Balance of payments plays an important role in finding out the reason for existence of positive or negative account balance of an organization.
In the era of multinational corporations and the dependence of countries on each other, it is considered essential that all financial executives have an understanding of at least the basics of international finance. While there is a greater number of similar things that varies between international and national finance, one must understand the differences.
How to measure the balance of payments?
There are different ways to measure the balance of payments. The balance of payments is composed of the sum of following five components:
1. Net investments in balance of payments: in balance of payments account is the difference between the total investment value in foreign countries vs Overall investment value in the United states.
2.Net Consumption in balance of payments: Net consumption in balance of payments account is the difference between the total exports of consumer goods vs total imports by a financial institution.
3. Net exchange of productive assets in balance of payment: The net exchange of productive assets in balance of payment account is the difference between the total capital goods exported vs good imported.
4. Net investment income in balance of payment: The net investment income in balance of payment account is the difference between the income from investment vs income from investment by foreigners.
5. Miscellaneous: Government transactions are miscellaneous in a balance of payment account.
All countries should have a positive balance of payments. But having balance of payments is equally important to know the reason for the existence of a positive or negative balance.
Consider the following four components and its effect on the balance of payments.
Factors affecting the balance of payments:
1. Negative balance of payments by net investment: A negative balance of payments caused by net investment may not be considered as an adverse event. Investments represent rights for the future, and the benefits must outweigh the initial payments.
2. Negative balance of payments by net consumption: A negative balance of payments caused by the net consumption is considered unfavorable from the point of view of long-term planning at the national level. Excessive consumption can weaken the value of the currency, which will make it more expensive to import extra goods.
3. Difficult to assess the effect of productive assets: It is more difficult to assess the effect of productive assets, considering net balance of payments, since the import of goods production turns out to be a type of investment and can not be considered similar to the import of goods consumption. The export of productive assets with utility may increase the ability to consume.
How do negative income affect balance of payment?
If the net income from investments is positive, the balance of payment will be positive and it will help to finance the purchase of consumer goods, buying assets, or purchase of foreign investment. If the income from investments is negative, the country will be paying for past investments or past consumption. Since consumption does not guarantee the generation of future income, borrowing or loan by a nation for the purpose of consumption is not considered as the right strategy.
Negative balance of payments: U.S Scenario
The balance of payments for the United States is an interesting problem. If the balance of payments in the US is positive and large, much of the rest of the world will experience liquidity problems (There is a saying that “if the US sneezes, the rest of the world will have a cold“). If the balance of payments of the country is negative due to excess consumption, the value of United States Dollar (USD) will weaken creating a different set of problems.
If the USA had a considerable negative balance of payments caused by the importation of consumer goods, and if the rest of the world believes that the country is experiencing a higher rate than allowed, sooner or later the country will consume all your credit and will have to reduce its own consumption or proceed to increase the amount of exports.