Prelims Crash Course

Balance of Payments(BoP)

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 Introduction

Balance of payment account of India is a systematic statement of all

economic transactions between the residents of India and the residents of
the rest of the world in an accounting period (say one year).

The BOP accounts of a country is constructed on the basis of an accounting

procedure known as double entry book - keeping. Double entry book
keeping means that each international transaction is recorded twice, once
as a credit entry and once as a debit entry of equal amount. The reason for
this is that in general every transaction has two sides that is credit and
debit.

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 Introduction

Credit transactions(Exports): include - exports of goods and services,

unilateral receipts such as gifts, grants etc .from foreigners, borrowings
from abroad, investments by foreigners in the country,(capital inflows) and
official sale of reserve assets including gold to foreign countries and
international agencies.

Debit transactions (Imports): include - import of goods and services,

unilateral payments such as gifts, grants, etc. to foreigners, lending to
foreign countries, investments by residents in foreign countries, (capital
outflows) and official purchase of reserve assets or gold from foreign
countries and international agencies.

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 Export vs Imports

Export: Exports are the goods and services produced in one country and
purchased by citizens of another country. It doesn't matter what the good or
service is. It doesn't matter how it is sent. It can be shipped, sent by email,
or carried in personal luggage on a plane. If it is produced domestically and
sold to someone from a foreign country, it is an export.

Import: Imports are foreign goods and services bought by residents of a

country. Residents include citizens, businesses and the government. It
doesn't matter what the imports are or how they are sent.

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 Introduction

Components of BoP:
• Current Account: includes all the transactions related to export and
import of goods and services, investment income, and unilateral
transfers (remittances, gifts, grants etc.).
• Capital Account: includes all international asset transactions (FDI
etc.).
• Official Reserve Transactions: These are conducted by central banks
like RBI whenever there is BoP deficit or BoP surplus. These
transactions are conducted in the form of international reserve assets,
such as gold and major international currencies.
The sum of the three BoP components should be zero.

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 Current Account Transactions

Current account of the BoP, transactions can be classified into merchandise

(exports and imports) and invisibles.
Merchandise Trade: When we export goods, we credit money to the
current account. When we import goods, we debit money from the current
account. The difference between export and import is called merchandise
Trade Balance.
If exports are more than imports there will be trade surplus and if imports
are more than exports there will be trade deficit.
Except for two years in the 1970s, India has a trade deficit consistently.

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 Current Account Transactions

Current account of the BoP, transactions can be classified into merchandise

(exports and imports) and invisibles.
Invisible transactions are further classified into three categories, namely
a) Services- travel, transportation, insurance, Government not included
elsewhere (GNIE) and miscellaneous (such as, communication,
construction, financial, software, news agency, royalties, management and
business services etc).

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 Current Account Transactions

(b) Income (investment income & compensation of employees):

Investment income covers receipts and payments of income associated,
respectively, with residents’ holdings of external financial assets and with
residents’ liabilities to non-residents.
Investment income consists of direct investment income, portfolio
investment income, and other investment income.
(c) Current Transfers (grants, gifts, remittances, etc.) which do not have
any quid pro quo.

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 Capital Account Transactions

The former balance of payments capital account has been redesignated as

the capital and financial account as per the fifth edition of Balance of
Payments Manual(IMF) and the revised account has two major
components:
• The Capital Account
• The Financial Account
These are in accordance with the same accounts in the System of National
Accounts (SNA). Assets represent claims on residents and liabilities
represent indebtedness to non residents.

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 Capital Account Transactions

The capital transfers are usually irregular in nature, can be large

(particularly in the case of capital transfers) and are usually limited in
sector (to government, insurance, and charitable organizations), or industry
(mining, forestry, fishing, communications, etc.).
Components:
Capital transfers are transfers in which the ownership of an asset (other
than cash or inventories) changes from one party to another; or which
obliges one or both parties to acquire or dispose of an asset (other than
cash or inventories); or where a liability is forgiven by the creditor.
Non-produced nonfinancial assets include intangible assets covering
contracts, leases, licenses, and marketing assets; and natural resources
(generally land). The capital transfers include debt forgiveness and
assumption, extraordinary claims associated with nonlife insurance, and
investment grants.

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 Financial Account Transactions

All components are classified according to type of investment or by

functional subdivision (a) direct investment, (b) portfolio
investment, (c) other investment,(d) reserve assets.
a) Foreign Direct Investment: When foreigners purchase the Indian
capital assets such as factories, machines, companies, we credit the money
to the capital account. If Indians make FDI investment abroad, we debit the
money from the capital account.

b) Portfolio Investment: When foreigners purchase the Indian securities

such as stocks, bonds, CDs, money-market accounts, the money is credited
to capital Account. When Indians purchase the foreign securities abroad,
the money is debited from the capital Account.

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 Financial Account Transactions

All components are classified according to type of investment or by

functional subdivision (a) direct investment, (b) portfolio investment, (c)
other investment,(d) reserve assets.
c) Other investment: equity or debt securities, trade credits, loans,
currency and deposits, other assets or liabilities.

d) Reserve Assets: Forex reserves with RBI.

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 Balance of Trade

Balance of Trade:
Balance of trade is the difference between the value of goods & services
exported and imported by a country.
In the familiar macro-economic equation, Y=C+I+G+(X–M)
The expression X – M denotes balance of trade.

Current Account Deficit(CAD):

The current account balance includes the sum of three balances –
merchandise balance, services balance and unilateral transfers balance. In
other words, it includes trade balance and transfers balance.
Balance of Current Account = Merchandise balance + Services Balance +
Investment Balance + Unilateral transfers balance.

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 Balance of Payment(BoP)

Balance of Payment(BoP): Current Account Balance + capital & financial

account Balance
Balance of Payments (BoP) statistics systematically summaries the
economic transactions of an economy with the rest of the World (i.e.
transactions between resident & non resident entities) during a given
period.

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 Balance of Payment(BoP)

Foreign Exchange Management Act (FEMA) 2000

FEMA covers three areas:
• Rupee Convertibility
• Setting up of a separate Enforcement Directorate (ED) for trying out
criminal offenses in foreign exchange
• Borrowings by the corporate sector

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 Rupee Convertibility

Rupee Convertibility:
Currency convertibility is the ease with which a country's currency can be
converted into gold or another currency. It means freedom to convert local
financial assets into foreign ones at market-determined exchange rates.
• At present, India allows full convertibility in current account but only
partial convertibility in capital account(CA).
• S. S. Tarapore Committee has recommended to move towards full
CAC.

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 Exchange Rate

Types of Exchange Rates:

1. Fixed Exchange rate: A fixed exchange rate is when a country ties the
value of its currency to some other widely-used commodity or currency.
Today, most fixed exchange rates are pegged to the U.S. dollar. That's
because the dollar is used for most transactions in international trade.

Devaluation: It means the reduction in the external value ofthe country’s

currency unit, undertaken by government fiat or official proclamation. It
means reduction of the official rate at which one currency is exchanged for
another. It is the deliberate action which reduces the value of a country’s
currency in terms of another (exchange rate).

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 Exchange Rate

Revaluation: It means an increase in the external value of the

country’s currency unit, undertaken by government or central
monetary authority. It means deliberate increase of the official rate
at which one currency is exchanged for another.
When a currency is undervalued, the prices and costs in the country
are low in relation to world price. The country has a strong
competitive advantage in the world market for its exports, while its
own demand for imports is comparatively low.

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 Exchange Rate

2. Floating Exchange Rate: Exchange rates fluctuate on a moment-by-moment

basis. Most exchange rates are determined by the foreign exchange market, or
forex. That's called a flexible exchange rate. The flexible rates follow what forex
traders think the currency is worth.
Those judgments depend on a lot of factors. The three most important are central
bank’s interest rates, the country's debt levels and the strength of its economy.
Depreciation: Depreciation of the rupee refers to the decrease in the external value
of the domestic currency occurred due to the operation of market forces. Here, the
exchange rate is moving with demand and supply of dollar. Depreciation happens
under a flexible exchange rate system or under a managed floating exchange rate
system.
Appreciation: Appreciation of the rupee refers to the increase in the external value
of the domestic currency occurred due to the operation of market forces. Here, the
exchange rate is moving in accordance with the demand and supply of dollar.
Appreciation happens under a flexible exchange rate system or under a managed
floating.

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 Exchange Rate

3. Managed floating or Intermediate Exchange rate System: India is

having this type of exchange rate system. In this hybrid exchange rate
system, the exchange rate is basically determined in the foreign exchange
market through the operation of market forces. Market forces mean the
selling and buying activities by various individuals and institutions. So far,
the managed floating exchange rate system is similar to the flexible
exchange rate system. But during extreme fluctuations, the central bank
under a managed floating exchange rate system (like the RBI) intervenes in
the foreign exchange market. Objective of this intervention is to minimise
the fluctuation in the exchange rate of rupee.

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 Exchange Rate

Real Exchange Rate is a rate which measures how many times an item of
goods purchased locally can be purchased abroad. So, it indicates the ratio
of items purchased in the domestic market to the items purchased in the
foreign market.
It measures the purchasing power of domestic currency to the foreign
currency at a prevailing time.

Nominal Exchange Rate is the nominal exchange rate describes the rate at
which an individual can trade the currency of one country for the currency
of another country.

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 Exchange Rate

Nominal effective Exchange Rate (NEER): Nominal exchange rate is the

price of one currency in terms of number of units of some other currency.
This is determined by fiat in a fixed rate regime and by demand and supply
for the two currencies in the foreign exchange rate market in a floating rate
regime.
Real effective Exchange Rate (REER): Real effective exchange rate is
defined as “a weighted average of nominal exchange rates adjusted for
relative price differential between the domestic and foreign countries,
relates to the purchasing power parity (PPP) hypothesis”.
As the definition highlights, REER takes price differential and inflation
into account and, therefore, is said to be a better indicator of the
competitiveness of the country in terms of exchange rates.
RBI is calculating NEER and REER with respect to 36 currencies. In other
words, RBI is considering India’s trading partners to be 36.

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