Balance is the key to a fruitful life and this applies to economics as well. When it comes to finances, creating a budget is essential, as it allows us to balance our income and expenditures. Although it is fairly easy to do so on a personal level, balancing finances in industries can be a daunting task, which requires a separate accountant. Therefore, balancing the finances of an entire country requires more than an accountant, and this is where the balance of payment comes in.
What is the Balance of Payments?
In present times, international trade has become synonymous with economic growth, as nations participating in foreign trades are economically strong. Once a trade is conducted internationally, in addition to the flow of significant capital, countries also have to deal with foreign currency. The balance of payment is a record of all the international transactions that occur between a nation and the world in a certain period. The transactions don’t have to be limited to business deals, transactions made by the state, such as foreign aid, are also recorded in the balance of payments. Ideally, the balance of payment must be zero, but as the world does not work according to the theories, budget surplus or deficits are commonly observed in the balance of payment. The balance of payment is recorded in 3 accounts; current account, financial account, and capital account.
1. Current Account
This can be considered the primary account that is used in the balance of payment. It measures the flow of import and export of goods and services between the country and the rest of the world. In addition to goods and services, the current account also measures investment income, which is a type of income that is received by investments in property, share market, and other sources. Lastly, the current account also records the transfer of payments. Furthermore, there are four components of the current account.
- Visible Balance: Exclusive trade of tangible goods like iron.
- Invisible Balance: As the name suggests, it exclusively deals in services, such as insurance.
- Investment incomes: As mentioned previously, all the profits that are made by investments in shares or by interest come under investment income.
- Net transfers: Foreign transactions, such as international aid.
2. Financial Account
The second-largest part of the balance of payments is the financial account. Primarily, the financial account records the transaction that causes a change in the ownership of the assets and liabilities among the citizens of a country and non-residents. Moreover, the financial account can be seen in two parts. The first one is the local ownership of foreign assets while another part is the foreign ownership of local assets. An increase in the financial account is observed when domestic ownership of foreign assets is increased. The financial account deals in three transactions.
- Portfolio Investment Transaction: Buying and selling of financial assets, such as bonds and stocks.
- Foreign Direct Investment: When a company decides to open an operational facility in another nation, then, that country, in which the facility is established receives credit, making it a foreign direct investment.
- Reserves: As the name suggests, it measures the reserves of currency and gold.
3. Capital Account
Compared to the previous two accounts, the capital account is significantly smaller, and it deals with the expenditure and income in international transactions that are extremely small in value. Despite that, there are certain components in the capital account that are important.
- Debt Forgiveness: If a country’s debt is canceled out without its being recorded negatively, it is called debt forgiveness.
- Inheritance Tax: A tax paid by the individual that inherited the assets of a deceased person.
- Sales of Tangible and Intangible Assets: Foreign purchase of property and patents, respectively.
- Transfer of Financial Assets: Such as buying foreign copyrights or trademarks.
To understand why the concept of balance of payment even came to be, understanding the history of international trade is important. Trading commodities between nations has been ongoing for centuries. With the dawn of the 16th century, mercantilism became the dominant transaction policy, and it remained like that until 1820. In Mercantilism, the basic idea was to export more and import less. Undoubtedly, it was opposed by economists. Following this, the balancing of international transactions was done with gold, which allowed countries to have little flexibility in terms of financial imbalances. It used to be the go-to method; however, the Great Depression caused countries to let go of the gold standard. This is when the devaluation of the currencies began, and slowly the concept of the current account and the financial account was introduced, creating the balance of payment.
Importance of the Balance of Payment
As recording the payments within a personal account is important to understand the flow of money, the balance of payment is required for similar reasons; however, on an international level for a country’s assets and currency. Managing international finances is also carried out by the balance of payment. Additionally, the balance of payment also determines if a country has the potential to become a constructive economic partner. Lastly, just like any other aspect of economics, the balance of payment trends can be analyzed to determine if future transactions will benefit or harm the economy of a nation.
Example of the Balance of Payment
Each international transaction that is carried out between a nation and the rest of the world is recorded in the balance of payment, therefore, the transfer of finances by any import and export business becomes a part of the balance of payment. Take an American automaker, for example, that is selling its product, i.e., cars, to India. In the United States’ balance of payment, the transaction will be recorded as a credit, as an equal amount of funds are being received to make the balance of payment zero.