Balance of payment

12.1 MEANING OF BALANCE OF PAYMENTS

Every government keeps a record of the transactions that take place between the country and

the rest of the world during a given period of time. This record is termed as the country's

Balance of Payments (BOP). Balance of Payment is an accounting statement that provides a

systematic record of all the economic transactions, between Residents of a country and the

rest of the world, in a given period of time.

BOP is a summary statement in which all the 'Economic Transactions' between 'Residents' and rest

of the world are recorded during a particular period of time (usually, one year).

Who are included in Residents?

Residents of a country include individuals, firms and government agencies. However, residents

do not include Diplomatic staff, foreign military personnel, tourists, migratory workers and

branches of foreign companies, even though they work and operate within the domestic territory

of the country.

Economic Transactions

Economic transactions refer to those transactions which involve transfer of the title or

Goods, services, money and assets. They are broadly categorised as under:

1. Visible Items: These include all types of physical goods which are exported and imported.

These are called ‘visible items’ as they are made of some matter or material and can be

Seen, touched and measured. The movement of such items is open and can be verified by

The custom officials.

2. Invisible Items: Invisible items of trade refer to all types of services like shipping, banking,

They cannot

Insurance etc., which are given and received. These are called invisible items as t

Be seen, felt, touched or measured.

3. Unilateral Transfers: Unilateral transfers include gifts, personal remittances and other

Claim for repayment,

‘one-way transactions’. Since these transactions do not involve

They are also known as unrequited transfers.

Any

Ownership of

4. Capital Transfers: Capital transfers relate to capital receipts (through borrowings or sale

Of assets) and capital payments (through capital repayments or purchase of assets).

Structure of Balance of Payments

Balance of payments accounting uses the ‘Double Entry System’ for recording the transactions

With the rest of the world. Like a typical business account, BOP account also has two sides:

(i) Credit side: All inflows or sources of foreign exchange are recorded on the credit side.
(ii) Debit side: All outflows or uses of foreign exchange are recorded on debit side.

In the accounting sense, BOP is always balanced like Trial Balance as it is prepared as per double

Entry system. However, in economic sense, BOP need not be always equal. It means, BOP can be:

• Balanced BOP: BOP is balanced when receipts of foreign exchange are equal to payments

Of foreign exchange.

Surplus BOP: BOP is in surplus when receipts of foreign exchange are more than payments

Of foreign exchange.

• Deficit BOP: BOP is in deficit when receipts of foreign exchange are less than payments

Of foreign exchange.

Quick Recap of BOP

1. BOP is a systematic record of all economic transactions between residents of a country and rest
of

The world.

2. It includes transactions relating to visible items, invisible items, unilateral transfers & capital transfers.

3. It is a flow concept as it is related to a given period of time.

4. It is prepared as per Double Entry System. Inflows of foreign exchange are recorded on the credit

Side and outflows on the debit side.

12.2 MEANING OF BALANCE OF TRADE

Balance of trade (BOT) refers to difference between the amounts of exports and imports of
Visible items (goods).

Balance of Trade = Exports of goods – Imports of goods

Exports are entered as credit (positive) items in the BOP account, while imports are entered as

debit (negative) items. BOT is just a part of BOP account and plays a crucial role in deciding

the overall situation of BOP of a country. BOT is also known as 'Balance of Visible Trade' or 'Trade

Balance

Balance on Balance of Trade

The balance of trade need not balance itself, i.e., it is not necessary that export of goods is always

equal to import of goods. Balance on BOT can also be surplus (positive) or deficit (negative).

Surplus BOT: If a country exports more goods than what it imports, then the balance of

trade is said to be in surplus, i.e., balance of trade is 'favourable' for the country.

Deficit BOT: If import of goods exceeds the export of goods, then the country is said to

have a deficit BOT, i.e., balance of trade is 'unfavourable' for the country.

Difference Between Balance of Trade and Balance of Payments

Balance of trade and Balance of payments are two related terms, which are often used in the

international economic scenario. However, they should be carefully distinguished from each

other as they do not have the same meaning.

Let us analyse some of the important points of difference between the two:
12.3 COMPONENTS OF BALANCE OF PAYMENTS

All transactions in balance of payments can be grouped under two broad categories: (1) Current

Account; (2) Capital Account. Let us discuss each of these accounts in detail.

Current Account

Current Account refers to an account which records all the transactions relating to export and

import of goods and services and unilateral transfers during a given period of time. Current

Account contains the receipts and payments relating to all the transactions of visible items,

invisible items and unilateral transfers.

Current Account includes those transactions which do not impact assets and liabilities position of a
country

in relation to rest of the world, i.e. Current Account transactions do not give rise to future claims.

Components of Current Account

The main components of Current Account are:

1. Export and Import of Goods (Merchandise Transactions or Visible Trade): A major part

of transactions in foreign trade is in the form of export and import of goods (visible items).

Payment for import of goods is written on the negative side (debit items) and receipt from

exports is shown on the positive side (credit items). Balance of these visible exports and imports

is known as balance of trade (or trade balance).

Trade Balance can be of two types:

(i) Trade Deficit: It refers to the excess of the payments for imports of visible items over the value of

receipts of exports of visible items.

(ii) Trade Surplus: It refers to the excess of the receipts of exports of visible items over the value of

payments for imports of visible items.

2. Export and Import of Services (Invisible Trade): It includes a large variety of non-factor

services (known as invisible items) sold and purchased by the residents of a country, to

and from the rest of the world. Payments are either received or made to the other countries

for use of these services. Services are generally of three kinds: (a) Shipping, (b) Banking,

and (c) Insurance. Payments for these services are recorded on the negative side and receipts on

the positive side.

3. Unilateral or Unrequited Transfers to and from abroad (One sided Transactions): Unilateral

transfers include gifts, donations, personal remittances and other 'one-way' transactions.

These refer to those receipts and payments, which take place without any service in

return. Receipt of unilateral transfers from rest of the world is shown on the credit side

and unilateral transfers to rest of the world on the debit side.

4. Income receipts and payments to and from abroad: It includes investment income in the

form of interest, rent and profits.

Current Account shows the Net Income

Current Account records all the actual transactions of goods and services which affect the

income, output and employment of a country. So, it shows the net income generated in the

foreign sector.
Balance on Current Account

In the current account, receipts from export of goods, services and unilateral receipts are entered

As credit or positive items and payments for import of goods, services and unilateral payments

Are entered as debit or negative items. The net value of credit and debit balances is the balance

On current account.

• Current Account Surplus (CAS) arises when credit items are more than debit items. It indicates

Net inflow of foreign exchange. CAS arises when the value of exports of goods and services

is more than the value of imports of goods and services. CAS signifies that the nation is a

lender to the rest of the world.

• Current Account Deficit (CAD) arises when debit items are more than credit items, i.e. when

foreign exchange receipts in the current account fall short of foreign exchange payments,

it leads to current account deficit. It indicates net outflow of foreign exchange. CAD arises

when the value of exports of goods and services is less than the value of imports of goods

and services. CAD signifies that the nation is a borrower from rest of the world.
Capital Account

Capital account of BOP records all those transactions, between the residents of a country

And the rest of the world, which cause a change in the assets or liabilities of the residents of

The country or its government. It is related to claims and liabilities of financial nature. Capital

Account is used to: (i) Finance deficit in current account; or (ii) Absorb surplus of current account.

Capital Account is concerned with financial transfers. So, it does not have direct effect on income, output

And employment of the country.

Components of Capital Account

The main components of capital account are:

1. Borrowings and lendings to and from abroad: It includes:

All transactions relating to borrowings from abroad by private sector, government,

Etc. Receipts of such loans and repayment of loans by foreigners are recorded on the

Positive (credit) side.

• All transactions of lending to abroad by private sector and government. Lending abroad

Repayment of loans to abroad is recorded as negative or debit item.

And

2. Investments to and from abroad: It includes:

• Investments by rest of the world in shares of Indian companies, real estate in India,

Etc. Such investments from abroad are recorded on the positive (credit) side as they

Bring in foreign exchange.

• Investments by Indian residents in shares of foreign companies, real estate abroad,

Etc. Such investments to abroad are recorded on the negative (debit) side as they lead

To outflow of foreign exchange.

'Investments to and from abroad' includes two types of investments

(i) Foreign Direct Investment (FDI): It refers to purchase of an asset, such that it gives direct control

to the purchaser over the asset. For example, purchase of land and building.

(ii) Portfolio Investment: It refers to purchase of an asset, such that it does not give any direct

control over the asset to the purchaser. For example, purchase of shares. It also includes Foreign

Institutional Investment (FII).

3. Change in Foreign Exchange Reserves: The foreign exchange reserves are the financial

assets of the government held in the central bank. A change in reserves serves as the

financing item in India's BOP. So, any withdrawal from the reserves is recorded on the positive

(credit) side and any addition to these reserves is recorded on the negative (debit) side. It must be

noted that 'change in reserves' is recorded in the BOP account and not 'reserves'.

It must be noted that export and import of Capital Goods (like Plant and Machinery, Equipments, etc.)
are

included in Current Account under the head visible items and not in Capital Account.

Balance on Capital Account

The transactions, which lead to inflow of foreign exchange (like receipt of loan from abroad, sale

of assets or shares in foreign countries, etc.) are recorded on the credit or positive side of capital

account. Similarly, transactions, which lead to outflow of foreign exchange (like repayment of

loans, purchase of assets or shares in foreign countries, etc.) are recorded on the debit or negative

side. The net value of credit and debit balances is the balance on capital account.

Surplus in capital account arises when credit items are more than debit items. It indicates

net inflow of capital.

Deficit in capital account arises when debit items are more than credit items. It indicates net

outflow of capital.

In addition to current account and capital account, there is one more element in BOP, known as

'Errors and Omissions'. It is the balancing item, which reflects the inability to record all international

transactions accurately.
Balance on Current Account Vs Balance on Capital Account

Balance on current account and balance on capital account are interrelated.

• A deficit in the current account must be settled by a surplus on the capital account.

• A surplus in the current account must be matched by a deficit on the capital account.

12.4 AUTONOMOUS AND ACCOMMODATING ITEMS/

The transactions recorded in the balance of payments accounts can be categorized as

'Autonomous Transactions' & 'Accommodating Transactions'. Let us discuss each of them in detail.

Autonomous Items

Autonomous items refer to those international economic transactions, which take place due

to some economic motive such as profit maximisation. These items are also known as 'above

the line items'.

Autonomous transactions are independent of the state of BOP account. For example, if a foreign

company is making investments in India with the aim of earning profit, then such a transaction

is independent of the country's BOP situation. Autonomous transactions take place on both current

and capital accounts.

. On the current account, merchandise exports and imports of goods are autonomous

transactions.

. On the capital account, receipts and repayments of long-term loans by private individuals
are autonomous transactions.

Surplus or Deficit in BOP: Autonomous items are cause of BOP imbalance (BOP surplus or deficit)

• BOP account is in surplus when autonomous receipts are more than the autonomous payments.

BOP is in deficit when autonomous receipts are less than autonomous payments.

Accommodating Items

Accommodating items refer to the transactions that are undertaken to cover the gap in the

balance of payments, i.e. such transactions are undertaken to cover deficit or surplus in

autonomous transactions. These items are also known as 'below the line items'.

Accommodating transactions are compensating capital transactions which are meant to correct

the disequilibrium in autonomous items of balance of payments. For example, if there is a

current account deficit in the BOP, then this deficit is settled by capital inflow from abroad. The

sources used to meet a deficit in BOP, are: (i) Foreign exchange reserves; (ii) Borrowings from

IMF or foreign monetary authorities.

BOP is always Balanced in Accounting Sense

As stated before, BOP is based on the principles of double entry system. Any deficit or surplus

created through autonomous transactions is corrected by the corresponding surplus or deficit

in the accommodating transaction by monetary authority.

12.5 DEFICIT (DISEQUILIBRIUM) IN THE BALANCE OF PAYMENTS

There is little possibility for the balance of payments to be in equilibrium during a given period

of time. Disequilibrium in BOP of a country may be either in the form of deficit or as a surplus.

A surplus in BOP does not pose much of a problem. However, a deficit often creates difficult

problem for the economy.

Deficit in balance of payments account arises when total inflows on account of autonomous

transactions are less than total outflows on account of such transactions. On the other hand,

if total inflows on account of autonomous transactions exceed total outflows on account of such

transactions, then there is surplus in balance of payments account.

Official Reserve Transactions

The transactions carried on by monetary authorities of a country, which causes changes in official

reserves are termed as Official Reserve Transactions. Autonomous receipts and autonomous payments

give rise to either deficit or surplus on Balance of Payments. The Central Bank may finance a deficit by:

(i) Reducing reserves of foreign currency.

(ii) Borrowings from monetary authorities like IMF.

The Central Bank may use surplus to purchase foreign securities, foreign currency, gold, etc. which may

result in increase in reserves of the nation.