Balance of Payment

All details of the trade and financial transactions made amongst businesses, consumers and the government of one country with several others for a particular period are recorded in a statement. 

This statement provides a basic idea regarding the pattern of trade in goods and services across national borders. In the field of commerce and economics, such a statement is known as the Balance of Payment or BOP. 

What is the Balance of Payment?

Balance of Payments can be defined as a record for all the financial transactions between a nation and the rest of the world, in different areas under the economy within a specific period. The Balance of Payment is an essential indicator for a nation’s financial stability and sheds light on its foreign trade relations with the global economy.

The BOP meaning comprises financial records with details regarding all the inflows and outflows of foreign exchange for a country up to a specified period (for example, a specific financial year). Such inclusions typically involve financial details of exports, imports, foreign transfers and remittances, lending and borrowing from abroad, purchase of foreign assets, foreign investments, etc.

The data mentioned above regarding the country’s foreign exchange is tabulated on the Balance of Payment account, which possesses a dual entry system. It indicates that this statement has two sides, i.e. credit and debit. The primary objective to create this financial record is to determine whether the nation has a shortage or excess of foreign currency.

What are Inflow and Outflow of Foreign Currency?

As per the Balance of Payment definition, it is mandatory to classify financial transactions based on their type of flow, i.e. whether they fall under the credit side or the debit side. 

  • The inflow of foreign currency is considered as a means of credit. It is always denoted as a positive entry in the Balance of Payments. 

For example, the USA has bought large quantities of medical equipment from India, and in this case, these Indian medicinal items are exports which are being sold overseas. So, they will be mentioned in the credit side of India’s BOP account.

  • Meanwhile, foreign currency outflow is regarded as a means of debit. It is always denoted as a negative entry in the Balance of Payment account. 

From the same example given above, it can be determined that the Indian medical equipment is an imported good for the USA. Hence, it will be mentioned on the debit side of the USA’s BOP account. 

What are the Types of Balance of Payment Accounts?

Balance of Payment accounts can be categorised into mainly 3 types which are –

1. Current Account

A current account Balance of Payment comprises all the details regarding inflow and outflow of certain commodities and services between two nations. The balances of such commodities and services which are mentioned under this account are:

  • Balance of trade in goods (for example cars, medicine, computers, etc.)

  • Balance of trade in services (for example health, education, tourism, etc.)

  • Net primary income (for example interests on foreign savings accounts, profits from businesses owned and operated overseas, migrant remittances, etc.)

  • Net secondary income (for example expenses on military aid, contributions to overseas development budget, etc.)

2. Capital Account

A capital account deals with purchases in non-financial elements. Such balances include:

  • Patents and copyrights’ sale or transfer

  • Ownership of franchises, leases and other transferable contracts’ sale or transfer

  • Fixed assets ownership transfer

Any imbalance in the current account regarding a nation’s BOP is usually adjusted through the components in the capital account and vice-versa.

3. Finance Account

The two main focuses regarding the different Balance of Payment accounts in a country are firstly the current account and secondly the finance account. This account includes all the transactions that result in an ownership change for foreign assets between a nation’s residents and non-residents. Three essential aspects stand out in such an account, which are:

  • Foreign direct investment flows or the FDI’s net balance

  • Portfolio flows (for example individuals buying and selling foreign shares) net balance

  • Banking flows (for example short term money which is transferred between banks of countries in search of a better rate of interest) net balance 

For example, balances in foreign trade in goods and services fall under current accounts, those involving patents, copyrights etc. fall under capital accounts and financial transactions which authenticate a change in foreign assets ownership amongst a country’s residents and non-resident belong to the finance accounts category.

Importance of Balance of Payment

The importance of Balance of Payment account can be gauged from the following pointers –

  • A financial record such as the BOP analyses all the transactions under any nation’s economy regarding goods and services’ exports and imports and other finances for a financial year.

  • The BOP helps the government to identify the various sectors in its economy, which possess the potential for export-oriented growth.

  • With the help of the BOP, the government can implement higher tariffs and tax rates on the inflow of foreign exchange to encourage domestic industries to become more self-sufficient and minimise non-essential items’ import.

  • If a nation possesses a flourishing export trade, its BOP can provide the government with accurate details so that it can adopt measures like currency devaluation to let its goods and services be availed at affordable rates and thereby improve foreign exchange outflow exponentially.

Another important reason why a BOP account is essential for an economy is that it is a major indicator for a government to formulate its standards on monetary and fiscal policies, control of inflation, etc. Students can gain a more in-depth idea about Balance of Payment with study materials provided by Vedantu online. Check out available study material and online classes today for better exam preparations.

FAQ (Frequently Asked Questions)

1. What is a Balance of Payment?

The Balance of Payments is a statement that records all the financial transactions made between consumers, business heads, and a country’s government with several other nations.

2. What are the Types of Balance of Payment?

Balance of Payment accounts can be broadly categorised into 3 types which are current account, capital account and finance account. A Balance of Payment account is prepared only after a proper identification and categorisation for transactions under the three heads.