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BALANCE OF PAYMENTS
CONCEPT QUESTIONS
BALANCE OF PAYMENTS
The balance of payments of a country is a systematic record of all
economic transactions between the residents of a country and the rest of
the world. It presents a classified record of all receipts on account of
goods exported, services rendered and capital received by residents and
payments made by theme on account of goods imported and services
received from the capital transferred to non-residents or foreigners.
- Reserve Bank of India
The above definition can be summed up as following: - Balance of
Payments is the summary of all the transactions between the residents of
one country and rest of the world for a given period of time, usually one
year.
The definition given by RBI needs to be clarified further for the following
points:
A. Economic Transactions
An economic transaction is an exchange of value, typically an act in which
there is transfer of title to an economic good the rendering of an economic
service, or the transfer of title to assets from one economic agent
(individual, business, government, etc) to another. An international
economic transaction evidently involves such transfer of title or rendering
of service from residents of one country to another. Such a transfer may
be a requited transfer (the transferee gives something of an economic
value to the transferor in return) or an unrequited transfer (a unilateral
gift). The following are the basic types of economic transactions that can
be easily identified:
1. Purchase or sale of goods or services with a financial quid pro quo
cash or a promise to pay. [One real and one financial transfer].
2. Purchase or sale of goods or services in return for goods or services
or a barter transaction. [Two real transfers].
3. An exchange of financial items e.g. purchase of foreign securities
with payment in cash or by a cheque drawn on a foreign deposit. [Two
financial transfers].
4. A unilateral gift in kind [One real transfer].
5. A unilateral financial gift. [One financial transfer].
B. Resident
The term resident is not identical with citizen though normally there is a
substantial overlap. As regards individuals, residents are those individuals
whose general centre of interest can be said to rest in the given economy.
They consume goods and services; participate in economic activity within
the territory of the country on other than temporary basis. This definition
may turnout to be ambiguous in some cases. The Balance of Payments
Manual published by the International Monetary Fund provides a set of
rules to resolve such ambiguities.
International organisations like the UN, the World Bank, and the IMF are
not considered to be residents of any national economy although their
offices are located within the territories of any number of countries.
To certain economists, the term BOP seems to be somewhat obscure.
Yeager, for example, draws attention to the word payments in the term
BOP; this gives a false impression that the set of BOP accounts records
items that involve only payments. The truth is that the BOP statements
records both payments and receipts by a country. It is, as Yeager says,
more appropriate to regard the BOP as a balance of international
transactions by a country. Similarly the word balance in the term BOP
does not imply that a situation of comfortable equilibrium; it means that it
is a balance sheet of receipts and payments having an accounting
balance.
Like other accounts, the BOP records each transaction as either a plus or a
minus. The general rule in BOP accounting is the following:-
a) If a transaction earns foreign currency for the nation, it is a credit
and is recorded as a plus item.
b) If a transaction involves spending of foreign currency it is a debit
and is recorded as a negative item.
BALANCE OF TRADE
Balance of trade may be defined as the difference between the value of
goods and services sold to foreigners by the residents and firms of the
home country and the value of goods and services purchased by them
from foreigners. In other words, the difference between the value of goods
and services exported and imported by a country is the measure of
balance of trade.
If two sums (1) value of exports of goods and services and (2) value of
imports of goods and services are exactly equal to each other, we say that
there is balance of trade equilibrium or balance; if the former exceeds the
latter, we say that there is a balance of trade surplus; and if the later
exceeds the former, then we describe the situation as one of balance of
trade deficit. Surplus is regarded as favourable while deficit is regarded as
unfavourable.
Regardless of which idea is adopted, one thing is certain i.e. that balance
of trade is a national injection and hence it is appropriate to regard an
active balance (an excess of credits over debits) as a desirable state of
affairs. Should this then be taken to imply that a passive trade balance (an
excess of debits over credits) is necessarily a sign of undesirable state of
affairs in a country? The answer is no. Because, take for example, the
case of a developing country, which might be importing vast quantities of
capital goods and technology to build a strong agricultural or industrial
base. Such a country in the course of doing that might be forced to
experience passive or adverse balance of trade and such a situation of
passive balance of trade cannot be described as one of undesirable state
of affairs. This would therefore again suggest that before drawing
meaningful inferences as to whether passive trade balances of a country
are desirable or undesirable, we must also know the composition of
imports which are causing the conditions of adverse trade balance.
It is also worth remembering that BOP on current account covers all the
receipts on account of earnings (or opposed to borrowings) and all the
payments arising out of spending (as opposed to lending). There is no
reverse flow entailed in the BOP on current account transactions.
BASIC BALANCE
The basic balance was regarded as the best indicator of the economys
position vis--vis other countries in the 1950s and the 1960s. It is defined
as the sum of the BOP on current account and the net balance on long
term capital, which were considered as the most stable elements in the
balance of payments. A worsening of the basic balance [an increase in a
deficit or a reduction in a surplus or even a move from the surplus to
deficit] was seen as an indication of deterioration in the [relative] state of
the economy.
The short term capital account balance is not included in the basic
balance. This is perhaps for two main reasons:
a) Short term capital movements unlike long term capital movements
are relatively volatile and unpredictable. They move in and out of the
country in a period of less than a year or even sooner than that. It
would therefore be improper to treat short term capital movements on
the same footing as current account BOP transactions which are
extremely durable in nature. Long term capital flows are relatively
more durable and therefore they qualify to be treated along side the
current account transactions to constitute basic balance.
b) In many cases, countries dont have a separate short term capital
account as they constitute a part of the Errors and Omissions
Account.
A deficit on the basic balance could come about in various ways, which
are not mutually equivalent. E.g. suppose that the basic balance is in
deficit because a current account deficit is accompanied by a deficit on
the long term capital account. The long term capital outflow will, in the
future, generate profits, dividends and interest payments which will
improve the current account and so, ceteris paribus, will reduce or
perhaps reduce the deficit. On the other hand, a basic balance surplus
consisting of a deficit on current account that is more than covered by
long term borrowings from abroad may lead to problems in future, when
profits, dividends etc are paid to foreign investors.
THE OFFICIAL SETTLEMENT CONCEPT
An alternative approach for indicating, a deficit or surplus in the BOP is to
consider the net monetary transfer that has been made by the monetary
authorities is positive or negative, which is the so called settlement
concept.
If the net transfer is negative (i.e. there is an outflow) then the BOP is said
to be in deficit, but if there is an inflow then it is surplus. The basic
premise is that the monetary authorities are the ultimate financers of any
deficit in the balance of payments (or the recipients of any surplus). These
official settlements are thus seemed as the accommodating item, all other
being autonomous.
Direct investment is the act of purchasing an asset and the same time
acquiring control of it (other than the ability to re-sell it). The acquisition
of a firm resident in one country by a firm resident in another is an
example of such a transaction, as is the transfer of funds from the parent
company in order that the subsidiary company may itself acquire assets
in its own country. Such business transactions form the major part of
private direct investment in other countries, multinational corporations
being especially important. There are of course some examples of such
transactions by individuals, the most obvious being the purchase of the
second home in another country.
The net value of the balances of direct and portfolio investment defines
the balance on capital account.
Essentially the distinction between both the capital flow lies in the motives
underlying a transaction, which are almost impossible to determine. We
cannot attach the labels to particular groups of items in the BOP accounts
without giving the matter some thought. For example a short term capital
movement could be a reaction to difference in interest rates between two
countries. If those interest rates are largely determined by influences
other than the BOP, then such a transaction should be labelled as
autonomous. Other short term capital movements may occur as a part of
the financing of a transaction that is itself autonomous (say, the export of
some good), and as such should be classified as accommodating.
Finally, there are changes in the reserves of the country whose balance of
payments we are considering, and changes in that part of the reserves of
other countries that is held in the country concerned. Reserves are held in
three forms: in foreign currency, usually but always the US dollar, as gold,
and as Special Deposit Receipts (SDRs) borrowed from the IMF. Note that
reserves do not have to be held within the country. Indeed most countries
hold a proportion of their reserves in accounts with foreign central banks.
The changes in the countrys reserves must of course reflect the net value
of all the other recorded items in the balance of payments. These changes
will of course be recorded accurately, and it is the discrepancy between
the changes in reserves and the net value of the other record items that
allows us to identify the errors and omissions.
UNILATERAL TRANSFERS
Unilateral transfers or unrequited receipts, are receipts which the
residents of a country receive for free, without having to make any
present or future payments in return. Receipts from abroad are entered as
positive items, payments abroad as negative items. Thus the unilateral
transfer account includes all gifts, grants and reparation receipts and
payments to foreign countries. Unilateral transfer consist of two types of
transfers: (a) government transfers (b) private transfers.
BOP accounts are intimately with the overall saving investment balance in
a countrys national accounts. Continuing deficits or surpluses may lead to
fiscal and monetary actions designed to correct the imbalance which in
turn will affect exchange rates and interest rates in the country. In nutshell
corporate finance managers must monitor the BOP data being put out by
government agencies on a regular basis because they have both short
term and long term implications for a host of economic and financial
variables affecting the fortunes of the company.
Thus it is clear that if we record all the entries in BOP in a proper way,
debits and credits will always be equal. So that in accounting sense the
BOP will be in balance.
H. Capital Account
2. Private
a. Long Term
b. Short Term
3. Banking
4. Official
a. Loans
b. Amortisation
c. Miscellaneous
Total Capital Account (1+2+3)
I. IMF
J. SDR Allocation
K. Capital Account, IMF & SDR Allocation
(B+C+D)
L. Total Current Account, Capital Account,
IMF & SDR Allocation (A+E)
Current Account
The current account includes all transactions which give rise to or use up
national income. The current account consists of two major items, namely,
(a) merchandise export and imports and (b) invisible imports and exports.
Merchandise exports i.e. sale of goods abroad, are credit entries because
all transactions giving rise to monetary claims on foreigners represent
credits. On the other hand, merchandise imports, i.e. purchase of goods
abroad, are debit entries because all transactions giving rise to foreign
money claims on the home country represent debits. Merchandise exports
and imports form the most important international transactions of most of
the countries.
Invisible exports i.e. sale of services, are credit entries and invisible
imports i.e. purchase of services are debit entries. Important invisible
exports include sale abroad of services like insurance and transport etc.
while important invisible imports are foreign tourist expenditures in the
home country and income received on loans and investment abroad
(interests or dividends).
Capital Account
The capital account separates the non monetary sector from the monetary
one, that is to say, the trading or ordinary private business element in the
economy together with the ordinary institutions of central or local
government, from the central bank and the commercial bank, which are
directly involved in framing or implementing monetary policies. The
capital account consists of long term and short term capital transactions.
Capital outflow represents debit and capital inflow represent credit. For
instance, if an American firm invests rupees 100 million in India, this
transaction will be represented as a debit in the US BOP and a credit in the
BOP of India.
Other Accounts
The IMF account contains purchases (credits) and repurchases (debits)
from the IMF. SDRs Special Drawing Rights are a reserve asset created
by the IMF and allocated from time to time to member countries. Within
certain limitations it can be used to settle international payments between
monetary authorities of member countries. An allocation is a credit while
retirement is a debit. The Reserve and Monetary Gold account records
increases (debits) and decreases (credits) in reserve assets. Reserve
assets consist of RBIs holdings of gold and foreign exchange (in the form
of balances with foreign central banks and investment in foreign
government securities) and governments holding of SDRs. Errors and
Omissions is a statistical residue. Errors and omissions (or the balancing
item) reflect the difficulties involved in recording accurately, if at all, a
wide variety of transactions that occur within a given period of (usually 12
months). It is used to balance the statement because in practice it is not
possible to have complete and accurate data for reported items and
because these cannot, therefore, ordinarily have equal entries for debits
and credits.
The critical question is how to make this division so that BOP statistics, in
particular the deficit and surplus figures, will be economically meaningful.
Suggestions made by economist and incorporated into the IMF guidelines
emphasis the purpose or motive a transaction, as a criterion to decide
whether a transaction should go above or below the line. The principle
distinction between autonomous transaction and accommodating or
compensatory transactions. Transactions are said to Autonomous if their
value is determined independently of the BOP. Accommodating capital
flows on the other hand are determined by the net consequences of the
autonomous items. An autonomous transaction is one undertaken for its
own sake in response to the given configuration of prices, exchange rates,
interest rates etc, usually in order to realise a profit or reduced costs. It
does not take into account the situation elsewhere in the BOP. An
accommodating transaction on the other hand is undertaken with the
motive of settling the imbalance arising out of other transactions. An
alternative nomenclature is that capital flows are above the line
(autonomous) or below the line (accommodating). The terms balance of
payments deficit and balance of payments surplus will then be
understood to mean deficit or surplus on all autonomous transactions
taken together.
SHORT NOTES
BALANCE OF PAYMENTS
(Refer to Concept Questions)
CURRENT ACCOUNT
The current account records exports and imports of goods and services
and unilateral transfers. Exports whether of goods or services are by
convention entered as positive items in the account. Imports accordingly
are entered as negative items. Exports are normally calculated f.o.b i.e.
cost from transportation, insurance etc are not included whereas imports
are normally calculated c.i.f. i.e. transportation, insurance cost etc are
included.
In many cases the payment for imports and exports will result in transfer
of money between the trading countries. For example a UK firm importing
a good from US may settle its debt by instructing its UK bank to make a
payment to the US account of the exporter. This is not necessarily the
case however. If the UK firm holds a bank account in the US, then it may
make payment to the US exporter from that account. In the former case
the financial side of the transaction will appear in the UK BOP account as
part of the net change in UK foreign currency reserves. In the later it will
appear as the part of the capital account since the UK firm has reduced its
claims on the US bank.
The net value of the balances of visible trade and of invisible trade and of
unilateral transfers defines the balance on current account.
CAPITAL ACCOUNT
(Refer to Concept Questions)