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 oods e!ported" ser#ices rendered and capital recei#ed by residents and payments made by theme on account of oods imported and ser#ices - Reserve Bank of India The abo#e definition can be summed up as followin % $ &alance of Payments is the summary of all the transactions between the residents of one country and rest of the world for a year. The definition points% A. E ono!i Transa "ions (n economic transaction is an e!chan e of #alue" typically an act in which there is transfer of title to an economic ood the renderin of an economic ser#ice" or the transfer of title to assets from one economic a ent )indi#idual" business" o#ernment" etc* to another. (n international economic transaction e#idently in#ol#es such transfer of title or renderin of ser#ice from residents of one country to another. Such a transfer may be a re+uited transfer )the transferee i#es somethin of an economic #alue to the transferor in return* or an unre+uited transfer )a unilateral i#en by '&I needs to be clarified further for the followin i#en period of time" usually one recei#ed from the capital transferred to non$residents or forei ners.

ift*. The followin be easily identified% ,. 0. 1.

are the basic types of economic transactions that can

Purchase or sale of oods or ser#ices with a financial +uid pro +uo cash or a promise to pay. .One real and one financial transfer/. Purchase or sale of oods or ser#ices in return for oods or ser#ices or a barter transaction. .Two real transfers/. (n e!chan e of financial items e. . - purchase of forei n securities with payment in cash or by a che+ue drawn on a forei n deposit. .Two financial transfers/.

2. 4. B.

( unilateral ift in 3ind .One real transfer/. ( unilateral financial ift. .One financial transfer/. Residen"

The term resident is not identical with 5citi6en7 thou h normally there is a substantial o#erlap. (s re ards indi#iduals" residents are those indi#iduals whose eneral centre of interest can be said to rest in the i#en economy. They consume oods and ser#ices8 participate in economic acti#ity within the territory of the country on other than temporary basis. This definition may turnout to be ambi uous in some cases. The 5&alance of Payments 9anual7 published by the 5International 9onetary :und7 pro#ides a set of rules to resol#e such ambi uities. (s re ards non$indi#iduals" a set of con#entions ha#e been e#ol#ed. E. . o#ernment and non profit bodies ser#in comple!" particularly to those concernin forei n multinationals. (ccordin resident indi#iduals are residents of respecti#e countries" for enterprises" the rules are somewhat unincorporated branches of to I9: rules these are considered to be

residents of countries in which they operate" althou h they are not a separate le al entity from the parent located abroad. International or anisations li3e the UN" the ;orld &an3" and the I9: are not considered to be residents of any national economy althou h their offices are located within the territories of any number of countries.

To certain economists" the term &OP seems to be somewhat obscure. <ea er" for e!ample" draws attention to the word =payments> in the term &OP8 this i#es a false impression that the set of &OP accounts records items that in#ol#e only payments. The truth is that the &OP statements records both payments and receipts by a country. It is" as <ea er says" more appropriate to re ard the &OP as a 5balance of international transactions7 by a country. Similarly the word =balance> in the term &OP does not imply that a situation of comfortable e+uilibrium8 it means that it is a balance sheet of receipts and payments ha#in balance. ?i3e other accounts" the &OP records each transaction as either a plus or a minus. The eneral rule in &OP accountin is the followin %$ a* b* If a transaction earns forei n currency for the nation" it is a credit and is recorded as a plus item. If a transaction in#ol#es spendin and is recorded as a ne ati#e item. The &OP is a double entry accountin statement based on rules of debit of forei n currency it is a debit an accountin

and credit similar to those of business accountin @ boo3$3eepin " since it records both transactions and the money flows associated with those transactions. (lso in case of statistical discrepancy the difference amount is adAusted with errors and omissions account and thus in accountin sense the &OP statement always balances. The #arious components of a &OP statement are% (. &. C. B. E. :. Current (ccount Capital (ccount I9: SB' (llocation Errors @ Omissions 'eser#es and 9onetary Cold

BALANCE OF TRA#E

&alance of trade may be defined as the difference between the #alue of oods and ser#ices sold to forei ners by the residents and firms of the home country and the #alue of oods and ser#ices purchased by them from forei ners. In other words" the difference between the #alue of oods and ser#ices e!ported and imported by a country is the measure of balance of trade. If two sums ),* #alue of e!ports of oods and ser#ices and )0* #alue of

imports of oods and ser#ices are e!actly e+ual to each other" we say that there is balance of trade e+uilibrium or balance8 if the former e!ceeds the latter" we say that there is a balance of trade surplus8 and if the later e!ceeds the former" then we describe the situation as one of balance of trade deficit. Surplus is re arded as fa#ourable while deficit is re arded as unfa#ourable. The abo#e mentioned definition has been i#en by Dames. E. 9eade - a

Nobel Pri6e &ritish Economist. Eowe#er" some economists define balance of trade as a difference between the #alue of merchandise ) oods* e!ports and the #alue of merchandise imports" ma3in it the same as the =Coods &alance7 or the 5&alance of 9erchandise Trade7. There is n doubt that the balance of merchandise trade is of reat si nificance to e!portin countries" but still the &OT as defined by D. E. 9eade has si nificance. 'e ardless of which idea is adopted" one thin is certain i.e. that balance reater

of trade is a national inAection and hence it is appropriate to re ard an acti#e balance )an e!cess of credits o#er debits* as a desirable state of affairs. Should this then be ta3en to imply that a passi#e trade balance )an e!cess of debits o#er credits* is necessarily a si n of undesirable state of affairs in a countryF The answer is 5no7. &ecause" ta3e for e!ample" the case of a de#elopin capital country" which mi ht be importin #ast +uantities of oods and technolo y to build a stron a ricultural or industrial that mi ht be forced to

base. Such a country in the course of doin

e!perience passi#e or ad#erse balance of trade and such a situation of passi#e balance of trade cannot be described as one of undesirable state of affairs. This would therefore a ain su are desirable or undesirable" we est that before drawin meanin ful inferences as to whether passi#e trade balances of a country must also 3now the composition of imports which are causin the conditions of ad#erse trade balance.

BALANCE OF C$RRENT ACCO$NT &OP on current account refers to the inclusion of three balances of namely - 9erchandise balance" Ser#ices balance and Unilateral Transfer balance. In other words it reflects the net flow of oods" ser#ices and unilateral transfers ) ifts*. The net #alue of the balances of #isible trade and of in#isible trade and of unilateral transfers defines the balance on current account. &OP on current account is also referred to as Net :orei n In#estment because the sum represents the contribution of :orei n Trade to CNP. Thus the &OP on current account includes imports and e!ports of merchandise )trade balances*" military transactions and ser#ice and transactions )in#isibles*. The ser#ice account includes in#estment income )interests and di#idends*" tourism" financial char es )ban3in insurances* and transportation e!penses )shippin which no specific ser#ices are rendered. It is also worth rememberin payments arisin that &OP on current account co#ers all the )as opposed to lendin *. There is no and air tra#el*.

Unilateral transfers include pensions" remittances and other transfers for

receipts on account of earnin s )or opposed to borrowin s* and all the out of spendin re#erse flow entailed in the &OP on current account transactions.

BASIC BALANCE The basic balance was re arded as the best indicator of the economy>s position #is$G$#is other countries in the ,H4I>s and the ,HJI>s. It is defined as the sum of the &OP on current account and the net balance on lon term capital" which were considered as the most stable elements in the balance of payments. ( worsenin of the basic balance .an increase in a deficit or a reduction in a surplus or e#en a mo#e from the surplus to deficit/ was seen as an indication of deterioration in the .relati#e/ 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 mo#ements unli3e lon term capital mo#ements are relati#ely #olatile and unpredictable. They mo#e in and out of the country in a period of less than a year or e#en sooner than that. It would therefore be improper to treat short term capital mo#ements on the same footin as current account &OP transactions which are term capital flows are relati#ely side the e!tremely durable in nature. ?on

more durable and therefore they +ualify to be treated alon current account transactions to constitute basic balance. b*

In many cases" countries don>t ha#e a separate short term capital account as they constitute a part of the 5Errors and Omissions (ccount.7

( deficit on the basic balance could come about in #arious ways" which are not mutually e+ui#alent. E. . suppose that the basic balance is in deficit because a current account deficit is accompanied by a deficit on the lon future" term capital account. The lon term capital outflow will" in the enerate profits" di#idends and interest payments which will

impro#e the current account and so" ceteris paribus" will reduce or perhaps reduce the deficit. On the other hand" a basic balance surplus consistin lon of a deficit on current account that is more than co#ered by term borrowin s from abroad may lead to problems in future" when

profits" di#idends etc are paid to forei n in#estors.

T%E OFFICIAL SETTLEMENT CONCEPT (n alternati#e approach for indicatin " a deficit or surplus in the &OP is to consider the net monetary transfer that has been made by the monetary authorities is positi#e or ne ati#e" which is the so called - settlement concept. If the net transfer is ne ati#e )i.e. there is an outflow* then the &OP 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 accommodatin item" all other bein autonomous. The monetary authorities may finance a deficit by depletin their reser#es of forei n currencies" by borrowin from the I9: or by borrowin from other forei n monetary authorities. The later source is of particular importance when other monetary authorities hold the domestic currency as a part of their own reser#es. ( country whose currency is used as a reser#e currency )such as the dollars of US* may be able to run a deficit in its balance of payments without either depletin borrowin its own reser#es or from the I9: since the forei n authorities mi ht be ready to ed e!chan e rates than

purchase that currency and add it to its own reser#es. The settlements approach is more rele#ant under a system of pe when the e!chan e rates are floatin . T%E CAPITAL ACCO$NT The capital account records all international transactions that in#ol#e a resident of the country concerned chan in either his assets with or his liabilities to a resident of another country. Transactions in the capital account reflect a chan e in a stoc3 - either assets or liabilities.

It is often useful to ma3e distinctions between #arious forms of capital account transactions. The basic distinctions are between pri#ate and official transactions" between portfolio and direct in#estment and by the term of the in#estment )i.e. short or lon us too much" e!cept for notin pri#ate. Birect in#estment is the act of purchasin ac+uirin an asset and the same time term*. The distinction between pri#ate and official transaction is fairly transparent" and need not concern that the bul3 of forei n in#estment is

control of it )other than the ability to re$sell it*. The ac+uisition

of a firm resident in one country by a firm resident in another is an e!ample of such a transaction" as is the transfer of funds from the =parent company in order that the =subsidiary> company may itself ac+uire assets in its own country. Such business transactions form the maAor part of pri#ate direct in#estment in other countries" multinational corporations bein especially important. There are of course some e!amples of such the purchase of the transactions by indi#iduals" the most ob#ious bein =second home> in another country. Portfolio in#estment by contrast is the ac+uisition of an asset that does not i#e the purchaser control. (n ob#ious e!ample is the purchase of o#ernment. o#ernments come into the same broad are con#entional distinctions" althou h in cate ories are used*. The distinction term in#estment is often confusin " but shares in a forei n company or of bonds issued by a forei n ?oans made to forei n firms or the loan )short" medium or lon between short term and lon

cate ory. Such portfolio in#estment is often distin uished by the period of many cases only the short and lon

usually relates to the specification of the asset rather than to the len th of time of which it is held. :or e!ample" a firm or indi#idual that holds a ban3 account with another country and increases its balance in that account will be en a in indi#idual buyin in short term in#estment" e#en if its intention is to 3eep a lon term o#ernment bond in another country will be that money in that account for many years. On the other hand" an

ma3in

a lon

term in#estment" e#en if that bond has only one month to

o before the maturity. Portfolio in#estments may also be identified as either pri#ate or official" accordin to the sector from which they ori inate. The purchase of an asset in another country" whether it is direct or portfolio in#estment" would appear as a ne ati#e item in the capital account for the purchasin firm>s country" and as a positi#e item in the capital account for the other country. That capital outflows appear as a ne ati#e item in a country>s balance of payments" and capital inflows as positi#e items" often causes confusions. One way of a#oidin consider that direction in which the payment would this is to o )if made directly*. ood" and

The purchase of a forei n asset would then in#ol#e the transfer of money to the forei n country" as would the purchase of an )imported* so must appear as a ne ati#e item in the balance of payments of the purchaser>s country )and as a positi#e item in the accounts of the seller>s country*. The net #alue of the balances of direct and portfolio in#estment defines the balance on capital account.

ACCOMMO#ATIN& ' A$TONOMO$S CAPITAL FLO(S Economists ha#e often found it useful to distin uish between autonomous and accommodatin capital flows in the &OP. Transactions are said to (utonomous if their #alue is determined independently of the &OP. (ccommodatin capital flows on the other hand are determined by the net conse+uences of the autonomous items. (n autonomous transaction is one underta3en for its own sa3e in response to the i#en confi uration of prices" e!chan e rates" interest rates etc" usually in order to realise a profit or reduced costs. It does not ta3e into account the situation elsewhere in the &OP. (n accommodatin transaction on the other hand is underta3en with the moti#e of settlin the imbalance arisin out of other transactions. (n alternati#e nomenclature is that capital flows are =abo#e

the line> )autonomous* or =below the line> )accommodatin *. Ob#iously the sum of the accommodatin and autonomous items must be 6ero" since all entries in the &OP account must come under one of the two headin s. ;hether the &OP is in surplus or deficit depends on the balance of the autonomous items. The &OP is said to be in surplus if autonomous receipts are reater than the autonomous payments and in deficit if #ice a - #ersa. Essentially the distinction between both the capital flow lies in the moti#es underlyin a transaction" which are almost impossible to determine. ;e cannot attach the labels to particular roups of items in the &OP accounts without i#in the matter some thou ht. :or e!ample a short term capital mo#ement could be a reaction to difference in interest rates between two countries. If those interest rates are lar ely determined by influences other than the &OP" then such a transaction should be labelled as autonomous. Other short term capital mo#ements may occur as a part of the financin of a transaction that is itself autonomous )say" the e!port of some ood*" and as such should be classified as accommodatin . There is ne#ertheless a reat temptation to assi n the labels

=autonomous> and =accommodatin > to mo#ements assi nin are autonomous" and

roups of item in the &OP. i.e. to that most short term capital by

assume" that the reat maAority of trade in oods and of lon term capital mo#ements are accommodatin " so that we shall not o far wron

those labels to the #arious components of the &OP accounts.

;hether that is a reasonable appro!imation to the truth may depend in part on the policy re ime that is in operation. :or e!ample what is an autonomous item under a system of fi!ed e!chan e rates and limited capital mobility may not be autonomous when the e!chan e rates are floatin and capital may mo#e freely between countries.

BALANCE OF IN)ISIBLE TRA#E

Dust as a country e!ports

oods and imports

oods a country also e!ports

and imports what are called as ser#ices )in#isibles*. The ser#ice account records all the ser#ice e!ported and imported by a country in a year. Unli3e oods which are tan ible or #isible ser#ices are intan ible. (ccordin ly ser#ices transactions are re arded as in#isible items in the &OP. They are in#isible in the sense that ser#ice receipts and payments are not recorded at the port of entry or e!it as in the case with the merchandise imports and e!ports receipts. E!cept for this there is no meanin ful difference between oods and ser#ices receipts and payments. &oth constitute earnin and spendin of forei n e!chan e.

Coods and ser#ices accounts to ether constitute the lar est and economically the most si nificant components in the &OP of any country. The ser#ice transactions ta3e #arious forms. They basically include ,* transportation" ban3in " and insurance receipts and payments from and to the forei n countries" 0* tourism" tra#el ser#ices and tourist purchases of oods and ser#ices recei#ed from forei n #isitors to home country and paid out in forei n countries by home country citi6ens" 1* e!penses of students studyin abroad and receipts from forei n students studyin in the home country" 2* e!penses of diplomatic and military personnel stationed o#erseas as well as the receipts from similar personnel who are stationed in the home country and 4* interest" profits" di#idends and royalties recei#ed from forei n countries and paid out to forei n countries. These items are payments arisin enerally termed as in#estment income or receipts and out of what are called as capital ser#ices. 5&alance of

In#isible Trade7 is a sum of all in#isible ser#ice receipts and payments in which the sum could be positi#e or ne ati#e or 6ero. ( positi#e sum is re arded as fa#ourable to a country and a ne ati#e sum is considered as unfa#ourable. The terms are descripti#e as well as prescripti#e.

BALANCE OF )ISIBLE TRA#E

&alance of #isible trade is also 3nown as balance of merchandise trade" and it co#ers all transactions related to mo#able oods where the ownership of oods chan es from residents to non$residents )e!ports* and from non$residents to residents )imports*. The #aluation should be on :.O.& basis so that international frei ht and insurance are treated as distinct ser#ices and not mer ed with the #alue of oods themsel#es. E!ports #alued on :.O.& basis are the credit entries. Bata for these items are obtained from the #arious forms that the e!porters ha#e fill and submit to the desi nated authorities. Imports #alued at C.I.: are the debit entries. Kaluation at C.I.:. thou h inappropriate" is a forced choice due to data inade+uacies. The difference between the total of debits and credits appears in the 5Net7 column. This is the =&alance of Kisible Trade.> In #isible trade if the receipts from e!ports of oods happen to be e+ual to the payments for the imports of oods" we describe the situation as one of 6ero 5 oods balance.> Otherwise there would be either a positi#e or ne ati#e e!ceedin )ne ati#e*. oods balance" dependin payments )positi#e* or on whether we ha#e receipts payments e!ceedin receipts

ERRORS AN# OMISSIONS Errors and omissions is a 5statistical residue.7 It is used to balance the statement because in practice it is not possible to ha#e complete and accurate data for reported items and because these cannot" therefore" ordinarily ha#e e+ual entries for debits and credits. The entry for net errors and omissions often reflects unreported flows of pri#ate capital" althou h the conclusions that can be drawn from them #ary a dependin reat deal from country to country" and e#en in the same country from time to time" on the reliability of the reported information. Be#elopin reat difficulty in pro#idin countries" in particular" usually e!perience reliable information.

Errors and omissions )or the balancin in#ol#ed in recordin that occur within a than recordin

item* reflect the difficulties

accurately" if at all" a wide #ariety of transactions i#en period of )usually ,0 months*. In some cases

there is such lar e number of transactions that a sample is ta3en rather each transaction" with the ine#itable errors that occur when samples are used. In others problems may arise when one or other of the parts of a transaction ta3es more than one year% for e!ample wit a lar e e!port contract co#erin se#eral years some payment may be recei#ed by the e!porter before any deli#eries are made" but the last payment will not made until the contract has been completed. Bishonesty may also play a part" as when oods are smu led" in which case the merchandise side of the transaction is unreported althou h payment will be made somehow and will be reflected somewhere in the accounts. Similarly the desire to a#oid ta!es may lead to under$reportin items in order to reduce ta! liabilities. :inally" there are chan es in the reser#es of the country whose balance of payments we are considerin " and chan es in that part of the reser#es of other countries that is held in the country concerned. 'eser#es are held in three forms% in forei n currency" usually but always the US dollar" as old" and as Special Beposit 'eceipts )SB'>s* borrowed from the I9:. Note that reser#es do not ha#e to be held within the country. Indeed most countries hold a proportion of their reser#es in accounts with forei n central ban3s. The chan es in the country>s reser#es must of course reflect the net #alue of all the other recorded items in the balance of payments. These chan es will of course be recorded accurately" and it is the discrepancy between the chan es in reser#es and the net #alue of the other record items that allows us to identify the errors and omissions. of some

$NILATERAL TRANSFERS

Unilateral transfers or =unre+uited receipts>" are receipts which the residents of a country recei#e =for free>" without ha#in to ma3e any present or future payments in return. 'eceipts from abroad are entered as positi#e items" payments abroad as ne ati#e items. Thus the unilateral transfer account includes all ifts" rants and reparation receipts and payments to forei n countries. Unilateral transfer consist of two types of transfers% )a* o#ernment transfers )b* pri#ate transfers. :orei n economic aid or assistance and forei n military aid or assistance recei#ed by the home country>s o#ernment to forei n o#ernment )or i#en by the home o#ernment to o#ernments* constitutes

o#ernment transfers. The United States forei n aid to India" for &OP Hbut a debit item in the US &OP*. These are donations or o#ernment to o#ernment ifts. There no well wor3ed out theory to e!plain the o#ernment donations )or aid or assistance* i#en for either

beha#iour of this account because these flows depend upon political and institutional factors. The i#en to o#ernment of other countries is mi!ed ba

economic or political or humanitarian reasons. Pri#ate transfers" on the other hand" are funds recei#ed from or remitted to forei n countries on person -to -person basis. ( 9alaysian settled in the United States remittin L,II a month to his a ed parents in 9alaysia is a unilateral monthly pension a debit flow in transfer inflow item in the 9alaysian &OP. (n (merican pensioner who is settled after retirement in say Italy and who is recei#in from (merica is also a pri#ate unilateral transfer causin

the (merican &OP but a credit flow in the Italian &OP. Countries that attract retired people from other nations may therefore e!pect to recei#e an influ! of forei n receipts in the form of pension payments. (nd countries which render forei n economic assistance on a massi#e scale can e!pect hu e deficits in their unilateral transfer account. Unilateral transfer receipts and payments are also called unre+uited transfers because as the name itself su ests the flow is only in one direction with no automatic re#erse flow in the other direction. There is no repayment obli ation attached to these transfers because they are not borrowin s

and lendin >s but world.

ifts and

rants e!chan ed between

o#ernment and

people in one country with the o#ernments and peoples in the rest of the

ILL$STRATE T%E ITEMS (%IC% FALL $N#ER CAPITAL ACCO$NT AN# C$RRENT ACCO$NT (IT% E*AMPLES. Credits Current (ccount 9erchandise E!ports )Sale of Coods* In#isible E!ports )Sale of Ser#ices* a. Transport ser#ices sold abroad b. Insurance ser#ices sold abroad c. :orei n tourist e!penditure in country d. Other ser#ices sold abroad e. Incomes recei#ed on loans and in#estments abroad. Unilateral Transfers a. Pri#ate remittances recei#ed from abroad b. Pension payments recei#ed from abroad c. Co#ernment rants recei#ed from abroad Capital (ccount :orei n lon $term in#estments in the home country )less redemptions and repayments* a. Birect in#estments in the home country b. :orei n in#estments in domestic securities c. Other in#estments of forei ners in the home country d. :orei n Co#ernments> loans to the home country. Bebits Current (ccount ,. 9erchandise Imports )purchase of Coods* 0. In#isible Imports )Purchase of Ser#ices* a. Transport ser#ices purchased from abroad b. Insurance ser#ices purchased c. Tourist e!penditure abroad d. Other ser#ices purchased from abroad e. Income paid on loans and in#estments in the home country. 1. Unilateral Transfers a. Pri#ate remittances abroad b. Pension payments abroad Co#er nment rants abroad. Capital (ccount 1. ?on $term in#estments abroad )less redemptions and repayments* a. Birect In#estments abroad b. In#estments in forei n securities c. Other in#estments abroad d. Co#ernment loans to forei n countries c.

,. 0.

1.

1.

2.

:orei n short$term in#estments in the home country.

2. abroad.

Short$term in#estments

CAPITAL ACCO$NT CON)ERTIBILITY +CAC, ;hile there is no formal definition of Capital (ccount Con#ertibility" the committee under the chairmanship of S.S. Tarapore has recommended a pra matic wor3in definition of C(C. (ccordin ly C(C refers to the freedom to con#ert local financial assets into forei n financial assets and #ice - a - #ersa at mar3et determined rates of e!chan e. It is associated with chan es of ownership in forei n M domestic financial assets and liabilities and embodies the creation and li+uidation of claims on" or by" the rest of the world. C(C is coe!istent with restrictions other than on e!ternal payments. It also does not preclude the imposition of monetary M fiscal measures relatin prudential nature. :ollowin are the prere+uisites for C(C% ,. 0. 1. 2. 4. J. 9aintenance of domestic economic stability. (de+uate forei n e!chan e reser#es. 'estrictions on inessential imports as lon position is not #ery comfortable. Comfortable current account position. (n appropriate industrial policy and a conduci#e in#estment climate. (n outward oriented de#elopment strate y and sufficient incenti#es for e!port rowth. as the forei n e!chan e to forei n e!chan e transactions" which are of

BESC'IPTIKE QUESTIONS
#ISC$SS T%E RELE)ANCE IMPORTANCE OF T%E BOP

STATEMENTS. &OP statistics are re ularly compiled" published and are continuously monitored by companies" ban3s and accounts do not tell us what is causin o#ernment a encies. ( set of &OP accounts is useful in the same way as a motion picture camera. The ood or bad" nor do they tell us what is so that we can what. &ut they do let us see what is happenin

reach our own conclusions. &elow are 1 instances where the information pro#ided by &OP accountin is #ery necessary% ,. Dud in the stability of a floatin e!chan e rate system is easier with &OP as the record of e!chan es that ta3e place between nations help trac3 the accumulation of currencies in the hands of those indi#iduals more willin to hold on to them. 0. Dud in the stability of a fi!ed e!chan e rate system is also easier in forei n the fi!ed with the same record of international e!chan e. These e!chan es a ain show the e!tent to which a currency is accumulatin hands" raisin 1. +uestions about the ease of defendin e!chan e rate in a future crisis. To spot whether it is becomin more difficult for debtor counties to repay forei n 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 forei n e!chan e for future repayment. ( set of &OP accounts supplies this information. This point is further elaborated below. The &OP statement contains useful information for financial decision ma3ers. In the short run" &OP deficit or surpluses may ha#e an immediate impact on the e!chan e rate. &asically" &OP records all transactions that create demand for and supply of a currency. ;hen e!chan e rates are mar3et determined" &OP fi ures indicate e!cess demand or supply for the currency and the possible impact on the e!chan e rate. Ta3en in

conAunction with recent past data" they may conform or indicate a re#ersal of percei#ed trends. They also si nal a policy shift on the part of the monetary authorities of the country unilaterally or in concert with its tradin partners. :or instance" a country facin a current account deficit from chronic deficits may may raise interest to attract short term capital inflows to pre#ent depreciation of its currency. Countries sufferin find their credit ratin s bein down raded because the mar3ets interpret

the data as e#idence that the country may ha#e difficulties its debt. &OP accounts are intimately with the o#erall sa#in in#estment balance in a country>s national accounts. Continuin deficits or surpluses may lead to fiscal and monetary actions desi ned to correct the imbalance which in turn will affect e!chan e rates and interest rates in the country. In nutshell corporate finance mana ers must monitor the &OP data bein put out by o#ernment a encies on a re ular basis because they ha#e both short term and lon term implications for a host of economic and financial #ariables affectin the fortunes of the company.

IN T%E ACCO$NTIN& SENSE T%E BOP AL(AYS BALANCES/ The &OP is a double entry accountin statement based on rules of debit and credit similar to those of business accountin @ boo3$3eepin " since it records both transactions and the money flows associated with those transactions. :or instance" e!ports )li3e sales of a business* are credits" and imports )li3e the purchases of a business* are debits. (s in business accountin the &OP records increases in assets )direct in#estment abroad* and decreases in liabilities )repayment of debt* as debits" and decreases in assets )sale of forei n securities* and increases in liabilities )the utilisation of forei n oods* as credits. (n elementary rule that may assist in understandin in#estment these con#entions is that in such transactions it is the abroad in#ol#es the import of a documentary mo#ement of a document" not of the money that is recorded. (n made ac3nowled ement of the in#estment" it is therefore a debit. The &OP has

one important cate ory that has no counter part or at least no si nificant counter part in business accountin " i.e. international ifts and rants and other so called transfer payments. In eneral credits may be concei#ed as receipts and debits as payments.

Eowe#er this is not always possible. In particular the chan e in a country>s international reser#es in old and forei n e!chan e is treated as a debit if it is an increase and a credit if it is a decrease. The procedure is to offset chan es in reser#es a ainst chan es in the other items in the table so that the rand total is always 6ero" )e!cept for errors and omissions*. ( transaction enterin the &OP usually has two aspects and in#ariably i#es rise to two entries" one a debit and the other a credit. Often the two aspects fall in different cate ories. :or instance" an e!port a ainst cash payment may result in an increase in the e!portin country>s official forei n e!chan e holdin s. Such a transaction is entered in the &OP as a credit for e!ports and as a debit for the capital account. &oth aspects of a transaction may sometimes be appropriate to the same account. :or instance the purchase of a forei n security may ha#e as its counter part reduction in official forei n e!chan e holdin s. Thus it is clear that if we record all the entries in &OP in a proper way" debits and credits will always be e+ual. So that in accountin &OP will be in balance. sense the

#ETAILE# O$TLINE OF T%E BOP STATEMENT ' S$B ACCO$NTS &alance of Payments is the summary of all the transactions between the residents of one country and rest of the world for a accounts" as shown in the table below. C. Items Current (ccount ,. 9erchandise a. Pri#ate Credits Bebits Net i#en period of time" sub usually one year. ( &OP statement )re#ised* includes the followin

b. Co#ernment 0. In#isibles a. Tra#el b. Transportation c. Insurance d. In#estment Income e. Co#ernment )not included elsewhere* f. 9iscellaneous 1. Transfer Payments a. Official b. Pri#ate Total Current (ccount ),N0N1* E. Capital (ccount 0. Pri#ate a. ?on Term b. Short Term 1. &an3in 2. Official a. ?oans b. (mortisation c. 9iscellaneous Total Capital (ccount ),N0N1* I. D. O. I9: SB' (llocation Capital (ccount" I9: @ SB' (llocation )&NCNB* ?. Total Current (ccount" Capital (ccount" I9: @ SB' (llocation )(NE* 9. N. Errors @ Omissions 'eser#es and 9onetary Cold

Current (ccount The current account includes all transactions which i#e rise to or use up national income. The current account consists of two maAor items" namely" )a* merchandise e!port and imports and )b* in#isible imports and e!ports. 9erchandise e!ports i.e. sale of all transactions i#in oods abroad" are credit entries because oods

rise to monetary claims on forei ners represent i#in rise to forei n

credits. On the other hand" merchandise imports" i.e. purchase of abroad" are debit entries because all transactions

money claims on the home country represent debits. 9erchandise e!ports

and imports form the most important international transactions of most of the countries. In#isible e!ports i.e. sale of ser#ices" are credit entries and in#isible imports i.e. purchase of ser#ices are debit entries. Important in#isible e!ports include sale abroad of ser#ices li3e insurance and transport etc. while important in#isible imports are forei n tourist e!penditures in the home country and income recei#ed on loans and in#estment abroad )interests or di#idends*. Transfers payments refer to unre+uited receipts or unre+uited payments which may be in cash or in 3ind and are di#ided into official and pri#ate transactions. Pri#ate transfer payments co#er such transactions as charitable contributions and remittances to relati#es in other countries. The main component of o#ernment transfer payments is economic aid in the form of rants. Capital (ccount The capital account separates the non monetary sector from the monetary one" that is to say" the tradin or local or ordinary pri#ate business element in the economy to ether with the ordinary institutions of central o#ernment" from the central ban3 and the commercial ban3" or implementin monetary policies. term and short term capital which are directly in#ol#ed in framin

The capital account consists of lon

transactions. Capital outflow represents debit and capital inflow represent credit. :or instance" if an (merican firm in#ests rupees ,II million in India" this transaction will be represented as a debit in the US &OP and a credit in the &OP of India. Other (ccounts The I9: account contains purchases )credits* and repurchases )debits* from the I9:. SB's - Special Brawin 'i hts - are a reser#e asset created by the I9: and allocated from time to time to member countries. ;ithin

certain limitations it can be used to settle international payments between monetary authorities of member countries. (n allocation is a credit while retirement is a debit. The 'eser#e and 9onetary Cold account records increases )debits* and decreases )credits* in reser#e assets. 'eser#e assets consist of '&I>s holdin s of o#ernment securities* and old and forei n e!chan e )in the form of SB's. Errors and accurately" if at all" a of balances with forei n central ban3s and in#estment in forei n o#ernment>s holdin Omissions is a 5statistical residue.7 Errors and omissions )or the balancin item* reflect the difficulties in#ol#ed in recordin wide #ariety of transactions that occur within a i#en period of )usually ,0 months*. It is used to balance the statement because in practice it is not possible to ha#e complete and accurate data for reported items and because these cannot" therefore" ordinarily ha#e e+ual entries for debits and credits.

%O( (ILL YO$ I#ENTIFY A #EFICIT OR S$RPL$S IN BALANCE OF PAYMENTS. - MEANIN& OF #EFICIT AN# S$RPL$S IN T%E BALANCE OF PAYMENTS. If the balance of payment is a double entry accountin record" then apart from errors and omissions" it must always balance. Ob#iously" the terms 5deficit7 or 5surplus7 cannot refer to the entire &OP but must indicate imbalance on a subset of accounts included in the &OP. The 5imbalance7 must be interpreted in some sense as an economic dise+uilibrium. Since the notion of dise+uilibrium is usually associated within a situation that calls for policy inter#ention of some sort" it is important to decide what is the optimal way of roupin the #arious accounts within the &OIP i#e the appropriate so that an imbalance in one set of accounts will

si nals to the policy ma3ers. In the lan ua e of an accountant e di#ide the entire &OP into a set of accounts 5abo#e the line7 and another set 5below the line.7 If the net balance )credits$debits* is positi#e abo#e the line we will say that there is a 5balance of payments surplus78 if it is ne ati#e e

will say there is a 5balance of payments deficit.7 The net balance below the line should be e+ual in ma nitude and opposite in si n to the net balance abo#e the line. The items below the line can be said to be a 5compensatory7 nature - they 5finance7 or 5settle7 the imbalance abo#e the line. The critical +uestion is how to ma3e this di#ision so that &OP statistics" in particular the deficit and surplus fi ures" will be economically meanin ful. Su estions made by economist and incorporated into the I9: uidelines emphasis the purpose or moti#e a transaction" as a criterion to decide whether a transaction should o abo#e or below the line. The principle distinction between 5autonomous7 transaction and 5accommodatin 7 or compensatory transactions. Transactions are said to (utonomous if their #alue is determined independently of the &OP. (ccommodatin capital flows on the other hand are determined by the net conse+uences of the autonomous items. (n autonomous transaction is one underta3en for its own sa3e in response to the i#en confi uration of prices" e!chan e rates" interest rates etc" usually in order to realise a profit or reduced costs. It does not ta3e into account the situation elsewhere in the &OP. (n accommodatin transaction on the other hand is underta3en with the the imbalance arisin out of other transactions. (n moti#e of settlin

alternati#e nomenclature is that capital flows are =abo#e the line> )autonomous* or =below the line> )accommodatin *. The terms 5balance of payments deficit7 and 5balance of payments surplus7 will then be understood to mean deficit or surplus on all autonomous transactions ta3en to ether. The other measures of identifyin statement are% Beficit or Surplus in the C0rren" A o0n" andMor Trade A o0n". The Basi Ba1an e which shows the relati#e deficit or surplus in the &OP. a deficit or surplus in the &OP

A #EFICIT IN T%E BASIC BALANCE IS #ESIRABLE OR $N#ESIRABLE/ The basic balance was re arded as the best indicator of the economy>s position #is$G$#is other countries in the ,H4I>s and the ,HJI>s. It is defined as the sum of the &OP on current account and the net balance on lon term capital" which were considered as the most stable elements in the balance of payments. ( worsenin of the basic balance .an increase in a deficit or a reduction in a surplus or e#en a mo#e from the surplus to deficit/ is seen as an indication of deterioration in the .relati#e/ state of the economy. Thus it is #ery much e#ident that a deficit in the basic balance is a clear indicator of worsenin of the state of the country>s &OP position" and thus can be said to be undesirable at the #ery outset. Eowe#er" on further thou hts" a deficit in the basic balance can also be understood to be desirable. This can be e!plained as follows% ( deficit on the basic balance could come about in #arious ways" which are not mutually e+ui#alent. E. . suppose that the basic balance is in deficit because a current account deficit is accompanied by a deficit on the lon term capital account. This deficit in lon clearly obser#ed in a de#elopin hea#ily on capital term capital account could be country>s which mi ht be in#estin

oods for ad#ancement on the a ricultural and

industrial fields. This lon term capital outflow will" in the future" enerate profits" di#idends and interest payments which will impro#e 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 leadin to a deficit in the lon term capital account.

SEO'T NOTES

BALANCE OF PAYMENTS )'efer to Concept Questions*

C$RRENT ACCO$NT The current account records e!ports and imports of and unilateral transfers. E!ports whether of oods and ser#ices oods or ser#ices are by

con#ention entered as positi#e items in the account. Imports accordin ly are entered as ne ati#e items. E!ports 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 e!ports will result in transfer of money between the tradin countries. :or e!ample a UO firm importin a ood from US may settle its debt by instructin its UO ban3 to ma3e a payment to the US account of the e!porter. This is not necessarily the case howe#er. If the UO firm holds a ban3 account in the US" then it may ma3e payment to the US e!porter from that account. In the former case the financial side of the transaction will appear in the UO &OP account as part of the net chan e in UO forei n currency reser#es. In the later it will appear as the part of the capital account since the UO firm has reduced its claims on the US ban3. &OP accounts usually differentiate between trades in oods and trade in

ser#ices. The balance of imports and e!ports of the former is referred to in the UO accounts as the balance of #isible 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 e!ports and imports of ser#ices is called the balance of in#isible trade in the UO statistics. In#isible trade is a much more hetero eneous cate ory than is #isible trade. It helps in distin uishin between factor and non$factor ser#ices.

Trade in the later of which shippin " ban3in

and insurance ser#ices and oods. That is" e!ports oods.

payments by residents as tourists abroad are usually the most important" is in economic terms little different from trade in and imports are flows of outputs whose #alues will be determined by the same #ariables that would affect the demand and supply for :actors ser#ices" which consist in the main of interest" profits and di#idends" are on the other hand payments for inputs. E!ports and imports of such ser#ices will depend in lar e part on the accumulated stoc3 of past in#estment in and borrowin from forei n residents. Unilateral transfer forms a maAor part of the current account. It refers to unre+uited receipts or unre+uited payments which may be in cash or in 3ind and are di#ided into official and pri#ate transactions. Unilateral transfers or =unre+uited receipts>" are receipts which the residents of a country recei#e =for free>" without ha#in payments abroad as ne ati#e items. The net #alue of the balances of #isible trade and of in#isible trade and of unilateral transfers defines the balance on current account. to ma3e any present or future payments in return. 'eceipts from abroad are entered as positi#e items"

CAPITAL ACCO$NT )'efer to Concept Questions*

OFFICIAL RESER)ES ACCO$NT Official reser#e account forms a special feature of the capital account. This account records the chan es in the part of the reser#es of other countries that is held in the country concerned. T2ese reserves are 2e1d in "2ree for!s3 in forei4n 0rren 56 0s0a115 70" no" a18a5s "2e $S do11ars6 as 4o1d6 and as S9e ia1 #e9osi" Re ei9"s +S#Rs, 7orro8ed fro! "2e IMF. Note that the reser#es do not ha#e to be held

by the country. Indeed most of the countries hold a proportion of the reser#es in accounts with forei n central ban3s. The I9: account contains purchases )credits* and repurchases )debits* from the I9:. SB's - Special Brawin 'i hts - are a reser#e asset created by the I9: and allocated from time to time to member countries. ;ithin certain limitations it can be used to settle international payments between monetary authorities of member countries. (n allocation is a credit while retirement is a debit. The 'eser#e and 9onetary Cold account records increases )debits* and decreases )credits* in reser#e assets. 'eser#e assets consist of '&I>s holdin s of old and forei n e!chan e )in the form of balances with forei n central ban3s and in#estment in forei n o#ernment securities* and o#ernment>s holdin of SB's. The chan e in the reser#es account measures a nation>s surplus or deficit on its current and capital account transactions by nettin increase in official holdin s of forei n currencies andMor normally cause a reduction in these assets. :or most of the countries" there is a correlation between balance$of$ payments deficits and reser#e declines. ( drop in reser#es will occur" for instance" when a nation sells old to ac+uire forei n currencies that it can use to meet the deficit in the balance of payments. reser#e liabilities from reser#e assets. :or e!ample" a surplus will lead to an old8 a deficit will

BIBLIO&RAP%Y
&alance of Payments $ Paul 9adson International :inancial 9ana ement $ P C (pte International Economics $ ?indert International Economics $ :rancis Chernuliam International Economics $ C P Oindelber er International Economics $ Ceoffrey 'eed International Economics $ E C 9annur