International trade has become an important part of many entity’s business activities. Globalization across countries has provided a boost to international trade. International trade comprises of two components – import and export. Import is the purchase of goods or services from a foreign country and export is the sale of goods or services to a foreign country. As there is an exchange of goods or services, international trade also involves an exchange of currency between the two trading countries or nations. All countries maintain detailed records of their international trades.
This article looks at meaning of and differences between two important means of recording and analyzing international trade – balance of trade and balance of payments.
Definitions and meanings
Balance of trade:
The balance of trade of a country is the difference in the value of exports of a country and the value of its imports for a specific period, generally a fiscal year. It can be calculated only for goods or for both goods and services.
Countries strive to achieve a balance in their balance of trade numbers. When the value of a country’s exports exceeds the value of its imports i.e., its balance of trade is positive, it is said to have a ‘trade surplus’. On the other hand, when the balance of trade is negative, the country is said to have a ‘trade deficit’.
When a country has an excess of imports, it is required to purchase more foreign currency to pay for the imports which results in devaluation of its own currency. Excess imports also negatively impact a country’s gross domestic product. Growing imports can however also indicate a growing consumer demand and economy, especially when imports constitute production machinery. A country that has trade surplus indicates a growing, strong economy that is operating at good levels to ensure high value of exports.
Accordingly, growth in both exports and imports is important for an economy, making it necessary to achieve balance in the balance of trade position. Balance of trade thus is an indicator of the relative financial position of a country as compared to the global economy.
Balance of payments:
Balance of payments is a comprehensive record of monetary transactions that a country has undertaken with all other countries of the world. It essentially logs all inflow and outflow of foreign exchange.
Balance of payments is bifurcated into 3 major categories:
- Current account: This category maps all transactions related to payments and receipts on inflow and outflow of goods and services. These include various imports and exports of goods and services, transfer of funds on personal account etc.
- Capital account: This category maps capital transactions such as payments and receipts related to movement of fixed assets, loans and other borrowings etc.
- Financial account: This category maps investment related transactions. For example, when an entity in one country invests in a business enterprise in another country, the related flow of funds is mapped in the financial account of balance of payments.
Theoretically, the net result of balance of payments (BOP) should be zero as the balance of current account should be covered by flow of finance through capital account (or financial account). Just like a double entry book keeping system wherein the balance of receipts and payments match. Practically speaking however this rarely happens owing to foreign exchange differences and other errors and omissions.
Differences between balance of trade and balance of payments:
The key points of difference between balance of trade and balance of payments have been detailed below:
- Balance of trade represents the difference between the value of the country’s imports and exports in a given time period.
- Balance of payments is a detailed account (total) of all monetary transactions entered into between one country and other countries in the world.
- Balance of trade comprises only of exports and imports of goods and serves
- Balance of payments comprise of several more type of transactions including import and export of all types of goods and services, foreign inward and outward investments, receipt and payment of monetary aid from other countries etc.
3. Comparison of
- Balance of trade is essentially a comparison of imports and exports.
- Balance of payments is essentially a comparison of receipt and payment of foreign exchange.
- The scope of balance of trade is narrower. In fact, it is a component of balance of payments.
- The scope of balance of payments is wider as it includes all transactions which goes beyond only imports and exports that are covered by balance of trade.
5. Purpose of calculating
- The primary purpose of calculating balance of trade is to determine the trade surplus or trade deficit of a country.
- The primary purpose of calculating balance of payments is to have a detailed account of all international monetary transactions.
6. Ideal quantum
- In the case of balance of trade, typically a positive figure or a trade surplus is desired. But this can change depending on the country’s financial position and phase of economic cycle of growth that it is in.
- In the case of balance of payments, theoretically the value should net off to zero. However, this may not be the case owing to factors such as foreign exchange fluctuations and other errors.
7. Indicator of country’s comparative financial position
- Balance of trade gives a more limited view of the country’s economic status as it is limited to imports and exports.
- Balance of payments gives a more comprehensive and holistic view of the country’s economic status as it covers all international transactions.
Conclusion – balance of trade vs balance of payments
Complete recording of balance of trade and balance of payments is essential for all countries. It is on the basis of these statements that the government takes several policy measures relating to its international trade. It can introduce export incentives to boost a surplus situation and implement import restrictions or increase import duties to control a trade deficit situation. Other economic policies directed towards boosting foreign investments can also be taken by studying these statements.