Chapter 7: Balance of Payment (BOP) Statement and its

Components
MEANING OF BALANCE OF PAYMENT ACCOUNT

 It is a statement that summarises the country’s economic

transactions with other countries of the world during a specific
time period
 RBI states that –
 BOPA is a statistical statement that systematically
summarises, for a specific time period, the economic
transactions of an economy with the rest of the world
 IMF describes it as –
 The Balance of Payments is a statistical statement for a
given period showing –
• Transactions in goods and services and income
between an economy and the rest of the world
• Changes of ownership and other changes in that
country’s monetary gold, Special Drawing Rights
(SDRs) and claims on liabilities to the rest of the
world
• Unrequited transfers and counterparty entries that
are needed to balance, in the accounting sense, any
entries for the foregoing transactions and changes
which are not mutually offsetting

 "Balance of Payments is a macro level statement showing

inflow and outflow of foreign exchange.” – V . Sharan
 It is a statement that records the flow of foreign exchange
arising as a result of international economic transactions
 International economic transactions in and out of a country
include –
 Export and import of goods and services
 Unilateral transfers, FDI, foreign portfolio investments,
etc.
 Balance of Payments can be defined as, "the statistical record
of a country's international transactions over a certain period
of time presented in the form of double-entry book keeping.” –
Cheol S. Eun and Bruce G. Resnik
 This definition shows that Balance of Payments statement has
a time dimension that is, it is prepared over a certain time
period which can be a quarter, a year, etc.
  Record of all Receipts and Payments – Since BOP is a
statement showing inflow and outflow of foreign currency in a
country –
 All receipts from foreigners will be recorded as credit,
bearing a positive sign – Receipts accrue to a country in
case of –
• Exports (sale of goods and services abroad results
in inflow of foreign exchange into the country)
• Sale of financial and real assets
 All payments to foreigners will be recorded as debit,
bearing a negative sign, indicating an outflow of foreign
exchange – Payment of foreign exchange arises due to –
• Import of goods and services
• Purchase of financial and real assets
 Inflow of foreign exchange +ve entry (CREDIT)
 Outflow of foreign exchange -ve entry (DEBIT)

CHARACTERISTICS OF BOP

 Summary –
 It is a summary prepared according to the double entry
system of accounting
 Two sides – debit and credit
 Economic transactions –
 Transactions involving receipts on account of exports of
goods and services
 Capital received by residents
 Payments made for imports of goods and services
 Capital transferred to non-residents foreigners
 Income on investment remitted abroad or received from
abroad
 Increase or decrease in the international reserves of the
country
 Transactions between a country with rest of the world –
 Transactions between the residents of the same country
are not included
 Increase in a country’s monetary gold and foreign assets
exchanged between residents may be included in the
balance of payment account
  A flow statement –
 It is a compilation of the flow of economic transactions
 It is not a statement of the position on a particular date
 More like a funds flow statement
 Definite time period –
 Covers a specific time period, usually one year
 May be prepared for shorter time period, say six months,
depending upon a country’s requirement
 Double entry system –
 Each transaction results in a debit entry and credit entry
of equal account
 BOP account must always balance – debits equal to
credits
 Balancing item errors and omissions is added to balance
the BOP account

DIFFERENCE BETWEEN BALANCE OF TRADE AND BOP

 BOT is a narrow concept in comparison to BOP –

 BOT covers only the transactions arising out of the
exports and imports of visible items (goods); and does
not include the exports and imports of invisible items
(services) like, banking, insurance, etc.
 The BOP takes into account the exports and imports of
both visible and invisible items (goods and services)
 BOP presents a comprehensive account of economic and
financial transactions of a country with the rest of the
world

COMPONENTS OF BALANCE OF PAYMENT

 The BOP statement covers and records all types of

international economic transactions that a country engages in
over a certain time period
 Based on the type of transactions, the BOP sub accounts are
as follows –
 Current account
 Capital account
 Unilateral payments account
 Statistical errors and discrepancies
  Official reserves/ assets account

Balance of Payments Account

I. Current Account

 Records all international economic transactions involving

export and import of goods and services and unilateral (or
unrequited) transfers occurring within the current period
 Consists of the following major groups of items –
 Visible or merchandise exports and imports
 Invisible or service exports and imports
 Factor Income
 Unilateral Transfers

 Visible or merchandise exports and imports –

 Most basic and traditional form of international economic
transaction
 The export and import of goods is included in this
subcategory
 The export of goods cause an inflow of foreign exchange
into the country while the import of goods cause an
outflow of foreign exchange
 Export of goods is recorded as a credit or +ve item in the
BOP statement and are calculated f.o.b. (free on board)
which means that costs of transportation, insurance, etc.
are excluded
  Import of goods is recorded as a debit or a –ve item in the
BOP statement and are calculated c.i.f. (costs, insurance
and freight)
 The difference between the export and import of goods is
known as Balance of trade (BOT)
 If export of goods is more than the import of goods, the
BOT is in surplus; if import of goods exceed the export of
goods, the BOT is in deficit –
• Thus, Exports – Imports = BOT
• Exports> Imports = BOT surplus/+ve BOT
• Exports< Imports = BOT deficit/-ve BOT

 Invisible or service exports and imports –

 Includes export and import of services, i.e., the intangible
commodities; known as invisible trade as they do not
have a physical substance
 Service transactions include costs of travel and
transportation, insurance, income and payments of
foreign investments, financial charges for banking and
insurance, royalties for intellectual property rights,
constructions services, etc.
 The rendering or export of these services, entitles a
country to receipt of foreign exchange and is therefore
recorded as a credit or +ve item
 The utilization or import of these services, creates a
foreign exchange payment liability and is hence, recorded
as a debit or a –ve item
 This sub-category of the current account has recorded
the fastest growth for many industrial countries in the last
two decades

 Factor Income –
 This sub-category of the current account includes income
by way of –
• Interest and dividend on investments made abroad
in previous periods
• Eg. If an Indian company sets up a subsidiary in
Singapore, the proportion of net income of the
subsidiary (as dividend) is paid to the parent
company(in India), in the current period, it shall be
treated as current investment income for India
• Also, wages and salaries to non-resident workers
shall be included in this sub-category
  Unilateral Transfers –
 As the name suggests, this sub-category of current
account includes one-direction flows
 Unlike exports and imports, unilateral transfers are
unrequited or unreciprocated flow of funds – there is no
offsetting flow against unilateral transfers
 Flow of funds by way of gifts, remittances, pension,
foreign aid, official and private remittances or grants,
charitable donations, and other similar transfers received
from foreign individuals and governments to foreigners,
against which no services are rendered or goods
provided are included in this sub-category
 Receipt of such transfers causes in inflow of foreign
exchange and is recorded as a credit or +ve item and vice
versa

Balancing Current Account

 The debit and the credit side of the various sub-categories of

current account need to be balanced –
 If the credit side is bigger than the debit side, the
difference is known as current account surplus
 When the debit side is bigger than the credit side, the
difference is known as current account deficit
 A deficit in the current account is to be met by either of
the following –
• Borrowings from foreigners, or
• Selling off past foreign investments

II. The Capital Account/ Financial Account

 The capital account records all international economic

transactions relating to investment in or withdrawal from
financial assets and real estate
 It reflects the flow of funds relating to international loans,
investments and banking funds
 Investment in or purchase of financial and real estate abroad is
recorded as a debit item in the capital account since it involves
an outflow of capital
 Likewise, sale of financial assets and real estate to foreigners
is recorded as a credit item in the capital account since it
results in receipt of foreign exchange
  Capital account is divided in three parts –
 Private capital –
• Includes short term and long term capital
transactions
• Short term capital is with a maturity period of one
year whereas long term capital has a maturity period
of more than one year
• Long term capital consists of foreign investments
(both direct and indirect), long term loans, foreign
currency deposits, etc.
 Banking capital –
• Includes movements in the external financial assets
and liabilities of commercial banks and cooperative
banks which are authorised to deal in foreign
exchange
 Official capital –
• Refers to Reserve Bank of India’s holdings in
foreign currency and Special Drawing Rights with
the Government

Items of Capital Account

 Foreign Direct Investment (FDI) –

 When a foreign investor acquires 10% or more of the
voting rights of a domestic business, with an intent to
control it, such an investment is called foreign direct
investment or FDI
 Eg. When the Japanese automobile manufacturer, Honda,
built an assembly plant in Ohio, it made a foreign direct
investment in Ohio; Acquisition of Carnation, a U.S. firm
by the Swiss multinational, Nestle Corporation, amounted
to FDI
 Giant multinationals locating their production facilities in
India, China and other Asian countries to benefit from
cheap labour also amounts to FDI
 When a country receives FDI, capital flows into the
country and it is hence recorded as a credit or a +ve item
in the capital account of the BOP statement
 When a country makes FDI abroad, capital flight takes
place, it is recorded as a debit or a –ve item in the BOP
  Portfolio Investment –
 This sub-category of the capital account includes the –
• Sale and purchase of foreign financial assets such
as bonds, stocks, money market instruments,
financial derivatives and the like which does not
cause a transfer of control
 Purchase of Indian financial assets by foreigners causes
an inflow of foreign exchange and hence, it should be
recorded as a credit or +ve item in the BOP statement
 Likewise, Purchase of foreign financial assets by Indians
causes a capital flight and hence, should be recorded as
a debit or –ve item in the capital account
 In the same way, withdrawal of investment in foreign
financial assets by Indians causes an inflow of capital and
withdrawal of investment in Indian financial assets by
foreigners causes an outflow of capital

 Other Investments –
 This sub-category of capital account includes –
• Transactions in trade credit, currency, bank
deposits, etc.

Capital Account Flows

 Based on the above, capital account flows can be of two types –

 Accommodating capital flows –
• Accommodating capital flows or above the line capital
flows is the inflow of capital meant to cover the overall
BOP deficit
• The objective of such flows is to bring the BOP
statement into equilibrium
• It usually includes drawings from the IMF
 Autonomous capital flows –
• Autonomous capital flows or below the line capital
flows is the inflow of capital which occurs regardless
of any deficit in the BOP
• Eg. Foreigners repaying loan, FDI inflows in a country,
etc.
III. Errors and Omissions

 This is an item in the BOP statement which is also known as

statistical discrepancy and is considered while arriving at the
overall balance
 The statistical discrepancy in the BOP arises due to the
following reasons –
 Difficulty in data collection –
• Data for the BOP statement is collected from different
sources and these sources differ in their approach of
data compilation
• Statistics from different sources vary resulting in
statistical discrepancy in the BOP statement
 Lead or lag transactions –
• Movement of foreign exchange may lead or lag the
transactions that they are financing
• Eg. If goods are shipped in March'2013 and payment
for them is received in April'2013. The sent shipment
will be recorded in the financial year ending 31st
March'2013. However, payment for it shall be recorded
in the following financial year ending 31st March'2014.
This difference leads to statistical discrepancy in the
BOP statement
 Estimates –
• The BOP statement uses estimates to arrive at certain
figures relating to travel, tourism, etc. for which exact
amounts are difficult to ascertain. Estimates are based
on samples
• If the sample chosen is defective, statistical
discrepancy is bound to arise
 Unrecorded illegal transactions

 Once statistical discrepancy is identified, the overall balance

can be arrived at
 The balancing between all credits and debits in the current
account, capital account and the statistical discrepancies
represent the overall balance
 If the overall balance is in surplus the surplus amount is used
to repay borrowings from the IMF and the balance (if any) is
carried to the official reserves account
 If the overall balance is in deficit, the monetary authorities of
the country arrange for capital flows via drawings from the IMF
 or official borrowings or by bringing down the foreign
exchange reserves, to make good the deficit in a country, etc.

IV. Official Reserves Account

 The official reserves account records monetary gold, SDR

allocations to a country by the IMF and foreign currency assets
held by the monetary authorities of a country
 If the overall BOP is in surplus, the surplus gets added to the
official reserves account
 If the overall BOP is in deficit, the official reserves account gets
reduced by the deficit amount, if accommodating capital flows
are unavailable

DISEQUILIBRIUM IN BALANCE OF PAYMENT

 BOP is in equilibrium when – Debit side is equal to Credit side

or Demand for and supply of foreign currency are equal
 Disequilibrium in BOP means either a surplus or deficit in it
 Demand for foreign currency > supply = Deficit in BOP
 A country facing continuous deficit takes steps to reduce
or eliminate the deficit
 Demand for foreign currency < supply = Surplus in BOP
 Not a matter of worry for the country

CAUSES OF DISEQUILIBRIUM IN BOP

 Economic Factors –
 Development disequilibrium –
• Developing countries undertake heavy expenditure on
the development of industries, power plants,
infrastructure
• Requires huge imports of machinery, equipment and
capital goods
• Increases income and demand and imports of consumer
goods
• Large scale imports of capital goods and consumer
goods result in deficit
 Cyclical disequilibrium –
 • Fluctuations in imports and exports caused by business
cycles results in disequilibrium
• Boom in business activity in a country increases
aggregate demand, consumption and prices – import of
consumer goods increases; and vice-versa
 Secular disequilibrium –
• Disequilibrium persists for a long period due to this
• Developed country US – high disposable income,
aggregate demand – high wages and hence, cost of
production is high – huge import of goods at lower
costs – deficit BOP in US
 Structural disequilibrium –
• Structural changes in the economy like shift from
agriculture to service sector, development of
alternative sources of supply, development of better
substitutes, exhaustion of productive resources,
changes in transport routes and costs
• Structural changes increase imports of both capital
goods and consumer goods causing deficit

 Political Factors –
 Political instability, civil war, riots, terrorism, war, etc.
 Political disturbances create a threat for industry and
investment
 These factors may lead to large capital outflows and
decline in domestic production and exports
 Sociological Factors –
 Changes in tastes, preferences, fashion
 Affect imports and exports
 Create disequilibrium in the balance of payments

MEASURES TO CORRECT DISEQUILIBRIUM IN BOP

A country facing continuous deficit takes steps to reduce or

eliminate the deficit. The measures to correct disequilibrium are
as follows –

 Automatic correction –
• Assumption – If the market forces of demand and
supply are allowed to play freely, in course of time,
equilibrium in BOP will be automatically achieve
• For Example, India facing deficit –
  Demand for foreign currency exceeds its supply
 This will increase the exchange rate and a fall in
the external value of rupee
 India's exports become cheaper and its imports
become costly
 Increase in exports and decrease in imports
 Restores equilibrium in the BOP

 Deliberate measures – When disequilibrium is not

automatically corrected, deliberate steps are taken –

i. Monetary measures –

 Reduction or expansion of money supply –

 Deficit can be corrected by reducing money supply
in the economy by central bank, RBI, through
playing with bank rate, open market operation, SLR,
CRR
 This leads to fall in domestic demand and prices –
increases exports and decreases imports – reduces
deficit
 Money supply can be expanded to reduce surplus in
BOP
 Devaluation –
 Country with considerable deficit may devalue the
currency to encourage exports and discourage
imports
 Devaluation leads to reduction in the official
exchange rate of a currency

ii. Exchange control –

 Government/ central bank exercises complete

control over the forex reserves and earning of the
country
 Exporters are required to surrender forex for the RBI
in exchange in domestic currency; Importers need
prior permission of RBI to use foreign exchange

iii. Trade measures –

 Export promotion –

 Reducing or abolishing export duties

  Providing export subsidy
 Encouraging export promotion and marketing
through monetary, fiscal, institutional and physical
incentives and facilities
 Example, liberal loans to EOUs; setting up EPZs

 Import Control –

 Imposing or increasing import duties

 Fixing import quotas
 Import licensing
 Prohibiting altogether the imports of certain non-
essential items

iv. Miscellaneous measures –

 Raising foreign currency loans

 Encouraging foreign investment in the home
country
 Developing tourism to attract foreign tourists
 Giving incentives to encourage foreign remittances