Balance of Payments

Meaning
The BOP of a country can be defined as a systematic
statement of all transactions of a country with the
rest of the world during a period of time, usually one
year.
The purpose of BOP accounting is to take the stock
of countrys foreign receipts & payment obligations
and of assets & liabilities arising out of international
economic transactions with a view to correcting
unhealthy trends

Important Uses of BOP account

First, BOP accounting serves a very useful purpose as it
gives necessary information on the strength & weakness of
the country in international economic relations
Second, by analyzing the BOP accounts of past years, one
can find the overall gains & losses from the international
economic transactions. It can be ascertained whether
composition & direction of international trade and capital
movements have improved or caused deterioration in the
economic condition of the country.
Third, BOP statements give warning signals for future
policy formulation. For, even if the BOP position in recent
past has not been a matter of concern, there may be
unhealthy developments which might create problem in
future.

BOP Accounts

BOP a/c has been grouped under two broad

categories :

1. Current transactions
2. Capital transaction

Current Transaction

Capital Transactions

include export & import of

goods & services, ie. Visible
& invisible trade, unrequited
receipts & payments in the
current year

include inflows & outflows of

capital including foreign
investments, gold & foreign
exchange reserves

It changes the current level of Here capital transaction

consumption / national
changes the capital stock of
income of the country
the country
These are flow in nature

These are stock in nature

These are reflected in current These are reflected in capital

account
account

 Current Account : The items under this are

classified as visible items which includes export &
import of goods ,called merchandise trade &
invisible items listed from 2 onwards
- 1. Merchandise
- 2. Foreign Travel
- 3. Transportation
- 4. Insurance premium
- 5. Banking
- 6. Investment income
- 7. Government (purchase & sale of Goods &
Service)
- 8. Miscellaneous

Capital Account: The items are

Short term capital movements : which includes

a. Purchase of short term securities , like commercial
bills, treasury bills & acceptance bills
b. Speculative purchase of foreign currency
c. Cash balance held by foreigners for such reasons
as war, political uncertainty etc.

2. Long-term capital movements: This includes

a. Direct investment in shares, bonds, real estate or physical
assets like plant, building & equipment in which the
investor holds a controlling power.
b. Portfolio investment, including all other stocks & bonds,
eg. Government securities, securities of firms which do
not entitle the holder with a controlling power
c. Amortization of capital, i.e. repurchase & resale of
securities sold to the foreigners.
Note that direct import & export of capital goods fall under the
category of FDI. Also note that export of capital falls
under debit item & inflow falls under credit items as in the
former there is outflow of forex & in the latter, there is
inflow of forex.

3. Inflow & outflow of gold & foreign exchange

reserves : Here gold & foreign exchange reserves
are maintained to stabilize the exchange rate of the
home currency & to make payments in case there is
payment deficits on current accounts. The foreign
exchange reserves increase or decrease depending
on the net balances of other transactions

Balance of Trade (BOT)

This is the net balance of the visible trade.
If X = M , there is trade balance
If X<M, there is trade deficit
If X>M, there is trade surplus.
Both visible & invisible trade gives the total
current a/c .

 Trade Balance = Exports Imports

Current A/c Balance = TB +/- Net Invisibles
Overall balance = Current a/c balance Capital a/c
balance
BOP = current a/c + capital a/c +/- Balancing item =0

Autonomous & Induced Transaction

Autonomous Transaction : are carried out on there
own with a view to consuming more or making profit.
It takes place both in current & capital a/cs. . Eg.
Merchandise trade.
Accommodating transaction/ Induced transaction : If
X is not equal to M then it requires some balancing
transactions. This is in the form of international
borrowing or lending that lead to short term capital
flow as or outflows, This kind of transactions are
made for making payments for deficits in the BOT
and are termed as accommodating transactions

Assessment of BOP Disequilibrium

In BOP assessment, only autonomous transaction
is taken into consideration
If total receipts > total payment , we have BOP
surplus
If total receipts < total payments , we have BOP
deficits.
Current a/c deficit is financed by either sale of
foreign assets or by net borrowing ,
so Current a/c deficit = Net capital inflow
Note CA deficit is the result of autonomous
transaction & net capital inflow is induced
transaction

 From adjustment point of view, capital a/c

transaction is divided into
1. autonomous transaction ie, capital transaction
carried out by the private sector
2.Official transaction ie, transaction by the central
bank
Bop deficit = decrease in official foreign exchange
reserves
= current a/c deficit + net capital inflows

Causes & kinds of BOP disequilibrium

Cyclical disequilibrium : This is caused by the
fluctuations in the economic activity or trade cycles.
The changes in income of the people & prices of
goods during the period of prosperity & depression,
affects the export & imports of goods ,thereby
influence the balance of payments and cause
disequilibrium.

 Secular or Long run disequilibrium : This occurs

because of long-run & deep-seated changes in an
economy as it develops from one stage of growth to
another. In the initial stages of development,
domestic investment exceeds domestic savings and
imports exceed exports. Disequilibrium arises due to
lack of sufficient funds available to finance the
import surplus. Then come the stage when domestic
saving tends to exceed domestic investment &
export exceed import, here disequilibrium may
arise because long term capital outflow falls short
of surplus savings.

 Technological Disequilibrium This is caused by

various technological changes which involves
inventions or innovations of new goods or new
techniques of production. These technological
changes affect the demand for goods and productive
factors which in turn influence the various items in
the BOP. The innovation may lead to increased
exports if it is export biased innovation & may lead
to decline in imports, if it is an import biased
innovation. This will create disequilibrium

 Structural Disequilibrium : This occurs when the

change in demand or supply of exports alters a
previously existing equilibrium. Suppose demand in
foreign country for Indian handicrafts falls. The
resources engaged in the production of these
handicrafts must shift to some other line or country
must restrict imports, otherwise the country will
experience a structural disequilibrium.

Corrective measures
Expenditure switching policy
- devaluation
- import tariff
- import restriction
- impose quota on import
Expenditure reducing policy
- increase in taxes
- increase in interest rates
- reduce subsidies