a report on balance of payment

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A REPOTR ON “BALANCE OF PAYMENT”October 1, 2009

This is to certify that Priyank Shrivastava, student of M.B.E (Master of Business Economic) at Institute for excellence in higher education, Bhopal has successfully completed his project on the topic “A REPORT ON BALANCE OF PAYMENT” under our supervision for the paper titled “International Economics”

This project report embodies the original work done by the candidate on the data collection during the field work on actual survey basis, by the means of questionnaire, a copy of which is attached at the end of this project.

Mrs. Kalpana Malik

(Economic Department)

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This project bears the imprints of many a person, who has tooled all the pains and efforts to help me out, in some or the other way. First of all I would like to thanks Dr. PRAMILA MAINI (Director, Institute for excellence in higher education, Bhopal) for granting us the permission for conducting this project. I would like to express my gratitude to Dr. H.B. Gupta (Head of the Economic Department).

This project would be incomplete without me expressing gratitude towards all my respondents who help me with the required information and data, which is the base of my study. I would avail the opportunity to thank all those, specially the almighty, parents, and friends, who provided me with their valuable suggestions and help which has a major contribution to my project. Needless to say I am alone responsible for such blemishes as the report may have.

Priyank Shrivastava

M.B.E(Final)

Roll No:-9016

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TABLE OF CONTENTS

Topics

BALANCE OF PAYMENTS4

BALANCE OF TRADE 6

BALANCE OF CURRENT ACCOUNT 7

THE OFFICIAL SETTLEMENT CONCEPT 9

THE CAPITAL ACCOUNT 10

ACCOMMODATING & AUTONOMOUS CAPITAL FLOWS11

BALANCE OF INVISIBLE TRADE 13

CAPITAL ACCOUNT CONVERTIBILITY (CAC) 17

IN THE ACCOUNTING SENSE THE BOP ALWAYS BALANCES! 20

DETAILED OUTLINE OF THE BOP STATEMENT & SUB

ACCOUNTS

21

A DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR

UNDESIRABLE!25

OFFICIAL RESERVES ACCOUNT 28

Bibliography 30

Annexure 31

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A REPORT ON

“BALANCE OF PAYMENTS”

CONCEPT QUESTIONS

BALANCE OF PAYMENTS

The balance of payments of a country is a systematic record of all economic

transactions between the residents of a country and the rest of the world. It

presents a classified record of all receipts on account of goods exported, services

rendered and capital received by residents and payments made by theme on

account of goods imported and services received from the capital transferred to

non-residents or foreigners.

- Reserve Bank of India

The above definition can be summed up as following: - Balance of Payments is the

summary of all the transactions between the residents of one country and rest of

the world for a given period of time, usually one year.

The definition given by RBI needs to be clarified further for the following points:

A. Economic Transactions

An economic transaction is an exchange of value, typically an act in which there is

transfer of title to an economic good the rendering of an economic service, or the

transfer of title to assets from one economic agent (individual, business,

government, etc) to another. An international economic transaction evidently

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involves such transfer of title or rendering of service from residents of one country

to another. Such a transfer may be a requited transfer (the transferee gives

something of an economic value to the transferor in return) or an unrequited

transfer (a unilateral gift). The following are the basic types of economic

transactions that can be easily identified:

1. Purchase or sale of goods or services with a financial quid pro quo – cash or a

promise to pay. [One real and one financial transfer].

2. Purchase or sale of goods or services in return for goods or services or a

barter transaction. [Two real transfers].

3. An exchange of financial items e.g. – purchase of foreign securities with

payment in cash or by a cheque drawn on a foreign deposit. [Two financial

transfers].

4. A unilateral gift in kind [One real transfer].

5. A unilateral financial gift. [One financial transfer].

B. Resident

The term resident is not identical with “citizen” though normally there is a

substantial overlap. As regards individuals, residents are those individuals whose

general centre of interest can be said to rest in the given economy. They consume

goods and services; participate in economic activity within the territory of the

country on other than temporary basis. This definition may turnout to be ambiguous

in some cases. The “Balance of Payments Manual” published by the “International

Monetary Fund” provides a set of rules to resolve such ambiguities.

As regards non-individuals, a set of conventions have been evolved. E.g. –

government and non profit bodies serving resident individuals are residents of

respective countries, for enterprises, the rules are somewhat complex, particularly

to those concerning unincorporated branches of foreign multinationals. According to

IMF rules these are considered to be residents of countries in which they operate,

although they are not a separate legal entity from the parent located abroad.

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International organisations like the UN, the World Bank, and the IMF are not

considered to be residents of any national economy although their offices are

located within the territories of any number of countries.

To certain economists, the term BOP seems to be somewhat obscure. Yeager, for

example, draws attention to the word ‘payments’ in the term BOP; this gives a false

impression that the set of BOP accounts records items that involve only payments.

The truth is that the BOP statements records both payments and receipts by a

country. It is, as Yeager says, more appropriate to regard the BOP as a “balance of

international transactions” by a country. Similarly the word ‘balance’ in the term

BOP does not imply that a situation of comfortable equilibrium; it means that it is a

balance sheet of receipts and payments having an accounting balance.

Like other accounts, the BOP records each transaction as either a plus or a minus.

The general rule in BOP accounting is the following:-

a) If a transaction earns foreign currency for the nation, it is a credit and is

recorded as a plus item.

b) If a transaction involves spending of foreign currency it is a debit and is

recorded as a negative item.

The BOP is a double entry accounting statement based on rules of debit and credit

similar to those of business accounting & book-keeping, since it records both

transactions and the money flows associated with those transactions. Also in case of

statistical discrepancy the difference amount is adjusted with errors and omissions

account and thus in accounting sense the BOP statement always balances.

The various components of a BOP statement are:

A. Current AccountB. Capital Account

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C. IMFD. SDR AllocationE. Errors & OmissionsF. Reserves and Monetary Gold

BALANCE OF TRADE

Balance of trade may be defined as the difference between the value of goods and

services sold to foreigners by the residents and firms of the home country and the

value of goods and services purchased by them from foreigners. In other words, the

difference between the value of goods and services exported and imported by a

country is the measure of balance of trade.

If two sums (1) value of exports of goods and services and (2) value of imports of

goods and services are exactly equal to each other, we say that there is balance of

trade equilibrium or balance; if the former exceeds the latter, we say that there is a

balance of trade surplus; and if the later exceeds the former, then we describe the

situation as one of balance of trade deficit. Surplus is regarded as favourable while

deficit is regarded as unfavourable.

The above mentioned definition has been given by James. E. Meade – a Nobel Prize

British Economist. However, some economists define balance of trade as a

difference between the value of merchandise (goods) exports and the value of

merchandise imports, making it the same as the ‘Goods Balance” or the “Balance of

Merchandise Trade”. There is n doubt that the balance of merchandise trade is of

great significance to exporting countries, but still the BOT as defined by J. E. Meade

has greater significance.

Regardless of which idea is adopted, one thing is certain i.e. that balance of trade is

a national injection and hence it is appropriate to regard an active balance (an

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excess of credits over debits) as a desirable state of affairs. Should this then be

taken to imply that a passive trade balance (an excess of debits over credits) is

necessarily a sign of undesirable state of affairs in a country? The answer is “no”.

Because, take for example, the case of a developing country, which might be

importing vast quantities of capital goods and technology to build a strong

agricultural or industrial base. Such a country in the course of doing that might be

forced to experience passive or adverse balance of trade and such a situation of

passive balance of trade cannot be described as one of undesirable state of affairs.

This would therefore again suggest that before drawing meaningful inferences as to

whether passive trade balances of a country are desirable or undesirable, we must

also know the composition of imports which are causing the conditions of adverse

trade balance.

BALANCE OF CURRENT ACCOUNT

BOP on current account refers to the inclusion of three balances of namely –

Merchandise balance, Services balance and Unilateral Transfer balance. In other

words it reflects the net flow of goods, services and unilateral transfers (gifts). The

net value of the balances of visible trade and of invisible trade and of unilateral

transfers defines the balance on current account.

BOP on current account is also referred to as Net Foreign Investment because the

sum represents the contribution of Foreign Trade to GNP.

Thus the BOP on current account includes imports and exports of merchandise

(trade balances), military transactions and service transactions (invisibles). The

service account includes investment income (interests and dividends), tourism,

financial charges (banking and insurances) and transportation expenses (shipping

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and air travel). Unilateral transfers include pensions, remittances and other

transfers for which no specific services are rendered.

It is also worth remembering that BOP on current account covers all the receipts on

account of earnings (or opposed to borrowings) and all the payments arising out of

spending (as opposed to lending). There is no reverse flow entailed in the BOP on

current account transactions.

BASIC BALANCE

The basic balance was regarded as the best indicator of the economy’s position vis-

à-vis other countries in the 1950’s and the 1960’s. It is defined as the sum of the

BOP on current account and the net balance on long term capital, which were

considered as the most stable elements in the balance of payments. A worsening of

the basic balance [an increase in a deficit or a reduction in a surplus or even a move

from the surplus to deficit] was seen as an indication of deterioration in the

[relative] state of the economy.

The short term capital account balance is not included in the basic balance. This is

perhaps for two main reasons:

a) Short term capital movements unlike long term capital movements are

relatively volatile and unpredictable. They move in and out of the country in a

period of less than a year or even sooner than that. It would therefore be

improper to treat short term capital movements on the same footing as current

account BOP transactions which are extremely durable in nature. Long term

capital flows are relatively more durable and therefore they qualify to be treated

along side the current account transactions to constitute basic balance.

b) In many cases, countries don’t have a separate short term capital account

as they constitute a part of the “Errors and Omissions Account.”

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A deficit on the basic balance could come about in various ways, which are not

mutually equivalent. E.g. suppose that the basic balance is in deficit because a

current account deficit is accompanied by a deficit on the long term capital account.

The long term capital outflow will, in the future, generate profits, dividends and

interest payments which will improve the current account and so, ceteris paribus,

will reduce or perhaps reduce the deficit. On the other hand, a basic balance surplus

consisting of a deficit on current account that is more than covered by long term

borrowings from abroad may lead to problems in future, when profits, dividends etc

are paid to foreign investors.

THE OFFICIAL SETTLEMENT CONCEPT

An alternative approach for indicating, a deficit or surplus in the BOP is to consider

the net monetary transfer that has been made by the monetary authorities is

positive or negative, which is the so called – settlement concept.

If the net transfer is negative (i.e. there is an outflow) then the BOP is said to be in

deficit, but if there is an inflow then it is surplus. The basic premise is that the

monetary authorities are the ultimate financers of any deficit in the balance of

payments (or the recipients of any surplus). These official settlements are thus

seemed as the accommodating item, all other being autonomous.

The monetary authorities may finance a deficit by depleting their reserves of

foreign currencies, by borrowing from the IMF or by borrowing from other foreign

monetary authorities. The later source is of particular importance when other

monetary authorities hold the domestic currency as a part of their own reserves. A

country whose currency is used as a reserve currency (such as the dollars of US)

may be able to run a deficit in its balance of payments without either depleting its

own reserves or borrowing from the IMF since the foreign authorities might be ready

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to purchase that currency and add it to its own reserves. The settlements approach

is more relevant under a system of pegged exchange rates than when the exchange

rates are floating.

THE CAPITAL ACCOUNT

The capital account records all international transactions that involve a resident of

the country concerned changing either his assets with or his liabilities to a resident

of another country. Transactions in the capital account reflect a change in a stock –

either assets or liabilities.

It is often useful to make distinctions between various forms of capital account

transactions. The basic distinctions are between private and official transactions,

between portfolio and direct investment and by the term of the investment (i.e.

short or long term). The distinction between private and official transaction is fairly

transparent, and need not concern us too much, except for noting that the bulk of

foreign investment is private.

Direct investment is the act of purchasing an asset and the same time acquiring

control of it (other than the ability to re-sell it). The acquisition of a firm resident in

one country by a firm resident in another is an example of such a transaction, as is

the transfer of funds from the ‘parent company in order that the ‘subsidiary’

company may itself acquire assets in its own country. Such business transactions

form the major part of private direct investment in other countries, multinational

corporations being especially important. There are of course some examples of such

transactions by individuals, the most obvious being the purchase of the ‘second

home’ in another country.

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Portfolio investment by contrast is the acquisition of an asset that does not give the

purchaser control. An obvious example is the purchase of shares in a foreign

company or of bonds issued by a foreign government. Loans made to foreign firms

or governments come into the same broad category. Such portfolio investment is

often distinguished by the period of the loan (short, medium or long are

conventional distinctions, although in many cases only the short and long

categories are used). The distinction between short term and long term investment

is often confusing, but usually relates to the specification of the asset rather than to

the length of time of which it is held. For example, a firm or individual that holds a

bank account with another country and increases its balance in that account will be

engaging in short term investment, even if its intention is to keep that money in

that account for many years. On the other hand, an individual buying a long term

government bond in another country will be making a long term investment, even if

that bond has only one month to go before the maturity. Portfolio investments may

also be identified as either private or official, according to the sector from which

they originate.

The purchase of an asset in another country, whether it is direct or portfolio

investment, would appear as a negative item in the capital account for the

purchasing firm’s country, and as a positive item in the capital account for the other

country. That capital outflows appear as a negative item in a country’s balance of

payments, and capital inflows as positive items, often causes confusions. One way

of avoiding this is to consider that direction in which the payment would go (if made

directly). The purchase of a foreign asset would then involve the transfer of money

to the foreign country, as would the purchase of an (imported) good, and so must

appear as a negative item in the balance of payments of the purchaser’s country

(and as a positive item in the accounts of the seller’s country).

The net value of the balances of direct and portfolio investment defines the balance

on capital account.

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ACCOMMODATING & AUTONOMOUS CAPITAL FLOWS

Economists have often found it useful to distinguish between autonomous and

accommodating capital flows in the BOP. Transactions are said to Autonomous if

their value is determined independently of the BOP. Accommodating capital flows

on the other hand are determined by the net consequences of the autonomous

items. An autonomous transaction is one undertaken for its own sake in response to

the given configuration of prices, exchange rates, interest rates etc, usually in order

to realise a profit or reduced costs. It does not take into account the situation

elsewhere in the BOP. An accommodating transaction on the other hand is

undertaken with the motive of settling the imbalance arising out of other

transactions. An alternative nomenclature is that capital flows are ‘above the line’

(autonomous) or ‘below the line’ (accommodating). Obviously the sum of the

accommodating and autonomous items must be zero, since all entries in the BOP

account must come under one of the two headings. Whether the BOP is in surplus or

deficit depends on the balance of the autonomous items. The BOP is said to be in

surplus if autonomous receipts are greater than the autonomous payments and in

deficit if vice – a – versa.

Essentially the distinction between both the capital flow lies in the motives

underlying a transaction, which are almost impossible to determine. We cannot

attach the labels to particular groups of items in the BOP accounts without giving

the matter some thought. For example a short term capital movement could be a

reaction to difference in interest rates between two countries. If those interest rates

are largely determined by influences other than the BOP, then such a transaction

should be labelled as autonomous. Other short term capital movements may occur

as a part of the financing of a transaction that is itself autonomous (say, the export

of some good), and as such should be classified as accommodating.

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There is nevertheless a great temptation to assign the labels ‘autonomous’ and

‘accommodating’ to groups of item in the BOP. i.e. to assume, that the great

majority of trade in goods and of long term capital movements are autonomous,

and that most short term capital movements are accommodating, so that we shall

not go far wrong by assigning those labels to the various components of the BOP

accounts. Whether that is a reasonable approximation to the truth may depend in

part on the policy regime that is in operation. For example what is an autonomous

item under a system of fixed exchange rates and limited capital mobility may not

be autonomous when the exchange rates are floating and capital may move freely

between countries.

BALANCE OF INVISIBLE TRADE

Just as a country exports goods and imports goods a country also exports and

imports what are called as services (invisibles). The service account records all the

service exported and imported by a country in a year. Unlike goods which are

tangible or visible services are intangible. Accordingly services transactions are

regarded as invisible items in the BOP. They are invisible in the sense that service

receipts and payments are not recorded at the port of entry or exit as in the case

with the merchandise imports and exports receipts. Except for this there is no

meaningful difference between goods and services receipts and payments. Both

constitute earning and spending of foreign exchange. Goods and services accounts

together constitute the largest and economically the most significant components in

the BOP of any country.

The service transactions take various forms. They basically include 1)

transportation, banking, and insurance receipts and payments from and to the

foreign countries, 2) tourism, travel services and tourist purchases of goods and

services received from foreign visitors to home country and paid out in foreign

countries by home country citizens, 3) expenses of students studying abroad and

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receipts from foreign students studying in the home country, 4) expenses of

diplomatic and military personnel stationed overseas as well as the receipts from

similar personnel who are stationed in the home country and 5) interest, profits,

dividends and royalties received from foreign countries and paid out to foreign

countries. These items are generally termed as investment income or receipts and

payments arising out of what are called as capital services. “Balance of Invisible

Trade” is a sum of all invisible service receipts and payments in which the sum

could be positive or negative or zero. A positive sum is regarded as favourable to a

country and a negative sum is considered as unfavourable. The terms are

descriptive as well as prescriptive.

BALANCE OF VISIBLE TRADE

Balance of visible trade is also known as balance of merchandise trade, and it

covers all transactions related to movable goods where the ownership of goods

changes from residents to non-residents (exports) and from non-residents to

residents (imports). The valuation should be on F.O.B basis so that international

freight and insurance are treated as distinct services and not merged with the value

of goods themselves. Exports valued on F.O.B basis are the credit entries. Data for

these items are obtained from the various forms that the exporters have fill and

submit to the designated authorities. Imports valued at C.I.F are the debit entries.

Valuation at C.I.F. though inappropriate, is a forced choice due to data

inadequacies. The difference between the total of debits and credits appears in the

“Net” column. This is the ‘Balance of Visible Trade.’

In visible trade if the receipts from exports of goods happen to be equal to the

payments for the imports of goods, we describe the situation as one of zero “goods

balance.’ Otherwise there would be either a positive or negative goods balance,

depending on whether we have receipts exceeding payments (positive) or

payments exceeding receipts (negative).

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ERRORS AND OMISSIONS

Errors and omissions is a “statistical residue.” It is used to balance the statement

because in practice it is not possible to have complete and accurate data for

reported items and because these cannot, therefore, ordinarily have equal entries

for debits and credits. The entry for net errors and omissions often reflects

unreported flows of private capital, although the conclusions that can be drawn

from them vary a great deal from country to country, and even in the same country

from time to time, depending on the reliability of the reported information.

Developing countries, in particular, usually experience great difficulty in providing

reliable information.

Errors and omissions (or the balancing item) reflect the difficulties involved in

recording accurately, if at all, a wide variety of transactions that occur within a

given period of (usually 12 months). In some cases there is such large number of

transactions that a sample is taken rather than recording each transaction, with the

inevitable errors that occur when samples are used. In others problems may arise

when one or other of the parts of a transaction takes more than one year: for

example wit a large export contract covering several years some payment may be

received by the exporter before any deliveries are made, but the last payment will

not made until the contract has been completed. Dishonesty may also play a part,

as when goods are smuggled, in which case the merchandise side of the transaction

is unreported although payment will be made somehow and will be reflected

somewhere in the accounts. Similarly the desire to avoid taxes may lead to under-

reporting of some items in order to reduce tax liabilities.

Finally, there are changes in the reserves of the country whose balance of

payments we are considering, and changes in that part of the reserves of other

countries that is held in the country concerned. Reserves are held in three forms: in

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foreign currency, usually but always the US dollar, as gold, and as Special Deposit

Receipts (SDR’s) borrowed from the IMF. Note that reserves do not have to be held

within the country. Indeed most countries hold a proportion of their reserves in

accounts with foreign central banks.

The changes in the country’s reserves must of course reflect the net value of all the

other recorded items in the balance of payments. These changes will of course be

recorded accurately, and it is the discrepancy between the changes in reserves and

the net value of the other record items that allows us to identify the errors and

omissions.

UNILATERAL TRANSFERS

Unilateral transfers or ‘unrequited receipts’, are receipts which the residents of a

country receive ‘for free’, without having to make any present or future payments in

return. Receipts from abroad are entered as positive items, payments abroad as

negative items. Thus the unilateral transfer account includes all gifts, grants and

reparation receipts and payments to foreign countries. Unilateral transfer consist of

two types of transfers: (a) government transfers (b) private transfers.

Foreign economic aid or assistance and foreign military aid or assistance received

by the home country’s government (or given by the home government to foreign

governments) constitutes government to government transfers. The United States

foreign aid to India, for BOP 9but a debit item in the US BOP). These are

government to government donations or gifts. There no well worked out theory to

explain the behaviour of this account because these flows depend upon political and

institutional factors. The government donations (or aid or assistance) given to

government of other countries is mixed bag given for either economic or political or

humanitarian reasons. Private transfers, on the other hand, are funds received from

or remitted to foreign countries on person –to –person basis. A Malaysian settled in

the United States remitting $100 a month to his aged parents in Malaysia is a

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unilateral transfer inflow item in the Malaysian BOP. An American pensioner who is

settled after retirement in say Italy and who is receiving monthly pension from

America is also a private unilateral transfer causing a debit flow in the American

BOP but a credit flow in the Italian BOP. Countries that attract retired people from

other nations may therefore expect to receive an influx of foreign receipts in the

form of pension payments. And countries which render foreign economic assistance

on a massive scale can expect huge deficits in their unilateral transfer account.

Unilateral transfer receipts and payments are also called unrequited transfers

because as the name itself suggests the flow is only in one direction with no

automatic reverse flow in the other direction. There is no repayment obligation

attached to these transfers because they are not borrowings and lending’s but gifts

and grants exchanged between government and people in one country with the

governments and peoples in the rest of the world.

ILLUSTRATE THE ITEMS WHICH FALL UNDER CAPITAL ACCOUNT AND CURRENT ACCOUNT WITH

EXAMPLES.

Credits DebitsCurrent Account Current Account

1. Merchandise Exports (Sale of Goods)

1. Merchandise Imports (purchase of Goods)

2. Invisible Exports (Sale of Services)

2. Invisible Imports (Purchase of Services)

a. Transport services sold abroad

a. Transport services purchased from abroad

b. Insurance services sold abroad

b. Insurance services purchased

c. Foreign tourist expenditure in country

c. Tourist expenditure abroad

d. Other services sold abroad

d. Other services purchased from abroad

e. Incomes received on loans and investments abroad.

e. Income paid on loans and investments in the home country.

3. Unilateral Transfers 3. Unilateral Transfers

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a. Private remittances received from abroad

a. Private remittances abroad

b. Pension payments received from abroad

b. Pension payments abroad

c. Government grants received from abroad

c. Government grants abroad.

Capital Account Capital Account3. Foreign long-term investments

in the home country (less redemptions and repayments)

3. Long-term investments abroad (less redemptions and repayments)

a. Direct investments in the home country

a. Direct Investments abroad

b. Foreign investments in domestic securities

b. Investments in foreign securities

c. Other investments of foreigners in the home country

c. Other investments abroad

d. Foreign Governments’ loans to the home country.

d. Government loans to foreign countries

4. Foreign short-term investments in the home country.

4. Short-term investments abroad.

CAPITAL ACCOUNT CONVERTIBILITY (CAC)

While there is no formal definition of Capital Account Convertibility, the committee

under the chairmanship of S.S. Tarapore has recommended a pragmatic working

definition of CAC. Accordingly CAC refers to the freedom to convert local financial

assets into foreign financial assets and vice – a – versa at market determined rates

of exchange. It is associated with changes of ownership in foreign / domestic

financial assets and liabilities and embodies the creation and liquidation of claims

on, or by, the rest of the world. CAC is coexistent with restrictions other than on

external payments. It also does not preclude the imposition of monetary / fiscal

measures relating to foreign exchange transactions, which are of prudential nature.

Following are the prerequisites for CAC:

1. Maintenance of domestic economic stability.

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2. Adequate foreign exchange reserves.

3. Restrictions on inessential imports as long as the foreign exchange position is

not very comfortable.

4. Comfortable current account position.

5. An appropriate industrial policy and a conducive investment climate.

6. An outward oriented development strategy and sufficient incentives for

export growth.

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DESCRIPTIVE QUESTIONS

DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP STATEMENTS?

BOP statistics are regularly compiled, published and are continuously monitored by

companies, banks and government agencies. A set of BOP accounts is useful in the

same way as a motion picture camera. The accounts do not tell us what is good or

bad, nor do they tell us what is causing what. But they do let us see what is

happening so that we can reach our own conclusions. Below are 3 instances where

the information provided by BOP accounting is very necessary:

1. Judging the stability of a floating exchange rate system is easier with BOP as

the record of exchanges that take place between nations help track the

accumulation of currencies in the hands of those individuals more willing to hold

on to them.

2. Judging the stability of a fixed exchange rate system is also easier with the

same record of international exchange. These exchanges again show the extent

to which a currency is accumulating in foreign hands, raising questions about the

ease of defending the fixed exchange rate in a future crisis.

3. To spot whether it is becoming more difficult for debtor counties to repay

foreign creditors, one needs a set of accounts that shows the accumulation of

debts, the repayment of interest and principal and the countries ability to earn

foreign exchange for future repayment. A set of BOP accounts supplies this

information. This point is further elaborated below.

The BOP statement contains useful information for financial decision makers. In the

short run, BOP deficit or surpluses may have an immediate impact on the exchange

rate. Basically, BOP records all transactions that create demand for and supply of a

currency. When exchange rates are market determined, BOP figures indicate excess

demand or supply for the currency and the possible impact on the exchange rate.

Taken in conjunction with recent past data, they may conform or indicate a reversal

of perceived trends. They also signal a policy shift on the part of the monetary

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authorities of the country unilaterally or in concert with its trading partners. For

instance, a country facing a current account deficit may raise interest to attract

short term capital inflows to prevent depreciation of its currency. Countries

suffering from chronic deficits may find their credit ratings being downgraded

because the markets interpret the data as evidence that the country may have

difficulties its debt.

BOP accounts are intimately with the overall saving investment balance in a

country’s national accounts. Continuing deficits or surpluses may lead to fiscal and

monetary actions designed to correct the imbalance which in turn will affect

exchange rates and interest rates in the country. In nutshell corporate finance

managers must monitor the BOP data being put out by government agencies on a

regular basis because they have both short term and long term implications for a

host of economic and financial variables affecting the fortunes of the company.

IN THE ACCOUNTING SENSE THE BOP ALWAYS BALANCES!

The BOP is a double entry accounting statement based on rules of debit and credit

similar to those of business accounting & book-keeping, since it records both

transactions and the money flows associated with those transactions. For instance,

exports (like sales of a business) are credits, and imports (like the purchases of a

business) are debits. As in business accounting the BOP records increases in assets

(direct investment abroad) and decreases in liabilities (repayment of debt) as

debits, and decreases in assets (sale of foreign securities) and increases in liabilities

(the utilisation of foreign goods) as credits. An elementary rule that may assist in

understanding these conventions is that in such transactions it is the movement of

a document, not of the money that is recorded. An investment made abroad

involves the import of a documentary acknowledgement of the investment, it is

therefore a debit. The BOP has one important category that has no counter part or

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at least no significant counter part in business accounting, i.e. international gifts

and grants and other so called transfer payments.

In general credits may be conceived as receipts and debits as payments. However

this is not always possible. In particular the change in a country’s international

reserves in gold and foreign exchange is treated as a debit if it is an increase and a

credit if it is a decrease. The procedure is to offset changes in reserves against

changes in the other items in the table so that the grand total is always zero,

(except for errors and omissions).

A transaction entering the BOP usually has two aspects and invariably gives rise to

two entries, one a debit and the other a credit. Often the two aspects fall in different

categories. For instance, an export against cash payment may result in an increase

in the exporting country’s official foreign exchange holdings. Such a transaction is

entered in the BOP as a credit for exports and as a debit for the capital account.

Both aspects of a transaction may sometimes be appropriate to the same account.

For instance the purchase of a foreign security may have as its counter part

reduction in official foreign exchange holdings.

Thus it is clear that if we record all the entries in BOP in a proper way, debits and

credits will always be equal. So that in accounting sense the BOP will be in balance.

DETAILED OUTLINE OF THE BOP STATEMENT & SUB ACCOUNTS

Balance of Payments is the summary of all the transactions between the residents of one country and

rest of the world for a given period of time, usually one year. A BOP statement (revised) includes the

following sub accounts, as shown in the table below.

Items Credits Debits NetG. Current Account

1. Merchandise

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a. Privateb. Government

2. Invisiblesa. Travelb. Transportationc. Insuranced. Investment Incomee. Government (not included elsewhere)f. Miscellaneous

3. Transfer Paymentsa. Officialb. Private

Total Current Account (1+2+3)

H. Capital Account2. Private

a. Long Termb. Short Term

3. Banking4. Official

a. Loansb. Amortisationc. Miscellaneous

Total Capital Account (1+2+3)

I. IMFJ. SDR AllocationK. Capital Account, IMF & SDR Allocation (B+C+D)L. Total Current Account, Capital Account, IMF & SDR

Allocation (A+E)

M. Errors & OmissionsN. Reserves and Monetary Gold

Current Account

The current account includes all transactions which give rise to or use up national

income. The current account consists of two major items, namely, (a) merchandise

export and imports and (b) invisible imports and exports.

Merchandise exports i.e. sale of goods abroad, are credit entries because all

transactions giving rise to monetary claims on foreigners represent credits. On the

other hand, merchandise imports, i.e. purchase of goods abroad, are debit entries

because all transactions giving rise to foreign money claims on the home country

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represent debits. Merchandise exports and imports form the most important

international transactions of most of the countries.

Invisible exports i.e. sale of services, are credit entries and invisible imports i.e.

purchase of services are debit entries. Important invisible exports include sale

abroad of services like insurance and transport etc. while important invisible

imports are foreign tourist expenditures in the home country and income received

on loans and investment abroad (interests or dividends).

Transfers payments refer to unrequited receipts or unrequited payments which may

be in cash or in kind and are divided into official and private transactions. Private

transfer payments cover such transactions as charitable contributions and

remittances to relatives in other countries. The main component of government

transfer payments is economic aid in the form of grants.

Capital Account

The capital account separates the non monetary sector from the monetary one, that

is to say, the trading or ordinary private business element in the economy together

with the ordinary institutions of central or local government, from the central bank

and the commercial bank, which are directly involved in framing or implementing

monetary policies. The capital account consists of long term and short term capital

transactions. Capital outflow represents debit and capital inflow represent credit.

For instance, if an American firm invests rupees 100 million in India, this transaction

will be represented as a debit in the US BOP and a credit in the BOP of India.

Other Accounts

The IMF account contains purchases (credits) and repurchases (debits) from the

IMF. SDRs – Special Drawing Rights – are a reserve asset created by the IMF and

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allocated from time to time to member countries. Within certain limitations it can be

used to settle international payments between monetary authorities of member

countries. An allocation is a credit while retirement is a debit. The Reserve and

Monetary Gold account records increases (debits) and decreases (credits) in reserve

assets. Reserve assets consist of RBI’s holdings of gold and foreign exchange (in the

form of balances with foreign central banks and investment in foreign government

securities) and government’s holding of SDRs. Errors and Omissions is a “statistical

residue.” Errors and omissions (or the balancing item) reflect the difficulties

involved in recording accurately, if at all, a wide variety of transactions that occur

within a given period of (usually 12 months). It is used to balance the statement

because in practice it is not possible to have complete and accurate data for

reported items and because these cannot, therefore, ordinarily have equal entries

for debits and credits.

HOW WILL YOU IDENTIFY A DEFICIT OR SURPLUS IN BALANCE OF

PAYMENTS? / MEANING OF “DEFICIT” AND “SURPLUS” IN THE BALANCE OF

PAYMENTS.

If the balance of payment is a double entry accounting record, then apart from

errors and omissions, it must always balance. Obviously, the terms “deficit” or

“surplus” cannot refer to the entire BOP but must indicate imbalance on a subset of

accounts included in the BOP. The “imbalance” must be interpreted in some sense

as an economic disequilibrium.

Since the notion of disequilibrium is usually associated within a situation that calls

for policy intervention of some sort, it is important to decide what is the optimal

way of grouping the various accounts within the BOIP so that an imbalance in one

set of accounts will give the appropriate signals to the policy makers. In the

language of an accountant e divide the entire BOP into a set of accounts “above the

line” and another set “below the line.” If the net balance (credits-debits) is positive

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above the line we will say that there is a “balance of payments surplus”; if it is

negative e will say there is a “balance of payments deficit.” The net balance below

the line should be equal in magnitude and opposite in sign to the net balance above

the line. The items below the line can be said to be a “compensatory” nature – they

“finance” or “settle” the imbalance above the line.

The critical question is how to make this division so that BOP statistics, in particular

the deficit and surplus figures, will be economically meaningful. Suggestions made

by economist and incorporated into the IMF guidelines emphasis the purpose or

motive a transaction, as a criterion to decide whether a transaction should go above

or below the line. The principle distinction between “autonomous” transaction and

“accommodating” or compensatory transactions. Transactions are said to

Autonomous if their value is determined independently of the BOP. Accommodating

capital flows on the other hand are determined by the net consequences of the

autonomous items. An autonomous transaction is one undertaken for its own sake

in response to the given configuration of prices, exchange rates, interest rates etc,

usually in order to realise a profit or reduced costs. It does not take into account the

situation elsewhere in the BOP. An accommodating transaction on the other hand is

undertaken with the motive of settling the imbalance arising out of other

transactions. An alternative nomenclature is that capital flows are ‘above the line’

(autonomous) or ‘below the line’ (accommodating). The terms “balance of

payments deficit” and “balance of payments surplus” will then be understood to

mean deficit or surplus on all autonomous transactions taken together.

The other measures of identifying a deficit or surplus in the BOP statement are:

Deficit or Surplus in the Current Account and/or Trade Account.

The Basic Balance which shows the relative deficit or surplus in the BOP.

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A DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR UNDESIRABLE!

The basic balance was regarded as the best indicator of the economy’s position vis-

à-vis other countries in the 1950’s and the 1960’s. It is defined as the sum of the

BOP on current account and the net balance on long term capital, which were

considered as the most stable elements in the balance of payments.

A worsening of the basic balance [an increase in a deficit or a reduction in a surplus

or even a move from the surplus to deficit] is seen as an indication of deterioration

in the [relative] state of the economy. Thus it is very much evident that a deficit in

the basic balance is a clear indicator of worsening of the state of the country’s BOP

position, and thus can be said to be undesirable at the very outset.

However, on further thoughts, a deficit in the basic balance can also be understood

to be desirable. This can be explained as follows: A deficit on the basic balance

could come about in various ways, which are not mutually equivalent. E.g. suppose

that the basic balance is in deficit because a current account deficit is accompanied

by a deficit on the long term capital account. This deficit in long term capital

account could be clearly observed in a developing country’s which might be

investing heavily on capital goods for advancement on the agricultural and

industrial fields. This long term capital outflow will, in the future, generate profits,

dividends and interest payments which will improve the current account and so,

ceteris paribus, will reduce or perhaps reduce the deficit.

Thus a deficit in basic balance can be desirable as well as undesirable, as it clearly

depends upon what is leading to a deficit in the long term capital account.

SHORT NOTES

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BALANCE OF PAYMENTS

(Refer to Concept Questions)

CURRENT ACCOUNT

The current account records exports and imports of goods and services and

unilateral transfers. Exports whether of goods or services are by convention entered

as positive items in the account. Imports accordingly are entered as negative items.

Exports are normally calculated f.o.b i.e. cost from transportation, insurance etc are

not included whereas imports are normally calculated c.i.f. i.e. transportation,

insurance cost etc are included.

In many cases the payment for imports and exports will result in transfer of money

between the trading countries. For example a UK firm importing a good from US

may settle its debt by instructing its UK bank to make a payment to the US account

of the exporter. This is not necessarily the case however. If the UK firm holds a bank

account in the US, then it may make payment to the US exporter from that account.

In the former case the financial side of the transaction will appear in the UK BOP

account as part of the net change in UK foreign currency reserves. In the later it will

appear as the part of the capital account since the UK firm has reduced its claims

on the US bank.

BOP accounts usually differentiate between trades in goods and trade in services.

The balance of imports and exports of the former is referred to in the UK accounts

as the balance of visible trade in other countries it may be referred to as the

balance of merchandise trade, or simply as the balance of trade. The net balance of

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exports and imports of services is called the balance of invisible trade in the UK

statistics.

Invisible trade is a much more heterogeneous category than is visible trade. It helps

in distinguishing between factor and non-factor services. Trade in the later of which

shipping, banking and insurance services and payments by residents as tourists

abroad are usually the most important, is in economic terms little different from

trade in goods. That is, exports and imports are flows of outputs whose values will

be determined by the same variables that would affect the demand and supply for

goods. Factors services, which consist in the main of interest, profits and dividends,

are on the other hand payments for inputs. Exports and imports of such services will

depend in large part on the accumulated stock of past investment in and borrowing

from foreign residents.

Unilateral transfer forms a major part of the current account. It refers to unrequited

receipts or unrequited payments which may be in cash or in kind and are divided

into official and private transactions. Unilateral transfers or ‘unrequited receipts’,

are receipts which the residents of a country receive ‘for free’, without having to

make any present or future payments in return. Receipts from abroad are entered

as positive items, payments abroad as negative items.

The net value of the balances of visible trade and of invisible trade and of unilateral

transfers defines the balance on current account.

CAPITAL ACCOUNT

(Refer to Concept Questions)

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OFFICIAL RESERVES ACCOUNT

Official reserve account forms a special feature of the capital account. This account

records the changes in the part of the reserves of other countries that is held in the

country concerned. These reserves are held in three forms: in foreign

currency, usually but not always the US dollars, as gold, and as Special

Deposit Receipts (SDRs) borrowed from the IMF. Note that the reserves do

not have to be held by the country. Indeed most of the countries hold a proportion

of the reserves in accounts with foreign central banks.

The IMF account contains purchases (credits) and repurchases (debits) from the

IMF. SDRs – Special Drawing Rights – are a reserve asset created by the IMF and

allocated from time to time to member countries. Within certain limitations it can be

used to settle international payments between monetary authorities of member

countries. An allocation is a credit while retirement is a debit. The Reserve and

Monetary Gold account records increases (debits) and decreases (credits) in reserve

assets. Reserve assets consist of RBI’s holdings of gold and foreign exchange (in the

form of balances with foreign central banks and investment in foreign government

securities) and government’s holding of SDRs.

The change in the reserves account measures a nation’s surplus or deficit on its

current and capital account transactions by netting reserve liabilities from reserve

assets. For example, a surplus will lead to an increase in official holdings of foreign

currencies and/or gold; a deficit will normally cause a reduction in these assets.

For most of the countries, there is a correlation between balance-of-payments

deficits and reserve declines. A drop in reserves will occur, for instance, when a

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nation sells gold to acquire foreign currencies that it can use to meet the deficit in

the balance of payments.

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BIBLIOGRAPHY

Balance of Payments

- Paul Madson

International Financial Management

- P G Apte

International Economics

- Lindert


- Francis Chernuliam


- C P Kindelberger


- Geoffrey Reed


- H G Mannur

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Major Items of India's balance of Payments (April-March, 2008-09) (In $ million) April-March

(2008-09) (P)April-March (2007-08) (PR)

Exports 175,184 166,163Imports 294,587 257,789Trade Balance -119,403 -91,626Invisibles, net 89,586 74,592Current Account Balance -29,817 -17,034Capital Account* 9,737 109,198Change in Reserves#(+ indicates increase;- indicates decrease)

20,080 -92,164

Including errors & omissions; # On BoP basis excluding valuation; P: Preliminary, PR: Partially revised. R: revisedSOURCE: Reserve Bank of India Report

INDIA’s cumulative value of exports for the period April- June, 2009 was $ 35432 million (Rs.172762 crore) as against $ 51545 million (Rs.214808 crore) registering a negative growth of 31.3 percent in Dollar terms and 19.6 percent in Rupee terms over the same period last year. Again, the cumulative value of imports for the period April- June, 2009 was $ 50936 million (Rs.248171 crore) as against $ 80187 million (Rs.334191 crore) registering a negative growth of36.5 percent in Dollar terms and 25.7 percent in Rupee terms over the same period last year.

EXPORTS & IMPORTS (April-June, FY 2009-10) In $ Million In Rs CroreExports including re-exports2008-09 51545 2148082009-10 35432 172762Growth 2009-10/2008-2009 (percent)

-31.3 -19.6

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Imports2008-09 80187 3341912009-10 50936 248171Growth 2009-10/2008-2009 (percent)

-36.5 -25.7

Trade Balance2008-09 -28642 -1193832009-10 -15504 -75409

Figures for 2008-09 and 2009-10 are provisional

The trade deficit for April- June, 2009 was estimated at $ 15504 million which was lower than the deficit at $ 28642 million during April- June, 2008.

Source: Federal Ministry of Commerce, Government of India

Inflows & Outflows from NRI Deposits and Local Withdrawals(In $ million)

Inflows Outflows Local Withdrawals2006-07 (R) 19914 15593 132082007-08 (PR) 29401 29222 18919April-March 2008-09 (P)

37,089 32,799 20,617

P: Preliminary, PR: Partially revised. R: revised

SOURCE: Reserve Bank of India report, 2008-09

KEY INDICATORS OF INDIA'S BALANCE OF PAYMENTS

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April-March 2008-09 2007-08 2006-07Merchandize TradeExports ($ on BoP basis) Growth Rate (percent)

5.4 28.9 22.6

Imports ($ on BoP basis) Growth Rate (percent)

14.3 35.2 21.4

Crude Oil Prices, Per Barrel (Indian Basket)

82.4 79.5 62.4

Trade Balance ($ billion) -119.4 -91.6 -61.8InvisiblesNet Invisibles ($ Billion) 89.6 74.6 52.2Net Invisibles Surplus/Trade Deficit (Percent)

75.0 81.4 84.5

Invisible Receipts/Current Receipts (Percent)

48.1 47.2 47.1

Services Recipts/Current Receipts (Percent)

30.0 28.6 30.3

Private Transfers/Current Receipts (Percent)

13.7 13.8 12.7

Current AccountCurrent Receipts ($ Billion) 337.7 314.8 243.4Current Payments ($ Billion) 367.6 331.8 253.0Current Account Balance ($ Billion)

--29.8 -17.0 -9.6

Capital AccountGross Capital Inflows ($ Billion)

302.5 433.0 233.3

Gross Capital Outflows ($ Billion)

293.3 325.0 188.1

Net Capital Flows ($ Billion) 9.1 108.0 45.2Net FDI/Net Capital Flows (Percent)

191.3 14.3 17.0

Net Portfolio Investment/Net capital Flows (Percent)

-153.4 27.4 15.6

Net ECBs/Net capital Flows (Percent)

89.2 21.0 35.5

ReservesImport Cover of Reserves (In months)

10.3 14.4 12.5

Outstanding Reserves as at end period ($ Billion)

252.0 309.7 199.2

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SOURCE: Reserve bank of India Report on Balance of Payment, December 2008

India's Merchandize Trade (2003-04 to 2008-09 (April-March) Year Exports Growth

(Percent)Imports Growth

(Percent)2003-04 63.8 - 78.1 -2004-05 83.5 30.8 111.5 42.72005-06 103.1 23.4 149.2 33.82006-07 126.3 22.5 185.6 24.42007-08 162.9 29.0 251.4 35.52008-09 (April-March)

- 5.4 - 14.3

SOURCE: Federal Ministry of Commerce, Government of India

Gross Capital Inflows and Outflows (In $ Million) HEADS

Gross Inflows Gross Out flowsApril-March April-March2008-09 P

2007-08 PR

2006-07 R 2008-09 P

2007-08 PR

2006-07 R

Foreign Direct Investment

36,258 36838 23590 18,762 21437 15897

Portfolio Investment

128,651 235924 109620 142,685 206368 102560

External Assistance

5,042 4241 3767 2,404 2127 1992

External Commercial Borrowings

15,382 30376 20883 7,224 7743 4780

NRI Deposits 37,089 29401 19914 32,799 29222 15593Banking capital excluding NR Deposits

27,909 26412 17295 35,596 14834 19703

Short-term trade Credits

39,734 48,911 29,992 45,529 31,728 23,380

Rupee Debt Service

0 0 0 101 121 162

Other Capital 12,391 20904 8230 8,210 11434 4021

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TOTAL 302,456

433007 233291 293,310

325014 188088

R: Revised; P: Preliminary; PR: Partially RevisedSOURCE: Reserve Bank of India Report on Balance of Payment, December 2008

Business Services (In $ Million) Item

Receipts PaymentsApril-March April-March

2008-09 P

2007-08 PR

2006-07 R 2008-09 P

2007-08 PR

2006-07 R

Trade Related 2,008 2233 1325 1,642 2285 1801Business & Management Consultancy

4,847 4433 4476 3,512 3653 3484

Architectural, Engineering & other Technical

1,759 3144 3457 3,106 3173 3025

Maintenance of Offices

2,980 2861 2638 3,283 3,496 4,032

Others 4,657 4100 2648 3,726 4,108 3,522TOTAL 16,25

116771

14544 15,269

16715

15866

R: Revised; P: Preliminary; PR: Partially Revised

SOURCE: Reserve Bank of India Report on Balance of Payment, December 2008

a report on balance of payment

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