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Understanding The Balance Of Payments: Meaning, Classification etc
Ever wondered as to how the recording is being done for the transactions that takes place in and around countries having a different system, currency, and economic status. In this article, we will discuss such recording.
The balance of payments or BOP is a statement or summary of all transactions that take place between entities of one country with the rest of the world over a specified period.
The transactions specified above consists of import, export of goods or services or both, capital, transfer payments, i.e., remittances made by the resident of a country from outside of the country and foreign aid, the relief provided to a nation.
When the Company imports more than the exports of Goods,Services and Capital then such a situation is termed as a Deficit of BoP.
Moreover, the situation where the imports are less than the exports is termed as the Surplus of BoP. This implies that the government and residents are savers. They provide enough capital to meet the requirement of domestic production which is a good situation for boosting the economic condition.
Classification of the Balance of Payments (BoP)
Majorly the BoP is classified in two accounts which are as follows:
- The Current Account and
- The Capital Account.
The Capital Account can also be termed as the financial account and can be listed separately as a different account. So the third classification is:
- Finance Account
BoP on Current Account refers to the inclusion of three balances of:
- Merchandise balance, i.e., Goods,
- Services balance and
- Unilateral Transfer balance
The current account is the summary of the trade balance that a country has along with the net of Income and payments. In other words, it reflects the net flow of goods, services, and unilateral transfers. The net value of the balances of visible, invisible trade and unilateral transfers defines the balance on the current account.
The Current Account deficit is a situation in which the residents of a country spend more on the imports.
Current Account Trade Deficit is a situation in which the countries import are more than the companies exports. The imports of any goods or services that are produced in a foreign country, even if the domestic company is producing these goods or services overseas.
The transactions and their treatment in the Current Account
BoP on Capital Account
The capital account reflects the transactions that generally do not affect the country’s income, expenditure, production, or savings. This account considers the details of the acquisition or disposal of non-financial assets such as land, machinery, etc. and non-produced assets. Usually, the capital account is the smallest constituent of the balance of payments.
BoP on Financial Account
The financial account consists of details such as:
- Changes related to the domestic ownership of foreign assets and
- Foreign ownership of assets held locally.
The deficit is created in the financial account when foreign ownership increases more than domestic ownership. This implies that the country is acquiring assets such as gold, commodities, stocks, and shares at relatively less pace than selling off foreign assets.
Importance of BoP
BoP is used by the Businesses to ascertain whether a market of a country has a potential or it can be a prospective market for the business. As a country having a very large trade deficit is less likely to import goods and services in comparison to a country with a trade surplus. The trade deficit with large quantum may even lead to the restriction on the imports in the form of Trade restrictions such as Tariff rates, Quotas, etc.
Monetary policies and fiscal policies are formed keeping in mind the Balance of Payment as these policies decide the flow of foreign currency in a nation and ultimately results in checking the Balance of payments.
To understand the balance of payments, let's consider a small fictional example: not a country, but a family farm.
Let's say that we know the following about how last year went financially for Mr. Hari, who owns a small farm in Rajasthan:
- They made ?1,00,000 by selling Chana Dal.
- They spent ?70,000 on operating expenses of the farm, including purchases of new machinery, and another ?40,000 for buying food, paying bills, replacing their worn-out tractor.
- Their interest income from bank deposits is ?500 but paid ?10,000 for interest on their mortgage.
- They took out a new farm loan of ?25,000 to help pay for farm irrigation system but did not use the complete loan amount immediately. So they deposited the extra amount in the bank.
|Particulars||Sources of Cash||Uses of Cash||Net|
|Purchase or sale of goods and services||Chana Dal sales: ?100,000||Farm Operation and Living expenses: (70,000+40,000) ?110,000||– ? 10,000|
|Interest Payments||Interest Received on Bank Account: ?500||Interest Paid on their mortgage: ?10,000||– ? 9,500|
|Loans and Deposits||Funds Received from new Loan: ?25,000||Funds Deposited in Bank: ?5,500||+ ? 19,500|
The last row shows all the inflows of cash coming in from all sources and outflow of the cash used. These sums are equal, by definition: every unit of money has a source, and every money received gets used somewhere.
A country's balance of payments accounts is a table which summarizes the country's transactions with the rest of the world for a given year in a manner very similar to the way we just summarized Mr. Hari's financial year.
A country's balance of payments accounts show payments from foreigners sources of cash for the Country as a whole and payments to foreigners uses of cash for the Country as a whole.
|Particulars||Payments from Foreigners||Payments to Foreigners||Net|
|Sales and Purchases of Goods and Services||1,646||2,346||-700|
|Official Asset Sales and Purchases||411||22||389|
|Private Sale and Purchases of assets||1653||1267||386|