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Balance of Payments
Introduction

• International Monetary Fund (IMF) defines the Balance of Payments (BoP) as a

statistical statement that summarizes economic transactions between residents and
non-residents during a specific time period.
• The BoP, thus, includes all transactions showing:
(a) Transactions in goods, services and income between an economy and the rest of
the world,
(b) Change of ownership and other changes in that economy’s monetary gold, special
drawing rights (SDRs), and financial claims on and liabilities to the rest of the world
(c) Unrequited transfers- transfer of money in which nothing is expected in return.
Example- Foreign aid, debt forgiveness etc.
• BoP account composition is different from that of the Budget. The key difference is
that budget includes the flow of domestic currency, i.e. Rupee, whereas BoP talks
about the flow of foreign currency.
• Three key components of BoP Account:
(i) Current Account
(ii) Capital Account
• (iii) International Forex Reserves Account
• The balance of payments is, basically, the record of all international financial
transactions made by a country's residents.
• The balance of payments tells us whether the country has a surplus or deficit. It also
reveals whether the country produces enough economic output to pay for its growth.

Current Account

• The current account measures the short-term (less than one year) international
transactions of real resources (goods, services, income and transfers) between an
economy and the rest of the world.
• The current account is further subdivided into a merchandise account and invisible
account.
• The merchandise account consists of transactions relating to exports and imports of
goods only. It is also called as Visible Trade or Balance of Trade account.

Hence, Net Exports (goods) = Export (goods) – Import (goods)

Export (goods) > Import (goods): Trade Surplus

Export (goods) < Import (goods): Trade Deficit (India’s case)

• In the Invisible account, there are three broad categories namely-

(a) Non-factor services such as travel, transportation, insurance and miscellaneous
services;

Similarly, Net Services Exports = Export (services) – Import (services)

(b) Net transfers can be classified into:

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• Private Transfers (gifts, remittances, grants)

• Official Transfers (money received by GoI in the form of gifts or grants, etc.)

There is no repayment liability on this.

(c) Net factor income from abroad, i.e. income which includes compensation for
employees (wages) and net investment income (e.g. getting rent on the land placed
abroad or getting the interest for the capital invested abroad).

If Net Services Export + Net factor income from abroad + Net transfers > 0, then we
have Net Invisibles Surplus, otherwise (less than 0) it is a deficit. India has a surplus
condition in this segment.

Current Account Deficit (CAD)

• Current Account Deficit (CAD) implies that Net Exports + Net Invisibles < 0

Note: India’s Trade deficit is much more than the Invisibles surplus; thus, it leads to
an overall CAD (1.5% of India’s GDP).

Capital Account

• Capital account records long-term international transactions like borrowings, foreign

investment, etc.
• The capital account can be broadly broken up into the following categories:
(i) Net Foreign Investments

(ii) Net External Assistance (Borrowings of the Government from external agencies
like WB, IMF, NDB or from any other country)

(iii) Net External Commercial Borrowings, i.e. borrowings of companies from abroad.

(iv) Net Banking Capital (NRI deposits)

If, (i) + (ii) + (iii) + (iv) > 0: Capital Account Surplus

(i) + (ii) + (iii) + (iv) < 0: Capital Account Deficit

India has Capital Account Surplus since the 2000s

The sum of the current account and capital account indicates the overall balance, which could
either be in surplus or in deficit. The movement in overall balance is reflected in changes in
the international reserves of the country.

If, Current A/c + Capital A/c > 0: BoP A/c Surplus (International Forex Reserves Account
will increase)

Current A/c + Capital A/c < 0: BoP A/c Deficit (International Forex Reserves Account
will decrease)
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* International Forex Reserves Account contains currencies of those countries with which
India is trading, e.g. USD, Yen, Euro, Gold Reserves, SDR, etc.

When BoP is a deficit, it implies

• A balance of payments deficit might mean that the country imports more goods,
services and capital than it exports (e.g. India).
• The country may have to borrow from other countries to pay for its imports.
• In the short-term, it fuels economic growth. But, in the long-term, the country
becomes a net consumer, not a producer, of the world's economic output.

The country goes into debt to pay for consumption instead of investing in future growth. If
the deficit continues for long, the country gets into the debt trap and might end up selling its
assets to pay off its debt.

When BoP is surplus, it implies

• A balance of payments surplus might mean that the country exports more than it
imports.
• The country basically saves more than it spends. This boosts capital formation with its
additional income. They might even lend outside the country.
• A surplus boosts economic growth in the short term.

In the long run, the country becomes too dependent on export-driven growth. It must
encourage its residents to spend more. A larger domestic market will protect the country from
exchange rate fluctuations.

Exchange Rate

It is the rate at which one can exchange one (foreign) currency for the other (domestic). It
may also be understood as the price of foreign currency in terms of domestic currency.

(a) Fixed Exchange Rate System: From 1947-1991, India maintained a closed economy
system with not much trade. Hence, for such a system to sustain, India followed a Fixed
Exchange Rate System.

Under this system, RBI arbitrarily fixed the exchange rates in consultation with the
government. But this system was not very rational, and the value of rupees was deliberately
kept higher to discourage imports. Hence, this was famously known as Import Substitution
Policy of India.

With the coming of Economic Reforms 1991, one of the conditions imposed by IMF was the
transition of India from a fixed exchange rate system to the Market Exchange Rate system.

(b) Market Exchange Rate System: Market entities’ behaviour, which deal in foreign
currencies (importers & exporters), is responsible for the setting up of the exchange rate.
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Supply of dollar by exporters

Exchange rate (‘x’ Rupee/Dollar)

Demand of dollar by importers

Foreign exchange (quantity of dollars)

(c) Purchasing Power Parity based Exchange Rate: Purchasing Power Parity is that price level
in a country (for e.g. India) with which an Indian can buy the same consumption basket
which can be bought with $1.

This system goes beyond the concept of comparing two countries merely on the basis of their
volumes of imports and exports.

To imply this method, a basket of common goods, which are consumed in both countries, is
prepared, and the value of the basket is calculated in terms of domestic as well as foreign
currencies. Let us say that this value comes out to be Rs. 6500 in Indian currency and $100 in
terms of USD.

Hence, it implies that: $100 = Rs. 6500

So, PPP-based Exchange Rate comes out to be Rs. 65/USD