What is the balance of payments?

We know that banks allow us to make payments only up to the credit balance available in our Savings Bank Account or Current Account. Whatever amount we have deposited to the account is credited to our account and whatever payments made through the account or amount withdrawn from the account is debited to the account. We may determine the net credit balance or debit balance (overdraft) maintained in the account by summarizing all the transactions in the account. Accordingly, we are spending money within the credit balance available in the account.

Similarly, in international trades, all transactions in goods, services, and assets of a country with the rest of the world for a specified period, are accounted for in the balance of payments (BOP) usually for a year. If a country has received money from abroad, this is known as a credit, and if a country has paid or given money abroad, the transaction is counted as a debit. For example, while going on a trip abroad, one needs to have the currency of that country. If you are going to the United States, you need US dollars. If you are travelling to the UK, you need pounds. You can convert rupees into a given foreign currency. The payments made in foreign currency from India are counted as a debit. Similarly, the credit of foreign currency comes to India through foreign direct investment (FDI), foreign institutional investments (FII), or in the form of gifts, aids, and other remittances is credits.

The balance of payments shows whether a country saves enough funds to pay for imports and can produce enough output to cover the costs associated with economic growth. There are three major parts of a balance of payments – current account, financial account, and capital account. Transactions in goods and services are recorded in the current account of the balance of payments. Financial transactions are recorded in the capital account or financial account of the balance of payments. Financial account components include direct investment, portfolio investment, and reserve assets broken down by sector. The financial account covers all transactions associated with the changes of ownership of foreign financial assets and liabilities in an economy. The capital account covers all transactions that involve the receipt or payment of capital transfers and the acquisition or disposal of non-produced, nonfinancial assets. 

An important aspect of a nation’s balance of payments is its balance of trade. The balance of trade represents the difference between how much a country imports and how much it exports. The balance of payments shows how much money is going out of the country and how much money comes in. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance, but in practice, this rarely happens. If the value of a country’s imports exceeds the value of its exports, the country has a negative balance of trade, also known as a trade deficit. When a nation’s current account is in deficit, it has to borrow money from other countries to fund its deficit. Over time, economic growth can slow if the deficit country can’t get out of debt.  When funds are not available to cover the debts, the government has to sell its assets, commodities, and natural resources to pay its debt or initiate harsh corrective measures to restrict the outflow of money by banning full or partial import of certain goods to save the enough funds only to pay for imports of most essential goods and services. Whenever a deficit occurs continuously in the balance of payments account of a country, the economic growth of that country would slow down.

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