Week 1: Balance of Payment 1
Balance of Payments (BOP)
The Balance of Payments (BOP) is a record of all financial transactions made
between a country and the rest of the world in a given period (usually a year
or a quarter). It includes all imports and exports of goods, services,
investments, and transfers. The BOP is crucial for assessing the economic
health of a nation and the sustainability of its international economic
relations.
Balance of payment may be defined as the relationship between the sum
total of a country’s payment for imports and receipts for her export. It is a
statement that reveals the relationship between a country’s total payment to
other countries and its total receipts from them in a year.
The BOP is divided into three main components:
1. Current Account: This is made up of the total receipts and payment on
both visible and invisible goods and services. Invisible services are
insurance, banking, transportation, intrest payment, tourism, etc. while
visible goods are automobiles, cocoa and crude oil.
2. Capital/Financial Account: This account is made up of the movement or
flow of money or capital from one country to another such as investment,
international grants and loans. There are short term and long term capital
movement.
3. Monetary Movement Account: This account shows how the balance on
both current and capital account is settled. It shows how the surplus or
deficit on both accounts is settled.
Terms of Trade (ToT) and Measurement
Terms of Trade (ToT) refers to the ratio at which a country can exchange its
exports for imports. It measures the rate at which one country's goods trade
for those of another country. Essentially, it reflects the relative prices of a
country's exports and imports.
Formula:
Terms of Trade=Index of Export Prices. x 100
Index of Import Prices
Improvement in Terms of Trade: This occurs if the export prices increase
relative to the import prices, meaning the country can get more imports for
the same amount of exports. This is typically seen as beneficial for the
exporting country.
Deterioration in Terms of Trade: This happens when export prices fall
relative to import prices, meaning the country needs to export more to pay
for the same amount of imports, which can be economically
disadvantageous.
Measurement:
Index of Export Prices: Measures the price level of a country’s exports.
Index of Import Prices: Measures the price level of a country’s imports.
A favorable Terms of Trade means a country is getting more value for its
exports, and an unfavorable ToT means it is getting less value for the same
exports.
Favorable and Unfavorable Balance of Payments and Their Effects
The Balance of Payments can either show a surplus or a deficit, and each
situation has its economic implications.
Favorable Balance of Payments (BOP Surplus)
A surplus occurs when a country’s total income from exports, investments,
and financial transactions exceeds its total expenditure on imports and
payments to the rest of the world.
Effects of a BOP Surplus:
1. Currency Appreciation: A surplus often leads to increased demand for the
country’s currency as foreign buyers need the local currency to pay for
exports. This can lead to the currency appreciating, making imports cheaper
but potentially harming the competitiveness of exports.
2. Increased Foreign Reserves: A surplus allows the country to accumulate
foreign exchange reserves, providing a buffer against economic shocks.
3. Economic Growth: A surplus generally indicates a strong economy, driven
by high exports, favorable investment inflows, or both.
4. Inflationary Pressures: If a surplus leads to excessive demand, it can
create inflationary pressures, especially if the economy is near full capacity.
Unfavorable Balance of Payments (BOP Deficit)
A deficit occurs when a country spends more on imports, investments, and
financial obligations than it earns through exports and foreign inflows.
Essentially, the country needs to borrow or draw on its reserves to finance
the gap.
Effects of a BOP Deficit:
1. Currency Depreciation: A deficit generally leads to a decrease in demand
for the country’s currency, causing it to depreciate. This can make imports
more expensive and increase inflation.
2. External Debt: To finance the deficit, a country might need to borrow from
foreign creditors, increasing its debt burden.
3. Pressure on Foreign Reserves: A persistent deficit may deplete a country’s
foreign exchange reserves if the country uses them to balance the
payments.
4. Lower Economic Growth: A deficit could reflect weak export performance
or excessive imports, which might be a sign of structural economic issues.
Balance of Payments Concepts: Surplus and Deficit
Surplus in the Balance of Payments means that a country is earning more
from foreign transactions than it is spending. This is a positive economic
indicator and suggests that the country is net-exporting capital and
goods/services.
Balance of Payment Surplus: A country is able to sell more than it buys
from the rest of the world. The country may see a buildup of foreign
exchange reserves and lower external debt. It also strengthens the local
currency.
Deficit in the Balance of Payments means that a country is spending
more on imports and foreign transactions than it is earning. This can lead to
borrowing from foreign sources or using foreign exchange reserves to cover
the difference.
Balance of Payment Deficit: A country is importing more than it exports,
which could lead to a loss of foreign exchange reserves or an increase in
external debt. A prolonged deficit can lead to a currency crisis if the market
loses confidence in the country’s ability to meet its obligations.
Key Points Summary:
Terms of Trade (ToT): Reflects the relative price of exports to imports.
Improvement in ToT is favorable; deterioration is unfavorable.
Balance of Payments:
BOP Surplus: More exports or financial inflows than outflows. Positive effects
include currency appreciation, economic growth, and more foreign reserves.
BOP Deficit: More imports or financial outflows than inflows. Negative effects
include currency depreciation, increased external debt, and depletion of
foreign reserves.
BOP Surplus vs. Deficit:
Surplus indicates a healthy economy with good export performance.
Deficit may signal economic weaknesses, requiring borrowing or reducing
reserves.
In conclusion, the balance of payments is a crucial indicator of a
country's economic standing. A surplus is generally favorable, while
a deficit needs careful management to avoid financial instability.
The Terms of Trade further help in evaluating how favorable or
unfavorable a country's external economic environment is in
relation to its trade.
