Balance of Payments

Definition
A Balance of Payment (BOP) account is a systematic record of all economic transactions (involving foreign payments) between residents of a country and the rest of the world carried out in specific period of time. Provides data for economic analysis Reveals changes in the composition & magnitude of foreign trade Provides indications of future repercussions of countrys past trade performances Reveals the weak and strong points of a countrys foreign trade relations

Features of BOP
1. 2. 3. 4. 5. 6. 7. Systematic Record Fixed Period of Time Comprehensiveness Double Entry System Self-balanced Adjustment of Differences All items-Government and Non Government

Importance of BOP
1. 2. 3. 4. 5. 6. 7. 8. 9. Guide to Economic Conditions and Direction Pictogram of Economic Changes Indicator of Foreign Changes Indicator of Foreign Dependency Knowledge of Foreign Investment Indicator of Foreign Trade Helpful in National Planning Determinant of National Economic Policy Helpful for International Financial Organisations

BOP-Surplus or Deficit
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.

Sources and Use of Funds

Sources of fund includes Export of goods & services Investment & Interest earning Unilateral Transfer received from Abroad & Loans from foreigners. Uses of fund includes Imports of goods & services Dividend paid to foreign investors Transfer payment abroad & loans to foreigners Increase in reserve assets.

BALANCE OF PAYMENTS

Current Account

Capital Account

Official Reserve Account

Decrease or increase in foreign exchange reserves

Foreign Direct Investment (FDI)

Portfolio Investment

Private Short-term Capital Flows

Goods account: Exports & Imports

Services account: Travel, transportation, Insurance etc. Unilateral transfers: Gifts, donations & subsidies

Investment Income : Interest, Dividends etc.

CURRENT ACCOUNT
All transactions relating to goods, services and unrequited transfers constitute current account Flow of items pertaining to specific period of time Visible items include goods Invisible items include services

CAPITAL ACCOUNT
All transactions indicating changes in stock magnitudes concerning capital receipts and payments constitute capital account Relates to - Borrowing - Capital repayment - Sale of assets - Change in stock of gold - Change in reserve of foreign currency

DIFFERENCE BETWEEN CURRENT ACCOUNT AND CAPITAL ACCOUNT

CURRENT ACCOUNT

CAPITAL ACCOUNT

Indicates flow aspect of countrys national transactions Relates to goods , services and unrequited transfers

Indicates changes in stock magnitudes Relates to all transactions constituting debts and transfer of ownership

Balance of Payments Data

Credits Current Account 1 2 3 Exports Imports Unilateral Transfers Balance on Current Account Capital Account 4 5 6 Direct Investment Portfolio Investment Other Investments Balance on Capital Account 7 Statistical Discrepancies Overall Balance Official Reserve Account $287.68 $474.39 $262.64 $444.26 0.73 $0.30 ($0.30) $10.24 $1,418.64 Debits

In 2000, the U.S. imported more than it thus ($1,809.18) exported, running a current deficit of ($64.39) account $444.69 billion.
($444.69)

During the same year, the U.S. attracted net ($124.94) investment of $444.26 billionclearly the rest ($303.27) of the world found the U.S. to be a good place
($152.44)

to invest

Balance of Payments and the Exchange Rate

Credits Current Account 1 2 3 Exports Imports Unilateral Transfers Balance on Current Account Capital Account 4 5 6 7 Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance Official Reserve Account $287.68 $474.39 $262.64 $444.26 0.73 $0.30 ($0.30) ($152.44) ($124.94) ($303.27) $10.24 $1,418.64 ($1,809.18) ($64.39) ($444.69) Debits

Exchange rate $

D
Q

As U.S. citizens import, they are supply dollars to the FOREX market.

COMPONENTS OF BALANCE OF PAYMENT

A. CURRENT ACCOUNT
The Current Account includes all transactions which gives rise to or use up national income.

The current account has four components: 1. Merchandise: Records exports and imports of physical, relocatable merchandise. EXAMPLE: Export of kiwifruit, brings in a credit, while the import of cars creates a debit.

Contd
2. Invisibles or Services: Records transactions relating to the provision of non-physical items such as transport, travel and insurance.

3. Income From investments: Records dividends, royalties and interest payments that a resident earn on assets held overseas, and also payments to foreign residents on assets held in their country.

Contd
4. Current Transfers: Records transactions relating to the
provision of goods, services, cash or other items of value between residents and non-residents that are intended to be used for consumption in the short term and for which there is no payment.

Payouts on insurance claims Aid from overseas governments/nations Pensions received from foreign governments Money sent from overseas relatives Gifts from charities in other countries Work remittances from people working overseas

B. CAPITAL ACCOUNT & FINANCIAL ACCOUNT

CAPITAL ACCOUNT: Records capital transfers both
short term & long term. Capital transfers also involve the movement of cash or other items of value, but are intended to be for investment rather than consumption.

EXAMPLE: If an American firm investsRs.100 million in

India, this transaction will be represented as a debit in the US balance of payments and a credit in the balance of payments of India.

FINANCIAL ACCOUNT
FINANCIAL ACCOUNT: Records one countrys
financial transactions with foreign countries, including short-term & long-term movements of capital.

Three main kinds of flows in the financial accounts:

Direct Investment: Investments in the ownership or control of a business . Officially it is an investment in at least 10% of the voting capital (or equity) of a company . Portfolio Investment: which are purchases of company stocks and bonds, Reserve assets: which are financial assets that can be bought and sold only by monetary authorities (central banks) & include a countrys official reserves of foreign exchange. Other investment: which is a residual category that includes trade credits & private holdings of foreign currency.

C. OFFICIAL SETTLEMENTS ACCOUNT

OFFICIAL RESERVES: represent the holdings by
the government or official agencies of the means of payment that are generally accepted for the settlement of international claim.

EXAMPLES: FOREX, GOLD

BALANCE OF PAYMENT ACCOUNTING ENTRIES

ACCOUNT Merchandise Services Net Investment Income Net Transfer Income Capital Flows CREDITS A. Export of Goods C. Export of Services E. Income from foreign Investments G. Transfers from Overseas to India I. Increase in foreign investments in India/ Decrease in India investments overseas K. Decrease in official holding of FX & Gold DEBITS B. Import of Goods D. Import of Services F. Income paid to foreign Investors H. Transfers to Overseas by India J. Decrease in foreign investments in India/ Increase in India investments overseas L. Increase in official holding of FX & Gold

Official Reserve

Contd
Balance of Trade = (A-B)+ (C-D) Current Account Balance = (A-B)+ (C-D) + (E-F)+(G-H) Capital Account Balance = (I-J) Official Reserve Balance =(K-L) Current Account + Capital Account+ Official Reserve = 0

Balance Of Payments Adjustments

If part of the balance of payments is in deficit or surplus for a period of time, mechanisms are needed to restore equilibrium Adjustment mechanisms can be:
Automatic - economic processes Discretionary - government policies

Automatic Adjustment Under Fixed Exchange Rates

Key variables
Prices Interest rates Income Money

Price Adjustment - Background

Under the gold standard, each nations currency was backed by gold and had a fixed price in terms of gold Imports and exports were paid for in gold A nations money supply (total amount of gold and gold-backed currency) was directly tied to balance of payments - whether gold was flowing in or out overall

Price Adjustment - Background

(Contd)

Balance of payments surplus would expand money supply; deficit would shrink money supply By the classical quantity theory of money, increases in the money supply led directly to an increase in overall prices (and a shrinking money supply caused overall prices to fall)

Price adjustment of the BOP

Deficit nations
Would be losing gold, therefore shrinking their money supply and causing prices to fall Lower prices would make their exports more competitive and lessen demand for imports, restoring equilibrium

Surplus nations
Would be gaining gold, increasing money supply and price level Higher prices would cut exports and encourage imports until the surplus was eliminated

Problems with price adjustment theory

Gold flows are not directly linked to domestic money supply Nations are often not at full employment If economy is not at capacity, less likely that prices will rise as money supply does Prices and wages are often not able to fall in the short run Falling money supply will cut output and employment rather than prices

Interest Rate Adjustment

Inflows of gold expand the money supply, causing short-term interest rates to fall; outflows cause rates to rise Investors in surplus nations would send gold abroad in search of higher rates; deficit nations would receive gold from abroad for investment, restoring equilibrium

Income Adjustment
Surplus nations will experience rising national income, leading to an increased demand for imports partially offsetting the surplus Deficit nations will experience falling income, leading to a drop in demand for imports - partially offsetting the deficit Foreign repercussions effect - one countrys deficit is anothers surplus, so that while income is declining in one country, its exports will increase to the country with rising income

Disadvantages Of Automatic Mechanisms

Require governments not to intervene Automatic systems seem desirable when they are believed to lead to full employment; when nations face unemployment and shrinking output, automatic mechanisms seem inadequate

Monetary adjustment - background

BOP disequilibrium represents an imbalance between the supply and demand for money Demand for money is:
Directly related to income and prices Inversely related to interest rates

Supply of money has two components:

Domestic component - credit created by national government International component - foreign exchange reserves

Monetary Adjustment
Payments deficits are the result of an excess supply of money at home
Excess supply of money encourages imports, which results in foreign exchange reserves flowing overseas and reducing the money supply

Monetary Adjustment
Excess demand for money leads to a payments surplus
Excess demand is reflected in higher interest rates and less spending on imports, encouraging a flow of foreign exchange into the country

Monetary Adjustment - Implications

Theory focuses on domestic monetary policy as key to balance of payments Other policies designed to affect the balance of payments - tariffs, quotas, devaluation of the currency - are ineffective in the long run according to the theory

Policy issues of balance of payment

BALANCE OF PAYMENTS DEFICIT

An imbalance in a nation's balance of payments in which payments made by the country exceed payments received by the country. Such an unequal flow of currency will reduce the supply of money in the nation. A balance of trade deficit is often the source of a balance of payments deficit, but other payments can turn a balance of trade deficit into a balance of payments surplus.

Monetary Measures for Correcting the BoP

1. Deflation
2. Exchange Depreciation 3. Devaluation 4. Exchange Control

Expenditure Changing policy

policy makers need to achieve two goals of macroeconomic stability, viz. internal and external balances. Attaining internal and external balances requires two independen policy tools. It is a policy to balance a countrys current account by altering the composition of expenditures on foreign and domestic goods

UNEMPLOYMENT DEFICIT
This issue was written at a time when the major source of deficits was recession. The President and Congress try to outdo one another on who can cut the Federal budget deficit the most. The recent reduction in the deficit is due to the decline in unemployment.

The Elasticity Approach

Income of the nation (Y) or receipt from the expenditure on its final goods and services is Y =C+I+G+X A = C+I+G+M Y-A = X-M Or, B = Y-A, B = current account surplus

Foreign exchange rate through intervention

The sale of the currency on the exchange market by the fiscal authority or the monetary authority, in order to influence the value of the domestic currency. There are many reasons for the authority to intervene the foreign exchange market. When there is an inordinate instability, exchange rate uncertainty generates extra costs and reduces profits for firms

BALANCE OF PAYMENTS SURPLUS

An imbalance in a nation's balance of payments in which payments made by the country are less than payments received by the country. Unequal flow of currency will expand the supply of money in the nation and subsequently cause a decrease in the exchange rate relative to the currencies of other nations.

Trend of BOP
CURRENT CAPITAL ERRORS & ACC ACC OMMISION 2011 -38.2 51.6 -.01 OVERALL BALANCE 13.4

2010 -45.9
2009 -29.6 2008 -28.3

62
38.9 35.2

-3
.3 .4

13.1
7 4.9

Reasons For Increase In BOP In 2011-12

Capital Flow Increases

CHANGES IN BOP
1990-91
POL IMPORTS
PHYSICAL TRADE EXTERNAL DEBT RATIO

2011-12
25% OF IMPORTS
US, ASIA 20%

25% OF IMPORTS
EAST EUROPE 35%

FISCAL DEFICIT
PHYSICAL TRADE

SPIL OVER EXTERNAL SECTORS

HIGH TARRIF, WEAK INFRASTRUCTURE, INFLEXIBLE LABOUR, & OTHER FACTORS

SPIL OVER EXTERNAL SECTORS

HIGH TARRIF, WEAK INFRASTRUCTURE, INFLEXIBLE LABOUR, & OTHER FACTORS

Current BOP Trends: SWOT Analysis

Strengths Equity flows on capital account Adequate liquidity to defend currency Self-adjusting market determined exchange rate. Weaknesses Dependence on POL imports Physical exports Ability of domestic investment to absorb large FC inflows.

Opportunities Pre-payment of costly debt Supplement domestic savings to boost growth rates Boost infrastructural investments.

Threats Instability in US and European economies. Rupee depreciation Fiscal deficit

Conclusion
WTO Agreements has opened the doors for removal of trade barriers & Anti-Dumping Duties, leading to expansion of exports. Removal of trade barriers in Textile and Agriculture Sector China's Accession to WTO is poised to challenge Indian industries. Improvement in Infrastructural Facilities like Power, Ports, Rail-Road networks. Technological Upgrading and Movement along with the Value Chain. Crude OIL Bio-fuel & mixing ethanol will reduce export bill.

Conclusion
Trade Related Intellectual Property System (TRIPs) attempts to harmonize the intellectual property protection regime. India has emerged as a significant supplier of certain knowledge intensive services such as custom software and other IT enabled services like BPOs and KPOs . Emerging Patterns of Comparative Advantage in Goods and Services And the most important Self-sufficiency in military goods production will lead to substantial reduction in BOP. Hence we can say that Healthy BOP Scenario in an economy augurs well for its future growth and its future prospects in positioning itself in world setup.