BALANCE OF PAYMENTS

By Amina Momin

Introduction
All modem economies prepare and publish detailed statistics about their transactions with the rest of the world. A systematic accounting record of a country's economic transactions with the rest of the world forms a part of its National Accounts. It can also be looked upon as a record of all the factors, which create the demand for, and the supply of the country's currency. Definition: Balance of payments of a country is a systematic accounting record of all economic transactions during a given period of time between the residents of the country and residents of foreign countries. The phrase "residents of foreign countries" may often be replaced by "non-residents", "foreigners" or "rest of the world (ROW)".

The definition refers to economic transactions. By this we mean transfer of economic value from one economic agent (individual, business, government, etc.) to another. The transfer may be a requited transfer, that is, the transferee gives something of economic value to the transferor in return or an unrequited transfer, that is, a unilateral gift.

Introduction
The following basic types of economic transactions can be identified: 1. Purchase or sale of goods or services with a financial quid pro quo--or a promise to pay. One real and one financial transfer. 2. Purchase or sale of goods or services in return for goods or services or a barter transaction. Two real transfers. 3. An exchange of financial items, for instance, purchase of foreign securities with payment in cash or by a cheque drawn on a foreign deposit. Two financial transfers. 4. A unilateral gift in kind. One real transfer. 5. A unilateral financial gift. One financial transfer.

Clarification relates to the term "resident". This term certainly is not identical with the term "citizens" though there is normally a substantial overlap. As regards individuals, "residents" means those individuals whose general centre of interest can be said to rest in the given economy. They consume goods and services, participate in the productive process or otherwise carry out economic activity within the territory of the country on other than a temporary basis. As regards non-individuals, a set of conventions has been evolved. For example, governments and nonprofit bodies serving resident individuals are residents of the respective countries; for enterprises, the rules are somewhat complex particularly those concerning unincorporated branches of foreign multinationals. According to the IMF rules, these are considered to be residents of countries where they operate; though they are not a separate legal entity from the parent located abroad. International organisations like the UN, the World Bank, the IMF are not considered to be residents of any national economy even though their offices may be located within the territories of any number of countries.

ACCOUNTING PRINCIPLES IN BALANCE OF PAYMENTS

The BOP is a standard double-entry accounting record and as such is subject to all the rules of double entry book-keeping, viz. for every transaction two entries must be made, one credit (+) and one debit (-) and leaving aside errors and omissions, the total of credits must exactly match the total of debits, that is, the balance of payments must always "balance.

Some simple rules of thumb will enable the reader to understand (and remember) the application of the above accounting principles in the context of the BOP:
(a) All transactions which lead to an immediate or prospective payment from the rest of the world (ROW) to the country should be recorded as credit entries. The payments themselves, actual or prospective, should be recorded as the offsetting debit entries. Conversely, all transactions which result in an actual or prospective payment from the-country to the ROW should be recorded as debits and the corresponding payments as credits. Note carefully the obvious corollary of this rule; a payment received from the ROW increases the country's foreign assets--either the payment will be credited to a bank account held abroad by a resident entity or a claim is acquired on a foreign entity. Thus an increase in foreign assets (or a decrease in foreign liabilities) must appear as a debit entry. Conversely, a payment to the ROW, reduces the country's foreign assets or increases its liabilities owed to foreigners; a reduction in foreign assets or an increase in foreign liabilities must therefore appear as a credit entry. This may appear somewhat paradoxical but the second rule of thumb below will make it clear.

ACCOUNTING PRINCIPLES IN BALANCE OF PAYMENTS

Rule a: Inflow Credit Assets Decrease Liability Increase

Outflow

Debit

Assets Increase

Liability Decrease

Rule b:

Increase in Demand of FX Increase in Supply of FX

Debit Credit

ACCOUNTING PRINCIPLES IN BALANCE OF PAYMENTS

(b) A transaction which results in an increase in demand for foreign-exchange is to be recorded as a debit entry while a transaction which results in an increase in the supply of foreign exchange is to be recorded as a credit entry. Thus an increase in foreign assets or reduction in foreign liabilities because it uses up foreign exchange now, is a debit entry, while a reduction in foreign assets or an increase in foreign liabilities, because it is a source of foreign exchange now, is a credit entry. Capital outflow-such as when a resident purchases . foreign securities or pays off a foreign bank loan-is thus a debit entry while a capital inflow, such as a / disbursement of a World Bank loan-is a credit entry. We will look at a few simple examples to illustrate the application of these rules for the five 1 basic types of transactions identified above. 1. Country A exports goods worth 500 to country B. The goods have been invoiced in 'and will be paid for in country B's currency. Payment will be effected by crediting the bank account which country A exporter holds with a bank in country B. The balance in such an account is a foreign asset for country A and a foreign liability for country B. In country A's BOP this will be recorded as follows:
Increase in SS of FX Increase in Asset

In accordance with the thumb rule (a), exports appear as a credit entry in the current account (more accurately in the merchandise trade account) while the payment appears as a debit entry in the capital account- an increase in foreign assets, a use of foreign exchange hence a debit according to rule (b). Country B, will record its imports as a debit in its current account and the payment for them as a credit in its capital account--one of its bank's liabilities to foreigners has increased.

ACCOUNTING PRINCIPLES IN BALANCE OF PAYMENTS

2. Country A agrees to supply leather goods worth 300 to country B in return for crude oil worth 300 both valued in country B's currency. Country A's BOP will have the following entries:

Increase in SS of FX Increase in DD of FX

Country B's BOP will show identical entries except that A's exports will be B's imports and vice versa. 3. A bank in country A purchases securities issued by the Government of country B, valued at 200 in B's currency and pays for them by drawing on an account it has with its correspondent bank in country B. Here country A has exchanged one financial asset (the bank deposit) for another (the bonds). This will show up in its capital account as follows:

Increase in Asset Increase in SS of FX

Country B's BOP will show similar entries in its capital account

ACCOUNTING PRINCIPLES IN BALANCE OF PAYMENTS

4. Country A gifts medical supplies, blankets and so on, worth 150 to country B. This is shown as exports, a credit entry in the current account of country A; the contra entry, a debit, appears under "unrequited transfers" also in the current account. Country B would have a debit entry under merchandise trade and a credit entry under unrequited transfers both in its current account. The entries for A are:
Increase in SS of FX Corresponding Debit entry

5. A resident of country A makes a gift worth 50 in A's currency to a charitable organization in country B. The transfer is effected by crediting the recipient organization's account with a bank in country A. The entries would be as follows:
Corresponding Debit entry Increase in SS of FX

In country B's BOP, a credit entry will appear under unrequited transfers and a debit in the capital account since its foreign assets have increased.

VALUATION AND TIMING

In addition to the accounting conventions, two further considerations are important. One is the procedure adopted for valuation of goods and services and the other is the timing of recording a transaction.
Let us take the valuation problem first. Unless a uniform system of pricing is adopted for all transactions, a number of problems can arise. The credit and debit sides of a transaction, if not valued on the same basis, will not equal each other. Cross-country comparisons of balance of payments data would be meaningful only when a common system of pricing is used by all countries. The IMF recommends the use of "market prices" this being defined as the price paid by a "willing buyer" to a "willing seller", where the seller and the buyer are "independent parties" and the transaction is governed solely by commercial considerations. While this principle is adhered to wherever possible, in some cases departure is inevitable. Another aspect of valuation is the choice between f.0.b. and c.i.f. valuation.IMF recommends the former as the latter includes value of transportation and insurance in addition to the value of the goods. In India's BOP statistics, while exports are valued on f.0.b. basis, imports are at c.i.f. valuation. Still another difficulty concerns translation of foreign currency values into domestic currency. Theoretically, it should be done at the exchange rate prevailing at the time of the transaction. In practice, in most cases, for transactions during a particular month, the average exchange rate for the month is used. For reasons similar to those in case of valuation, a uniform system of timing of recording is also desirable. The two sides of transaction should be recorded in the same time period. Various conventions have been evolved for this purpose, for instance, exports are recorded when cleared by customs, imports when payment is made, and so forth.

COMPONENTS OF THE BALANCE OF PAYMENTS

The BOP is a collection of accounts conventionally grouped into three main categories with subdivisions in each. The three main categories are: (a) The Current Account: Under this are included imports and exports of goods and services and unilateral transfers of goods and services. (b) The Capital Account: Under this are grouped transactions leading to changes in foreign financial assets and liabilities of the country. (c) The Reserve Account: In principle this is no different from the capital account in as much as it also relates to financial assets and liabilities. However, in this category only "reserve assets" are included. These are the assets which the monetary authority of the country uses to settle the deficits and surpluses that arise on the other two categories take together.

The Current Account

The structure of the current account in India's BOP statement

The Current Account

The structure of the current account in India's BOP statement I. Merchandise: In principle, merchandise trade should cover all transactions relating to movable goods, with a few exceptions," where the ownership of goods changes from residents to non-residents (exports), and from non-residents to residents (imports). The valuation should be on f.0.b. basis so that international freight and insurance are treated as district services and not merged with the value of the goods themselves. Exports, valued on f.0.b. basis, are credit entries. Data for these items are obtained from the various forms exporters have to fill in and submit to designated authorities. Imports valued at c.i.f. are the debit entries. The difference between the total of credits and debits appears in the "Net" column. This is the Balance on Merchandise Trade Account, a deficit if negative and a surplus if positive. II. Lnvisibles: Conventionally, trade in physical goods is distinguished from trade in services. The invisibles account includes services such as transportation and insurance, income payments, and receipts for factor services-labour and capital-and unilateral transfers. Credits under invisibles consist of services rendered by residents to non-residents, income earned by residents from their ownership of foreign financial assets (interest, dividends), income earned from the use, by non-residents, of non-financial assets such as patents and copyrights owned by residents and the offset entries to the cash and gifts received in-kind by residents from non-residents. Debits consist of same items with the roles of residents and non-residents reversed. A few examples will be useful:

The Current Account

1. Receipts in foreign exchange, reported by authorized dealers in foreign exchange, remitted to them by organizers of foreign tourist parties located abroad for meeting hotel and other local expenses of the tourists. This will be a credit under "travel". 2. Freight charges paid to non-resident steamship or airline companies directly when imports are invoiced on f.0.b. basis by the foreign exporter will appear as debits under "transportation". 3. Premiums on all kinds of insurance and re-insurance provided by Indian insurance companies to nonresident clients is a credit entry under "insurance". 4. Profits remitted by the foreign branch of an Indian company to the parent represent a receipt of "investment income". It will be recorded as a credit under "investment income". Interest paid by a resident entity on a foreign borrowing will appear as a debit. 5. Funds received from a foreign government for the maintenance of their embassy, consulates and so on in India will constitute a credit entry under "government not included elsewhere".

6. Payment to a foreign resident employed by an Indian company will appear as a debit under "compensation to employees".
7. Revenue contributions by the Government of India to international institutions such as the UN, or a gift of commodities by the Government of India to non-residents will constitute a debit entry under "official transfers". Cash remittances for family maintenance from Indian nationals residing abroad will be a credit entry under "private transfers".

The Capital Account

The capital account in India's BOP is laid out

The Capital Account

The capital account consists of three major subgroups. The first relates to foreign equity investments in India either in the form of direct investments-for instance, Ford Motor Co. starting a car plant in India or portfolio investments such as purchase of Indian companies' stock by foreign institutional investors, or subscriptions by non-resident investors to GDR and ADR issues by Indian companies. The next group is loans. Under this are included concessional loans received by the government or public sector bodies, long and medium-term borrowings from the commercial capital market in the form of loans, bond issues and so forth, and short-term credits such as trade related credits. Disbursements received by Indian resident entities are credit items while repayments and loans made by Indians are debits. The third group separates out the changes in foreign assets and liabilities of the banking sector. An increase (decrease) in assets are debits (credits) while increase (decrease) in liabilities are credits (debits). Non-resident deposits with Indian banks are shown separately. The total capital account consists of these three major groups and two other minor items shown under "rupee debt service" and "other capital".

The Other Accounts

The remaining accounts in India's BOP

The IMF account contains, as mentioned above, purchases (credits) and repurchases (debits) from the IMF. The Foreign Exchange Reserves account records increases (debits), and decreases (credits) in reserve assets. Reserve assets consist of RBI's holdings of gold and foreign exchange (in the form of balances with foreign central banks and investments in foreign government securities) and holdings of SDRs. SDRs-Special Drawing Rights-are a reserve asset created by the IMF and allocated from time to time to member countries.' Within certain limitations it can be used to settle international payments between monetary authorities of member countries. An allocation is a credit while retirement is a debit.

BOP

MEANING OF "DEFICIT" AND "SURPLUS" IN THE BALANCE OF PAYMENTS

If the BOP is a double-entry accounting record, then apart from errors and omissions, it must always balance. Obviously, the terms "deficit" or "surplus" cannot then refer to the entire BOP but must indicate imbalance on a subset of accounts included in the BOP. The "imbalance" must be interpreted in some sense as an economic disequilibrium. Since the notion of disequilibrium is usually associated with a situation that calls for policy intervention of some sort, it is important to decide what is the optimal way of grouping the various accounts within the BOP so that an imbalance in one set of accounts will give the appropriate signals to policy makers.

In the language of an accountant we divide the entire BOP into a set of accounts "above the line" and another set "below the line". If the net balance (credits-debits) is positive above the line, we say that there is a "balance of payments surplus; if it is negative we say there is a "balance of payments deficit". The net balance below the line should be equal in magnitude and opposite in sign to the net balance above the line. The items below the line can be said to be of a "compensatory" nature-they "finance" or "settle" the imbalance above the line.
The critical question is how to make this division so that BOP statistics, in particular the deficit and surplus figures, will be economically meaningful. Suggestions made by economists and incorporated into the IMF guidelines emphasize the purpose or motive behind a transaction as the criterion to decide whether the transaction should go above or below the line. The principal distinction is between autonomous transactions and accommodating or compensatory transactions.

MEANING OF "DEFICIT" AND "SURPLUS" IN THE BALANCE OF PAYMENTS

An autonomous transaction is one undertaken for its own sake, in response to the given configuration of prices, exchange rates, interest rates and so on, usually in order to realize a profit or reduce costs. It does not take into account the situation elsewhere in the BOP. An accommodating transaction on the other hand is undertaken with the motive of settling the imbalance arising out of other transactions, for instance, financing the deficits arising out of autonomous transactions. All autonomous transactions should then be grouped together "above the line" and all accommodating transactions should go "below the line". The terms balance of payments deficit and balance of payments surplus will then be understood to mean deficit or surplus on all autonomous transactions taken together.

Such a distinction, while easy to propose in theory (and economically sensible) is difficult to implement in practice in some cases. For some transactions there is no difficulty in deciding the underlying motive, for instance, exports and imports of goods and services, private sector capital flows, migrant workers' remittances, unilateral gifts are all clearly autonomous transactions. Monetary authority's sales or purchases of foreign exchange in order to engineer certain movements in exchange rate is clearly an accommodating transaction. But consider the case of the government borrowing from the World Bank. It may use the proceeds to finance deficits on other transactions or to finance a public sector project or both. In the first case, it is an accommodating transaction; in the second case it is an autonomous transaction while in the third case it is a mixture of both.

MEANING OF "DEFICIT" AND "SURPLUS" IN THE BALANCE OF PAYMENTS

In practice, depending upon the context and purpose for which it is used, several concepts of "balance" have evolved. We will take a look at some of them. 1. Trade Balance: This is the balance on the merchandise trade account, that is, item I in the current account. 2. Balance on Goods and Services: This is the balance between exports and imports of goods and services. In terms of our presentation, it is the net balance on item I and sub-items 1-6 of item II taken together.

3. Current Account Balance: This is the net balance on the entire current account, items I+II. When this is negative we have a current account deficit, when positive, a current account surplus and when zero, a balanced current account.
4. Balance on Current Account and Long Term Capital: This is sometimes called basic balance. This is supposed to indicate long term trends in the BOP, the idea being that while short-term capital flows are highly volatile, long-term capital flows are of a more permanent nature, and indicative of the underlying strengths or weaknesses of the economy. "Errors and Omissions". While changes in reserve assets are accurately measured, recording of other items is subject to errors arising out of data inadequacy, discrepancies of valuation and timing, erroneous reporting and so on. These have to be reconciled by introducing a fictitious head of account called errors and omissions.

WHY ARE BOP STATISTICS IMPORTANT

Balance of Payments statistics (at least estimates of major items) are regularly compiled, published and are continuously monitored by companies, banks, and government agencies. the BOP statement contains useful information for financial decision matters. In the short-run, BOP deficits or surpluses may have an immediate impact on the exchange rate. Basically, BOP records all transactions that create demand for and supply of a currency. When exchange rates are market determined, BOP figures indicate excess demand or supply for the currency and the possible impact on the exchange rate. Further they may signal a policy shift on the part of the monetary authorities of the country, unilaterally or in concert with its trading partners. For instance, a country facing a current account deficit may raise interest rates to attract short-term capital inflow to prevent depreciation of its currency. Or it may otherwise tighten credit and money supply to make it difficult for domestic banks and firms to borrow the home currency to make investments abroad. It may force exporters to realize their export earnings quickly, and bring the foreign currency home. Movements in a country's reserves have implications for the stock of money and credit circulating in the economy. Central bank's purchases of foreign exchange in the market will add to the money supply and vice versa unless the central bank "sterilizes" the impact by compensatory actions such as open market sales or purchases. Countries suffering from chronic deficits may find their credit ratings being downgraded because the markets interpret the data as evidence that the country may have difficulties in servicing its debt. Finally, BOP accounts are connected with the overall saving-investment balance in a country's national accounts. Continuing deficits or surpluses may lead to fiscal and monetary actions designed to correct the imbalance, which in turn will affect exchange rates and interest rates in the country.

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