INTRODUCTION

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
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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
3

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.

Current Account
Capital Account
IMF
SDR Allocation
Errors & Omissions

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 economys position vis-vis other countries in the 1950s and the 1960s. 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
7

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 dont 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.
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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.
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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,
that

even if its intention is to keep that money in

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.
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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 firms country, and as a positive item in the capital account for the other
country. That capital outflows appear as a negative item in a countrys 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 purchasers
country (and as a positive item in the accounts of the sellers country).
The net value of the balances of direct and portfolio investment defines the balance
on capital account.

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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
12

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
13

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 nonresidents (exports) and from non-residents to residents (imports).
14

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 payments (positive) or
payments exceeding receipts (negative).

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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
16

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 underreporting 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 (SDRs) 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 countrys 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
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.
17

Foreign economic aid or assistance and foreign military aid or assistance received
by the home countrys 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 lendings but gifts and grants exchanged between government and people in
one country with the governments and peoples in the rest of the world.

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ILLUSTRATE THE ITEMS WHICH FALL UNDER CAPITAL ACCOUNT AND

CURRENT ACCOUNT WITH EXAMPLES.

Credits
Current Account
1.
Merchandise Exports (Sale of
Goods)
2.
Invisible Exports (Sale of
Services)
a.
Transport services sold
abroad
b.
Insurance services sold
abroad
c.
Foreign tourist
expenditure in country
d.
Other services sold
abroad
e.
Incomes received on
loans and investments abroad.

Debits
Current Account
1.
Merchandise Imports
(purchase of Goods)
2.
Invisible Imports (Purchase of
Services)
a.
Transport services
purchased from abroad
b.
Insurance services
purchased
c.
Tourist expenditure
abroad
d.
Other services
purchased from abroad
e.
Income paid on loans
and investments in the home
country.
3. Unilateral Transfers
a. Private remittances abroad

3. Unilateral Transfers
a. Private remittances received
from abroad
b. Pension payments received
b. Pension payments abroad
from abroad
c. Government grants received
c.
Gover
from abroad
nment grants abroad.
Capital Account
Capital Account
3.
Foreign long-term investments 3.
Long-term investments abroad
in the home country (less
(less redemptions and
redemptions and repayments)
repayments)
a.
Direct investments in
a.
Direct Investments
the home country
abroad
b.
Foreign investments in
b.
Investments in foreign
domestic securities
securities
c.
Other investments of
c.
Other investments
foreigners in the home country
abroad
d.
Foreign Governments
d.
Government loans to
loans to the home country.
foreign countries
4.
Foreign short-term
4.
Short-term investments
19

investments in the home country.

abroad.

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.

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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
21

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
countrys 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!
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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 countrys 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 countrys official foreign exchange holdings. Such a transaction is
23

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.

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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.
25

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.

26

DEFICIT

IN

THE

BASIC

BALANCE

IS

DESIRABLE

OR

UNDESIRABLE!
The basic balance was regarded as the best indicator of the economys position vis-vis other countries in the 1950s and the 1960s. 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
countrys 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 countrys 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.

27

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.

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.

28

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.

29

The net value of the balances of visible trade and of invisible trade and of
unilateral transfers defines the balance on current account.

BALANCE OF PAYMENT CRISIS

A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay
for essential imports and/or service its debt repayments. Typically, this is
accompanied by a rapid decline in the value of the affected nation's currency.
Crises are generally preceded by large capital inflows, which are associated at first
with rapid economic growth However a point is reached where overseas investors
become concerned about the level of debt their inbound capital is generating, and
decide to pull out their funds. The resulting outbound capital flows are associated
with a rapid drop in the value of the affected nation's currency.
Balancing mechanisms

One of the three fundamental functions of an international monetary system is to

provide mechanisms to correct imbalances.
Broadly speaking, there are three possible methods to correct BOP imbalances,
though in practice a mixture including some degree of at least the first two
methods tends to be used. These methods are adjustments of exchange rates;
adjustment of a nations internal prices along with its levels of demand; and rules
based adjustment.[36] Improving productivity and hence competitiveness can also
help, as can increasing the desirability of exports through other means, though it is
generally assumed a nation is always trying to develop and sell its products to the
best of its abilities.

Rebalancing by changing the exchange rate

30

An upwards shift in the value of a nation's currency relative to others will make a
nation's exports less competitive and make imports cheaper and so will tend to
correct a current account surplus. It also tends to make investment flows into the
capital account less attractive so will help with a surplus there too. Conversely a
downward shift in the value of a nation's currency makes it more expensive for its
citizens to buy imports and increases the competitiveness of their exports, thus
helping to correct a deficit (though the solution often doesn't have a positive impact
immediately due to the MarshallLerner condition).
Exchange rates can be adjusted by government [38] in a rules based or managed
currency regime, and when left to float freely in the market they also tend to
change in the direction that will restore balance. When a country is selling more
than it imports, the demand for its currency will tend to increase as other countries
ultimately need the selling country's currency to make payments for the exports.
The extra demand tends to cause a rise of the currency's price relative to others.
When a country is importing more than it exports, the supply of its own currency
on the international market tends to increase as it tries to exchange it for foreign
currency to pay for its imports, and this extra supply tends to cause the price to fall.
BOP effects are not the only market influence on exchange rates however, they are
also influenced by differences in national interest rates and by speculation.

Rebalancing by adjusting internal prices and demand

When exchange rates are fixed by a rigid gold standard,[40] or when imbalances
exist between members of a currency union such as the Eurozone, the standard
approach to correct imbalances is by making changes to the domestic economy. To
31

a large degree, the change is optional for the surplus country, but compulsory for
the deficit country. In the case of a gold standard, the mechanism is largely
automatic. When a country has a favorable trade balance, as a consequence of
selling more than it buys it will experience a net inflow of gold. The natural effect
of this will be to increase the money supply, which leads to inflation and an
increase in prices, which then tends to make its goods less competitive and so will
decrease its trade surplus. However the nation has the option of taking the gold out
of economy (sterilizing the inflationary effect) thus building up a hoard of gold and
retaining its favorable balance of payments. On the other hand, if a country has an
adverse BOP it will experience a net loss of gold, which will automatically have a
deflationary effect, unless it chooses to leave the gold standard. Prices will be
reduced, making its exports more competitive, and thus correcting the imbalance.
While the gold standard is generally considered to have been successful [41] up until
1914, correction by deflation to the degree required by the large imbalances that
arose after WWI proved painful, with deflationary policies contributing to
prolonged unemployment but not re-establishing balance. Apart from the US most
former members had left the gold standard by the mid-1930s.
A possible method for surplus countries such as Germany to contribute to rebalancing efforts when exchange rate adjustment is not suitable, is to increase its
level of internal demand (i.e. its spending on goods). While a current account
surplus is commonly understood as the excess of earnings over spending, an
alternative expression is that it is the excess of savings over investment.[42] That is:

where CA = current account, NS = national savings (private plus government

sector), NI = national investment.
32

If a nation is earning more than it spends the net effect will be to build up savings,
except to the extent that those savings are being used for investment. If consumers
can be encouraged to spend more instead of saving; or if the government runs a
fiscal deficit to offset private savings; or if the corporate sector divert more of their
profits to investment, then any current account surplus will tend to be reduced.
However, in 2009 Germany amended its constitution to prohibit running a deficit
greater than 0.35% of its GDP[43] and calls to reduce its surplus by increasing
demand have not been welcome by officials,[44] adding to fears that the 2010s will
not be an easy decade for the eurozone.[45] In their April 2010 world economic
outlook report, the IMF presented a study showing how with the right choice of
policy options governments can transition out of a sustained current account
surplus with no negative effect on growth and with a positive impact on
unemployment.[46]

Rules based rebalancing mechanisms

Nations can agree to fix their exchange rates against each other, and then correct
any imbalances that arise by rules based and negotiated exchange rate changes and
other methods. The Bretton Woods system of fixed but adjustable exchange rates
was an example of a rules based system. John Maynard Keynes, one of the
architects of the Bretton Woods system had wanted additional rules to encourage
surplus countries to share the burden of rebalancing, as he argued that they were in
a stronger position to do so and as he regarded their surpluses as negative
externalities imposed on the global economy. Keynes suggested that traditional
balancing mechanisms should be supplemented by the threat of confiscation of a
portion of excess revenue if the surplus country did not choose to spend it on
33

additional imports. However his ideas were not accepted by the Americans at the
time. In 2008 and 2009, American economist Paul Davidson had been promoting
his revamped form of Keynes's plan as a possible solution to global imbalances
which in his opinion would expand growth all round without the downside risk of
other rebalancing methods.

34

BALANCE OF PAYMENT ADJUSTMENT THEORIES

Any system of stable exchange rates is one in which the quantity of money in each
country is determined primarily by the balance of payments. Discrepancies in the
balance of payments may be settled temporarily by movements of gold or by
changes in the balance of international short-term indebtedness, but to eliminate
discrepancies caused by secular changes and secure real adjustment the domestic
money supply must be adjusted. The traditional classical theory of this adjustment
process was the only explanation of the mechanism of re-equilibrium until the
recent studies carried out by Harrod and Whale, who applied the Keynesian theory
of employment to international trade problems. Harrod's theory2 is merely a
development of the classical, but Whale's analysis^3 of the working of the pre1914 gold standard has given an alternative explanation of the mechanism of reequilibrium. These various theories of the mechanism of adjustment of the balance
of international payments will be examined in turn and an attempt will be made to
determine the validity of Whale's theory, which has been found to fit better the
known facts of the working of the pre-1914 gold standard, in the new setting of the
fixed exchange relationship between Ireland and Great Britain within the sterling
area.

35

Methods of Correcting Disequilibrium ill Balance of

Payments
When serious disequilibrium arises in a countrys balance of payments, steps must
be taken to correct it. if the countrys economy is to be kept in a sound condition.
Obviously, the causes which are responsible for such a slate of affairs must be
removed. The classical view of the adjustment mechanism is: An active or
passive balance, accompanied by an inflow or outflow of gold, was normally
supposed not result in an expansion or contraction of the domestic money supply;
and this expansion or contraction was expected to bring about a rise or fall in the
level of domestic costs and prices tending, in the former case, to stimulate imports
and discourage exports or, in the latter, to discourage imports and stimulate
exports. Gold flows, changes in relative price levels thus appeared as the principal
factors in the mechanism of adjustments:
Recent currency experience has, however, led to certain modifications in the
classical theory. It i~now thought that changes in the flow of income induced by
balance of payments serve as an calibrating factor. The main point is that any
active or passive balance of current transaction tends directly to expand or contract
the total now of money income within a given country The change induced by the
balance of payments in the flow of income and outlay affect, in turn, the demand
for imported us well as home-produced goods and 1>0 react on the balance in an
equilibrium manner .

36

There are five well-known methods of correcting an adverse balance of payments:

Iii Stimulating exports and or checking important If the exports have fallen off.
step should be taken to encourage them. To encourage exports the level of costs in
the country may have to be brought down. This may involve Lulling down of
wages and interest rates and other incomes and also contraction of currency to
bring the prices down. Exports arc also encouraged by granting bounties to
manufacture res and exporters. Imports may be discouraged either by total
prohibition or by imposition of import duties or by adopting the quota
system. Another method is to depreciate the value of the home currency. thus
cheapening domestic goods for the foreigner. This latter course, however. has
serious limitations. because other countries may start doing likewise and
competitive depreciation of exchange rates may start. as

during the depression years in the thirties. It may be not cd that the rate of
exchange serves as an calibrating factor between he balance of payments. If, for
instance, the demand for American goods increases, the demand for the dollars will
increase, and, in the absence of exchange control the price of dollar in terms of
foreign currencies will go up. This by itself will discourage the foreign buy from
buying j;l America and encourage Americans to ~uy from abroad. In this way the
balance may be restored, Normally, it will be such But if a further rise in the price
of the dollar is feared. the foreigners will increase their purchases f American
goods now lest they should become dearer still; it will also hold back the
Americans from buying more from abroad. In this way, the disequilibrium may be
accentuated. instead of being cured.
(ii,) The think method is to Toltec the reverence. Is currency contracts, prices will
fall. which will stimulate exports and check imports. But the . method of deflation
37

is also full of dangers. If prices arc forced down while I.. IS. which are
proverbially rigid (especially as regards wages in countries where trade unions arc
well organised), L10 not follow suit, the country may face a serious depression and
unemployment. Correcting

the

balance

of

payments, therefore,

once

disequilibrium has arisen is nut an easy matter.

(iv) The fourth method is devaluation.devaluation. its effect is the same as that of
depreciation. When a currency is devalued (i.e., its metallic content is reduced), its
value ill terms of foreign currency decreases. The result i~ that foreigners arc able
to buy in our country more goods than before with the same amount of their
currency. This would stimulate exports. But when we want to buy foreign goods,
our currency, having become cheaper. we have to pay more for them. Imports arc
thus discouraged, and, in course of time, the balance of trade turns in our favor
and corrects the balance of payments .
Theories Concerning Disequilibrium in balance of Payments
There arc broadly the following!! three main theories, which explain how a
discipline ium in balance of payments is caused:
1. Classical Theory of Pncc Theory.
2. Keynesian Theory or Income Theory.

3. Demonstration Effect Theory.

This theory explains dequalinium the balance of payment country in of
relative .1rice structures. A country i, likely to have all adverse hnlancc of
payments if her cost and price structure is relatively hi!!hn as pared with that
of her trading partners. This theory as umcx that there exists a significant
38

clement of sustainability between the home-made goods and 0f reign goods.

If this is so, then the consumers in the country whose cost and price structure
is relatively higher will substitute home-made goods by foreign goods. This
will increase the imports of the country significantly and thus create balance
of payments problem for the country. loan Robinson, Harrod and Haberler
were mainly responsible for developing this theory. By using Keynesian
tools, these economists came to the conclusion that tile disequilibrium in
the balance of payments of a country can be explained in terms of relative
incomes. According to this theory, a country would face a disequilibrium in
the balance of payments if her income is rising faster than that of her trading
partners.This theory assumes that imports arc a function of income, i.e., with
an increase in income, import. of a country would rise. Therefore. if the
income of a country is rising faster than that of her trading partner countries,
her imports are bound to increase faster, which in turn will give rise to a
disequilibrium in her balance of payments.
4. This theory was propounded. chiefly by Ranger Nurkse. it was
suggested Nurkse and also by MacDougal, that the high standards of living
of the advanced countries had the effect of inducing the developing countries
also to raise theirs. The aspirations of these countries to imitate the Ii ving
standards of the advanced countries, resulted in their undertaking heavy
investment programmes and in huge imports of luxury items. In other words,
the standards of living of advanced countries serve as a demonstration
model: for the less developed countries, The result of this is a fantastic
increase in their imports, which in turn Creates balance
of payments problems for them. Cuncluxiuu. No single theory can explain
the
39

disequilibrium in the balance of payments of a developing

economy, Thcre arc a number of factors operating
simultaneously which cause this disequilibrium.
The main causes are.
5. (i) Ambitious development programmer necessitating lilac-scale imports of
machinery, plant and equipment, raw materials and technical know how
6. (ii) Exports lagging behind owing to low level of productivity ill agro-based
industries and competition and stagnant or declining demand for traditional
ex- PI)r1S. and increased domestic consumption.
7. (iii) Food imports owing to high elasticity of demand lor food and increase
ill population.

40

CONCLUSION
India current account surplus has been low as compare to china and Russia because
India is in the stage of industrial development requiring foreign capital.
Export oriented policies we have not been able to diversify our export basket
especially in favor of more technology and knowledge intensive goods that are less
susceptible to price pressures and are much value adding and faster growing. India
should consolidate its presence in traditional export industries and move up the
value chain in traditional products.
Terms of trade this in turn depends upon relative price ratio of tradable to non
tradable goods .

41