Balance of Payments

A.10.1] Definition

• Balance of Payments (BoP) is a systematic record of all economic transactions between a country and the rest of the world over a specified period.
• It is a comprehensive accounting statement that captures all inflows and outflows of money.
• It is divided into three main accounts: Current Account, Capital Account, and Financial Account.

A.10.2] Components of Balance of Payments

A.10.2.1] Current Account

• Definition: Records the flow of goods, services, income, and current transfers between a country and the rest of the world.
• Components:
  • Trade Balance: Difference between exports and imports of goods.
  • Services Balance: Trade in services (e.g., tourism, transportation).
  • Income Balance: Earnings from investments and employment abroad.
  • Current Transfers: Unilateral transfers (e.g., remittances, foreign aid).

A.10.2.2] Capital Account

• Definition: Records capital transfers and the acquisition or disposal of non-financial assets.
• Components:
  • Capital Transfers: One-time transfers (e.g., debt forgiveness, asset transfers).
  • Non-Financial Assets: Acquisition or disposal of assets like land, buildings, etc.

A.10.2.3] Financial Account

• Definition: Records transactions involving financial assets and liabilities.
• Components:
  • Direct Investment: Long-term investments in physical assets.
  • Portfolio Investment: Purchase of foreign securities (e.g., stocks, bonds).
  • Other Investment: Short-term financial flows (e.g., loans, deposits).
  • Reserve Assets: Holdings of foreign currency, gold, etc.

A.10.3] Balance of Payments Equilibrium

• Definition: When the sum of all accounts (Current + Capital + Financial) equals zero.
• Equation:
  Current Account + Capital Account + Financial Account = 0
• Key Concept: A surplus in one account is offset by a deficit in another.

A.10.4] Balance of Payments Surplus/Deficit

• Surplus: When total inflows exceed outflows.
• Deficit: When total outflows exceed inflows.
• Impact: Surplus may indicate strong exports, while deficit may signal reliance on foreign capital.

A.10.5] Important Terms and Definitions

• Debit and Credit:
  • Debit: Outflow of money (e.g., imports).
  • Credit: Inflow of money (e.g., exports).
• Exchange Rate: Affects the value of a country’s currency and thus its trade balance.
• Foreign Exchange Reserves: Assets held by a country’s central bank to stabilize its currency.

A.10.6] Key Facts for Competitive Exams

• Balance of Payments is always in balance.
• Current Account is the most volatile component.
• India’s Balance of Payments has historically shown a current account deficit, offset by capital and financial account surpluses.
• Remittances are a major source of current account surplus in India.
• Foreign Direct Investment (FDI) and Portfolio Investment are key components of the Financial Account.
• India’s foreign exchange reserves are managed by the Reserve Bank of India (RBI).

A.10.7] Context and Examples

• Example 1: India’s trade deficit with the US is often offset by remittances and FDI.
• Example 2: The Current Account Deficit (CAD) is a common feature of developing economies.
• Example 3: The Financial Account is crucial for maintaining economic stability through foreign capital inflows.

A.10.8] Differences