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BALANCE OF PAYMENTS The balance of payments of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world. It presents a classified record of all receipts on account of goods exported, services rendered and capital received by residents and payments made by theme on account of goods imported and services received from the capital transferred to non-residents or foreigners. - Reserve Bank of India The above definition can be summed up as following: - Balance of Payments is the summary of all the transactions between the residents of one country and rest of the world for a given period of time, usually one year. The definition given by RBI needs to be clarified further for the following points: A. Economic Transactions An economic transaction is an exchange of value, typically an act in which there is transfer of title to an economic good the rendering of an economic service, or the transfer of title to assets from one economic agent (individual, business, government, etc) to another. An international economic transaction evidently involves such transfer of title or rendering of service from residents of one country to another. Such a transfer may be a requited transfer (the transferee gives something of an economic value to the transferor in return) or an unrequited transfer (a unilateral
gift). The following are the basic types of economic transactions that can be easily identified: 1. Purchase or sale of goods or services with a financial quid pro quo – cash 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 e.g. – 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]. B. Resident The term resident is not identical with “citizen” though normally there is a substantial overlap. As regards individuals, residents are those individuals whose general centre of interest can be said to rest in the given economy. They consume goods and services; participate in economic activity within the territory of the country on other than temporary basis. This definition may turnout to be ambiguous in some cases. The “Balance of Payments Manual” published by the “International Monetary Fund” provides a set of rules to resolve such ambiguities. As regards non-individuals, a set of conventions have been evolved. E.g. – government and non profit bodies serving resident individuals are residents of respective countries, for enterprises, the rules are somewhat complex, particularly to those concerning unincorporated branches of foreign multinationals. According to IMF rules these are considered to be residents of countries in which they operate, although they are not a separate legal entity from the parent located abroad. International organisations like the UN, the World Bank, and the IMF are not considered to be residents of any national economy although their offices are located within the territories of any number of countries.
To certain economists, the term BOP seems to be somewhat obscure. Yeager, for example, draws attention to the word ‘payments’ in the term BOP; this gives a false impression that the set of BOP accounts records items that involve only payments. The truth is that the BOP statements records both payments and receipts by a country. It is, as Yeager says, more appropriate to regard the BOP as a “balance of international transactions” by a country. Similarly the word ‘balance’ in the term BOP does not imply that a situation of comfortable equilibrium; it means that it is a balance sheet of receipts and payments having an accounting balance. Like other accounts, the BOP records each transaction as either a plus or a minus. The general rule in BOP accounting is the following:a) If a transaction earns foreign currency for the nation, it is a credit and is recorded as a plus item. b) If a transaction involves spending of foreign currency it is a debit and is recorded as a negative item. The BOP is a double entry accounting statement based on rules of debit and credit similar to those of business accounting & book-keeping, since it records both transactions and the money flows associated with those transactions. Also in case of statistical discrepancy the difference amount is adjusted with errors and omissions account and thus in accounting sense the BOP statement always balances. The various components of a BOP statement are: A. B. C. D. E. F. Current Account Capital Account IMF SDR Allocation Errors & Omissions Reserves and Monetary Gold
BALANCE OF TRADE
Balance of trade may be defined as the difference between the value of goods and services sold to foreigners by the residents and firms of the home country and the value of goods and services purchased by them from foreigners. In other words, the difference between the value of goods and services exported and imported by a country is the measure of balance of trade. If two sums (1) value of exports of goods and services and (2) value of imports of goods and services are exactly equal to each other, we say that there is balance of trade equilibrium or balance; if the former exceeds the latter, we say that there is a balance of trade surplus; and if the later exceeds the former, then we describe the situation as one of balance of trade deficit. Surplus is regarded as favourable while deficit is regarded as unfavourable. The above mentioned definition has been given by James. E. Meade – a Nobel Prize British Economist. However, some economists define balance of trade as a difference between the value of merchandise (goods) exports and the value of merchandise imports, making it the same as the ‘Goods Balance” or the “Balance of Merchandise Trade”. There is n doubt that the balance of merchandise trade is of great significance to exporting countries, but still the BOT as defined by J. E. Meade has greater significance. Regardless of which idea is adopted, one thing is certain i.e. that balance of trade is a national injection and hence it is appropriate to regard an active balance (an excess of credits over debits) as a desirable state of affairs. Should this then be taken to imply that a passive trade balance (an excess of debits over credits) is necessarily a sign of undesirable state of affairs in a country? The answer is “no”. Because, take for example, the case of a developing country, which might be importing vast quantities of capital goods and technology to build a strong agricultural or industrial base. Such a country in the course of doing that might be forced to
experience passive or adverse balance of trade and such a situation of passive balance of trade cannot be described as one of undesirable state of affairs. This would therefore again suggest that before drawing meaningful inferences as to whether passive trade balances of a country are desirable or undesirable, we must also know the composition of imports which are causing the conditions of adverse trade balance.
BALANCE OF CURRENT ACCOUNT BOP on current account refers to the inclusion of three balances of namely – Merchandise balance, Services balance and Unilateral Transfer balance. In other words it reflects the net flow of goods, services and unilateral transfers (gifts). The net value of the balances of visible trade and of invisible trade and of unilateral transfers defines the balance on current account. BOP on current account is also referred to as Net Foreign Investment because the sum represents the contribution of Foreign Trade to GNP. Thus the BOP on current account includes imports and exports of merchandise (trade balances), military transactions and service transactions (invisibles). The service account includes investment income (interests and dividends), tourism, financial charges (banking and insurances) and transportation expenses (shipping and air travel). Unilateral transfers include pensions, remittances and other transfers for which no specific services are rendered. It is also worth remembering that BOP on current account covers all the receipts on account of earnings (or opposed to borrowings) and all the payments arising out of spending (as opposed to lending). There is no reverse flow entailed in the BOP on current account transactions.
BASIC BALANCE The basic balance was regarded as the best indicator of the economy’s position vis-à-vis other countries in the 1950’s and the 1960’s. It is defined as the sum of the BOP on current account and the net balance on long term capital, which were considered as the most stable elements in the balance of payments. A worsening of the basic balance [an increase in a deficit or a reduction in a surplus or even a move from the surplus to deficit] was seen as an indication of deterioration in the [relative] state of the economy. The short term capital account balance is not included in the basic balance. This is perhaps for two main reasons: a) Short term capital movements unlike long term capital movements are relatively volatile and unpredictable. They move in and out of the country in a period of less than a year or even sooner than that. It would therefore be improper to treat short term capital movements on the same footing as current account BOP transactions which are extremely durable in nature. Long term capital flows are relatively more durable and therefore they qualify to be treated along side the current account transactions to constitute basic balance. b) In many cases, countries don’t have a separate short term capital account as they constitute a part of the “Errors and Omissions Account.” A deficit on the basic balance could come about in various ways, which are not mutually equivalent. E.g. suppose that the basic balance is in deficit because a current account deficit is accompanied by a deficit on the long term capital account. The long term capital outflow will, in the future, generate profits, dividends and interest payments which will improve the current account and so, ceteris paribus, will reduce or perhaps reduce the deficit. On the other hand, a basic balance surplus consisting of a deficit on current account that is more than covered by long term borrowings from abroad may lead to problems in future, when profits, dividends etc are paid to foreign investors.
THE OFFICIAL SETTLEMENT CONCEPT An alternative approach for indicating, a deficit or surplus in the BOP is to consider the net monetary transfer that has been made by the monetary authorities is positive or negative, which is the so called – settlement concept. If the net transfer is negative (i.e. there is an outflow) then the BOP is said to be in deficit, but if there is an inflow then it is surplus. The basic premise is that the monetary authorities are the ultimate financers of any deficit in the balance of payments (or the recipients of any surplus). These official settlements are thus seemed as the accommodating item, all other being autonomous. The monetary authorities may finance a deficit by depleting their reserves of foreign currencies, by borrowing from the IMF or by borrowing from other foreign monetary authorities. The later source is of particular importance when other monetary authorities hold the domestic currency as a part of their own reserves. A country whose currency is used as a reserve currency (such as the dollars of US) may be able to run a deficit in its balance of payments without either depleting its own reserves or borrowing from the IMF since the foreign authorities might be ready to purchase that currency and add it to its own reserves. The settlements approach is more relevant under a system of pegged exchange rates than when the exchange rates are floating. THE CAPITAL ACCOUNT The capital account records all international transactions that involve a resident of the country concerned changing either his assets with or his liabilities to a resident of another country. Transactions in the capital account reflect a change in a stock – either assets or liabilities.
It is often useful to make distinctions between various forms of capital account transactions. The basic distinctions are between private and official transactions, between portfolio and direct investment and by the term of the investment (i.e. short or long term). The distinction between private and official transaction is fairly transparent, and need not concern us too much, except for noting that the bulk of foreign investment is private. Direct investment is the act of purchasing an asset and the same time acquiring control of it (other than the ability to re-sell it). The acquisition of a firm resident in one country by a firm resident in another is an example of such a transaction, as is the transfer of funds from the ‘parent company in order that the ‘subsidiary’ company may itself acquire assets in its own country. Such business transactions form the major part of private direct investment in other countries, multinational corporations being especially important. There are of course some examples of such transactions by individuals, the most obvious being the purchase of the ‘second home’ in another country. Portfolio investment by contrast is the acquisition of an asset that does not give the purchaser control. An obvious example is the purchase of shares in a foreign company or of bonds issued by a foreign government. Loans made to foreign firms or governments come into the same broad category. Such portfolio investment is often distinguished by the period of the loan (short, medium or long are conventional distinctions, although in many cases only the short and long categories are used). The distinction between short term and long term investment is often confusing, but usually relates to the specification of the asset rather than to the length of time of which it is held. For example, a firm or individual that holds a bank account with another country and increases its balance in that account will be engaging in short term investment, even if its intention is to keep that money in that account for many years. On the other hand, an individual buying a long term government bond in another country will be
making a long term investment, even if that bond has only one month to go before the maturity. Portfolio investments may also be identified as either private or official, according to the sector from which they originate. The purchase of an asset in another country, whether it is direct or portfolio investment, would appear as a negative item in the capital account for the purchasing firm’s country, and as a positive item in the capital account for the other country. That capital outflows appear as a negative item in a country’s balance of payments, and capital inflows as positive items, often causes confusions. One way of avoiding this is to consider that direction in which the payment would go (if made directly). The purchase of a foreign asset would then involve the transfer of money to the foreign country, as would the purchase of an (imported) good, and so must appear as a negative item in the balance of payments of the purchaser’s country (and as a positive item in the accounts of the seller’s country). The net value of the balances of direct and portfolio investment defines the balance on capital account.
ACCOMMODATING & AUTONOMOUS CAPITAL FLOWS Economists have often found it useful to distinguish between autonomous and accommodating capital flows in the BOP. Transactions are said to Autonomous if their value is determined independently of the BOP. Accommodating capital flows on the other hand are determined by the net consequences of the autonomous items. An autonomous transaction is one undertaken for its own sake in response to the given configuration of prices, exchange rates, interest rates etc, usually in order to realise a profit or reduced 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. An alternative nomenclature is that capital flows are ‘above
the line’ (autonomous) or ‘below the line’ (accommodating). Obviously the sum of the accommodating and autonomous items must be zero, since all entries in the BOP account must come under one of the two headings. Whether the BOP is in surplus or deficit depends on the balance of the autonomous items. The BOP is said to be in surplus if autonomous receipts are greater than the autonomous payments and in deficit if vice – a – versa. Essentially the distinction between both the capital flow lies in the motives underlying a transaction, which are almost impossible to determine. We cannot attach the labels to particular groups of items in the BOP accounts without giving the matter some thought. For example a short term capital movement could be a reaction to difference in interest rates between two countries. If those interest rates are largely determined by influences other than the BOP, then such a transaction should be labelled as autonomous. Other short term capital movements may occur as a part of the financing of a transaction that is itself autonomous (say, the export of some good), and as such should be classified as accommodating. There is nevertheless a great temptation to assign the labels
‘autonomous’ and ‘accommodating’ to groups of item in the BOP. i.e. to assume, that the great majority of trade in goods and of long term capital movements are autonomous, and that most short term capital movements are accommodating, so that we shall not go far wrong by assigning those labels to the various components of the BOP accounts. Whether that is a reasonable approximation to the truth may depend in part on the policy regime that is in operation. For example what is an autonomous item under a system of fixed exchange rates and limited capital mobility may not be autonomous when the exchange rates are floating and capital may move freely between countries.
BALANCE OF INVISIBLE TRADE
Just as a country exports goods and imports goods a country also exports and imports what are called as services (invisibles). The service account records all the service exported and imported by a country in a year. Unlike goods which are tangible or visible services are intangible. Accordingly services transactions are regarded as invisible items in the BOP. They are invisible in the sense that service receipts and payments are not recorded at the port of entry or exit as in the case with the merchandise imports and exports receipts. Except for this there is no meaningful difference between goods and services receipts and payments. Both constitute earning and spending of foreign exchange. Goods and services accounts together constitute the largest and economically the most significant components in the BOP of any country. The service transactions take various forms. They basically include 1) transportation, banking, and insurance receipts and payments from and to the foreign countries, 2) tourism, travel services and tourist purchases of goods and services received from foreign visitors to home country and paid out in foreign countries by home country citizens, 3) expenses of students studying abroad and receipts from foreign students studying in the home country, 4) expenses of diplomatic and military personnel stationed overseas as well as the receipts from similar personnel who are stationed in the home country and 5) interest, profits, dividends and royalties received from foreign countries and paid out to foreign countries. These items are generally termed as investment income or receipts and payments arising out of what are called as capital services. “Balance of Invisible Trade” is a sum of all invisible service receipts and payments in which the sum could be positive or negative or zero. A positive sum is regarded as favourable to a country and a negative sum is considered as unfavourable. The terms are descriptive as well as prescriptive.
BALANCE OF VISIBLE TRADE
Balance of visible trade is also known as balance of merchandise trade, and it covers all transactions related to movable goods 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.O.B basis so that international freight and insurance are treated as distinct services and not merged with the value of goods themselves. Exports valued on F.O.B basis are the credit entries. Data for these items are obtained from the various forms that the exporters have fill and submit to the designated authorities. Imports valued at C.I.F are the debit entries. Valuation at C.I.F. though inappropriate, is a forced choice due to data inadequacies. The difference between the total of debits and credits appears in the “Net” column. This is the ‘Balance of Visible Trade.’ In visible trade if the receipts from exports of goods happen to be equal to the payments for the imports of goods, we describe the situation as one of zero “goods balance.’ Otherwise there would be either a positive or negative goods balance, depending on whether we have receipts exceeding (negative). payments (positive) or payments exceeding receipts
ERRORS AND OMISSIONS Errors and omissions is a “statistical residue.” It is used to balance the statement because in practice it is not possible to have complete and accurate data for reported items and because these cannot, therefore, ordinarily have equal entries for debits and credits. The entry for net errors and omissions often reflects unreported flows of private capital, although the conclusions that can be drawn from them vary a great deal from country to country, and even in the same country from time to time, depending on the reliability of the reported information. Developing countries, in particular, usually experience great difficulty in providing reliable information.
Errors and omissions (or the balancing item) reflect the difficulties involved in recording accurately, if at all, a wide variety of transactions that occur within a given period of (usually 12 months). In some cases there is such large number of transactions that a sample is taken rather than recording each transaction, with the inevitable errors that occur when samples are used. In others problems may arise when one or other of the parts of a transaction takes more than one year: for example wit a large export contract covering several years some payment may be received by the exporter before any deliveries are made, but the last payment will not made until the contract has been completed. Dishonesty may also play a part, as when goods are smuggled, in which case the merchandise side of the transaction is unreported although payment will be made somehow and will be reflected somewhere in the accounts. Similarly the desire to avoid taxes may lead to under-reporting of some items in order to reduce tax liabilities. Finally, there are changes in the reserves of the country whose balance of payments we are considering, and changes in that part of the reserves of other countries that is held in the country concerned. Reserves are held in three forms: in foreign currency, usually but always the US dollar, as gold, and as Special Deposit Receipts (SDR’s) borrowed from the IMF. Note that reserves do not have to be held within the country. Indeed most countries hold a proportion of their reserves in accounts with foreign central banks. The changes in the country’s reserves must of course reflect the net value of all the other recorded items in the balance of payments. These changes will of course be recorded accurately, and it is the discrepancy between the changes in reserves and the net value of the other record items that allows us to identify the errors and omissions.
Unilateral transfers or ‘unrequited receipts’, are receipts which the residents of a country receive ‘for free’, without having to make any present or future payments in return. Receipts from abroad are entered as positive items, payments abroad as negative items. Thus the unilateral transfer account includes all gifts, grants and reparation receipts and payments to foreign countries. Unilateral transfer consist of two types of transfers: (a) government transfers (b) private transfers. Foreign economic aid or assistance and foreign military aid or assistance received by the home country’s government (or given by the home government to foreign governments) constitutes government to government transfers. The United States foreign aid to India, for BOP 9but a debit item in the US BOP). These are government to government donations or gifts. There no well worked out theory to explain the behaviour of this account because these flows depend upon political and institutional factors. The government donations (or aid or assistance) given to government of other countries is mixed bag given for either economic or political or humanitarian reasons. Private transfers, on the other hand, are funds received from or remitted to foreign countries on person –to –person basis. A Malaysian settled in the United States remitting $100 a month to his aged parents in Malaysia is a unilateral transfer inflow item in the Malaysian BOP. An American pensioner who is settled after retirement in say Italy and who is receiving monthly pension from America is also a private unilateral transfer causing a debit flow in the American BOP but a credit flow in the Italian BOP. Countries that attract retired people from other nations may therefore expect to receive an influx of foreign receipts in the form of pension payments. And countries which render foreign economic assistance on a massive scale can expect huge deficits in their unilateral transfer account. Unilateral transfer receipts and payments are also called unrequited transfers because as the name itself suggests the flow is only in one direction with no automatic reverse flow in the other direction. There is no repayment obligation attached to these transfers because they are not borrowings
and lending’s but gifts and grants exchanged between government and people in one country with the governments and peoples in the rest of the world.
ILLUSTRATE THE ITEMS WHICH FALL UNDER CAPITAL ACCOUNT AND CURRENT ACCOUNT WITH EXAMPLES. Credits Debits Current Account Current Account 1. Merchandise Exports (Sale of 1. Merchandise Imports (purchase Goods) of Goods) 2. Invisible Exports (Sale of 2. Invisible Imports (Purchase of Services) Services) a. Transport services sold abroad a. Transport services purchased from abroad b. Insurance services sold b. Insurance services purchased abroad c. Foreign tourist expenditure in c. Tourist expenditure abroad country d. Other services sold abroad d. Other services purchased from abroad e. Incomes received on loans e. Income paid on loans and and investments abroad. investments in the home country. 3. Unilateral Transfers 3. Unilateral Transfers a. Private remittances received a. Private remittances abroad from abroad b. Pension payments received b. Pension payments abroad from abroad c. Government grants received c. Government grants abroad. from abroad Capital Account Capital Account 3. Foreign long-term investments in 3. Long-term investments abroad the home country (less (less redemptions and redemptions and repayments) repayments) a. Direct investments in the a. Direct Investments abroad home country b. Foreign investments in b. Investments in foreign domestic securities securities c. Other investments of c. Other investments abroad foreigners in the home country d. Foreign Governments’ loans d. Government loans to foreign to the home country. countries 4. Foreign short-term investments 4. Short-term investments abroad.
in the home country.
CAPITAL ACCOUNT CONVERTIBILITY (CAC) While there is no formal definition of Capital Account Convertibility, the committee under the chairmanship of S.S. Tarapore has recommended a pragmatic working definition of CAC. Accordingly CAC refers to the freedom to convert local financial assets into foreign financial assets and vice – a – versa at market determined rates of exchange. It is associated with changes of ownership in foreign / domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC is coexistent with restrictions other than on external payments. It also does not preclude the imposition of monetary / fiscal measures relating to foreign exchange transactions, which are of prudential nature. Following are the prerequisites for CAC: 1. Maintenance of domestic economic stability. 2. Adequate foreign exchange reserves. 3. Restrictions on inessential imports as long as the foreign exchange position is not very comfortable. 4. Comfortable current account position. 5. An appropriate industrial policy and a conducive investment climate. 6. An outward oriented development strategy and sufficient incentives for export growth.
DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP
STATEMENTS? BOP statistics are regularly compiled, published and are continuously monitored by companies, banks and government agencies. A set of BOP accounts is useful in the same way as a motion picture camera. The accounts do not tell us what is good or bad, nor do they tell us what is causing what. But they do let us see what is happening so that we can reach our own conclusions. Below are 3 instances where the information provided by BOP accounting is very necessary: 1. Judging the stability of a floating exchange rate system is easier with BOP as the record of exchanges that take place between nations help track the accumulation of currencies in the hands of those individuals more willing to hold on to them. 2. Judging the stability of a fixed exchange rate system is also easier with the same record of international exchange. These exchanges again show the extent to which a currency is accumulating in foreign hands, raising questions about the ease of defending the fixed exchange rate in a future crisis. 3. To spot whether it is becoming more difficult for debtor counties to repay foreign creditors, one needs a set of accounts that shows the accumulation of debts, the repayment of interest and principal and the countries ability to earn foreign exchange for future repayment. A set of BOP accounts supplies this information. This point is further elaborated below. The BOP statement contains useful information for financial decision makers. In the short run, BOP deficit 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. Taken in
conjunction with recent past data, they may conform or indicate a reversal of perceived trends. They also 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 to attract short term capital inflows to prevent depreciation of its currency. 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 its debt. BOP accounts are intimately 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. In nutshell corporate finance managers must monitor the BOP data being put out by government agencies on a regular basis because they have both short term and long term implications for a host of economic and financial variables affecting the fortunes of the company.
IN THE ACCOUNTING SENSE THE BOP ALWAYS BALANCES! The BOP is a double entry accounting statement based on rules of debit and credit similar to those of business accounting & book-keeping, since it records both transactions and the money flows associated with those transactions. For instance, exports (like sales of a business) are credits, and imports (like the purchases of a business) are debits. As in business accounting the BOP records increases in assets (direct investment abroad) and decreases in liabilities (repayment of debt) as debits, and decreases in assets (sale of foreign securities) and increases in liabilities (the utilisation of foreign goods) as credits. An elementary rule that may assist in understanding these conventions is that in such transactions it is the movement of a document, not of the money that is recorded. An investment made abroad involves the import of a documentary acknowledgement of the investment, it is therefore a debit. The BOP has
one important category that has no counter part or at least no significant counter part in business accounting, i.e. international gifts and grants and other so called transfer payments. In general credits may be conceived as receipts and debits as payments. However this is not always possible. In particular the change in a country’s international reserves in gold and foreign exchange is treated as a debit if it is an increase and a credit if it is a decrease. The procedure is to offset changes in reserves against changes in the other items in the table so that the grand total is always zero, (except for errors and omissions). A transaction entering the BOP usually has two aspects and invariably gives rise to two entries, one a debit and the other a credit. Often the two aspects fall in different categories. For instance, an export against cash payment may result in an increase in the exporting country’s official foreign exchange holdings. Such a transaction is entered in the BOP as a credit for exports and as a debit for the capital account. Both aspects of a transaction may sometimes be appropriate to the same account. For instance the purchase of a foreign security may have as its counter part reduction in official foreign exchange holdings. Thus it is clear that if we record all the entries in BOP in a proper way, debits and credits will always be equal. So that in accounting sense the BOP will be in balance.
DETAILED OUTLINE OF THE BOP STATEMENT & SUB ACCOUNTS Balance of Payments is the summary of all the transactions between the residents of one country and rest of the world for a given period of time, usually one year. A BOP statement (revised) includes the following sub accounts, as shown in the table below. Items G. Current Account 1. Merchandise a. Private Credits Debits Net
b. Government 2. Invisibles a. Travel b. Transportation c. Insurance d. Investment Income e. Government (not included elsewhere) f. Miscellaneous 3. Transfer Payments a. Official b. Private Total Current Account (1+2+3) H. Capital Account 2. Private a. Long Term b. Short Term 3. Banking 4. Official a. Loans b. Amortisation c. Miscellaneous Total Capital Account (1+2+3) I. IMF J. SDR Allocation K. Capital Account, IMF & SDR Allocation (B+C+D) L. Total Current Account, Capital Account, IMF & SDR Allocation (A+E) M. Errors & Omissions N. Reserves and Monetary Gold Current Account The current account includes all transactions which give rise to or use up national income. The current account consists of two major items, namely, (a) merchandise export and imports and (b) invisible imports and exports. Merchandise exports i.e. sale of goods abroad, are credit entries because all transactions giving rise to monetary claims on foreigners represent credits. On the other hand, merchandise imports, i.e. purchase of goods abroad, are debit entries because all transactions giving rise to foreign money claims on the home country represent debits. Merchandise exports
and imports form the most important international transactions of most of the countries. Invisible exports i.e. sale of services, are credit entries and invisible imports i.e. purchase of services are debit entries. Important invisible exports include sale abroad of services like insurance and transport etc. while important invisible imports are foreign tourist expenditures in the home country and income received on loans and investment abroad (interests or dividends). Transfers payments refer to unrequited receipts or unrequited payments which may be in cash or in kind and are divided into official and private transactions. Private transfer payments cover such transactions as charitable contributions and remittances to relatives in other countries. The main component of government transfer payments is economic aid in the form of grants. Capital Account The capital account separates the non monetary sector from the monetary one, that is to say, the trading or ordinary private business element in the economy together with the ordinary institutions of central or local government, from the central bank and the commercial bank, which are directly involved in framing or implementing monetary policies. The capital account consists of long term and short term capital transactions. Capital outflow represents debit and capital inflow represent credit. For instance, if an American firm invests rupees 100 million in India, this transaction will be represented as a debit in the US BOP and a credit in the BOP of India. Other Accounts The IMF account contains purchases (credits) and repurchases (debits) from the IMF. 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. The Reserve and Monetary Gold 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 investment in foreign government securities) and government’s holding of SDRs. Errors and Omissions is a “statistical residue.” Errors and omissions (or the balancing item) reflect the difficulties involved in recording accurately, if at all, a wide variety of transactions that occur within a given period of (usually 12 months). It is used to balance the statement because in practice it is not possible to have complete and accurate data for reported items and because these cannot, therefore, ordinarily have equal entries for debits and credits.
HOW WILL YOU IDENTIFY A DEFICIT OR SURPLUS IN BALANCE OF PAYMENTS? / MEANING OF “DEFICIT” AND “SURPLUS” IN THE BALANCE OF PAYMENTS. If the balance of payment is a double entry accounting record, then apart from errors and omissions, it must always balance. Obviously, the terms “deficit” or “surplus” cannot 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 within 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 BOIP so that an imbalance in one set of accounts will give the appropriate signals to the policy makers. In the language of an accountant e 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 will say that there is a “balance of payments surplus”; if it is negative e
will 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 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 economist and incorporated into the IMF guidelines emphasis the purpose or motive a transaction, as a criterion to decide whether a transaction should go above or below the line. The principle distinction between “autonomous” transaction and “accommodating” or compensatory transactions. Transactions are said to Autonomous if their value is determined independently of the BOP. Accommodating capital flows on the other hand are determined by the net consequences of the autonomous items. An autonomous transaction is one undertaken for its own sake in response to the given configuration of prices, exchange rates, interest rates etc, usually in order to realise a profit or reduced 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. An alternative nomenclature is that capital flows are ‘above the line’ (autonomous) or ‘below the line’ (accommodating). 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. The other measures of identifying a deficit or surplus in the BOP statement are: Deficit or Surplus in the Current Account and/or Trade Account. The Basic Balance which shows the relative deficit or surplus in the BOP.
A DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR UNDESIRABLE! The basic balance was regarded as the best indicator of the economy’s position vis-à-vis other countries in the 1950’s and the 1960’s. It is defined as the sum of the BOP on current account and the net balance on long term capital, which were considered as the most stable elements in the balance of payments. A worsening of the basic balance [an increase in a deficit or a reduction in a surplus or even a move from the surplus to deficit] is seen as an indication of deterioration in the [relative] state of the economy. Thus it is very much evident that a deficit in the basic balance is a clear indicator of worsening of the state of the country’s BOP position, and thus can be said to be undesirable at the very outset. However, on further thoughts, a deficit in the basic balance can also be understood to be desirable. This can be explained as follows: A deficit on the basic balance could come about in various ways, which are not mutually equivalent. E.g. suppose that the basic balance is in deficit because a current account deficit is accompanied by a deficit on the long term capital account. This deficit in long term capital account could be clearly observed in a developing country’s which might be investing heavily on capital goods for advancement on the agricultural and industrial fields. This long term capital outflow will, in the future, generate profits, dividends and interest payments which will improve the current account and so, ceteris paribus, will reduce or perhaps reduce the deficit. Thus a deficit in basic balance can be desirable as well as undesirable, as it clearly depends upon what is leading to a deficit in the long term capital account.
BALANCE OF PAYMENTS (Refer to Concept Questions)
CURRENT ACCOUNT The current account records exports and imports of goods and services and unilateral transfers. Exports whether of goods or services are by convention entered as positive items in the account. Imports accordingly are entered as negative items. Exports are normally calculated f.o.b i.e. cost from transportation, insurance etc are not included whereas imports are normally calculated c.i.f. i.e. transportation, insurance cost etc are included. In many cases the payment for imports and exports will result in transfer of money between the trading countries. For example a UK firm importing a good from US may settle its debt by instructing its UK bank to make a payment to the US account of the exporter. This is not necessarily the case however. If the UK firm holds a bank account in the US, then it may make payment to the US exporter from that account. In the former case the financial side of the transaction will appear in the UK BOP account as part of the net change in UK foreign currency reserves. In the later it will appear as the part of the capital account since the UK firm has reduced its claims on the US bank. BOP accounts usually differentiate between trades in goods and trade in services. The balance of imports and exports of the former is referred to in the UK accounts as the balance of visible trade in other countries it may be referred to as the balance of merchandise trade, or simply as the balance of trade. The net balance of exports and imports of services is called the balance of invisible trade in the UK statistics. Invisible trade is a much more heterogeneous category than is visible trade. It helps in distinguishing between factor and non-factor services.
Trade in the later of which shipping, banking and insurance services and payments by residents as tourists abroad are usually the most important, is in economic terms little different from trade in goods. That is, exports and imports are flows of outputs whose values will be determined by the same variables that would affect the demand and supply for goods. Factors services, which consist in the main of interest, profits and dividends, are on the other hand payments for inputs. Exports and imports of such services will depend in large part on the accumulated stock of past investment in and borrowing from foreign residents. Unilateral transfer forms a major part of the current account. It refers to unrequited receipts or unrequited payments which may be in cash or in kind and are divided into official and private transactions. Unilateral transfers or ‘unrequited receipts’, are receipts which the residents of a country receive ‘for free’, without having to make any present or future payments in return. Receipts from abroad are entered as positive items, payments abroad as negative items. The net value of the balances of visible trade and of invisible trade and of unilateral transfers defines the balance on current account.
CAPITAL ACCOUNT (Refer to Concept Questions)
OFFICIAL RESERVES ACCOUNT Official reserve account forms a special feature of the capital account. This account records the changes in the part of the reserves of other countries that is held in the country concerned. These reserves are held in three forms: in foreign currency, usually but not always the US dollars, as gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF. Note that the reserves do not have to be held by the country.
Indeed most of the countries hold a proportion of the reserves in accounts with foreign central banks. The IMF account contains purchases (credits) and repurchases (debits) from the IMF. 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. The Reserve and Monetary Gold 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 investment in foreign government securities) and government’s holding of SDRs. The change in the reserves account measures a nation’s surplus or deficit on its current and capital account transactions by netting reserve liabilities from reserve assets. For example, a surplus will lead to an increase in official holdings of foreign currencies and/or gold; a deficit will normally cause a reduction in these assets. For most of the countries, there is a correlation between balance-ofpayments deficits and reserve declines. A drop in reserves will occur, for instance, when a nation sells gold to acquire foreign currencies that it can use to meet the deficit in the balance of payments.
Balance of Payments - Paul Madson International Financial Management - P G Apte International Economics - Lindert International Economics - Francis Chernuliam International Economics - C P Kindelberger International Economics - Geoffrey Reed International Economics - H G Mannur