Balance of Payments

Balance of Payments
Introduction: The Balance of Payments (BOP) is the single most important aspect of International economy that matters most in macroeconomic analysis. In this chapter, we will discuss: The meaning and purpose of BOP The accounting method of BOP The causes and kinds of disequilibrium in BOP The methods of correcting disequilibrium in BOP under free market system and policy regime.

1. 2. 3. 4.

The Balance of Payments: Meaning and Purpose

Meaning: The countries having economic transactions with other countries prepare periodically their final accounts with a view to taking stock of their foreign receipts and payment and also of their assets and liabilities that arise out of international transactions. This account is known as Balance of Payments (BOP). The BOP of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a period of time, usually one year. The BOP can also be defined as a systematic accounting of all economic transactions between the residents of a nation and the rest of the world during a period of time, usually one year.

The Balance of Payments Accounts

For preparing the BOP accounts, economic transactions between a country and the rest of the world are grouped under two categories 1. Current Transactions 2. Capital Transactions

Current Account
Transactions 1. 2. 3. 4. 5. 6. 7. 8. Merchandise Foreign Travel Transportation (shipping) Insurance Premium Banking Investment Income Government (Purchase and sale of Goods and Services) Miscellaneous Credit Export Earnings Earnings Receipts Receipts Receipts Receipts Receipts Debit Import Payments Payments Payments Payments Payments Payments Payments Net Bal. + or ---------

Current Account Balance: Surplus / Deficit

Balance of Trade (BOT): The net balance of the visible trade, that is, the difference between exports (X) and imports (M) of goods is called trade balance. If X>M, it shows trade surplus, and if M>X, it means trade deficit. The sum of the visible net and invisible net gives the balance on the current account is called current account balance. If sum of the entries in the credit column is greater than that of the debit column, it shows a current account surplus, and if sum of credit is less than that of the debit items. It shows a current account deficit. The current account balance (surplus or deficit) is transferred to the capital account.

Capital Account: The broad items of capital account are following: a. Short-term capital movements b. Long-term capital movements c. Inflow and Outflow of gold and foreign exchange reserves

a. Short-term capital movements include i. Purchase of short-term securities, for example, treasury bills, commercial bills and acceptance bills ii. Speculative purchase of foreign currency iii. Cash balance held by foreigners for such reasons as war, political uncertainty etc.

b. i. ii.

iii.

Long-term capital movements include Direct investment in shares, bonds, real estate or physical assets like plant, building and equipment in which the investor holds a controlling power. Portfolio investment, including all other stocks and bonds, eg, government securities, securities of firms which do not entitle the holder with a controlling power. Amortization of capital, i.e., repurchase and resale of securities sold to the foreigners. Direct import or export of capital goods fall under the category of foreign direct investment (FDI). It is important to note here that export of capital is a debit item because it causes outflow of foreign exchange, and import of capital is a credit item as it results in inflow of foreign exchange

c. Gold and Foreign Exchange Reserves are maintained to stabilize the exchange rate of the home currency and to make payments in case there is payment deficits on current accounts. The foreign exchange reserves increase or decrease depending on the net balances of other transactions.

Items of Transaction

1990-91 (Million US Dollar)

1995-96

2000-01

A. Current Account 1. Imports (c.i.f.) 2. Exports (f.o.b.) 3. Trade Balance 4. Invisibles a) Receipts b) Payments c) Net Receipts 5. Current Account Balance [3+4( c) ] B. Capital Account i) Foreign investment (Net) ii) Loans a) external assistance (net) b) Commercial borrowings (net) iii) Banking (net of receipts and payments) iv) Rupee debt service v) Other capital transactions (net) vi) Errors and Omissions

27,915 18,477 -9,438

43,670 32,311 -11,359

59,264 44,894 -14,370

7,464 7,706 -242 -9,680

17,676 12,216 5,460 -5,899

34,786 24,006 10,780 -3,590

103 2,204 3,329 682 -1,193 1,931 132 7,188 -2,492

4,604 867 1,334 762 -952 -2,537 600 4,678 -1,221

5,862 410 3,842 811 -617 -290 -588 10,018 5,856

6. Total Capital Account (I vi) 7. Overall Balance (5+6) 8. Monetary Transactions a) IMF Transactions (net= purchase repurchase) b) SDR Allocations c) Increase (+)/ Decrease (-) on reserves d) Total (a+ b+ c)

1,214 --1,278 2,492

-1,715 --2,936 1,221

-26 ---5,830 -5,856

Disequilibrium in Balance of Payments

Since BOP accounting follows double entry book-keeping system, the two sides of the BOP accounts are always in balance. Therefore, the BOP statements prepared on the principles of this accounting system shows that BOP is always in balance. Furthermore, a close look at the BOP accounts reveals that a deficit in the current account is offset either by a surplus on the capital account or by running down the gold and foreign exchange reserves.

Autonomous and Induced Transactions

a) Autonomous transactions, b) Induced transactions actions or accommodating capital flows. Autonomous transactions are those that are carried out on their own view to consuming more or making profit. The autonomous transactions take place on both current and capital accounts. On the current account, merchandise exports and imports of goods are autonomous transactions. If receipts from export of goods (Xg) and payments of import of goods (Mg) are always equal in value terms, there will be no other transactions.

But if Xg Mg, i.e. if Xg < Mg or Xg>Mg, it requires some balancing transactions. Balancing transactions are in the form of international borrowing or lending that lead to short-term capital inflows or outflows. This kind of international borrowing or lending are not made for their own sake, but for making payments for deficits in the balance of trade. Such transactions are called Induced or Accommodating transactions. The unrequited items like gifts, donations and aid are voluntary and are treated as Autonomous transactions.

On the capital account, exports and imports of long-term capital are Autonomous transactions. Also, the short-term flows motivated by a desire to invest abroad are autonomous transactions. On the other hand, short-term capital movements, for instance, gold and accommodating capital flows on account of the Autonomous transactions are Induced transactions. Such Induced transactions result in either rise or fail in gold and foreign exchange reserves of the country.

Assessment of BOP Disequilibrium

In the assessment of BOP position, only autonomous transactions are taken into account. If total receipts from and payments for autonomous transactions are equal, the BOP is in equilibrium. If total receipts from and payments for autonomous transactions are substantially unequal, it means BOP disequilibrium. If autonomous receipts. Are much greater than autonomous payments, it gives BOP disequilibrium of surplus nature and if foreign payments requirements exceed foreign receipts to a considerable extent, it gives BOP disequilibrium of deficit nature. A BOP disequilibrium of surplus nature results in increase in foreign exchange reserves. On the other hand, a BOP disequilibrium of deficit nature lead to sale of foreign assets, if any, or borrowing abroad which results in foreign indebtedness.

From BOP accounting point of view, one needs to look at the process of balancing the current and capital accounts. In case there is current account deficit, it has to be financed either by sale of foreign assets or by net borrowing, i.e. net capital inflow. Thus
Current account deficit = Net capital inflow

Note that the current account deficit is the result of autonomous transactions and the net capital inflow is induced transactions. As noted above, current account deficit (or surplus) has to be adjusted in the capital account. From an adjustment point of view, it is useful to divide capital account transition into two kind of two kind of transactions

 Autonomous Transaction, i.e., capital transactions carried out by the private sector. Official Transactions, i.e., transactions by the central bank. As shown above, a current account deficit can be financed by borrowing abroad. However, if foreign loans are not available, the central bank has to sell foreign currency to the private sector for making payment abroad. This runs down the foreign exchange reserves held by the central bank. The decrease in official foreign exchange reserves gives the measure of BOP deficit. Thus, BOP deficit = decrease in official foreign exchange reserves = current account deficit + net capital inflow

 Causes and Kinds of BOP Disequilibrium 1. Inflation and Fundamental Disequilibrium 2. Business Cycle and Cyclical Disequilibrium 3. Structural Changes and Structural Disequilibrium 4. Short-term Disequilibrium