What is the Balance of Payments (BOP)?

Balance-of-payments (BOP) is a statement that contains monetary transactions that have been made from one country to another over a given period. The statement records all transactions that have been undertaken by or to individuals, corporations, and governments. By recording the transactions effectively, the balance of payment enables monitoring of the flow of funds in the economy. The ideal balance of payment must be zero. This means that the level of cash inflows must be equal to the level of cash outflows. However, this is quite impractical in the real world.

Trade Balance and BOP

The BOP also indicates the surplus or deficit of funds present in the country. When the export of a country is comparatively higher than the import, it is said to have a surplus of funds. Similarly, if the import is higher than the export, it indicates a deficit of funds. This difference in export and import is called the trade balance. The trade balance is crucial in identifying the economy’s surplus and deficit.

Accounting Techniques

Double-entry

The BOP records transactions using a double-entry system that is similar to accounting. All the transaction has two sides to them. This means that, in every foreign transaction, one country account is debited while the other one is credited. Any monetary transaction that causes cash inflow is a credit to the BOP account while cash outflow is a debit to the BOP account. Therefore, the credit entry is considered a positive entry while the debit entry is considered a negative entry. For example, if a German company sends an interest payment on a loan to a bank in the US, the Germany BOP represents a debit while the US BOP account represents a credit. Since all BOP transactions have two entries that offset each other, the total sum of BOP must be zero.

Net errors and omissions

In reality, it is not always possible to get the sum to be zero. There could be errors in measurements. It is almost impossible to accurately record all transactions that happen between one country and the rest of the world. There are also possibilities of omission. To effectively manage this issue, an additional item called ‘net errors and omissions’ is included in the BOP to make the sum reach zero.

Elements of BOP

BOP is categorized into the following three components:

1. Current account

It is used to monitor the flow of goods and services between one country and the rest of the world. All the payments and receipts of the transfer of goods are recorded in this account. Apart from regular non-produced goods and finished goods, the current account also includes services such as tourism, consultancy, law, and accounting. Reserve asset such as gold and transferable currency is included as well. Fees and royalties charged on patents and copyright also fall under this account. The current account also takes into account unilateral transfers. Unilateral transfers refer to one-way transfers such as foreign aid and gifts.

2. Capital account

Capital transfers such as the purchase and sale of non-financial assets such as land and properties are monitored using the capital account. The transaction recorded in the capital account includes taxes, purchase of assets, and sale of assets done by migrants moving to other countries. It also includes all assets and goods brought into the country as non-residents enter. It also includes all foreign-owned and domestic assets that are taken out of the country as migrants leave. The capital account also includes taxes on gifts and inheritance, death duties, and damage to uninsured assets. Apart from regular assets, the purchase and sale of intangible assets such as patents, lease, trademark, copyright, and franchise are also recorded through capital account.

3. Financial account

Financial assets of one country owned in another country fall under the financial account. The account is used to monitor the change in ownership of foreign and domestic assets. Assets include foreign currencies, reserve positions in monetary funds, and foreign securities. Therefore, through the financial account, the country can identify if more assets are being sold or purchased. Investments made in or from other countries are also monitored using the financial account. These investments could include business ventures and foreign direct investment. Portfolio investment made overseas also falls under this account.

Surplus and Deficit

Theoretically, the sum of BOP must be zero. This means that the sum of capital and financial account must be equal to the current account. A deficit or surplus in either one or all the accounts could cause the sum of the BOP to be higher or lower than zero. For example, if one country is purchasing more goods and services than it sells, it causes a current account deficit. This must be adjusted through a surplus in either capital account or financial account. A capital account surplus can be created if more assets are sold than purchased. Similarly, the current account surplus can be offset by creating a deficit in capital or financial account. The current account deficit over the long term can heavily impact the economy of the country if they are not able to attract foreign investments. However, in reality, the current account deficit cannot be accurately adjusted. This is because of statistical differences, accounting techniques, and exchange rate movements.

Advantages and disadvantages of BOP

Advantages

• All the exports and imports are thoroughly monitored by the country for a given period.
• The tariffs on imports and exports along with tax expenses can be identified and changed to encourage more exports.
• The industry with the most growth potential and export can be identified and supported.
• Balance of payment helps better understand the state of the economy. Upon understanding, expansion plans can be made effectively.
• The balance of payment also plays a crucial role in setting monetary and fiscal policies in the country.

Disadvantages

• The central bank and other government authorities regularly enter autonomous transactions and market-induced transactions which make it difficult to track overall BOP surplus or deficit.
• Illegal transfer of funds through unregulated financial channels and smuggling exists in countries. However, this is not recorded in the official BOP statement causing inadequate coverage of funds.
• A large time gap may be present in the case of legal agreements. This means that the long-term transactions that take place may happen over two or more BOP statements. This causes multiple problems and makes recording transactions complex.

Context and Applications

The aspiring students can pursue further specialization in this field into the following streams:

• Masters in Export/Import Management
• Masters in International Monetary Fund

Practice Pyeproblems

Question 1: Which of the following is not an element of BOP?

1. 1. Capital account
   2. Current account
   3. Profit and Loss account
   4. All of the above

Answer: (c) Profit and Loss account

Explanation: The three elements of BOP are the current account, capital account, and financial account.

Question 2: Which of the following is not recorded in the current account?

1. 1. Raw materials
   2. Consultation fees
   3. Foreign direct investment
   4. None of the above

Answer: (c) Foreign direct investment

Explanation: The current account monitors all the goods and services moved from one country to another country. Therefore, raw materials and fees charged on a consultation can be included but not foreign direct investment.

Question 3: What should be the sum of BOP?

1. 1. 0
   2. 1
   3. -1
   4. 2

Answer: (a) 0

Explanation: The ideal BOP must have a sum of zero. This means that the sum of the financial and capital account must be equal to the current account.

Question 4: Which of the following creates a deficit in the capital account?

1. 1. More goods are sold than purchased
   2. More assets are purchased than sold
   3. More goods are purchased than sold
   4. None of the above

Answer: (b) More assets are purchased than sold

Explanation: The capital account can create a deficit by purchasing more assets from other countries. This deficit can help offset a current account surplus.

Question 5: Which of the following causes inadequate coverage of funds?

1. 1. Ownership of foreign assets
   2. Intangible assets
   3. Smuggling
   4. All of the above

Answer: (c) Smuggling

Explanation: Smuggling is considered an illegal activity. Given that the BOP is an official document, illegal activities cause inadequate coverage.

Common Mistakes

Since the BOP cannot be 100% accurate, it is incorrect to assume that a deficit identified will not have an impact. BOP is an official statement used for understanding the economy of the country. A current account deficit indicates an imbalanced economy that focuses on short-term consumption in export rather than the long term. The deficit also causes a depreciation in the exchange rate of the country while causing inflation. Therefore, the impact could be very large in monetary terms.

Related Concepts

While studying about BOP, it is important to read the following to get a better knowledge:

• International trade
• International transactions
• Foreign direct investments
• Currency Market
• Economic Inflation