In balance of payments accounting, the balance of payments should be zero because every transaction is two-sided with debits balancing credits. However, in practice, the balance of payments will rarely be equal to zero. This is due to, among other things, a country’s central bank (RBI in India’s case) doing transactions that are not part of the balance of payment, or even lack of statistical data to record all transactions.
Balance of payments is classified as:
- Balance of payment on current account.
- Balance of payment on capital account.
Balance of Payment on Current Account:
The balance of payment on current account records the current position of the country in the transfer of goods, services, and merchandise as well as invisible items, donations, unilateral transfers, etc. A current account is like an income and expenditure account. Surplus or deficit in current account is transferred to the capital account, which is like a balance sheet and thus balances itself in the overall picture.
Balance of Payment on Capital Account:
Balance of payments on capital account shows the country’s financial position in the global context. It covers accumulated foreign exchange reserves, foreign assets and liabilities and the bearing of current transactions on international financial positions. The changes in foreign exchange reserves effected by current account transactions are part of the capital account. This helps in finding out the exact foreign exchange reserve of the country on a given date. The capital account offers relief to deteriorating balance of payment positions. Its favorable effect is directly related, to the availability of net capital transfers, i.e. gross inflow of capital nanus payment by way of amortization.
Capital account thus reflects changes in foreign assets and liabilities of a country and directly shows its creditor/ debtor position. Net changes in current account are reflected by a relevant opposite change in the capital accounts altering the foreign assets and liabilities position of the country.