What is Balance of Payment? What is balance of Trade? What is current account deficit/ Surplus and capital account deficit / Surplus? What is forex reserve? What is Trade Deficit/ Surplus?

Finance & Economy

There is many terms like Balance of payment, Balance of Trade, Current A/c Deficit, Capital account deficit, trade deficit, forex reserve which appears to be confusing to many students. Read the complete article to develop such understanding about these terms that you will never forget. Please refer following basic points before going ahead in learning the concept of Balance of payment, Balance of Trade, Current A/c Deficit, Capital account deficit, trade deficit, forex reserve:-

  1. Each country have its own currency.
  2. All the countries does not have all the resources to fulfil demand of its population like some countries are rich in cereals and some in metals and some in fuels like crude oil. Hence Countries need to buy some goods & services from foreign countries and International trade came into effect.
  3. International trade is import and export of goods & services.
  4. To facilitate import & export and to meet its requirement of foreign currencies to facilitate international monetary transactions, countries need to keep some reserve of currencies of foreign countries, which is called Forex Reserve.
  5. A country need not keep reserve of currencies of all the countries but some major currencies as per its trade practice. Hence only handful currencies are kept in official reserve.
  6. As explained above, people of different countries live in different countries and they need to send money to their home in currency of their home country. Hence they need to buy the currencies.
  7. In the same way, some investors invest in the assets in different countries which results in flow of capital in different currencies.
  8. In the same way, services are also imported and exported which results in flow of money in the form of foreign currencies.

Balance of Payment (BoP)

Due to transactions mentioned in above points, a country need to track total inflow and outflow of its foreign currency transactions, otherwise its economy could collapse without any early warning, the record prepared for this purpose is called as Balance of Payment. Hence balance of payment is an annual statement of accounts of all monetary transactions of a country with the rest of world. These monetary transactions may be due to–

flow of goods (when a country export goods it receives foreign currency and when it import goods it pays in foreign currency)

flow of services (when a country export services it receives foreign currency and when it import services it pays in foreign currency)

flow of capital. (A country receive foreign currency when capital flows in from rest of the worlds and it pays in foreign currency when capital flows out)

Balance of payment statement records, all these transactions in foreign exchange on an annual basis. Balance of payment is divided in two parts:

  1. Balance of payment in Current Account
  2. Balance of payment in Capital Account

Balance of Payment in Current Account.

Balance of payment in current account records only current account transactions i.e. Balance of trade (goods) and balance of invisibles (services).

In balance of trade (BoT), value of imports and exports of goods in included. Hence difference of value of exports and value of imports in a given period of time (one year) is known as balance of trade. If value of exports is more than value of imports during the year then it is a situation of positive trade balance known as trade surplus. If the value of imports during the year is mote than the value of exports during the year then it is a situation of negative trade balance known as trade deficit. If values of exports is equal to value of imports during a year then it is a situation of balanced balance of trade.

In balance of invisibles (BoI), following types of transactions are included in balance of Invisibles:-

  1. Factor services like services of land, labor etc.
  2. Non-Factor services like tourism, transportation, Insurance, banking etc.
  3. Private Transfers like donations, gifts, remittances etc.
  4. Official Transfers like grants from abroad etc.

If value of specified receipts is more than the value of payments then it is positive balance of invisibles. But if value of specified receipts is less than the value of specified payments then it is negative balance of invisibles. If value of specified receipts is equal to the value of specified payment then balance of invisible is said to be in balance.

Total of balance of trade (BoT) and balance of invisible(BoI) is known as Balance of payment in current account.

Balance of Payment in current A/c = Balance of Trade + Balance of invisibles

Balance of Payment in Current Account may be favorable, unfavorable or balanced. If a country has earned more foreign exchange than it has spent combing BoT and BoI (balance of trade and balance of invisibles) during the year then it is a situation of favorable balance of payment in current account known as Current account Surplus.

If a country has spent more foreign exchange than it has earned combing BoT and BoI (balance of trade and balance of invisibles) during the year then it is a situation of unfavorable balance of payment in current account known as Current account Deficit.

If a country has spent as much foreign exchange as has earned combing BoT and BoI (balance of trade and balance of invisibles) during the year then it is a situation of balanced balance of payment in current account.

Balance of Payment in Capital Account.

Balance of payment in capital account records the inflows and outflows of capital for a country during a year. Capital can flow in any of the following forms:-

  1. Non-Debt Creating Flows of capital:– This part includes those inflows & outflows of capital which does not create any debt liability like capital inflows in the form of Foreign Direct investment (FDI) and Foreign Portfolio Investment (FPI).
  2. Debt Creating Flows of Capital:- This part includes those inflows & outflows of capital which create debt liability for first receiver. like capital inflows in the form of External Assistance, External Commercial Borrowings, Short term borrowings, and NRI deposits.

If total inflow of capital is more than total outflow of capital during the year then it is a situation of capital account surplus. But if total inflow of capital is less than total outflow of capital during the year then it is a situation of negative BoP in capital account and it is known as Capital Deficit. If total inflow & outflow of capital is of same value then BoP in capital account is said to be in balance.

Relation between BoP in Current Account and BoP in Capital Account / why the BoP of a country will always be in balance?

Capital flows is managed to settle the surplus or deficit of BoP in current account. A country which has a current account surplus should be sending out its capital in different forms. It ought to have a Capital Account deficit. This deficit will cancel the current account Surplus. A country which has a current account deficit must arrange inflow of capital in foreign currency to make capital account surplus to meet the current account deficit.

Thus a country which has a current account surplus will manage a capital account deficit. But a country which has a current account deficit will manage to have a capital account surplus.

Overall balance of payment is the sum total of BoP in current account and BoP in capital account.

Balance of payment (BoP) = BoP in current A/c + BoP in capital A/c

Hence Balance of payment of a country will always be in balance due to adjustment of surplus/deficit of current a/c with surplus / deficit of capital a/c. But in case value of Capital account surplus is not equal to the value of current account deficit, the country will take balance to its foreign exchange reserve.

Foreign Exchange Reserve

As explained above All the countries does not have all the resources to fulfil demand of its population like some countries are rich in cereals and some in metals and some in fuels like crude oil. Hence Countries need to buy some goods & services from foreign countries and International trade came into effect. To facilitate import & export and to meet its requirement of foreign currencies to facilitate international transactions , countries need to keep some reserve of currencies of foreign countries, which is called Forex Reserve (Foreign Exchange Reserve). Its relation with BoP can be explained with the following points:-

  1. At the beginning of year all , assume a country is having $XXX balance of forex reserve.
  2. During the year all the international monetary transaction (for both capital & current account) are record in balance of payment statement.
  3. In case BoP statement is in balance then current account and capital account will nullify the effect of each other (as explained in relation of capital account & current account) and no value will be adjusted from forex reserve.
  4. In case there is surplus in capital account as well as current account then there will be increase in foreign exchange reserve account.
  5. In case there is deficit in capital account as well as current account then there will be decrease in foreign exchange reserve account.
  6. In case value of Capital account surplus is more than the value of current account deficit, the country will take balance to its foreign exchange reserve.
  7. The closing balance of Foreign Exchange reserve = Opening balance + (adjustment due to overall Balance of BoP)
  8. Hence in case the overall BoP (total of current account & capital account) is in surplus then credit balance will be transferred to forex reserve and it will increase But if the overall BoP is in deficit then debit balance will be entered in forex reserve and it will decrease.

Please refer the following chart which is showing Balance of payment, Components of BoP, trade surplus/deficit, Current Account Deficit/ surplus and Capital Account Deficit/ Surplus and Adjustment to Foreign exchange reserve account.

Chart showing Balance of Payment & its components

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