Why balance of payments matters?

Let us begin our discussion with the meaning of balance of payments. Balance of payments refers to the comprehensive and systematic records of all the economic transactions between the residents of a country and the rest of the world within a specific period of time.

The balance of payments may be positive or negative. A country earns foreign currency in case of a positive balance of payments while a negative balance of payments depletes foreign currency reserve. Also, countries with a high outflow of foreign currency must put up with a negative balance of payments.

In simple words, a positive balance of payments results when the inflows of foreign currency are more than the outflow of foreign currency. Likewise, a negative balance of payments results when the inflows of foreign currency are less than the outflow of foreign currency.

Balance of payments matters a lot in a globalized world. Countries trade with a multitude of other countries. Moreover, huge unilateral flows such as remittances and other governmental transfers take place between countries. The trade flows and other unilateral flows come under the current account. Also, capital flows such as FDI are also major financial flows that come under the capital account.

Balance of payments, though considered a major external sector indicator, has a crucial implication in the financial sector too. The monetary base of a country relies on net foreign assets. While the net foreign assets is actually the balance of payments position of a country.

The monetary base or high-powered money can be decomposed as:

$H = NFA + NDA$

Here, H = High-powered money; NFA = Net foreign assets; NDA = Net domestic assets

NFA is the balance of payments position of a country. As NFA expands, the monetary base of high-powered money also expands and vice-versa. When the balance of payments is negative, the monetary base also decreases thereby reducing currency in circulation and broad money supply. For example, when the balance of payments plunged to negative Rs. 255 billion in 2020/21 in Nepal, both the currency in circulation and the broad money supply plummeted. The abated money supply was due to a contraction in reserve money, but was widely misinterpreted as "theft of currency" and "money laundering".

Balance of payments matters as the monetary base of a country heavily relies on it. Also, the balance of payments is one of the indicators of the health of an economy and also provides a glimpse of the economic whatabouts of a country.