BALANCE OF PAYMENT

A precise definition of the Balance of Payments (BOP) of a country can be stated as follows:
The balance of payments of a country is a systematic accounting record of all economic
transactions during a given period of time between the residents of the country and
residents of foreign countries. In other words, it is a statement of account recording all
international receipts and payment of a country with the rest of the world. Thus, the balance
of payments of a country serves as an important index that reflects the true economic position
of a country.
The economic transactions of a country with the rest of the world can be broadly classified
as:
(1) Visible items which include the export of all types of physical goods of which are
recorded at the ports,
(2) Invisible items which include the export and import of all types of services like those
rendered by shipping, banking and insurance companies, payment of interest etc.
which are not recorded at the ports, and
(3) Capital transfers that involve the transfer of assets. Such transfers are concerned with
capital receipts and payments of a country with the other countries.
Thus, the balance of payment shows the country’s trading position in its net position as
foreign lender or borrower, and changes in its official reserve holding.
BOP= Current Account Balance + Capital Account Balance + Errors & Omission (+
Balancing item)
BOP will be favourable if the country is able to pay off all past loans in her capital
account from the surplus in the current account. However, BOP is said to be infavourable
if the country borrows from the foreigners to offset its current account deficit.
CURRENT ACCOUNT OF BALANCE OF PAYMENT
The current account of balance of payments includes all transactions relating to trade
(imports and exports) in goods, services, income and current transfers and thus, constitutes an
important segment of balance of payment.
Components of Current Accounts
In the current account, the merchandise exports and imports are the most important items. For
the purpose of compilation of balance of payments, exports are valued on the basis of ‘free on
board’ whereas imports are valued on the basis of ‘cost, insurance and freight (C.I.F). The
difference between the exports and imports of a country is its balance of visible trade or
merchansise trade or simply balance of trade. If visible exports exceed the visible imports, the
balance of trade is favourable whereas it is unfavourable if the visible imports exceed the
visible exports.
It is however, the invisible items of the Current Account, namely services, income and
transfer payment that reflects the true position of the balance of payment account. While
service transaction include cost of travel, transportation, insurance, communications,
royalties, financial and computer services and other business services that are becoming
increasingly important, income and transfers include receipts and payments of interest and
dividens on investments and gifts, donations, grants etc., respectively.
The net value of these visible and invisible trade balance of the current account that may be
favourable or unfavourable.
Exports and imports of goods { Exports of goods are credits (+) to the current account
{ Imports of goods are debits (-) to the current account
Exports and imports of services { Exports of services are credits to the current account (+)
{ Imports of services are debits to the current account (-).
Interest payments on international investments. { Interest, dividends and other income
received on U.S. assets held abroad are credits (+) { Interest, dividends and payments made
on foreign assets held in the U.S. are debits (-). Since 1994, the U.S. has run a net debit in the
investment income account: more payments are made to foreigners than foreigners make to
U.S. investors.

Current transfers { Remittances by Americans working abroad, pensions paid by foreign

countries to their citizens living in the U.S., aid offered by foreigners to the U.S. count as
credits (+). { Remittances by foreigners working in the U.S., pensions paid by the United
States to its citizens living abroad, aid offered to foreigners by the U.S. count as debits (-) As
expected the U.S. runs a deficit in current transfers.

The sum of these components is known as the current account balance. A negative number is
called a current account deficit and a positive number called a current account surplus. As
expected, given that it runs a surplus only in the services component of the current account,
the U.S. runs a substantial current account deficit.

CAPITAL ACCOUNT OF BALANCE OF PAYMENT

The capital account of the balance of payments shows an international flow of loans and
investments between residents of a country and the rest of the world. In other words, the
capital account represents a change in the asset and liability status of the residents of a
country or its government. In short, Capital Account transactions record long term as well as
short term capital receipts and payments.
Components of Capital Account
The main components of Capital Account, as classified by the Reserve Bank of India, are as
follows-
1. Loan/Borrowings
(i) Commercial Borrowings- Commercial borrowings include borrowings by the
government and the private sector from the world money market at the market rate
of interest without considerations of any concession.
(ii) External Assistance- External assistance include borrowings by the country from
the foreign countries under concessional rate of interest. Thus, borrowings as
external assistance involve a lower rate of interest as compared to the interest rate
prevailing in the open market.
2. Foreign Investment
(i) Foreign Direct Investment (FDI) – Foreign Direct Investment refers to the
purchase of assets in the world market by acquiring control over them. For
example, purchase of a firm or selling up a plant by Reliance in the rest of the
world.
(ii) Portfolio Investment- When the residents of a country purchase shares in the
foreign governments over which they have no control is referred as portfolio
investment. For example, the Reliance industries buy shares in foreign companies.
3. Banking Capital – Banking capital refers to the capital transactions in the firms of
the foreign exchange transactions and investment in foreign currency and securities
by the foreign branches of Indian commercial banks. It also includes deposits made by
non-residents and changes in gold and forex reserves with the RBI.
4. Other Capital- All movements of capital not included above are recorded under the
head.
Thus, Capital Account in the balance of payments shows international lending and
borrowing of long term as well as short term capital.
Errors and Omissions
Imperfect compaction procedures and different data sources may lead to imbalance in the
balance of payments account. This imbalance is termed as net errors and omissions and is
explicitly identified in the balance of payment. In simple terms, net errors and omissions is
the difference between the current balance and the capital Balance.

Q4 What are factors affecting the components of BOP account?

Ans Exports of goods and services Imports of goods or services Exports of goods and
services affected by Following factors The prevailing rate of domestic currency Inflation
rate Income of foreigners World price of the commodity Trade barriers. Imports of Goods
and services Level of Domestic Income International prices Inflation rate Value of
Domestic Currency Trade Barriers
Department of Commerce
Export Import Data Bank
Total Trade :: Top countries
Dated: 23/12/2019
Values in Rs Crore
Year: 2019-2020(Apr-Oct(P))

Trade
Rank Country Export Import Total Trade
Balance

1. USA 219,889.20 153,930.98 373,820.18 65,958.22

2. CHINA P RP 69,880.84 293,068.94 362,949.78 -

223,188.10

3. U ARAB EMTS 121,626.13 116,969.92 238,596.05 4,656.21

4. SAUDI ARAB 23,321.18 108,694.11 132,015.29 -85,372.93

5. HONG KONG 49,826.03 72,318.17 122,144.20 -22,492.14

6. SINGAPORE 42,309.06 61,134.81 103,443.87 -18,825.75

7. IRAQ 8,241.96 92,758.94 101,000.89 -84,516.98

8. GERMANY 34,403.21 54,040.23 88,443.44 -19,637.02

9. KOREA RP 19,133.98 68,077.78 87,211.76 -48,943.80

10. SWITZERLAND 5,192.02 79,321.50 84,513.52 -74,129.48

11. INDONESIA 15,514.96 57,404.90 72,919.86 -41,889.93

12. JAPAN 19,275.34 53,610.77 72,886.11 -34,335.43

13. MALAYSIA 25,228.91 43,047.53 68,276.45 -17,818.62

14. UK 35,615.41 28,562.42 64,177.83 7,052.99

15. BELGIUM 23,927.45 36,763.59 60,691.03 -12,836.14

16. NIGERIA 15,035.18 42,881.63 57,916.81 -27,846.45

17. AUSTRALIA 11,874.49 44,670.81 56,545.30 -32,796.31

18. VIETNAM SOC REP 21,433.43 34,694.98 56,128.42 -13,261.55

19. NETHERLAND 37,185.46 16,191.35 53,376.82 20,994.11

20. THAILAND 18,120.18 29,828.24 47,948.43 -11,708.06

21. SOUTH AFRICA 17,378.50 26,906.53 44,285.04 -9,528.03

 22. KUWAIT 5,400.14 38,431.60 43,831.74 -33,031.46

23. QATAR 4,981.63 37,760.49 42,742.12 -32,778.86

24. FRANCE 20,788.04 20,531.79 41,319.82 256.25

25. RUSSIA 11,723.68 27,788.52 39,512.20 -16,064.84

Total of Top countries 877,306.41 1,639,390.5 2,516,696.9 -

3 4 762,084.1
2

India's Total 1,302,947.27 1,991,642.48 3,294,529.63 -

688,695.21

% Share of Top 67.33 82.31 76.39 110.66

countries

DOC-NIC
Determinants of Balance of Payments:
There are several variables which determine balance of payments position of a country.
They are:
(1) National income at home and abroad,
(2) Exchange rate of national currency,
(3) The domestic prices of goods and factors,
(4) International oil and commodity prices and
(5) Demand for and supply of foreign currency.
At the back of these variables lie the supply factors, production function, the state of
technology, tastes, distribution of income, economic conditions, the state of expectations, etc.
If there is a change in any of these variables and there are no appropriate changes in other
variables, disequilibrium in balance of payments will occur.

The main cause of disequilibrium in the balance of payments arises from imbalance between
exports and imports of goods and services, that is, deficit or surplus in balance of trade. When
for one reason or another value of exports of goods and services of a country are smaller than
the value of its imports the disequilibrium in balance of payments is likely to occur.

The value of exports may be small due to the lack of exportable surplus which in turn results
from the low production of goods to be exported or the exports may be small because of the
high cost and prices of exportable goods and severe competition in the world markets.
The important causes of lower exports are inflation or rising prices in the country or over-
valued exchange rate. When there is higher rate inflation in a country resulting in higher
prices of exportable goods, its exports are discouraged and imports encouraged. If it is not
matched by other items in the balance of payments, disequilibrium will occur.

Distinction between Current Account and Capital Account:

The distinction between the current account and capital account may be noted. The current
account deals with payment for currently produced goods and services; it includes also
interest earned or paid on claims and also gifts and donations. The capital account, on the
other hand, deals with payments of debts and claims.

The current account of the balance of payments affects the level of national income directly.
For instance, when India sells its currently produced goods and services to foreign countries,
the producers of those goods get income. In other words, current account receipts have the
effect of increasing the flow of income in the country.

Components of Balance of Payments The BOP is a collection of accounts conventionally

grouped into three main categories with subdivisions in each. The three main categories are:
(a) The Current Account: Under this are included imports and exports of goods and services
and uni-lateral transfers of goods and services. (b) The Capital Account: Under this are
grouped transactions leading to changes in foreign financial assets and liabilities of the
country. (c) The Reserve Account: In principle this is no different from the capital account in
as much as it also relates to financial assets and liabilities. However, in this category only
“reserve assets” are included.
Structure the Current Account in India’s BOP Statement
A. CURRENT ACCOUNT
Credit Debits Net
I. Merchandise
II. Invisibles (a+b+c)
a.) Services
1. Travel
2. Transportation
3. Insurance
4. Government not else where Classified
5. Miscellaneous
b.) Transfers
6. Official
7. Private
C. Income
i) Investment income
ii) Compensation to Employees

Structure of the Capital Account

B. CAPITAL ACCOUNT (l to 5)
credit Debit Net
1. Foreign Investment (a + b) a) In India
i. Direct
ii. Portfolio
b) Abroad
2. Loans (a + b - c)
a) External Assistance
i. By India
ii. To India
b) Commercial Borrowings (MT and LT)
i. By India
ii. To India
b) Short-term to India
3. Banking Capital (a + b)
a) Commercial Banks
i. Assets
ii. Liabilities

iii. Non-resident Deposits

b) Others
4. Rupee debt Service
5. Other capital
The Other Accounts
Credit Debits Net
C. Errors and Omissions
D. Overall Balance (Total of Capital and Current Accounts and Errors and Omissions)
E. Monetary Movements
i) IMF
ii) Foreign Exchange Reserves (Increase-/Decrease+)

Why balance of payment is vital for a country?

A country’s BOP is vital for the following reasons:

 BOP of a country reveals its financial and economic status.

 BOP statement can be used as an indicator to determine whether the country’s
currency value is appreciating or depreciating.
 BOP statement helps the Government to decide on fiscal and trade policies.
 It provides important information to analyze and understand the economic dealings of
a country with other countries.

By studying its BOP statement and its components closely, one would be able to identify
trends that may be beneficial or harmful to the economy of the county and thus, then take
appropriate measures.

Important methods of correcting Balance of payment are as follows:

The disequilibrium in the balance of payments can be corrected or controlled by adopting the
measures as discussed below:
1. Deflation:
It is the classical medicine for correcting deficit in Balance of payment. Deflation refers to
the policy of reducing the quantity of money in order to reduce price and money income of
the people.
The Central Bank by raising the bank rate, by selling the securities in the open market and by
other methods can reduce the volume of credit in the economy which will lead to fall in
prices and money income of people. Fall in prices will stimulate exports and reduction in
income checks imports.
Thus deflationary policy restores equilibrium to the Balance of payment:
(a) By encouraging exports through reduction in their prices
(b) By discouraging imports through the reduction in incomes at home.
Moreover higher interest rates in domestic market will attract foreign funds which can be
used for correcting disequilibrium.
But it is also pointed out that deflation is not considered as a suitable method to correct
adverse Balance of payment because of following reasons:
(a) It means reduction in income or wages which is strongly opposed by trade unions.
(b) It causes unemployment and sufferings of the working class.
(c) In a developing country expansionary monetary policy rather than deflationary monetary
policy is required to meet the development needs.
2. Depreciation:
It means a fall in the rate of exchange of one currency in terms of another. A currency will
depreciate when its supply in the foreign exchange market is large in relation to its demand.
In other words, a currency is said to depreciate if its value falls in terms of foreign currency,
i.e. if more domestic currency is required to buy a unit of foreign currency. The effect of
depreciation of a currency is to make imports dearer and exports cheaper. Thus, depreciation
helps a country to achieve a favourable balance of payment by checking imports and
stimulating exports.
3. Devaluation:
Devaluation refers to the official reduction of the external values of a currency. Thus,
devaluation serves only as an alternative method of depreciation.
The success of devaluation depends upon following condition:
(a) The elasticity of demand for the country’s export should be greater than unity.
(b) The elasticity of demand for the country’s import should be less than unity.
(c) The exports of the country should be non-traditional and are increasingly demanded by
other countries.
(d) The domestic price should not rise and should remain stable after devaluation.
(e) Other countries should not retaliate by restoring to corresponding devaluation. Such a
measure will affect each other’s gain.
Devaluation also suffers from certain defects:
(i) Devaluation is a clear reflection of the country’s economic weakness.
(ii) It reduces the confidence of the people in country’s currency and this may lead to
speculative outflow of capital.
(iii) It encourages inflationary pressures in the home country.
(iv) It increases the burden of foreign debt.
(v) It involves large time lag to produce effects.
(vi) It is temporary device and does not provide permanent remedy to correct adverse Balance
of payment (BOP).
4. Exchange Control:
Exchange control is the most widely used method for correcting disequilibrium in the
Balance of payment. It refers to the control over the use of foreign exchange by Central Bank.
Under this method, all the exporters are directed by the Central Bank to surrender their
foreign exchange earnings. Foreign exchange is rationed among the licenced importers. Only
essential imports are permitted.
Exchange control is the most direct method of restricting a country’s imports. The major
draw-back of this method is that it deals with the deficit only and not its causes. Rather it may
aggravate these causes and thus may create a more basic disequilibrium. It does not provide a
permanent solution for a chronic disequilibrium.
5. Capital Movement:
Inflow of capital or capital imports can be used to correct a deficit in balance of payment. If
the capital is perfectly mobile between the countries, an increase in the domestic rate of
interest above the world rate will result in the inflow of capital. This will reduce the deficit in
the balance of payment.
6. Export Promotion: Exports can be pushed by the government by

(a) Reducing or completely abolishing the export duties. The goods become cheaper in
foreign countries thereby encouraging exports.
(b) Giving subsidies and cash assistance to the exporters. This helps in cutting down their
production costs on one hand and improving their competitive position in the
international market on the other.
(c) Providing incentives to the exporters in the form of tax exemption on exportable goods.
7. Import Control- The deficit in the balance of payments can be kept in check by reducing
imports. The imports can be down by
(a) Imposing new Import Duties or tariffs and increasing the existing import duties. The
Price of the imported goods rises. They become more expensive in the domestic economy
and as a consequence the demand for imported goods will decline. This helps in lowering the
deficit in the balance of payments.
(b) Adopting the Import Quota system. The volume of imports are restricted by quotas by
applying quantitative restrictions i.e., the imports of the country cannot exceed the quota
fixed by the government. If, however, the importers import more than the fixed quota, they
have to pay a penal rate of import duty.
(c) Import Substitution:Yet another method of correcting disequilibrium in the balance of
payment through reducing imports is to encourage industries producing import substitutes. It
helps the national economy to become more self- sufficient and reduce its dependence on
imports.
Therefore, it becomes clear that India should go for globalisation and open up its economy
considerably by liberalising the import export regime. In fact, the policy package offered by
the World Bank and IMF to the developing countries facing balance of payment problems
specifically included import liberalisation and a more ‘open’ trade and industrial policy as a
condition for grant of assistance. But it is seen that liberalisation of imports pushed up import
bill immediately and the export sector failed to respond at such a fast pace. Therefore, the
deficits actually increased. It is thus obvious that such a programme can be undertaken only if
adequate financing for a sufficiently long period is available.
Much more positive action is needed on the export front. According to Bimal Jalan, a feasible
goal is to raise India’s share of trade to at least 1.5 percent in the world trade in next ten years
i.e. by about 0.1 percent per annum.
Therefore, to solve the problem of Balance of payment careful mixture of inward and
outward strategy is required. The Government should import only those commodities which
need high capital and export those Goods and commodities in which it has relative advantage.

FOREIGN EXCHANGE RESERVE

Foreign exchange reserves are the foreign currencies held by a country's central bank. They
are also called foreign currency reserves or foreign reserves. There are seven reasons why
banks hold reserves. The most important reason is to manage their currencies' values.

How Foreign Exchange Reserves Work

The country's exporters deposit foreign currency into their local banks. They transfer the
currency to the central bank. Exporters are paid by their trading partners in U.S.
dollars, euros, or other currencies. The exporters exchange them for the local currency. They
use it to pay their workers and local suppliers.

The banks prefer to use the cash to buy sovereign debt because it pays a small interest rate.
The most popular are Treasury bills because most foreign trade is done in the U.S. dollar due
to its status as the world's global currency.

Banks are increasing their holdings of euro-denominated assets, such as high-

quality corporate bonds. That continued despite the eurozone crisis. They'll also
hold gold and special drawing rights. A third asset is any reserve balances they've deposited
with the International Monetary Fund.
Purpose

There are seven ways central banks use foreign exchange reserves.

First, countries use their foreign exchange reserves to keep the value of their currencies at
a fixed rate. A good example is China, which pegs the value of its currency, the yuan, to the
dollar. When China stockpiles dollars, it raises the dollar value compared to that of the yuan.
That makes Chinese exports cheaper than American-made goods, increasing sales.3

Second, those with a floating exchange rate system use reserves to keep the value of their
currency lower than the dollar. They do this for the same reasons as those with fixed-rate
systems. Even though Japan's currency, the yen, is a floating system, the Central Bank of
Japan buys U.S. Treasury’s to keep its value lower than the dollar. Like China, this keeps
Japan's exports relatively cheaper, boosting trade and economic growth. Such currency
trading takes place in the foreign exchange market.4

A third and critical function is to maintain liquidity in case of an economic crisis. For

example, a flood or volcano might temporarily suspend local exporters' ability to produce
goods. That cuts off their supply of foreign currency to pay for imports. In that case, the
central bank can exchange its foreign currency for their local currency, allowing them to pay
for and receive the imports.

Similarly, foreign investors will get spooked if a country has a war, military coup, or other
blow to confidence. They withdraw their deposits from the country's banks, creating a severe
shortage in foreign currency. This pushes down the value of the local currency since fewer
people want it. That makes imports more expensive, creating inflation. 

The central bank supplies foreign currency to keep markets steady. It also buys the local
currency to support its value and prevent inflation. This reassures foreign investors, who
return to the economy. 

 A fourth reason is to provide confidence. The central bank assures foreign investors that it's
ready to take action to protect their investments. It will also prevent a sudden flight to safety
and loss of capital for the country. In that way, a strong position in foreign currency reserves
can prevent economic crises caused when an event triggers a flight to safety. 

Fifth, reserves are always needed to make sure a country will meet its external obligations.
These include international payment obligations, including sovereign and commercial debts.
They also include financing of imports and the ability to absorb any unexpected capital
movements.

Sixth, some countries use their reserves to fund sectors, such as infrastructure. China, for
instance, has used part of its forex reserves for recapitalizing some of its state-owned banks.5  

Seventh, most central banks want to boost returns without compromising safety. They know
the best way to do that is to diversify their portfolios. They'll often hold gold and other safe,
interest-bearing investments.6

India currently has the fourth largest foreign exchange reserves in the world, Minister of State
for Finance Pankaj Chaudhary told Lok Sabha on Monday. As on November 19, 2021, he
 said the forex reserve stood at USD 640.4 billion.

Key Takeaways

 Foreign exchange reserves take the form of banknotes, deposits, bonds, treasury bills, and
other government securities.
 Foreign exchange reserves are a nation’s backup funds in case of an emergency, such as a
rapid devaluation of its currency.
 Most reserves are held in U.S. dollars, the global currency. China has the highest foreign
currency reserve in U.S. dollars.
 Countries use foreign currency reserves to keep a fixed rate value, maintain competitively
priced exports, remain liquid in case of crisis, and provide confidence for investors. They also
need reserves to pay external debts, afford capital to fund sectors of the economy, and profit
from diversified portfolios.  

https://www.thebalance.com/foreign-exchange-reserves-3306258