Definition of Balance of Payments
Balance of payments may be defined as the relationship between the sum total of a country’s payment for her imports and receipts for her exports. It is thus a statement of income and expenditure on international account, for a period of time, usually one year. It can also be referred to as a statement or record showing the relationship between a country’s total payments to other countries and its total receipts from them in a year.
Components of Balance of Payments
A country’s balance of payments can be divided into three major components, namely, current account, capital account and monetary movement account.
- Current account: This is made up of the total receipts and payments on both visible and invisible goods and services. Invisible services are insurance, banking, transportation, interest payment, tourism etc. while visible goods are automobiles, cocoa, crude oil etc.
- Capital account: This account is made up of the movement or flow of money or capital from one country to another such as investments, international grants and loans. These are short and long term capital movements. A country’s balance of payments is favourable when money received is more than the amount she pays out and vice versa.
- Monetary movement account: This account shows how the balance on both current and capital accounts is settled. It shows how the surplus or deficit on both accounts is settled.
Role of Money in International Transactions
Money plays an important role in international transactions. Both internal and external trades are similar because both are transacted with the use of money. However, they still differ in many ways. In internal trade, buyers and sellers use the same currency and so no currency problems arise. In foreign trade, however, this is not the case. Countries have different currencies and thus; it becomes necessary to change one for another for trade to take place.
Money also acts as a unit of measurement in which records of transactions are kept. Just as individuals and firms keep records of their sales and purchases in order to know whether or not they are making profit, countries also keep records of the money they spend on imports and the money they earn from exports in order to know whether international trade has been profitable or not in the period. This kind of record-keeping, which is done by countries in units of money, is precisely what balance of payments is all about.
Money is also useful in international transaction when it involves foreign exchange market. All exchanges that take place between the residents of one country and another, require the use of money. Foreign exchange market came into existence as a result of the need to resolve the differences between one country’s currency and that of another.
Money also facilitates economic development. By means of foreign exchange, foreign capital and skills are being imported, thereby assisting the development process of the underdeveloped.
Balance of Payment Disequilibrium
Balance of payment disequilibrium may be defined as a situation which occurs when the total receipts of a country on the combined current and capital accounts are not equal to the payments. In other words, a balance of payment disequilibrium occurs when total receipts are not equal to total payments of a country.
It should be noted that balance of payment equilibrium can exist. There is equilibrium balance of payment if the total receipts from other countries equals total payments to other countries.
Types of Balance of Payment Disequilibrium
a) Balance of payment surplus: There is balance of payments surplus when the total receipts from all other countries exceed the total payments to other countries during a given trading period. This situation gives rise to what is referred to as favourable balance of payments. The reporting country in this case is financially strong in its international trade transactions.
Effects of a balance of payments surplus
- Increase in economic activities: There will be an increase in economic activities, since surplus enables the citizens of a country to have more funds at their disposal.
- Greater net income: A balance of payment surplus means a greater inflow of earnings from abroad. This will lead to a higher level of net income at home through the operation of the multiplier effect.
- Inflationary tendency: Balance of payments surplus must be well managed by the government so that it will not result into inflation.
- Debt retirement: Balance of payments surplus situation can help a country to retire (payoff) previously accumulated debt.
b) Balance of payments deficit: Balance of payments deficit may be defined as a situation which occurs when the combined receipts on the current and long term capital accounts of a country are less than the corresponding payments. In other words, balance of payments deficit occurs when a country’s expenditure flows are more than the country’s income flows.
Types of balance of payments deficit
- Temporary balance of payment deficit: This type of deficit also called short term deficit is the type which can easily be corrected or adjusted within a short time. They do not pose serious problems. They can be financed or paid for by the use of reserves or international borrowing.
- Fundamental or chronic balance of payments deficit: This is also called long term deficit and this cannot be corrected or adjusted within a short time and this usually has an adverse effect on the country’s reserves.
Causes of balance of payments deficit
The causes of balance of payments in Nigeria for example include:
- Low level of agricultural production: This makes Nigeria dependant on food imports and imported inputs for our agro-allied industries.
- Low level of technological development: Low level of technological development makes the country a greater importer of advanced technology.
- Inadequacies in export promotion strate gies: Export promotion strategies to encourage more earnings for the country are grossly inadequate.
- Political instability: Political instability discourages export drive but encourages massive importation of goods and services.
- Excessive government expenditure: This attitude encourages the government to engage in massive importation of all kinds of goods into the country.
- Servicing of huge external debts: This can go a long way to deplete the external reserves and use all earnings to settle external debts.
- Existence of import dependent industries: These industries reduce the country’s earnings as they demand for the scarce foreign exchange to enable them procure machines and raw materials from abroad.
- Poor social and economic infrastructure: Poor social and economic infrastructure contribute greatly to low capacity utilization in the industrial sector e.g. bad roads, irregular supply of electricity, water, poor telecommunications, etc.
Balance of Payments Adjustments
Balance of payments adjustment refers to the various ways by which balance of payments disequilibrium (especially balance of payments deficit) can be reduced or corrected. Balance of payments deficit can either be financed or reduced (corrected).
Ways by which balance of payments deficit can be financed
Some of the means by which balance of payments deficit of a country can be financed include:
- Running down external reserves and SDRs.
- Drawing (or borrowing) from International Monetary Fund (I.M.F.)
- Short term credit from various sources (borrowing).
- Purchase of goods and services (export promotion).
- Sale of foreign investments.
- Increased export of goods and services (export promotion).
- Grants and aids from friendly countries.
Measures to reduce or correct balance of payments deficit
Balance of payments deficit of a country can be reduced or corrected by the following measures:
- Foreign exchange control: Foreign exchange control involves the rationing of foreign exchange in order to reduce balance of payment deficit.
- Expenditure reduction: This is used in order to cut down domestic demand and reduce imports.
- Expenditure switching: This involves the manipulation of exchange rates to induce people to patronise locally made goods.
- Fiscal control: This involves the raising of tariffs (i.e. increase in import duties) in order to reduce balance of payment deficit.
- Raising interest rates: The raising of interest rates is to reduce bank lending.
- Devaluation: Devaluation cheapens exports and makes imports expensive, thus improving the balance of payments.
- Reduction of imports: The governments can restrict imports by the use of tariffs, quotas and outright embargo on imports.
- Grants and aids: This can be obtained from richer or friendly nations to offset the deficit that occurs in the balance of payments.
- Borrowing: A country can borrow money from IMF or other richer nations in order to correct her balance of payment.
- Promotion of import substitution industries: This is done to replace the commodities that were previously brought from foreign countries.
- Selling investments abroad: Selling of the country’s investment abroad and using it to pay the creditors can also serve as a solution.
- Drawings on foreign reserves: Drawings on the value of the country’s foreign reserves to pay the creditors.
- Increase in experts: The encouragement of experts can be promoted through subsidies and concession.
- Increase in production: With a spectacular rise in production, domestic prices of goods would be brought down and export of goods stimulated. Demand for imported goods will reduce.