If you want to know about the transactions your country makes with the rest of the world or foreign exchange or international trade, you must know what Balance of Trade (BoT) and Balance of Payment (BoP) mean. Often both these terms are used interchangeably. But, both are very different from each other. To understand what both these terms mean, we need to know the differences between Balance of Trade vs Balance of Payment.
Balance of Trade
Balance of Trade (BoT) is the balance of a country’s export minus imports. Exports imply anything that is manufactured or sourced locally but is sold in a foreign land. This could be anything from clothes to heavy equipment and so on. On the other hand, import here means all the goods the country buys from foreign countries. A point to note is that BoT includes only visible goods and not services.
We can calculate the balance of trade using a simple formula. The formula to calculate the balance of trade is Exports of the country – Imports of the country.
Interpretation of the balance of trade is not as simple as it seems and often leads to misconception. The common understanding is that the positive trade balance is always good for the economy, and the negative is always bad. However, a positive or negative trade balance does not always mean if an economy is in good shape or not. Although the balance of trade offers some insight into the condition of the economy, it should always be read in combination with other economic factors.
Whether BoT is positive or negative for the country depends on various other factors. These factors are trade policies, political scenarios, global factors, and more. A positive balance of trade or trade surplus occurs when the export value is more than the import value. On the other hand, when the import is higher, and the export is less, then it results in a trade deficit.
Balance of Payment
Balance of Payment (BoP) includes all the transactions that entities (people, companies, and government) in a country make with the rest of the world within a definite period of time. BoP includes all imports and exports, along with transfer payments, such as remittances, aid from other countries, and more.
BoP could be for a quarter, six months, or a year. The primary objective of preparing a BoP is to keep a close eye on the flow of money and develop policies accordingly to make the economy stronger. Apart from the government, a company or an individual can also prepare a BoP for themselves.
In an ideal scenario, the balance of payment should be zero. This means the amount of money entering the economy and going out are equal. However, such things don’t happen in the real world, and the balance of payment for a country is negative or positive, or we can say in surplus or deficit of funds.
Balance of Payment has three main components/accounts – Current Account, Capital Account, and Financial Account. The current account has two parts – Visible Trade and Invisible trade.
The Balance of Payments formula is written as:
Current account + Capital Account + Financial Account+ Balancing Items = 0
Now that you know what these terms mean let’s see the differences between Balance of Trade vs Balance of Payment.
Balance of Trade vs Balance of Payment – Differences
Following are the differences between Balance of Trade vs Balance of Payment:
BoT measures the export and import that a country does with the rest of the world. On the other hand, BoP includes all the financial transactions that a country does with other countries.
How to Calculate?
To calculate BoT, we need to subtract exports from imports. We need to add BoT, foreign investment, cash transfer from abroad, capital account, and any balancing item to calculate BoP. Another way to calculate BoP is to add the Current Capital account and adjust for errors and omissions.
BoT has a smaller scope as it only deals with exports and imports of goods. BoP has a much wider scope. In fact, BoT is a part of BoP.
What does it Tell?
BoT helps a country know whether it is standing at net profit or loss in terms of exports and imports. On the other hand, BoP ensures that all the transactions have been recorded or not.
A country should have a positive BoT, which means exports more than imports. An ideal BoP scenario is a zero balance.
When is it Favorable?
BoT is favorable when exports are more than imports. BoP is favorable when there is a surplus in a current account, and that is then used to pay loans in the Capital account.
BoT is the difference between the export and import of goods. On the other hand, BoP is the difference between the foreign exchange that a country receives and the total foreign exchange it pays.
Entries in the BoT are related to the exports and imports of goods. Transactions in BoP could be for goods, services, transfers, remittances, foreign aid, and more.
BoT comes in the Current account of the Balance of Payment. BoP includes both the Current account and Capital account.
Inclusion of Capital Transfer
Balance of trade does not include capital transfers. Balance of payment, on the other hand, includes Capital transfers.
Balance of trade does not affect the exchange rate much. On the other hand, the balance of payment has a major impact on the exchange rate.
Which is Better?
Since BoT includes only exports and imports, it gives an incomplete view of a country’s economic standing. BoP gives a better view of the country’s economic standing as it includes all transactions that a country makes with the rest of the world.
Both balances of trade and balance of payment may appear simple from the outside, but their computation and calculation are very complex. Nevertheless, if you know can conceptualize both, it will become somewhat easier for you to extract relevant information, as well as understand the foreign exchange policies of the country.