What is the Balance of Payment? Explain the factors affecting the BOP.

Balance of payment (BOP) of a country is a systematic record of all economic transactions between the residents of the reporting country and the residents of foreign countries during a given period of time. In other words, balance of payments is a statement of inflow and outflow payments for a particular country.

The main components of balance of payments (BOP) are:

• Current account and
• Capital account.

Hence, the factors affecting the balance of payments can be grouped into two:

• Factors affecting current account
• Factors affecting capital account

Factors affecting Current Account.

Inflation Rate in the Domestic Economy:

If a country is facing higher inflation relative to its trading partner, the imports become cheaper and residents of the country will like to purchase more foreign goods. If a country is facing higher inflation relative to its trading partner, the exports become costly and loose competitiveness and foreign nationals will net like to purchase country’s goods. As a result, imports will increase while exports will decline. In this way, the current account balance is adversely affected.

National Income of the Economy:

Impact of increase in national income is not straight forward. There are two opinions on this. Most of the empirical studies suggest that if country’s national income rises by a higher percentage than those of other countries, it may result into deterioration of current account balance because with the increase in income, residents may start buying foreign products and imports would increase. But in some cases the current account balance may improve because the production in the economy has also increased and export surplus is generated.

Government Restrictions on Imports:

If government imposes taxes (tariffs) on imported goods, the prices of imported goods will rise and imported goods will become dearer to domestic goods. As a result, imports will decline and current account balance will improve. Apart from tariff, a government may put quota restrictions on the imported goods. Quota restrictions are quantity restrictions commonly used by developed countries. If government fixes quota restrictions, on imports, current account balance will improve due to limited imports.

Exchange Rate:

Exchange rate is the price of a country’s currency in terms of currencies of other countries. Exchange rate may be manipulated by the government. Since current account is a function of real exchange rate (RER), it may be manipulated to adjust current account balance. With higher real exchange rate, we expect fewer exports and more imports, while low real exchange rate would result in greater exports and lower imports. It implies that by lowering real exchange rate, current account balance-will improve. Real exchange rate may be lowered by devaluation of currency.

Factors affecting Capital Account.

The government imposes controls on the flow of trade. In the similar fashion, a government may impose controls on the free movement of capital. Apart from these controls, there are other economic factors which also affect the movement of capital and, therefore, the capital account balance. Following factors influence capital account:

The government may impose a tax on income accrued to the local investors who invested in foreign markets. It discourages outflow of capital.

Liberalization of economies affect the capital accounts.

The anticipated change in exchange rate affects capital flows because it tends to change the expectation about the rate of return on foreign investment.

Changes in interest rate also affect the international capital flows. An increase in interest rates relative to other countries may affect capital inflows from abroad. Similarly, a reduction in domestic rates may induce people to invest abroad.