CHAPTER- 3

BALANCE OF PAYMENTS
 WHAT IS BOP?
 Balance of Payment is described by the IMF in its
Balance of Payments Manual as a statistical statement
giving summary of the flow of economic transactions
between the residents of a country and the rest of the
world during a given period.
 It covers:
 Transactions in goods, services and income.
 Changes in economy’s monetary gold, SDRs (Special
Drawing Rights), and claims and liabilities to the rest of
the world.
 Unrequited transfers and counterpart entries that are
needed to balance.
 Transaction
 The word Transaction refers to exports and imports of
goods and services; lending and borrowing of funds;
remittances; government aid and military expenditures.
 Economic Transaction
 Economic transactions include all those activities
whereby two entities exchange something of economic
value, like exports/imports of goods and services,
payment of dividend/interest, investment in assets, etc.
These transactions are broadly classified into current
account and capital account.
 Residents
 The term Residents include all individuals and business
enterprises, including financial institutions, that are
permanently residing within a country’s borders, as well
as government agencies at all levels.
PRINCIPLES FOR VALUATION
OF TRANSACTIONS
 The transactions should be valued at market
prices.
 Imports should be valued on c.i.f (cost, insurance,
freight) basis and exports should be valued on
f.o.b (free on board) basis.
 Any transaction denominated in foreign currency
should be converted into the domestic currency at
the exchange rate prevailing in the market at the
time the transaction took place.
 Double entry book keeping
system
 Any transaction which creates demand for the domestic
currency in the foreign exchange markets enters credit
side; any transaction increasing its supply enters the
debit side.
 Source of foreign currency- credit entry(+)
 Use of foreign currency- debit entry(-)
 COMPONENTS OF BOP
 These are divided into three sections:-
A.) The Current Account
B.) The Capital Account
C.) The Official Reserves Account
 A. The Current Account
 It is divided into three sub-categories:
1. The Merchandise Trade Balance
2. The Services Balance
3. The Unilateral Transfers
 Merchandise trade balance
 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).
 Exports, valued on f.o.b basis, are credit entries.
 Imports, valued at c.i.f are the debit entries.
 The difference between the total of credits and
debits appears in the “net” column. This is the
Balance on Merchandise Trade Account, a deficit
if negative and a surplus if positive.
 Services balance
 It covers services such as transportation and
insurance, income payments and receipts for
factor services- labour and capital.
 Credit entries are: services rendered by residents
to non-residents, income earned by residents from
their ownership of foreign financial
assets(interest, dividends), income earned from
the use, by non-residents, of non-financial assets
such as patents and copyrights owned by
residents,etc.
 Unilateral Transfers
 These are the gifts and grants by both private
parties and governments.
 Private gifts and grants include personal gifts of
all kinds and also relief organization shipments.
 Government transfers include money, goods and
services sent as aid to other countries.
 Unlike other accounts in the BOP, unilateral
transfers have only one-directional flow without
offsetting flows.
 B. The Capital Account
 It is divided into three sub-categories:
1. Direct Investment
2. Portfolio Investment
3. Other Capital Flows
 Direct Investment
 It occurs when the investor acquires equity such
as purchases of stocks, the acquisition of entire
firms, or the establishment of new subsidiaries.
 FDI takes place when firms tend to take
advantage of various market imperfections.
 Firms undertake FDIs when the expected returns
from foreign investment exceed the cost of
capital, allowing for foreign exchange and
political risks.
 Portfolio Investment
 It represents sales and purchases of foreign financial
assets such as stocks and bonds that do not involve a
transfer of management control.
 A desire for return, safety and liquidity in investments is
same for international and domestic portfolio investors.
 Capital flows
 It represents claims with a maturity of less than
one year.
 Such claims include bank deposits, short-term
loans, short-term securities, money market
instruments and so forth.
 These investments are quite sensitive to both
changes in relative interest rates between
countries and the anticipated change in the
exchange rate.
 C. The Official Reserves
Account
 These are govt. owned assets.
 It represents only purchases and sales by the central bank
of the country (e.g., the Reserve Bank of India)
 The changes in official reserves are necessary to account
for the deficit or surplus in the balance of payments.
 In case of BOP deficit, the Central Bank will have to
either run down its official reserve assets such as gold,
foreign exchange and SDRs or borrow fresh from foreign
central banks.
 In case of BOP surplus, it’ll acquire additional reserve
assets from foreigners or retire some of its foreign debts.
 BOP ACCOUNTING
 The BOP always balances. The sum of the debits and
credits on the current account, the capital account and
the official financing is always equal.
 This arises because balance of payments tabulations are
built on double-entry book keeping principles.
STRUCTURE OF BOP
STATEMENT
 If BOP Account always balances, then
what do we mean by BOP Deficits or
Surpluses?

 Depending on a sub-group selected,

Net Balance on these can be Negative
(Deficit) or Positive (Surplus)
 A. CURRENT ACCOUNT Credit Debit Net

 I.Merchandise
 II.Invisibles (a+b+c)
a)Services
(Travel,Transportation,
Insurance,Govt. not elsewhere
classified,Miscellaneous)
b)Transfers
(Official&Private)
c)Income
(Invtt.income,Compensation
to employees)
TOTAL CURRENT ACCOUNT(I. + II.)
 B. CAPITAL ACCOUNT Credit Debit Net
 I.Foreign Investment (a+b)
a. In India (Direct, Portfolio)
b. Abroad
 II.Loans (a+b+c)
a. External Assistance (By & To India)
b. Commercial Borrowing(MT,LT)
(By & To India)
c. Short term loan (By & To India)
 III.Banking Capital (a+b)
a. Commercial Banks(Assets, Liabilities,
NR Deposits)
b. Others
 CONTD…
 IV. Rupee Debt Service
 V. Other Capital
TOTAL CAPITAL ACCOUNT
(I.+II.+III.+IV.+V.)
C. ERRORS AND OMMISSIONS
D. OVERALL BALANCE (A+B+C)
E. MONETARY MOVEMENTS (I+II)
I. IMF
II. Foreign Exchange Reserves
(Increase-/ Decrease+)
 BALANCE OF PAYMENT
ADJUSTMENT- A Conscious
Policy Decision Influencing
Financial Environment
 BOP Adjustment Policy
Decision
 It is a macro economic decision, therefore it is going
to affect the business opportunities in the economy.
 Once these policies are expected to be implemented,
the finance manager of an MNC has to take note of it
and adjust these changes in the strategic decisions of
the firm.
 These categories are:
i. Expenditure reducing policies
ii. Expenditure switching policies
 I. Expenditure Reducing
Policies
 The BOP Deficit is given by:
B=O-E
where, O=domestic output of the economy
E=domestic expenditure of the economy
 If the total domestic expenditure of the economy is more than the
domestic output, then the BOP Deficit occurs.
 These policies are classified into two categories:
1. Monetary policies
2. Fiscal policies
 1. Monetary policies
(a) Increase in the interest rates
(b) Change in credit policies by increasing cash reserve
ratio or liquidity ratio
(c) Issue of Treasury bills, bonds and securities by the
government as a part of open market operation
(d) Increasing the margin requirements.
 Effects of Monetary Policy
changes
 Money with the public reduces.
 Market slows down.
 Reduces the investment activity in the economy.
 Fall in the national income through multiplier effect.
 Reducing the total quantity of imports.
 Reducing the deficit.
 2. Fiscal policies
 On the income side of the budget:
(a) Indirect Taxes like excise duties, sales tax, etc. are
increased to curtail consumption.
(b) Increase in Direct Taxes reduce consumption and
also the savings.
 On the expenditure side:

(a) Govt. can directly reduce the budget.

(b) If the Govt. reduces the non-productive expenditure,
it would directly help in reducing the BOP Deficit.
 II. Expenditure Switching
Policies
 The monetary authorities resort to devaluation or let the
currency depreciate resulting in the change of relative prices.
 Devaluation is a conscious effort to change the price.
 In case of depreciation, the relative price of domestic currency
is allowed to decline as per the market forces.
 In both the cases the price of domestic currency declines against
the foreign currencies.
 Change in the relative prices of goods and services make others
to spend more on the goods and services of the home economy.
 The demand for the domestic products and services increases,
leading to the increased flow of foreign currency towards
domestic economy.
 PURPOSE OF BOP
 For Policymakers:
(i) Performance of an economy internationally.
(ii) Signals fundamental changes in the competitiveness of
countries.
 For Government:
(i) Provides valuable information for the conduct of economic
policy.
(ii) Affects the value of the currency.
(iii) Policy towards foreign investments.
(iv) Influences important macro economic variables like GNP,
interest rates, price levels, employment scenario and exchange
rate.
 Contd…
(v.) Monetary and Fiscal Policy of the country also takes
into account the BOP position of a country.
 For Business People:
(i) Identify emerging markets for goods and services.
(ii) Warns of possible new policies.
(iii) Indications about future exchange rates.
 Contd…
 For International Managers:
i. Interested in a foreign country’s BOPs for
predicting the country’s overall ability
regarding exports, imports, the payment of foreign
debts and dividend remittances.
ii. Provides clues about expectations relating to the
volume of different types of trade and capital
flows.