Prof.

Ruchi M
Alliance Business School
12/08/21 1
 Denotes the differnce between the exports
and imports of a country.
Balance of trade = value of exports of visible goods -
value of imports of visible goods.

 Balance of trade refer to the visible items or

merchandise items only.

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 The balance of payments is a comprehensive
statement of a country’s economic transactions
with the rest of the world for a given period of time
—normally a quarter or a year
 It is composed of the current account and the capital
account
 Favourable BOT- Export more than import

 Unfavourable BOT- Import more than export

 Equilibrium BOT- Export equals import

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 It can be defined as a systematic record of all
economic transactions between the residents
of one country and the residents of other
country during a given period of time.
 Economic transaction are categorized as:-
(a) visible items
(b) invisible items
(c) unilateral transfers, and
(d) capital transfer.
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BALANCE OF TRADE
 Refers to diff between
exports & imports of
goods in a year.
 It is narrow concept
 Not a true indicator of
economic relations with
other countries.
 May be surplus or deficit
in BOT
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BALANCE OF PAYMENT
 Is a statement of all economic
transactions between the
residents of a country & rest of
the world in a year.
 It is wider concept.
 Complete record of economic
transaction with rest of the
world.
 BOP always balances in
accounting sense
6
 Capital account, and

 Current account

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 Current account records the following three
items:-
- visible items,
- invisible items,and
- unilateral transfers.

Balance of payments on current a/c =

Balance of trade + Balance of invisibles

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 Receipts & payments on account of :-
 Trade in services – travel, tourism transport etc
 Investment income such as interest & dividend
 Unilateral transfers - pension, gifts ,donations ….

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 If credit of all these transactions – on a/c of
trade in goods & services, investment
income, unilateral transfers is GREATER than
the debit side – Balance of current account
turns SURPLUS
 If debit of these transactions is greater than
credit, then balance of current account turns
deficit, like the eg.

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 BOP on current a/c during a year can be
favourable,unfavourable and balanced.
Favourable - earns more foreign
exchange(account surplus)
Unfavorable – spends more foreign
exchange(current account deficit)

Current account transactions are called

account by actual transaction, bcoz all the
items included is actually transacted.
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 ( US $ BLN)
S.NO. TYPE OF ACCOUNT CREDIT DEBIT BALANCE
A CURRENT ACCOUNT      
  MERCHANDISE IMPORT   120  
  MERCHANDISE EXPORT 100    
  BALANCE OF TRADE     -20
  INVISIBLES      
  SERVICES (NET) 4    
  UNILATERAL TRANSFERS (NET) 2    
  INVESTMENT INCOME (NET)   1  
  BALANCE OF CURRENT A/C     -15
B CAPITAL ACCOUNT      
  LONG TERM      
  DIRECT INVESTMENT ABROAD   11  
  DIRECT FOREIGN INVSTMENT INFLOW 18    
  PORTFOLIO INVESTMENT (NET)   9  

  LOANS- OFFICIAL & PVT NET OF REPAYMENTS 12    

  BASIC BALANCE     -5 NOT IN INDIA

  SHORT TERM      
  HOLDINGS WITH BANKS 4    
  OTHER SHORT TERM TRANSACTIONS   3  
  BALANCE OF CAPITAL ACCOUNT     11
C ERRORS & OMISSIONS     -1
  OVERALL BALANCE (A+B+C)     -5
D OFFICAL RESERVES      
  SDR ALLOCATIONS 3    
  NET OFFICIAL RESERVES 2    
  OVERALL BALANCE -5    
  OFFICIAL RESERVES MOVEMENT 5     12
 It deals with financial transactions – all kinds
of short term and long term international
capital transfers.
 Two types of flows takes place between
different nation :-
- Autonomous capital flows, and
- Accommodating flows.

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 Autonomous capital flows:-Takes place coz of
economic consideration such as earning
interest income, dividends & other incomes
by foreign investment or lending. ‘Normal
course of business’

 Accommodating flows:- Takes place to bring

BOP in equilibrium. “to meet BOP defict’

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 Private loans.
 Movement of banking capital.
 Official capital transaction.
 Reserve, monetary gold and SDR.
 Gold movement.
 Miscellaneous.

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 Also called statistical discrepancy – reasons
 Difficulties in collecting BOP data – like RBI
info & DGCIS might not match
 Movement of capital may precede or follow
the transactions
 Some figures are based on estimates –
sample based
 Un-recorded transactions

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 Current a/c records economic transactions
relating to exchange of goods & services , while
capital a/c records capital transaction ,eg;-
borrowing & lending , sales & purchase of
assets.
 Current a/c are of flow nature , while capital
transaction are of stock nature.
 Current a/c bring about a change in the current
level of a country’s income whereas capital
transactions bring about a change in the capital
stock of a country.

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 Held by monetary authorities of the country
 Includes – gold, SDRs allocation by IMF & foreign
currency assets – balance with foreign banks & foreign
govt. securities
 If overall BOP is surplus then surplus amount adds on to
ORs
 If overall BOP is deficit then central bank will have to run
down its reserve assets such as gold, SDRs, Forex or else
borrow fresh from foreign central bank.

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 Info given :-
 Inflow on account of services – 1000$
 Outflow on account of services – 800$
 Outflow of dividend, royalty – 1100$
 Inflow of dividend 560$
 Export of goods : 10,000$
 Import of goods : 12,000$
 Remittances (net) : 1200$

Answer is (1140) us$

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 Inflow of loans : 2000$
 Repayment of loan : 2150$
 FDI : (inflow) : 7000$
 FDI outflow : 1500$
 FII investment : 500$
 Short term movement of funds paid200$

 Ans. 5650$
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 Development Programmes.
 Fall in export demand.
 Growth of population.
 Inflation.
 Huge international borrowings.
 Technological changes.
 Changes in foreign exchange rates.
 Natural factors.

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 Price – specie mechanism shows a relationship b/w
trade, movement of gold & domestic price levels
 Inc in money supply - raises domestic prices –
exports become uncompetitive, export earnings
drop, foreign goods become cheaper & Imports
RISE – current a/c balance –deficit
 Precious metal outflows for imports – quantity of
money drops & lowers the price levels – hence
exports increases – so TRADE balance regaining
equilibrium
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 Deflation.
 Exchange depreciation.
 Devaluation.
 Exchange control.
 Capital movement.
 Monetary and fiscal policy.
 Export promotion.
 Attraction to foreign tourists.

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Current Account
 The current account measures transactions
associated with trade in goods and services, income
from abroad and also transfers and gifts - Trade
balance & Net factor income from abroad
 Remember the current account is more than
simply the balance of trade, which is a narrower
concept
 Items included will be - Merchandise Trade Balance,
/Trade Balance on Services/ Overall Trade Balance, Net Foreign Income
From Abroad, Balance on Goods and Services and Income, Net Unilateral
Transfers (e.g. foreign aid donations), small interest payments or
receipts , dividends (investment incomes) payments/ receipts as well.
Capital Account

 The capital account measures financial transactions,

such as purchases of bonds and equities or direct
investment activities
Capital Account

 The capital account measures financial

transactions, such as purchases of bonds
and equities or direct investment activities -
Net private inflows & Change in foreign reserves
 Items like Capital Inflows (e.g. foreign borrowing, receive
+ sign)
Capital Outflows (e.g. US lending, receive a – sign)
Statistical discrepancy
Change in Official Reserves
The Balance of Payments –
Must Balance

 The current account and capital account should

balance each other out
 Each international transaction gives rise to two
offsetting entries one appearing in the current
account and the other appearing in the capital
account
 Thus a current account surplus is matched by a
capital account deficit and a current account deficit
is matched by a current account surplus
Example

Current Account Capital account

Trade balance = -$90 billion Net private inflows = $80 billion

Net factor income from abroad = Change in foreign reserves = -

-$10 billion $20 billion
Current account balance = - Capital account balance = +
$100 billion $100 billion
 Assumption of Forex market – All currencies of
various countries are convertible into other
currencies –NOT TRUE.
 Countries restrict the ability of residents & non-
residents to convert the local currency into foreign
currency.
Currency Convertibility
 Convertibility of a currency implies that a currency can be
transferred into another currency without any limitations
or any control.
 A currency is said to be fully convertible, if it can be
converted into some other currency at the market price of
that currency.
 If currency has to be convertible, it shall not be subjected
to these restrictions.
Current account convertibility

 Refers to currency convertibility required in the case of

transactions relating to exchange of goods and services, money
transfers and all those transactions that are classified in the
current account.
 The value of trade in merchandise, services, investment,
income and unilateral transfers.
 It is essential to the development of multilateral trade.
Capital account convertibility

 Capital account includes transactions of financial assets.

 Its convertibility refers to the freedom to convert local
financial assets into foreign assets in any form and vice
versa at market-determined rates of exchange.
 Capital controls normally restrict or prohibit cross-border
movement of capital.
Capital account convertibility

 Thus, controls on capital movements include prohibitions:

 need for prior approval;
 authorization and notification;
 multiple currency practices;
 discriminatory taxes; and reserve requirements
 interest penalties imposed by the authorities that regulate the
conclusion or execution of transactions.
The coverage of the regulations would apply to receipts as well as
payments and to actions initiated by non-residents and residents.
Govt. Allows both residents
& non-residents to purchase
UN-LIMITED amounts of
foreign currencies with the
local currencies.
When neither residents nor
non-residents are allowed to
convert local currency into
foreign currency.

Countries follow Non-convertibility to preserve their foreign

exchange reserves. Countries need Forex reserves to serve its
International Debt commitments & to pay for imports as
well.
RECOMMENDATIONS OF TARAPORE
COMMITTEE ON CAPITAL ACCOUNT
CONVERTIBILITY
  Reduction of the Gross fiscal deficit to GDP
ratio. (4.5% to 3.5%)
 A consolidated sinking fund has to be set
up to meet government's debt repayment
needs.
 Inflation rate should remain between an
average 3-5%.
 Reduce the level of NPA’s (13.7% to 5% by 2000.)
 CRR needs to be brought down from the current 9.3% to 3% 
 RBI should have a Monitoring Exchange Rate Band of plus
minus 5% around a neutral Real Effective Exchange Rate RBI
should be transparent about the changes in REER 
 External sector policies should be designed to increase
current receipts to GDP ratio and bring down the debt
servicing ratio from 25% to 20% 
 (PHASE-1)
(i)Allowing Indian companies to invest upto $50 million in
venture abroad.

ii) Exporters/exchange earners may be allowed 100 per cent

retention of earnings in Exchange Earners Foreign Currency
(EEFC) accounts with complete flexibility in operation of
these accounts
iii) Individual residents may be allowed to invest in assets in
financial market abroad up to:
US $ 25,000 in Phase I
US $ 50,000 in Phase II and
US$ 100,000 in Phase III.
iv) SEBI registered Indian investors may be allowed to set funds for
investments abroad subject to overall limits of:
$ 500 million in Phase I,
$ 1 billion in Phase II and
$ 2 billion in Phase III.
v) Banks may be allowed much more liberal limits in regard to
borrowings from abroad and deployment of funds outside India.
vi)Allowing FII portfolio funds to be invested and repatriated
without prior RBI scrutiny.

vii)Allowing FII’s, NRIs and foreign banks full access to forward

cover to the extent of their assets in India.

viii)Permitting banks and financial institutions to participate in

gold markets abroad.