Balance of Payments (BoP)IF & TradeBatch 2010

syllabusBalance of PaymentsInternational Monetary SystemAn overview of International Financial MarketsExchange Rate Determination and Forecasting

BOP

BOPhttp://rbidocs.rbi.org.in/rdocs/Content/docs/FSBPS3031_Full.xls

National Income AccountingGDP: National Spending = National IncomeY = C + I + G + X MY = GDP; C = Consumption; I = Physical Investment; G = Government Spending; X = Exports; M = ImportsC + I + G = Domestic Absorption (spending on domestic output)(X M) = Trade Balance = Net ExportsTrade Balance = Natl Income less Domestic AbsorptionX M = Y (C + I + G)Trade Balance = Net Domestic SavingY = C + Saving + Taxes = C + I + G + X MX M = (S I) + (T G) Trade Imbalances must be met with International Borrowing or Lending, i.e., trade deficit borrow from rest of world.Note No Causation Implied!

BOPThe balance of payments of a country is a systematic accounting record of all economic transactions during a given period of time between residents of the country and residents of foreign countriesFlow

Balance of PaymentsThe BOP is a statistical record of the flow of all of the payments between the residents of a country and the rest of the world in a given year.

Transactions are recorded on the basis of double entry bookkeeping by definition it has to balance.Every source must have a use.

The two main components are: Current Account Capital/Financial Account

Accounting Principles in BOPUses of FXDEBITSources of FXCREDITCapital OutflowCapital Inflow

Accounting PrinciplesAny transaction resulting in a payment to foreigners is entered in the BOP accounts as a debit and is given a negative sign. Any transaction resulting in a receipt from foreigners is entered as a credit and given a positive sign. Current Account records transactions involving exports and imports of goods and servicesCapital Account records transactions involving the purchase and sale of assets. Double-Entry book keeping: Every international transaction automatically enters twice, once as a credit and once as a debit.

Examples of TransactionsCredit Transactions (+ve): Provision of goods and services to non-residents Income receivable from non-residents A decrease in foreign financial assets An increase in foreign financial liabilities Debit Transactions (-ve): Purchase of goods & services from non-residents Income payable to non-residents An increase in foreign financial assets A decrease in foreign financial liabilities

Balance of PaymentsRecord of Payments to & Receipts from Foreign EntitiesDouble-entry bookkeeping system.Every transaction has two entries a credit (+) and a debit (-)!Payment = Debit (-)Receipt = Credit (+)Multiple AccountsCurrent Account (CA) and Capital Account (KA)Is a summary (net) record of flows, not stocks

BOPCurrent accountInvisiblesServices

Transfers

incomeMerchandiseCapital accountTravelTransportationInsuranceGovt not eslewhere specifiedmiscellaneousOfficialPrivate1. Investment income2. Compensation to Employees

BOPCurrent AccountCapital AccountForeign InvestmentsLoans (a+b-c)Banking capitalRupee Debt ServiceOther CapitalIn India: Direct; Portfolio +AbroadExternal Assistance ( by India, to India)Commercial Borrowing (MT+LT)Short termCommercial Banks (assets, liabilities, NRI deposits)others

Balance of Payments

Current Account (CA)This is record of a countrys trade in goods and services in the current period.

CA = Exports (X) Imports (M)

It is divided into 4 sub-categories:Goods tradeServices tradeIncomeCurrent transfers

The sum of the four sub-categories = CA balance

Capital Account (KA)This includes all short- and long-term transactions pertaining to financial assets.KA = Capital Inflow (cr) Capital outflow (dr)The two main components:Capital account. Financial account (direct, portfolio, other).

KA balance = Sum of capital account and financial account.

Official ReservesRecords the purchase or sale of official reserve assets by the central bank. These assets includeCommercial paper, Treasury bills and bondsForeign currencyMoney deposited with the IMFThis account shows the change in foreign exchange reserves held by the central bank.Since the BOP must balanceCA + KA + RFX = 0CA + KA = RFXThe Balance of Payments IdentityFor floating rate regime countries, such as the U.S., official reserves are relatively unimportant.

Statistical Discrepancy (E&O)The identity CA + KA = RFX assumes that all transactions are measured accurately.

Inaccurate recording of transactions (errors & omissions), results in the above equality not holding. For BOP to balance,CA + KA + E&O = RFXAssuming changes in official reserves, errors are approximately zero: Current Account = () Capital Account This will hold approximately for floating rate countries

Country A exported 500 worth goods to country BCountry A Exporter gets his bank account credited with a bank in B country

Invoice in B currency and paid in B currencyThe balance in Exporter A country is an asset for Country A and a liability for B CountryNormal a/cAnchor the a/c entry on claims

BOP country ACu.A/cCrDtMerchandise Ex500Cap. a/cUp in claims on a Foreign Bank500

Exchanged 300 worth Leather goods for crude oil

BOP country ACu.A/cCrDtMerchandise Ex300Merchandise Imports300Cap. a/c

A bank in country A purchases B country Govt securities and pays by drawing its correspondent bank a/c in B country

BOP country ACu.A/cCrDt

Cap. a/cUp in Foreign Bank holdings200Fall in Foreign Bank deposits200

A country gifts medical supplies, blankets..worth 150

BOP country ACu.A/cCrDtMerchandise Ex150Unrequited transfers150Cap. a/c

country A resident makes a gift of 50 in As currency to a charitable organisation in B

BOP country ACu.A/cCrDtUnrequited transfers50

Cap. a/cIncrease in Foreign Liabilities50

Example TransactionsRecord transactions in the following accountsCA: A = merchandise; B = services; C = invest. income; D = Unilateral TransfersKA: E = Change in U.S. claims on foreign assets; F = Change in foreign claims on U.S. assetsU.S. firm sells $1m wheat to Romania, paid for out of Romanian-owned deposit account in U.S.A (+), F(-): merchandise export is credit decrease in foreign-owned dollar deposits = K-out = decreased foreign claims on U.S.U.S. tourist spends DM10,000 deposit in German bank while traveling in GermanyB(-), E(+)tourist spending abroad is service import ~ a debitdecrease in U.S. claims on foreigners ~ K-in

Example Transactions, cont.U.S. citizen receives DM10k interest payment from German bonds, deposits in German bankC (+), E(-)U.S. citizen converts DM to US$ at German BankE (+), F(-)debit = K-out = decrease foreign claims on U.S. (they gave up $)credit = K-in = decrease in U.S. claims on foreigners (we gave up DM)U.S. Bank loans US$ to German BankF(+), E(-)debit = K-out = increase in U.S. claims on foreigner (future debt payments)credit = K-in = increase in foreign claims on U.S. (acquire $)German resident sells U.S Government Bond to French residentdoes not show on U.S. Balance of Payments! U.S. charity donates medicine to NicaraguaA (+), D(-): merchan. export, paid for by gift (unilateral transfer)

Valuation and TimingMarket Prices willingness of partiesF.O.B. Vs. C.I.F former is preferred Indias exports are valued @ fob; imports are cifTranslation Timing : exports are recorded when cleared by customs, imports when payment is made - conventions

Balance in BOPimbalance refers to disequilibriumAutonomous transactions arising from normal businessAccommodating transactions undertaken with the motive of settling the imbalances funding deficits arising out of autonomous transactions

Balance in BOPTrade balanceBalance in Goods & servicesCurrent account BalanceBalance on CA and LT capital

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.BOP in Total

Country faces current account deficitPolicy shift by Govt to increase short term interest rates to attract short term capital inflow to prevent depreciation of currencyTighten credit & money supply and make it difficult for domestic banks and firms to borrow the home currency to invest abroad; force exporters realise export earnings quickly & bring it home

INTERLINKAGES IN FINANCIAL MARKETS Cap Money Market Bullion Market inflation interest rate currency exchange rate Commodity derivatives

Balance in BOPCorporate Finance Managers monitor the data on a regular basis to understand how pressures in international market will impact their firm in short term or long term

Interpretation of Deficit and SurplusThis is a difficult issue. Ever wonder why economics is called a dismal science? An account deficit theoretically means that foreign goods are more competitive and that perhaps national industries arent making competitive products, which could then signal recession, depression, or closure of economies or business firms . A surplus, could theoretically mean there is excess demand, that could trigger inflation and eventual economic slowdown.

Interpretation: Does it matter?Another group of people believe the interpretations of deficit and surplus are only good for politicians. They believe that with globalization, the older interpretations of deficit and surplus are becoming meaningless.

A nations balance of payments interacts with nearly all of its key macroeconomic variables.Interacts means that the BOP affects and is affected by such key macroeconomic factors as:Gross Domestic Product (GDP)Exchange rateInterest ratesInflation ratesBOP & Macroeconomic Variables

A countrys BOP can have a significant impact on the level of its exchange rate and vice versa.The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes the BOP (see next slide).BOP & Exchange Rates

(X M) + (CI CO) + (FI FO) + FXB = BOP

Where:X = exports of goods and servicesM = imports of goods and servicesCI = capital inflowsCO = capital outflowsFI = financial inflowsFO = financial outflowsFXB = official monetary reservesBOP & Exchange Rates

Fixed Exchange Rate CountriesUnder a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero.Floating Exchange Rate CountriesUnder a floating exchange rate system, surpluses/deficits influence exchange rate.BOP & Exchange Rates

A countrys import and export of goods and services is affected by changes in exchange rates.The transmission mechanism is in principle quite simple: changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand.Theoretically, this is straightforward, in reality global business is more complex.Trade Balances & Exchange Rates

Trade Balances & Exchange Rates

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*Activity: Find out who is a resident, NRI, Foreign national as per FEMA *********http://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=874