A REPORT ON“BALANCE OF PAYMENTS”

BALANCE OF PAYMENTS

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
tonon-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. 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

A REPOTR ON “BALANCE OF PAYMENT “October 1, 2009to 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 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].

Resident

The term resident is not identical with “citizen” though normally there is
substantial overlap. As regards individuals, residents are those individuals whose
general center 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 turn out 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 nonprofit 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
time 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 organizations 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 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 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’s)
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. The various components of a BOP statement are:

A.Current Account

B.Capital Account

C.IMF

D.SDR Allocation

E.Errors & Omissions

F.Reserves and Monetary Gold

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
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
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 favorable while
deficit is regarded as unfavorable.

The above mentioned definition has been given by James. E. Meade – a Nobel
Prize British Economist. However, some economists define balance of trade as
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 no 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 Isa 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.

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.

BASIC BALANCE
 The basic balance was regarded as the best indicator of the economy’s position
vis-à-vis other countries in the 1950’s and the 1960’s. It is defined as the sum of
the BOP on current account and the net balance on long term capital, which were
considered as the most stable elements in the balance of payments. A worsening
of the basic balance [an increase in a deficit or a reduction in a surplus or even a
move from the surplus to deficit] was seen as an indication of deterioration in the
[relative] state of the economy.

The short term capital account balance is not included in the basic balance. This is
perhaps for two main reasons:

a) Short term capital movements unlike long term capital movements are
relatively volatile and unpredictable. They move in and out of the country in a
period of less than a year or even sooner than that. It would therefore be
improper to treat short term capital movements on the same footing as current
account BOP transactions which are extremely durable in nature. Long term
capital flows are relatively more durable and therefore they qualify to be treated
alongside the current account transactions to constitute basic balance.

b) In many cases, countries don’t have a separate short term capital account as
they constitute a part of the “Errors and Omissions Account. A deficit on the basic
balance could come about in various ways, which are not mutually equivalent. E.g.
suppose that the basic balance is in deficit because current account deficit is
accompanied by a deficit on the long term capital account. The long term capital
outflow will, in the future, generate profits, dividends and interest payments
which will improve the current account and so, ceteris paribus, will reduce or
perhaps reduce the deficit. On the other hand, a basic balance surplus consisting
of a deficit on current account that is more than covered by long term borrowings
from abroad may lead to problems in future, when profits, dividends hectare paid
to foreign investors.
THE OFFICIAL SETTLEMENT CONCEPT

An alternative approach for indicating, a deficit or surplus in the BOP is to consider

the net monetary transfer that has been made by the monetary authorities is
positive or negative, which is the so called – settlement concept.

If the net transfer is negative (i.e. there is an outflow) then the BOP is said to be in
deficit, but if there is an inflow then it is surplus. The basic premise is that the
monetary authorities are the ultimate financers of any deficit in the balance of
payments (or the recipients of any surplus). These official settlements are thus
seemed as the accommodating item, all other being autonomous.

The monetary authorities may finance a deficit by depleting their reserves of

foreign currencies, by borrowing from the IMF or by borrowing from other foreign
monetary authorities. The later source is of particular importance when other
monetary authorities hold the domestic currency as a part of their own reserves.
A country whose currency is used as a reserve currency (such as the dollars of US)
may be able to run a deficit in its balance of payments without either depleting its
own reserves or borrowing from the IMF since the foreign authorities might be
ready to purchase that currency and add it to its own reserves. The settlements
approach is more relevant under a system of pegged exchange rates than when
the exchange rates are floating.

THE CAPITAL ACCOUNT

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 firm’s country, and as a positive item in the capital account for the
other country. That capital outflows appear as a negative item in a country’s
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 purchaser’s country(and as a positive item in the accounts of the
seller’s country).

The net value of the balances of direct and portfolio investment defines the
balance on capital account.

ACCOMMODATING & AUTONOMOUS CAPITAL FLOWS

Economists have often found it useful to distinguish between autonomous and

accommodating capital flows in the BOP. Transactions are said to Autonomous if
their value is determined independently of the BOP. Accommodating capital flows
on the other hand are determined by the net consequences of the autonomous
items. 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 treatise a profit or reduced costs. It does not take into account the situation
elsewhere in the BOP. An accommodating transaction on the other hand is
undertaken with the motive of settling the imbalance arising out of other
transactions. An alternative nomenclature is that capital flows are ‘above the line’
(autonomous) or ‘below the line’ (accommodating). Obviously the sum of the
accommodating and autonomous items must be zero, since all entries in the BOP
account must come under one of the two headings. Whether the BOP is in surplus
or deficit depends on the balance of the autonomous items. The BOP is said to be
in surplus if autonomous receipts are greater than the autonomous payments and
in deficit if vice – a – versa.

Essentially the distinction between both the capital flow lies in the motives
underlying a transaction, which are almost impossible to determine. We cannot
attach the labels to particular groups of items in the BOP accounts without giving
the matter some thought. For example a short term capital movement could be
are action to difference in interest rates between two countries. If those interest
rates are largely determined by influences other than the BOP, then such a
transaction should be labelled as autonomous. Other short term capital
movements may occur as a part of the financing of a transaction that is itself
autonomous (say, the export of some good), and as such should be classified as
accommodating.

There is nevertheless a great temptation to assign the labels ‘autonomous’ and

‘accommodating’ to groups of item in the BOP. i.e. to assume, that the great
majority of trade in goods and of long term capital movements are autonomous,
and that most short term capital movements are accommodating, so that we shall
not go far wrong by assigning those labels to the various components of the BOP
accounts. Whether that is a reasonable approximation to the truth may depend
impart on the policy regime that is in operation. For example what is an
autonomous item under a system of fixed exchange rates and limited capital
mobility may not be autonomous when the exchange rates are floating and capital
may move freely between countries.
BALANCE OF INVISIBLE TRADE

Just as a country exports goods and imports goods a country also exports and
imports what are called as services (invisibles). The service account records all the
service exported and imported by a country in a year. Unlike goods which are
tangible or visible services are intangible. Accordingly services transactions are
regarded as invisible items in the BOP. They are invisible in the sense that service
receipts and payments are not recorded at the port of entry or exit as in the case
with the merchandise imports and exports receipts. Except for this there is no
meaningful difference between goods and services receipts and payments. Both
constitute earning and spending of foreign exchange. Goods and services accounts
together constitute the largest and economically the most significant components
in the BOP of any country.

The service transactions take various forms.

They basically include

1) Transportation, banking, and insurance receipts and payments from and to the
foreign countries

2) Tourism, travel services and tourist purchases of goods and services received
from foreign visitors to home country and paid out in foreign countries by home
country citizens

3) Expenses of students studying abroad and receipts from foreign students

studying in the home country

4) Expenses of diplomatic and military personnel stationed overseas as well as the

receipts from similar personnel who are stationed in the home country and

5) Interest, profits, dividends and royalties received from foreign countries and
paid out to foreign countries.
These items are generally termed as investment income or receipts and payments
arising out of what are called as capital services. “Balance of Invisible Trade” is a
sum of all invisible service receipts and payments in which the sum could be
positive or negative or zero. A positive sum is regarded as favorable to country and
a negative sum is considered as unfavorable. The terms are descriptive as well as
prescriptive.

BALANCE OF VISIBLE TRADE

Balance of visible trade is also known as balance of merchandise trade, and it

covers all transactions related 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 goods themselves. Exports valued on F.O.B basis are the credit entries.
Data for these items are obtained from the various forms that the exporters have
fill and submit to the designated authorities. Imports valued at C.I.F are the debit
entries. Valuation at C.I.F. though inappropriate, is a forced choice due to data
inadequacies. The difference between the total of debits and credits appears in
the “Net” column. This is the ‘Balance of Visible Trade.’

In visible trade if the receipts from exports of goods happen to be equal to the
payments for the imports of goods, we describe the situation as one of zero
“goods balance.’ Otherwise there would be either a positive or negative goods
balance, depending on whether we have receipts exceeding payments (positive)
or payments exceeding receipts (negative).

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 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 with 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 (SDR’s) 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 country’s 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.

UNILATERAL TRANSFERS

Unilateral transfers or ‘unrequited receipts’, are receipts which the residents of

country receive ‘for free’, without having to make any present or future payments
in return. Receipts from abroad are entered as positive items, payments abroad as
negative items. Thus the unilateral transfer account includes all gifts, grants and
reparation receipts and payments to foreign countries.

Unilateral transfer consist of two types of transfers:

(a) Government transfers

(b) Private transfers.

Foreign economic aid or assistance and foreign military aid or assistance received
by the home country’s government (or given by the home government to foreign
governments) constitutes government to government transfers. The United States
foreign aid to India, for BOP 9but a debit item in the US BOP). These are
government to government donations or gifts. There no well worked out theory to
explain the behavior of this account because these flows depend upon political
and institutional factors. The government donations (or aid or assistance) given to
government of other countries is mixed bag given for either economic or political
or humanitarian reasons.

Private transfers, on the other hand, are funds received from or remitted to
foreign countries on person –to –person basis. A Malaysian settled in the United
States remitting $100 a month to his aged parents in Malaysia is a unilateral
transfer inflow item in the Malaysian BOP. An American pensioner who is settled
after retirement in say Italy and who is receiving monthly pension from America is
also a private unilateral transfer causing a debit flow in the American BOP but a
credit flow in the Italian BOP.

Countries that attract retired people from other nations may therefore expect to
receive an influx of foreign receipts in the form of pension payments. And
countries which render foreign economic assistance on a massive scale can expect
huge deficits in their unilateral transfer account. Unilateral transfer receipts and
payments are also called unrequited transfers because as the name itself suggests
the flow is only in one direction with no automatic reverse flow in the other
direction.

There is no repayment obligation attached to these transfers because they are

not borrowings and lending’s but gifts and grants exchanged between government
and people in one country with the governments and peoples in the rest of the
world.

ILLUSTRATE THE ITEMS WHICH FALL UNDER CAPITAL ACCOUNT ANDCURRENT

ACCOUNT WITH EXAMPLES.
CAPITAL ACCOUNT CONVERTIBILITY (CAC)

While there is no formal definition of Capital Account Convertibility, the

committee under the chairmanship of S.S. Tara pore has recommended a
pragmati c working definiti on of CAC. Accordingly CAC refers to the
freedom to convert local financial assets into foreign financial assets and vice
– a – versa at market determined
rateso f   exc h an g e .   I t   i s   a s s o c i ate d   w i t h   c h a n ge s   o f   o w n e rs h ip   i n   fo r
e i g n   /   d o m e sti c fi nancial assets and liabiliti es and embodies the
creati on and liquidati on of claims on, or by, the rest of the world.

CAC is coexistent with restricti ons other than on external payments. It

also does not preclude the impositi on of monetary / fiscal measures
relating to foreign exchange transactions, which are of prudential nature.
Following are the prerequisites for CAC:

1. Maintenance of domesti c economic stability.

2. Adequate foreign exchange reserves.
3. Restricti ons on inessenti al imports as long as the foreign exchange
positi on is not very comfortable.
4. Comfortable current account positi on.
5. An appropriate industrial policy and a conducive investment climate.
6. An outward oriented development strategy and suffi cient incenti ves
for export growth.