Balance of Payments: Definition, Types, and Functions in Trading

What is the meaning of balance of payments and its components and functions in international trade, here is the full explanation from the Actively Share blog!

For a country that adheres to an open economic system like Indonesia, of course, there are many transactions made with other countries. To find out the details of these transactions, a record called the balance of payments is needed.

Economic relations or transactions between these countries, for example, such as exports, imports, investment or it can be in the form of loans.

All these transactions must be recorded in order to benefit each country.

Definition of Balance of Payments

Because we are discussing economic relations between countries, we will clarify the meaning of the international balance of payments.

In simple terms, the definition of balance of payments is a systematic record of economic transactions between residents of one country and another.

Where the recording is valid for a certain period of time, usually for a year.

In the accounting system, the recording is better known as double entry book keeping or transactions that can be recorded twice for debits and credits.

Debit is a place for recording debts of residents of a country (government, individuals and legal entities) that must be paid to residents of other countries.

The debt in question can be in the form of imports, purchases of foreign currency, payment of fines, and so on.

While credit is to record the addition of the rights of residents of one country from residents of other countries.

The rights in question are proceeds from exports, sales of foreign currency, dividends and interest yields, and many others.

If the note on the credit side is greater than the debit, it means that the balance of payments is in surplus.

However, if the opposite happens, it means that the balance of payments is in a state of deficit.

Often people interpret surplus is a better condition. In fact, the surplus in the long term if it is not intended for the welfare of the people equally, of course there is no meaning.

While a deficit is not always a bad thing. You just have to dig deeper into which components are experiencing a deficit.

If the deficit occurs in the current account component, for example. You can still close by attracting foreign investors or seeking foreign loans.

In this way, a balanced balance of payments can be realized.

Short-term deficits will not have a significant effect.

However, if this happens in the long term, it could lead to an economic crisis that endangers the welfare of a country.

Balance of Payments Function

The functions of making systematic records of economic transactions from one country to another are to:

  1. To be taken into consideration by the government in determining the steps of economic transactions with other countries. Where the transaction can be in the form of investment or investment, export, import or foreign loan
  2. As a material for consideration of monetary policy and fiscal policy made by the government. The policy is intended for the economic welfare of the country.
  3. Helping the government to see the influence of economic relations between countries with the amount of national income of the country. That way it will be easier to decide whether the economic relationship is worth continuing or not
  4. It is used as a material for consideration or reference for policies related to international trade politics made by the government. With the aim that economic relations between these countries can be profitable and become one of the sources of the country’s economic resilience.

Components in the Balance of Payments

Components in the Balance of Payments
Components in the Balance of Payments

To create an international balance of payments, you must understand what components are in it.

The following is an explanation of some of the components in it.

1. Current Account

Current transactions are further divided into:

  • Income on investment
  • unilateral transfer
  • The trade balance which contains export and import transactions

2. Capital Transaction

This component contains the activity or transaction of buying and selling assets. It can also contain sales records of non-financial assets, such as income from rental and marketing.

3. Financial Transactions

In this component, you can record everything related to investment.

Both direct investment, portfolio, financial derivatives and so on.

The working mechanism is that if the current transaction results in a positive value, then the capital transaction including financial transactions must have a negative value or it could be in the opposite position.

That way, when added up as a whole, the result is zero or reaches a balance of payments balance.

However, if the results show a deficit position, it means that the country needs an injection of funds to cover its deficit.

Types of Balance of Payments

The following are the types of balance of payments:

Current account

  • The trade balance records export and import transactions between two or more countries. There are three possibilities that occur in the trade balance, namely surplus, deficit, or balance.
  • Service balance, records service transactions from or to other countries. Transactions that are included in this balance are all exports and imports of services such as labor, remittances, transportation costs, insurance costs, and tourism.
  • One-sided transaction balance (unilateral transaction) , records unilateral transactions in the form of gifts or social assistance received or given from/to overseas without an obligation to pay back.

As for further explanation of the three possibilities that occur in the trade balance are:

  • The balance of payments deficit shows the number of payment transactions from abroad (debits) whose value is greater than transactions received from abroad (credit).
  • Balance of payments surplus,   showing smaller debit transactions.
  • Balance of payments balance , showing debit transactions equal to credit transactions.

Capital account

The capital account records receipts or payments related to borrowing and investment (capital exports and imports) that occur between two or more countries for short-term or long-term investments.

For example, short-term investments such as buying bonds to make a profit.

While that includes long-term investment is to buy shares.

In addition, this type of balance also records the sale and purchase of securities, foreign investment, foreign aid, and payment of foreign debt.

Monetary balance

The monetary balance records mutations in relation to the IMF and shows the development/change of a country’s foreign exchange reserves, which can be in the form of gold or other foreign currencies.

Purpose of Making a Balance of Payments

The balance of payments is definitely not without a purpose. In addition to being a record of proof of a country’s transactions with other countries, it is also for the following purposes.

1. Identifying Resources

By making systematic records, it will be easier to find out how many resources a country produces as well as other countries.

From there it will be easier to identify which countries have more roles as exporters and importers.

2. Identifying the Role of the External Sector for the Country’s Economy

From the number of requests for domestic products by local residents or non-residents, it can provide an illustration of the role of the external sector for the economy.

The more demand for domestic products by non-residents, it can also be seen from that the role of the external sector to encourage the development of domestic products.

3. Finding Transaction Patterns and Economic Structure

With a systematic record of all transactions, it will be possible to find the pattern of transactions used by a country. From there it will also be found that the country’s economy depends a lot on any sector.

Is it from trade between countries such as exports and imports? It can also be from financial transactions such as investments or foreign loans.

4. Identifying Economic Problems in a Country

The next goal is to find economic problems or economic stability. This can be seen from how the country is in fulfilling its debt obligations.

5. Information on Foreign Exchange Reserves

With the results of a surplus or deficit, from there it will be known how much foreign exchange reserves are owned. This can also be used as a reference in anticipating economic problems.

6. As a reference in the preparation of the foreign exchange budget

Through the results of monitoring the surplus as well as the deficit on the balance sheet, it will be known how much foreign exchange is needed in the following year.

With this data, it also makes it easier to determine the amount of loan needed.

7. As Reference Data for Calculation of National Income

To calculate the amount of national income, it is very necessary to have a balance of payments. This is because national income is part of the income from exports or imports in the balance sheet.

From the explanation above regarding the meaning, components, objectives and functions, there are several conclusions. That the balance of payments is a tool for the government to consider every policy it makes.

Both related to international trade or the economic resilience of their own country. Solely to maintain the welfare of the people and avoid an economic crisis.

By having such systematic records, it will be easier to monitor a country’s economic condition, whether it is in a state of surplus or deficit.

From there it will also be seen what policies or actions are needed to overcome or take advantage of them.

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