Chapter 1

BALANCE OF PAYMENTS
INTRODUCTION:
Balance of Payment (BoP) of a country is defined as, "Systemetic Record of all
economic transactions between the residents of a foreign countries" Thus
balance of payments includes all visible and non-visible transactions of a
country during a given period, usually a year. It represent a summation of
country's current demand and supply of the claims on foreign currencies and of
foreign claims on its currency.
Balance of payments accounts are an accounting record of all monetary
transactions between a country and the rest of the world. These transactions
include payments for the country's exports and imports of goods, services,
financial capital, and financial transfers. The BOP accounts summarize
international transactions for a specific period, usually a year, and are prepared
in a single currency, typically the domestic currency for 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 negative or deficit
items.
When all components of the BOP accounts are included they must sum to zero
with no overall surplus or deficit. For example, if a country is importing more
than it exports, its trade balance will be in deficit, but the shortfall will have to
be counterbalanced in other ways such as by funds earned from its foreign
investments, by running down central bank reserves or by receiving loans from
other countries.
While the overall BOP accounts will always balance when all types of payments
are included, imbalances are possible on individual elements of the BOP, such

as the current account, the capital account excluding the central bank's reserve
account, or the sum of the two. Imbalances in the latter sum can result in surplus
countries accumulating wealth, while deficit nations become increasingly
indebted. The term "balance of payments" often refers to this sum: a country's
balance of payments is said to be in surplus (equivalently, the balance of
payments is positive) by a specific amount if sources of funds (such as export
goods sold and bonds sold) exceed uses of funds (such as paying for imported
goods and paying for foreign bonds purchased) by that amount. There is said to
be a balance of payments deficit (the balance of payments is said to be negative)
if the former are less than the latter.

Definition:
Balance of payments accounts are an accounting record of all monetary
transactions between a country and the rest of the world. These transactions
include payments for the country's exports and imports of goods, services,
financial capital, and financial transfers.
In simple words, it is the method countries use to monitor all international
monetary transactions at a specific period of time. Usually, the BOP is
calculated every quarter and every calendar year. All trades conducted by both
the private and public sectors are accounted for in the BOP in order to determine
how much money is going in and out of a country. If a country has received
money, this is known as a credit, and if a country has paid or given money, the
transaction is counted as a debit. Theoretically, the BOP should be zero,
meaning that assets (credits) and liabilities (debits) should balance, but in
practice this is rarely the case. Thus, the BOP can tell the observer if a country
has a deficit or a surplus and from which part of the economy the discrepancies
are stemming.

In other words:
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
The above definition can be summed up as following: - 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.

Purpose:
The BOP is an important indicator of pressure on a countrys foreign
exchange rate, and thus on the potential for a firm trading with or
investing in that country to experience foreign exchange gains or losses.
Changes in the BOP may predict the imposition or removal of foreign
exchange controls.
Changes in a countrys BOP may signal the imposition or removal of
controls over payment of dividends and interest, license fees, royalty fees,
or other cash disbursements to foreign firms or investors.
The BOP helps to forecast a countrys market potential, especially in the
short run. A country experiencing a serious trade deficit is not likely to
expand imports as it would if running a surplus. It may, however,
welcome investments that increase its exports.

Terminologies:
a. Favorable Balance Of Payments
Value of total receipts more than total payments

b. Adverse Balance Of Payments

Value of total receipts less than total payments

c. Balanced Balance Of Payments:

Value of total receipts equals total payments.

d. Unrequited receipts:
Receipts for which nothing has to be paid in return.

e. Unrequited payments:
Payments for which nothing is received in return.

The definition given by RBI needs to be clarified further for the following
points:
A.

Economic Transactions

An economic transaction is an exchange of value, typically an act in which there

is transfer of title to an economic good the rendering of an economic service, or
the transfer of title to assets from one economic agent (individual, business,

government, etc) to another. An international economic transaction evidently

involves such transfer of title or rendering of service from residents of one
country to another. Such a transfer may be a requited transfer (the transferee
gives something of an economic value to the transferor in return) or an
unrequited transfer (a unilateral gift). The following are the basic types of
economic transactions that can be easily identified:
1.

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].

2.

Purchase or sale of goods or services in return for goods or services or a

barter transaction. [Two real transfers].

3.

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].

4.

A unilateral gift in kind [One real transfer].

5.

A unilateral financial gift. [One financial transfer].

B.

Resident

The term resident is not identical with citizen though normally there is a
substantial overlap. As regards individuals, residents are those individuals
whose general centre of interest can be said to rest in the given economy. They
consume goods and services; participate in economic activity within the
territory of the country on other than temporary basis. This definition may
turnout to be ambiguous in some cases. The Balance of Payments Manual
published by the International Monetary Fund provides a set of rules to
resolve such ambiguities.
As regards non-individuals, a set of conventions have been evolved. E.g.
government and non profit bodies serving resident individuals are residents of

respective countries, for enterprises, the rules are somewhat complex,

particularly to those concerning unincorporated branches of foreign
multinationals. According to IMF rules these are considered to be residents of
countries in which they operate, although they are not a separate legal entity
from the parent located abroad.
International organisations like the UN, the World Bank, and the IMF are not
considered to be residents of any national economy although their offices are
located within the territories of any number of countries.
To certain economists, the term BOP seems to be somewhat obscure. Yeager, for
example, draws attention to the word payments in the term BOP; this gives a
false impression that the set of BOP accounts records items that involve only
payments. The truth is that the BOP statements records both payments and
receipts by a country. It is, as Yeager says, more appropriate to regard the BOP
as a balance of international transactions by a country. Similarly the word
balance in the term BOP does not imply that a situation of comfortable
equilibrium; it means that it is a balance sheet of receipts and payments having
an accounting balance.
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 statistical discrepancy the difference amount is adjusted with errors

and omissions account and thus in accounting sense the BOP statement always
balances.

BALANCE OF TRADE
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 favourable while deficit is regarded as unfavourable.
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 Trade. There is n 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.

DIFFERENCE BETWEEN BOT & BOP:

BOT

BOP
Records

only

Records transactions

merchandise

goods and services

transactions

Does not record

transactions

of

capital nature

relating to both

Records transaction of capital nature

Includes BOT , Balance of services ,
Balance Of Unrequited Transfers and
Balance Of Capital Transactions.

A part of current
account of BOP

CHAPTER 2

CURRENT ACCOUNT

In economics, a country's current account is one of the two components of its

balance of payments, the other being the capital account. The current account
consists of the balance of trade, net factor income (earnings on foreign
investments minus payments made to foreign investors) and net cash transfers.
The current account balance is one of two major measures 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
A country's balance of trade is the net or difference between the country's
exports of goods and services and its imports of goods and services, ignoring all
financial transfers, investments and other components. A country is said to have
a trade surplus if its exports exceed its imports, and a trade deficit if its imports
exceed its exports.

Positive net sales abroad generally contributes to a current account surplus;

negative net sales abroad generally contributes to a current account deficit.
Because exports generate positive net sales, and because the trade balance is
typically the largest component of the current account, a current account surplus
is usually associated with positive net exports.
In the net factor income or income account, income payments are outflows, and
income receipts are inflows. Income are receipts from investments made abroad
(note: investments are recorded in the capital account but income from

investments is recorded in the current account) and money sent by individuals

working abroad, known as remittances, to their families back home. If the
income account is negative, the country is paying more than it is taking in
interest, dividends, etc.

The various subcategories in the income account are linked to specific

respective subcategories in the capital account, as income is often composed of
factor payments from the ownership of capital (assets) or the negative capital
(debts) abroad. From the capital account, economists and central banks
determine implied rates of return on the different types of capital. The United
States, for example, gleans a substantially larger rate of return from foreign
capital than foreigners do from owning United States capital.

In the traditional accounting of balance of payments, the current account equals

the change in net foreign assets. A current account deficit implies a paralleled
reduction of the net foreign assets.

Current account = changes in net foreign assets

If an economy is running a current account deficit, it is absorbing (absorption =

domestic consumption + investment + government spending) more than that it
is producing. This can only happen if some other economies are lending their
savings to it (in the form of debt to or direct/ portfolio investment in the
economy) or the economy is running down its foreign assets such as official
foreign currency reserve.

On the other hand, if an economy is running a current account surplus it is

absorbing less than that it is producing. This means it is saving. As the economy
is open, this saving is being invested abroad and thus foreign assets are being
created.
Calculation
Normally, the current account is calculated by adding up the 4 components of
current account: goods, services, income and current transfers.
Goods
Being movable and physical in nature, goods are often traded by
countries all over the world. When a transaction of certain good's
ownership from a local country to a foreign country takes place, this is
called an "export." The other way around, when a good's owner changes
to a local inhabitant from a foreigner, is defined to be an "import." In
calculating current account, exports are marked as credit (the inflow of
money) and imports as debit. (the outflow of money.)
Services
When an intangible service (e.g. tourism) is used by a foreigner in a local
land and the local resident receives the money from a foreigner, this is
also counted as an export, thus a credit.

Income
A credit of income happens when an individual or a company of domestic
nationality receives money from a company or individual with foreign

identity. A foreign company's investment upon a domestic company or a

local government is considered as a credit.
Current transfers
Current transfers take place when a certain foreign country simply
provides currency to another country with nothing received as a return.
Typically, such transfers are done in the form of donations, aids, or
official assistance.
A country's current account can be calculated by the following formula:

When CA is the current account, X and M the export and import of goods and
services respectively, NY the net income from abroad, and NCT the net current
transfers.

Reducing current account deficits

Action to reduce a substantial current account deficit usually involves
increasing exports (goods going out of a country and entering abroad countries)
or decreasing imports (goods coming from a foreign country into a country).
Firstly, this is generally accomplished directly through import restrictions,
quotas, or duties (though these may indirectly limit exports as well), or by
promoting exports (through subsidies, custom duty exemptions etc.).
Influencing the exchange rate to make exports cheaper for foreign buyers will
indirectly increase the balance of payments. Also, Currency wars, a
phenomenon evident in post recessionary markets is a protectionist policy,
whereby countries devalue their currencies to ensure export competitiveness.

Secondly, adjusting government spending to favor domestic suppliers is also

effective.

Less obvious methods to reduce a current account deficit include measures that
increase domestic savings (or reduced domestic borrowing), including a
reduction in borrowing by the national government.

A current account deficit is not always a problem. The Pitchford thesis states
that a current account deficit does not matter if it is driven by the private sector.
It is also known as the "consenting adults" view of the current account, as it
holds that deficits are not a problem if they result from private sector agents
engaging in mutually beneficial trade. A current account deficit creates an
obligation of repayments of foreign capital, and that capital consists of many
individual transactions. Pitchford asserts that since each of these transactions
were individually considered financially sound when they were made, their
aggregate effect (the current account deficit) is also sound.
Interrelationships in the balance of payments

Absent changes in official reserves, the current account is the mirror image of
the sum of the capital and financial accounts. One might then ask: Is the current
account driven by the capital and financial accounts or is it vice versa? The
traditional response is that the current account is the main causal factor, with
capital and financial accounts simply reflecting financing of a deficit or
investment of funds arising as a result of a surplus. However, more recently
some observers have suggested that the opposite causal relationship may be
important in some cases. In particular, it has controversially been suggested that

the United States current account deficit is driven by the desire of international
investors to acquire U.S. assets (See Ben Bernanke, William Poole links below).
However, the main viewpoint undoubtedly remains that the causative factor is
the current account and that the positive financial account reflects the need to
finance the country's current account deficit.

BALANCE OF CURRENT ACCOUNT

BOP on current account refers to the inclusion of three balances of namely
Merchandise balance, Services balance and Unilateral Transfer balance. In other
words it reflects the net flow of goods, services and unilateral transfers (gifts).
The net value of the balances of visible trade and of invisible trade and of
unilateral transfers defines the balance on current account.
BOP on current account is also referred to as Net Foreign Investment because
the sum represents the contribution of Foreign Trade to GNP.
Thus the BOP on current account includes imports and exports of merchandise
(trade balances), military transactions and service transactions (invisibles). The
service account includes investment income (interests and dividends), tourism,
financial charges (banking and insurances) and transportation expenses
(shipping and air travel). Unilateral transfers include pensions, remittances and
other transfers for which no specific services are rendered.
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.

STRUCTURE OF CURRENT ACCOUNT

Transactions

Credit

Debit

Net Balance

Export

Import

2. Foreign Travel

Earning

Payment

3. Transportation

Earning

Payment

4. Insurance (Premium)

Receipt

Payment

5. Investment Income

Dividend

Dividend

Receipt

Payment

of Receipt

Payment

Surplus (+)

1. Merchandise

6.Government

(purchase

goods & services)

CURRENT A/C Balance

Deficit (-)

CHAPTER 3
CAPITAL ACCOUNT

The capital account of the balance of payments is record of the flow of

payments between one country and other countries that result from: (1)

domestic purchases of financial and physical capital from the foreign sector and
(2) foreign purchases of financial and physical capital from the domestic sector.
In essence, the capital account tracks investment by the domestic sector in
foreign assets going in one direction and investment by the foreign sector in
domestic assets going in the other direction. These investments are for the
purchase of physical capital, such as factories and equipment, or financial
capital, such as currency and bonds.
The two primary players in the capital account are businesses and governments.
Businesses undertake the bulk of the investment in physical capital, which is
used for the obvious purpose of engaging in production. Governments purchase
a lot of currency, which is used by their central banks to undertake exchange
rate policies.
The capital account in macroeconomics

At high level:

Breaking this down:

The International Finance Centre in Hong Kong, where many capital account
transactions are processed.

Foreign direct investment (FDI) refers to long-term capital investment,

such as the purchase or construction of machinery, buildings, or whole
manufacturing plants. If foreigners are investing in a country, that
represents an inbound flow and counts as a surplus item on the capital
account. If a nation's citizens are investing in foreign countries, that
represents an outbound flow and counts as a deficit. After the initial
investment, any yearly profits that are not reinvested will flow in the

opposite direction but will be recorded in the current account rather than
as capital.

Portfolio investment refers to the purchase of shares and bonds. It is

sometimes grouped together with "other" as short-term investment. As
with FDI, the income derived from these assets is recorded in the current
account; the capital account entry will just be for any buying or selling of
the portfolio assets in the international capital markets.

Other investment includes capital flows into bank accounts or provided as

loans. Large short-term flows between accounts in different nations
commonly occur when the market can take advantage of fluctuations in
interest rates and/or the exchange rate between currencies. Sometimes
this category can include the reserve account.

Reserve account. The reserve account is operated by a nation's central

bank to buy and sell foreign currencies; it can be a source of large capital
flows to counteract those originating from the market. Inbound capital
flows (from sales of the nation's foreign currency), especially when
combined with a current account surplus, can cause a rise in value
(appreciation) of a nation's currency, while outbound flows can cause a
fall in value (depreciation). If a government (or, if authorized to operate
independently in this area, the central bank itself) does not consider the
market-driven change to its currency value to be in the nation's best
interests, it can intervene.

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 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 firms country, and as a positive item in the capital account for the
other country. That capital outflows appear as a negative item in a countrys
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 purchasers country (and as a positive item in the accounts of
the sellers country).
The net value of the balances of direct and portfolio investment defines the
balance on capital account.
Short term capital movement includes:
Purchase of short term securities
Speculative purchase of foreign currency
Cash balances held by foreigners
Net balance of current account
Long term capital movement includes:

 Investments in shares, bonds, physical assets etc.

Amortization of capital

CAPITAL ACCOUNT CONVERTIBILITY (CAC)

While there is no formal definition of Capital Account Convertibility, the
committee under the chairmanship of S.S. Tarapore has recommended a
pragmatic working definition of CAC. Accordingly CAC refers to the freedom
to convert local financial assets into foreign financial assets and vice a versa
at market determined rates of exchange. It is associated with changes of
ownership in foreign / domestic financial assets and liabilities and embodies the
creation and liquidation of claims on, or by, the rest of the world. CAC is
coexistent with restrictions other than on external payments. It also does not
preclude the imposition of monetary / fiscal measures relating to foreign
exchange transactions, which are of prudential nature.
Following are the prerequisites for CAC:
1.

Maintenance of domestic economic stability.

2.

Adequate foreign exchange reserves.

3.

Restrictions on inessential imports as long as the foreign exchange

position is not very comfortable.

4.

Comfortable current account position.

5.

An appropriate industrial policy and a conducive investment climate.

6.

An outward oriented development strategy and sufficient incentives for

export growth.

DIFFERENCE BETWEEN CURRENT ACCOUNT AND CAPITAL

ACCOUNT
CURRENT ACCOUNT

CAPITAL ACCOUNT

Indicates flow aspect of

countrys

national

transactions

changes

Relates

to

all

stock

transactions

constituting debts and transfer of

ownership

STRUCTURE OF BALANCE OF PAYMENTS ACCOUNT

CREDITS

in

magnitudes

Relates to goods , services

and unrequited transfers

Indicates

DEBITS

Current A/c:

Current A/c:

Exports of goods(Visible items)

Imports of goods(Visible items)

Exports of services (Invisibles)

Imports of services(Invisibles)

Unrequited

receipts(gifts

remittances, indemnities, etc.

from foreigners)

indemnities etc. to foreigners)

Capital A/c:

Capital A/c:

Capital payments (lending to , capital

Capital receipts (Borrowings

from

Unrequited payments( gifts, remittance,

abroad

repayments to , or purchase of assets

capital

from foreigners, reduction in stock of

repayments by , or sale of assets

gold and reserves of foreign currency

to foreigners, increase in stock

etc.)

of gold and reserves of foreign

currency etc.)

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 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.
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 (SDRs) 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 countrys 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 omissions.

CHAPTER 4
RESERVE ACCOUNT

The official reserve account, a subdivision of the capital account, is the foreign
currency and securities held by the government, usually by its central bank, and
is used to balance the payments from year to year. In the United States, the New
York Federal Reserve serves as the Treasury's fiscal agent. The official reserves
increases when there is a trade surplus and decreases when there is a deficit.
Sometimes the central bank will use it to intervene in the foreign exchange
market to set the exchange rate to some objective. However, foreign
interventions rarely work because, while central banks only intervene for a short
period of time, market forces are always influencing the exchange rate, so the
market equilibrium will soon return after the intervention.
Under this account, foreign asset transactions of a country and foreign
central banks are recorded.

International or Official Reserves

 holdings of foreign currency denominated assets by central banks,

including
1. gold,
2. government holdings of foreign exchanges,
3. special drawing rights (SDRs), and
4. reserve positions in the IMF.

An increase in foreign assets held by the central bank is recorded with a

negative sign because an increase in assets held by the central bank is a use
of foreign currency.

A decrease in the central banks stock of foreign assets is a source of foreign

currency for the country.

The change in official reserves measures a nations surplus or deficit on its

current and capital account transactions by netting reserve liabilities from
reserve assets.

Example: Surplus

An Increase in official holdings of foreign

currencies or gold or both

CHAPTER 5
BALANCE OF PAYMENTS

In the accounting sense, the balance of payments of a country is always in

equilibrium. The statement of balance of payments is prepared in terms of
credits and debits based on the system of double-entry book-keeping.

In the double-entry system, each transaction gives rise to two equal entries: a
credit entry (i.e., a receipt) and a debit entry (i.e., payment). Thus the sum of all
credits equals the sum of all debits.

Similarly, an international transaction generates two equal entries: a credit (+)

for an export of a good or service, or for a foreign borrowing, or for the receipt
of a unilateral transfer (gifts, donations, grants, etc.); and a debit (-) for an
import of a good or service, or for a foreign lending, or for the making of a
unilateral transfer.

In other words, a country must pay for its imports of goods and services, or
foreign borrowings, or receipts of unilateral transfers by the equal-valued export
of goods and services or foreign lending, or making unilateral transfers. Thus,

the sum of all international receipts (credit items) always equals the sum all
international payments (debit items).

While receipts and payments in the international transactions always must be

equal or must balance in the accounting sense, they may not be equal or in
equilibrium in operational sense.

The accounting balance of a balance of payments account, which is merely a

truism, should not be confused with the 'economic balance which recognised the
possibility of a deficit or a surplus in the balance of payments.

When the current account of the balance of payments shows a deficit or a

surplus, the balance is restored through changes in the capital account. In fact,
the capital account is specially prepared to neutralise the imbalance in the
current account.

The deficit in the current account is neutralised by the equal amount of surplus
in the capital account; and the surplus in the current account is neturalised by
the equal amount of deficit in the capital account. Thus, the current and capital
accounts together balance each other and restore equilibrium in the balance of
payments.

Suppose, a country experiences a deficit in the current account of its balance of

payments statement due to excess of imports over exports. Such a deficit can be
met by resorting to the following changes in the capital account:

(i) By raising loans and getting grants from other countries:

(ii) By drawing on past accumulated balances of the country which it may be

keeping in the foreign countries;

(iii) By exporting gold;

(iv) By drawings from International Monetary Fund.

The debit side shows the use of total foreign exchange acquired in a particular
period.

The credit side shows the sources from which the foreign exchange is acquired
during a particular period.

Against every credit entry, there is an offsetting debit entry & vise-versa, so the
receipts and payments on these two sides must be equal. Hence the two sides
must necessary balance.
If X imports from Y, Y would also import from X. Hence there would be a debit
and credit entries in the balance of payments of both the countries X & Y.
The individual items in the balance of payments may not balance. But the total
credits of the country must be equals to its total debits.
If there is any deficit in any individual account, it would be covered by a surplus
in other accounts, if there is any difference between total debits and total credits,
it would be settled under 'errors & omissions'. Hence in the accounting sense,
the balance of payments of a country always balances.

Balance of Payments (BOP) Account of a Country

The items 1 to 7 show the total receipts from all sources. These receipts amount
to Rs. 1000 Crores.
The items 1(a) to 7(a) Show the total payments on all accounts. These payments
amount to Rs. 990 Crores. When item 8 included, the total payment is Rs. 1000
Crores, hence the total credit is equal to the total debit.
Thus the current account and capital account Balance each other. Thus surplus
in the current account is equal to the deficit in the capital account. A deficit in
the current account is equal to the surplus in the capital account.
In the above given table, the balance of current account shows a deficit of Rs.
200 crores But there is a corresponding surplus of Rs. 200 crores in the balance
of capital account.
Hence the credit and debit sides balance & the balance of payments is in
equilibrium.

The balance of trade of a country may not balance. For instance, if exports
exceed imports, there is a surplus and a favourable balance of trade and viceversa. Only if the value of exports is equal to the value of imports, the balance
of trade is said to be in equilibrium.
But the balance of payments always balances because every transaction must be
settled. Hence total debits must be equal to the total credits.

Bibliography:
en.wikipedia.org/wiki/Balance_of_payments/
www.investopedia.com/articles/03/060403.asp
www.economicshelp.org/blog/glossary/balance-payments/
Balance of Payments

- Paul Madson

International Financial Management

- P G Apte

International Economics
International Economics

- Lindert
- Francis Chernuliam