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Balance of Trade and Balance of Payment!

Balance Of Trade (BOT)

The balance of trade of a nation is a systematic financial record usually of a year, of its imports and exports of visible commodities from and to the rest of the World. For many years until now, the value of Bangladesh’s imports
of commodities from other countries exceeded the value of its exports, showing consistent deficit in balance of trade.

 

Balance Of Payments (BOP)

The balance of payments, on the other hand, is a systematic financial statement of a nation’s total international transactions, visible and invisible, generally covering a one-year period. One basic-purpose of the balance payments accounts is to summarize how the nation’s goods and services trade is financed. It also serves as an indicator of changes in a nation’s financial position in an accounting year. It indicates net inflow and outflow of the nation’s international earnings and payments. Accounts are maintained on the principle of entry book-keeping system.

 

Entries:

There are two types of entries in the balance of payments accounts: Credits & debits. A credit entry records an international transaction that gives rise to receipt by the hoe country from the foreigner (e. g., for exports of
goods). A debit entry is the record of payment to the foreigner by the home country (e.g., for import of goods).

Another way of distinguishing debit & credit transactions is the increase or decrease of the home country’s assets and liabilities.

 

Credit: A decrease in assets (inventories of goods, stock, bond, gold, bank account held by the home country overseas).

 

Credit: An increase in liability (claims owed to foreigners such as an Englishman’s bank Balance in XYZ Bank.

Debit: An increase in asset or a decrease in liability in the above sense.
Balance of payments entries are usually grouped under six headings. Each major Account summarizes a particular class of international transaction and the transactions entered it can sometimes be explained by an appropriate body
of international economic theory.

The six customary account headings are:

I. Trade of goods & services Account
II. Unilateral Transfer A/C
III. Long-term Capital Account
IV. Short term Capital A/C
V. Unrecorded Transaction or Errors & Omissions A/C
VI. International Liquidity A/C

 

The first account (I) summarizes all goods & services transactions.

I. Trade of Goods & Services A/C

A. Goods (Visible)
1. Merchandise export -Credit
2. Merchandise imports- Debit

 

B. Services(Invisible)

1. Transfer Costs (transportation, banking, insurance services)
a. Receipts from foreigners Credit
b. Payments to foreigners Debit

 

2. Tourism, travel services, tourist purchase of goods
a. Receipt from visitors Credit
b. Spending abroad by citizens Debit

 

3. Interest, Dividend, Royalties (Capital Services)

4. Military Spending International trade theory is supposed to explain why nations buy goods and services from each other (cost & price advantage). The invisibles are not well explained by trade theory. There can be reasonable explanations. Tourists visit places that have appealing history, climates, scenic spots and sea beaches or people, but also pay attention to rice. Inflows of dividend, profits and royalty depends upon the nation’s economic power, size and technical superiority over others. Military spending depends on how world politics and military games are being played at the moment and in whose backyard.

 

Balance of Trade = When balance of visible trade (Foreign Trade Account) shows a net credit, it is said to be favorable. A net debit, on the other hand, indicates an unfavorable BOT.

II. Unilateral/ Unrequited Transfers (one-sided/ Unreturned)
A. 1. Received by home Govt.
2. Paid to foreign Govt.

B. Person to Person (Private)
I + II = BOP on Current Account (A/C)
a. Receipt from foreign countries Credit
b. Payments to foreigners Debit
a. Paid to home country by foreigners Credit
b. Expenditure by home country abroad Debit
a. Foreign eco. Assistance Credit
b. Military assistance Credit
a. Foreign eco. Assistance Debit
b. Military assistance Debit
a. Received from foreign countries (Emigrant/ Wage Earners’ Remittance) Credit
b. Sent to foreign country (remittances) Debit

III. Long-term Capital Account

This sums up the nation’s inward and outward flows of longer maturity private and Govt. capital funds (Direct or Portfolio investment)

Direct: Buying Plants abroad
Portfolio: Buying foreign stocks or bonds with no control

Long-term Capital
A. Private Direct Investment
B. Private Portfolio Investment
C. Govt. Loans

 

The usual explanation of long-term capital investment is:
a) Profit rate difference
b) Varying technological levels of nations
c) Exploration of market and raw materials

Also look at the return for capital services in the Services A/C which has close connection with the Long-term

Capital A/C.
I + II + III = Basic Balance
IV. Short term Capital A/C

Unlike other accounts mentioned, the short-term capital entries are net changes for the year and not totals. It includes bank deposits and other short-term payments and credit arrangements. Short-term capital items fall due on
demand or within one year, while long-term capital obligations have maturities from one year to infinity. The vast majority of the short-term transactions represent bank transfers that finance trade and long term capital movement.
Short Term Capital Interest rate differentials, political unrest, risk, fear of devaluation etc. explain Short-Term Capital movements.

a. By foreigners in the home country Credit
b. By home country nationals in foreign country Debit
a. By foreigners in the home country Credit
b. By home country nationals in foreign country Debit
a. To home govt. by foreign Govt. Credit
b. To foreign govt. by home Govt Debit
a. Decease in home held foreign bank balances Credit
b. Increase in home held foreign bank balances Debit
c Decrease in foreign held bank balance in home country Debit
d Increase in foreign held bank balance in home country Credit
V. Unrecorded Transaction or Errors & Omissions A/C

It attempts to estimate the items that have been omitted in the other accounts as well as to compensate for errors. It is difficult to record all international transactions and in many cases, say tourism, only crude estimates can be made.

Since it is impossible to know the actual quantity of errors, what is done is simply add all recorded credits and debits and then take the difference which then offset by a single debit or credit entry in this account.

 

Items that might contribute to the total of unrecorded transactions are:
(a) Statistical or recording error
(b) Smuggling
(c) Clandestine capital movement
(d) Poor estimation procedure (travel)

 

VI. International Liquidity:
A. Gold Stock (Gold is a commodity and should be treated as export or import of a good.)
B. Govt. Dollar or Pound Holdings
C. IMF Account Holding

 

This sixth (VI) account summarizes all transactions internationally acceptable means of setting international obligations. If a nation buys goods and services, it must pay for these in any of the three ways:

1. Exporting goods & services.
2. Borrowing Long-Term or Short-Term capital
3. Transferring some acceptable means of payment e.g., (Gold/hard currency) to the foreigner.

 

The creditor country may not want the debtor country’s goods and may not be willing to grant credit for purchases, but it will accept (i) Gold (2) IMF deposits or (3) Any hard currency.

Thus if obligations cannot be met by exports, unilateral transfer and short-term or Long-term capital movements, a nation must dip into items in its international liquid account to satisfy its trade obligations.

 

In other words, the sixth account summarizes the net changes in the nation’s international financial position. The balance of payments is defined as the net credit or debit balance resulting from summing up the credits and debits
appearing in account-I through

V. This imbalance would equal but have a sign opposite to the net credit or debit position of account VI.

 

Not credit for I-V is called BOP surplus which means the account VI has a debit and that gold & other liquidity holding of the nation has increased. A net debit in I-V is called BOP deficit and this means that account VI has a
credit, and that nation’s gold and other liquidity holdings have decreased.

a. Increase (inflow to home Nation Debit
b. Decrease (Outflow to foreign nation) Credit
a. Increase Debit
b. Decrease Credit
a. Increase Debit
b. Decrease Credit

 

Difference between Balance of Trade and Balance of Payment
Following is the list which is showing difference between balance of trade and balance of payment. It has been made on some basis.

 

Basis of Difference Balance of Trade (BOT) Balance of Payment (BOP)

1. Definition Balance of trade may be defined as difference between export and
import of goods and services.

Balance of payment is flow of cash between domestic country and all
other foreign countries. It includes not only import and export of goods
and services but also includes financial capital transfer.

 

2. Formula BOT = Net Earning on
Export – Net payment for imports
BOP = BOT + (Net Earning
on foreign investment – payment
made to foreign investors) + Cash
Transfer + Capital Account + or –
Balancing Item
or
BOP = Current Account + Capital
Account + or – Balancing item
(Errors and omissions)

 

3. Favourable or Unfavourable If export is more than import, at that
time, BOT will be favourable. If import is more than export, at that
time, BOT will be unfavourable.

Balance of Payment will be favourable, if you have surplus in current account for paying your all past loans in your capital account.

Balance of payment will be unfavourable, if you have current account deficit and you took more loan from foreigners. After this, you have to pay high interest on extra loan and this will make your BOP unfavourable.

 

4. Solution of Unfavourable Problem
To Buy goods and services from domestic country. To stop taking of loan from foreign countries.

 

5. Factors Following are main factors which affect BOT
a) cost of production
b) availability of raw materials
c) Exchange rate
d) Prices of goods manufactured at home

Following are main factors which affect BOP
a) Conditions of foreign lenders.
b) Economic policy of Govt.
c) all the factors of BOT
6. Meaning of Debit and Credit If you see BB Overall balance of
payment report, it shows debit and credit of current account.

 

Credit means total export of different goods and services and
debit means total import of goods and services in current account.

Credit means to receipt and earning both current and capital account and
debit means total outflow of cash both current and capital account and
difference between debit and credit will be net balance of payment.
Convertibility of Taka Bangladesh Bank declared Taka convertible on 24th March 1994 for current Account transactions in terms of Article
viii of the IMF article of agreement. The declaration symbolized a turning point in the country’s exchange management and exchange rate systems.
Simultaneously Bangladesh Bank worked towards systematically liberalizing the exchange restrictions. These measures coincided with the overall macro-economic reforms undertaken by the Government concerning trade
liberalization, export orientation and deregulations. These measures were aimed at creating an environment conducive to growth in Investment and productivity and pave the way for entry into global village (Globalization).
Convertible means the ability of the residents to convert Local Currency into foreign currencies at the ruling exchange rates for paying their external obligations. In other words, Convertibility means free floating of the Taka
with least intervention from the Govt. and the central bank in the fixation of exchange rate and making foreign exchange freely available for all transactions.

Convertibility of the Taka implies a process of strengthening the Taka to the status of an International Liquidity to create more confidence in the domestic and par value of Taka for its easy acceptability both in national and
international economic transactions. The ideas of freeing the Taka had been prompted by the continuous stability in Macro-economic management, especially the maintenance of monetary stability and reduction of budgetary deficits through effective fiscal measures.

 

A currency is said to be convertible when it may be fully exchanged for another currency. Convertibility of currency is not meant for domestic transactions propose. It is also required for international transactions.

 

In Bangladesh, our currency is convertible in current Account transactions. We know that economic transactions of a country with the rest of the world are recorded in Balance of payment (BOP). A country’s BOP is a summary
statement of all its economic transactions with other countries of the world during a particular period of time.

 

The main components of BOP are:
A) CURRENT ACCOUNT
B) CAPITAL ACCOUNT
C) OFFICIAL RESERVE ACCOUNT

 

CURRENT ACCOUNT: The account that includes trade in goods (visible exports & imports) services and unilateral transfers.

 

CAPITAL ACCOUNT: The account shows the change in the nation’s assets abroad and foreign assets in the nation. It includes direct investments, the purchase and sale of foreign securities and nation’s bank and non-bank
claims on and liabilities to foreigners.

 

OFFICIAL RESERVE ACCOUNT: The account shows the change in a nation’s official reserve assets and change in the foreign official assets in the nation. (It is not related with convertibility of currencies).

 

The basic requirements of convertibility are: –
a. An appropriate exchange rate
b. An adequate level of international liquidity
c. Sound macro-economic policies
d. Incentives for domestic economic agents to respond to market prices.
Nonetheless, several factors have contributed us to join in convertibility and foremost among them is gradual adjustment of external value of Taka to a realistic level. Moreover, substantial growth of exports earnings and
expatriates remittances encouraged Bangladesh to go for convertibility. Convertibility creates an environment conducive to foreign investment. For rapid development of the economy, we should go for more liberalization of
trade and exchange restrictions.

Floating Exchange Rate

A country’s exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Thus, floating exchange rates change freely and are
determined by trading in the forex market.

In some instances, if a currency value moves in any one direction at a rapid and sustained rate, central banks intervene by buying and selling its own currency reserves in the foreign-exchange market in order to stabilize the
local currency. However, central banks are reluctant to intervene, unless absolutely necessary, in a floating regime.

 

The way through which a country manages its currency in relation to other currencies and the foreign exchange market is known as an Exchange Rate

 

System. Basically there are three types of exchange rate systems:

1) Floating Exchange Rate Systems or Flexible exchange rate system.
2) Fixed Exchange Rate System or Pegged Exchange Rate System.
3) Managed Floating Exchange Rate System.

 

In a Floating Exchange Rate System, the market determines the value of the currency by its movement, i.e., many banks and financial institutions interacts for various purposes like transactions, clearing and settlement. In a Fixed
Exchange Rate System a Central Bank always stands ready to exchange the local currency or a foreign currency at a predetermined or preannounced rate i.e; an explicit rate.

 

Advantages of Floating Exchange Rate:

No need for international management of exchange rates: Unlike fixed exchange rates based on a metallic standard, floating exchange rates don’t require an international manager such as the International Monetary Fund to
look over current account imbalances. Under the floating system, if a country has large current account deficits, its currency depreciates.

 

No need for frequent central bank intervention: Central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect the gold parity, but such is not the case under the floating regime. Here there’s no parity to uphold.

No need for elaborate capital flow restrictions: It is difficult to keep the parity intact in a fixed exchange rate regime while portfolio flows are moving in and out of the country. In a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets, which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency.

Greater insulation from other countries’ economic problems: Under a fixed exchange rate regime, countries export their macroeconomic problems to other countries.

Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for European goods, which then increases the Euro-zone’s price level. Under a floating exchange rate system, however, countries are more
insulated from other countries’ macroeconomic problems. A rising U.S. inflation instead depreciates the dollar, curbing the U.S. demand for European goods.

Disadvantages of Floating Exchange Rate:

Higher volatility: Floating exchange rates are highly volatile. Additionally, macroeconomic fundamentals can’t explain especially short-run volatility in floating exchange rates.

Use of scarce resources to predict exchange rates: Higher volatility in exchange rates increases the exchange rate risk that financial market participants face. Therefore, they allocate substantial resources to predict the changes in
the exchange rate, in an effort to manage their exposure to exchange rate risk.
Tendency to worsen existing problems: Floating exchange rates may make worse existing problems in the economy. If the country is already experiencing economic problems such as higher inflation or unemployment, floating exchange rates may make the situation worse.

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