Balance of Payments: Meaning, Components, Importance and Factors affecting BoP

The factors which affect the Balance of Payments (BoP) are divided into two groups:  

• The factors affecting the Current Account 

• • Rate of Inflation in the Resident (domestic) Country: 
    • A higher rate of inflation in the domestic economy, compared to its trading partners, lead to: 
      • cheaper imports which lead to increase in purchase of foreign goods. Imports therefore, tend to rise with rise in the inflation rate
      • rise in the cost of the exports in the foreign market, as a result of which the foreign nationals will less likely be purchasing the domestic country’s goods. Exports, therefore, tend to decline. 
    • Thus, rise in imports and fall in exports will lead to a current account deficit. 
  • National Income: According to most of the empirical studies, an increase in national income of a country, in comparison with its trading partners, may lead to: 
    • higher tendency among domestic residents to purchase more of foreign products which will generate a significant rise in imports and thus, more outflow of foreign reserves from the country leading to current account deficit;
    • In some exceptional cases, a rise in national income may also lead to improvement in the current account as it may be associated with increase in production capacity in the economy and surplus generation of exports. 
  • Import Restrictions by Government: Imposition of taxes (such as tariffs) by the government on the goods imported, leads to a rise in its prices in the domestic economy. As a result, domestic residents will reduce their purchase of foreign products, thereby improving the current account. Sometimes, the government also imposes quota restrictions on its imports which again, lead to decline in the imports and generates a current account surplus. 
  • Exchange Rate: The Exchange rates measure the prices of the domestic currencies in terms of the foreign currencies. The Current account is a function of Real Exchange Rate (RER). A higher RER is associated with lowering of exports and increase in imports whereas a lower RER is associated with higher number of exports and decline in imports. Thus, it can be interpreted that lowering of RER (which might happen through devaluation of currency) might lead to improvement of the current account. 
• The factors affecting the Capital Account 
  • Capital movement across borders are affected by the following factors: 
    • Imposition of tax by the government on the income accumulated by the domestic investors, who have invested in the foreign markets. This will lead to lower outflow of capital.
      • Taxing income earned by domestic investors from foreign assets reduces the net returns from overseas investment. This discourages residents from shifting capital abroad and helps check capital outflows, especially during periods of external sector stress. 
      • Suppose an Indian investor invests money in the US stock market, foreign bonds or overseas funds. From this investment, the investor may earn:
        • dividend income, interest income, capital gains or other returns
      • • Now, if the Indian government imposes or increases tax on such foreign investment income, the investor’s net return falls.
    • Economic liberalization might have an impact on the capital account. 
      • When an economy is liberalised, the government usually relaxes restrictions on foreign investment, borrowing and capital movement. This can lead to higher capital inflows. 
      • For example:
        • FDI liberalisation allows foreign companies to invest more easily in India.
        • FPI liberalisation allows foreign investors to invest in Indian shares and bonds.
    • An expected change in the exchange rates may affect the flow of capital as it tends to have an impact on the expected rate of return in the foreign investment.