Balance of payments (BOP) is a record of all transactions between the residents of an economy and the rest of the world over a period of time. In other words, it records all the money inflows and outflows between a country and the rest of the world. Money inflows are recorded as credit, and money outflows are recorded as debit. Of course, theoretically, we should be expecting the BOP to be zero, just like accounting, but in practice, it is rarely the case. This is how we can observe whether a country has a BOP deficit and surplus.
The BOP is divided into three main accounts: current account, capital account and financial account. Each of these accounts for a different type of international monetary transaction.
The current account records imports and exports of goods and services, income remittances and current transfers. The current account balance is the sum of goods and services balance, the primary income balance and the secondary income balance. Goods refer to raw materials and manufactured goods that are imported or exported. Services refer to receipts from tourism, transportation, business service fees etc. When both are combined, goods and services make up a country’s balance of trade (BOT). The BOT is usually the biggest bulk of a country’s BOP as it makes up the total imports and exports. If a country has a BOT deficit, it means it imports more than it exports. If it has a BOT surplus, it means it exports more than it imports.
The capital account is where all international capital transfers are recorded, such as transfer of funds by migrants, development aid funds, acquisition and disposal of non-produced, non-financial assets such as land, patents, copyrights and franchises, etc. The capital account balance is the net capital transfers where inward capital transfers minus outward capital transfers.
The financial account documents changes in international monetary flows related to business investments, real estate, holding of shares, government securities, corporate bonds, deposits, loans and official reserves etc. The financial account balance is the sum of net direct investment, net portfolio investment and net official reserves.
Direct investment refers to investment made with the objective of having a vested interest in the company and holds a certain degree of influence of the management of the company. Direct investment is usually defined as having at least 10 per cent of ordinary shares.
Portfolio investment refers to investment in paper assets such as shares (usually less than 10 per cent), government securities and corporate bonds.
In theory, the sum of the current account balance and the capital and financial account balance is always equal to zero. However, this rarely happens as exchange rates can cause the change in the value of money to lead to discrepancies. The balance of payment is said to be in equilibrium when money inflows is equivalent to money outflows. It is also said to be in surplus or deficit when money inflows exceeds money outflows or vice versa.