What is Balance of Payments?

Balance of Payments (BOP) is a systematic and summary record of a country’s economic and financial transactions with the rest of the world, over a period of time, say one year.

Structure of Balance of Payments

The format of the balance of payments given below shows the important types of transactions that enter the balance of payments. The various debit and credit entries are generally grouped under the following heads;

Current Account

All transactions that increase or decrease national Income. It consists of two major items (a) merchandise exports (credit to home country) and imports (debit to home country) (b) invisible exports (sale of services) and imports (purchase of services). Software exports have emerged as a very important invisible item of India’s current account.

Capital Account

The capital account consists of short-term and long-term capital transactions. Capital outflow represents debit and capital inflow represents credit. For instance, if an American firm invests $100 million in India, these transactions will be represented as a debit in the US Balance of Payments and a credit in the Balance of Payments of India.

Unilateral Payments Account

This is another terms for gifts, and includes private remittances, government grants, reparations and disaster relief. Unilateral payments received from abroad are credits and those made abroad are debits.

Official Reserves Assets Account

Official reserves represent the holdings by the government of official agencies of the means of payment that are generally accepted for the settlement of international claims.

Balance of Payments Disequilibrium

The balance of payments of a country is said to be in equilibrium when the demand for foreign exchange in exactly equivalent to the supply of it. The balance of payments is regarded as being in disequilibrium when it shows either a surplus or a deficit. There will be a deficit in the balance of payments when the demand for foreign exchange exceeds its supply, and three will be a surplus when the supply of foreign exchange exceeds the demand. There are a number of factors that may cause disequilibrium in the balance of payments like economic factors, political factors, sociological factors, Economic Factors.

Economical Factors:

Large scale development expenditures generally increase the purchasing power, aggregate demand and prices, which results in substantially large imports. Development disequilibrium is common in developing countries, because the above factors and the large scale import of capital goods needed for carrying out the various development programmes give rise to a deficit in their balance of payments.

Boom & Depression in Economy

Cyclical fluctuations of general business activity such as boom and depression are one of the prominent reasons for balance of payments disequilibrium. Depression always brings about a drastic shrinkage in world trade, while prosperity stimulates it.

Demand & Prices

Sometimes, the balance of payments disequilibrium persists for long periods due to certain secular trends in the economy. For instance, in a developed country, the disposable income is generally very high and, therefore, so is the aggregate demand. At the same time, the production costs are also very high due to the higher wages. This naturally results in higher prices. These two factors – high aggregate demand and higher domestic prices may result in the imports being much higher than the exports.

Structural Disequilibrium

Development of alternative source of supply, development of better substitutes, exhaustion of productive resources or change in transport routes and costs.

Political Factors

Political instability may experience large capital outflow and inadequacy of domestic investment and production. Factors like war of changes in the world trade routes could also produce similar difficulties.

Social Factors

Changes in the tastes, preferences and fashions, may affect imports and exports and thereby affect the balance of payments.

Problem of BOP

A country may not be bothered about a surplus in the balance of payments but every country strives to remove or at least reduce a balance of payments deficit.
Measures to correct BOP problem may be broadly grouped into

Monetary Measures

The important monetary measures are outlined below:

  1. Monetary Contraction:Contraction of money supply is likely to reduce the purchasing power and thereby, the aggregate demand. It is also likely to reduce domestic prices. The fall in the domestic aggregate demand and domestic prices reduces the demand for imports. The fall in domestic prices is likely to increase exports. Thus, the fall in imports and rise in exports would help correct the disequilibrium.
  2. Devaluation:A country with fundamental disequilibrium in the balance of payments may devalue to currency in order to stimulate its exports and discourage imports to correct the disequilibrium. Devaluation makes export goods cheaper and imports dearer.
  3. Exchange Control:The recipients of foreign exchange, like exporters, are required to surrender foreign exchange to the government/central bank in exchange for domestic currency. By virtue of its control over the use of foreign exchange, the government can control imports.
 Trade Measures

Trade measures include export promotion measures and measures to reduce imports.

  1. Export Promotion:Exports may be encouraged by reducing or abolishing export duties, providing export subsidy, encouraging export production and export marketing by giving monetary, fiscal, physical and institutional incentives and facilities.
  2. Import Control:Imports may be controlled by improving or enhancing import duties, restricting imports through import quotas, licensing and even prohibiting altogether the import of certain inessential items.
Miscellaneous Measures

Apart from the measures mentioned above, there are a number of other measures that can help make the balance of payments position more favorable, like obtaining foreign tourists and providing incentives to enhance inward remittances.

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  • Naveen

    A deficit reflects an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements.

    A deficit is not necessarily a bad thing for an economy like India, especially for an economy in the developing stages or under reform an economy sometimes has to spend money to make money.