Balance of Trade and Balance of Payments: Concepts and Components

Balance of Trade:

The balance of trade is the difference between the value of a country's imports and exports for a given period. The balance of trade is the largest component of a country's balance of payments. Economists use the BOT to measure the relative strength of a country's economy. The balance of trade is also referred to as the trade balance or the international trade balance.
The balance of trade is the difference between the monetary value of a nation's exports and imports over a certain time period. Sometimes a distinction is made between a balance of trade for goods versus one for services. The balance of trade measures a flow of exports and imports over a given period of time. If a country exports a greater value than it imports, it has a trade surplus or positive trade balance, and conversely, if a country imports a greater value than it exports, it has a trade deficit or negative trade balance. As of 2016, about 60 out of 200 countries have a trade surplus.

Balance of Payment:

Balance of payments (BOP) of a country is a systematic summary statement of a country’s international economic transactions during a given period of time, usually a year. In other words, the balance of payments (BoP) is the international balance sheet of a nation that records all international transactions in goods, services, and assets over a year. The BoP is that of a simple accounting tool, similar to balance sheets of companies that report transactions such as goods bought and sold, or assets borrowed and acquired.
In general, the Balance of Payments (BOP) of a country is “a systematic record of all economic transactions between the residents of the reporting country and the residents of the rest of the world for a given period of time usually a year.” Thus, it comprises all types of transactions of a country like – exports and imports of goods and services, purchase and sale of foreign assets, foreign direct investment and portfolio investment as well as borrowing from and lending to the rest of the world.

Balance of Payments Accounting: 

The BOP accounts of a country are constructed on the basis of an accounting procedure known as double-entry book-keeping. Double-entry bookkeeping means that each international transaction is recorded twice, once as a credit entry and once as a debit entry of equal amount. The reason for this is that in general, every transaction has two sides - they are credit and debit.  
When a payment is received from a foreign country, it is a credit transaction or credit entry, while payment to a foreign country is a debit transaction or debit entry. In a country’s BOP, credit transactions or entries are entered with a positive sign (+), and debit transactions or entries are entered with a negative sign (-). 
In general, the credit transactions would include - exports of goods and services, unilateral receipts such as gifts, grants, etc .from foreigners, borrowings from abroad, investments by foreigners in the country,(capital inflows), and official sale of reserve assets including gold to foreign countries and international agencies. While, the debit transactions would include - import of goods and services, unilateral payments such as gifts, grants, etc. to foreigners, lending to foreign countries, investments by residents in foreign countries, (capital outflows), an official purchase of reserve assets or gold from foreign countries and international agencies. 
These credit and debit transactions are shown vertically in the balance of payments account of a country. Horizontally they are divided into three categories: - the current account, the capital account, and the official settlements account or the official reserves account.

Key Components/Structure of the Balance of Payments:

1. Current Account: 

The current account of a country’s balance of payments consists of all transactions related to trade in goods, services, income, and unilateral transfers. The current account includes the following items: -

a) Merchandise Exports & Imports: Merchandise exports and imports are the most important items in the current account. In general, it covers a significant portion of total transactions recorded in the BOP of a country. Generally, exports are calculated on a free on board (f.o.b.) basis which means that the costs of transportation, insurance, etc. are excluded. Generally, imports are calculated on a carriage, insurance, and freight (c.i.f.) basis which means that costs of transportation, insurance, and freight are included. 

b) Invisible-Exports & Imports: Invisible exports & imports also known as service exports & imports are another important component of the current account. Important invisible items would include – travel, insurance, transportation, investment income in the form of profits, dividends, etc., and Government not included elsewhere.

c) Unilateral Transfers: Unilateral transfers or transfer payments are the third important component of the current account. Unilateral transfers include gifts, grants, etc. either received from abroad (credits) or given abroad (debits). They are one-sided transactions, without a quid pro quo that has a measurable value. The unilateral transfers could be official or private. 

2. Capital Account: 

The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lending and borrowing and private and official investments. In other words, the capital account shows the international flow of loans and investments and represents a change in the country’s foreign assets and liabilities. The capital account mainly consists of –

a) Borrowing from & Lending to Foreign Countries: Borrowing from foreign countries are credit entries because they are receipts from foreign countries. Lending to foreign countries is debit entries because they are payments to foreign countries. This borrowing or lending could be of the short term i.e. up to one year or long term i.e. more than one year. Borrowing from & lending to foreign countries could be also called the net sale of assets to foreigners and net purchases of assets from foreigners. 

b) Direct Investment & Portfolio Investment: Direct investment is an investment in enterprises located in one country but effectively controlled by residents of another country. As a rule, direct investment takes the form of investment in branches and subsidiaries by parent companies located in another country. Portfolio investment refers to purchases of foreign securities that do not carry any claim on control or ownership of foreign enterprises. In brief, borrowing from foreign countries and direct & portfolio investment by foreign countries represent capital inflows. On the other hand, lending to foreign countries and direct & portfolio investment in foreign countries represent capital outflows. 

3. Other Components: 

Apart from the above two main accounts, the BOP of a country also includes some other entries like – 

(a) Transactions with IMF, 

(b) SDR allocations, 

(c) Errors & Omissions, and 

(d) Official settlements / Reserve account. 

Table: Broad Components/Structure of Balance of Payments

Sl. No.	Particulars	Credits (+)	Debits (-)
1	Current Account
		(A) Exports	(A) Imports
		(a) Goods (b) Services	(a) Goods (b) Services
		(B) Unilateral Transfer receipts from abroad (Gifts, Grants, etc. received)	(B) Unilateral Transfer receipts from abroad (Gifts, Grants, etc. given)
2	Capital Account
		(A) Borrowing from Foreign Countries/ Net sale of assets to foreigners. (B) Direct & Portfolio Investment by Foreign Countries	(A) Lending from Foreign Countries/ Net sale of assets to foreigners. (B) Direct & Portfolio Investment in Foreign Countries
3	Error & Omissions
4	Overall Balance of payments
5	Official Settlement/Reserves Account