In the short run, the balance of payments (BoP) may tilt to one side or the other when every day trillions of different currencies are changing hands among people of different countries. But in the long run, the world economy is better off with countries keeping their BoP accounts balanced. The fall of a single 200kg gorilla is enough to shake the lives of hundreds of squirrels. But even then we will continue to hear about BoP crises brewing in different parts of the world. Let’s find out what forces shape a country’s BoP.
Jinny: Hi, Johnny! What are you counting on your fingers today?
Johnny: Well, Jinny, I was trying to remember how many different kinds of terms we have talked about. GDP, GNP, interest rates, inflation and so many others, but somehow I forgot to ask you about BoP. I hope you will now fill this gap.
Jinny: Okay, let’s talk about BoP today. Just like individuals, countries also have to maintain an account of all their dealings with the rest of the world. A record of all transactions of money moving in or out of a country over a period of time is what we call a BoP account. Broadly, we can divide a BoP account into two components: current account and capital account. However, the International Monetary Fund uses a threefold classification of a BoP account: current account, capital account and financial account. For the sake of simplicity, let’s talk about only the twofold classification in which the financial account is treated as part of the capital account.
Johnny: What kinds of transactions are included in the current account?
Jinny: The current account first of all includes all transactions relating to exports and imports of physical goods, which we also call visible trade. Second, the current account includes receipts and payments in respect of services such as banking, tourism and intangible properties such as patents and copyrights, which we also call invisible trade or simply invisibles. The difference between the visible trade and the invisibles is obvious. The physical goods being traded can actually be seen and held, whereas trade in services escapes our vision and grasp. A foreign tourist enjoying a snow-capped mountain cannot hold its beauty in his hands. The receipts and payments in respect of both visible and invisible trade are together known as trade account.
Third, the current account includes private transfers such as money sent by expatriate workers, dividends and interest payments, etc., that are also called the net factor income from abroad and, finally, the current account includes all official transfers between governments such as international aid.
Johnny: What kinds of transactions are included in the capital account?
Jinny: The capital account includes all transactions related to long-term capital flows between different countries, such as investment of money for purchasing land and factories, which we also call foreign direct investment. It also includes short-term capital flows such as investments in the stock market by foreign institutional investors or borrowing of money by firms (external commercial borrowings) and government. In short, the capital account includes all transactions related to investment in either physical assets or financial assets of one country by the residents of another country.
Johnny: Tell me, what does a surplus or deficit in different components of the BoP account indicate?
Jinny: A surplus or deficit in different components of the BoP account can provide a snapshot of a country’s economy. However, for any meaningful conclusion we need to look at the full picture. In general terms, a surplus in the current account may mean that the country is receiving more money by exporting its goods and services to other countries whereas a deficit indicates that the country is importing more goods and services from the outside world, for which it has to pay money. But the reasons for surplus or deficit in the current account in each case could vary. Sometimes the overall current account may show a surplus even in the face of a deficit in the trade account. This could be due to high inward remittances received from the residents of the country living abroad or high profits and dividends earned by the country’s firms abroad.
A high surplus or deficit in the capital account has its own meaning. Overall surplus in the capital account indicates that foreign investors are investing more in the assets of the country than what the residents of that country are investing in the assets of other countries. A deficit in the capital account indicates the opposite scenario. In general, we can say that a surplus in the capital account means international investors have confidence in the domestic economy whereas a deficit could be due to lack of confidence.
But always keep in mind that after taking all surpluses and deficits of current and capital account, ultimately it is the overall balance in the BoP account that matters.
Johnny: That’s true, Jinny. Next week I will ask you how countries are able to maintain overall balance even an adverse economic scenario.
What: A balance of payments (BoP) account is a record of all transactions of money moving in or out of a country over a period of time.
How: We can broadly divide the BoP account into two components: current account and capital account.
Significance: A surplus or deficit in different components of the BoP account can provide a snapshot of a country’s overall economy.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com