MACRO ECONOMICS PROJECT

BALANCE OF PAYMENTS

Submitted by :

Neeraj Sancheti, Akash Bharihoke, Rajat Sharma

Roll nos. 09/BBS0040 09/BBS0033 09/BBS0047

B.B.S. I semester

To :

Ms. Yogeita Mehra

Department of Business Studies

DEEN DAYAL UPADHYAYA COLLEGE

UNIVERSITY OF DELHI
 INDEX

1. Meaning of Balance Of Payments

a. Basic Definition

b. IMF Definition

2. The Balance of Payments Identity

3. Role of IMF

a. Why Problems occur?

b. How the IMF helps

4. Current Account

5. Capital Account

6. Balance of Trade

a. Definition

b. Physical BOT

7. Summary & Conclusion

8. Bibliography
MEANING OF BALANCE OF PAYMENTS

Balance of Payments is the difference between the money coming into a country and the
money leaving the same country. In economics, the balance of payments, (or BOP)
measures the payments that flow between any individual country and all other countries.
It is used to summarize all international economic transactions for that country during a
specific time period, usually a year. The BOP is determined by the country's exports and
imports of goods, services, and financial capital, as well as financial transfers. It reflects all
payments and liabilities to foreigners (debits) and all payments and obligations received
from foreigners (credits). Balance of payments is one of the major indicators of a country's
status in international trade, with net capital outflow.

The balance, like other accounting statements, is prepared in a single currency, usually the
domestic. Foreign assets and flows are valued at the exchange rate of the time of
transaction.

IMF definition
The International Monetary Fund (IMF) definition: "Balance of Payments is a statistical
statement that summarizes transactions between residents and nonresidents during a
period."

The balance of payments comprises the current account and the capital account (or the
financial account). "Together, these accounts balance in the sense that the sum of the
entries is conceptually zero."

 The current account consists of the goods and services account, the primary
income account and the secondary income account.
 The capital account is much smaller than the other two and consists primarily
of debt forgiveness and assets from migrants coming to or leaving the
country.
 The financial account consists of asset inflows and outflows, such as
international purchases of stocks, bonds and real estate.
 Balance of payments identity
The balance of payments identity states that:

Current Account = Capital Account + Financial Account + Statistical Discrepancy

This is a convention of double entry accounting, where all debit entries must be booked
along with corresponding credit entries such that the net of the Current Account will have a
corresponding net of the Capital and Financial Accounts:

where:

 X = exports
 M = imports
 Ki = capital inflows
 Ko = capital outflows

Rearranging, we have:

yielding the BOP identity.

The basic principle behind the identity is that a country can only consume more than it can
produce (a current account deficit) if it is supplied capital from abroad (a capital account
surplus).

Mercantile thought prefers a so-called balance of payments surplus where the net current
account is in surplus or, more specifically, a positive balance of trade.

A balance of payments equilibrium is defined as a condition where the sum of debits and
credits from the current account and the capital and financial accounts equal to zero; in
other words, equilibrium is where

This is a condition where there are no changes in Official Reserves. When there is no change
in Official Reserves, the balance of payments may also be stated as follows:

or:
Canada's Balance of Payments currently satisfies this criterion. It is the only large monetary
authority with no Changes in Reserves.

HOW THE IMF HELPS TO RESOLVE

BALANCE OF PAYMENTS DIFFICULTIES
Balance of payments difficulties can arise—and, in the worst case, build into crises—even in
the face of strong prevention efforts. The IMF assists countries in restoring economic
stability by helping to devise programs of corrective policies and providing loans to support
them.

Why do balance of payments problems occur?

Bad luck, inappropriate policies, or a combination of the two may create balance of
payments difficulties in a country—that is, a situation where sufficient financing on
affordable terms cannot be obtained to meet international payment obligations. In the
worst case, the difficulties can build into a crisis. The country's currency may be forced to
depreciate rapidly, making international goods and capital more expensive, and the
domestic economy may experience a painful disruption. These problems may also spread to
other countries.

The causes of such difficulties are often varied and complex. Key factors have included weak
domestic financial systems; large and persistent fiscal deficits; high levels of external and/or
public debt; exchange rates fixed at inappropriate levels; natural disasters; or armed
conflicts or a sudden and strong increase in the price of key commodities such as food and
fuel. Some of these factors can directly affect a country's trade account, reducing exports or
increasing imports. Others may reduce the financing available for international transactions;
for example, investors may lose confidence in a country's prospects leading to massive asset
sales, or "capital flight." In either case, diagnoses of, and responses to, crises are
complicated by linkages between various sectors of the economy. Imbalances in one sector
can quickly spread to other sectors, leading to widespread economic disruption.

How IMF lending helps

IMF lending aims to give countries breathing room to implement adjustment policies and
reforms that will restore conditions for strong and sustainable growth, employment, and
social investment. These policies will vary depending upon the country's circumstances,
including the causes of the problems. For instance, a country facing a sudden drop in the
price of a key export may simply need financial assistance to tide it over until prices recover
and to help ease the pain of an otherwise sudden and sharp adjustment. A country suffering
from capital flight needs to address the problems that led to the loss of investor confidence:
perhaps interest rates that are too low, a large government budget deficit and debt stock
that is growing too fast, or an inefficient, poorly regulated domestic banking system.

Before a member country can receive a loan, the country's authorities and the IMF must
agree on a program of economic policies. A country's commitments to undertake certain
policy actions are an integral part of IMF lending. They are designed to ensure that the funds
will be used to resolve balance of payments problems. They would also help to restore or
create access to support from other creditors and donors. A country's return to economic
and financial health allows the IMF to be repaid, making the funds available to other
members.

In the absence of IMF financing, the adjustment process for the country would be more
difficult. For example, if investors become unwilling to provide new financing, the country
has no choice but to adjust—often though a painful compression of imports and economic
activity. IMF financing can facilitate a more gradual and carefully considered adjustment.

IMF loan programs are tailored to the specific circumstances of individual countries. In
recent years, the largest number of loans has been made through the Poverty Reduction
and Growth Facility (PRGF), which provides funds at a concessional interest rate to low-
income countries to address protracted balance of payments problems. However, the
largest amount of funds is provided through Stand-By Arrangements (SBA), which charge
market-based interest rates on loans to assist with short-term balance of payments
problems. The IMF also provides other types of loans including emergency assistance to
countries that have experienced a natural disaster or are emerging from armed conflict.

Globalization has vastly increased the size of private capital flows relative to official flows
and IMF quotas, albeit unevenly so. Many emerging market countries currently see an
unmet need for insurance against large and volatile capital flows. In recent years, the IMF
has been re-examining its instruments that help prevent and respond to crises to ensure
they continue to meet emerging-market members’ needs. Low-income countries have
differing needs. Some require debt relief, and others concessional financing. Meanwhile,
some no longer need financing, but seek the reassurance of policy support and signaling.

Fast Facts on IMF Lending

(as of August 28, 2008)

Loanable funds $201.0 billion

Loans outstanding $18.3 billion to 65 countries

of which: concessional $6.3 billion to 57 countries

loans
 Current Account

In economics, the current account is one of the two primary components of the balance of
payments, the other being the capital account. It is the sum of the balance of trade (exports
minus imports of goods and services), net factor income (such as interest and dividends)
and net transfer payments (such as foreign aid).

current account = balance of trade + net factor income from abroad + net unilateral
transfers from abroad

The current account balance is one of two major measures of the nature of a country's
foreign trade (the other being the net capital outflow). A current account surplus increases a
country's net foreign assets by the corresponding amount, and a current account deficit
does the reverse. Both government and private payments are included in the calculation. It
is called the current account because goods and services are generally consumed in the
current period.

The balance of trade is the difference between a nation's exports of goods and services and
its imports of goods and services, if all financial transfers, investments and other
components are ignored. A nation is said to have a trade deficit if it is importing more than
it exports.

Positive net sales abroad generally contributes to a current account surplus; negative net
sales abroad generally contributes to a current account deficit. Because exports generate
positive net sales, and because the trade balance is typically the largest component of the
current account, a current account surplus is usually associated with positive net exports.
This however is not always the case with open economies such as that of Australia featuring
an income deficit larger than the CAD itself.

The net factor income or income account, a sub-account of the current account, is usually
presented under the headings income payments as outflows, and income receipts as inflows.
Income refers not only to the money received from investments made abroad (note:
investments are recorded in the capital account but income from investments is recorded in
the current account) but also to the money sent by individuals working abroad, known as
remittances, to their families back home. If the income account is negative, the country is
paying more than it is taking in interest, dividends, etc. For example, the United States' net
income has been declining exponentially since it has allowed the dollar's price relative to
other currencies to be determined by the market to a point where income payments and
receipts are roughly equal.

The difference between Canada's income payments and receipts have been declining
exponentially as well since its central bank in 1998 began its strict policy not to intervene in
the Canadian Dollar's foreign exchange. The various subcategories in the income account
are linked to specific respective subcategories in the capital account, as income is often
composed of factor payments from the ownership of capital (assets) or the negative capital
(debts) abroad. From the capital account, economists and central banks determine implied
rates of return on the different types of capital. The United States, for example, gleans a
substantially larger rate of return from foreign capital than foreigners do from owning
United States capital.

In the traditional accounting of balance of payments, the current account equals the change
in net foreign assets. A current account deficit implies a paralleled reduction of the net
foreign assets.

current account = changes in net foreign assets

Reducing current account deficits

Action to reduce a substantial current account deficit usually involves increasing exports
(goods coming out of a country and entering abroad countries) or decreasing imports
(goods coming from a foreign country into a country). This is generally accomplished directly
through import restrictions, quotas, or duties (though these may indirectly limit exports as
well), or subsidizing exports. Influencing the exchange rate to make exports cheaper for
foreign buyers will indirectly increase the balance of payments. This is primarily
accomplished by devaluing the domestic currency. Adjusting government spending to favor
domestic suppliers is also effective.

Less obvious but more effective methods to reduce a current account deficit include
measures that increase domestic savings (or reduced domestic borrowing), including a
reduction in borrowing by the national government.

The Pitchford thesis

It should be noted that a current account deficit is not always a problem. The Pitchford
Thesis states that a current account deficit does not matter if it is driven by the private
sector. Some feel that this theory has held true for the Australian economy, which has had a
persistent current account deficit, yet has experienced economic growth for the past 18
years (1991-2009). This has been attributed to persistent drawing on foreign investment
(Around 60% in the form of debt securities)generating a significant income deficit. Others
argue that Australia is accumulating a substantial foreign debt that could become
problematic, especially if interest rates increase. A deficit in the current account also implies
that the country is a net capital importer.

Interrelationships in the balance of payments

Absent changes in official reserves, the current account is the mirror image of the sum of
the capital and financial accounts. One might then ask: Is the current account driven by the
capital and financial accounts or is it vice versa? The traditional response is that the current
account is the main causal factor, with capital and financial accounts simply reflecting
financing of a deficit or investment of funds arising as a result of a surplus. However, more
recently some observers have suggested that the opposite causal relationship may be
important in some cases.
 Capital Account

In financial accounting, the capital account is one of the accounts in shareholders' equity.
Sole proprietorships have a single capital account in the owner's equity. Partnerships
maintain a capital account for each of the partners.

In Macroeconomics, the capital account is one of two primary components of the balance
of payments, the other being the current account. Whereas the current account reflects a
nations net income , the capital account reflects net change in ownership of assets.

The Capital account in Macroeconomics

At high level:

Breaking this down:

The International Finance Centre in Hong Kong. The Capital account records change in the
ownership of financial assets a nations and the rest of the world.

 Foreign direct investment (FDI) , refers to long term capital investment such as the
purchase or contruction of machinery, buildings or even whole manufacturing
plants. If foreigners are investing in a country, that is an inbound flow and counts as
a surplus item on the capital account. If a nations citizens are investing in foreign
countries, that's an outbound flow that will count as a deficit. After the initial
 investment, any yearly profits not re-invested will flow in the opposite direction, but
will be recorded in the current account rather than as capital.

 Portfolio investment refers to the purchase of shares and bonds. Its sometimes
grouped together with "other" as short term investment. As with FDI, the income
derived from these assets is recorded in the current account - the capital acount
entry will just be for any international buying and selling of the portfolio assets.

 Other investment includes capital flows into bank accounts or provided as loans.
Large short term flows between accounts in different nations are commonly seen
when the market is able to take advantage of fluctuations in interest rates and / or
the exchange rate between currencies. Sometimes this category can include the
reserve account.

 Reserve account. The reserve account is operated by a nations central bank, and can
be a source of large capital flows to counteract those originating from the market.
Inbound capital flows, especially when combined with a current account surplus, can
cause a rise in value ( appreciation ) of a nations currency - while outbound flows can
cause a fall in value ( depreciation ). If a government ( or if its independent the bank
itself) doesn't consider the market driven change to its currency value is in the
nations interests', the bank can intervene.

Central Bank operations and the Reserve account

A nation's ability to prevent its own currency falling in value is limited by the size of its
foreign reserves; it needs to use the reserves to buy back its currency. Conversely, there are
no immediate limits preventing a nation from keeping its currency from appreciating - as it
just needs to sell its own currency, and can always prints more in order to do this - however
this can cause inflation if additional mitigation measures arent implemented and can lead to
political pressure from other countries if they consider the nation is making its exports
excessively competitive.

For example, in the 20th century Great Britains central bank, the Bank of England, would
sometimes use her reserves to buy large amounts of pound Stirling to prevent her currency
falling in value - Black Wednesday was a case where she had insufficient reserves of foreign
currency to do this successfully. Conversely, China in the early 21st century has effectively
sold large amounts of Reminbi in order to prevent its value rising - and in the process
building large reserves of foreign currency, principally the dollar.

Sometimes the reserve account is classed as "below the line" and so not reported as part of
the capital account. Flows to or from the reserve account can substantially affect the overall
capital account. Taking again the example of China in the early 21st century, then excluding
the activity of her central bank, China's capital account had a large surplus as she had been
the recipient of much foreign investment. If the reserve account is included however,
China's capital account was been in large deficit as her central bank purchased large
amounts of foreign assets (chiefly US government bonds) to a degree sufficient to offset not
just the rest of the capital account, but her large current account surplus as well.

Sterilization
In the financial literature, a term commonly used to refer to a central banks operations
which mitigates the two potentially undesirable effects of inbound capital (currency
appreciation and inflation) is sterilization. Depending on the source, sterilization can mean
the relatively straight forward re-cycling of inbound capital to prevent currency appreciation
and / or a wide range of measures to check the inflationary impact of inbound capital. The
classic way to sterilize the inflationary effect of the extra money flowing into the domestic
base from the capital account is for the central bank to use Open market operations where
it sells bonds domestically, which soaks up cash that would otherwise circulate around the
home economy. However this can be inefficient if it causes interest rates to rise and hence
encourages even more inbound flows. A variety of other measures are sometimes used. A
central bank normally makes a small loss from its overall sterilisation operations, as the
interest it earns from buying foreign assetts to prevent appreciation is usually less than what
it has to pay out on the bonds it issues domestically to check inflation. However in rare cases
a profit can be made.

The IMF definition

The above definition is the one most widely used in economic literature, in the financial
press, by corporate and government analysts (except when they are reporting to the IMF)
and by the World Bank. In contrast, what the rest of the world calls the capital account is
labelled the Financial account by the IMF , by the OECD , and by the United Nations' SNA. In
the IMF definition , the capital account represents a small sub set of what the standard
definition designates the capital account, largely comprising transfers. Transfers are one
way flows, such as gifts, as opposed to commercial exchanges (i.e. buying/selling and
barter).

The biggest transfers between nations is typically foreign aid, however that is mostly
recorded in the current account. An exception is debt forgiveness, as that in a sense is the
transfer of ownership of an asset. When a country receives significant debt forgiveness it
will typically comprise the bulk of its overall IMF capital account entry for that year.

The IMF's capital account does include some non transfer flows, which are sales involving
non-financial and non-produced assets - e.g. natural resources like land, leases & licenses,
and marketing assets such as brands - however the sums involved here are typically very
small as most movement in these items occurs when both seller and buyer are of the same
nationality.

Transfers apart from debt forgiveness recorded in IMF's Capital account include the transfer
of goods and financial assets by migrants leaving or entering a country, the transfer of
ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed
assets, gift and inheritance taxes, death levies, and uninsured damage to fixed asset. In a
non IMF representation, these items might be grouped in the other sub total of the capital
account. They typically sum to a very small amount in comparison to loans and flows into
and out of short term bank accounts.
Capital Controls
Capital controls are imposed by a state's government and can include outright prohibitions
against some or all capital account transactions, transaction taxes on the international sale
of specific financial assets, or caps on the size of certain international transaction. While
usually aimed at the financial sector, controls can affect ordinary citizens, for example in the
1960s British families were at one point restricted from taking more than £50 with them out
of the country for their foreign holidays. Countries without capital controls are said to have
full Capital Account Convertibility.

At the close of World War II an agreement, The Bretton Woods agreement was established
according to which, most nations put in place capital controls to prevent large flows either
into or out of their capital account. This included even developing nations; in basic theory it
may be supposed that large inbound investments will speed a nations development, but
empirical evidence suggests this does not reliablly occur, and in fact large capital inflows can
hurt a nations economic development by causing its currency to appreciate, by contributing
to financial crisis and by the associated capital flight after the crises occurs.

As part of the displacement of Keynesianism in favour of free market orientated policies,

countries began abolishing their capital controls, starting with the US in 1974 and Great
Britain in 1979. Most other advanced and emerging economies followed, chiefly in the
1980s and early 1990s.

An exception to this trend was Malaysia, which in 1998 imposed capital controls in the wake
of the 1997 Asian Financial Crisis. While most Asian economies didn't impose controls, after
the 1997 crises they ceased to be net importers of capital and became net exporters
instead. Large inbound flows were directed "uphill" from emerging economies to the US and
other developed nations. According to economist C. Fred Bergsten the large inbound flow
into the US was one of the causes of the financial crisis of 2007-2008. By the second half of
2009, low interest rates and other aspects of the government led response to the global
crises have resulted in increased movement of Capital back towards emerging economies. In
November 2009 the Financial Times reported several emerging economies such as Brazil
and India have began to implement or at least signal the possible adoption of capital
controls to reduce the flow of foreign capital into their economies.
 Balance Of Trade

The balance of trade (or net exports, sometimes symbolized as NX) is the difference
between the monetary value of exports and imports of output in an economy over a certain
period. It is the relationship between a nation's imports and exports. A favourable balance
of trade is known as a trade surplus and consists of exporting more than is imported; an
unfavourable balance of trade is known as a trade deficit or, informally, a trade gap. The
balance of trade is sometimes divided into a goods and a services balance.

Primitive understanding of the functioning of balance of trade informed the economic

policies of Early Modern Europe that are grouped under the heading mercantilism. An early
statement appeared in Discourse of the Common Weal of this Realm of England, 1549: "We
must always take heed that we buy no more from strangers than we sell them, for so should
we impoverish ourselves and enrich them."

Definition
The balance of trade form part of the current account, which include other transactions
such as income from the international investment position as well as international aid. If the
current account is in surplus, the country's net international asset position increases
correspondingly. Equally, a deficit decrease the net international asset position.

The trade balance is identical to the difference between a country's output and its domestic
demand (the difference between what goods a country produces and how many goods it
buys from abroad; this does not include money re-spent on foreign stock, nor does it factor
the concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and
collecting data. As an illustration of this problem, when official data for all the world's
countries are added up, exports exceed imports by a few percent; it appears the world is
running a positive balance of trade with itself. This cannot be true, because all transactions
involve an equal credit or debit in the account of each nation. The discrepancy is widely
believed to be explained by transactions intended to launder money or evade taxes,
smuggling and other visibility problems. However, especially for developed countries,
accuracy is likely.

Factors that can affect the balance of trade include:

 The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting
economy vis-à-vis those in the importing economy;
 The cost and availability of raw materials, intermediate goods and other inputs;
 Exchange rate movements;
 Multilateral, bilateral and unilateral taxes or restrictions on trade;
 Non-tariff barriers such as environmental, health or safety standards;
 The availability of adequate foreign exchange with which to pay for imports; and
 Prices of goods manufactured at home (influenced by the responsiveness of supply)
In addition, the trade balance is likely to differ across the business cycle. In export led
growth (such as oil and early industrial goods), the balance of trade will improve during an
economic expansion. However, with domestic demand led growth (as in the United States
and Australia) the trade balance will worsen at the same stage in the business cycle.

Since the mid 1980s, United States has had a growing deficit in tradeable goods, especially
with Asian nations (China and Japan) which now hold large sums of U.S debt that has funded
the consumption. The U.S. has a trade surplus with nations such as Australia and Canada.
The issue of trade deficits can be complex. Trade deficits generated in tradeable goods such
as manufactured goods or software may impact domestic employment to different degrees
than trade deficits in raw materials.

Economies such as Canada, Japan, and Germany which have savings surpluses, typically run
trade surpluses. China, a high growth economy, has tended to run trade surpluses. A higher
savings rate generally corresponds to a trade surplus. Correspondingly, the United States
with its lower savings rate has tended to run high trade deficits, especially with Asian
nations.

Physical balance of trade

Monetary balance of trade is different from physical balance of trade (which is expressed in
amount of raw materials). Developed countries usually import a lot of primary raw materials
from developing countries at low prices. Often, these materials are then converted into
finished products, and a significant amount of value is added. Although for instance the EU
(as well as many other developed countries) has a balanced monetary balance of trade, its
physical trade balance (especially with developing countries) is negative, meaning that a lot
less material is exported than imported.
 SUMMARY & CONCLUSION

The Balance Of Payments is an important statistical statement which gives the difference
between money coming in and leaving the country.

Why do balance of payments problems occur?

The causes of such difficulties are often varied and complex. Key factors have included :

 weak domestic financial systems

 large and persistent fiscal deficits
 high levels of external and/or public debt
 exchange rates fixed at inappropriate levels

How IMF lending helps

IMF lending aims to give countries breathing room to implement adjustment policies and
reforms that will restore conditions for strong and sustainable growth, employment, and
social investment. These policies will vary depending upon the country's circumstances,
including the causes of the problems.

BOP CONSISTS OF :

 CURRENT ACCOUNT
 CAPITAL ACCOUNT

CURRENT ACCOUNT : It is one of the major components of Balance Of Payments.

Current Account = Balance Of Trade + Net Factor Income From Abroad + Net Unilateral
Transfers From Abroad

CAPITAL ACCOUNT : It indicates the net change in ownership of assets.

Capital Account = Foreign Direct Investment + Portfolio Investment + Other Investment +

Reserve Account

BALANCE OF TRADE : The balance of trade (or net exports, sometimes symbolized as NX) is
the difference between the monetary value of exports and imports of output in an economy
over a certain period.
 BIBLIOGRAPHY

1. www.imf.org/external/np/exr/facts/crises.htm

2. en.wikipedia.org/wiki/Balance_of_payments

3. www.investopedia.com/terms/b/bop.asp

4. www.rbi.org.in/scripts/SDDS_ViewDetails.aspx?ID=5

5. http://en.wikipedia.org/wiki/IMF_Balance_of_Payments_Manual