Balance of Payments
Balance of Payments is the accounting statement of a country’s sources (inflows) and uses (outflows) of foreign exchange with respect to rest of the world.
- Sources/ supply of foreign exchange (causing inflow of foreign exchange) are:- exports, transfers from abroad, incomes from investment abroad, foreign investments, borrowings from abroad etc.
- Uses of / demand for foreign exchange (causing outflow of foreign exchange) are:- imports, transfers to abroad, incomes paid on foreign investments, investments abroad, lending abroad etc.
Structure of Balance of Payments Account
- The BOP account has two sides: the credit side and the debit side.
- The credit side records the inflows (sources) of foreign exchange while the debit side records the outflows (uses) of foreign exchange.
- There are two main accounts in the BOP — the current account and the capital account.
Structure or Components of BOP
Credit (inflow of foreign exchange) |
Debit (outflow of foreign exchange) |
Net Credit
(Credit – Debit) |
Current Account (records all inflows and outflows of foreign exchange arising from foreign trade, transfers and factor incomes with no effect on foreign exchange assets and liabilities of the economy with respect to rest of the world.) | ||
1. Merchandise/ Visible Trade | ||
Exports of goods |
Imports of goods | Exports-Imports of goods
(Balance of trade) |
2. Invisibles | ||
(i) Exports of services | Imports of services | Exports-Imports of services |
(ii) Factor income from abroad | Factor payments made abroad | Net factor incomes from abroad |
(iii)Transfer receipts from abroad (Official/ govt. and private transfers like gifts, grants etc.) | Transfer payments to abroad | Net transfer receipts |
Current receipts (1+2) | Current payments | Net current receipts
(Balance on current account) |
Capital Account (all inflows and outflows of foreign exchange arising from changes in foreign exchange assets and liabilities of the economy with respect to rest of the world.) | ||
Credit
|
Debit
|
|
3. Investments from abroad | Investments made (to) abroad | Net investments from abroad |
4. Borrowings from Abroad
|
Loans given abroad
(decrease in foreign liabilities) |
Net borrowings from abroad |
5. Decrease in foreign exchange reserves | Increase in foreign exchange reserves | Net decrease in foreign exchange reserves |
Capital receipts (3+4+5) | Capital payments | Net capital receipts
(Balance on capital account) |
Current Account
Current Account records all inflows and outflows of foreign exchange arising from foreign trade, transfers and factor incomes with no effect on foreign exchange assets and liabilities of the economy with respect to rest of the world.
Components of Current Account
- Merchandise/Trade in goods: It includes exports and imports of goods.
- Invisibles/ Trade in services: It includes factor income and non-factor income transactions. It includes:-
(i) Exports and imports of services,
(ii) Transfer from and to abroad and
(iii) Income from and to abroad.
-
- Services include tourism, transportation, insurance, etc
- Transfers/ unilateral or unrequited transfers comprises of all receipts and payments between residents and non-residents for which the provider does not receive a quid pro quo (any goods or services) in return. It includes both official (i.e. government) and private transfers like gifts, grants, donations, cash remittances by families.
- Income comprises of investment income in the form of interest, rent, profits/ dividends and compensation of employees.
Balance of Trade (BOT) :-
Balance of Trade is defined as the difference between the value of exports and value of imports of goods of a country in a given period of time.
Balance of Trade = Exports of goods – Imports of goods
Export of goods is entered as a credit item in BOT, whereas import of goods is entered as a debit item in BOT. It is also known as Trade Balance.
- BOT is said to be in Balance when exports of goods are equal to the imports of goods. BOT can be positive or negative.
- Positive BOT also called Surplus BOT or Trade surplus will arise if country’s exports of goods is more than imports of goods.
- Negative BOT also called Deficit BOT or Trade deficit will arise if a country’s exports of goods is less than imports of goods.
Balance on Current Account
It is defined as the difference between the sum of credits on current account and the sum of debits on current account.
Balance on current account = Sum of credits on current account – Sum of debits on current account
- Current Account is in balance when receipts on current account are equal to the payments on the current account.
- Current Account Surplus (CAS) is a situation that arises when the receipts on current account is more than the payments on current account. It indicates net inflow of foreign exchange. In simple words, Current Account Surplus arises when the value of exports of goods and services is more than the value of imports of goods and services.
CAS signifies that the nation is a lender to other countries (or ROW)
- Current Account Deficit (CAD) is a situation that arises when the receipts on current account are less than the payments on current account. It indicates net outflow of foreign exchange. In simple words, Current Account Deficit arises when the value of exports of goods and services is less than the value of imports of goods and services.
CAD signifies that the nation is a borrower from other countries (or from ROW). This is unfavourable for the economy since it reflects that the country does not have enough foreign exchange to finance its international payments.
Current Account Surplus | Balanced Current Account | Current Account Deficit |
Receipts > Payments | Receipts = Payments | Receipts < Payments |
Balance on Current Account has two components :-
- Balance of Trade or Trade Balance
- Balance on Invisibles
- Balance of Trade (BOT) is the difference between the value of exports and value of imports of goods of a country in a given period of time.
- Balance on Invisibles/ Net Invisibles is the difference between the value of exports and value of imports of invisibles of a country in a given period of time. Invisibles include services, transfers and flows of income that take place between different countries. Services trade includes both factor and non-factor income. Factor income includes net international earnings on factors of production (like labour, land and capital). Non-factor income is net sale of service products like shipping, banking, tourism, software services, etc.
Capital Account
Capital account records all inflows and outflows of foreign exchange arising from changes in foreign exchange assets and liabilities of the economy with respect to rest of the world.
Components of Capital Account:-
1. Borrowings and lending to and from abroad
All transactions relating to borrowings from abroad by private individuals, institutions, government etc. and loan repayments by foreigners are recorded as credit items
All transactions of lending to abroad by private individuals and institutions, government etc. and repayments of foreign loan are recorded as debit items
2. Investments to and from abroad
Investments by ROW in shares of Indian companies, in Indian branches of foreign companies, in real estate, etc. are recorded as credit items.
Investments by Indian residents in shares of foreign companies, in foreign branches of Indian companies, in real estate abroad, etc are recorded as debit items.
’Investments to and from abroad’ includes two types of investments
- Foreign Direct Investment (FDI):- It refers to purchase of an asset, such that it gives direct control to the purchaser over the asset. For example, purchase of land and building.
- Portfolio Investment: It refers to purchase of an asset, such that it does not give any direct control over the asset to the purchaser. For example, purchase of shares. It also includes Foreign Institutional Investment (FII).
3. Change in Foreign Exchange Reserves :- The foreign exchange reserves are the financial assets of the government held in the central bank. A withdrawal from the reserves leads to decrease in financial assets and is recorded on the credit side. Any addition to these reserves is increase in foreign financial assets, and is recorded on the debit side.
Components of Capital Account
Investments :-
- Direct Investment :=Examples: FDI, Equity Capital, Reinvested earnings and other Direct Capital Flows
- Portfolio investment :- Example: FII, Offshore funds
External Borrowings :-
- Example: External commercial Borrowings, short term debts,
External Assistance :-
Example: Government Aids, Inter government, multilateral and Bilateral Loans, Change in foreign exchange reserves
Balance on Capital Account
It is defined as the difference between the sum of credits on capital account and the sum of debits on capital account
Balance on capital account = Sum of credits on capital account – Sum of debits on capital account
Positive balance of capital account/ Surplus
- Positive balance of capital account/ Surplus in capital account means value of credit or inflows (decrease in Foreign Assets and increase in Foreign Liabilities) is greater than value of outflows or payments (decrease in Foreign Liabilities and increase in Foreign Assets).
- This is unfavourable for the economy or leads to a fall in Net Asset (Foreign Assets – Foreign Liabilities) position of the economy with respect to rest of the world.
Negative balance of capital account/ Deficit
- Negative balance of capital account/ Deficit in capital account means value of credit or inflows (decrease in Foreign Assets and increase in Foreign Liabilities) is less than value of outflows or payments (decrease in Foreign Liabilities and increase in Foreign Assets). This is favourable for the economy or leads to a rise in Net Asset (Foreign Assets – Foreign Liabilities) position of the economy with respect to rest of the world.
Errors and Omissions
- In addition to current account and capital account, there is one more element in BOP, known as ‘Errors and Omissions’. It is the balancing item, which reflects the inability to record all international transactions accurately.
Autonomous vs Accommodating Transaction
Autonomous transactions | Accommodating transactions |
Autonomous transactions are those transactions of BOP which takes place due to some economic motive such as profit maximisation and are voluntary and independent of all other transactions | Accommodating transactions are short-term capital transactions of BOP which are meant to correct disequilibrium in the autonomous items of BOP.
|
They are independent of the state of BOP account. | They are undertaken to maintain the balance in BOP account |
These items are also called ‘Above the Line’ items. | These items are also called ‘Below the Line’ items. |
The balance of payments is said to be in surplus (or deficit) if autonomous receipts are greater (or less) than autonomous payments | Overall deficit (or surplus) in BOP results in accommodating capital transactions which removes the deficit (or surplus). |
Autonomous transactions take place in both current and capital account. | Accommodating transactions take place only in capital account. |
Example: Exports, Foreign investments.
|
Example: External assistance from abroad, Borrowings from (or Lending to) abroad, Changes in foreign Exchange Reserves like withdrawal from foreign exchange reserves to cover to the deficit in BOP. |
Note: BOP is always balanced only in an accounting sense since any surplus (or deficit) in the current account is balanced by an equal amount of deficit (or surplus) in the capital account.
But a BOP deficit (or surplus) occurs when autonomous payments exceed autonomous receipts (or autonomous receipts exceed autonomous payments).
Official Reserve Transactions
Official Reserve Transactions refer to transactions by the central bank that cause changes in its official reserve of foreign exchange. Such transactions take place when a country withdraws from its stock of foreign exchange reserves to finance deficit in its overall balance of payments (BOP). A country with surplus in its overall BOP leads to rise in foreign exchange reserves.
Significance: Official Reserve Transactions are very important as they help to bring a balance in the country’s overall balance of payments. So, such transactions act as accommodating item in BOP.
Imbalance in Balance of Payment :-
An imbalance is a condition in which the balance of payments is either saving or deficit. An imbalance in the balance of payments is found when all receipts are more than payments, then the payment is saving and when all receipts are from payments. The balance of payments is deficit.
Following are the reasons for balance of payment imbalance:-
Development Programs :- In developing countries large scale imports are done by the government for development programs. This creates an imbalance in the balance of payments.
Increase in population :- The population of underdeveloped countries is increasing faster than developed countries. Due to which the demand for goods and services is increasing rapidly. As a result, exports are decreasing and imports are increasing, causing imbalance in the balance of payments production.
Inflation: – Due to the high rates of inflation in the domestic market, large quantities of essential goods have to be imported, which creates an imbalance in the balance of payments of the economy.
Business Cycle:- The running of the business cycle in the form of recession or bullishness. During boom times, large quantities are exported into the country, which creates an imbalance in the balance of payments.
Natural causes: – Natural calamities like: drought, flood, earthquake etc. have a bad effect on the production of the country. Due to which the situation of balance of payments arises as a result of the country.
Note:
|