Balance of Payments

Balance of payments refers to a systematic record of all economic transactions

between the residents of a country and the rest of the world during a given period
of time.
It is a flow concept. All the economic flows (eg: flow of goods, flow of services
and flow of capital) as shown in BOP are related to a certain time period usually a
financial year.
Economic transactions are characterized as:
1. Transactions involving visible items – Transactions in visible are also called
transactions in merchandise. These include export and import of all physical
goods which can be seen or touched, counted, measured or weighed.
2. Transactions involving invisible items – Transactions in invisibles include
transactions in services. These include export and import of different kind of
services such as shipping, banking, insurance, services of experts etc.
3. Unilateral transfers – These include receipts and payments of gifts,
donations, personal remittances and other ‘one-way transactions’. Since, the
transactions do not involve any claim or repayment, they are also known as
unrequited transfers. Such transfers can either be private or government.
Government transfers include grants and aids.
4. Income from investment and work – It includes profit, interest, dividends
etc. from investment and compensation of employees.
5. Capital transactions – Capital transactions relate to capital receipts (through
borrowing or sale of assets) and capital payments (through capital
repayments or purchase of assets).
Thus, there are two types of activities that cause economic transactions
among the nations. These are:
(i) Current production resulting in export and import of goods and
services.
(ii) Sale and purchase of assets both real (like machines) and financial
(like shares).
Structure of BOP

Like a typical business account, BOP account has two sides – the credit side
and the debit side. All inflows or sources of foreign exchange are recorded
on the credit side. All outflows or uses of foreign exchange are recorded on
the debit side.
Another feature of BOP account is that it is subdivided into two parts: the
current account and the capital account.

Current Account
Current account is that part of BOP which records all the transactions
relating to export and import of goods and services, unilateral transfers and
income from investment and work. The transactions recorded in the current
account do not cause a change in the assets or liabilities of the residents of
the country or its government.

Components of current account

1. Export and import of visible items or goods.
2. Export and import of invisible items or services.
3. Receipts and payments of unilateral transfers.
4. Income receipts and payments from and to abroad.

Capital Account
Capital account is that part of BOP account which records all such
transactions, between the residents of a country and the rest of the world,
which cause a change in the assets or liabilities of the residents of a country
or its government. Credit in capital account represents increase in liabilities
or decrease in assets. Debit represents decrease in liabilities or increase in
assets.

Components of capital account

1. Borrowing and lending from and to abroad – All the transactions relating
to borrowings from abroad by private sector, government etc. are
recorded in capital account. Receipt of such loans and repayment of loans
by foreigners are recorded on the credit side.
 All transactions of lending to abroad by private sector and government
and repayment of loans to abroad is recorded as debit item.
2. Investments to and from abroad – It includes two types of investment –
a. Foreign Direct Investment: It refers to purchase of an asset in the rest
of the world which gives full control to the buyer over the asset.
Purchase of assets abroad by residents of our country is recorded on
the debit side and sale of assets abroad by residents of our country is
recorded on the credit side of BOP.
b. Portfolio Investment: It refers to purchase of an asset in the rest of the
world which does not give full control over the asset (investment in
shares of a company).
Purchase of shares of foreign companies by residents of our country is
recorded on the debit side and sale of shares of Indian companies to
foreigners is recorded on the credit side.
3. Change in foreign exchange reserves – Foreign exchange reserves are the
financial assets of the government held by the central bank. Any
withdrawal from the reserves is recorded on the credit side of BOP
because there is inflow of foreign exchange to BOP account from foreign
exchange reserves and any addition to these reserves is recorded on the
debit side of BOP because there is outflow of foreign exchange from
BOP account to foreign exchange reserves.

Balance Of Trade
BOT refers to the difference between the value of merchandise or visible
exports (goods only) and the value of merchandise or visible imports.
BOT = Value of export (X) of goods – Value of import (M) of goods.
It is also known as Balance of visible trade or trade balance.

Balance On Current Account

In the current account, receipts from export of goods and services, unilateral
transfers and incomes from investment and work are entered as credit items
as they represent inflow of foreign exchange. Payment for import of goods
and services, unilateral transfers and incomes pad for investment and work
are entered as debit items as they represent outflow of foreign exchange. The
difference between the credit and debit sides is the balance on current
account. The balance on current account during the year may be favourable
(surplus), unfavourable (deficit) or balanced.
Surplus on current account implies net inflow of foreign exchange.
Deficit on current account implies net outflow of foreign exchange.

Balance on capital account

Transactions which lead to inflow of foreign exchange like loan from
abroad, sale of assets or shares in foreign company etc. are recorded on the
credit side of the capital account. Similarly transactions which lead to
outflow of foreign exchange like repayment of loans, purchase of assets or
shares in foreign countries etc. are recorded on the debit side. The difference
between the credit and the debit side is the balance on capital account. Like
balance on current account balance on capital account may also be
favourable, unfavourable or balanced.
Surplus on capital account implies net inflow of foreign exchange.
Deficit on capital account implies net outflow of foreign exchange.

Difference between Current account and Capital account

Current Account Capital Account

1. It records those economic 1. It records all those transactions
transactions between residents between the residents of a
of a country and the rest of the country and the rest of the
world, which do not cause world, which cause a change
change in the assets or in the assets or liabilities of the
liabilities of the residents of residents of the country or its
the country or its government. government.
2. Current account transactions 2. Capital account transactions
are of flow nature as they are are of stock nature as they are
measured over a period of measured at a point of time.
time.
3. Components of current 3. Components of capital account
account are visible trade, are borrowing and lending,
invisible trade, unilateral foreign direct investment and
 transfers and incomes from portfolio investment and
investment and work. change in foreign exchange
reserves.
4. Current account deals with 4. Capital account deals with
currently produced goods and payment of debts and claims.
services.

Difference between Balance of trade and Balance of payment

BOT BOP
1. BOT refers to the difference 1. BOP is a systematic record of
between value of merchandise all economic transactions
or visible exports and the between the residents of a
value of merchandise or country and the rest of the
visible imports. It records the world during a given period of
value of only merchandise time.
goods.
2. It does not record transactions 2. It records transactions of
of capital nature. capital nature also.
3. It is a part of current account 3. It includes BOT, balance of
of BOP. services, balance of unrequited
transfers and balance of capital
transactions.

Autonomous vs Accomodating transactions

Autonomous transactions in a BOP refer to those international economic
transactions which occur due to some economic motive such as profit
maximization, earning of interest income etc. for eg: MNC’s making
investments in India. It is done with the objective of earning profit. All such
transactions are voluntary in nature and are undertaken for their own sake.
Autonomous transactions take place on both current and capital account.
These transactions are known as above the line items.
Accomodating transactions in a BOP are those transactions which take place
due to some other activity in the BOP. They are undertaken to cover deficit
or surplus in autonomous transactions. Eg: If there is a current account
deficit in BOP, then this is settled by capital inflow from abroad either by
borrowing from some other country or by running down country’s foreign
exchange reserves by the government.
Accomodating transactions take place only on capital account.
These transactions are known as below the line items.

Disequilibrium in the Balance of Payments

Balance of payment account always balances. In the accounting sense, the
BOP of a country is always in equilibrium. A surplus in the current account
must be settled by a deficit in the capital account. A deficit in the current
account must be settled by a surplus in the capital account.
Then what is meant by disequilibrium in BOP?
Disequilibrium in BOP occurs when the inflow of foreign exchange on
account of autonomous transactions is not equal to outflow of foreign
exchange on account of autonomous transactions.
Deficit in BOP account arises when total inflows on account of autonomous
transactions are less than outflows on account of such transactions.
Surplus in BOP account arises when total inflows on account of autonomous
transactions are more than outflows on account of such transactions.

Rule of recording transactions in BOP:

Any transaction that brings in foreign exchange for a country is a credit
item.
Any transaction that causes a country to loose foreign exchange is a debit
item.