The Balance of Payment , Balance of Payments Adjustments, BoP

Balance of Payment      BOP

BOP is an accounting of a country’s international transactions by individuals, firms and government agencies) for a specific time period (quarter or year)

Money coming in is a credit (b/c you sell domestic goods or assets)

Money going out is a debit (b/c you buy foreign goods or assets)

According to Kindleberger, balance of payments as “a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period of time.

” It thus follows that:

i) Balance of payments is a statement of systematic record of all economic transactions between one country and the rest of the world.

ii) It is a record pertaining to a period of time. Usually, it is an annual statement.

iii) It includes all transactions, current as well as capital.

Other characteristics of the balance of payment account are’

i) it is a way of listing receipts and payments in international transactions of a country.

ii) It adopts a double-entry book keeping system. It has two sides: debit and credit. Payments are

recorded on the debit side and receipts on the credit side.

iii). In the accounting sense, debit and credit will always balance each other.

iv) It contains two sets of account: (i) current account and (ii) capital account.

BOP is comprised of two major accounts

Current account – includes merchandise trade, services, interest and dividend income, and one-way transfers = CA.  Real and short-term transactions are recorded under current account.

Financial account – includes financial assets (stocks, bonds) and direct foreign investment (businesses, real estate). This account tracks U.S. owned assets abroad and foreign owned assets in the U.S. = FA. Capital Account records all financial and long­ term transactions.

 Account of the Balance of Payments /  Balance of Payments Statement

The balance of payment statement records all types of international transactions that a country consummates over a certain period of time.

The balance of payments is composed of two primary subaccounts, the Current Account and  the Financial/Capital Account. In addition, the Official Reserves Account tracks government currency transactions, and a fourth statistical subaccount, the Net Errors and Omission Account, is produced to preserve the balance in the BOP.

Current Account

The current account of the balance of payments records India’s total transactions, both, visible and invisible (i.e., merchandise, services and transfers) with the rest of the world.

Merchandise Exports and Imports: Merchandise exports include the sale of goods to foreign countries. Most of these transactions are on credit basis. All these transactions give rise to monetary claims on foreign  importing companies. These claims are credits. Contrary to these transactions, merchandise imports  include purchase of goods from foreign countries. Debit entries are made for these transactions as they rise to foreign exchange claims on the home country. These claims are debits.

Invisibles Exports and  Imports:  Invisibles include cost of services, income and transfer payments. The IMF Manual classifies invisible account into as many as 121 items while the Indian authorities classified into eight heads. They are: travel, transportation, insurance, investment income, government not included elsewhere, miscellaneous (receipts/payments for patents and royalties), transfer payments official and transfer payments private.

Invisible exports  include the sale of services to the foreigners like insurance, tourism, transportation, banking, financial services, salaries etc. Similarly, invisible exports also include interest and dividends received from the foreign countries. These items are the debits.

Invisible imports  include the purchase of services from the foreigners tike insurance, tourism, transportation, banking and financial services, payment of interest and dividend to the foreigners. These items are placed on the credit side of the balance of payments.

Balance of Payments: Items under Current Account

Credits                                                                                                  Debits

1 ) Merchandise Exports (Sale of Goods)                                1) Merchandise Imports (Purchase of Goods)

2) Invisible Exports (Sales of Services]                                    2) Invisible Imports (Purchase of Services)

i) Transport services sold abroad                                                  i) Transport services purchased from abroad

ii) Insurance services sold abroad                                                ii) Insurance services purchased from abroad

iii) Foreign tourists expenditure in the country                      iii) Tourists expenditure abroad

iv) Other services sold abroad                                                       iv) Other services purchased from abroad

v) Incomes received on loans and investments abroad      v) Income paid on loans and investments in the home                                                                                                                      country

Capital Account

The capital account represents transfers of money and other capital items and changes in the country’s foreign assets and liabilities resulting form the transactions recorded in the current account. Flows recorded in the capital account are divided into three sectors private, banking and official. The transactions with the IMF, SDR allocation by the IMF and movement in reserves are shown separately.

1) Private Capital: This item includes capital transactions of resident individuals, firms, privately owned non-financial corporate enterprises and non-bank financial enterprises, with non­residents including international institutions. Private capital is sub-divided into Long-term and Short-term.

i) Long-term

Credits cover mainly

a) Foreign investment in shares of Indian joint stock companies, both foreign controlled and non-foreign controlled,

b) Investment (including loans and overdrafts) by Head Offices abroad in their Indian branches

c) Repatriation/sale proceeds of Indian investments abroad,

d) Funds received from abroad for investment in real estate by non-residents (including diplomatic missions, etc., located in India),

e) Long-term loans received by private individuals/enterprises/institutions, other than banking institutions, in India, from foreign companies and official sources abroad. They also include commercial borrowings raised abroad by non-banking private sector entitles/financial institutions,

f) Repayments, by non-residents, of long-term loans obtained from private individuals, etc, in India, credits also cover non-cash inflow in the form of supply of plant and machinery by parent companies in exchange for issue of shares by the Indian companies as well as undistributed profits attributable to direct investors (notionally treated as investment income paid out and reinvested by the direct investor),

g) Deposits received from non-resident Indians into Non-Resident (External) Rupee [NR (E) R]Accounts and Foreign Currency Non-Resident (FCNR) Accounts and

h) Estimated portion of unclassified receipts allocated to capital account

Debits comprise generally repatriation/out flow of funds corresponding to items (a to c)  covered under credits Further, it also covers ‘

a) Long-term loans including deferred credits extended to non-residents by individuals and private institutions other than banking institutions.

b) Repayment of long-term loans/external commercial borrowings raised abroad, etc., corresponding to the item (e) under credits and

c) Repatriation of balances in [NR (E) R) and FCNR accounts on maturity. These outflows may include both principal and interest

d) Short-term: Private short-term capital receipts and payments cover transactions in the nature of short-term borrowings and repayments Short-term loans are loans with an original maturity of one year or less.

Credit – cover

a) Loans secured form foreigners.

b) Advance payment on deferred credit exports and

c) Miscellaneous capital receipts

Debits – cover

a) Loans repaid to foreigners and

b) Miscellaneous capital payments

2)  Banking Capital: This item covers changes in the foreign financial assets and liabilities of deposit money banks, comprising commercial banks, whether privately owned or state owned, and such co-operative banks which are authorized to deal in foreign exchange. There are five constituents of foreign financial assets and liabilities o.f deposit money banks and changes in these items are recorded in banking capital. The five items are recorded in banking capital.

.The five items are:

i) Foreign currency holdings: Foreign currency holdings comprise credit balances in the form of current accounts or fixed deposit accounts held by the ADs in India with their foreign branches or correspondents (NOSTRO accounts) and investments in foreign currency securities.

ii) Rupee overdrafts: Rupee overdrafts relate to the debit balances held by foreign branches or foreign banking institution with the ADs in India representing overdraft facilities granted by the latter

iii)  Foreign currency liabilities:  Foreign currency liabilities are the debit balances in the  accounts held by the  ADs  in India with their foreign branches and correspondents representing overdraft facilities obtained or loans taken by the ADs in India from their foreign branches or correspondents representing overdraft facilities obtained or loans taken by the ADs  in India from their foreign branches or correspondents.

iv) Rupee balances of non-resident: Rupee balances of non-resident official and semi-official institutions (excluding international institutions) held with the ADs in India.

v) Rupee liabilities on account of non-resident: Rupee liabilities on account of non-resident banks and correspondents relate to credit balances in the accounts with the Indian ADs held by foreign branches and correspondents.

Official Reserve Account

Official reserves are government owned assets. The official reserve account represents only purchases and sales by the central bank of the country (for example, The Reserve Bank of India). The changes in official reserves are necessary to account for the deficit or surplus in the balance of Payments. For example, if a country has a BOP deficit, the central bank will have to either run down its official reserve assets such as gold, foreign exchange and SDRs or borrow fresh from foreign central banks. However, if a country has a BOP surplus, its central bank will either acquire additional reserve assets from foreigners or retire some of its foreign debts.

Balance of Trade and Balance of Payments

There is a marked distinction between the concepts of balance of trade and balance of payments. Balance of trade refers to the merchandise account ot exports and imports only. Balance of payments is a broader term and it includes balance of trade. It is more comprehensive than the balance of trade. It includes all international economic transactions and items such as merchandise trade, services, banking, insurance, capital flows, gold buying and selling, etc.

Balance of Payments Disequilibrium

The balance of payments of a country is said to be in equilibrium when the demand for foreign  exchange is exactly equivalent to the supply of it. The balance of payments is in disequilibrium when there is either a surplus or a deficit in the balance of payments. When there is a deficit in the balance of payments, the demand for foreign exchange exceeds the demand for it.

Causes of Disequilibrium in the Balance of Payments

The various causes of disequilibrium in the balance of payments may be classified under three  heads:

1) Natural Factors: Natural calamities, such as, the failure of rains or the coming of floods may  easily cause disequilibrium in the balance of payments by adversely affecting agricultural and industrial production in the country. The exports may decline while the imports may go up, causing a discrepancy in the country’s balance of payments.

2) Economic Factors: The economic factors can be further subdivided under the following four sub­ heads:

i) Cyclical Fluctuations: Business fluctuations induced by the operation of the trade cycle may also cause disequilibrium in a country’s balance of payments. For example, if there occurs a business recession in foreign countries it may easily cause a fall in the exports and exchange earnings of the country concerned resulting in a disequilibrium in the balance of payments.

ii) Inflationary Spiral at Home: an inflationary rise in prices within the country may also produce disequilibrium in the balance of payments. The prices of export items may go up, causing a decline in the volume of exports from the country concerned. The inflationary spiral within the country may also result in an increase in the volume of imports.

iii) Capital Movements: The capital movements (if they happen to be on a large scale) can also cause  disequilibrium in  the balance of payments of a country. A massive inflow of foreign capital into a country is followed by an unfavorable balance of payments. A large outflow of capital on the other hand, is accompanied by a favorable balance of payments.

iv) Miscellaneous Factors: The changes in the tastes, habits, fashions of the people; the  discovery of new substitutes for exports; the development of alternative sources of supply, etc.. may also produce disequilibrium in the country’s balance of payments. For example, the invention of synthetic rubber led to a serious decline in the export of natural rubber from countries like Malaysia, Myanmar, etc., during and after the Second World War.

3) Political Factors:  The political factors may also produce serious disequilibrium in the country’s  balance of payments. For example, the existence of political instability may result in disrupting the productive apparatus within the country, causing a decline in exports and an increase in imports. Likewise, the payment of war reparations or indemnities may also cause serious disequilibrium in the country’s balance of payments. The imposition of heavy war reparations on Germany after the First World War produced a serious disequilibrium in its balance of payments.

Methods of Correcting Disequilibrium in the Balance of Payments

1) Monetary Policy: Monetary policy may be devised to correct a deficit in the balance of payments of a country The deficit occur because of high imports and low exports. This is to be reversed. In this regard, the country may adopt deflationary or dear money policy by raising the bank rate and restricting credit Under deflation, prices fall which makes exports attractive and imports relatively costlier. This eventually leads to a rise in exports and fall in imports.

2) Exchange Depreciation: By exchange depreciation is meant a decline in the rate of exchange of one country in terms of another. Suppose the Indian rupee exchanges for 30 cents of American currency. If India experiences an adverse balance of payments with regard to America, the Indian demand for American currency (Dollar) will rise. Consequently the price of dollar in terms of rupee will appreciate in its external value. Thus, the rate of exchange of Indian rupee in terms of . American dollar may change from Re.1 = 30 cents to Re.1 = 20 cents. Such a depreciation in the value of currency is what is called “exchange depreciation.”

3) Devaluation: It is an alternative to exchange depreciation. It is suitable under the present IMF System. Devaluation means official decrease in the external value of a currency in terms of  foreign currency or good or SDRs. Suppose 1$ = Rs.8 and if Indian Government puts it as 1 $ = Rs.1O.  it means a 25 percent devaluation of the Indian rupee in terms of the U.S. dollar. When a country has a persistent deficit in its balance of payments, it may devalue its currency with the permission of the IMF.

When a country’s currency is devalued, the impact would be relative cheapness of its exports to the foreigners and relative dearness of its imports. Consequently, export will rise and imports decline This will help removal of the deficits in the balance of payments. The success of devaluation, however, depends on certain conditions.

i) Elasticity of demand for the country’s exports should be greater than unity,

ii) Elasticity of supply of the country’s imports should be greater than unity,

iii) Devaluing the country’s terms of trade should not be exceedingly adverse, otherwise it will not gain  anything from trade,

iv) There should not be any retaliation from other countries, that is, other countries should not have corresponding devaluation that nullifies each other’s gain.

Moreover, these are the following drawbacks of devaluation:

i) Devaluation is the acknowledgment of a country’s economic weakness,

ii) It may induce inflationary tendencies in the domestic economy.

iii) it inflates the burden of debt servicing.

Iv) It involves a considerable time lag in creating its effects.

v) Its effect is general and drastic.

4)  Exchange  Control: Restrictions on the use of foreign exchange by the central bank is called “exchange control”. When exchange control is adopted, all the exporters have to surrender their foreign exchange earnings to the central bank. Under exchange control, the central bank releases foreign exchanges only for essential imports and conserves the rest of the balance. This is the most direct method of curbing imports.

5) Fiscal Policy: Fiscal policy is another method of correcting unfavorable balance of payments. Under budgetary provisions, tariff or import duties may be imposed so that import becomes dearer and the propensity to import is checked. As a result, imports are reduced and the balance of payments become favorable.

6) Import Quotas: Fixing of import quotas is another and perhaps a better device used for  correcting an adverse balance of payments. Under the quota system, the government may fix and  permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system deficit is reduced or eliminated and thereby the balance of payments position is improved.

7) Export Promotion: To correct disequilibrium in the balance of payments, it is necessary that  exports should be increased. Government may adopt export promotion programs for this purpose.  Export promotion program includes subsidies, tax concessions to exporters, marketing facilities,  incentives for exports, etc.