Balance of Payments (BoP)

IF & Trade
Batch 2010

syllabus
Balance of Payments
International Monetary System
An overview of International Financial
Markets
Exchange Rate Determination and
Forecasting

BOP

BOP
http://rbidocs.rbi.org.in/rdocs/Content/docs/FS
BPS3031_Full.xls

National Income Accounting

GDP: National Spending = National Income
Y=C+I+G+XM
Y = GDP; C = Consumption; I = Physical Investment; G =
Government Spending; X = Exports; M = Imports

C + I + G = Domestic Absorption (spending on domestic

output)
(X M) = Trade Balance = Net Exports

Trade Balance = Natl Income less Domestic Absorption

X M = Y (C + I + G)

Trade Balance = Net Domestic Saving

Y = C + Saving + Taxes = C + I + G + X M
X M = (S I) + (T G)
Trade Imbalances must be met with International Borrowing or
Lending, i.e., trade deficit borrow from rest of world.

Note No Causation Implied!

BOP
The balance of payments of a country is a
systematic accounting record of all
economic transactions during a given
period of time between residents of the
country and residents of foreign countries
Flow

Balance of Payments
The BOP is a statistical record of the flow of
all of the payments between the residents of a
country and the rest of the world in a given
year.
Transactions are recorded on the basis of
double entry bookkeeping by definition it
has to balance.
Every source must have a use.

The two main components are:

Current Account
Capital/Financial Account

Accounting Principles in BOP

Capital Inflow
Sources of FX

CREDIT
Capital Outflow

Uses of FX

DEBIT

Accounting Principles
1.

2.
3.
4.
5.

Any transaction resulting in a payment to foreigners is

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

Examples of Transactions
Credit Transactions (+ve):
Provision of goods and services to non-residents

Income receivable from non-residents

A decrease in foreign financial assets
An increase in foreign financial liabilities

Debit Transactions (-ve):

Purchase of goods & services from non-residents

Income payable to non-residents

An increase in foreign financial assets
A decrease in foreign financial liabilities

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

1. Travel

BOP
a. Services
Current account
Merchandise
Invisibles

2. Transportation
3. Insurance
4. Govt not
eslewhere
specified
5. miscellaneous

b. Transfers

Official
Private

c. income
1. Investment
income

Capital account

2. Compensation to
Employees

BOP
Current Account
Capital Account

a. External Assistance
( by India, to India)

1. Foreign
Investments
2. Loans (a+b-c)
3. Banking capital

b. Commercial
Borrowing (MT+LT)

4. Rupee Debt
Service

c. Short term

5. Other Capital

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Balance of Payments

Current Account (CA)

This is record of a countrys trade in goods and
services in the current period.
CA = Exports (X) Imports (M)
It is divided into 4 sub-categories:

Goods trade
Services trade
Income
Current transfers

The sum of the four sub-categories = CA balance

Capital Account (KA)

This includes all short- and long-term
transactions pertaining to financial assets.

KA = Capital Inflow (cr) Capital outflow

(dr)
The two main components:
Capital account.
Financial account (direct, portfolio, other).

KA balance = Sum of capital account and

financial account.

Official Reserves
Records the purchase or sale of official reserve assets
by the central bank. These assets include
Commercial paper, Treasury bills and bonds
Foreign currency
Money deposited with the IMF

This account shows the change in foreign exchange

reserves held by the central bank.
The Balance of
Since the BOP must balance
Payments Identity
CA + KA + RFX = 0
CA + KA = RFX
For floating rate regime countries, such as the U.S., official
reserves are relatively unimportant.

Statistical Discrepancy (E&O)

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

Country A exported 500 worth

goods to country B
n B The balance in Exporter A
i
aid
p
country is an asset for Country
nd
a
A and a liability for B Country
cy
n
e
r
r
cu

nB
i
ice y
o
Inv rrenc
cu
Country A Exporter gets his bank
account credited with a bank in B
country

Normal a/c

BOP country A
Cu.A/c
Cr
Dt
Merchandise Ex
500
Cap. a/c
Up in claims on
500
a Foreign Bank
Anchor the a/c
entry on claims

Exchanged 300 worth Leather

goods for crude oil
BOP country A
Cu.A/c

Cr

Merchandise Ex

300

Merchandise Imports
Cap. a/c

Dt

300

A bank in country A purchases B country Govt

securities and pays by drawing its correspondent
bank a/c in B country
BOP country A
Cu.A/c

Cr

Dt

Cap. a/c
200

Up in Foreign Bank holdings

Fall in Foreign Bank

deposits

200

A country gifts medical supplies,

blankets..worth 150
BOP country A
Cu.A/c

Cr

Merchandise Ex

150

Unrequited transfers
Cap. a/c

Dt

150

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

charitable organisation in B

BOP country A
Cu.A/c

Cr

Unrequited transfers

50

Cap. a/c
Increase in Foreign
Liabilities

Dt

50

Example Transactions

Record transactions in the following accounts

CA: A = merchandise; B = services; C = invest. income; D =
Unilateral Transfers
KA: E = Change in U.S. claims on foreign assets; F = Change in
foreign claims on U.S. assets

U.S. firm sells $1m wheat to Romania, paid for out of

Romanian-owned deposit account in U.S.
A (+), F(-):
merchandise export is credit
decrease in foreign-owned dollar deposits = K-out = decreased foreign
claims on U.S.

U.S. tourist spends DM10,000 deposit in German bank while

traveling in Germany
B(-), E(+)
tourist spending abroad is service import ~ a debit
decrease in U.S. claims on foreigners ~ K-in

Example Transactions, cont.

U.S. citizen receives DM10k interest payment from German bonds,
deposits in German bank
C (+), E(-)

U.S. citizen converts DM to US$ at German Bank

E (+), F(-)
debit = K-out = decrease foreign claims on U.S. (they gave up $)
credit = K-in = decrease in U.S. claims on foreigners (we gave up DM)

U.S. Bank loans US$ to German Bank

F(+), E(-)
debit = K-out = increase in U.S. claims on foreigner (future debt payments)
credit = K-in = increase in foreign claims on U.S. (acquire $)

German resident sells U.S Government Bond to French resident

does not show on U.S. Balance of Payments!

U.S. charity donates medicine to Nicaragua

A (+), D(-): merchan. export, paid for by gift (unilateral transfer)

Valuation and Timing

Market Prices willingness of parties
F.O.B. Vs. C.I.F former is preferred
Indias exports are valued @ fob; imports
are cif
Translation
Timing : exports are recorded when
cleared by customs, imports when
payment is made - conventions

Balance in BOP
imbalance refers to disequilibrium
Autonomous transactions arising from
normal business
Accommodating transactions undertaken
with the motive of settling the imbalances
funding deficits arising out of autonomous
transactions

Balance in BOP

Trade balance
Balance in Goods & services
Current account Balance
Balance on CA and LT capital

BOP in Total
A surplus in the BOP implies that the demand for
the countrys currency exceeded the supply and
that the government should allow the currency
value to increase in value or intervene and
accumulate additional foreign currency reserves
in the Official Reserves Account.
A deficit in the BOP implies an excess supply of
the countrys currency on world markets, and the
government should then either devalue the
currency or expend its official reserves to support
its value.

Country faces current account

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

INTERLINKAGES IN FINANCIAL
MARKETS
Cap
Market
interest rate

Money Market
inflation

currency

exchange rate
Commodity

derivatives

Bullion

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

Interpretation of Deficit and

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

Interpretation: Does it matter?

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

BOP & Macroeconomic Variables

A nations balance of payments
interacts with nearly all of its key
macroeconomic variables.
Interacts means that the BOP affects
and is affected by such key
macroeconomic factors as:
Gross Domestic Product (GDP)
Exchange rate
Interest rates
Inflation rates

BOP & Exchange Rates

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

BOP & Exchange Rates

(X M) + (CI CO) + (FI FO) + FXB = BOP
Where:
X = exports of goods and services CurrentAccountBalance
M = imports of goods and services
CI = capital inflows
CapitalAccountBalance
CO = capital outflows
FI = financial inflows
FinancialAccountBalance
FO = financial outflows
FXB = official monetary reserves

BOP & Exchange Rates

Fixed Exchange Rate Countries
Under a fixed exchange rate system, the
government bears the responsibility to
ensure that the BOP is near zero.

Floating Exchange Rate Countries

Under a floating exchange rate system,
surpluses/deficits influence exchange rate.

Trade Balances & Exchange Rates

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

Trade Balances & Exchange Rates

Thank You