The Balance of Payments (BoP) is a systematic record of a country’s economic transactions with the rest of the world over a period of time. It records all transactions of individual residents, firms and the government with the rest of the world. The analysis of BoP helps to understand a country’s trade position, foreign exchange position, international indebtedness, flow of capital and overall economic status.

Importance of Balance of Payments

1. Helps to Know the Country’s External Position: The Balance of Payment provides information about the financial and economic position of a country with respect to other countries in the world.

2. As a Guide to Know the Appreciation or Depreciation of Currency: The change in a country’s BoP over a period of time indicates the pressure on a country’s currency to appreciate or depreciate.

3. Helps to Take Policy Decisions: Balance of Payment helps the government to make fiscal, trade and external sector policy decisions.

4. Helps to Know a Country’s Foreign Exchange Transactions: It helps to understand the country’s foreign exchange dealings with the rest of the world.

5. Helps to Know the Country’s Competitive Position: The analysis of a country’s BoP helps to know the competitive strengths and weaknesses of the country which in turn helps to take policy decisions to make the country more competitive.

Components of Balance of Payments

According to the given source, the Balance of Payments comprises the following two accounts:

1. Current Account
2. Capital Account

1. Current Account

The current account comprises of those transactions which have a direct impact on the assets or liabilities of Indians to the rest of the world and the liabilities or assets of the rest of the world to Indians. The current account involves trade in goods and services, income and transfers.

Trade Balance: Trade balance refers to the difference between the value of a country’s exports and its imports of goods.

Trade Surplus: A situation where a country’s exports of goods exceed its imports of goods.

Trade Deficit: On the other hand, if a country’s imports of goods exceed its exports, it is called as trade deficit.

Invisible Transactions: The term invisible transactions refers to services, income and transfers.

Services: Services include travel, transport, insurance, government services, communication, construction, financial services, software, royalties, management and business services, etc.

Income: Income comprises of investment income and compensation of employees.

Transfers: Transfers comprise of remittances, grants and gifts of various origins but not of a commercial nature.

The trade in services is also referred to as invisible trade as no physical items change hands.

Transactions Under Current Account According to FEMA

According to FEMA, 1999, current account transactions include the following:

1. Trade and Business Payments: They comprise of trade in goods, current business, payments for services and short term banking and credit facilities in the normal course of business.

2. Interest and Investment Income: The payments of interest on loans and net investment income.

3. Family Support Payments: Remittances for the support of the parents, spouse and children living abroad.

4. Expenses on Travel, Education and Medical Attendance of Family Members: Expenses on travel, education and medical attendance of parents, spouse and children.

2. Capital Account

The capital account comprises of those transactions which have an indirect impact on the assets and liabilities.

According to FEMA, capital account transactions comprises of those transactions which involve the acquisition of assets outside India and India, by persons resident outside India and persons resident in India, respectively, and the incurrence of liabilities by them.

In other words, the transactions that involve receipts and payments related to the assets and contingent liabilities.

The following are some of the examples of capital account transactions:

1. Inflow and outflow of Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
2. External commercial borrowings.
3. Banking capital, which includes deposits by Non-Resident Indians (NRIs), etc.

BoP Equation According to the Source

According to the source, the following equation holds true:

BoP = Current Account + Capital Account

Having said that, even if there was a deficit in the current account, it would not necessarily indicate that there is deficit in the overall BoP as the deficit in the current account can be made up by a surplus in the capital account or the other way round.

Determinants of the Balance of Payments

The various determinants of the BoP can be broadly classified into determinants of the current account and the capital account.

Determinants of the Current Account

Domestic Inflation

If domestic inflation is high compared to the inflation rate of our trading partners, domestic goods will be relatively expensive than the foreign goods.

It will discourage the imports of goods by domestic residents. At the same time, it will make domestic exports less competitive, discouraging exports to the foreign countries.

Thus, it impacts the trade balance of the country.

National Income

A rise in the level of national income may lead to rise in imports of goods.

However, the rise in domestic income may also lead to domestic residents buying more domestic goods.

So if the domestic production is rising and exports are rising, it would improve the trade balance.

Import Duties

Trade barriers like import duties and quotas discourage import of goods by domestic residents.

Thus, it will improve the trade balance.

Exchange Rate

An exchange rate refers to the rate at which the domestic currency can be exchanged for the foreign currency.

Changes in the exchange rate change the relative prices of the domestic and foreign goods and services.

Exchange rate changes are considered to be a major determinant of the trade balance.

The value of the domestic currency affects the price competitiveness of domestic exports and imports.

A rise in the value of the domestic currency relative to other currencies reduces the competitiveness of domestic exports and makes imports cheaper and more attractive leading to an improvement in the trade balance.

Determinants of the Capital Account

Taxation of Foreign Income

The change in tax rates on foreign income by the domestic government has an impact on the capital account.

For example, an Indian investor earns income through dividends, interest and capital gains.

If the tax rates on these incomes are increased, it will reduce their net income from these sources, discouraging them to invest abroad.

Liberalization of Foreign Investment and Capital Inflows

Liberalization of FDI and FPI inflows makes it easier for foreign investors to buy shares of Indian companies and mutual funds.

Thus, it encourages capital inflows into India.

Expectations of Change in Exchange Rate

If foreign investors expect the exchange rate of the domestic currency to depreciate, they will be discouraged to invest in India as they will find their returns to be lower when they convert their profits into their domestic currency.

Interest Rates

Differences in domestic and international interest rates determine capital flows.

Higher domestic interest rates attract capital inflows and encourage domestic residents not to send their savings overseas.

On the other hand, lower domestic interest rates discourage inflows of capital and encourage domestic residents to send their savings overseas.

Difference Between Current Account and Capital Account

Conclusion

Balance of Payments acts as a barometer of a country’s external position. It records the economic transactions of individuals, firms and the government with the rest of the world. It helps to understand the impact of trade with the rest of the world, invisibles, transfers, foreign investment, commercial borrowings, capital flows and capital controls in the economy. A healthy BoP requires maintaining a competitive advantage in exports over imports, attracting capital flows and maintaining a stable policy of external liabilities.

FAQs

What is the Balance of Payments?

The Balance of Payments (BoP) is a systematic record of a country’s economic transactions with the rest of the world over a period of time.

What are the main components of BoP?

The main components of BoP are the current account and the capital account.

What is the trade balance?

The trade balance refers to the difference between the value of a country’s exports and its imports of goods.

What is a trade deficit?

A situation where a country’s imports of goods exceed its exports of goods is termed as a trade deficit.

What are invisible transactions?

The invisible transactions comprises of services, income and transfers.

What is the difference between current and capital account transactions?

The current account transactions comprise of trade in goods and services whereas the capital account transactions comprise of changes in assets and liabilities.

Can a current account deficit cause an overall BoP deficit?

Not necessarily. A current account deficit can be made up by a surplus in the capital account.

Therefore, a deficit in the current account does not reflect an overall deficit in the BoP.

How does inflation affect BoP?

If domestic inflation is high compared to the inflation rate of our trading partners, domestic goods will be relatively expensive than the foreign goods.

It will discourage the imports of goods by domestic residents. At the same time, it will make domestic exports less competitive, discouraging exports to the foreign countries.

Thus, it impacts the trade balance of the country.

How do interest rates affect capital flows?

Higher domestic interest rates attract capital inflows and encourage domestic residents not to send their savings overseas.

On the other hand, lower domestic interest rates discourage inflows of capital and encourage domestic residents to send their savings overseas.

How does expected rupee depreciation affect foreign investment?

If foreign investors expect the rupee to depreciate, they will be discouraged to invest in India as they will find their returns to be lower when they convert their profits into their domestic currency.