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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 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.

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 Account
B. Capital Account
C. IMF
D. SDR Allocation
E. Errors & Omissions
F. 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 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 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.”

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 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.

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.

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.

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 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).

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 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 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 Debits
Current Account Current Account
1. Merchandise Exports (Sale of 1. Merchandise Imports (purchase
Goods) of Goods)
2. Invisible Exports (Sale of 2. Invisible Imports (Purchase of
Services) Services)
a. Transport services sold abroad a. Transport services purchased
from abroad
b. Insurance services sold b. Insurance services purchased
abroad
c. Foreign tourist expenditure in c. Tourist expenditure abroad
country
d. Other services sold abroad d. Other services purchased
from abroad
e. Incomes received on loans e. Income paid on loans and
and investments abroad. investments in the home
country.
3. Unilateral Transfers 3. Unilateral Transfers
a. Private remittances received a. Private remittances abroad
from abroad
b. Pension payments received b. Pension payments abroad
from abroad
c. Government grants received c. Government grants abroad.
from abroad
Capital Account Capital Account
3. Foreign long-term investments in 3. Long-term investments abroad
the home country (less (less redemptions and
redemptions and repayments) repayments)
a. Direct investments in the a. Direct Investments abroad
home country
b. Foreign investments in b. Investments in foreign
domestic securities securities
c. Other investments of c. Other investments abroad
foreigners in the home
country
d. Foreign Governments’ loans d. Government loans to foreign
to the home country. countries
4. Foreign short-term investments 4. Short-term investments abroad.
in the home country.

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.
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.
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 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 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 Net
G. Current Account
1. Merchandise
a. Private
b. Government
2. Invisibles
a. Travel
b. Transportation
c. Insurance
d. Investment Income
e. Government (not included elsewhere)
f. Miscellaneous
3. Transfer Payments
a. Official
b. Private
Total Current Account (1+2+3)

H. Capital Account
2. Private
a. Long Term
b. Short Term
3. Banking
4. Official
a. Loans
b. Amortisation
c. Miscellaneous
Total Capital Account (1+2+3)

I. IMF
J. SDR Allocation
K. Capital Account, IMF & SDR Allocation
(B+C+D)
L. Total Current Account, Capital Account, IMF &
SDR Allocation (A+E)

M. Errors & Omissions


N. 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 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 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 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.
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
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 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)

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 nation sells gold to acquire foreign currencies that it can
use to meet the deficit in the balance of payments.
BIBLIOGRAPHY
Balance of Payments
- Paul Madson
International Financial Management
- P G Apte
International Economics
- Lindert
International Economics
- Francis Chernuliam
International Economics
- C P Kindelberger
International Economics
- Geoffrey Reed
International Economics
- H G Mannur