Theory of BOP

Lecture 17
Balance of Payments and
National Income Accounting
 Balance of payments (BOP) is a record of values of all economic transactions of a country
with the rest of the world in a particular year

The BOP account is usually classified into a current account and a capital account
by the nature of transactions.

Balance of Payments

Current Account Capital Account

Exports (X) Remittances, Transfer Asset transactions, FDI,

Imports (M) Receipts and payments External borrowing/
lending
Balance of Trade (X – M)

Balance on Current Account

Current account transactions are essentially those that do not give rise to any future claims

First, transactions that relate to cross-border sale and purchase of goods and extension
of services, or exports and imports of goods and services.

Goods trade termed as visibles

Service exports and imports are termed as invisibles

The net receipts from these exports and imports constitute the balance of
trade (BOT).

Second, payments (or receipts) for which there are no corresponding receipts (or
payments).

These are called unrequited payments and receipts or unilateral transfers

Examples: incomes from assets held abroad by domestic citizens, remittances sent
by domestic citizens working abroad, and war compensations received by the country

interest paid on external loans or on domestic assets held by foreign citizens and
remittances sent by foreign citizens working in the domestic country
these transactions do not involve any exchange even at present

The net receipts from these transactions together with the transactions in
the trade account constitute the balance of current account.

Capital account transactions, on the other hand, give rise to future claims such as
Acquiring foreign assets or shares in companies located abroad.

These transactions yield interest incomes for domestic citizens and shareholders
(and constitute a part of current account transactions) from the next period onwards.

Advancing loans to foreign countries, which is another capital

account transaction, also yields interest incomes in the next period.

Though these capital account transactions are export of capital by the country under
consideration, these are actually debit items since foreign exchange flows out rather
than flowing in

Import of capital such as direct investment by foreign companies through setting up of

subsidiary production units, portfolio investment by foreign citizens, and external
borrowings by the domestic country are credit items since the country now earns
foreign exchange through these capital account transactions.
Note: imports of capital constitute claims of the rest of the world on the
domestic country under consideration

Thus, interest payments on loans taken—that is, debt servicing -- and on

interest bearing assets acquired by foreigners will be debit items in the
current account in the next year

A capital account surplus arises when the import of capital is larger than the export of
capital.
Fundamental difference between a current account surplus and a capital
account surplus:

The current account reflects the net income of a country.

The capital account indicates a net change in national ownership of assets.

A surplus in the capital account (import of capital exceeding export of capital)

means there is a net inflow of foreign currency, but that constitutes a net claim
of foreigners on the domestic economy.
This is because net inflows are effectively outcomes of larger borrowing
than lending and a larger sale of domestic assets than purchase
of foreign assets.

Therefore, in terms of asset creation, a capital account surplus, unlike a

surplus in the current account, indicates a country’s weakness rather than
its strength

A deficit in the capital account, on the other hand, means a net claim on foreign
assets and thus reflects a country’s strength
The final category of transactions listed in the capital account is changes in the stock of
gold and foreign currency reserves held by the central bank of the country.

An increase in such reserves is considered as import of capital and is thus listed

as a credit item in BOP accounts
a decrease in reserves is considered as export of capital and is thus listed
as a debit item.

Note: these transactions will either appear on the credit side or on the debit
side of a country’s BOP account since the stock of gold and foreign currency
reserves can either increase or decrease.

These transactions are actually official settlement transactions that

act as a balancing factor

BOP of a country is the sum of current account and capital account transactions
including the official settlement term.
In the example in the book (Table 20.1): India-USA Trade 2010-11 (in US $ million):

Receipts on Trade Account: 382440 Payments on Trade Account: 465243

Receipts on Current Account: 446934 Payments on Current Account: 490252

Receipts on Capital Account Payments on Capital Account

(Import of Capital): 403711 (Export of Capital): 348858

Errors & Omissions: 0 Errors & Omissions: 2416

Overall Receipts: 850645 Overall Payments: 841526

Official Settlement: 9119

The current account balance, the capital account balance, and net errors and omissions
together define the overall balance, which is in surplus in the above example by the
Amount USD 9,119 million.

But, BOP is a double-entry book keeping which requires that the debit
and the credit sides must match each other.

This is done through the official settlement of USD 9,119 million listed on the debit side.

Thus, the official settlement term is a balancing factor necessitated by the

double-entry book keeping principle of BOP accounting

An overall surplus means that India has a claim on the rest of the world.

The listing of official settlement on the debit side then means that as if India buys
its claim on the rest of the world in exchange for its foreign currency reserves (that is,
through export of capital).

The overall surplus is thus settled.

BOP Equilibrium: Autonomous and Accommodating Transactions

In the example, the total receipts equal USD 8,50,645 million and match with
total payments including the official settlement of USD 9,119 million

Thus, ex post, there was no imbalance in India’s BOP position for that year.

Yet, we can say that India had a BOP surplus in 2010–11, and this surplus was to the
tune of USD 9,119 million
This is because, the total receipts were larger than the total payments excluding
the official settlement exactly by this amount

The official settlement does not reflect transactions that were undertaken by relevant
economic agents purely on the basis of maximization of their economic objectives

the official settlement by the amount of USD 9,119 million was just a balancing factor

Accordingly, in the ex post sense after taking into account the official settlement or
the balancing factor, the BOP statement becomes an identity.
But, ex ante, taking into account all transactions up to the final entry of the official
settlement (or the change in the reserve position of the country’s central bank) but
not including it, we can indeed talk about a BOP imbalance

It is in this ex ante sense that economists use these deficit or surplus concepts.

An alternative classification of transactions listed in a country’s BOP is useful in

Identifying whether the country is running a BOP surplus or deficit

autonomous transactions and accommodating transactions

Autonomous transactions are outcomes of optimizing decisions of individual economic
agents (and of the government)

These transactions are thus planned ex ante regardless of the BOP position
of the country

these transactions may be constrained and influenced by the policies taken

by the government for BOP considerations (such as import tariff or import
quota to reduce value of imports and thus improve BoP), but are not caused
directly by BOP considerations

All current account transactions and some capital account transactions

are autonomous transactions.
Accommodating transactions are directly caused by BOP considerations

These are not ex ante planned but are ex post in nature since these are undertaken
with an intention to match the credit and the debit sides of BOP or the total receipts
and payments of a country.

undertaken only by the central bank of a country, in the form of accommodating

capital movements like changes in gold or foreign currency reserves held by the
central bank and official borrowing from abroad or extending loans to other
countries

accommodating transactions are purely capital account transactions and are

undertaken only at the official level
To summarize, accommodating capital movements (or official settlements) indicates the
BOP position of a country.

If it is an inflow (or accommodating capital imports) and is thus listed on the credit side,
it indicates a BOP deficit

if it is an outflow (or accommodating capital exports), it indicates a BOP surplus

But, ex post, BOP of a country always balances in the book keeping sense
and is thus an identity.