What is Balance of Payment?
The balance of payments theory is the modern and most satisfactory theory of the determination of the exchange rate. It is also called the demand and supply theory of exchange rate.
According to this theory, the rate of exchange in the foreign exchange market is determined by the balance of payments in the sense of demand and supply of foreign exchange in the market.
Here the term 'balance of payments' is used in the sense of a market balance. If the demand for a country's currency falls at a given rate of exchange, we can speak of a deficit in its balance of payments.
Similarly, if the demand for a country's currency rises at a given rate of exchange, we can speak of surplus in its balance of payments.
A deficit balance of payments leads to a fall or depreciation in the external value of the country's currency. A surplus balance of payments leads to an increase or appreciation in the external value of the country's currency.
According to Ellsworth, "If market forces are allowed to work unimpeded, the demand and supply of foreign exchange establish a rate of exchange that automatically clears the market so that no actual or exposit payments deficit or surplus can appear."
In the words of Walter, "If the exchange rate is permitted to respond fully to changing supply and demand conditions, the status of the balance of payments of a country tends to determine the value of its currency relative to the currencies of other nations."
There is a close relation between the balance of payments and the demand and supply of foreign exchange. Balance of payments is a record of international payments made due to various international transactions, such as, imports, exports, investments and other commercial, financial and speculative transactions.
The balance of payments includes all payments made by the foreigners to the nationals as well as all payments made by the nationals to the foreigners. The incoming payments are credits and outgoing payments are debits.
The credits in balance of payments or the export items constitute the supply of foreign exchange; the supply of foreign exchange is made by the exporting countries.
On the other hand, the debits in the balance of payments or the import items constitute the demand for foreign exchange; the demand for foreign exchange arises from the importing countries.
Any deficit or surplus in the balance of payments causes changes in the demand and supply of foreign exchange and thus leads to fluctuations in the exchange rate. When there is deficit in the balance of payments the debits (or the demand for foreign exchange) will exceed the credits (or the demand for foreign exchange).
As a result, the rate of exchange will rise (or the exchange value of domestic currency in terms of foreign currency will fall).
On the other hand, a surplus in the balance of payments means credits (or the supply of foreign exchange), exceeding debits (or the demand for foreign exchange), which in turn, will lead to a fall in the rate of exchange (or a rise in the external value of domestic currency).
The supply of foreign exchange curve, on the other hand slopes upwards from left to right indicating that lower the exchange rate (i.e., rupees per dollar), lower the supply of foreign exchange (dollars) and vice versa.
Investopedia defines Balance of Payment as "A record of all transactions made between one particular country and all other countries during a specified period of time. BOP compares the dollar difference of the amount of exports and imports, including all financial exports and imports. A negative balance of payments means that more money is flowing out of the country than coming in, and vice versa.
Wikipedia defines as follows: Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of
goods,
services,
financial capital, and
financial transfers. The BoP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.
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.
Balance of payment (BoP) is a statistical statement that summarizes, for a specific period, transactions between residents of a country and the rest of the world. BoP positions indicate various signals to businesses. BoP comprises current account, capital account and financial account.
and services, income and current transfers. In the capital account, transactions of capital transfers, capital acquisition and non-produced non-financial assets like buildings and patents are included, while in the financial account, transactions relating to financial assets and liabilities like portfolio investments and foreign exchange reserves are included.
However, the BoP account of most countries still classify transactions under two heads only—capital account and current account. In such a case, financial and capital accounts are treated as one. Transactions in BoP are recorded on a double-entry bookkeeping system that is, a transaction is recorded on each side—debit and credit of the BoP account.
There are many signals that the BoP account of a country gives out. For example, large current account transactions indicate towards openness of an economy. This was the case with India as reduction in trade restrictions and duties led to increase in both exports and imports after 1991. Also large capital account transactions may indicate well-developed capital markets of an economy.
Balance of payments may be used as an indicator of economic and political stability. For example, if a country has a consistently positive BOP, this could mean that there is significant foreign investment within that country. It may also mean that the country does not export much of its currency.
This is just another economic indicator of a country's relative value and, along with all other indicators, should be used with caution. The BOP includes the trade balance, foreign investments and investments by foreigners.
Division of Balance of Payment:
The BOP is divided into three main categories: the
current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction.
The Current AccountThe current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account.
Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports.
Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received.
The Capital AccountThe capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds.
The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets (assets such as equipment used in the production process to generate income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to fixed assets.
The Financial AccountIn the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented.
Also included are government-owned assets such as foreign reserves, gold,
special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.
The Balancing ActThe current account should be balanced against the combined-capital and financial accounts. However, as mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies. When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account. If a country has a
fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded.
When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP.
Liberalizing the AccountsThe rise of global financial transactions and trade in the late-20th century spurred BOP and macroeconomic liberalization in many developing nations. With the advent of the emerging market economic boom - in which capital flows into these markets tripled from USD 50 million to USD 150 million from the late 1980s until the Asian crisis - developing countries were urged to lift restrictions on capital and financial-account transactions in order to take advantage of these capital inflows. Many of these countries had restrictive macroeconomic policies, by which regulations prevented foreign ownership of financial and non-financial assets. The regulations also limited the transfer of funds abroad. But with capital and financial account liberalization, capital markets began to grow, not only allowing a more transparent and sophisticated market for investors, but also giving rise to foreign direct investment. For example, investments in the form of a new power station would bring a country greater exposure to new technologies and efficiency, eventually increasing the nation's overall
gross domestic product by allowing for greater volumes of production. Liberalization can also facilitate less risk by allowing greater diversification in various markets.
Causes of Disequilibrium:
Though the credit and debit are written balanced in the balance of payment account, it may not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of surplus.
Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to foreigners. It arises when the effective demand for foreign exchange of the country exceeds its supply at a given rate of exchange. This is called an 'unfavourable balance'.
Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a situation arises when the effective demand for foreign exchange is less than its supply. Such a surplus disequilibrium is termed as 'favourable balance'.
Various causes of disequilibrium in the balance of payments or adverse balance of payments are as follows:
1. Development Schemes: Developing countries which have embarked upon planned development programmes require to import capital goods, some raw materials which are not available at home and highly skilled and specialized manpower. Since development is a continuous process, imports of these items continue for the long time landing these countries in a balance of payment deficit.
Therefore, the main reason for adverse balance of payments in the developing countries is the huge investment in development schemes in these countries. The propensity to import of the developing countries increases for want of capital for industrialization. The exports, on the other hand, may not increase because these countries are traditionally primary producing countries. Moreover the volume of exports may fall because newly created domestic industries may need them. All this leads to structural changes in the balance of payment resulting in structural disequilibrium.
2. Price-Cost Structure/Inflation:
An increase in income and price level owing to rapid economic development in developing countries, will increase imports and reduce exports causing a deficit in balance of payments.
Changes in price-cost structure of export industries affect the volume of exports and create disequilibrium in the balance of payments. Increase in prices due to higher wages, higher cost of raw materials, etc. reduces exports and makes the balance of payments unfavorable.
3. Changes in Foreign Exchange Rates:
Changes in the rate of exchange is another cause of disequilibrium in the balance of payments. An increase in the external value of money makes imports cheaper and exports dearer; thus, imports increase and exports fall and balance of payments become unfavourable. Similarly, a reduction in the external value of money leads to a reduction in imports and an increase in exports.
4. Fall in Export Demand:
There has been a considerable decline in (he export demand for the primary goods of the underdeveloped countries as a result of the large increase in the domestic production of foodstuffs raw materials and substitutes in the rich countries. Similarly, the advanced countries also find a fall in their export demand because of loss of colonial markets. However, the deficit in the balance of payment due to the fall in export demand is more persistent in the underdeveloped countries than in the advanced countries.
5. Demonstration Effect:
According to Nurkse, the people in the less developed countries tend to follow the consumption patterns of the developed countries. As a result of this demonstration effect, the imports of the less developed countries will increase and create disequilibrium in the balance of payments.
When the people in the less developed countries imitate the consumption pattern of the people in the developed countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the balance of payments.
6. International Borrowing and Lending:
International borrowing and lending is another reason for the disequilibrium in the balance of payments. The borrowing country tends to have unfavourable balance of payments, while the lending country tends to have favourable balance of payments.
7. Cyclical Fluctuations:
Cyclical fluctuations cause cyclical disequilibrium in the balance of payments. During depression, the incomes of the people in foreign countries fall. As a result, the exports of these countries tend to decline which, in turn, produces disequilibrium in the home country's balance of payment.
Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments.
8. Newly Independent Countries:
The newly independent countries, in order to develop international relations, incur huge amounts of expenditure on the establishment of embassies, missions, etc. in other countries. This adversely affects the balance of payments position.
9. Population Explosion:
Another important reason for adverse balance of payments in the poor countries is population explosion. Rapid growth of population in countries like India increases imports and decreases the capacity to export.
Most countries experience an increase in the population and in some like India and China the population is not only large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may increase as population increases.
10. Natural factors:
Natural calamities, such as the failure of rains, droughts, floods, etc., adversely affect the production in the country. As a result, the exports fall, the imports increase and the country experiences deficit in its balance of payments.
These calamities can easily cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial production in the country. The exports may decline while the imports may go up causing a discrepancy in the country's balance of payments.
11) Poor Marketing Strategies
The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the developing countries have pushed them into huge deficits.
12) Flight Of Capital
Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing countries may also shift their capital to developed countries to safeguard against political uncertainties. These capital movements adversely affect the balance of payments position.
13) Globalisation
Due to globalisation there has been more liberal and open atmosphere for international movement of goods, services and capital. Competition has beer increased due to the globalisation of international economic relations. The emerging new global economic order has brought in certain problems for some countries which have resulted in the balance of payments disequilibrium.
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