external economic transactions. Thus, the aim is to present an account of all receipts and payments on account of goods exported, services rendered and capital received by residents of a country, and goods imported, service received and capital transferred by residents of the country. The main purpose of keeping these records is to know the international economic position of the country and to help the Government in reaching decision on monetary and fiscal policies on the hand, and trade and payments questions on the other.
These transactions may be made by the individuals, firms and the government of a country. Broadly, the monetary transactions relate to: (i) export and import of goods. In the BoP language, it is called ‘merchandise’ or ‘visible trade’ (simply because goods are visible when they cross the borders. Goods can be seen), (ii) export and import of services. It is called ‘invisible trade’ (simply because services are not visible when they cross the borders. Services cannot be seen), (iii) international sale and purchase of financial assets. These assets include stocks and bonds, and (iv) international sale and purchase of real assets. Real assets are like plant and machinery.
There is a flow of foreign exchange into the country when we export goods and services or when the foreigners invest in our financial or real assets. Likewise, there is a flow of foreign exchange from our country to rest of the world when we import goods and services or when our residents invest in the financial or real assets of other countries. BoP accounts record all receipts and payments of foreign exchange. Receipts are recorded as credit items, while payments are recorded as debit items. The BoP accounts, thus prepared, reflect performance of our economy in relation to rest of the world.
Components of Balance of Payments Accounts
Economic transactions between a country and the rest of the world are grouped under two broad categories i.e., current transactions, and capital transactions.
Current Account
It includes export and imports of goods and services, i.e., visible and invisible trade, unrequited or unilateral (non-repayable) transfers in the current year.
In the current account, merchandise exports and imports are the most important items. Exports are shown as a positive item and are calculated which means that costs of transportation, insurance, etc. are excluded. On the other side, imports are shown as a negative item and are calculated which means that costs, insurance and freight are included. The difference between exports and imports of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is favourable. In the opposite case when imports exceed exports, it is unfavourable.
It is, however, services and transfer payments or invisible items of the current account that reflect the true picture of the balance of payments account. The balance of exports and imports of services and transfer payments is called the balance of invisible trade. The invisible items along with the visible items determine the actual current account position. If exports of goods and services exceed imports of goods and services, the balance of payments is said to be favourable. In the opposite case, it is unfavourable.
In the current account, the exports of goods and services and the receipts of transfer payments are entered as credits because they represent receipts from foreigners. On the other hand, the imports of goods and services and grant of transfer payments to foreigners are entered as debits because they represent payments to foreigners. The net value of these visible and invisible trade balances is the balance on current account.
Components of Current Account
Components of current account BoP are as under:
- Export and Import of Goods: Export and import of goods is treated as ‘merchandise’ or ‘visible trade’. This is a visible trade because goods are tangible and therefore, can be seen while crossing the borders. Example: Export or import of cellular phones can be seen while crossing the borders.
- Export and import of services: Export and import of services is treated as ‘invisible trade’. This is because services are not tangible and therefore, cannot be seen while crossing the borders. Example: Insurance services being rendered across the border cannot be seen as crossing the borders.
Services are further classified as: factor services and non-factor services
- Factor services: Factor services are those which lead to factor payments or factor income. In the BoP accounts, monetary transactions related to factor incomes are split as: (i) investment income, and (ii) compensation of employees. Investment income includes income on account of rent, interest and profit.
- Non-factor services: Non-factor services include all services, other than factor services. Insurance and banking services may be citied as examples. Monetary transactions related to non-factor services are recorded as receipts when these services are imported.
3. Current Transfers: Current transfers refer to ‘transfers for free’. These are unilateral transfers made by way of gifts, grants and remittances (by the residents settled abroad). In the Bop accounts, current transfers are treated as an element of ‘invisibles’.
Capital Account
Capital account records receipts and payments of such transactions which cause an impact on asset-liability status of a country in relation to rest of the world. Liabilities or assets of a country are either raised or reduced. In other words, capital account transactions lead to future claims.
The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lending and borrowings, and private and official investments. In other words, the capital account shows international flow of loans and investments, and represents a change in the country’s foreign assets and liabilities. Long-term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investments like the purchase of foreign bonds and stocks, and international loans. On the other hand, short-term international capital transactions are for a period ranging between three months and less than one year.
There are two types of transactions in the capital account – private and government. Private transactions include all types of investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.
In the capital account, borrowings from foreign countries and direct investment by foreign countries represents capital inflows. They are positive items or credits because these receipts from foreigners. On the other hand, lending to foreign countries and direct investments in foreign countries represent capital outflows. They are negative items or debits because they are payments to foreigners. The net value of the balances of short-term and long-term direct and portfolio investments in the balance on capital account.
Sodersten and Reed refer to the external wealth account of a country which shows the stocks of foreign assets held by the country and of domestic assets held by foreign investors. The net value of a country’s assets and liabilities is its balance of indebtedness. If its assets are more than its liabilities, then it is a net creditor. If its liabilities are more than its assets, than it is a net debtor.
Components of Capital account:
- Borrowing: Borrowing is split as:
- External commercial borrowing, and
- External assistance.
The principal difference between the two is that while external commercial borrowing is available at the market rate of interest (in the international money market), external assistance is available at the concessional rate of interest.
Borrowing from rest of the worlds raises our liability to rest of the world. But, note it carefully, that it carefully, that it is recorded as a ‘credit item’ in the capital account of BoP. The reason is this: all receipts of foreign exchange are recorded as credit items in the BoP accounts. Thus, borrowing of rest of the world would be recorded as ‘debit item’ in the capital account, as it causes flow of foreign exchange from our country to rest of the world.
2. Foreign Investment: Foreign investment is split as:
- Portfolio Investment: It basically refers to foreign institutional investment (FII). It is investment by rest of the world in shares and bonds of the domestic companies.
- Foreign Direct Investment: it relates to ownership of enterprises (in the domestic economy) by rest of the world. Example: Walmart stores in India.