What is the Balance of Payments

What Is the Balance of Payments
 | Updated on: January 3, 2023

Balance of Payments or BOP is a term used in a country's financial accounting. Countries also need to record their accounting transactions to determine the state of their economy. Cross-border transactions may be a good source of forex, profits, and international goodwill. The BOP gives a summary of the country’s transactions internationally. These transactions can be in trade, remittances, or foreign aid.

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What is the Balance of Payments (BOP)?

The balance of payments (BOP) or the balance of international payments states the overview of all the transactions made between companies, organizations, government bodies, and individuals within one country and other countries. The BOP can be prepared for a year, quarter, or defined period. It lists the net trade in goods and services, and the BOP also records other transactions such as investments, net earnings, and transfers.

Ideally, the sum of the transactions on the BOP should be zero, but since international transactions are subject to exchange rate fluctuations, they may not always be so. The complete international accounts of a country are analyzed and summarized in this comprehensive report. 

The BOP summarizes payments from the capital accounts and well current accounts. The current account section lists the transactions in current transfers, investments, goods, and services. Transactions in central bank reserves and financial instruments are broadly classified as capital accounts. The report can also list a financial account that contains the capital account, and a narrow classification lists only financial instrument transactions under the capital account.

Related transactions could also fall in both categories. For example, the export of an item is a current account transaction, but the foreign capital used to pay for the export is a capital transaction. Ideally, the country will have enough funds through its exports to fund its imports. But, if there is insufficient money, the country will pay from its reserves, causing a balance of payments deficit when the BOP excludes the central bank reserves under the capital account. However, it is best if the country’s balance of payments adds up to zero, indicating good financial health. Discrepancies creep in because of the sheer magnitude of recording every cross-border transaction compounded by fluctuating exchange rates. But, when every credit causes a debit in the BOP, the total report should add up to zero with a broad definition of the capital account.

History of Balance of Payments (BOP)

The balance of payments is a relatively new accounting item. This is because in the pre-19th century, gold was used to pay for international transactions and trade deficits were rare. Countries that had a trade surplus were world powers. It was not as severe as today to have a very steep imbalance in international trade, and economic integration in countries was poor. The industrial revolution that causes more economic integration changes the way international business. The Great Depression era saw a much-lowered reliance on gold, and countries started devaluing their currencies competitively.

From the end of World War II to the 1970s, the Bretton Woods system used a gold-convertible dollar with a fixed exchange rate with other international currencies. With changing modes of international transactions, the balance of payment crises started. The money supply increased, but the trade deficit worsened, and the government eventually could not redeem the central bank’s dollar reserves for gold. The system was finally abandoned, and the currency values were free again. However, countries with a trade deficit can hoard more foreign reserves and depress their currency. The enhanced exchange value then makes this country’s products more affordable to the rest of the world and boosts trade. International trade has also grown to such high volumes that there can be abrupt currency devaluations.

Another fallout of the change in international currency and trade practices after the Great Depression is that many governments implemented expansionary monetary policies, which caused their currencies to appreciate against the dollar. This helped these countries gain more export business and move on from the loss of demand that the Great Depression caused.

Today, countries form their economic and trade policies based on their balance of payments and other economic factors. When the BOP shows an imbalance in foreign payments and investments, countries seek to correct this imbalance through policy changes. We have seen US’s largest account deficit of $647 billion in 2020, and China’s largest surplus at $274 billion.

Countries seek to correct or create specific situations in their balance of payment. Some countries alter their policies to keep their currency value low to build up their currency reserves and create a favorable atmosphere for exports. Other countries try to attract more foreign investments through their policies. The results of these policy changes will be seen in the subsequent BOP report.

What is BOP and its components?

BOP, or balance of payments, is a report that lists all the transactions between the individuals and entities in a country and the rest of the world over a specific time period. The key components of this report are the current account, capital account, and financial account. Ideally, the current account balances the capital and financial accounts and the report’s sum will be zero.

What is a Balance of Payments (BOP) example?

Let us take the example of country A and country B which are engaged in international trade. They record the outflow of money as a debit in the BOP and inflows as a credit. So, if Country A exports items to Country B, the export amount is a debit on country A’s BOP, and there is a corresponding credit on the BOP of country B. In this manner, any trade, remittance, and investment across borders are recorded in the appropriate column of the BOPs of both countries.

What is the formula for Balance of Payments?

The formula for the balance of payments is:

Current Account + Capital Account + Financial Account + Balancing Item = 0

The balance of payment report is the statement that gives you an overview of how the country is doing business with the rest of the world. It covers all the aspects of money transactions across borders, including the remittances that a non-resident citizen may send back home or the investment that a foreign entity may make in the country. A thorough understanding of the balance of payment is essential to compare the economies of different countries.

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