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Non ± Trade
ECD¶s,
   Current External Repayments,
$%%&' $% %' Transactions Assistance, Investments
Foreign
Interest, Investments
Tourism, NRI Deposits
Dividend,
Technical-
Knowhow, etc.
In macro ± economic terms, Current Account deficit = Domestic investments ±
Domestic savings.
 |
The balance of payment statement records all types of international
transactions that a country consummates over a certain period of time.
It is divided into three sections :
I. The Current Account
II. The Capital Account
III. The Official Reserve Account
( )## )
The current account is typically divided into three sub-categories; the
merchandise trade balance, the services balance and the balance on
unilateral transfers. Entries in this account are ³current´ in value as
they do not give rise to future claims. A surplus in the current account
represents an inflow of funds while a deficit represents an outflow of
funds.
a. The balance of merchandise trade refers to the balance between
exports and imports of tangible goods such as automobiles,
computers, machinery and so on. A favourable balance of
merchandise trade (surplus) occurs when exports are greater in
value than imports. An unfavourable balance of merchandise trade
(deficit) occurs when imports exceed exports. Merchandise exports
and imports are the largest single component of total
international payments for most countries.
b. Services represent the second category of the current account.
Services include interest payments, shipping and insurance fees,
tourism, dividends and military expenditures. These trades in
services are sometimes called invisible trade.
c. Unilateral transfers are gifts and grants by both private parties and
governments. Private gifts and grants include personal gifts of all
kinds and also relief organization shipments. For example, money
sent by immigration workers to their families in their native country
represents private transfer. Government transfers include money,
goods and services sent as aid to other countries. For example, if
the United States government provides relief to a developing
country as part of its drought ± relief programme, this would
represent a unilateral government transfer.
Unlike other accounts in the BOP, unilateral transfers have only
one ± directional flow without offsetting flows. For double entry
book keeping, unilateral transfer are regarded as an act of buying
goodwill from the recipient.
 (  
 )

The capital account is an accounting measure of the total domestic

currency value of financial transactions between domestic residents
and the rest of the world over a period of time. This account consists of
loans, investments, other transfers of financial assets and the creation
of liabilities. It includes financial transactions associated with
international trade as well as flows associated with portfolio shifts
involving the purchase of foreign stock, bonds and bank deposits.
A country¶s current account deficit must be paid for either by borrowing
from foreigners or by selling off past foreign investment. In the absence
of the government reserve transaction, a current account surplus
equals a capital account deficit and a current account deficit equals a
capital account surplus. That is, the current account balance must be
equal to the capital account balance but with the opposite sign.
 The capital account can be divided into three categories : direct
investment, portfolio investment and other capital flows.
a. Direct investment occurs when the investor acquires equity such as
purchase of stocks, the acquisition of entire firms, or the establishment of
new subsidiaries.
Foreign Direct Investment (FDI) generally takes place when firms tend to
take advantage of various market imperfections. Firms also undertake
foreign direct investments when the expected returns from foreign
investment exceed the cost of capital, allowing for foreign exchange and
political risks. The expected returns from foreign profits can be higher than
those from domestic projects due to lower material and labour costs,
subsidised financing, investment tax allowances, exclusive access to local
markets, etc. For example, many US firms are engaged in direct
investment in foreign countries. Coca ± Cola has built bottling facilities all
over the world.
b. Portfolio investments represent sales and purchases of foreign financial
assets such as stocks and bonds that do not involve a transfer of
management control. A desire for return, safety and liquidity in investments
is the same for international and domestic portfolio investors. International
portfolio investments have specifically boomed in recent years due to
investors¶ desire to diversify risk globally.
 Investors generally feel that they can reduce risk more effectively if
they diversify their portfolio holdings internationally rather than purely
domestically. In addition, investors may also benefit from higher
expected returns from some foreign markets.
c. Capital flows represent the third category of capital account and
represent claims with a maturity of less than one year. Such claims
include bank deposits, short ± term loans, money market investments
and so forth. These investments are quite sensitive to both changes in
relative interest rates between countries and the anticipated change in
the exchange rate. For example, if the interest rates rise in India, with
other variables remaining constant, India will experience capital
inflows as investors would like to deposit or invest in India to take
advantage of the higher interest rate. But if the higher interest rate is
accompanied by an expected depreciation of the Indian rupee, capital
inflows to India may not materialise.

Short term capital flows are of two types : non liquid short-term capital and
liquid short term capital. Non ± liquid short ± term capital flows include bank
loans and other short-term funds that are very difficult to liquidate quickly
without loss. Liquid short-term capital flows represent claims such as demand
deposits and short-term securities that are easy to liquidate with minimum or no
loss.
Short- term capital accounts change for two specific reasons : compensating
adjustments and autonomous adjustments. Compensating adjustments or
accommodating adjustments are short ± term capital movements induced by
changes due to merchandize trade, services, unilateral transfers and
investments. These compensating accounts change so as to finance other
items in the balance of payments. Autonomous adjustments are short-term
capital movements due to differences in interest rates and also expected
changes in foreign exchange rate among nations. Autonomous changes take
place for purely economic reasons.
(  
##* )
Official reserves are government owned assets. The official reserve account
represents only purchases and sale by the central bank of the country (e.g. the
Reserve Bank of India). The changes in Official reserves necessary to account
for the deficit or surplus in the balance of payments. For example, if a country
has a BOP deficit, the central bank will have to either run down its official
reserve assets such as gold, foreign exchange and SDRs or borrow fresh from
foreign central banks. However, if a country has a BOP surplus, its central bank
will either acquire additional reserve assets from foreigners or retire some of its
foreign debts.


)#  +
i. An Indian firm exports Rs. 80,000 worth of goods to be paid in three
months.
Debit Credit
Short ± term capital outflow Rs. 80,000
Merchandise exports Rs. 80,000
Short ±term capital outflow is debited because it represents an increase in
Indian assets abroad while merchandize export is credited since this will
lead to a receipt of payment from foreigners.

ii. An Indian resident visits UK and spends Rs. 1,00,000 on hotel and meals
and so on.
Debit Credit
Travel services Rs. 1,00,000
Short ± term capital i Rs.1,00,000
Travel services are debited for Rs. 1,00,000 because the transaction here
is similar to an Indian import. The payment itself is then entered as a short-
term credit because it represents an increase in foreign assets in India.
iii. An Indian resident purchases foreign stock for Rs. 50,000 and pays for it
by increasing the foreign bank balances in India.
Debit Credit
Long-term capital outflow Rs. 50,000
Short-term capital inflow Rs. 50,000
Purchase of foreign stock increases Indian assets abroad and thus long-
term capital outflow is debited. Short-term capital inflow is credited
because the increase in foreign bank balance in India represents an
increase in foreign assets in India.
iv. A foreign investor purchases Rs. 70,000 worth of Indian treasury bills
and pays by drawing down his bank balance in India by an equal
amount.
Debit Credit
Short-term capital outflow Rs. 70,000
Short-term capital inflow Rs. 70,000
Short-term capital outflow is debited because it represents a reduction in
foreign bank balances in India while short-term capital inflow is credited
since it represents a purchase of Indian treasury bills by a foreigner.
v. US government gives a US bank balance of $ 10,000 to the government
of a developing nation as part of the US aid programme.
Debit Credit
Unilateral transfers $10,000
Short-term capital inflow $10,000
Unilateral transfers are debited since extending aid involves a US
payment to foreigners. Short-term capital inflow is credited because it
represents an increase in foreign claims of foreign assets in the US.


)#  ,
Record the following transactions and prepare the balance of payments
statement.
a. A US firm exports $ 1,000 worth of goods to be paid in six months.
b. A US resident visits London and spends $400 on hotel, meals and so on.
c. US government gives a US bank balance of $ 200 to the government of a
developing nation as part of the US aid programme.
d. A US resident purchases foreign stock for $ 800 and pays for it by
increasing the foreign bank balances in the US.
e. A foreign investor purchases $ 600 of United States treasury bills and
pays by drawing down his bank balances in the United States by an
equal amount.

&"$-' $.'
$ /' $ /'
a. Short-term capital outflow 1,000
Merchandize Exports 1,000
b. Travel services purchased from foreigners 400
Short-term capital inflow 400
c. Unilateral transfer made 200
Short ± term capital inflow 200
d. Long-term capital outflow 800
Short-term capital inflow 800
e. Short-term capital outflow 600
(The reduction in foreign bank balances in
the US ± short- term capital inflow) 600
Short-term capital inflow
(The purchase of US treasury bills by a foreigner)
 If we assume that these five transactions are all the international transactions of
United States during the year, the US balance of payments is as follows

&"$-' $.'
$ /' $ /'
Merchandize 1,000
Services 400
Unilateral transfers 200
Long-term capital 800
Short-term capital, Net 400

1400 1400

The net short ± term capital credit balance of $ 400 is obtained by adding together
the five short-term capital entries (-$1,000,$400,$200, $800,$600,
-$600) examined separately. Total debits equal total credits because of double entry
book keeping