Balance of Payment (BOP), Current Account & Capital Account Explained


Balance of payments (BOP)

The Balance of payments (BOP) is the accounting record of all economic transactions between residents of the country and the rest of the world in a particular time period. These transactions are made by individuals, firms and the Government.

Hence, the BOP is the record of a country’s exports, imports, Foreign direct investments (FDI), remittances etc.

The two main components of Balance of payments are current account and capital account.

Current Account

The current account records all transactions related to exports, imports and unilateral transfers. Therefore, the current account includes:

  1. Export and Import of goods: Export involves receipt of payment and is a positive entry (credit). Import is a negative entry (debit). Net export of goods is also known as the balance of trade.
  2. Export and Import of services.
  3. Unilateral transfers or ‘one-way’ transfers like gifts, donations, remittances. Receipt of unilateral transfers from rest of the world is shown on the credit side (positive entry) and unilateral transfers to rest of the world on the debit side.
  4. Investment income: Investment income is in the form of interest, dividend rent and profits. Income received is shown on the positive side and paid on the negative side.
Capital Account

Capital account records all transactions which cause a change in the assets or liabilities of the residents/ Government. It includes

  1. Foreign direct investment (FDI): FDI inwards is a positive entry and FDI outwards is a negative entry.
  2. Foreign institutional investment (FII)
  3. Borrowings and lendings to and from abroad
  4. Change in foreign exchange (FOREX) reserves: Increase in FOREX is a negative entry and decrease is a positive entry.

The Balance of payment must always be in balance. The deficit in the current account is financed by a surplus in the capital account.

To illustrate- if the current account is in deficit (or the import is more than export), the excess import bill of the country is paid either by borrowing from other countries or selling its assets (FDI/ FII).

If in case, a country is unable to borrow money or attract capital inflows in the form of FDI/ FII, it has to use its foreign exchange reserves.

Therefore, BOP deficit (excluding FOREX reserves) is reflected in the decline in FOREX reserves and BOP surplus in the increase in FOREX reserves.

The BOP position of a country is an important indicator of its economic well-being.

In 1991, India had a BOP crisis. We had huge current account deficit and capital inflows were not adequate to finance the deficit. Even FOREX reserves were not sufficient to pay for the imports.

India had to mortgage gold to Bank of England and the central bank of Japan to get FOREX to pay for imports.

 

Other posts that you may like:

GDP Explained

Inflation Explained

Fiscal Deficit Explained

Changes in Methodology of Calculating GDP: India

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