What Is The Balance Of Payments? (And How To Calculate It)
Updated 30 September 2022
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The balance of payments (BOP) is an important metric that helps countries determine their financial status and understand their relationship with other countries. It helps nations understand whether their currency value is appreciating or depreciating and whether their exports and imports are in a surplus or a deficit. Learning about the balance of payments can help you understand how different entities within a country contribute to it. In this article, we answer the question, 'What is the balance of payments?', discover its components, understand how to calculate it, learn about its importance and explore an example of the BOP.
What Is The Balance Of Payments?
Knowing the answer to 'What is the balance of payments?' can help you understand why it is an important financial metric for countries. The balance of payments is a financial statement that includes all the transactions of a country by its different entities with the rest of the world. These entities can be individuals, companies or the government.
Like the double-entry accounting system, these transactions have a corresponding debit and credit entry in the books of each country. The BOP is ideally zero if the countries report all transactions correctly. Often it does not happen because of different accounting practices followed by different countries and fluctuations in exchange rates.
Related: Basics of Accounting - Terminology, Principles And Concepts
What Are The Components Of The Balance Of Payments?
The three components of the balance of payments are:
The current account records the inflow and outflow of goods and services between countries. It includes the trading of visible items like raw materials and manufactured products, along with other invisible services. This comprises the receipts from industries like engineering and transportation and payments from intellectual property rights and stocks, among others. The current account includes any gifts sent by residents of one country to their friends or relatives in another country.
It also includes personal transfers between people living in different countries for personal reasons like medical or living expenses. In an ideal situation, the total of the current account balances with the sum of the financial and capital accounts. If a country's current account is in deficit, it means that the residents spend more on imported goods and have lesser savings.
Related: How To Read A Balance Sheet (Components And Template)
The capital account records all the capital transactions between countries that are made by the selling or buying of non-financial assets. These include assets like lands, properties and other assets that are not produced in the country. The capital also includes all transactions of sale or purchase of fixed assets when migrants leave or enter the country. Whenever there is a deficit in the current account, countries manage it from the surplus in financial accounts and vice versa if there is any surplus.
The financial account records all the funds that enter or leave the country because of investments in real estate, businesses and other long-term foreign direct investments. If the domestic investments and ownerships of a nation are equal to the foreign investments and ownerships, it balances the financial account. A deficit arises when a country's entities invest more in foreign assets instead of domestic ones. A deficit may also arise when a country sells more of its assets to international owners before acquiring sufficient assets on its own.
Related: 8 Steps Of The Accounting Process (With Key Terms)
How To Calculate The Balance Of Payments
You can look at the following steps to understand how countries calculate their balance of payments:
1. Balance the current account
The first step for calculating the BOP is to calculate the total flow of goods and services between a country and the rest of the world. It takes into consideration the total imports and exports of goods and the total imports and exports of services. Countries then subtract the sum of imports from the sum of the exports. This calculates the total money that the country makes through transactions in raw materials and manufactured products after paying for all the imports.
2. Balance the capital account
A country's capital account comprises the transactions made by emigrants and immigrants while shifting between countries, money for debt forgiveness and non-produced assets. The net capital transfers consist of all the transactions made by acquiring or disposing of fixed assets. The complete calculation of the balance of the capital account takes into consideration the sum of the non-financial assets, net capital transfers and the surplus or deficits from the net non-produced assets.
3. Balance the financial account
The calculation for the balance of financial accounts includes all long-term direct investments, long-term portfolio investments and short-term capital flows. The short-term capital flows usually have a high-interest rate and can earn good returns for companies. Countries take into consideration the net direct investments, all asset funding, net portfolio investments and errors or omissions while calculating the balance of this account.
4. Apply the balance of payments formula
Once countries have calculated the balances of their current account, financial account and capital account, they can apply the BOP formula. The formula for calculating the BOP adds the balance of the capital account, the balance of the current account and the balance of the financial accounts, along with other balancing items for factors like inflation. A positive amount indicates a surplus, while a negative amount shows a deficit in the economy.
The formula for BOP is:
Balance of payments = Current account + financial account + capital account + balancing items
Why Is The Balance Of Payments Important?
The balance of payments of a country is important for:
Understanding the financial status
The balance of payments of a country helps in determining the economic position and strength of a country. It can help understand if a country's currency value is appreciating or depreciating. A surplus in the balance of payments means that the country exports more than its imports. A deficit can indicate that a country's imports are greater than its exports due to which they make larger payments to other countries. While it is good for both the numbers to balance, a surplus is a more desirable situation than a deficit.
Different experts, like investment managers, government policymakers, business managers and other financial experts, analyse the BOP to make important decisions for a country. By studying the balance of payments, economists can understand the economic relationships between countries. It can help them identify harmful or beneficial trends in imports and exports.
They use this data to make decisions about interest rates, import and export policies, inflation rates, cost of goods and employment rates. As different factors like exchange rates, geopolitical situations, employment and gross domestic product affect the BOP, economists refer to the BOP while formulating trade policies. Studying the BOP can also help them decide if a country's export or import policy requires any changes to encourage exports or discourage imports, depending on the surplus or deficit situation.
Related: Types Of Economists: Work Environment, Job Role And Salary
Implementing strategies for growth
The BOP can help financial experts identify areas of growth for countries. They can use this information to develop strategies to support growth and establish their international relationships with other countries. The government can also analyse this data to identify industries that have the potential for growth and create policies that support and sustain the growth of those industries.
Related: Macroeconomics: A Complete Guide (With History And Scope)
Example Of The Balance Of Payments Calculation
Here is an example that can help you understand how professionals apply the BOP formula:
In the year 2021, a country exports goods and services worth ₹90,00,000 and imports goods and services worth ₹40,00,000. Their net capital transfer for the same year is minus ₹40,00,000, while their non-financial assets are worth ₹30,00,000. The total of their foreign direct investments, portfolio investments and asset funding is minus ₹50,00,000. According to these numbers, there is a trade surplus of ₹50,00,000 where the exports are more than the imports.
The balance of their capital account is ₹10,00,000 in deficit and that of their financial account is a deficit of ₹50,00,000. You can then apply the BOP formula and add the balances of all three accounts. Based on the numbers here, this country's balance of payments indicates a negative balance of ₹10,00,000, which shows that there is a deficit in the economy and requires the attention of policymakers and financial experts as ideally it is zero.
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