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Subject

INTERNATIONAL FINANCE

Submitted by:-

Name Roll No. Class

Jenell Fonseca 3459 TYBMS (A)


PROJECT ON

BALANCE OF
PAYMENTS

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TABLE OF CONTENTS:

I. INTRODUCTION -4-

II. DEFINITION -5-

III. IMPORTANCE/CHARACTERISTICS -6-

IV. STRUCTURE/COMPONENTS -8-


 BALANCE OF TRADE -9-
 CURRENT ACCOUNT
-10-
 CAPITAL ACCOUNT -12-
 BASIC BALANCE
-15-
 ACCOMODATING & AUTONOMOUSCAPITAL -15-
 UNILATERAL TRANSFERS -16-
 BALANCE OF INVISIBLE TRADE
-17-
 BALANCE OF VISIBLE TRADE -19-
 RESERVES -19-
 ERRORS AND OMISSIONS
-20-
 ILLUSTRATION
-21-
V. EQUILIBRIUM AND DISEQUILIBRIUM IN BOP -22-

VI. INDIA’S BALANCE OF PAYMENTS -24-

VII. DESCRIPTIVE QUESTIONS -27-

VIII. BIBLIOGRAPHY -35-

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I. INTRODUCTION

Balance of payments of a country is a “systematic record of all economic and


commercial transactions between the residents of the reporting country and
residents of foreign countries”.

This account is for a period of time, normally one year. These transactions are as
between residents of one country with those of other countries. These transactions
include payments for the country's exports and imports of goods, services,
and financial capital, as well as financial transfers.
The basic idea is that balance of payments should record economic and commercial
transactions flowing from one geographical region to another, constituting the nation
states with the domestic incomes and output subject to the control of national
authorities. Such records may help the government of the reporting country to
measure the flows of goods and services or resources flows from their country to
others and vice versa. Monetary authorities of the reporting country should know the
receipts and payments as between the reporting country and others so as to access the
impact of such flows on domestic money supply and on the savings of the economy.
Besides, economists would like to study from these data the impact of foreign
transactions on national income of the reporting country – their impact on current
income and expenditure (current account) and on assets and liabilities of the country
(capital side).
The monetary and fiscal policies and foreign exchange policy would be formulated or
reformulated on the basis of these data. It would thus be seen that the balance of

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payments data are very useful from the point of view of formulation and
operation of the domestic economic policy.

II. DEFINITION

“A systematic record of all economic transactions between the residents of the


reporting country and residents of foreign countries during a given period of time”

- Kindleberger

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

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III.

IMPORTANCE/CHARACTERISTICS

1) BoP is a way of listing receipts and payments in the international transactions


of a country

2) BoP adopts a double – entry book – keeping system. It has two sides: debit and
credit. Payments are recorded on the debit side and receipts on the credit side.

3) BoP is a record pertaining to a period of time.

4) BoP is an annual statement

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5) In the accounting sense, debit and credit will always balance each other. That
is to say, debit or the payment side of the balance of payments account of a
country represents the total of all the uses made out of the total foreign
exchange acquired by the country during a given period, while the credit or
receipts side represents the sources from which this foreign exchange was
acquired by this country in the same period. Thus, the two sides as such must
necessarily balance. If, in the actual balance of payments account, the credits
and debits do not balance, the balance is usually achieved by adding an item
called errors and omissions.

6) BoP contains two sets of accounts:


a) Current account
b) Capital account
Real and short-term transactions are recorded under current account. Capital
account records all financial and long-term transactions.
7) BoP records all the transactions that create demand for and supply of a
currency. This indicates demand-supply equation of the currency. This can
drive changes in exchange rate of the currency with other currencies.

8) BoP may confirm trend in economy’s international trade and exchange rate of
the currency. This may also indicate change or reversal in the trend.

9) BoP is a record of payments and receipts of the country. Hence in the strict
sense it is a calculation of balance of Payments and Receipts.

10) BoP is a standard double entry accounting record to capture all the
transactions of an economy with the rest of the world.

11) The BoP summarizes international transactions for a specific period, usually a
year, and is prepared in a single currency, typically the domestic currency for

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the country concerned. Sources of funds for a nation, such as exports or the
receipts of loans and investments, are recorded as positive or surplus items.
Uses of funds, such as for imports or to invest in foreign countries, are
recorded as a negative or deficit item.

In short, the balance of payments (BoP) is flow statement that records a


country’s all transactions with the rest of the world or the foreign sector.

IV. STRUCTURE/COMPONENTS OF BALANCE OF


PAYMENTS

A balance of payment statement is a summary of a nation’s total economic


transactions undertaken on international trade account.

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

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statistical discrepancy the difference amount is adjusted with errors and omissions
account and thus in accounting sense the BoP statement always balances.

The various components of a BoP statement are:


1) Current Account
2) Capital Account
3) IMF
4) SDR Allocation
5) Errors & Omissions
6) Reserves and Monetary Gold

A] BALANCE OF TRADE (X+M=0)


Balance of trade is the most widely used concept where X is exports and M is imports
on the merchandise account. 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 favorable while
deficit is regarded as unfavorable.

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

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Trade”. There is no 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.

B] CURRENT ACCOUNT(X+M+X`+M`=0; X` is exports invisible trade account


and M` is imports on the same account)
On the current account, only transactions of currents nature resulting in incomes or
expenditure and not leading to asset formation are recorded. There are four sub-
categories under this head, namely:
(a) Transactions of merchandise or visible items of goods, namely, exports
and imports
(b) Transactions on invisible account, namely, foreign travel,
transportation , banking, insurance and other services, interest,
dividends, royalties, Government Embassy expenditures, etc
(c) Unilateral transfers like gifts, donations, charities, etc

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(d) Non-monetary gold movements

The current account balance is one of two major measures of the nature of a country's
foreign trade (the other being the net capital outflow). A current account surplus
increases a country's net foreign assets by the corresponding amount, and a current
account deficit does the reverse. Both government and private payments are included
in the calculation. It is called the current account because goods and services are
generally consumed in the current period.
The current account shows the net amount a country is earning if it is in surplus, or
spending if it is in deficit.
It is the sum of the balance of trade (net earnings on exports – payments for
imports), factor income (earnings on foreign investments – payments made to foreign
investors) and cash transfers. It is called the current account as it covers transactions
in the "here and now" - those that don't give rise to future claims.

For example, entries under Current account might include:

 Trade – buying and selling of goods and services

 Exports – a credit entry


 Imports – a debit entry
 Trade balance – the sum of Exports and Imports

 Factor income – repayments and dividends from loans and investments

 Factor earnings – a credit entry


 Factor payments – a debit entry
 Factor income balance – the sum of earnings and payments.

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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.

C] 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.

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

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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, even if its intention is to keep that money in that 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.

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
firm’s country, and as a positive item in the capital account for the other country. That
capital outflows appear as a negative item in a country’s 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 purchaser’s country (and as a positive
item in the accounts of the seller’s country).

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The net value of the balances of direct and portfolio investment defines the balance on
capital account.

Thus, the capital account transactions are short-term capital inflows and outflows for
private purposes, official purposes or banking purposes. Private flows of capital
include private company remittances for working capital purposes to subsidiaries or
branches of foreign companies or short-term loans, grants, etc., from foreign banks,
international financial institutions, foreign government etc. These short-term flows
may be for investment purposes or speculation on private account or for
compensatory purposes on government account. These can also be banking funds for
short-term purposes.

There are long-term capital movements which may again be private or governmental.
The private flows include loans and advances granted to private parties (Buyers’
credit), investment in shares, bonds, debentures, etc., by Indians abroad or by
foreigners in India, investment in joint ventures, consultancy, turn-key projects,
deferred payment credits, etc. Such flows on official account also take place through
governments or governmental agencies or financial institutions in India through lines
of credit, foreign government loans, credits, grants etc.,for private long-term
purposes.

The capital account reflects the changes in foreign assets and liabilities of the country
and affects its creditor / debtor position. An excess of foreign assets over foreign
liabilities indicates a net creditor position and vice versa. Net changes in current
account are reflected by a corresponding and opposite change in the capital account,
changing the foreign assets and liabilities position of the country.

The capital account deals with payments of debts and claims. It consists of all such
items as may be employed in financing both imports and exports, namely, private

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balances, assistance by international institution agencies and specie flow, and
balances held on government account.
Accordingly, it includes private capital account, international institutional capital
account, specie account and government capital account. Balances in the accounts
may rise or fall from year to year, depending upon the movements or fluctuations in
other items on capital account. Capital account transactions have effect in the Balance
Sheets of the respective entities.

The capital account records the net change in ownership of foreign assets. It includes
the reserve account (the international operations of a nation's central bank), along with
loans and investments between the country and the rest of world (but not the future regular
repayments / dividends that the loans and investments yield, those are earnings and will be
recorded in the current account).

Current account is like an income and expenditure statement with surplus or


deficit in it transferred to capital account which is like a balance sheet.

D] BASIC BALANCE (X+M+X`+M`+LTC = STC)


This concept was propagated by economists like Ragner Nurkse for the purposes of
economic analysis. It assumes that current account balance and long-term capital
flows are autonomous and they are counter-balanced by short-term capital flows
which are generally induced. There may, however be short-term capital flows which
are autonomous and motivated by investment or speculative gains. The concept helps
the analysis of transfer problem in international payments. Thus, if autonomous
receipts and payments leave a negative balance, it is to be counter-balanced or
financed by short-term inflow in the form of gold, international currencies or credits.
This would involve exchange of currencies or credit instruments in the foreign
exchange market.
The basic balance is useful in national income analysis, foreign exchange budgeting,
funds flow analysis, etc. Besides by the basic balance concept, equilibrium in the

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balance of payments can be judged and the pressure on the exchange market and the
extent of the transfer problem can be analyzed.

E] 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.
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
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.

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F] 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.

Foreign economic aid or assistance and foreign military aid or assistance received by
the home country’s government (or given by the home government to foreign
governments) constitutes government to government transfers. There is no well
worked out theory to explain the behavior 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 lending’s 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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G] 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 together constitute
the largest and economically the most significant components in the BoP of any
country.

It is interesting to note here that the International Monetary Fund (IMF) includes the
following items as invisible transactions:

 International transportation of goods including warehousing while in transit


and other transit expenses.
 Travel for reasons of business, education, health, international conventions or
pleasure.
 Insurance premiums and payments of claims.
 Investment income, including interest, rents, dividends and profits.
 Miscellaneous service items such as advertising, commissions, film rental,
pensions, patent fees, royalties, subscriptions to periodicals and membership
fees.
 Donations, migrant remittances and legacies.
 Repayment of commercial credits.

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 Contractual amortization and depreciation of direct investment.

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.

H] 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 non-residents (exports) and from non-residents to residents (imports). 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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I] RESERVES
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 (SDR’s)
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 country’s 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 omission
J] 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

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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 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 under-reporting of some
items in order to reduce tax liabilities.

Illustration

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The items that fall under the Current A/c and Capital A/c with example

V. EQUILIBRIUM AND DISEQUILIBRIUM IN BOP

Credits Debits
Current Account Current Account
1. Merchandise Exports (Sale of 1. Merchandise Imports (purchase of
Goods) Goods)
2. Invisible Exports (Sale of 2. Invisible Imports (Purchase of
Services) Services)
a. Transport services sold a. Transport services
abroad purchased from abroad
b. Insurance services sold b. Insurance services
abroad purchased
c. Foreign tourist expenditure c. Tourist expenditure abroad
in country
d. Other services sold abroad d. Other services purchased
from abroad
e. Incomes received on loans e. Income paid on loans and
and investments abroad. investments in the home country.
3. Unilateral Transfers 3. Unilateral Transfers
a. Private remittances received from a. Private remittances abroad
abroad
b. Pension payments received from b. Pension payments abroad
abroad
c. Government grants received from c. Gove
abroad rnment grants abroad.
Capital Account Capital Account
3. Foreign long-term investments in 3. Long-term investments abroad
the home country (less redemptions (less redemptions and repayments)
and repayments)
a. Direct investments in the a. Direct Investments abroad
home country
b. Foreign investments in b. Investments in foreign
domestic securities securities
c. Other investments of c. Other investments abroad
foreigners in the home country
d. Foreign Governments’ d. Government loans to
loans to the home country. foreign countries
4. Foreign short-term 4. Short-term investments
investments in the home country. abroad.

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A] EQUILIBIRUM IN BoP
The balance of payments, in the accounting sense, must always balance. Debits
must always equal credits if the entries are correctly made. Thys, there can be no
disequilibrium in the balance of payments as a whole.

However, while a nation’s international accounts must always balance, its


accounts need not be in equilibrium. Say, if a country’s balance of payments
shows a debit balance in merchandise and services accounts (on Current A/c side),
its credit balance in the other accounts (on the Capital A/c side) must be
sufficiently large so that total debits equal total credits. That is to say, when a
country has a debit balance on Current A/c, it is either importing capital on a long
or short term or it is exporting gold, or it is receiving donations from foreigners
and thereby its credit in the current A/c is extended to the extent of debit in the
Current A/c.

B] DISEQUILIBRIUM IN BoP
The following are the main types of disequilibrium in Bop:-
 Cyclical disequilibrium: It occurs on account of trade cycles. Depending
upon the difficult phases of trade cycles like prosperity and depression,
demand and other forces vary, causing changes in the terms of trade as well
as growth of trade and accordingly a surplus or deficit will result in the
Bop.
 Structural disequilibrium: It emerges on account of structural changes
occurring in some sectors of the economy at home or abroad which may
alter the demand or supply relations of imports or exports or both.

 Short-run disequilibrium: This type will be a temporary one, lasting for a


short period, which may occur once in a while. When a country borrows or
lends internationally, it will have short-run disequilibrium in its Bop, as

23
these loans are usually for a short period or even if they are for a long
duration, they are repayable later on: hence its position will be
automatically corrected and poses no serious problem.

 Long-run or secular disequilibrium: This type refers to a deep-rooted,


persisted deficit or surplus in the Bop of a country. It is secular
disequilibrium emerging on account of the chronologically accumulated
short-term disequilibria-deficits or surpluses. It endangers the exchange
stability of the country concerned. It tends to deplete it’s a country’s foreign
exchange reserves and the country may also not be able to raise any more
loans from foreigners during such a period of persistent deficits.

Fundamental Disequilibrium
I.M.F uses the term ‘fundamental disequilibrium’ to describe a persistent, long-
run disequilibrium, especially, deficits which exist continuously for a long
period of time in a country’s balance of payments.
Unchecked series of short-run disequilibria in a country’s Bop ultimately lead
to the ‘fundamental disequilibrium’ in the long run.

Causes of disequilibrium
(a) Trade Cycles
(b) Huge developmental and Investment Programmes
(c) Changing Export Demand
(d) Population Growth
(e) Huge External Borrowings
(f) Inflation
VI. INDIA’S BALANCE OF PAYMENTS

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In India, balance of payments compilation, concepts and techniques are almost similar
to those followed by the International Monetary Fund (IMF). These are codified by
the Fund in their Balance of Payments Manual given to member countries for their
reference and guidance.

In India, balance of payments had been showing consistent deficits which were
designed to finance the plan expenditure. Thus, our imbalance in balance of
payments is not really of a short-term disequilibrium nature but of a structural nature.
Massive doses of foreign aid (official loans, grants and commodity assistance) have
been used for financing a sizeable part of our import requirements for planned
investment. So the measurement of the deficit is being made in terms of drawal on
induced foreign official resources (loans and grants), borrowings from IMF and use of
foreign exchange reserves.

Sectoral Breakdowns
India’s balance of payments data are presented in a way as to be amenable to sectoral
analysis. The details of short-term and long-term nature under both government and
private sectors are presented separately. Thus, the contributions to the foreign sector
represented by the balance of payments from the government, business and financial
sectors are available from these data. In current account, imports and exports are
given as debits and credits. Under the category of invisibles, government and receipts
and expenditure and government remittances – inflows and outflows – and other
items to the extent possible, are presented for the government and the private business
sector. The transfer payments and receipts are presented separately for governments
and private sector. Balance of payments data are published both in Rupee and U.S.
dollar terms. Quarterly data for the recent years and Current Account data area given
area-wise, such as Sterling area, Dollar area, etc.
The details on capital account are also presented in terms of the government (official),
private and banking sectors. Private sector represents the business and household
sectors in India and primarily the former while the banking sector represents the flows

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of the financial sector. The government and private sector flows may be of both
short-term and long-term nature and are presented as Foreign Investment, loans,
banking sector, loans include external assistance, commercial borrowings and short
term capital flow. These details are given in the capital account. The data also
includes Rupee Debt Service and other capital. Errors and omissions are shown as
part of the Bop while the rest are shown as financing arrangements.

Source of data
In India, the Reserve Bank of India is the sole agency responsible for the compilation
of balance of payments data. The RBI in turn collects these data from various sources,
namely, banks, corporate units, government bodies and Indian Government missions
abroad, etc., and from the surveys conducted by them. As the exchange control
authority, the RBI gets some data from the banks who are authorized dealers in
foreign exchange, from customs and trade authorities who are in charge of import and
export licenses.

Trends in Balance of Payments


In the post-independent India, regular balance of payments data have been
maintained. During 1948-49 to 1950-51, the country incurred huge deficits in the
balance of payments amounting to a total of Rs. 629 crores, for the whole period
financed by the drawal on foreign exchange reserves, which are mostly sterling
reserves at that time, built up during the war period. The rupee was devalued in
September 1949 by 30.5% following the devaluation of sterling to maintain
competitiveness of Indian exports and to improve its earnings.

During the First Plan period, the balance of payments position improved
considerably and the overall deficit was brought down to a total of Rs. 348 crores
over the period. Both exports and imports were at low ebb.
It was only during the Second Plan period that the tempo of planned investment
gathered momentum and the effect of this was felt as pressures on the balance of

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payments. Imports far surpassed exports and the deficit over the period 1955-56 to
1960-61 amounted to Rs. 2135 crores.
In view of the continuous deficits in our Bop, it was often misunderstood as a
symptom of disequilibrium. But these deficits being planned, no action was taken for
corrective adjustment.
During the Third Plan period, there was a progressive rise in imports on account of
food grains scarcity and rising investment targets. The trade deficits amounted to Rs.
2295 crores and the total Bop deficit to Rs. 3056 crores. As in the Second Plan, this
deficit was mostly financed by external assistance (Rs. 2806 crores) and partly by
drawl on IMF (Rs. 244 crores). The rest (Rs. 6 crores) was financed by drawing down
of reserves which had already reached the rock-bottom level of Rs. 298 crores.

By the end of the Third Plan and with the outbreak of hostilities with Pakistan, there
was a set back to our prospects of securing external assistance, and planned growth
was slowed down. Greater emphasis was laid on self-reliance in respect of food and
foreign assistance. Besides, conditions forced us to a devaluation of the rupee by
36.5% in June 1966.

VII. DESCRIPTIVE QUESTIONS

Q1) Discuss the relevance of the Balance of Payments


Ans: BoP statistics are regularly compiled, published and are continuously monitored
by companies, banks and government agencies. A set of BOP accounts is

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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
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

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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
country’s 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.

Q2 ) In the accounting sense, the Bop always balances. Explain.


Ans: 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 utilization 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.

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In general credits may be conceived as receipts and debits as payments.
However this is not always possible. In particular the change in a country’s
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 country’s official foreign exchange holdings. Such a
transaction is 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.

Q3) Give a detailed outline of the Bop statement and sub-accounts


Ans: 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. A BoP statement includes the following sub accounts, as
shown in the table below.

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Items Credits Debits Net
A. Current Account
1. Merchandise
a. Private
b. Government
2. Invisibles
a. Travel
b. Transportation
c. Insurance
d. Investment Income
e. Government (not included elsewhere)
f. Miscellaneous
3. Transfer Payments
a. Official
b. Private
Total Current Account (1+2+3)

B. Capital Account
2. Private
a. Long Term
b. Short Term
3. Banking
4. Official
a. Loans
b. Amortisation
c. Miscellaneous
Total Capital Account (1+2+3)

C. IMF
D. SDR Allocation
E. Capital Account, IMF & SDR Allocation
(B+C+D)
F. Total Current Account, Capital Account, IMF &
SDR Allocation (A+E)

G. Errors & Omissions


H. Reserves and Monetary Gold

Current Account
The current account includes all transactions which give rise to or use up national
income. The current account consists of two major items, namely, (a) merchandise
export and imports and (b) invisible imports and exports.

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Merchandise exports i.e. sale of goods abroad, are credit entries because all
transactions giving rise to monetary claims on foreigners represent credits. On the
other hand, merchandise imports, i.e. purchase of goods abroad, are debit entries
because all transactions giving rise to foreign money claims on the home country
represent debits. Merchandise exports and imports form the most important
international transactions of most of the countries.

Invisible exports i.e. sale of services, are credit entries and invisible imports i.e.
purchase of services are debit entries. Important invisible exports include sale abroad
of services like insurance and transport etc. while important invisible imports are
foreign tourist expenditures in the home country and income received on loans and
investment abroad (interests or dividends).

Transfers payments refer to unrequited receipts or unrequited payments which may be


in cash or in kind and are divided into official and private transactions. Private
transfer payments cover such transactions as charitable contributions and remittances
to relatives in other countries. The main component of government transfer payments
is economic aid in the form of grants.

Capital Account
The capital account separates the non monetary sector from the monetary one, that is
to say, the trading or ordinary private business element in the economy together with
the ordinary institutions of central or local government, from the central bank and the
commercial bank, which are directly involved in framing or implementing monetary
policies. The capital account consists of long term and short term capital transactions.
Capital outflow represents debit and capital inflow represent credit. For instance, if an
American firm invests rupees 100 million in India, this transaction will be represented
as a debit in the US BoP and a credit in the BoP of India.

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Other Accounts
The IMF account contains purchases (credits) and repurchases (debits) from the IMF.
SDRs – Special Drawing Rights – are a reserve asset created by the IMF and
allocated from time to time to member countries. Within certain limitations it can be
used to settle international payments between monetary authorities of member
countries. An allocation is a credit while retirement is a debit. The Reserve and
Monetary Gold account records increases (debits) and decreases (credits) in reserve
assets. Reserve assets consist of RBI’s holdings of gold and foreign exchange (in the
form of balances with foreign central banks and investment in foreign government
securities) and government’s holding of SDRs. Errors and Omissions is a “statistical
residue.” 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). 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.

Q4) How can one identify a deficit or surplus in the Bop?


Ans: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

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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 BoP 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.

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

34
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.

VIII. BIBLIOGRAPHY

35
NO. NAME OF BOOK AUTHOR
(1) International Finance V.A Avadhani

(2) International Economics C P Kindelberger

(3) International Economics Francis Chernuliam


(4) Managerial Economics - II D.M. Mithani

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Thank You

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