BALANCE OF PAYMENTS

The Balance of Payments is a statement of a country’s transactions in the external

sector. The word ‘balance’ in the balance of payments is basically the difference between
inflows of capital into a country and the outflow of funds from a country. These inflows could
be due to transactions by individuals, firms or the government itself.

The relative inflow and outflow of capital can impact the country’s exchange rate
with regard to countries. For example, if more dollars flow into the country as opposed to out of
it, it results in an Excess Supply of dollars (ES$). This results in the appreciation of the
domestic currency, which can adversely impact exports from that country. If the country has a
fixed exchange rate, the Central Bank intervenes by buying dollars, thereby restoring the value
of the domestic currency vis-à-vis the dollar. Under floating exchange rates, the Central Bank.
Simply lets market forces of demand and supply determine the value of the exchanges rate. In
reality most countries have a ‘managed’ float, where the domestic currency is only allowed to
‘float’ in a pre-determined band. In such cases, the Central Bank intervenes when the domestic
currency value approaches the limits of the band.

2. COMPONENTS OF BALANCE OF PAY,MENTS:

The BoP consists of two broad components: The Current Account and the Capital
& Financial Account. The Current account is a record of transactions in the goods markets and
refers to the flow of capital; the Capital & Financial Accounts on the other hand are a record of
transactions in the asset market and refer to the net accretion (positive or negative) in the stock
of capital/ In equilibrium, any surplus in the current account is exactly balanced by a deficit in
the Capital & Financial Account and vice versa. If the surplus in either account exceeds the
deficit in the other, it leads to an increase in the Foreign Exchange (FX) reserves of the
country. FX reserves decrease if the deficit in one exceeds the surplus in the other.

Note that a country can have a surplus on both the Current and capital account. An
example of this is China, which over the years has witnessed a massive accretion of FX reserves
(estimated at $ 4 trillion in 2021) due to huge surpluses on both the current and capital account.
This is the cause of a growing savings imbalance, where some countries run huge deficits ( for
example the US) while others run huge surpluses.

(a)The Current Account:

The Components of the Current Account are as follows:

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 (1) Exports & Imports of Goods (merchandise Trade)
(2) Exports and Imports of Services
(1) and (2) together comprise the trade balance. Exports represent the inflow of
capital (‘receipt’s), while imports represent the outflow of capital (‘payments’)
Sometimes items included under ‘services; are called invisibles, because unlike
physical goods, they are not ‘visible’. These sectors typically include software
and information technology, travel & tourism, banking, health, consultancy etc.

(3) Unilateral transfers:

These include remittances, gifts to foreign nationals and institutions. Like

trade, there can be a both receipts and payments. Please note that like trade there can
be either an inflow or outflow of unilateral transfers. Too, especially with
remittances, we talk about both an inflow and outflow of remittances. Remittances to
India (money transfers by Indians living abroad to India) exceed outflows but there is
a two-way direction of Capital flows.

(4) Interest Earnings on Government Securities and Investments:

Governments of various treasury bonds issued by governments of other
countries (G-Sec), both as a source of diversification and as a safe haven. The US 5
and 10- year treasury bonds are firm favorites for their robustness. China currently
holds about $ 1 trillion in US treasury bonds. The interest on these securities is
included in the current account. Governments also invest in the equity and debt
markets of other countries, through ‘sovereign’ funds, interest and dividends on which
accrues to the current account.
(b) The Capital & Financial Account:
The main components of the Capital account are as follows:
(5) Official development Assistance (ODA): (Capital Account)
This in its original form, used to be in the form of Government-to-Government
assistance from developed to developing countries. As recipient countries have
developed, they no longer receive development assistance and in general the importance of
ODA in a recipient country’s development budget has sharply fallen. Note that countries
can be donors and recipients at the same time, which means that there would be entries in
both the receipts and payments sections of the capital account and hence the BoP.

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(6) Loan Waivers or Write offs: (Capital Account)
Developed countries or financial institutions like the World Bank and other
multilateral institutions often write off loans owed by highly indebted countries. This is
essentially to enable the indebted countries to use future income streams to invest in
development rather than repaying debt. A loan waiver (even if notional) is equivalent to a
capital infusion which would have been used to pay off a debt. This will manifest as a
receipt in the debtor’s capital account and a payment in the creditor’s capital account.

(7) Asset Transfers: (Capital Account)

This involves the transfer of an asset by the resident of one country to that of another.
Thus, if a resident of India, who owns a property in the UK ‘transfers’ it to a resident of
UK, it would count as receipt in the Indian current account and a payment in the UK
current account if the ‘transfer’ is a sale, involving the exchange of money. If it is a ‘gift’,
it would not be included in the capital account, but would attract tax payments in either
country.

(8) Foreign Direct Investment: (FDI)

In this case, a firm either starts a Greenfield project in a host country or acquires a
controlling stake in an existing firm through Merger & Acquisition or starts a Joint
Venture (JV) with an existing firm in a host country. The plants started by foreign auto
majors in India (Hyundai, Honda, Kia) would be examples of Greenfield FDI: Lafarge
stake acquisition on Ambuja Cement would be a case of FDI through M&A, while
Honda’s earlier arrangement with Hero Motors would be an example of FDI through a
JV.

(9) Foreign Institutional or Portfolio Investment: (FII or FPI)

Here unlike FDI, foreign institutional investors (mutual funds, Pension funds, private
equity investors) invest in the equity or debt market, without being part of the decision-
making process. Due to its volatility, FPI is also commonly called ‘hot money’.

(10) External Commercial Borrowing: (ECB)

These are typically short-term loans by domestic firms abroad. Since defaults are
highly likely when the payment horizon is short, Central Banks strongly discourage
ECBs from borrowing abroad on a short-term basis.

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(11) Long and Medium Term Loans:
Same principle as (10) above, except that likelihood of borrower default is
lower.