Concept, components and importance of balance of payments

When assessing a country’s economy, foreign exchange, cash flow, etc., a lot of factors are considered. One such component is the balance of payments, which plays an important role in assessing a country’s economy. So through this article, we are going to give you important information about this.

What is the balance of payment?

Balance of payments can be defined as the record of all monetary transactions between a country’s residents and other countries within a certain period of time. The details of transactions made by companies, individuals and the government are contained in the Balance of Payments statement. These are official records that help analysts monitor the flow of funds and analyze economic policies. The balance of payments plays an important role in determining the inflow and outflow of cash in the economy. Simply put, the balance of payments is the account of financial transactions between a country and other countries.

Balance of payment formula

The balance of payments is calculated using the following method –

Balance of Payments = Current Account Balance + Capital Account Balance + Reserve Balance

Balance of Payments (BOP) = (XM) + (CI – CO) + Forex

Here, X exports, M imports, CI capital inflows, CO capital inflows and forex means foreign currency reserve balance.

Importance of balance of payments

Balance of payment provides important data. There is a record of inward and outward flow of cash within an economy. This data plays an important role in monitoring the flow of funds for the development of the economy. There are several reasons why the balance of payments is important for an economy, some of which are –

  • It gives a picture of the financial and economic situation of the country. It is used to understand the economic relations of different countries. For this reason, it is considered an important part of international financial management.
  • The balance of payments is issued as a statement on a quarterly basis. These statements are used to determine the performance of the currency. At the same time, it shows that the currency has been devalued, increased or stabilized. The balance of payments thus shows how a country’s currency is performing compared to other currencies.
  • The government uses balance of payments statements to understand economic trends and develop efficient fiscal and trade policies.
  • Economists and analysts use this information to understand a country’s economic behavior with foreign nations. It helps in taking appropriate steps in those cases which are likely to harm the economy of the country or which are causing damage.
  • Along with this, the balance of payments helps in evaluating the potential of a country as a good economic partner. It also indicates the contribution made by a country to international economic development.

Types of the balance of payments

Balance of payments refers to the difference between “export – import”. The trade balance has to be included as an important part when calculating the balance of payments. The balance of payments is divided into two categories, which are as follows –

Favorable balance of payment

A favorable balance of payment is a scenario in which the value of total goods and services exported exceeds the value of total goods and services imported. This situation is considered good for the country.

Adverse balance of payments

When the value of total services and goods imported into a country exceeds the value of total services and goods exported, it is called the adverse balance of payments. It is not considered good for the economy of the country.

Components of balance of payments

The three components of the balance of payments are given below. An ideal economy requires a current account to balance the amount of financial and capital accounts. However, this is not the case in most cases. The balance of payments refers to the shortage or surplus of the fund.

Current account

The current account records and monitors the inflow and outflow of money from the trade in goods and services. Such accounts keep records of funds spent and received from tourism and services sector in revenue, manufacture of goods, transportation of raw materials, etc. Revenue and copyrights generated from stock and royalties are also recorded under current account.

Capital account

The country’s capital account keeps a record of and monitors cash flows from international capital transactions. These are transactions that occur through the purchase or disposal of non-financial and non-produced assets. Money received from the gift and loan waiver is also recorded in the capital account.

Financial account

The financial account monitors the flow of funds from businesses, real estate, shares, gold and government-owned assets. The financial account also keeps records of assets owned by foreign nationals in India, foreign investment and property owned by Indian citizens abroad.