Balance of Payment – Definition, Formula, Components

The Balance of Payment or BoP is a statement or record of all monetary and economic transactions made between a country and the rest of the world within a defined period (every quarter or year). These records include transactions made by individuals, companies and the government. Keeping a record of these transactions helps the country to monitor the flow of money and develop policies that would help in building a strong economy.

In a perfect scenario, the Balance of Payment (BoP) should be zero. That is, the money coming in and the money going out should balance out. But that doesn’t happen in most cases. A country’s BoP statement correctly indicates whether the country has a surplus or a deficit of funds. A BoP surplus indicates that a country’s exports are more than its imports. A BoP deficit, on the other hand, indicates that a country’s imports are more than exports. Both scenarios have short-term and long-term effects on the country’s economy.

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Components of Balance of Payment 

Now let’s understand the different components of the BoP. The BoP consists of three main components—current account, capital account, and financial account. As mentioned earlier, the BoP should be zero. The current account must balance with the combined capital and financial accounts.

Current Account

The current account monitors the flow of funds from goods and services trade (import and export) between countries. Now this includes money received or spent on manufactured goods and raw materials. It also includes revenue from tourism, transportation receipts, revenue from specialized services (medicine, law, engineering), and royalties from patents and copyrights. In addition, the current account includes revenue from stocks.

Capital Account

The capital account monitors the flow of international capital transactions. These transactions include the purchase or disposal of non-financial assets (for example, land) and non-produced assets. The capital account also includes money received from debt-forgiveness and gift taxes. In addition, the capital account records the flow of the financial assets by migrants leaving or entering a country and the transfer, sale, or purchase of fixed assets.The term “capital account” is also used in the narrower sense that excludes central bank foreign exchange market operations: Sometimes the reserve account is classified as “below the line” and so not reported as part of the capital account.

Expressed with the broader meaning for the capital account, the BoP identity states that any current account surplus will be balanced by a capital account deficit of equal size – or alternatively a current account deficit will be balanced by a corresponding capital account surplus:

Financial Account

The financial account monitors the flow of funds pertaining to investments in businesses, real estate, and stocks. It also includes government-owned assets such as gold and Special Drawing Rights (SDRs) held with the International Monetary Fund (IMF). In addition, it includes foreign investments and assets held abroad by nationals. Similarly, the financial account includes a record of the assets owned by foreign nationals.

The term “balance of payments surplus” (or deficit – a deficit is simply a negative surplus) refers to the sum of the surpluses in the current account and the narrowly defined capital account (excluding changes in central bank reserves). Denoting the balance of payments surplus as BoP surplus, the relevant identity is

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Why is BoP important?

• The BoP statement provides a clear picture of the economic relations between different countries. It is an integral aspect of international financial management. Now that you have understood BoP and its components, let’s look at why it is important.
• To begin with, the BoP statement provides information pertaining to the demand and supply of the country’s currency. The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries. Next, the country’s BoP determines its potential as a constructive economic partner. In addition, a country’s BoP indicates its position in international economic growth.
• By studying its BoP statement and its components closely, a country would be able to identify trends that may be beneficial or harmful to the economy and take appropriate measures.
• Balance of Payment (BOP) of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period usually one year.
• The systematic accounting is done on the basis of double entry book keeping (both sides of transactions credit and debit are included). Economic transaction includes all such transactions that involve the transfer of title or ownership of goods and services, money and assets.
• The Balance of Payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country.
• If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

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