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Balance of Payments

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Definition

A Balance of Payment (BOP) account is asystematic record of all economic transactions(involving foreign payments) between residentsof a country and the rest of the world carried out

in specific period of time. Provides data for economic analysis

Reveals changes in the composition & magnitudeof foreign trade

Provides indications of future repercussions ofcountrys past trade performances

Reveals the weak and strong points of acountrys foreign trade relations

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Features of BOP

1. Systematic Record

2. Fixed Period of Time

3. Comprehensiveness4. Double Entry System

5. Self-balanced

6. Adjustment of Differences7. All items-Government and Non Government

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Importance of BOP

1. Guide to Economic Conditions and Direction

2. Pictogram of Economic Changes

3. Indicator of Foreign Changes

4. Indicator of Foreign Dependency5. Knowledge of Foreign Investment

6. Indicator of Foreign Trade

7. Helpful in National Planning

8. Determinant of National Economic Policy

9. Helpful for International Financial Organisations

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BOP-Surplus or Deficit

A Surplus in the BOP implies that the demand for the

countrys currency exceeded the supply and that the

government should allow the currency value to increase

in value or intervene and accumulate additional foreign

currency reserves in the Official Reserves Account

A Deficit in the BOP implies an excess supply of the

countrys currency on world markets, and the government

should then either devalue the currency or expend its

official reserves to support its value.

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Sources and Use of Funds

Sources of fund includes

Export of goods & services

Investment & Interest earning

Unilateral Transfer received from Abroad & Loans fromforeigners.

Uses of fund includes

Imports of goods & services

Dividend paid to foreign investors

Transfer payment abroad & loans to foreigners

Increase in reserve assets.

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BALANCE OF

PAYMENTS

Current

Account

Capital

Account

Official Reserve

Account

Foreign

Direct

Investment (FDI)

Unilateral transfers: Gifts, donations & subsidies

Portfolio

Investment

Goods account: Exports & Imports

Services account: Travel, transportation, Insurance etc.

Private

Short-term

Capital Flows

Decrease orincrease in

foreign

exchange

reserves

Investment Income : Interest, Dividends etc.

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CURRENT ACCOUNT All transactions relating to goods, services

and unrequited transfers constitute currentaccount

Flow of items pertaining to specific period

of time Visible items include goods

Invisible items include services

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CAPITAL ACCOUNT All transactions indicating changes in stock

magnitudes concerning capital receipts and

payments constitute capital account

Relates to

- Borrowing

- Capital repayment

- Sale of assets

- Change in stock of gold- Change in reserve of foreign currency

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DIFFERENCE BETWEEN CURRENT

ACCOUNT AND CAPITAL ACCOUNT

CURRENT ACCOUNT CAPITAL ACCOUNT

Indicates flow aspect of

countrys nationaltransactions

Relates to goods ,

services and unrequitedtransfers

Indicates changes in

stock magnitudes

Relates to all transactions

constituting debts andtransfer of ownership

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Balance of Payments DataCredits Debits

Current Account

1 Exports $1,418.64

2 Imports ($1,809.18)

3 Unilateral Transfers $10.24 ($64.39)

Balance on Current Account ($444.69)

Capital Account

4 Direct Investment $287.68 ($152.44)

5 Portfolio Investment $474.39 ($124.94)

6 Other Investments $262.64 ($303.27)

Balance on Capital Account $444.26

7 Statistical Discrepancies

Overall Balance $0.30

Official Reserve Account ($0.30)

0.73

In 2000, the U.S.imported more than itexported, thusrunning a current

account deficit of$444.69 billion.

During the same year,the U.S. attracted net

investment of $444.26billionclearly the restof the world found theU.S. to be a good place

to invest.

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Balance of Payments and the Exchange

Rate

Q

P

As U.S. citizens import, they are supply dollars to the FOREX market.

Credits Debits

Current Account

1 Exports $1,418.64

2 Imports ($1,809.18)

3 Unilateral Transfers $10.24 ($64.39)

Balance on Current Account ($444.69)

Capital Account

4 Direct Investment $287.68 ($152.44)

5 Portfolio Investment $474.39 ($124.94)

6 Other Investments $262.64 ($303.27)Balance on Capital Account $444.26

7 Statistical Discrepancies

Overall Balance $0.30

Official Reserve Account ($0.30)

0.73

Exchange rate $

S

D

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COMPONENTS

OFBALANCE OF PAYMENT

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A. CURRENT ACCOUNT

The Current Account includes all transactions whichgives rise to or use up national income.

The current account has four components:1. Merchandise: Records exports and imports

ofphysical, relocatable merchandise.

EXAMPLE: Export of kiwifruit, brings in acredit, while the import of cars

creates a debit.

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Contd

2. Invisibles or Services: Records transactionsrelating to the provision ofnon-physical items

such as transport, travel and insurance.

3. Income From investments: Records

dividends, royalties and interest payments that

a resident earn on assets held overseas, and also

payments to foreign residents on assets held in

their country.

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Contd

4. Current Transfers: Records transactions relating to theprovision of goods, services, cash or other items of valuebetween residents and non-residents that are intended tobe used for consumption in the short term and for whichthere is no payment.

Payouts on insurance claims

Aid from overseas governments/nations

Pensions received from foreign governments

Money sent from overseas relatives

Gifts from charities in other countries

Work remittances from people working overseas

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B. CAPITAL ACCOUNT & FINANCIAL

ACCOUNT

CAPITAL ACCOUNT: Records capital transfers bothshort term & long term. Capital transfers also involve the

movement of cash or other items of value, but areintended to be for investment rather than consumption.

EXAMPLE: If an American firm investsRs.100 million inIndia, this transaction will be represented as a debit in

the US balance of payments and a credit in the balance

of payments of India.

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FINANCIAL ACCOUNT

FINANCIAL ACCOUNT: Records one countrys financial

transactions with foreign countries, including short-term & long-termmovements of capital.

Three main kinds of flows in the financial accounts:

Direct Investment:Investments in the ownership or control of a business .

Officially it is an investment in at least 10% of the voting capital (or equity)of a company .

Portfolio Investment: which are purchases of company stocks and bonds,

Reserve assets: which are financial assets that can be bought and soldonly by monetary authorities (central banks) & include a countrys officialreserves of foreign exchange.

Other investment: which is a residual category that includes trade credits

& private holdings of foreign currency.

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C. OFFICIAL SETTLEMENTS ACCOUNT

OFFICIAL RESERVES: represent the holdings bythe government or official agencies of the means of

payment that are generally accepted for the

settlement of international claim.

EXAMPLES: FOREX, GOLD

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BALANCE OF PAYMENT ACCOUNTING ENTRIES

ACCOUNT CREDITS DEBITS

Merchandise A. Export of Goods B. Import of Goods

Services C. Export of Services D. Import of Services

Net Investment Income E. Income from foreign

Investments

F. Income paid to foreign

Investors

Net Transfer Income G. Transfers from Overseas

to India

H. Transfers to Overseas by

India

Capital Flows I. Increase in foreigninvestments in India/

Decrease in India

investments overseas

J. Decrease in foreigninvestments in India/

Increase in India

investments overseas

Official Reserve K. Decrease in official

holding of FX & Gold

L. Increase in official

holding of FX & Gold

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Contd

Balance of Trade = (A-B)+ (C-D)

Current Account Balance = (A-B)+ (C-D) +

(E-F)+(G-H)

Capital Account Balance = (I-J)

Official Reserve Balance =(K-L)

Current Account + Capital Account+ OfficialReserve = 0

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Balance Of Payments Adjustments

If part of the balance of payments is in deficit

or surplus for a period of time, mechanisms are

needed to restore equilibrium

Adjustment mechanisms can be:

Automatic - economic processes

Discretionary - government policies

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Automatic Adjustment Under Fixed

Exchange Rates

Key variables

Prices Interest rates

Income

Money

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Price Adjustment - Background

Under the gold standard, each nations currency was

backed by gold and had a fixed price in terms of gold

Imports and exports were paid for in gold

A nations money supply (total amount of gold andgold-backed currency) was directly tied to balance of

payments - whether gold was flowing in or out

overall

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Price Adjustment - Background(Contd)

Balance of payments surplus would expand money

supply; deficit would shrink money supply

By the classical quantity theory of money, increases

in the money supply led directly to an increase in

overall prices (and a shrinking money supply caused

overall prices to fall)

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Price adjustment of the BOP

Deficit nations

Would be losing gold, therefore shrinking their money

supply and causing prices to fall

Lower prices would make their exports more competitiveand lessen demand for imports, restoring equilibrium

Surplus nations

Would be gaining gold, increasing money supply and price

level Higher prices would cut exports and encourage imports

until the surplus was eliminated

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Problems with price adjustment theory

Gold flows are not directly linked to domestic money

supply

Nations are often not at full employment

If economy is not at capacity, less likely that priceswill rise as money supply does

Prices and wages are often not able to fall in the short

run Falling money supply will cut output and

employment rather than prices

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Interest Rate Adjustment

Inflows of gold expand the money supply, causing

short-term interest rates to fall; outflows cause rates

to rise

Investors in surplus nations would send gold abroadin search of higher rates; deficit nations would

receive gold from abroad for investment, restoring

equilibrium

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Income Adjustment

Surplus nations will experience rising nationalincome, leading to an increased demand for imports -partially offsetting the surplus

Deficit nations will experience falling income,leading to a drop in demand for imports - partiallyoffsetting the deficit

Foreign repercussions effect - one countrys deficit is

anothers surplus, so that while income is declining inone country, its exports will increase to the countrywith rising income

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Disadvantages Of Automatic

Mechanisms

Require governments not to intervene

Automatic systems seem desirable when they arebelieved to lead to full employment; when nations

face unemployment and shrinking output, automatic

mechanisms seem inadequate

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Monetary adjustment - background

BOP disequilibrium represents an imbalance between

the supply and demand for money

Demand for money is:

Directly related to income and prices Inversely related to interest rates

Supply of money has two components:

Domestic component - credit created by national

government

International component - foreign exchange reserves

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Monetary Adjustment

Payments deficits are the result of an excess

supply of money at home

Excess supply of money encourages imports,

which results in foreign exchange reserves flowingoverseas and reducing the money supply

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Monetary Adjustment

Excess demand for money leads to a payments

surplus

Excess demand is reflected in higher interest rates

and less spending on imports, encouraging a flowof foreign exchange into the country

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Monetary Adjustment - Implications

Theory focuses on domestic monetary policy as key

to balance of payments

Other policies designed to affect the balance of

payments - tariffs, quotas, devaluation of the currency- are ineffective in the long run according to the

theory

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Policy issues of balance of payment

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BALANCE OF PAYMENTS DEFICIT

An imbalance in a nation's balance of payments in which

payments made by the country exceed payments received by

the country.

Such an unequal flow of currency will reduce the supply of

money in the nation.

A balance of trade deficit is often the source of a balance of

payments deficit, but other payments can turn a balance of

trade deficit into a balance of payments surplus.

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Monetary Measures for Correcting

the BoP

1. Deflation2. Exchange Depreciation

3. Devaluation

4. Exchange Control

Expenditure Changing

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Expenditure Changingpolicy

policy makers need to achieve two goals of macroeconomic

stability, viz. internal and external balances.

Attaining internal and external balances requires two

independen policy tools.

It is a policy to balance a countrys current account by altering

the composition of expenditures on foreign and domestic

goods

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UNEMPLOYMENT DEFICIT

This issue was written at a time when the major source of

deficits was recession.

The President and Congress try to outdo one another on who

can cut the Federal budget deficit the most.

The recent reduction in the deficit is due to the decline in

unemployment.

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The Elasticity Approach

Income of the nation (Y) or receipt from the expenditure on

its final goods and services is Y =C+I+G+X

A = C+I+G+M

Y-A = X-M

Or, B = Y-A, B = current account surplus

Foreign exchange rate through

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Foreign exchange rate throughintervention

The sale of the currency on the exchange market by the fiscal

authority or the monetary authority, in order to influence the

value of the domestic currency.

There are many reasons for the authority to intervene the

foreign exchange market.

When there is an inordinate instability, exchange rate

uncertainty generates extra costs and reduces profits for firms

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BALANCE OF PAYMENTS SURPLUS

An imbalance in a nation's balance of payments in which

payments made by the country are less than payments

received by the country.

Unequal flow of currency will expand the supply of money in

the nation and subsequently cause a decrease in the

exchange rate relative to the currencies of other nations.

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Trend of BOP

CURRENT

ACC

CAPITAL

ACC

ERRORS &

OMMISION

OVERALL

BALANCE

2011 -38.2 51.6 -.01 13.4

2010 -45.9 62 -3 13.1

2009 -29.6 38.9 .3 7

2008 -28.3 35.2 .4 4.9

R F I I BOP I

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Reasons For Increase In BOP In

2011-12

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Capital Flow Increases

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CHANGES IN BOP

1990-91 2011-12

POL IMPORTS 25% OF IMPORTS 25% OF IMPORTS

PHYSICAL TRADE EAST EUROPE US, ASIA

EXTERNAL DEBTRATIO

35% 20%

FISCAL DEFICIT SPIL OVER

EXTERNAL SECTORS

SPIL OVER

EXTERNAL SECTORS

PHYSICAL TRADE HIGH TARRIF, WEAK

INFRASTRUCTURE,

INFLEXIBLE LABOUR,

& OTHER FACTORS

HIGH TARRIF, WEAK

INFRASTRUCTURE,

INFLEXIBLE LABOUR,

& OTHER FACTORS

Current BOP Trends: SWOT Analysis

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Current BOP Trends: SWOT Analysis

Strengths

Equity flows on capital account

Adequate liquidity to defend

currency

Self-adjusting market

determined exchange rate.

Weaknesses

Dependence on POL imports

Physical exports

Ability of domestic investment

to absorb large FC inflows.

Opportunities

Pre-payment of costly debt

Supplement domestic savings

to boost growth rates

Boost infrastructural

investments.

Threats

Instability in US and European

economies.

Rupee depreciation

Fiscal deficit

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Conclusion

WTO Agreements has opened the doors for removal of trade

barriers & Anti-Dumping Duties, leading to expansion of

exports.

Removal of trade barriers in Textile and Agriculture Sector

China's Accession to WTO is poised to challenge Indian

industries.

Improvement in Infrastructural Facilities like Power, Ports,

Rail-Road networks.

Technological Upgrading and Movement along with the Value

Chain.

Crude OIL Bio-fuel & mixing ethanol will reduce export bill.

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Conclusion

Trade Related Intellectual Property System (TRIPs) attempts to

harmonize the intellectual property protection regime.

India has emerged as a significant supplier of certain

knowledge intensive services such as custom software and

other IT enabled services like BPOs and KPOs .

Emerging Patterns of Comparative Advantage in Goods and

Services And the most important Self-sufficiency in military

goods production will lead to substantial reduction in BOP.

Hence we can say that Healthy BOP Scenario in an economyaugurs well for its future growth and its future prospects in

positioning itself in world setup.