FEBRUARY 2010 MANOJ KUMAR AGRAWAL

Balance of Payment
Basics about A Country’s Balance Sheet

Balance of payment is defined as “Balance

of Payments of a country is a record of its
monetary transactions over a period with the
rest of the world”. Balance of Payment
consists of Current Account and Capital
Account.

Current Account: Shows all the money flows

to and from a country arising from exports
and imports or Goods and Services, plus
transfers of income and other net transfers.

Balance of payments on current account =

Visible trade + Invisible trade +
Transfers of funds

Trade Balance (Visible trade): Show the sum

of visible export revenue minus the sum of
visible Import expenditure.

Invisible Balance: (Intangible goods) • Current Account

Net flows in Services: (Tourism, Professional • Trade Balance
services, Transport, etc.)
• Invisible Balance
Net Flows in Income: (Wages, Returns of
Investment, Profits of Firms, Interest payment)
• Capital Account
Net transfers: (Subsidies from other
Governments to locals, Transfers from
• Disequilibrium in BoP
donations and remittances (presents, gifts to
families, prizes, etc.), and Government • Causes of Disequilibrium
transfers (received and sent)...
• Measures for Correction

Curious to know about balance of payments. How the deficits are

calculated? Then give a look to this document.
FEBRUARY 2010 MANOJ KUMAR AGRAWAL

Capital Account: If Capital Account is positive (+),

assets of the country decrease. If Capital Account is
negative (-), assets of the country increase.

Direct Investment: Long Term. A foreign firm building

a plant or buying an existing factory in local
economy is FDI (Foreign Direct Investment). Credit in
Capital account.

Portfolio Investment: Short Term. Purchase of foreign

currency. Buying stocks, shares, bills or bonds abroad
or foreigners buying local bonds, stocks, shares, bills,
bonds, etc. Net balance of current account.

Other financial flows: Savings Abroad. (Outflow of

foreign currency $). Loans to foreigners mean that K
account is decreasing but there is an asset that is
going to be recovered in the future.

Gold and Foreign Reserves: are the foreign currency

deposits held by Central Banks and monetary
authorities. These are assets of the central banks
which are held in different reserve currencies, such
as the dollar, euro and yen, and which are used to
back its liabilities. E.g. the local currency issued.

Balancing item (or statistical error)

Parallel Markets
Illegal trade (not reported flow of capital, illegal
trade, smuggling, etc.)

NOTE: Balance of payments should be always in

equilibrium. A deficit in Current Account has to be
covered by a Surplus in the Capital Account.

Economically healthy nations that provide good

investment opportunities tend to run trade deficits
and capital account surpluses.

Note: In fixed exchange rate system govt. ensures

BOP is zero, whereas in floating exchange rate
surplus / deficit influence the exchange rate.

Clarification: some says BOP consists of Current a/c,

Capital a/c, IMF, SDR Allocation, Errors and omission,
reserve and surplus. While many merge all in capital
a/c except current a/c.
FEBRUARY 2010 MANOJ KUMAR AGRAWAL

Disequilibrium in BOP
Following are the types of disequilibrium:

Cyclic disequilibrium: It occurs on account of

trade cycle. Caused by demand fluctuation due
to changes in output, price, employment and
income

Structural disequilibrium: Caused by demand

fluctuation due to change in fashion, habits,
economic progress, crop failure, labor strikes, raw
material supplies etc.

Short run disequilibrium: Short term International

loan or lending. Export Import imbalance.

Long run or Secular disequilibrium: aka

Fundamental disequilibrium. Accumulation of
deficits of surpluses,

Causes of Disequilibrium: Is deficit a burden on Government?

Trade Cycle
Huge development & investment programs
National output and national spending
Population growth
Huge external borrowing
Inflation
Demonstration effect
Exchange rates
Money supply
Interest rates
Tariffs and Quotas
FEBRUARY 2010 MANOJ KUMAR AGRAWAL

Measures for disequilibrium correction

Monetary measures:
v Monetary contraction or expansion: Money
supply is regulated. Thus by affecting
purchasing power, local demand is reduced,
which ultimately increases exports. This
includes changing interest rates etc.

v Devaluation / Revaluation: Currency is

devaluated to promote exports and
discourage imports.
Exchange rate matters
v Exchange Control: Governing the currency
exchange tightly.

Trade measures:
v Export promotions: Reduction in export duties,
Export subsidies, Export incentives.

v Import control: Import duties, Import quota,

and Import prohibition.

Other measures:
v Foreign loans.
v Incentive for investments.
v Tourism development.
v Import subsidization.
v Incentive for inward remittance.