Balance of Payment

Balance of Payments
Systematic record of all transactions (economic & financial) between residents of country & rest of world during a given period The BOP is determined by the country's exports, imports of goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits).

IMF publication BOP manual

With a view to standardizing concepts, definitions & conventions applied in compilation of BOP statistics by various countries, IMF has prescribed a Balance of Payment Manual India has adopted the same as a conceptual and methodological basis for compiling BOP account

However, there exist some departures from IMF framework due to constraints of data availability & to take account of countrys institutional structure

IMF publication BOP manual

BOP is a statistical statement showing: Transactions in goods & services & income between an economy & ROW Changes of ownership & other changes in countrys gold, SDRs & claims on & liabilities to ROW Unrequited transfers that are needed to balance any entry for forgoing transactions & changes which are not mutually offsetting

BOP & BOT

BOT refers to export & import of visible items BOP covers visible & invisible items (services such as transportation, banking, insurance)

Double-entry Accounting in the BOP

Each international transaction enters the accounts twice: once as a credit (+) and once as a debit (-) Credit transactions result in receipt of payment from foreigners Merchandise exports (valued f.o.b.) Transportation and travel receipts Income received from investments abroad Gifts received from foreign residents Aid received from foreign governments

Double-entry Accounting in the BOP

Debit transactions involve to payments to foreigners Merchandise imports Transportation and travel expenditures Income paid on investments of foreigners Gifts to foreign residents Aid given by home government Overseas investments by home country residents

Balance of Payments
Each transaction is classified according to the payment or receipts that it generates Transactions that generate a receipt of a payment from foreigners are a credit item in the accounts with a + sign; These represent a supply of foreign exchange Transactions that comprise a payment to foreigners are reported as a debit item with a sign; These represent demand for foreign exchange

Balance of Payments: Example

Suppose that Maplewood Bicycle, USA imports $100,000 worth of bicycle frames from Mercian Bicycles, England. There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewoods bank account. This will lead to a rise in the demand for British pounds.

Double-entry Accounting in the BOP

Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance. Sometimes balancing item errors & omissions is added to balance BOP

Components of BOP
It is composed of the following: The Current Account The Capital Account Errors & omissions Official reserves transactions

Components of BOP: Current account

Current account Trade Balance Net Exports (Exports - Imports) of Merchandise (tangible goods) (balance of visible trade) Net Exports (Exports - Imports) of Services (such as legal, consulting, banking, insurance services) (balance of invisible trade) Net Unilateral Transfers From Abroad (such as foreign aid, grants, gifts, workers remittances) Private unrequited transfers Official unrequited transfers

CONTD

Components of BOP: Current account

Balance on current account: Net value of balances of visible trade, invisible trade & unilateral transfers If the debits exceed the credits, then a country is running a trade deficit

CONTD

Merchandise on FOB/ CIF basis

As per the IMF Manual, imports & exports of goods (merchandise) should be presented under free-on-board (f.o.b. basis) i.e. without including freight & insurance costs Such freight and insurance paid to foreign shipping and air carriers should be treated as an outgo (debit) under the invisible sub-items, transportation and insurance services, while that earned by domestic carriers has to be treated as receipts (credit) under the same sub items However, the BOP data put out by the Indian authorities make a major departure from the IMF manual in that while they present exports on an FOB basis they set out imports on CIF (cost, insurance and freight) basis on the ground of the nature of data availability

Components of BOP: capital account

The records all international transactions that involve a resident of domestic country changing his assets with a foreign resident or his liabilities to a foreign resident

CONTD

Components of BOP: capital account

The various forms of capital account transactions are given below. Private transactions: transactions affecting assets/ liabilities by individuals, businesses, other non government entities Official transactions: Transactions affecting assets/ liabilities by government and its agencies Direct investment: purchasing an asset & acquiring control of it (acquisition of a firm in one country by a firm in another country, individuals purchasing house abroad)

Portfolio investment: acquisition of an asset that does not give the purchaser control over the asset (purchase of shares in a foreign company or bonds issued by a foreign government)
CONTD

Components of BOP: capital account

If an American firm invests Rs 100 million in India, this transaction will be represented as debit in US BOP & credit in Indias BOP

CONTD

Components of BOP: capital account

Purchase of an asset from another country appears as a negative item on the capital account for the purchasing country (outflow of foreign exchange). Thus, capital outflows are awarded a negative sign and capital inflows are awarded a positive sign. Balance on capital account: The net value of the balances of private, and official transactions & direct and portfolio investment

CONTD

basic types of economic transactions in BOP

Purchase or sale of goods or services with a financial quid pro quo cash or a promise to pay. [One real and one financial transfer] 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]

Example of BOP Accounting

You import a DVD from Japan by using your debit card. The Japanese seller deposits the funds in its bank account in San Francisco. The bank credits the account by the amount of the deposit. DVD purchase (current account) Credit (sale) of bank account by bank (capital account) $30 +$30

Example of BOP Accounting

You invest in the Japanese stock market by buying $500 in Sony stock. Sony deposits your funds in its Los Angeles bank account. The bank credits the account by the amount of the deposit.

Purchase of stock (capital account)

Credit (sale) of bank account by bank (capital account)

$500
+$500

Other items in BOP: errors & omissions

Credit side might not match debit side- discrepancies arising from differences in timing, coverage, valuation, possible inaccurate estimation, failure in recording all the wide variety of transactions that take place in the accounting period, sampling of transactions rather than recording each individual transaction Balancing act is performed by an item called errors and omissions A negative sign in it implying overstatement of receipts &/ or understatement of payments & positive sign signifying the reverse

Other items in BOP: official reserve transactions

The official reserve account records the government's current stock of reserves Reserves include official gold reserves, foreign exchange reserves, and IMF SDRs.

CONTD

Other items in BOP: official reserve transactions

Official reserve transactions are carried out by the government and the central banks in pursuit of some international economic policy objective; while keeping an eye on such transactions effect on the BOP and the exchange rate. As a result such transactions are not autonomous

They represent the holdings by govt/ official agencies of the means of payment that are generally accepted for the settlement of international claims

CONTD

Other items in BOP: official reserve transactions

In general, net increases in the Official Reserve Account will indicate that a country is buying its currency to try to keep the price dear from the perspective of whatever resource is being sold to acquire the currency. Countries with net decreases in the Official Reserve Account are usually attempting to keep the price of their currency cheap relative to whatever resource they are purchasing in exchange for the currency.

Autonomous & accommodating items

Autonomous item These transactions are independent of the state of the countrys BOP Undertaken for its own sake in response to a given configuration of prices, exchange rates- in order to realize profits/ reduce costs often called above the line items in the BOP.

Autonomous & accommodating items

Accommodating items refer to transactions that occur because of other activity in the BOP, such as government financing i.e. they are determined by net consequences of autonomous items undertaken with motive of settling imbalance arising out of other transactions also referred to as below the line items

Balance of payments always balance

Accounting sense: BOP is always in equilibrium Economic/ operational sense: recognizes possibility of surplus/ deficit

Disequilibrium in BOP
BOP deficit : excess of imports over exports (demand for foreign exchange exceeds its supply) BOP surplus: excess of exports over imports (supply of foreign exchange exceeds its supply)

Disequilibrium in BOP: types (1)

Cyclical disequilibrium: arise due to fluctuations in business cycles During prosperity: prices rise: a country with more elastic demand for imports will experience a decline in imports, leading to surplus in BOP Incomes increase: This may be offset by effects of income changes. Higher incomes may increase imports

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Disequilibrium in BOP: types (2)

Secular disequilibrium: long seated & deep routed changes in economy as it moves from one stage of growth to other Initial stage: domestic invt exceeds domestic savings, imports exceed exports; disequilibrium occurs due to lack of funds to finance import surplus

Domestic savings tend to exceed domestic invt, exports exceed imports; disequilibrium arise because surplus savings exceed invt opportunities abroad
Domestic savings tend to equal domestic invt

CONTD

Disequilibrium in BOP: types (3)

Structural disequilibrium: structural changes in some sectors of economy alter demand & supply forces influencing exports & imports (changes in technology, tastes & attitudes towards foreign invt, political disturbances, strikes, lockouts)

CONTD

Disequilibrium in BOP: types (4)

Fundamental disequilibrium: persistent & long term disequilibrium in BOP generally caused by dynamic factors Excessive/ inadequate internal demand for foreign goods Excessive/ inadequate competitive strength in world market Excessive capital movements

Disequilibrium in BOP: causes

Economic Factors Large-scale development expenditure that may cause large imports Cyclical fluctuations in general business activity such as recession or depression High domestic prices may result in imports New sources of supply, new and better substitutes to existing products and changes in costs will bring about a change in trade flows and hence BOP over a period of time.

Disequilibrium in BOP
Political Factors Political instability may cause large capital outflows and dampen the inflows of foreign capital. Social Factors Changes in tastes, preference and fashions

Balance of payments always balance

In case of deficit in current account, balance is restored through changes in capital account: current account deficit will be neutralized by equal amount of surplus in capital account

Balance of payments always balance

A deficit in current account can be restored by making following changes in capital account: By raising loans & getting grants from other countries By drawing on past accumulated balances of country from foreign countries By exporting gold By drawings from IMF

Correction of BOP disequilibrium

Automatic Correction

Deliberate Correction Miscellaneous measures foreign loans Incentive for foreign invts Tourism Incentives for foreign remittances Import substitution

Monetary measures Monetary contraction/ expansion Devaluation/ revaluation Exchange control

Trade measures

Export promotion Abolition/ reduction of export duties Export subsidies Export incentives

Import control import duties Import quotas Import prohibition

Correcting BOP disequilibrium: automatic correction

Equilibrium restored automatically by free play of market forces of demand & supply To cure Deficit in BOP: demand for foreign exchange exceeds supply, exchange rate increases, decline in external value of domestic currency, exports become cheaper, imports dearer, exports increase, imports fall, BOP equilibrium restored

Correcting BOP disequilibrium: Deliberate measures- monetary (1)

Monetary contraction/ expansion To remove BOP Deficit: Contraction of money supply; decline in purchasing power; decline in AD; decline in prices; decline in demand for imports & increase in exports; correction in BOP disequilibrium

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Correcting BOP disequilibrium: Deliberate measures- monetary (2)

Devaluation- reduction in official rate of exchange of currency To remove BOP Deficit: devalue currency; imports discouraged & exports stimulated

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Correcting BOP disequilibrium: Deliberate measures- monetary (3)

Exchange control- control over the use of foreign exchange by central bank Exporters are required to surrender foreign exchange to govt/ central bank in exchange for domestic currency. Foreign exchange is rationed among licenced importers. Only essential imports are permitted

Correcting BOP disequilibrium: Deliberate measures- trade

Export promotion: encouraging exports- providing export subsidy, encouraging export production & export marketing by giving monetary, fiscal, institutional incentives & facilities Import control: controlling imports by imposing/ enhancing import duties, restricting imports through import quotas, licensing

Correcting BOP disequilibrium: Miscellaneous measures

Obtaining foreign loans, encouraging foreign invt in home country, development of tourism to attract foreign tourists, providing incentives to enhance inward remittances

Financing of BOP deficit

Using forex reserves: drawings from reserves External assistance: IMF, commercial borrowings, NRI deposits