International Finance

1.Introduction:
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. 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) b) If a transaction earns foreign currency for the nation, it is a credit and is If a transaction involves spending of foreign currency it is a debit and is

recorded as a plus item. recorded as a negative item.

The BOP is a double entry accounting statement based on rules of debit and credit similar to those of business accounting & book-keeping, since it records both transactions and the money flows associated with those transactions. Also in case of statistical discrepancy the difference amount is adjusted with errors and omissions account and thus in accounting sense the BOP statement always balances.

International Finance Balance of Payment is a standard double entry accounting record to capture all transactions of an economy with the Rest of the World. It is a statistical statement showing: a. Transactions in goods and services between an economy and rest of the world. b. Changes of ownership and changes in countrys monetary, gold, SDRs, claims and liabilities to the rest of the world. c. Unrequited transfers and counterpart entries that are needed to balance, in the accounting sense.

2.The BOP Components

The various components of a BOP statement are:

A. Current Account B. Capital Account C. IMF D. SDR Allocation E. Reserves and Monetary Gold

F. Errors and omissions

Components of Balance of Payments

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Items I] Current Account 1. Merchandise: -Private -Government 2. Non-Monetary Gold Movement 3. Invisibles Total Current Account (1+2+3) II] Capital Account 1. Private: -Long Term -Short Term

Credit

Debit

Net

2. Banking 3. Official

-Loans -Amortization -Miscellaneous

Total Capital Account (1+2+3) *Basic Balance III] Reserves Account 1. IMF 2. SDR Allocation 3. Reserves and Monetary Gold IV] Errors and Omissions

A. Structure of Current Account

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1] Merchandise (Trade of Visible items) -Private -Government 2] Non Monetary Gold Movement 3] Invisibles - Trade in services - Investment income - Government not classified elsewhere - Transfer Payments - Unilateral Payments Total Current Account (1+2+3) Balance Of Current Account BOP on current account refers to the inclusion of three balances of namely Merchandise balance, Services balance and Unilateral Transfer balance. In other words it reflects the net flow of goods, services and unilateral transfers (gifts). The net value of the balances of visible trade and of invisible trade and of unilateral transfers defines the balance on current account. BOP on current account is also referred to as Net Foreign Investment because the sum represents the contribution of Foreign Trade to GNP. Thus the BOP on current account includes imports and exports of merchandise (trade balances), military transactions and service transactions (invisibles). The service account includes investment income (interests and dividends), tourism, financial charges (banking and insurances) and transportation expenses (shipping and air travel). Unilateral transfers include pensions, remittances and other transfers for which no specific services are rendered. 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.

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Identify a deficit or a surplus in Current account. Cr > Dr = surplus and visa versa
Balance Of Visible Trade Balance of visible trade is also known as balance of merchandise trade, and 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). The valuation should be on F.O.B basis so that international freight and insurance are treated as distinct services and not merged with the value of goods themselves. Exports valued on F.O.B basis are the credit entries. Data for these items are obtained from the various forms that the exporters have fill and submit to the designated authorities. Imports valued at C.I.F are the debit entries. Valuation at C.I.F. though inappropriate, is a forced choice due to data inadequacies. The difference between the total of debits and credits appears in the Net column. This is the Balance of Visible Trade. In visible trade if the receipts from exports of goods happen to be equal to the payments for the imports of goods, we describe the situation as one of zero goods balance. Otherwise there would be either a positive or negative goods balance, depending on whether we have receipts exceeding payments (positive) or payments exceeding receipts (negative).

Balance Of Trade The difference between the value of goods and services exported and imported by a country is the measure of balance of trade.

Non monetary gold movements: Traditionally gold is treated as both a commodity and a financial asset. The quantum of gold that is held by monetary authority as a part of International reserves is classified as financial asset. All the other gold that is with residents is commodity. While this commodity gold is traded by residents and non-residents, it is recorded in this account which is a part of the Current Account. It is simply import/ export transaction of gold by any one other than monetary authority. In India Monetary authority is RBI.

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Monetisation and Demonetisation of Gold: it may be observed that :Reserves and Monetary Gold part of Balance of Payments accounts for monetary gold. Monetary authority might sometimes acquire gold from residents to increase gold that forms part of international reserves. In this process commodity category gets transferred to financial asset category. Hence it is a debit to reserve account. Non-Monetary Gold movements current account. This process is called as Monetiasation of Gold. If it is reverse process i.e. monetary authority sells gold, debiting Non Monetary Gold Movement and crediting Reserves it is called Demonetisation of Gold. Balance Of Invisible Trade Just as a country exports goods and imports goods a country also exports and imports what are called as services (invisibles). The service account records all the service exported and imported by a country in a year. Unlike goods which are tangible or visible services are intangible. Accordingly services transactions are regarded as invisible items in the BOP. They are invisible in the sense that service receipts and payments are not recorded at the port of entry or exit as in the case with the merchandise imports and exports receipts. Except for this there is no meaningful difference between goods and services receipts and payments. Both constitute earning and spending of foreign exchange. Goods and services accounts together constitute the largest and economically the most significant components in the BOP of any country.

The

service

transactions

take

various

forms.

They

basically

include

1)

transportation, banking, and insurance receipts and payments from and to the foreign countries, 2) tourism, travel services and tourist purchases of goods and services received from foreign visitors to home country and paid out in foreign countries by home country citizens, 3) expenses of students studying abroad and receipts from foreign students studying in the home country, 4) expenses of diplomatic and military personnel stationed overseas as well as the receipts from similar personnel who are stationed in the home country and 5) interest, profits, dividends and royalties received from foreign countries and paid out to foreign countries. These items are generally termed as investment income or receipts and payments arising out of what are called as capital services. Balance of

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Invisible Trade is a sum of all invisible service receipts and payments in which the sum could be positive or negative or zero. A positive sum is regarded as favourable to a country and a negative sum is considered as unfavourable. The terms are descriptive as well as prescriptive.

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. Foreign economic aid or assistance and foreign military aid or assistance received by the home countrys government (or given by the home government to foreign governments) constitutes government to government transfers. The United States foreign aid to India, for BOP 9but a debit item in the US BOP). These are government to government donations or gifts. There no well worked out theory to explain the behaviour of this account because these flows depend upon political and institutional factors. The government donations (or aid or assistance) given to government of other countries is mixed bag given for either economic or political or humanitarian reasons. Private transfers, on the other hand, are funds received from or remitted to foreign countries on person to person basis. A Malaysian settled in the United States remitting $100 a month to his aged parents in Malaysia is a unilateral transfer inflow item in the Malaysian BOP. An American pensioner who is settled after retirement in say Italy and who is receiving monthly pension from America is also a private unilateral transfer causing a debit flow in the American BOP but a credit flow in the Italian BOP. Countries that attract retired people from other nations may therefore expect to receive an influx of foreign receipts in the form of pension payments. And countries which render foreign economic assistance on a massive scale can expect huge deficits in their unilateral transfer account. Unilateral transfer receipts and payments are also called unrequited transfers because as the name itself suggests the flow is only in one direction with no automatic reverse flow in the other direction. There is no repayment obligation attached to these transfers because they are not borrowings and lendings but gifts and grants exchanged

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between government and people in one country with the governments and peoples in the rest of the world.

B. Structure of capital a/c

CAPITAL A/c

PRIVATE SECTOR CAPITAL FLOWS - LONG TERM -SHORT TERM

The Capital Account

BANKING SECTOR CAPITAL FLOWS

OFFICIAL SECTOR CAPITAL FLOWS

The capital account records all international transactions that involve a resident of the country concerned changing either his assets with or his liabilities to a resident of another country. Transactions in the capital account reflect a change in a stock either assets or liabilities. It is often useful to make distinctions between various forms of capital account transactions. The basic distinctions are between private and official transactions, between portfolio and direct investment and by the term of the investment (i.e. short or long term). The distinction between private and official transaction is fairly transparent, and need not concern us too much, except for noting that the bulk of foreign investment is private. 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

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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. Portfolio investment by contrast is the acquisition of an asset that does not give the purchaser control. An obvious example is the purchase of shares in a foreign company or of bonds issued by a foreign government. Loans made to foreign firms or governments come into the same broad category. Such portfolio investment is often distinguished by the period of the loan (short, medium or long are conventional distinctions, although in many cases only the short and long categories are used). The distinction between short term and long term investment is often confusing, but usually relates to the specification of the asset rather than to the length of time of which it is held. For example, a firm or individual that holds a bank account with another country and increases its balance in that account will be engaging in short term investment, even if its intention is to keep that money in that account for many years. On the other hand, an individual buying a long term government bond in another country will be making a long term investment, even if that bond has only one month to go before the maturity. Portfolio investments may also be identified as either private or official, according to the sector from which they originate. The purchase of an asset in another country, whether it is direct or portfolio investment, would appear as a negative item in the capital account for the purchasing firms country, and as a positive item in the capital account for the other country. That capital outflows appear as a negative item in a countrys balance of payments, and capital inflows as positive items, often causes confusions. One way of avoiding this is to consider that direction in which the payment would go (if made directly).

The purchase of a foreign asset would then involve the transfer of money to the foreign country, as would the purchase of an (imported) good, and so must appear as a negative item in the balance of payments of the purchasers country (and as a positive item in the accounts of the sellers country).

The net value of the balances of direct and portfolio investment defines the balance on capital account.

Identify a deficit or a surplus in Capital account. Cr > Dr = surplus and visa versa

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The capital account consists of financial transactions that lead to changes in foreign assets and liabilities of the economy. Increase in assets (decrease in liabilities) is debit. Decrease in assets (increase in liabilities) is credit. It means capital inflow is credit and capital outflow is debit. The transactions are grouped by the institutional sector (banking, government and private) and by term to maturity of the original claim. 1. Private Sector Capital Flows: This consists of loans received by private entities (other than banks) in India from non-residents, investment by foreigners in shares of Indian companies, repayment of loans to residents by nonresidents, repatriation of Indian investments abroad i.e. capital inflows, on credit side. The capital outflows are recorded on the debit side such as investment by residents in shares abroad, investment by residents in foreign properties and assets, repatriation of foreign investments in India, disbursement of loans to non-residents. Short-term capital flows pertain to claims with maturities upto a year, rest are long term capital flows. 2. Banking Capital: This covers changes in assets and liabilities of commercial banks. This includes government banks, private banks as well as co-operative banks that are authorized to deal in foreign exchange. Assets are the balances held by foreign branches of Indian banks in India. Increase in assets is debit and Increase in liabilities is credit. Decrease in assets is credit and decrease in liabilities is debit. 3. Official Capital Flows: This includes transactions of Government of India (GOI) and RBI that affect foreign financial assets and liabilities of Government of India. In case of RBI, official reserve assets are excluded as they are covered under Reserves and Monetary Gold. Even transactions of GOI with International Monetary Fund are excluded and recorded separately. The net balance between the debit and credit entries under the private sector capital flows, Banking sector capital flows, Official sector capital flows taken together is Capital account. If credits exceed debits, it is a surplus and if debits exceed credits it is a deficit.

Accommodating & Autonomous Capital Flows

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Economists have often found it useful to distinguish between autonomous and accommodating capital flows in the BOP. 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 line the imbalance arising out of the other sum transactions. of the An alternative and nomenclature is that capital flows are above the line (autonomous) or below the (accommodating). Obviously accommodating autonomous items must be zero, since all entries in the BOP account must come under one of the two headings. Whether the BOP is in surplus or deficit depends on the balance of the autonomous items. The BOP is said to be in surplus if autonomous receipts are greater than the autonomous payments and in deficit if vice a versa. 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. There is nevertheless a great temptation to assign the labels autonomous and accommodating to groups of item in the BOP. i.e. to assume, that the great majority of trade in goods and of long term capital movements are autonomous, and that most short term capital movements are accommodating, so that we shall not go far wrong by assigning those labels to the various components of the BOP accounts. Whether that is a reasonable approximation to the truth may depend in part on the policy regime that is in operation. For example what is an autonomous item under a system of fixed exchange rates and limited capital

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mobility may not be autonomous when the exchange rates are floating and capital may move freely between countries.

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.

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BASIC BALANCE- total of the credit column of both current A/c and capital A/c and the totals of the debits of both these accounts.

CR Inflows (A) Current A/C (B) Capital A/C (C) Reserves BOP bal xxx xxx xx xx

DR outflows xxx xxx xxx xxx xx basic A/C surplus basic A/C deficit

(A+B)Basic balance xx

C. D. E. The IMF SDR & RESERVES AND MONETARY GOLD A/C.

,

Reserves Account
Official reserve account forms a special feature of the capital account. This account records the changes in the part of the reserves of other countries that is held in the country concerned. These reserves are held in three forms: in foreign currency, usually but not always the US dollars, as gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF. Note that the reserves do not have to be held by the country. Indeed most of the countries hold a proportion of the reserves in accounts with foreign central banks. 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

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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.

F. ERRORS AND OMISSIONS

Errors and omissions is a statistical residue. 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 entry for net errors and omissions often reflects unreported flows of private capital, although the conclusions that can be drawn from them vary a great deal from country to country, and even in the same country from time to time, depending on the reliability of the reported information. Developing countries, in particular, usually experience great difficulty in providing reliable information. 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). In some cases there is such large number of transactions that a sample is taken rather than recording each transaction, with the inevitable errors that occur when samples are used. In others problems may arise when one or other of the parts of a transaction takes more than one year: for example wit a large export contract covering several years some payment may be received by the exporter before any deliveries are made, but the last payment will not made until the contract has been completed. Dishonesty may also play a part, as when goods are smuggled, in which case the merchandise side of the transaction is unreported although payment will be made somehow and will be reflected somewhere in the accounts. Similarly the desire to avoid taxes may lead to under-reporting of some items in order to reduce tax liabilities. 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

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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. Illustrate the items which fall under capital account and current account with examples. CREDITS Current Account 1. Merchandise Exports (Sale of Goods) 2. Invisible Exports (Sale of Services) a. Transport services sold abroad b. Insurance services sold abroad c. Foreign tourist expenditure in country d. Other services sold abroad e. Incomes received on loans and investments abroad. 3. Unilateral Transfers a. Private remittances received from abroad b. Pension payments received from abroad c. Government grants received from abroad Capital Account 3. Foreign long-term investments in the home country (less redemptions and repayments) a. Direct investments in the home country b. Foreign investments in domestic securities c. Other investments of foreigners in the home country d. Foreign Governments loans to the home country. 4. Foreign short-term investments in the home country. DEBITS Current Account 1. Merchandise Imports (purchase of Goods) 2. Invisible Imports (Purchase of Services) a. Transport services purchased from abroad b. Insurance services purchased c. Tourist expenditure abroad d. Other services purchased from abroad e. Income paid on loans and investments in the home country. 3. Unilateral Transfers a. Private remittances abroad b. Pension payments abroad c. Gov ernment grants abroad. Capital Account 3. Long-term investments abroad (less redemptions and repayments) a. Direct Investments abroad b. Investments in foreign securities c. Other investments abroad d. Government loans to foreign countries 4. Short-term investments abroad.

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3. The Importance of the BOP Statements

BOP statistics are regularly compiled, published and are continuously monitored by companies, banks and government agencies. A set of BOP accounts is useful in the same way as a motion picture camera. The accounts do not tell us what is good or bad, nor do they tell us what is causing what. But they do let us see what is happening so that we can reach our own conclusions. Below are 3 instances where the information provided by BOP accounting is very necessary: 1. Judging the stability of a floating exchange rate system is easier with BOP as the record of exchanges that take place between nations help track the accumulation of currencies in the hands of those individuals more willing to hold on to them. 2. Judging the stability of a fixed exchange rate system is also easier with the same record of international exchange. These exchanges again show the extent to which a currency is accumulating in foreign hands, raising questions about the ease of defending the fixed exchange rate in a future crisis. 3. To spot whether it is becoming more difficult for debtor counties to repay foreign creditors, one needs a set of accounts that shows the accumulation of debts, the repayment of interest and principal and the countries ability to earn foreign exchange for future repayment. A set of BOP accounts supplies this information. This point is further elaborated below. The BOP statement contains useful information for financial decision makers. In the short run, BOP deficit or surpluses may have an immediate impact on the exchange rate. Basically, BOP records all transactions that create demand for and supply of a currency. When exchange rates are market determined, BOP figures indicate excess demand or supply for the currency and the possible impact on the exchange rate. Taken in conjunction with recent past data, they may conform or indicate a reversal of perceived trends. They also signal a policy shift on the part of the monetary authorities of the country unilaterally or in concert with its trading partners. For instance, a country facing a current account deficit may raise interest to attract short term capital inflows to prevent depreciation of its currency. Countries suffering from chronic deficits may find their credit ratings being downgraded because the markets interpret the data as evidence that the country may have difficulties its debt. BOP accounts are intimately with the overall saving investment balance in a countrys national accounts. Continuing deficits or surpluses may lead to fiscal

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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.

4. Imp questions:
1. IN THE ACCOUNTING SENSE THE BOP ALWAYS BALANCES!

The BOP is a double entry accounting statement based on rules of debit and credit similar to those of business accounting & book-keeping, since it records both transactions and the money flows associated with those transactions. For instance, exports (like sales of a business) are credits, and imports (like the purchases of a business) are debits. As in business accounting the BOP records increases in assets (direct investment abroad) and decreases in liabilities (repayment of debt) as debits, and decreases in assets (sale of foreign securities) and increases in liabilities (the utilisation of foreign goods) as credits. An elementary rule that may assist in understanding these conventions is that in such transactions it is the movement of a document, not of the money that is recorded. An investment made abroad involves the import of a documentary acknowledgement of the investment, it is therefore a debit. The BOP has one important category that has no counter part or at least no significant counter part in business accounting, i.e. international gifts and grants and other so called transfer payments. In general credits may be conceived as receipts and debits as payments. However this is not always possible. In particular the change in a countrys international reserves in gold and foreign exchange is treated as a debit if it is an increase and a credit if it is a decrease. The procedure is to offset changes in reserves against changes in the other items in the table so that the grand total is always zero, (except for errors and omissions). A transaction entering the BOP usually has two aspects and invariably gives rise to two entries, one a debit and the other a credit. Often the two aspects fall in different categories. For instance, an export against cash payment may result in an increase in the exporting countrys official foreign exchange holdings. Such a

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transaction is entered in the BOP as a credit for exports and as a debit for the capital account. Both aspects of a transaction may sometimes be appropriate to the same account. For instance the purchase of a foreign security may have as its counter part reduction in official foreign exchange holdings. 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.

In accounting sense BOP always balances. Double entry accounting record to capture all transactions Current A/C deficit are matched with capital A/C surplus and visa versa Reserves A/c DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR UNDESIRABLE!

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] is seen as an indication of deterioration in the [relative] state of the economy. Thus it is very much evident that a deficit in the basic balance is a clear indicator of worsening of the state of the countrys BOP position, and thus can be said to be undesirable at the very outset. However, on further thoughts, a deficit in the basic balance can also be understood to be desirable. This can be explained as follows: 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. This deficit in long term capital account could be clearly observed in a developing countrys which might be investing heavily on capital goods for advancement on the agricultural and industrial fields. This long term capital outflow will, in the

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future, generate profits, dividends and interest payments which will improve the current account and so, ceteris paribus, will reduce or perhaps reduce the deficit. Thus a deficit in basic balance can be desirable as well as undesirable, as it clearly depends upon what is leading to a deficit in the long term capital account.

Numericals
1. The following balance of payments information is available for a particular economy: Decline in foreign exchange reserves Long term Capital Inflow (net) Merchandise Exports Merchandise Imports Export of Services Import of Services Calculate short-term capital account. Solution: From the above data balance in the current account is determined as follows Particulars Merchandise Exports Merchandise Imports Export of Services Import of Services Total Therefore, Credit Debit = 5,000 - 4,000 = 1,000 Hence there is surplus on current account by Rs. 1,000/Now, Change in foreign = Balance in long term Reserves Capital Account Balance in Current + Balance in short term + Account capital account Credit (Inflow) 2,000 3,000 5,000 Debit (Outflow) 1,500 2,500 4,000 500 600 2,000 1,500 3,000 2,500

Surplus is denoted by + sign while deficit by - sign Therefore solving by above formula we get, -500 = 1000 + Balance in short term capital account + 600 -500 = 1600 + Balance in short term capital account

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Therefore balance in short term capital account = -500-1600 = -2100 Hence short term capital account has net outflow or deficit of Rs. 2100/-. 2. The following data pertains to the balance of payment for India for the year 2000 Particulars Government loans from abroad Government loans to abroad Direct investment abroad FDI in the country Foreign short term loans investments in the country Short-term loans and investments abroad Private remittances abroad (Transfer of Payments) Private remittances from abroad Rs. in crores 30 60 58 191 60 451 85 211

Calculate the balance on capital account in the balance of payments accounts of India Solution: Capital Account Particulars Government loans from abroad Government loans to abroad Direct investment abroad FDI in the country Foreign short term loans investments in the country Short-term loans and investments abroad Total Credit (Inflow) 30 191 60 281 Debit (Outflow) 60 58 451 569

Therefore, Credit Debit = 281 569 = -288 Hence there is deficit on current account = 288 (Note: Private Remittances have not been included as they are the part of current account of balance of payment)

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3. The following balance of payments data are available for an economy: Increase in foreign exchange reserves Short term Capital Outflow (net) Merchandise Exports Merchandise Imports Export of Services Import of Services Determine the long-term capital account Solution: The balance in current is a follows: Particulars Merchandise Exports Merchandise Imports Export of Services Import of Services Total Therefore, Credit Debit = 4700 - 3700 = 1,000 Hence there is surplus on current account by Rs. 1000/Since, Change in foreign = Balance in long term Reserves Capital Account Balance in Current + Balance in short term + Account capital account Credit (Inflow) 2,000 2,700 4,700 Debit (Outflow) 1,500 2,200 3,700 450 1,200 2,000 1,500 2,700 2,200

Therefore solving by above formula we get, 450 = 1000 + (-1200) + Balance in long term capital account Therefore balance in long term capital account = 450 1,000 + 1,200 = 650 = long term net inflow of capital

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4. Following details have been extracted from the balance of payments statements of Fairland for the year 2000-2001 Transactions on Capital Account FDI in Fairland Short-term loans given by Fairland Government loans given by Fairland Government loans received by Fairland Direct investment abroad (made by Fairland) Short-term loans raised by Fairland 201 80 40 23 58 68

It is also noticed that the balance of foreign exchange reserves as at the end of 2000-01 is exactly equal to the balance as at the beginning of 1999-2000. Calculate the deficit on Current Account. Solution: Transactions on Capital Account Particulars FDI in Fairland Short-term loans given by Fairland Government loans given by Fairland Government loans received by Fairland Direct investment abroad (made by Fairland) Short-term loans raised by Fairland Total Therefore, Credit Debit = 292 - 178 = 114 Hence there is surplus on current account = 114 In other words, theres a deficit on current account: (-) 114 (Since there is no change in foreign exchange reserves, surplus on capital account must have been equal to the deficit on current account) Credit (Inflow) 201 23 68 292 Debit (Outflow) 80 40 58 178

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5. You are given the following balance of payments data for the country X for the calendar year 2000. Particulars Merchandise imports Merchandise exports Exports of services including travel and transportation Imports of services including travel and transportation Earnings on loans and investments from abroad Earnings of loans and investments in X by foreigners Private remittances to abroad (transfers) Private remittances from abroad (transfers) Government loans to abroad Government loans from abroad Direct investments abroad FDI in X Short term loans and investments abroad Foreign short-term loans and investments in X Millions of country Xs currency unit 18,191 17,277 15,972 12,464 429 1,054 85 124 41 18 26 134 288 42

From the data given above, prepare a balance of payments (BoP) statement and answer the following questions: What is the trade balance on merchandise account? What is the balance on current account? What is the balance on long-term capital account? What will be the entry against the items change in country Xs official foreign exchange reserves in the BoP? Does this entry represent an increase or decrease in the stock of foreign exchange reserves?

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Solution: Balance of Payments of country X for the year 2001 (All amounts in millions of country Xs currency unit) Particulars Current Account Merchandise exports Merchandise imports Exports of services including travel and transportation Imports of services including travel and transportation Earnings on loans and investments from abroad Earnings of loans and investments in X by foreigners Private remittances from abroad (transfers) Private remittances to abroad (transfers) Total Capital Account Government loans to abroad Government loans from abroad Direct investments abroad FDI in X Short term loans and investments abroad Foreign short-term loans and investments in X Total 42 194 355 134 288 33,802 31,794 41 18 26 Credit (Inflow) 17,277 15,972 429 124 Debit (Outflow) 18,191 12,464 1,054 85

1. Trade Balance on Merchandise Account = Export Import = 17,277 18,191 = - 914

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2. Balance on current account

= 33,802 31,794 = 2,008

3. Balance on long term capital account

= (18 + 34) (41 + 26) = 152 67 = 85

4. Balance on Current Account

Balance on Capital Account

= 2,008 = 194 355 = -161

5. Overall Balance on Capital

= Balance on Current + Balance Account

Account = 2,008 + ( 161) = 1,847 Therefore, change in country Xs official foreign exchange reserves = 1,847 millions. Since the overall balance is favourable, this entry represents an increase in the stock of foreign exchange reserves.

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6. The following data pertains to the balance of payments for a country for the year 2001. Government loans from abroad Government loans to abroad Direct investment abroad Foreign direct investments in the country Foreign short-term loans investments in the country Short-term loans and investments abroad Private remittance to abroad (transfers) Private remittances from abroad (transfers) 35 65 60 193 65 456 78 300

Calculate the balance on capital account in the balance of payments account of the country. Solution: Capital Account Particulars Government loans from abroad Government loans to abroad Direct investment abroad FDI in the country Foreign short term loans investments in the country Short-term loans and investments abroad Total Credit (Inflow) 35 193 65 293 Debit (Outflow) 65 60 456 581

Therefore, Credit Debit = 293 581 = -288 Hence there is deficit in capital account = 288 (Note: Private Remittances have not been included as they are the part of current account of balance of payment and we have been asked to calculate the balance on capital account)

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7. The following balance of payments data are available for an economy: Increase in foreign exchange reserves Short-term capital outflow (net) Merchandise exports Merchandise imports Export of services Import of services Determine the long-term capital account. Solution: The balance in current is a follows: Particulars Merchandise Exports Merchandise Imports Export of Services Import of Services Total Therefore, Credit Debit = 4,800 3,200 = 1,600 Hence there is surplus on current account by Rs. 1,600/Since, Change in foreign = Balance in long term Reserves Capital Account Balance in Current + Balance in short term + Account capital account Credit (Inflow) 1,800 3,000 4,800 Debit (Outflow) 1,700 1,500 3,200 500 1,000 1,800 1,700 3,000 1,500

Therefore solving by above formula we get, 500 = 1,600 + (-1,000) + Balance in long term capital account Therefore balance in long term capital account = 500 1,600 + 1,000 = -100 Hence, long term net outflow of capital is 100

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8. Following details have been extracted form the Balance of statement of 'x' for the year 2000-2001

Transactions on Capital Account 1. 2. 3. 4. 5. 6. Foreign Direct Investment (In 'x') Short term loans given by 'x' Government loans given by 'x' Government loans received by 'x' Direct Investment abroad (made by 'x') Short term loans raised by 'x' 180 60 36 8 82 100

It is also noticed that the balance of foreign exchange reserves as at the end of 2000-01 is exactly equal to the balance as at the beginning of 2000-01. Calculate deficit on Current Account. Solution: Transactions on Capital Account Particulars Foreign Direct Investment (In 'x') Short term loans given by 'x' Government loans given by 'x' Government loans received by 'x' Direct Investment abroad (made by 'x') Short term loans raised by 'x' Total Therefore, Credit Debit = 288 - 178 = 110 Hence there is surplus on current account = 110 In other words, theres a deficit on current account: (-) 100 (Since there is no change in foreign exchange reserves, surplus on capital account must have been equal to the deficit on current account) Credit (Inflow) 180 8 100 288 Debit (Outflow) 60 36 82 178

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9. The following balance of payments information is available for an economy. 1. 2. 3. 4. 5. 6. Decline in foreign exchange reserves Long-term capital inflow (net) Merchandise exports Merchandise imports Export of services Import of services 300 600 2,000 1,500 3,000 2,500

Calculate the short-term capital account. Solution: From the above data balance in the current account is determined as follows Particulars Merchandise Exports Merchandise Imports Export of Services Import of Services Total Therefore, Credit Debit = 5000 - 4000 = 1000 Hence there is surplus on current account by Rs. 1000/Now, Change in foreign = Balance in long term Reserves Capital Account Balance in Current + Balance in short term + Account capital account Credit (Inflow) 2,000 3,000 5,000 Debit (Outflow) 1,500 2,500 4,000

Surplus is denoted by + sign while deficit by - sign Therefore solving by above formula we get, -300 = 1000 + Balance in short term capital account + 600 -300 = 1600 + Balance in short term capital account Therefore balance in short term capital account = -300-1,600 = -1,900 Hence short term capital account has net outflow or deficit of Rs. 1,900/-.

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10. You are given the following balance of payments data for country X f6r the calendar year 2001. (Millions of country Xs currency unit) Particulars Merchandise imports Merchandise exports Exports of services including travel and transportation Imports of services including travel and transportation Earnings of loans and investments from abroad Earnings of loans and investments in X by foreigners Private remittances to abroad (transfers) Private remittances from abroad (transfers) Government loans to abroad Government loans from abroad Direct investments abroad FDI in X Short term loans and investments abroad Foreign short-term loans and investments in X Amount 18,499 17,484 15,972 12,464 429 1,054 85 124 43 20 28 126 288 42

From the data given above, prepare a balance of payments (BOP) statement and answer the following questions 1. What is the trade balance on merchandise account? 2. What is the balance on current account? 3. What is the balance on the long-term capital account? 4. What will be the entry against the item 'change in country X's official foreign exchange reserves' in the BOP? Does this entry represent an increase or decrease in the stock of foreign exchange reserves?

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Solution: Balance of Payments of country X for the year 2001 (All amounts in millions of country Xs currency unit) Particulars Current Account Merchandise exports Merchandise imports Exports of services including travel and transportation Imports of services including travel and transportation Earnings on loans and investments from abroad Earnings of loans and investments in X by foreigners Private remittances from abroad (transfers) Private remittances to abroad (transfers) Total Capital Account Government loans to abroad Government loans from abroad Direct investments abroad FDI in X Short term loans and investments abroad Foreign short-term loans and investments in X Total 126 288 20 28 34,009 32,102 Credit (Inflow) 17,484 15,972 429 124 Debit (Outflow) 18,499 12,464 1,054 85

43

42 188 359

1. Trade Balance on Merchandise Account = Export Import

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= 17,484 18,499 = - 1015 2. Balance on current account = 34,009 32,102 = 1,907 3. Balance on long term capital account = (20 + 126) (43 + 28) = 146 71 = 75

4. Balance on Current Account

Balance on Capital Account

= 1,907 = 188 - 359 = -171

11. Overall Balance on Capital Account

= Balance on Current + Balance Account = 1,907 + ( 171) = 1,736

Therefore, change in country Xs official foreign exchange reserves = 1,736 millions. Since the overall balance is favourable, this entry represents an increase in the stock of foreign exchange reserves.

You are required to find out the overall balance, showing clearly all the sub-balances from the following data. (1) UC Corporation of the USA invests in India Rs. 3, 00,000 to modernize its Indians subsidiary. (2) A tourist from Egypt buys souvenirs worth Rs. 3,000 to carry with him. He also pays hotel and travel bills of Rs. 5,000 to Delhi Tourist Agency. (3) The Indian subsidiary of UC Corporation remits, as usual, Rs. 5,000 as dividends to the parent company in the USA. (4) The Indian subsidiary of UC Corporation sells a part of its production in other Asians countries for Rs. 1, 00,000.

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(5) The Indian subsidiary borrows a sum of Rs. 2, 00,000 (to be paid back in a years time) from German money market to resolve its urgent liquidity problem. (6) The Indian company buys a machine for Rs. 1, 00,000 from Japan and 60% payment is made immediately; the remaining amount is to be paid after 3 years. (7) An Indian subsidiary of French Company borrows Rs. 50,000 from the Indian public to invest in its modernization programme. Solution: Sr.no 1 2 3 4 5 6 Sources 3,00,000 a. 3,000 b. 5,000 5,000 1,00,000 2,,00,000 a. 1,00,000 b. 40,000 6,48,000 BOP Statement A. Current Account Goods Accounts Exports: Rs. 1, 03,000 (+) Imports: Rs. 1, 00,000 (-) Balance: Rs. 3,000 (+) 1,05,000 Uses Nature Direct Foreign Investment. Goods exported. Services (invisible) rendered. Dividend paid. Goods exported. Short-Term borrowing. Equipments imported. Increase in claim on India.

Invisible Accounts Payments Received: Rs. 5,000(+) Payments Made : Rs. 5,000(-) Balance : NIL

Current Account Balance: Rs. 3,000 (+) B. Capital Account Foreign Direct Investment Inflow : Rs. 3, 00,000 (+) Outflow: Rs. NIL Balance: Rs. 3, 00,000 (+) Portfolio Investment Inflow : Rs. 40,000 (+) Outflow: Rs. NIL

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Balance: Rs. 40,000 (+) Long-Term Capital Account: Rs. 3, 40,000 (+) (Foreign Direct Investment + Portfolio Investment) Short-term borrowings Inflow : Rs. 2,00,000 (+) Outflow: Nil Balance: Rs. 2,00,000 (+) Capital Account Balance: Rs. 5, 40,000 (+) Overall Balance: Rs. 5, 43,000 (+) There is a net surplus of Rs 5, 43,000 in the balance of payments. This means, there will be an increase of reserves by this amount. Note: The transaction No.7 did not enter into the BOP Statement since this transaction does not involve any foreign country. The entire transaction has taken place in Indian rupees within India.

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Case Study: Prepare a BOP statement for France from the following data: 1. France export goods worth FFrs. 5000. 2. France import goods worth FFrs. 4000. 3. Expenditure of foreign tourist in France; FFrs. 2500. 4. France makes interest and dividend payments to foreigners; FFrs. 2000. 5. A France working in USA sends a cheque to his wife in Paris worth FFrs. 500. 6. A American Immigrant working in France remits money to his account in LA; FFrs. 1000 7. France Telecom invest in India; FFrs.4500. 8. IBM invests in France; FFrs.2000. 9. A France resident buys a German Treasury bond; FFrs.300. 10. A Swiss resident buys a France Treasury bond; FFrs.5000. 11. France borrows FFrs. 3800 for short-term. 12. A short-term loan advanced by BNP to a British resident; FFrs. 4000. Solution: Sr.no 1 2 3 4 5 6 7 8 9 10 5,000 2,000 300 500 1,000 4,500 2,500 2,000 Sources 5,000 4,000 Uses Nature Exports Imports Exports Imports Unilateral transfer Unilateral transfer FDI FDI Portfolio investment Portfolio investment

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11 12

---------3,800 18,800

------------

-------Short-term borrowings

11,800

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BOP Statement: A. Current Account Goods Accounts Exports: Rs. 7,500 (+) Imports: Rs. 6,000 (-) Balance: Rs.1, 500 (+) Invisible Accounts Payments Received: Rs. 500 (+) Payments Made : Rs. 1,000(-) Balance : Rs. 500 (-)

Current Account Balance: Rs. 1,000 (+) B. Capital Account Foreign Direct Investment Inflow : Rs. 2,000 (+) Outflow: Rs. 4,500 (-) Balance: Rs. 1,500 (-) Portfolio Investment Inflow : Rs. 5,000 (+) Outflow: Rs. 300 (-) Balance: Rs. 4,700 (+) Long-Term Capital Account: Rs. 3,200 (+) (Foreign Direct Investment + Portfolio Investment) Short-term borrowings Inflow : Rs. 3800 (+) Outflow: Nil Balance: Rs. 3,800 (+) Capital Account Balance: Rs. 7,000 (+) Overall Balance: Rs. 8,000 (+)

There is a net surplus of Rs 8,000 in the balance of payments. This means, there will be an increase of reserves by this amount. Note: The transaction No11 did not enter into the BOP Statement since this transaction does not involve any foreign country. The entire transaction has taken place in France currency within France.

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Prepare a BoP statement for France from the following data:

1. France imports goods worth FFr 4,000. 2. Expenditure of foreign tourists in France FFr 2,500. 3. France makes interest and dividend payments to Foreigners FFr 2,000. 4. A French working in USA sends a cheque to his wife worth FFr 500. 5. A Bangladeshi immigrant working in France remits money to his account in Dhaka FFr 1,000.

6. France Telecom invests in India FFr 4,500. 7. IBM invests in France FFrs 2,000. 8. A French resident buys a German treasury bond FFr 300. 9. A Swiss resident buys a French treasury bond worth FFr 5,000.

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Balance of Payments Account for France (Amounts in FFr) Credit (Inflow of Funds) Current Account Balance Import of Goods Exports of goods (Purchase made by foreign tourist) Payment of Interests and dividends Cash remittance by French working in U.S (Unilateral Transfer of Payments) Transfer of Payments (by Bangladeshi immigrant working in France) Investment Income 8,000 7,000 500 2,000 4,000 Debit (Outflow of Funds)

2,500

5,000

1,000

Total (1) Capital Account Balance Foreign investments by France in India Foreign Direct Investment (FDI) in France by IBM Investment Abroad Total (2) Total Balance (1+ 2)

4,500 2,000 300

2,000 10,000

4,800 11,800

Therefore Balance of Payment = Credit Debit = 10,000 11,800 = - 1800

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Hence there is deficit in balance of payment of France by 1800 FFr which is unfavourable.

Prepare a BOP statement for France from the following data: 1. France export goods worth FFrs. 5000. 2. France import goods worth FFrs. 4000. 3. Expenditure of foreign tourist in France; FFrs. 2500. 4. France makes interest and dividend payments to foreigners; FFrs. 2000. 5. A France working in USA sends a cheque to his wife in Paris worth FFrs. 500. 6. A American Immigrant working in France remits money to his account in LA; FFrs. 1000 7. France Telecom invest in India; FFrs.4500. 8. IBM invests in France; FFrs.2000. 9. A France resident buys a German Treasury bond; FFrs.300. 10. A Swiss resident buys a France Treasury bond; FFrs.5000. 11. France borrows FFrs. 3800 for short-term. 12. A short-term loan advanced by BNP to a British resident; FFr. 4000.

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Solution: Sr.no 1 2 3 4 5 6 7 8 9 10 11 12 5,000 ---------3,800 18,800 11,800 -----------2,000 300 500 1,000 4,500 2,500 2,000 Sources 5,000 4,000 Uses Nature Exports Imports Exports Imports Unilateral transfer Unilateral transfer FDI FDI Portfolio investment Portfolio investment -------Short-term borrowings

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BOP Statement: C. Current Account Goods Accounts Exports: Rs. 7,500 (+) Imports: Rs. 6,000 (-) Balance: Rs.1,500 (+) Invisible Accounts Payments Received: Rs. 500 (+) Payments Made : Rs. 1,000(-) Balance : Rs. 500 (-)

Current Account Balance: Rs. 1,000 (+) B. Capital Account Foreign Direct Investment Inflow : Rs. 2,000 (+) Outflow : Rs. 4,500 (-) Balance : Rs. 1,500 (-) Portfolio Investment Inflow : Rs. 5,000 (+) Outflow : Rs. 300 (-) Balance : Rs. 4,700 (+) Long-Term Capital Account: Rs. 3,200 (+) (Foreign Direct Investment + Portfolio Investment) Short-term borrowings Inflow : Rs., 3800 (+) Outflow : Nil Balance : Rs. 3,800 (+) Capital Account Balance: Rs. 7,000 (+) Overall Balance : Rs. 8,000 (+) There is a net surplus of Rs 8,000 in the balance of payments. This means, there will be an increase of reserves by this amount.
Note: The transaction No11 did not enter into the BOP Statement since this transaction does not involve any foreign country. The entire transaction has taken place in France currency within France.