In the past two posts in the series on international trade, we covered the benefits of international trade and the different types of international trade restrictions. In this post we will cover an impotant aspect of international trading – balance of payments, known in short as BoP.
Balance of Payments
Balance of payments (BoP) is the record of all economic transactions that take place between a country and the rest of the world over a given period. These transactions are made by individuals, firms and governments.
In the course of international trade, individuals and firms import and export goods and services. When a good is imported from a foreign country, payment for that good needs to be made in the currency of the foreign country. For this purpose the importer has to sell his own currency and purchase the foreign currency for making the payment at a currency exchange rate .
You can read all about currency exchange rates in the articles below;
Basics of currency exchange rate
Similarly, when a good is exported payment is received in the domestic currency. For this purpose, the foreign country importing the good has to purchase the domestic currency against its own currency. Again, when foreign investments are made or foreign income is repatriated currencies are bought or sold. These payments from and to a country must balance each other. When these payments do not balance there is a surplus or deficit in the balance of payment (BoP).
The balance of payment records are segregated under three types of accounts, current account, capital account and financial account. All payments are recorded in the domestic currency.
Current account is that account of the BoP that shows the net amount earned by a country if it is in surplus or spent by a country if it is in deficit. Current account is the sum of three sub accounts , balance of trade and factor income.
Balance of trade is the difference between the domestic currency earned from exporting of goods and services and the domestic currency spent for importing them. If the exports are more than the imports, the balance of trade will be in surplus. Conversely, if the imports exceed the exports then the country has net spent its domestic currency and the balance of trade is in deficit.
Factor income is the difference between the income earned on foreign investments and payments made to foreign investors. It also includes unilateral transfers such as repatriations from citizens of a country working abroad and direct foreign aid.
Capital account comprises of two sub accounts, capital transfers and sales and purchases of non financial assets. Capital transfers include the assets that migrants to a country bring along with them and take away with them when they leave. Sales and purchases of non financial assets include rights to natural resources and intangible assets like copyrights, patents, trademarks, etc.
The financial account records the net change in ownership of foreign assets, assets owned abroad by the individuals, firms and government of a country minus the foreign owned assets in the country.
The balance of payments should be balanced at the end of the period. If there is a deficit in the current account it should be made up by a surplus in the capital and financial accounts and vice versa. Therefore a deficit in the current account must be offset by a sale of assets to foreign countries. Similarly, a current account surplus should be offset by purchases of foreign assets.
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In the next post we proceed to a discussion on currency exchange rates…..if you want the post in your inbox use the SUBSCRIBE options on the page and follow me by email…bye
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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