India’s Foreign Trade

SESSION TWO
India’s Foreign Trade
Chapter 3: Balance of
Payments
 Chapter Index
S. No Reference No Particulars Slide
From-To

1 Learning Objectives 35

2 Topic 1 Concept of Balance of Payments 36-37

3 Topic 2 Components of the Balance of 38-42

Payments

4 Topic 3 BOP Classification in India 43-45

5 Topic 4 Accounting Principles of BOP 46-47

6 Topic 5 Deficit and Surplus in BOP 48-49

7 Topic 6 Valuation and Timing of Balance 50-51

of Payments
 Chapter Index
S. No Reference No Particulars Slide
From-To

8 Topic 7 Importance of BOP 52

9 Topic 8 Limitations of BOP 53

10 Let’s Sum Up 54
• Define BOP

• Explain the concepts of BOP (Capital account and Current account)

• Describe BOP and its classification in India

• Explain accounting principles of BOP

• Describe the importance and limitations of BOP

• Explain how deficit and surplus in BOP

 1. Concept of Balance of Payments

• The balance of payments accounts of a country record the payments and receipts
of the residents of the country in their transactions with residents of other
countries.

• BOP is the record of the value of transactions between the citizen of the country
and other countries in the world.

• Reserve Bank of India issues the BOP data after compilation. BOP is based on
two accounts: capital account transactions and current account transactions.
 2. Concept of Balance of Payments

The different accounts of balance of payments are as follows:

1. The Current Account, which comprises:

• Net Export of goods and Services i.e. Exports minus Imports

• Net Investment Income

• Net Transfers (grants, gift, remittances etc.)

2. The Capital Account is the difference between financial capital inflows and
financial capital outflows. In other words, it includes those transactions that do not
affect the economic output.
 1. Components of Balance of Payments

• Broadly speaking, the BOP account comprises of the following three components:

a. The Current account

b. The Capital Account

c. Official Reserves Account

• Ideally, the sum of these three accounts i.e. the Current account balance plus the
Capital account balance plus the official reserve account balance is equal to Zero.
 2. Components of Balance of Payments

Current Account

A current account contains the following components:

a. Net Export of Goods and Services:

• This is the largest component of the Current account.

• It basically consists of the Exports and Imports of the country.

• Exchange ownership of goods and services between citizens of one country and
the citizens of other countries are the main aspects of exports and imports.

• Export is when the domestic producer (e.g. Indian Producer) will sell their goods
abroad or provide services to other countries. Since the Indian producer will
demand INR for the goods sold or services provided, it will create a demand for
INR in the foreign market. This will result in appreciation of Indian currency.
 3. Components of Balance of Payments

b. Net Investment Income: It is the difference between the income received by

country’s individuals, businesses and government from abroad over what they pay in.
These incomes are basically in the form of interest and dividend.

c. Net Transfers: This is the net of gifts, remittance, transfers etc. received from and
given to foreign countries.
 4. Components of Balance of Payments

The capital account is the difference between financial capital inflows and financial
capital outflows. Following are the components of capital account:

Reserve Account

Foreign Direct Investment

Portfolio Investment

Other Investment
 5. Components of Balance of Payments

Official Reserves Account

• Official reserves account is the official account of the central bank of the country.
In other words, the official reserve account is operated by a nation's central bank
to buy and sell foreign currencies.

• In India, this account is maintained by RBI.

• In order to maintain a fixed exchange rate of the country, Central Bank needs to
intervene in the forex market by buying or selling domestic currency in exchange
for the foreign reserve currency.
 1. BOP Classification in India

Indian BOP classification has the following elements:

a. Current Goods: RBI compiles all the data on merchandise, exports data on the
basis of the exports made, records the import data of which the imports are made
and whose payment are made through normal banking channels, details of the gold
and silver brought in and these are added back in the value of imports.
 2. BOP Classification in India

b. Services: RBI also compiles the data of various kinds of the services including:

• Transportation: This shall include the all modes of transport and port services.
The data of transportation collected is mainly from the database maintained by
the banks in respect to the exchange control records.

• Travel: The travel data is compiled by RBI through the various records
maintained by the Tourism Department, in regards with the foreign tourist
arrival and leaving India.

• Other Services: It basically covers the insurance services and various payments
made and receipts received in respect to the various insurance services. RBI
obtains this data from the various banks.
 3. BOP Classification in India

c. Income: The information regarding the Income is obtained by RBI from the
exchange control copy records maintained by various banks and banks also provides
the information regarding various amount of interest paid towards the foreign loan
etc.

d. Capital and Finance account transaction: The Capital and Finance Account
transaction includes the investment made by the various Companies in India which
can be in the forms like:

• Portfolio Investment

• Direct Investment

• Other Investment.
 1. Accounting Principles of BOP

• BOP account of a country captures the international flow of goods, services, and
financial claims between the domestic residents and rest of the world over a given
period of time, i.e. usually a year.

• This data is then often used by policy makers to predict the effects of
international conditions on the domestic economy.

• Successful use of the balance of payments accounts for policy purposes depends,
of course, on a sound understanding of their construction.

• The BOP accounting follows the double entry accounting system, i.e. for any
transaction there will be both debit and credit. An inflow of value is recorded as a
debit. An outflow of value is recorded as a credit.
 2. Accounting Principles of BOP

The accounting for BOP can be summarised as below:

• If a transaction creates supply of the nation's currency in the foreign exchange

market, it is recorded as a Debit (e.g. Imports). Debits results in increase in the
value of assets and decrease in the value of liabilities.

• If a transaction creates demand for the nation's currency in the foreign exchange
market, it is recorded as a Credit (e.g. Exports). Credits results in increase in the
value of liabilities and decrease in the value of assets.

• Since the foreign exchange market clears (i.e. Supply = Demand), DEBIT =
CREDIT
 1. Deficit and Surplus in BOP

• BOP deficit will arise when the payments made by the country exceed payments
received by the country.

• This is also termed an unfavourable balance of payments.

• It's considered unfavourable because more currency is flowing out of the country
than what is flowing in. Such an unequal flow of currency will reduce the supply
of money in the country and subsequently cause an increase in the exchange rate
relative to the currencies of other nations. This may then result in inflation,
unemployment, production, and other facets of the domestic economy.

• A balance of trade deficit is often the source of a balance of payments deficit,

because balance of trade is the most significant component of BOP. However, BOP
deficit can also arise on account of capital account deficit.
 2. Deficit and Surplus in BOP

• BOP surplus arises when the payments made by the country are lesser than the
payments received by it. When les money is going out of the country, it indicates a
favourable BOP.

• Such an unequal flow of currency will expand the supply of money in the country
and subsequently cause a decrease in the exchange rate relative to the currencies
of other nations (i.e. appreciation of the host country currency in international
trade). This may impact inflation, unemployment, production, and other facets of
the domestic economy.

• A balance of trade surplus is often the source of a balance of payments surplus,

because balance of trade is the most significant component of BOP. However, BOP
surplus can also arise on account of capital account surplus.
 1. Valuation and Timing of Balance of Payments

• It’s very important to have a consistent method of valuing transaction for the
preparation of balance of payment statement. It’s because of this that all the
transactions are valued at market price.

• Market price is the price that willing buyers pay to acquire something from
willing sellers; the exchanges are made between independent parties and on the
basis of commercial considerations only. Duplicating entries may lead to
inconsistent valuations resulting in errors and omissions.

• Sometimes it might happen that the market price may not be available. In such
cases, it is necessary to resort to the expedient of developing proxies, or
substitute measures.
 2. Valuation and Timing of BOP

• Each transaction should have double entries during the time and date of
transaction to keep a track of the time of recording. However, while this is the
ideal data recording methodology, it is not always possible, thus resulting in
"errors and omissions" in the BOP.

• An entry is recorded in the balance of payments when a transaction involves a

change of ownership. The change may be a legal one or a physical or economic
one involving control or possession.

• In case where a change of ownership is not obvious, then the transaction are
recorded when the parties enter it in their accounts.
 Importance of BOP

• It indicates the economic and financial status of a country in the short run.

• It serves as a guide to the policymaker for making monetary, fiscal, trade and
other policies.

• BOP also indicates the Balance of Trade position of the country i.e. whether the
country has positive net trade or negative net trade.

• In case of developing country, BOP shows the extent of dependence on the

financial assistance by the developed country.

• BOP is very useful in understanding the movements in the exchange rate, as the
demand and supply of foreign currencies is driven by the trend in BOP
components.
 Limitations of BOP

• Difficulty arises in classifying the external transactions of a country as there is

no classification which can be considered as an ideal for all the countries.

• Hawala transaction and other illegal means of trade transactions are not
recorded in the BOP accounts which may harm the data meant for analysis in an
economy.

• Another limitations of BOP, is the valuation of the transactions. Since the

external transactions of a country cannot be aggregated in physical units, it
needs to be converted into monetary terms which involve conversion of one
currency into another i.e. estimating the rupee equivalents of foreign currency
which is very difficult at times.
 Let’s Sum Up

• A BOP accounts is a record of transactions of trade between citizens of a country

with foreign traders.

• BOP consists of the Capital account, current account and the official reserves
account.

• The BOP account balance should match with the transactions happening between
citizens of a country with foreigner citizens and any discrepancy to a head known
as “errors and omissions.” BOP follows double entry accounting principles.

• BOP account will have a surplus when the when the payments made by the
country are less than the payments received by it.

• BOP account will have a deficit when the when the payments made by the
country are more than the payments received by it.