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Composition of Balance of Payments
Composition of Balance of Payments
Composition of Balance of Payments
Yashonidhi Shukla
According to the Reserve Bank of India, “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 them on account of goods imported and
services received and capital transferred to non-residents and foreigners.” It reflects all
payments and liabilities to people outside the country and all payments and obligations received
from people outside the country. 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. Balance of
payments (BoP) is a major indicator of a country’s status in international trade. In this, double
entry book keeping system is followed where the credit side shows the receipt of foreign
exchange from abroad and the debit side shows the payments in foreign exchange to foreign
residents.
1. Current account
2. Capital account
3. Errors and omissions
4. Official Reserves Account.
5. Unilateral Transfer Account
1. Current Account:- This is the country’s trade in goods and services in the current
period.
This is record of a country’s trade in goods and services in the current period.
CA = Exports (X) – Imports (M).
1. Goods trade
2. Services trade
3. Income
4. Current transfers
The sum of the four sub-categories = CA balance
Goods Trade, i.e., the sale of goods abroad, are credit entries because all transactions giving rise
to monetary claims on foreigners represent credits. On the other hand, goods imports, i.e.
purchase of goods from abroad, are debit entries because all transactions giving rise to foreign
money claims on the home country represent debits. Merchandise imports and exports form the
most important international transaction of most of the countries .Invisible exports, i.e., services
trade, are credit entries and invisible imports, i.e. Purchases of services, are debit entries.
Important invisible exports include the sale abroad of such services as transport, insurance, etc.,
foreign tourist expenditure abroad and income paid on loans and investments (by foreigners)in
the home country form the important invisible entries on the debit side.
Theoretically, the balance should be zero, but in the real world this is improbable, so if the
current account has a surplus or a deficit, this tells us something about the government and state
of the economy in question, both on its own and in comparison to other world markets.
A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how
much a country is saving as opposed to investing. What this means is that the country is
providing an abundance of resources to other economies, and is owed money in return. By
providing these resources abroad, a country with a CAB surplus gives other economies the
chance to increase their productivity while running a deficit. This is referred to as financing a
deficit.
Current Account Surplus (In Billion US $)
250
200
150
Current Account Surplus (In
Billion US $)
100
50
0
Germany China Saudi Arabia Kuwait
A deficit reflects government and an economy that is a net debtor to the rest of the world. It is
investing more than it is saving and is using resources from other economies to meet its domestic
consumption and investment requirements. For example, let us say an economy decides that it
needs to invest for the future (to receive investment income in the long run), so instead of saving,
it sends the money abroad into an investment project. This would be marked as a debit in the
financial account of the balance of payments at that period of time, but when future returns are
made, they would be entered as investment income (a credit) in the current account under the
income section.
Current Account Convertibility in India, In Current Account can be converted into Foreign
Currency (E.g. $) and Vice-versa. It is freely permitted in India by Reserve Bank of India.
2. Capital account (KA):- This includes all short- and long-term transactions pertaining to
financial assets. A = Capital Inflow (Credit) – Capital outflow (Debit).
1. Capital account.
2. Financial account (direct, portfolio, other).
The Capital Account consists of short- terms and long-term capital transactions A capital outflow
represents a debit and a capital inflow represents a credit. For instance, if an American firm
investsRs.100 million in India, this transaction will be represented as a debit in the US balance of
payments and a credit in the balance of payments of India. The payment of interest on loans and
dividend payments are recorded in the Current Account, since they are really payment s for the
services of capital. As has already been mentioned above, the interest paid on loans given by
foreigners of dividend on foreign investments in the home country are debits for the home
country, while, on the other hand, the interest received on loans given abroad and dividends on
investments abroad are credits
Capital Account Convertibility In India, Partial Capital Account convertibility is there, i.e. up to
$200,000 is allowed by Reserve bank of India .Up to $500 million the bank need not to take
permission from RBI for Foreign Loan.
Transactions in the external assets and liabilities of an economy constitute another significant
category of the balance of payments statistics. Short and long-term international financial flows
of the private and public sector are followed under this account. The financial flows, which are
an integral part of the international economic transactions, basically cover all transactions
associated with the change of ownership in external financial assets and liabilities of an
economy. According to the type of the financial flows, the “Financial Account” is classified as
follows;
i. Direct Investment
v. Reserve Assets.
i. Direct Investment:-
Direct investment is the category of international investment that reflects the objective of a
resident entity in one economy obtaining a lasting interest in an enterprise resident in another
economy. Direct investment definition requires that direct investor should have an ownership of
10 percent or more of the ordinary shares or the voting power in the management of an
enterprise. Being recorded on a directional basis (residents’ direct investment abroad and
nonresidents’ direct investment in the reporting economy), the major components of the direct
investment item are Equity Capital, Reinvested Earnings, and Other Capital:
Equity Capital refers to the investment of a direct investor for the establishment of a new
enterprise outside the economy in which the investor is located or the acquisition of the share of
ownership in an existing enterprise, Reinvested Earnings refers to direct investor’s share of
earnings not distributed as dividends and added to the equity capital,
Other Capital refers to investment associated with the borrowing and lending of funds between
direct investors and their subsidiaries, branches and associates.
The portfolio investment, which is briefly defined as investment on securities, generally includes
equity securities and debt securities in the form of bills and bonds issued by public and private
institutions as well as money market instruments. There are significant differences between
direct investment and portfolio investment, the most important being the issue of management
and control. In the case of direct investment, investors expect to have an effective voice in the
management and control of the enterprise. However, portfolio investors provide funds for the
resident enterprise from international capital markets without having an effective voice in
management. Also in addition to the investment capital, direct investors may provide production
technology and management skills to the direct investment enterprise. On the other hand, the
portfolio investor provides only capital to the enterprise. The portfolio investment sub items,
classified under assets and liabilities, are equity securities and debt securities.
Financial derivatives are financial instruments that are linked to an underlying asset
that may be purchased or sold in their own right. Derivatives are conducted by
present. There are two main types of financial derivative contracts: forward-type and
options-type.
All the other financial transactions, not covered by direct investment, portfolio
v) Reserve Assets
Reserve Assets include;
Monetary Gold
Special Drawing Rights (SDRs)
Reserve Position in the Fund
Foreign Exchange Holdings
Other claims
3. Net Omission:-
Unilateral transfers is another terms for gifts. These unilateral transfers include private
remittances, government grants, disaster relief, etc. Unilateral payments received from
abroad are credits and those made abroad are debits.