BALANCE OF PAYMENTS (BOP)

BOP topics to be covered

BOP definitions and meaning Format of BOP as per IMF Components of BOP BOP Accounting Examples & problems Measures to correct disequilibrium in BOP

Balance of Payments -Definition

As per the BOP Manual of IMF :
the balance of payments (BOP) is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. Transactions, for the most part between residents and non-residents, consist of those involving goods, services, and income; those involving financial claims on, and liabilities to, the rest of the world; and those (such as gifts) classified as transfers, which involve offsetting entries to balancein an accounting senseonesided transactions

Balance of Payments - Definition

summary of the economic transactions of the residents of a country with the rest of the world during a specified time period, normally a year. Economic Transactions- arises when values are exchanged or moved between nations which may arise from: Export and Import of goods. Rendering of services abroad and using foreign exchange. Gifts/grants from one country to another. Investment made abroad or received from abroad. Income on investments received from abroad or remitted abroad. Increase or decrease in the international reserves of the country.

Balance of payments is the systematic recording of

Balance of Payments
Residents with non-residents
Residents mean the individuals, institutions, corporate bodies, government department etc, domiciled in the country. Units/ branches of MNCs domiciled in the country are residents and their transactions with their parents are reflected in the BOP. Certain exceptions if gold is sold to the central bank of the country which increases the monetary gold of the country, it will appear in BOP. Also foreign assets exchanged between residents will be included in the BOP

Balance of payment
A Flow Statement
BOP is compilation of the flow of economic transactions of the country during the period and not a statement of the position as on a date. It is more like a funds flow statement rather than a balance sheet.

PeriodicityNormally BOP statement is prepared covering a period of one year. However, it can be prepared for shorter periods also such as a month, quarter or half year.

1. Current Account
1 1.A 1.A.a 1.A.b 1.A.b.1 1.A.b.2 1.A.b.3 1.A.b.4 1.A.b.5 1.A.b.6 1.A.b.7 1.A.b.8 1.A.b.9 1.A.b.10 1.A.b.11 1.A.b.12 1.B 1.C Current Account (1.A+1.B+1.C) Goods & Services (1.A.a+ 1.A.b) Goods (1.A.a.1 to 1.A.a.3) Services (1.A.b.1 to 1.A.b.13) Manufacturing services on physical inputs owned by others Maintenance and repair services n.i.e. Transport Travel Construction Insurance and pension services Financial services Charges for the use of intellectual property n.i.e. Telecommunications, computer, and information services Other business services Personal, cultural, and recreational services Government goods and services n.i.e. Primary Income (1.B.1to1.B.3) Secondary Income (1.C.1+1.C.2)

2. Capital Account
2 2.1 2.2 2.2.1 2.2.1.1 2.2.1.2 2.2.2 2.2.2.1 2.2.2.2 Capital Account (2.1+2.2) Gross acquisitions (DR.)/disposals (CR.) of non-produced nonfinancial assets Capital transfers General government Debt forgiveness Other capital transfers Financial corporations, nonfinancial corporations, households, and NPISHs Debt forgiveness Other capital transfers including migrants transfers

3.Financial Account
3 3.1 3.1.A 3.1.B 3.2 3.3 3.4 3.5 3 3.0.1 3.0.2 3.0.3 4 Financial Account (3.1 to 3.5) Direct Investment (3.1A+3.1B) Direct Investment in India Direct Investment by India Portfolio Investment Financial derivatives (other than reserves) and employee stock options Other investment Reserve assets Total assets/liabilities Of which: (by instrument): Equity and investment fund shares Debt instruments Other financial assets and liabilities Net errors and omissions

Balance of Payments (OLD FORMAT)

Credit(+) A I II CURRENT ACCOUNT MERCHANDISE INVISIBLES (a+b+c) (a) Services (I) Travel (ii) Transportation (iii)Insurance (iv)Government not indicated elsewhere (v)Miscellaneous of which Software Services (b) Transfers (i) Official (ii)Private (c) Income (i)Investment Income (ii)Compensation to Employees Debit (-) Net

Total Current Account (I+II)

CAPITAL ACCOUNT 1 Foreign Investment (a+b) (a) Foreign Direct Invesment (i) In India Equity Reinvested Earnings Other Capital (ii) Abroad Equity Reinvested Earnings Other Capital (b) Portfolio Investment In India Abroad 2 Loans (a+b+c) (a) External Assistance (i) By India (ii) To India (b) Commercial Borrowings (MT & LT) (i) By India (ii) To India ( c) Short-term to India 3 Banking Capital (a+b) (a) Commercial Banks (i) Assets (ii) Liabilities Of which : Non-resident deposits (b) Others 4 Rupee Debt Service 5 Other Capital Total Capital Account (1 to 5)

Credit (+)

Debit (-)

Net

Credit (+) C D E Errors & Omissions Overall Balance (A+B+C) Monetary Movements (i) IMF (ii) Foreign Exchange Reserves

Debit(-)

Net

Indias BOP
BOP September 2012.xls

Indi's trade performance.pdf

Components of Balance of Payments

BOP statement is presented with 3 major components:
Current Account Capital Account and Official reserves Account

Current Account refers to transactions in goods and services, income and current transfers. It covers all transactions between residents and non-residents.
Merchandise (Goods) represents export and import of commodities from/into India. Credit (+) refers to Exports and Debit (-) refers to Imports. The net balance being the difference between these two refers to Balance of Trade. Exports are at FOB and Imports are at CIF. If freight and insurance are paid separately, these are shown under transportation and insurance. Services (Invisibles) include services, transfers and investment income also known as intangibles to distinguish from merchandise trade.

Components of Balance of Payments ..

Travel - covers expenditure incurred by non-resident travellers during their stay in India Transportation all receipts and payments on account of international transportation services. Debits are expenses of Indian companies abroad, payments to foreign transport companies and credits include receipt of foreign earnings of Indian transport companies and other receipts. Insurance all receipts and payments relating to all types of insurance and reinsurance. Govt. not included elsewhere receipts and payments on government account account not included elsewhere. Includes receipts and payments on account of maintenance embassies and diplomatic missions & offices of UNO, WHO etc.

Components of Balance of Payments .

Miscellaneous items receipts and payments in respect of all other services such as agency services, technicians and professional services, technical knowhow, royalties, subscription for periodicals etc., Transfer payments/unilateral transfers receipts and payments without quid-pro-quo (grants received or extended to foreign governments, repatriation of savings, remittances for family maintenance, contributions and donations to religious organisations, charitable institutions etc. Investment income remittances, receipts and payments on account of profits, dividends, interest, commitment charges on foreign loans including IMF. Compensation to employees wages, salaries and benefits in cash or kind to non-resident workers (local staff of embassies)

Components of Balance of Payments .

Balance on Current Account two important measures are Balance of Trade and Balance of Payments.
Balance of Trade - is the net difference between the value of export and import of goods. When aggregate export of goods during a period exceed its aggregate imports, it is a favourable or surplus or positive and vice versa (unfavourable or deficit or negative). During any period balance of trade will be either a favourable or unfavourable. Balance of Payment includes visible trade and invisible items also. It represents balance of trade plus balance on invisibles. It is a more representative as it includes net balance of all items of current account. Similar to balance of trade, the amounts receivable and payable do not balance & for any given period ends up with favourable or unfavourable

Components of Balance of Payments .

Financial Account
Foreign investment in India investment by nonresidents in the equity of entities in India. FDI is one of intention of investor. FII refers to the portfolio investment, other than FDI. Loans external assistance, commercial borrowings and short term loans from multilateral organisation like World Bank and bilateral sources on concessional terms. Commercial borrowings debts owed to international banks, borrowings in bond markets, credits from export credit agencies and loans provided by multilateral or bilateral institutions like IFC on commercial terms. Short terms credits payable within one year Rupee debt service payments under rupee/rouble agreement with Russia

Components of Balance of Payments

Balance on Capital Account is the net inflows and outflows on capital transactions. Overall Balance is the total of balance on current account and balance on capital account. It is also called official settlements balance as it must be financed by official reserves or by other non-reserve transactions. It reflects countrys overall competitive position in terms of all private transactions and has influence on the exchange rate of the countrys currency.

BOP Accounting
In conformity with business and national accounting, in the balance of payments, the term credit is used to denote a reduction in assets or an increase in liabilities, and the term debit is used to denote a reduction in liabilities or an increase in assets. This usage has been supplemented by the rule that every recording of a debit movement shall be matched by the recording of a credit movement and vice versa. For example, India borrows $ 2 billion in USD from the government of US and deposits the money with a US commercial bank. India then acquires an asset (the bank balance) as well as incurring a liability (the debt to the government of US). The asset account is debited, and the liability account is credited. The Indian BOP entries to record the transaction are: Credit Debit Liabilities (obligation to US ) 200,000 Assets (bank balance in US) 200,000

BOP Accounting
In summary form, double entry accounting conventions used in the balance of payments consist of: Credit (CR) entries Exports of goods and services Income receivable Offsets to real or financial resources received without a quid pro quo (transfers) Increases in liabilities Decreases in financial assets Debit (DR) entries Imports of goods and services Income payable Offsets to real or financial resources provided without a quid pro quo (transfers) Increases in financial assets Decreases in liabilities

BOP Accounting
Credits (+) (inflow of foreign exchange) Current Account Export of merchandise Export of software Licensing fees earned by an Indian company. Interest earned on Loans given to a foreign entity. Profits earned on Indian owned companies abroad. Amount spent in foreign currency by foreign tourists in India. Capital /Financial Account Purchase of real estate by a nonresident Purchase of stocks of Indian companies by a non-resident Purchase of GOI bonds by a foreign bank abroad. Debits (-) (outflow of foreign exchange) Current Account Import of merchandise Import of software Hotel bills of Indian travellers overseas Amount spent by Indian travellers abroad Profit earned by foreign companies in India repatriated Remittances by foreigners working in India to their home country Capital/Financial Account New investment by an Indian company in USA Purchase of gold by RBI Purchase of US treasury bonds by RBI

BOP components

INDIAS BALANCE OF TRADE ASSOCHAM PROJETIONS OR 2012-13

Indias balance of trade (BoT) is projected between USD 262 billion and USD 280 billion in the fiscal 2012-13, exerting further pressure on the countrys current account deficit (CAD), according to an ASSOCHAM study. In the fiscal 2011-12, the countrys merchandise imports totalled USD 488 billion against exports of USD 303 billion leaving balance of trade (BoT) of USD 185 billion. Against the backdrop of weak recovery in the US economy and continuing troubles in the European markets, export shipments were up 21 per cent as there was some good performance in the initial months of the 2011-12 fiscal. But, imports shot up by 32 per cent thanks mainly to high crude prices and rising gold and silver imports. Import on these two counts itself was a whopping USD 217 billion, accounting for over 44 per cent of the countrys total import bill of USD 489 billion, said The Associated Chambers of Commerce and Industry of India (ASSOCHAM).

Disequilibrium in BOP
The statement that BOP should always balance is true from the accounting point of view on account of the double entry principle. In the economic sense, balance of payment is balanced only when each of the segments balances by itself. Balances that arise in each of the segment of the BOP indicates disequilibrium in that segment. Each of the segments like Balance of Trade, Balance on Current Account, Balance on Capital/Financial Account and Overall Balance when they are not zero means that there is a disequilibrium. The disequilibrium is considered surplus or favourable When the inflow of foreign exchange into the country is greater than the outflow means there is a surplus : net foreign exchange inflow into the country. The balance is deficit or unfavourable when inflow is lower than the outflow. This poses a more serious problem and requires various corrective measures from the government.

Disequilibrium in BOP
Imbalance in Current Account
Persistent surplus in the balance on current account would indicate that the countrys export of goods & services are more than imports. The total savings is not used for domestic capital formation but partly diverted for foreign investments. The country acquired foreign assets, but the residents are not enjoying the standard of living they are entitled to. The production of the country is not being enjoyed by the residents but by the importing countries A deficit indicates imports exceed exports for which payments are deferred or met by borrowings. If it persists over long term, it leads to dire consequences. For developing countries, the problem is of facing deficit rather than surplus.

Disequilibrium in BOP
Imbalance in Capital/Financial Account
Surplus in current account is generally welcome, it cannot be a similar situation in capital account A surplus in capital account indicates that the country is a net borrower. Unlike surplus in current account, surplus in capital account has to be repaid with interest/dividend. A deficit in capital account indicates that the country is a net lender or it is repaying its previous borrowings on a larger scale than the current borrowings. A country with surplus in current account and a deficit in capital account indicates deployment of surplus resources. A country with deficit in current account as well as deficit in capital account indicates a position of crisis.

Disequilibrium in BOP.
Imbalance in Overall BOP
It relates to the combined balance in current account and capital account. The overall balance has an immediate effect on the exchange rate of the currency of the country as it represents demand and supply of the currency in the foreign exchange market. The effect on foreign exchange depends on the exchange rate policy of the country Fixed exchange rate domestic currency is expected to suffer due to the shortage of supply of foreign currency. The government is expected to intervene in the market by selling foreign currency. But the government should have foreign exchange reserves. If it has no reserves, devaluation becomes inevitable.

Disequilibrium in BOP.
Imbalance in Overall BOP
Floating rate - under the system market determines the exchange rate & government has no obligation to maintain the rate. Theoretically this mechanism provides an automatic correction in the balance of payment disequilibrium. When BOP is in deficit the demand for foreign currency is more than its supply. It will lead to strengthening of the foreign currency which will in turn lead to exports becoming cheaper and competitive and imports costlier. It will ultimately lead to balance of payments correction. Managed Float though the day to day exchange rate is determined by the market forces of demand and supply, the government may intervene selectively or take other actions to lend stability to the exchange rate. The government may adopt interest rates and exchange controls to preserve the domestic currency value within a certain range.

Correction of disequilibrium in BOP

In a free market economy, it is expected that any imbalances in the BOP position will get adjusted by movement in the currencies forced by market. However, this may take a longer time and hence governments resort to other measures to correct the situation. Some of the methods adopted by the governments either singly or in combination are:
Devaluation Monetary & Fiscal Policies Exchange Control Trade Control Import restrictions Export Promotion

Devaluation: Means lowering the value of the local currency by the government. A currency undergoes depreciation under floating exchange system. It is devalued under fixed exchange rate system. While the devaluation is reduction in the external value of the local currency by the government, depreciation refers to reduction in value due to market forces.

Devaluation When the country faces chronic balance of payments deficit, with devaluation, exports from the country is made cheaper and imports costlier. The pre-conditions are (a) the demand for exports and imports should be price elastic, (b) there should not be any change in the internal value of the currency and (c) other countries should not indulge in competitive devaluation.
Year 1970 1975 1980 1985 1990 1995 2000 2006 2007 (Oct) 2008 (Jun) 2008 (Oct) 2009 (Oct) 2010 (Jan) 2011 (Apr) 2011 (Dec) Exchange rate (rupees per US$) 7.57 8.41 7.89 12.37 17.50 32.43 45.00 48.34 38.48 42.51 48.88 46.37 46.21 44.17 53.71

Correction of disequilibrium in BOP..

Monetary & Fiscal Policies Monetary and fiscal policy are the two instruments available to the government to affect the level of economic activity in the economy and through the balance of payments. Monetary policy influences the economy through the changes in the supply of money, while the fiscal policy relates to government expenditure and revenue. In a BOP deficit, the government will adopt expenditure reducing policies. The monetary policy will reduce money supply by increasing the lending rates or increase in the reserve requirements of banks, issuing of government bonds in open market operations. With the funds becoming scarce, cost of borrowing increases and traders find it difficult to hold stocks. Imports fall as they are costlier compared to the domestic goods and also the fall in the income levels make the imports difficult. In the Financial account, the rise in the interest rates would induce the foreign investors to invest in the country.

Correction of disequilibrium in BOP..

Exchange Control This refers to the regulation of foreign exchange transactions through exchange restrictions, exchange intervention. Exchange restrictions will take the form of supply side restrictions especially for imports (blocked accounts), multiple exchange rate for different commodities and exchange interventions Trade Control Regulation of import and exports which will take the form of import restrictions and export promotions. Import control is one the simplest to remedy the BOP problems by either restricting imports through licenses or by stiff import tariffs. This is resorted to non-essential and luxury goods, but is not done in the case of essential goods, raw materials, food and capital goods. Export promotion measures concessional interest rates, export incentives, encouragement to export oriented projects, value added products etc.,