International Financial Management

P G Apte

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 4.1 What is the Balance of Payments
• 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
Basic types of economic transactions
– Purchase or sale of goods or services with a
financial quid pro quo - or a promise to pay.
One real and one financial transfer.

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4.1 What is the Balance of Payments
– Purchase or sale of goods or services in return
for goods or services or a barter transaction.
Two real transfers.
– An exchange of financial items e.g. purchase of
foreign securities with payment in cash or by a
cheque drawn on a foreign deposit. Two
financial transfers.
– A unilateral gift in kind. One real transfer.
– A unilateral financial gift. One financial
transfer.

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 4.2 Accounting Principles in
Balance of Payments
• The BOP is a standard double-entry
accounting record and as such is subject to
all the rules of double-entry book-keeping
• Some simple rules of thumb
– All transactions which lead to an immediate or
prospective payment from the rest of the world
(ROW) to the country should be recorded as
credit entries. The payments themselves, actual
or prospective, should be recorded as the
offsetting debit entries.
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4.2 Accounting Principles in
Balance of Payments (contd.)
– A transaction which results in an increase in
demand for or reduction in supply of foreign
exchange is to be recorded as a debit entry
while a transaction which results in an increase
in the supply of or reduction in demand for
foreign exchange is to be recorded as a credit
entry
Use of forex: debit; Source of forex: credit

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 4.3 Valuation and Timing
• Valuation : At what prices? “Arm’s length”
FOB or CIF? Should use FOB. CIF prices include
transportation, insurance which should be
separately accounted for.
• Timing : When should an item be recorded? When
the transaction is effected or when payment is
settled?
• Some uniform conventions have to be adopted.
• IMF has recommended a set of uniform practices

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 4.4 Components of the Balance of
Payments
• Three main categories
– The Current Account: Under this are included
imports and exports of goods and services and
unilateral transfers of goods and services.
– The Capital Account: Under this are grouped
transactions leading to changes in foreign financial
assets and liabilities of the country.
– The Reserve Account: In this category only
"reserve assets" are included. These are the assets
which the monetary authority of the country uses to
settle the deficits and surpluses that arise on the
other two categories take together

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 4.4 Components of the BOP
• The Current Account
– Merchandise trade should cover all transactions
relating 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 the goods themselves.

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 4.4 Components of the BOP
– Exports, valued on f.o.b. basis, are credit
entries.
– Imports valued at c.i.f.(in practice) are the
debit entries.
– The difference between the total of credits and
debits appears in the "Net" column. This is the
Balance on Merchandise Trade
– What are the offsetting entries? Payments for
exports increase foreign assets – a “use” of
forex, a debit. Payments we make for imports
create foreign liabilities or reduce foreign assets
– a source of forex , a credit.
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 4.4 Components of the BOP
• Invisibles
– The invisibles account includes services such as
transportation and insurance, income payments
and receipts for factor services - labour and
capital - and unilateral transfers.
– Credits under invisibles consist of services
rendered by residents to non-residents, income
earned by residents from their ownership of
foreign financial assets (interest, dividends),
income earned from the use, by non-residents,
of non-financial assets such as patents and
copyrights owned by residents gifts received by
residents from non-residents.
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 4.4 Components of the BOP
– Debits consist of same items with the roles of
residents and non-residents reversed.
– The net balance between the credit end debit
entries under the heads merchandise, non-
monetary gold movements and invisibles taken
together is the Current Account Balance. The
net balance is taken as deficit if negative (debits
exceed credits), a surplus if positive (credits
exceed debits).

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 4.4 Components of the BOP
• The Capital Account
Records changes in foreign assets and liabilities.
Capital inflows are credits, outflows are debits.
Hence increase in foreign assets or reduction in
liabilities are debits; reduction in foreign assets or
increase in liabilities are credits.
Loans raised, portfolio investments by foreigners,
direct inward investment – credits
Loans repaid, investments by residents abroad,
disinvestment by foreigners – debits.

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 4.4 Components of the BOP
• The Other Accounts
– The IMF account contains, as mentioned above,
purchases (borrowings) and repurchases
(repayments) from the IMF. Former are credits,
latter debits.
– The Foreign Exchange Reserves account
records increases (debits) and decreases
(credits) in reserve assets (RBI's holdings of
gold and foreign exchange, SDRs - Special
Drawing Rights - are a reserve asset created by
the IMF and allocated from time to time to
member countries)

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 4.5 Meaning of “Deficit” and
“Surplus”in the Balance of Payments

• The terms "deficit" or "surplus" cannot then refer

to the entire BOP but must indicate imbalance on a
subset of accounts included in the BOP
• In popular parlance, BOP deficit or surplus refers
to deficit or surplus on current account.
• An economically meaningful distinction is
between “autonomous” and “compensating”
transactions. Balance on autonomous transactions-
“above the line”; on compensating transactions-
“below the line”
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 4.5 Meaning of “Deficit” and
“Surplus”in the BOP
• How to make this division so that BOP statistics,
in particular the deficit and surplus figures, will be
economically meaningful
• Emphasize the purpose or motive behind a
transaction as the criterion to decide whether the
transaction should go above or below the line
• 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 realize a profit or
reduce costs
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 4.5 Meaning of “Deficit” and
“Surplus”in the BOP
• An accommodating transaction on the other hand
is undertaken with the motive of settling the
imbalance arising out of other transactions e.g.
financing the deficits arising out of autonomous
transactions
• Compensatory official financing: Financing
undertaken by the monetary authority to provide
(foreign) exchange to cover a surplus or deficit in
the rest of the BOP

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 4.5 Meaning of “Deficit” and
“Surplus”in the BOP
• Several concepts of "balance" have evolved
– Trade Balance: This is the balance on the
merchandise trade account.
– Balance on Goods and Services: This is the
balance between exports and imports of goods
and services.
– Current Account Balance: This is the net
balance on the entire current account.

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 4.5 Meaning of “Deficit” and
“Surplus”in the BOP
– Balance on Current Account and Long Term
Capital: This is sometimes called basic
balance. This is supposed to indicate long term
trends in the BOP, the idea being that while
short term capital flows are highly volatile,
long term capital flows are of a more permanent
nature and indicative of the underlying
strengths or weaknesses of the economy.

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4.6 Why are BOP Statistics Important
• BOP statement contains useful information for
financial decision makers.
• In the short run, BOP deficits or surpluses may
have an immediate impact on the exchange rate
• When exchange rates are market determined, BOP
figures indicate excess demand or supply for the
currency and the possible impact on the exchange
rate
• May signal a policy shift on the part of the
monetary authorities of the country, unilaterally or
in concert with its trading partners

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 4.6 Why are BOP Statistics Important
(contd.)
• Movements in a countries reserves have
implications for the stock of money and credit
circulating in the economy
• Central bank's purchases of foreign exchange in
the market will add to the money supply and vice
versa unless the central bank "sterilizes" the
impact by compensatory actions such as open
market sales or purchases
• Intimately connected with the overall saving-
investment balance in a country's national
accounts
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 4.7 Summary
• The balance of payments of a county
records its economic transactions with the
rest of the world using a well defined set of
accounting conventions
• The phrase balance of payments deficit or
surplus normally refers to the balance
between credits and debits on the current
account

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 4.7 Summary (contd.)
• 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

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