Balance of Payments and Balance of Trade. Meaning, Components and Differences

Today, as a result of globalization almost every country are opened their economy to the rest of the world. Especially after the Second World War, there arose many international organizations which supported the mutual assistance between all countries. An opened economy is a four sector model economy, in which the external sector or foreign sector is considered as an important one with other three sectors like households, firms, and government. Today, no country can able to survive without keeping a better relationship with others. Anyway all these globalization changes ensured the role of foreign sector for a country. So, it is common that, there will be inflow and outflow of products, income, labor force etc. from one country to another. To record these transactions and to analyze the external relations, every country is preparing both balance of payments account and balance of trade accounts. Here this hub is aimed to explain both of them and also to analyze its meaning and components.

Balance of payments is the systematic record of all international transactions of a country. So, it highlights the international relations of a country. According to B.J Cohen, “Balance of payments shows the country’s position, change in its net position as foreign trader or borrower, and changes in its official reserve holding”.

In the account of balance of payments, all the payments to the foreign countries are considered as debits and all the receipts from foreign countries are considered as credits. There are three components for a balance of payments account. They are,

i) Current Account

ii) Capital Account and

iii) Official Reserve assets account.

Each of them is briefly explained below.

i) Current Account

Current account shows mainly imports and exports. That is, if visible goods or commodities are traded, it will record in the balance of payments account. This is also known as “balance of trade”. When we take the invisible imports and exports, it will show the main contents of the balance of payments account. Invisible items includes services, software etc. In short, if visible export exceeds visible imports, it will be a gain for the country in the balance of trade. Similarly if both visible and invisible exports and imports are added, the excess exports over excess imports show a better picture of the economy.

Transfer payments are also taken in to consideration while balance of payments account is being prepared. That is transfer payments to foreign sector will be debited and receipts of transfer payments will be credited. Similarly all the imports of goods and services are debited and all the exports of goods and services are credited.

ii) Capital Account

Capital account consists of two major items. That is

a) Lending and borrowings between countries and

b) Investment flow among countries.

In the capital account, lending of loans and advances are considered as debit item. Because when loans are given the money will flow to outside the country. On the opposite side, borrowings considered as a credit item. This is because, when a country takes loan from another country, more money will be injected to the domestic economy.

If foreigners invest in the country, it will record as a credit item since it is the flow in to the economy. On the other side, investment in the foreign economy made by domestic investors is considered as an out flow. So, it will be debited.

iii) Official Reserve Assets Account

Items in official reserves asset account will highlights a clear cut position of any economy and also which shows the strength of an economy. Major items in this account are the reserve of gold and foreign currencies etc. So, an increase in the reserves will be credited while decreasing of reserves will be debited.

The final value of the balance of payments account is estimated after clearing the errors and omissions. So, the reliability of balance of payments account can be ensured.

As mentioned above Balance of Trade is the systematic record of exports and imports of visible items of a country. That is balance of trade shows only the net imports and exports of goods or commodities. When the export exceeds over net imports, the country’s foreign relations will be better. At the same time excess imports over exports shows a weak strength of an economy. Following table shows major differences between Balance of Payments and Balance of Trade.

Balance of Payments and Balance of Trade are two important records of any opened economy. It shows the foreign interactions or transactions of a country. Today, since economic matters are highly influencing to measure a country’s status, both Balance of Payments account and Balance of Trade account are very vital. Above all Balance of Payment shows the openness or how much the economy is liberalized. Normally developed countries are performing better in the figures of these accounts, which mean the surplus balance or surplus trade.