A nation’s BOP is a summary statement of all economic transactions between the residents of a country and the rest of the world during a given period of time.
A BOP account is divided into current account and capital account. Former is made up of trade in goods (i.e., visibles) and trade in services (i.e., invisibles) and unrequited transfers.
The latter account is made up of transaction in financial assets. These two accounts comprise BOP.
A BOP account is prepared according to the principle of double-entry book-keeping. This accounting procedure gives rise to two entries—a debit and a corresponding credit. Any transaction giving rise to a receipt from the rest of the world is a credit item in the BOP account. Any transaction giving rise to a payment to the rest of the world is a debit item.
The left hand side of the BOP account shows the receipts of the country. Such receipts of external purchasing power arise from the commodity export, from the sale of invisible services, from the receipts of gift and grants from foreign governments, international lending institutions and foreign individuals, from the borrowing of money from foreigners or from repayment of loans by foreigners.
The right hand side shows the payments made by the country on different items to foreigners. It shows how the total of external purchasing power is used for acquiring imports of foreign goods and services as well as purchase of foreign assets. This is the accounting procedure.
However, no country publishes BOP accounts in this format. Rather, by convention, the BOP figures are published in a single column with positive (credit) and negative (debit) signs. Since payments side of the account enumerates all the uses which are made up of the total foreign purchasing power acquired by this country in a given period, and since the receipts of the accounts enumerate all the sources from which foreign purchasing power is acquired by the same country in the same period, the two sides must balance. The entries in the account should, therefore, add up to zero.
In reality, why should they add up to zero? In practice, this is difficult to achieve where receipts equal payments. In reality, total receipts may diverge from total payments because of: (i) the difficulty of collecting accurate trade information; (ii) the difference in the timing between the two sides of the balance; (iii) a change in the exchange rates.
Because of such measurement problems, resource is made to ‘balancing item’ that intends to eliminate errors in measurement. The purpose of incorporating this item in the BOP account is to adjust the difference between the sums of the credit and the sums of the debit items in the BOP accounts so that they add up to zero by construction. Hence the proposition: ‘the BOP always balances’. It is a truism. It only suggests that the two sides of the accounts must always show the same total. It implies only an equality. In this book-keeping sense, BOP always balances.
Thus, by construction, BOP accounts do not matter. In fact, this is not so. The accounts have both economic and political implications. Mathematically, receipts equal payments but it need not balance in economic sense. This means that there cannot be disequilibrium in the BOP accounts. A combined deficit in the current and capital accounts is the most unwanted macroeconomic goal of an economy.
Again, a deficit in the current account is also undesirable. All these suggest that BOP is out of equilibrium. But can we know whether the BOP is in equilibrium or not? Tests are usually three in number: (i) movements in foreign exchange reserves including gold, (ii) increase in borrowing from abroad, and (iii) movements in foreign exchange rates of the country’s currency in question.
Firstly, if foreign exchange reserves decline, a country’s BOP is considered to be in disequilibrium or in deficit. If foreign exchange reserves are allowed to deplete rapidly it may shatter the confidence of people over domestic currency. This may, ultimately, lead to a run on the bank.
Secondly, to cover the deficit a country may borrow from abroad. Thus, such borrowing occurs when imports exceed exports. This involves payment of interest on borrowed funds at a high rate of interest.
Finally, the foreign exchange rate of a country’s currency may tumble when it suffers from BOP disequilibrium. A fall in exchange rate of a currency is a sign of BOP disequilibrium.
Thus, the above (mechanical) equality between receipts and payments should not be interpreted to mean that a country never suffers from the BOP problem and the international economic transactions of a country are always in equilibrium.