A REPORT ON

BALANCE OF PAYMENTS


CONCEPT QUESTIONS

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 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.

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.

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 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.


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 economys position vis--
vis other countries in the 1950s and the 1960s. 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 along side the current
account transactions to constitute basic balance.
b) In many cases, countries dont 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 a
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 etc
are 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
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.


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 to realise 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 a
reaction 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 in part 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 favourable to a country and a negative sum is considered as
unfavourable. 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 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.


UNILATERAL TRANSFERS
Unilateral transfers or unrequited receipts, are receipts which the residents of a
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 countrys 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
behaviour 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 lendings 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
AND CURRENT ACCOUNT WITH EXAMPLES.
Credits Debits
Current Account Current Account
1. Merchandise Exports (Sale of Goods) 1. Merchandise Imports (purchase of
Goods)
2. Invisible Exports (Sale of Services) 2. Invisible Imports (Purchase of
Services)
a. Transport services sold abroad a. Transport services purchased
from abroad
b. Insurance services sold abroad b. Insurance services purchased
c. Foreign tourist expenditure in
country
c. Tourist expenditure abroad
d. Other services sold abroad d. Other services purchased from
abroad
e. Incomes received on loans and
investments abroad.
e. Income paid on loans and
investments in the home country.
3. Unilateral Transfers 3. Unilateral Transfers
a. Private remittances received from
abroad
a. Private remittances abroad
b. Pension payments received from
abroad
b. Pension payments abroad
c. Government grants received from
abroad
c. Government grants abroad.
Capital Account Capital Account
3. Foreign long-term investments in the
home country (less redemptions and
repayments)
3. Long-term investments abroad (less
redemptions and repayments)
a. Direct investments in the home
country
a. Direct Investments abroad
b. Foreign investments in domestic
securities
b. Investments in foreign securities
c. Other investments of foreigners in
the home country
c. Other investments abroad
d. Foreign Governments loans to the d. Government loans to foreign
home country. countries
4. Foreign short-term investments in
the home country.
4. Short-term investments abroad.


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.
DESCRIPTIVE QUESTIONS

DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP
STATEMENTS?
BOP statistics are regularly compiled, published and are continuously monitored by
companies, banks and government agencies. A set of BOP accounts is useful in the
same way as a motion picture camera. The accounts do not tell us what is good or
bad, nor do they tell us what is causing what. But they do let us see what is happening
so that we can reach our own conclusions. Below are 3 instances where the
information provided by BOP accounting is very necessary:
1. Judging the stability of a floating exchange rate system is easier with BOP as the
record of exchanges that take place between nations help track the accumulation
of currencies in the hands of those individuals more willing to hold on to them.
2. Judging the stability of a fixed exchange rate system is also easier with the same
record of international exchange. These exchanges again show the extent to which
a currency is accumulating in foreign hands, raising questions about the ease of
defending the fixed exchange rate in a future crisis.
3. To spot whether it is becoming more difficult for debtor counties to repay foreign
creditors, one needs a set of accounts that shows the accumulation of debts, the
repayment of interest and principal and the countries ability to earn foreign
exchange for future repayment. A set of BOP accounts supplies this information.
This point is further elaborated below.

The BOP statement contains useful information for financial decision makers. In the
short run, BOP deficit or surpluses may have an immediate impact on the exchange
rate. Basically, BOP records all transactions that create demand for and supply of a
currency. When exchange rates are market determined, BOP figures indicate excess
demand or supply for the currency and the possible impact on the exchange rate.
Taken in conjunction with recent past data, they may conform or indicate a reversal
of perceived trends. They also signal a policy shift on the part of the monetary
authorities of the country unilaterally or in concert with its trading partners. For
instance, a country facing a current account deficit may raise interest to attract short
term capital inflows to prevent depreciation of its currency. Countries suffering from
chronic deficits may find their credit ratings being downgraded because the markets
interpret the data as evidence that the country may have difficulties its debt.

BOP accounts are intimately with the overall saving investment balance in a
countrys national accounts. Continuing deficits or surpluses may lead to fiscal and
monetary actions designed to correct the imbalance which in turn will affect
exchange rates and interest rates in the country. In nutshell corporate finance
managers must monitor the BOP data being put out by government agencies on a
regular basis because they have both short term and long term implications for a host
of economic and financial variables affecting the fortunes of the company.


IN THE ACCOUNTING SENSE THE BOP ALWAYS BALANCES!
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. For instance,
exports (like sales of a business) are credits, and imports (like the purchases of a
business) are debits. As in business accounting the BOP records increases in assets
(direct investment abroad) and decreases in liabilities (repayment of debt) as debits,
and decreases in assets (sale of foreign securities) and increases in liabilities (the
utilisation of foreign goods) as credits. An elementary rule that may assist in
understanding these conventions is that in such transactions it is the movement of a
document, not of the money that is recorded. An investment made abroad involves
the import of a documentary acknowledgement of the investment, it is therefore a
debit. The BOP has one important category that has no counter part or at least no
significant counter part in business accounting, i.e. international gifts and grants and
other so called transfer payments.

In general credits may be conceived as receipts and debits as payments. However this
is not always possible. In particular the change in a countrys international reserves
in gold and foreign exchange is treated as a debit if it is an increase and a credit if it is
a decrease. The procedure is to offset changes in reserves against changes in the
other items in the table so that the grand total is always zero, (except for errors and
omissions).
A transaction entering the BOP usually has two aspects and invariably gives rise to
two entries, one a debit and the other a credit. Often the two aspects fall in different
categories. For instance, an export against cash payment may result in an increase in
the exporting countrys official foreign exchange holdings. Such a transaction is
entered in the BOP as a credit for exports and as a debit for the capital account. Both
aspects of a transaction may sometimes be appropriate to the same account. For
instance the purchase of a foreign security may have as its counter part reduction in
official foreign exchange holdings.

Thus it is clear that if we record all the entries in BOP in a proper way, debits and
credits will always be equal. So that in accounting sense the BOP will be in balance.


DETAILED OUTLINE OF THE BOP STATEMENT & SUB ACCOUNTS
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. A BOP
statement (revised) includes the following sub accounts, as shown in the table below.
Items Credits Debits Net
G. Current Account
1. Merchandise
a. Private
b. Government
2. Invisibles
a. Travel
b. Transportation
c. Insurance
d. Investment Income
e. Government (not included elsewhere)
f. Miscellaneous
3. Transfer Payments
a. Official
b. Private
Total Current Account (1+2+3)

H. Capital Account
2. Private
a. Long Term
b. Short Term
3. Banking
4. Official
a. Loans
b. Amortisation
c. Miscellaneous
Total Capital Account (1+2+3)

I. IMF
J. SDR Allocation
K. Capital Account, IMF & SDR Allocation (B+C+D)
L. Total Current Account, Capital Account, IMF & SDR
Allocation (A+E)


M. Errors & Omissions
N. Reserves and Monetary Gold

Current Account
The current account includes all transactions which give rise to or use up national
income. The current account consists of two major items, namely, (a) merchandise
export and imports and (b) invisible imports and exports.

Merchandise exports i.e. sale of goods abroad, are credit entries because all
transactions giving rise to monetary claims on foreigners represent credits. On the
other hand, merchandise imports, i.e. purchase of goods abroad, are debit entries
because all transactions giving rise to foreign money claims on the home country
represent debits. Merchandise exports and imports form the most important
international transactions of most of the countries.

Invisible exports i.e. sale of services, are credit entries and invisible imports i.e.
purchase of services are debit entries. Important invisible exports include sale abroad
of services like insurance and transport etc. while important invisible imports are
foreign tourist expenditures in the home country and income received on loans and
investment abroad (interests or dividends).

Transfers payments refer to unrequited receipts or unrequited payments which may
be in cash or in kind and are divided into official and private transactions. Private
transfer payments cover such transactions as charitable contributions and
remittances to relatives in other countries. The main component of government
transfer payments is economic aid in the form of grants.

Capital Account
The capital account separates the non monetary sector from the monetary one, that
is to say, the trading or ordinary private business element in the economy together
with the ordinary institutions of central or local government, from the central bank
and the commercial bank, which are directly involved in framing or implementing
monetary policies. The capital account consists of long term and short term capital
transactions. Capital outflow represents debit and capital inflow represent credit. For
instance, if an American firm invests rupees 100 million in India, this transaction
will be represented as a debit in the US BOP and a credit in the BOP of India.

Other Accounts
The IMF account contains purchases (credits) and repurchases (debits) from the
IMF. SDRs Special Drawing Rights are a reserve asset created by the IMF and
allocated from time to time to member countries. Within certain limitations it can be
used to settle international payments between monetary authorities of member
countries. An allocation is a credit while retirement is a debit. The Reserve and
Monetary Gold account records increases (debits) and decreases (credits) in reserve
assets. Reserve assets consist of RBIs holdings of gold and foreign exchange (in the
form of balances with foreign central banks and investment in foreign government
securities) and governments holding of SDRs. Errors and Omissions is a statistical
residue. 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). 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.


HOW WILL YOU IDENTIFY A DEFICIT OR SURPLUS IN BALANCE OF
PAYMENTS? / MEANING OF DEFICIT AND SURPLUS IN THE
BALANCE OF PAYMENTS.
If the balance of payment is a double entry accounting record, then apart from errors
and omissions, it must always balance. Obviously, the terms deficit or surplus
cannot refer to the entire BOP but must indicate imbalance on a subset of accounts
included in the BOP. The imbalance must be interpreted in some sense as an
economic disequilibrium.

Since the notion of disequilibrium is usually associated within a situation that calls
for policy intervention of some sort, it is important to decide what is the optimal way
of grouping the various accounts within the BOIP so that an imbalance in one set of
accounts will give the appropriate signals to the policy makers. In the language of an
accountant e divide the entire BOP into a set of accounts above the line and
another set below the line. If the net balance (credits-debits) is positive above the
line we will say that there is a balance of payments surplus; if it is negative e will
say there is a balance of payments deficit. The net balance below the line should be
equal in magnitude and opposite in sign to the net balance above the line. The items
below the line can be said to be a compensatory nature they finance or settle
the imbalance above the line.

The critical question is how to make this division so that BOP statistics, in particular
the deficit and surplus figures, will be economically meaningful. Suggestions made by
economist and incorporated into the IMF guidelines emphasis the purpose or motive
a transaction, as a criterion to decide whether a transaction should go above or below
the line. The principle distinction between autonomous transaction and
accommodating or compensatory transactions. 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 to realise 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). The terms balance of payments
deficit and balance of payments surplus will then be understood to mean deficit or
surplus on all autonomous transactions taken together.

The other measures of identifying a deficit or surplus in the BOP statement are:
Deficit or Surplus in the Current Account and/or Trade Account.
The Basic Balance which shows the relative deficit or surplus in the BOP.


A DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR UNDESIRABLE!
The basic balance was regarded as the best indicator of the economys position vis--
vis other countries in the 1950s and the 1960s. 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] is seen as an indication of deterioration in
the [relative] state of the economy. Thus it is very much evident that a deficit in the
basic balance is a clear indicator of worsening of the state of the countrys BOP
position, and thus can be said to be undesirable at the very outset.

However, on further thoughts, a deficit in the basic balance can also be understood to
be desirable. This can be explained as follows: 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 a current account deficit is accompanied by a
deficit on the long term capital account. This deficit in long term capital account
could be clearly observed in a developing countrys which might be investing heavily
on capital goods for advancement on the agricultural and industrial fields. This 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.

Thus a deficit in basic balance can be desirable as well as undesirable, as it clearly
depends upon what is leading to a deficit in the long term capital account.


SHORT NOTES

BALANCE OF PAYMENTS
(Refer to Concept Questions)


CURRENT ACCOUNT
The current account records exports and imports of goods and services and unilateral
transfers. Exports whether of goods or services are by convention entered as positive
items in the account. Imports accordingly are entered as negative items. Exports are
normally calculated f.o.b i.e. cost from transportation, insurance etc are not included
whereas imports are normally calculated c.i.f. i.e. transportation, insurance cost etc
are included.

In many cases the payment for imports and exports will result in transfer of money
between the trading countries. For example a UK firm importing a good from US
may settle its debt by instructing its UK bank to make a payment to the US account of
the exporter. This is not necessarily the case however. If the UK firm holds a bank
account in the US, then it may make payment to the US exporter from that account.
In the former case the financial side of the transaction will appear in the UK BOP
account as part of the net change in UK foreign currency reserves. In the later it will
appear as the part of the capital account since the UK firm has reduced its claims on
the US bank.

BOP accounts usually differentiate between trades in goods and trade in services. The
balance of imports and exports of the former is referred to in the UK accounts as the
balance of visible trade in other countries it may be referred to as the balance of
merchandise trade, or simply as the balance of trade. The net balance of exports and
imports of services is called the balance of invisible trade in the UK statistics.

Invisible trade is a much more heterogeneous category than is visible trade. It helps
in distinguishing between factor and non-factor services. Trade in the later of which
shipping, banking and insurance services and payments by residents as tourists
abroad are usually the most important, is in economic terms little different from
trade in goods. That is, exports and imports are flows of outputs whose values will be
determined by the same variables that would affect the demand and supply for
goods. Factors services, which consist in the main of interest, profits and dividends,
are on the other hand payments for inputs. Exports and imports of such services will
depend in large part on the accumulated stock of past investment in and borrowing
from foreign residents.

Unilateral transfer forms a major part of the current account. It refers to unrequited
receipts or unrequited payments which may be in cash or in kind and are divided into
official and private transactions. Unilateral transfers or unrequited receipts, are
receipts which the residents of a 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.

The net value of the balances of visible trade and of invisible trade and of unilateral
transfers defines the balance on current account.


CAPITAL ACCOUNT
(Refer to Concept Questions)


OFFICIAL RESERVES ACCOUNT
Official reserve account forms a special feature of the capital account. This account
records the changes in the part of the reserves of other countries that is held in the
country concerned. These reserves are held in three forms: in foreign
currency, usually but not always the US dollars, as gold, and as Special
Deposit Receipts (SDRs) borrowed from the IMF. Note that the reserves do
not have to be held by the country. Indeed most of the countries hold a proportion of
the reserves in accounts with foreign central banks.

The IMF account contains purchases (credits) and repurchases (debits) from the
IMF. SDRs Special Drawing Rights are a reserve asset created by the IMF and
allocated from time to time to member countries. Within certain limitations it can be
used to settle international payments between monetary authorities of member
countries. An allocation is a credit while retirement is a debit. The Reserve and
Monetary Gold account records increases (debits) and decreases (credits) in reserve
assets. Reserve assets consist of RBIs holdings of gold and foreign exchange (in the
form of balances with foreign central banks and investment in foreign government
securities) and governments holding of SDRs.

The change in the reserves account measures a nations surplus or deficit on its
current and capital account transactions by netting reserve liabilities from reserve
assets. For example, a surplus will lead to an increase in official holdings of foreign
currencies and/or gold; a deficit will normally cause a reduction in these assets.

For most of the countries, there is a correlation between balance-of-payments
deficits and reserve declines. A drop in reserves will occur, for instance, when a
nation sells gold to acquire foreign currencies that it can use to meet the deficit in the
balance of payments.
BIBLIOGRAPHY
Balance of Payments
- Paul Madson
International Financial Management
- P G Apte
International Economics
- Lindert
International Economics
- Francis Chernuliam
International Economics
- C P Kindelberger
International Economics
- Geoffrey Reed
International Economics
- H G Mannur