BALANCE OF PAYMENTS

INTRODUCTION

In the realm of international finance, one of the most heavily used data sources is an
accounting statement known as the balance of payment, which records the economic
transactions between residents and government of a particular country and the residents and
government of the rest of the world during a given period of time, usually a year.

For governments, the BOP provides valuable information for the conduct of economic and fiscal
policy.

For firms and individuals, it provides clues about expectations for such matters as volume of
trade and capital flows, the movement of exchange rate and profitable course of economic
policy.

A country’s balance of payments affects the value of its currency, its ability to obtain currencies
of other countries and its policy towards foreign investment.

MEANING of BALANCE OF PAYMENTS

The Balance of Payments (BOP) is an accounting system that records the economic transactions
between residents and government of a particular country and the residents and government
of the rest of the world during a given period of time, usually a year.

ECONOMIC TRANSACTIONS include exports and imports of goods and services, lending and
borrowing of funds (capital transfers), remittances (gifts), government aids, and military
expenditures.

RESIDENTS include individuals, business enterprises, including financial institutions that are
permanently residing within a country’s borders, as well as all government agencies.

BALANCE OF PAYMENTS ACCOUNTING

The balance of payment statement is based on the principle of double entry bookkeeping,
every credit in the account is balanced by matching debit and vice versa.

A BOP statement is kept in the form of sources (credits) and uses (debits) of funds. This record
enables us to know whether the country has/had a net surplus or deficit during the referred
period. If a country receives more funds from abroad then it spends, it has a surplus of BOP. If
expenditures abroad by residents exceed what the residents earn or receive from abroad, the
country has a deficit of BOP.

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The major sources of funds for a country accrue from:

 Export of goods and services;

 Sale of existing foreign financial assets;

 Foreign loans/borrowings.

Likewise, the major uses are:

 Imports of goods and services;

 Purchase of foreign financial assets;

 Foreign lending.

Typical BOP Statement

A. Current Account

a. Goods Account

Exports (+)

Imports (-)

Balance on goods account = A (1)

b. Services Account

Receipts as interest and dividends, tourism receipts for travel and financial charges (+)

Payments as interest and dividends, tourism receipts for travel and financial charges (-)

Balance on services account = A (2)

c. Unilateral transfers

Gifts, donations, subsidies received from foreigners (+)

Gifts, donations, subsidies made to foreigners (-)

Balance on unilateral transfers = A (3)

Current Account Balance = A (1) +A (2) +A (3) = A

B. Capital Account

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 a. Foreign Direct Investment

Direct investments by foreigners (+)

Direct Investment abroad (-)

Balance on FDI = B (1)

b. Portfolio Investment

Foreigners investments in securities of the country (+)

Investments in securities abroad (-)

Balance on Portfolio Investment = B (2)

c. Private Short term Capital Account

Foreigners claim on the country (+)

Short term claim on foreigners (-)

Balance on short term capital a/c= B (3)

Capital Account Balance = B (1) +B (2) +B (3) = B

Overall Balance = A + B

THE BALANCE OF PAYMENT STATEMENTS

A BOP statement is divided into several intermediate accounts. The three major segments are:
(i) Current Account, (ii) Capital Account, and (iii) Official reserves Account.

The data needed to prepare different accounts are collected from various sources. For instance,
the data on imports and exports are gathered from customs authorities whereas the financing
of these transactions appears largely among the data on changes in foreign assets and liabilities
reported by financial institutions.

1. Current Account: It is a record of the trade in goods and services and unilateral transfers
among countries. Entries in this account are ‘current’ in value as they do not give rise to future
claims.

a. The trade in goods is composed of exports (selling merchandize to foreigners) and imports
(buying merchandize from abroad). Exports are a source of funds and result in a decrease in

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real assets. On the other hand, imports are a use of funds and result in an acquisition of real
assets.

b. The trade in services (also called invisibles) includes interest, dividends, tourism/travel
expenses and financial charges, etc., Interest and dividends measure the services that the
country’s capital renders abroad. Payments coming from tourists measure the services that the
country’s shops and hotels provide to foreigners who visit the country. Financial, insurance and
shipping charges measure the services that the country’s financial and shipping sectors render
to foreigners. Receipts obtained by servicing foreigners on these counts constitute source of
funds. On the other hand, when the country’s residents receive the services from foreign
owned assets, utilization of funds, takes place.

c. Unilateral transfers consist of remittances by migrants to their friends and family, and gifts,
donations and subsidies received from abroad. Remittances so received are obviously sources;
remittances made in forms of gifts/donations, etc., by immigrants cause utilization of funds.

2. Capital Accounts: It is divided into foreign direct investment (FDI), portfolio investment and
private short term capital flows.

a. Direct Investment occurs when the investor acquires equity, acquisition of firms or
establishment of new subsidiaries. Firms undertake FDI when expected returns from foreign
investment exceed cost of capital.

b. Portfolio investments represent sales and purchases of foreign financial assets such as stocks
and bonds. A desire for higher expected returns is what makes them invest in other country
markets.

FDIs are for relatively longer period of time and portfolio investments have a maturity of more
than one year when they are made. The short term capital flows mature in a period of less than
one year.

c. Short term capital flows represent claims with a maturity of less than one year. Such claims
include bank deposits, short-term loans, securities, money market investments, etc. These

3. Official Reserves Account

As regards to Official Reserves Account, the monetary authority of a country, using the central
bank, owns international reserves. These reserves are composed of gold, convertible currencies
like dollar, euro, yen, SDRs (Special Drawing rights), etc., since BOP is expressed in national
currency; an increase in any of these assets means a use of funds while their decrease implies a
source of funds.

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If overall balance (current plus capital) is in deficit, this implies either a reduction in reserves or
an increase in foreign debt or reduction of credit. It is important to note that, by convention, a
deficit is shown by a + sign. In other words, it appears on the sources side. As a result, sum of all
sources and uses becomes equal. The reverse is true when overall balance (i.e. the sum of
current and capital account) is in surplus.

Disequilibrium in Balance of Payment

Though the credit and debit are written balanced in the balance of payment account, it may not remain
balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in
the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may
take place either in the form of deficit or in the form of surplus.

 Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to
foreigners. It arises when the effective demand for foreign exchange of the country exceeds its
supply at a given rate of exchange. This is called an 'unfavourable balance'.
 Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a
situation arises when the effective demand for foreign exchange is less than its supply. Such a
surplus disequilibrium is termed as 'favourable balance'.

Causes of Disequilibrium in Balance of Payment

1. Population Growth

Most countries experience an increase in the population and in some like India and China the
population is not only large but increases at a faster rate. To meet their needs, imports become
essential and the quantity of imports may increase as population increases.

2. Development Programmes

Developing countries which have embarked upon planned development programmes require to
import capital goods, some raw materials which are not available at home and highly skilled and
specialized manpower. Since development is a continuous process, imports of these items continue
for the long time landing these countries in a balance of payment deficit.

3. Demonstration Effect

When the people in the less developed countries imitate the consumption pattern of the people in
the developed countries, their import will increase. Their export may remain constant or decline
causing disequilibrium in the balance of payments.

4. Natural Factors

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Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in
the balance of payments by adversely affecting agriculture and industrial production in the country.
The exports may decline while the imports may go up causing a discrepancy in the country's balance
of payments.

5. Cyclical Fluctuations

Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium
in the country's balance of payments. For example, if there occurs a business recession in foreign
countries, it may easily cause a fall in the exports and exchange earning of the country concerned,
resulting in a disequilibrium in the balance of payments.

6. Inflation

An increase in income and price level owing to rapid economic development in developing
countries, will increase imports and reduce exports causing a deficit in balance of payments.

7. Poor Marketing Strategies

The superior marketing of the developed countries have increased their surplus. The poor marketing
facilities of the developing countries have pushed them into huge deficits.

8. Globalisation

Due to globalisation there has been more liberal and open atmosphere for international movement
of goods, services and capital. Competition has been increased due to the globalisation of
international economic relations. The emerging new global economic order has brought in certain
problems for some countries which have resulted in the balance of payments disequilibrium.

Measures of Correcting Disequilibrium

(i) Export promotion:

Exports should be encouraged by granting various bounties to manufacturers and exporters. At the
same time, imports should be discouraged by undertaking import substitution and imposing
reasonable tariffs.

(ii) Import:

Restrictions and Import Substitution are other measures of correcting disequilibrium.

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 (iii) Reducing inflation:

Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore,
government should check inflation and lower the prices in the country.

(v) Devaluation of domestic currency:

It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign
exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a
government order when a country has adopted a fixed exchange rate system. Care should be taken
that devaluation should not cause rise in internal price level.

(vi) Depreciation:

Like devaluation, depreciation leads to fall in external purchasing power of home currency.
Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the
supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in
fixed exchange rate system.)

Solved Exercises

A. Current Account
a. Goods Account (A1)
Export of souvenirs 3,000 (+)
Sale of part of the production in Asian countries 1,00,000 (+)
Import of Machinery 1,00,000 (-)
b. Services Account (A2)
Hotel and Travel bills (export of services) 5,000 (+)
Dividends paid 5,000(-)
c. Unilateral transfers (A3) Nil

Current Account Balance = A(1) +A(2) +A(3) = 3,000 (+)

B. Capital Account
a. Foreign Direct Investment (B1)
Modernization of Indian Subsidiary 3,00,000(+)
b. Portfolio Investment (B2)
Increase in claim on India 40,000(+)
c. Private Short term Capital Account (B3)
Borrowings from German Money Market 2,00,000(+)

Capital Account Balance = B(1) +B(2) +B(3) = 5,40,000 (+)

Overall Balance = Capital A/C + Current A/C = 5,43,000 (+)

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 INTERNATIONAL EXCHANGE RATE THEORIES

Exchange Rate is the number of units of a given currency that can be purchased
for one unit of another currency. E.g. $1 = €4 read as 4 units of Euros can be
purchased for 1 unit of Dollar.

Exchange rates are influenced by supply and demand of one currency for another.
It is the reflection / mirror of the economic well being of a country. NRI
investments and business depends on it. When exchange rates move in wrong
direction, profitable transactions can turn unprofitable for the business and
economy. It is therefore important to predict the future exchange rate to protect
from potential unfavorable future developments.

The subject of exchange rate movement is an important issue in global finance

and managers of MNCs, international investors, importers, exporters and
government officials attach much importance to it. Still, the determination of
exchange rates remains something of a mystery. Forecasters with the most
impressive records often go wrong in their calculations by substantial margins.

 Are changes in exchange rates predictable?

 How does interest rate related to exchange rate?
 What is the proper exchange rate in theory?

To answer fundamental questions like these, it is essential to understand the

different theories of exchange rate determination.

The two theories of exchange rate determination are:

1. Purchasing Power Parity (PPP) Theory

2. Interest Rate Parity (IRP) Theory

Purchasing Power Parity Theory

A Swedish economist, Gustav Cassel, stated in 1938 that purchasing power of a

currency is determined by the amount of goods and services that can be
purchased with one unit of that currency. If there are two currencies, it would be

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fair to say that the exchange rate between these two currencies would be such
that it reflects their respective purchasing power. This principle is referred to as
Purchasing Power Parity (PPP). If the current exchange rate is such that it does
not reflect purchasing power parity, it is a situation of disequilibrium. It is
expected that, eventually, the exchange rate between the two currencies will
move in such a manner as to reflect purchasing power parity.
Let us consider an example. Suppose at the period zero a basket of goods and
services is costing £100 in the UK and $ 180 in US. There is no restriction of buying
this basket of goods and services either from the UK or from the US. Then, it
would be correct to conclude that the two amounts paid in respective currencies
are equivalent. In other words,

£100 = $180 or £1 = $1.80

or, we can simply say that the exchange rate at the time zero is $1.80/£. If we use
the symbol S0 to designate this exchange rate, then we write:

S0 = $1.80/£

Calculation of Prices -
It should be noted that, often, inflation rates are calculated by using price indices
rather than taking prices of individual goods and services. Generally, all countries
have developed some price index series which are readily available from
economic databases and can be used to calculate inflation rates.
Deviations from Purchasing Power Parity
Though this relationship has a sound theoretical base, in practice, it does not
always give satisfactory results. In other words, there are differences between the
rate predicted by the PPP and the actual future rate obtained in the market.

Several factors could be responsible for the deviation

1. Different Basket Used for Calculating Inflation Rates: One factor could be
inflation rates themselves that are used for calculating future exchange rates.
Each country has its own standard basket with certain weights of goods and

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services to make its price index. These standard baskets are not identical across
countries and are not constituted by the items actually traded across borders.
So if the price indices included only the items traded between countries, the
exchange rate predictions might improve.

2. Capital Account Ignored: Another reason for deviation is that the PPP takes
into account only movement of goods and services. It does not factor in the
capital flows. In other words, it is concerned with only the current account part of
the BOP, leaving out the capital account part totally.

3. Government Intervention: Still, another reason causing deviation may have to

do with the government intervention in the exchange market directly or through
trade restrictions, etc., The latter is becoming less and less significant in view of
the constant endeavor through the bodies like WTO to liberalize the movement of
goods and services across borders.

4. Speculative Activity: Speculative activity in the exchange market also affects

the exchange rates since buying/selling of currencies has no underlying
commercial transaction in the real economy.
It has been seen that, despite its limitations the PPP has good predictive power
over relatively longer periods and in conditions of higher inflation rates.

Interest Rate Parity Theory

It was made popular in 1920s by economists such as John M. Keynes. The theory
underlying this relationship says that premium or discount of one currency
against another should reflect interest rate differential between the two
countries. In perfect market conditions, where there are no restrictions on the
flow of money and there are no transaction costs, it should be possible to gain the
same real value of one’s monetary assets irrespective of the country (or currency)
in which they are invested.

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For example, an investor has one unit of pound sterling. He can invest it in the UK
money market and earn an interest of i£ on it. The resulting value after one year
will be: £1(1 + i£)

The equilibrium condition demands that these two sums be equal. If the two
sums were not equal, then the investor would invest in that currency where the
end value of their monetary assets is going to be more. But once this action is
generalized by the similar expectations of all investors, equilibrium is going to be
established.
Two major reasons why IRP does not hold fully in practice are:
(i) Capital controls and,
(ii) Transaction costs
The governments the world over impose capital controls in varying degrees. To
bring certain desired outcomes at macroeconomic level, governments restrict
capital flows. At times, these transactions are only for outbound flows but they
can be for both inbound as well as outbound flows. These restrictions on capital
flows do not permit the arbitrage activity and thereby prevent equilibrium from
being established.

The other important reason for deviations from IRP is the existence of transaction
costs. The interest rate at which an arbitrageur borrows is generally higher than
the rate at which he can lend his money. Similarly, there is a spread in the
exchange rates, meaning thereby, that there exists a difference between bid and
ask rate. The arbitrageur buys foreign exchange at the higher rate and sells it at
the lower rate.

Besides the above two reasons, deviations from IRP can be also due to market
structure and ease/difficulty of placement in a particular market. Speculation is an
equally important factor. This becomes very significant during the crisis of
confidence in the future of a currency. In such a situation, premium or discount
on a currency becomes much larger than what the IRP can explain.

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