COMPONENTS OF BALANCE OF PAYMENTS

INTRODUCTION:
The BoP consists of three main components—current account, capital account, and financial account.
The current account measures international trade, net income on investments and direct payments.
The financial account describes the change in international ownership of assets. The capital
account includes any other financial transactions that don't affect the nation's economic output.

Let us analyse these components in details as below:

COMPONENTS OF BOP:
1. CURRENT ACCOUNT:
Current account on BOP is a statement of actual receipts and payments in short period. It includes all
the transactions relating to export and import of goods and services and unilateral transfers during a
given period of time. It also includes receipts from engineering, tourism, transportation, business
services, stocks, and royalties from patents and copyrights. When all the goods and services are
combined, together they make up to a country’s Balance Of Trade (BOT).

The main components of current account are as under:

a. Merchandise transactions or visible trade: This is the net of exports and imports of visible
items i.e. goods. The earnings from exports of goods are credited to the current account,
whilst payments for imported goods are debited. The balance between the totals is known
as the Balance of Trade.
b. Invisible trade (export and import o services): It includes a large variety of non-factor
services which are known as invisible items sold and purchased by the residents of a
counrty, to and from the rest of the world. Payments are either received or made to the
other countries for use of these services. Services are generally of generally from – shipping,
banking, insurance, interest, profits, dividends, transport, tourism, private transfers,
government expenditure such as expenditure on embassies, contributions to IMF or ADB,
military forces abroad etc and etc. Payments of these services are recorded on the debit side
and receipts on the credit side of the current account.
c. Unilateral or unrequited transfers (one sided transactions): Unilateral transfers include
gifts, donations, personal remittances and other ‘one-way’ transactions. These refer to those
receipts and payments, which take place without any service in return. Receipts of unilateral
transfers are shown on the credit side and unilateral transfers to rest of the world on the
debit side.

2. CAPITAL ACCOUNT:

All international capital transactions between the countries are monitored through the capital
account. These transactions include the purchase or sale of non-financial and non-produced assets.
The capital account also includes money received from debt-forgiveness and gift taxes. In addition,
the capital account records the flow of the financial assets by migrants leaving or entering a country
and the transfer, sale, or purchase of fixed assets. It is related to claims and liabilities of financial
nature.
The capital account is an account used to finance the deficit in the current account or absorb the
surplus in the current account. This can be done by borrowing more money from abroad or lending
more money to non-residents. There are three major components on the capital account.

a. Loans and borrowings from abroad: These consist of all loans and borrowings given to or
received from abroad. It includes both private sector loans, as well as public sector loans.
Receipts of such loans and repayment of loans by foreigners are recorded on the credit side.
Whilst lending abroad and repayment of loans to abroad is recorded on the debit items.
b. Investment to and from abroad: These are investments made by non-residents in
shares/stocks in the home country or investment in real estate in any other country.
Investments by rest of the world in the shares of Indian companies, real estate in India, etc
from abroad are recorded on the credit side as they bring in foreign exchange. Investments
by Indian residents in shares of foreign companies, real estate abroad are recorded on the
debit side as they lead to outflow of foreign exchange.
c. Changes in foreign Exchange Reserve: Foreign Exchange Reserves are the financial assets of
the government held in the central bank. The Central Bank maintained such reserves to
control the exchange rate and ultimately balance the BOP. A change is reserves serves as the
financing item in India’s BOP. So, any withdrawal from the reserves is recorded in the credit
side and any addition to these reserves is recorded on the negative side.

Balance on Current Account and Balance on Capital Account:

Balance between current account balance and capital account balance throws a light on the
country’s economic health as they are interrelated. For equilibrium Balance of Payments condition,
for a country:
 A deficit in the current account must be settled by a surplus on the capital account.
 A surplus in the current account must be matched by a deficit on the capital account.

3. Financial Account:

The flow of funds from and to foreign countries through various investments in real estates, business
ventures, foreign direct investments etc is monitored through the financial account. This account
measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign
assets. It also includes government-owned assets such as gold and Special Drawing Rights (SDRs) held
with the International Monetary Fund (IMF). In addition, it includes foreign investments and assets held
abroad by nationals. Similarly, the financial account includes a record of the assets owned by foreign
nationals. On analyzing these changes, it can be understood if the country is selling or acquiring more
assets (like gold, stocks, equity etc). A positive figure reveals a net inflow of funds into a country.
Alternatively, a net outflow is represented by a negative figure.
When there is a negative figure, the amount has to be paid for either by:

(a) borrowing from other central banks and international organisations, or

When the balance for official financing is positive, then loans can be repaid and reserves replenished.
Governments do sometimes borrow even when the balance for official financing is positive; this is in
order to build up reserves for the future.

A country has a balance of payments problem when a section of its accounts are in regular deficit or
surplus. Deficit problems are more serious than surplus ones, as surpluses usually result from
successful international trading, whilst deficits indicate failure. Persistent imbalances indicate that the
balance of payments is in fundamental disequilibrium. This usually requires the government to
undertake remedial measures.

CONCLUSIONS:

In a perfect scenario, the Balance of Payments (BoP) should be zero, that is, the current account must
balance with the combined capital and financial accounts. In other words, the money coming in and the
money going out should balance out. But that doesn’t happen in most cases. A country’s BoP statement
correctly indicates whether the country has a surplus or a deficit of funds. Both scenarios have short-
term and long-term effects on the country’s economy.

Thus, by studying a country’s BoP statement and its components closely, a country would be able to
identify trends that may be beneficial or harmful to the economy and take appropriate measures.