Balance of Payments

Meaning of Balance of Payments

• Balance of payments is a statement listing receipts and payments in international
transactions of a country.
• Balance of payments accounts are an accounting record of all monetary transactions
between a country and the rest of the world during a specific period of time.
• These transactions include payments for the country's exports and imports of goods,
services, financial capital, and financial transfers.
• Usually, the BOP is calculated every quarter and every calendar year.
• All trades conducted by both the private and public sectors are accounted for in the
BOP in order to determine how much money is going in and out of a country.
• The term ‘balance’ means that it is a balance sheet of receipts and payments having an
accounting balance.
Accounting Equilibrium
• It is based on the concept of double-entry book-keeping where credit balance shows
the receipts of foreign exchange from abroad and debit balance shows payments in
foreign exchange to foreign residents.
• If a country has received / earned foreign exchange, this is known as a credit, and if a
country has paid or given foreign exchange, the transaction is counted as a debit.
• Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities
(debits) should balance, but in practice this is rarely the case. Capital account + Current
account = 0
• Monetary value of exports (receipts from abroad) = credit transaction (+);
• Monetary value of imports (payments to foreigners) = debit transaction (-)
BOP Equilibrium
BOP Equilibrium occurs when a surplus or deficit is eliminated from the BOP.
Balanced BOP: Value of total receipts equals total payments.
BOP Disequilibrium occurs when the two sides of the flows differ in size.
Favorable BOP: Value of total receipts more than total payments
Adverse BOP: Value of total receipts less than total payments
Balance of Trade

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 • Balance of Trade is the difference between exports and imports.
• When value of exports > value of imports = surplus in BOT
• When value of imports > value of exports = deficit in BOT
International Transactions
• Payments received by a country
– Exports of goods
– Services provided to foreigners such as transportation
– Income received from investments in other countries
– Gifts received from foreign residents
– Aid from foreign governments or residents
– Borrowings from other countries
– Sale of assets to foreign residents
– Investment in the country by foreign residents
• Payments made by a country
– Import of goods
– Services received from foreign residents
– Income payable on investments made by foreigners in the country
– Gifts to foreign governments or residents
– Aid provided to foreign governments or residents
– Lending to foreigners
– Purchase of assets from foreign residents
– Investments made in other countries
Purpose of BOP
1. The BOP is an important indicator of pressure on a country’s foreign exchange rate,
and thus on the potential for a firm trading with or investing in that country to experience
foreign exchange gains or losses. Changes in the BOP may predict the imposition or
removal of foreign exchange controls.
2. Changes in a country’s BOP may signal the imposition or removal of controls over
payment of dividends and interest, license fees, royalty fees, or other cash disbursements
to foreign firms or investors.

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 3. The BOP helps to forecast a country’s market potential, especially in the short run. A
country experiencing a serious trade deficit is not likely to expand imports as it would if
running a surplus. It may, however, welcome investments that increase its exports.
Structure of Balance of Payments
• Receipts and payments are compartmentalized into two heads:
– Current account
– Capital account
– Errors & Omissions
• Official Reserves
Structure of Balance of Payments
CREDITS DEBITS
Current A/c: Current A/c:
• Exports of goods (Visible items) • Imports of goods (Visible items)
• Exports of services (Invisibles) • Imports of services (Invisibles)
• Unrequited receipts (gifts, • Unrequited payments (gifts, remittance,
remittances, indemnities, etc. from indemnities etc. to foreigners)
foreigners)

Capital A/c: Capital A/c:

• Capital receipts (Borrowings from • Capital payments (lending to, capital
abroad, capital repayments by, or repayments to, or purchase of assets
sale of assets to foreigners, increase from foreigners, reduction in stock of
in stock of gold and reserves of gold and reserves of foreign currency
foreign currency etc.) etc.)

1. Current Account Transactions: Records the receipts and payments of foreign exchange in
the following ways:
• Current account receipts
– Export of goods – effects the flow of foreign exchange into the country
– Invisibles
– Non-monetary movement of gold
• Current Account payments

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 – Import of goods – causes the flow of foreign exchange from the country
– Invisibles
– Non-monetary movement of gold
– Invisibles – include receipts and payments on account of
• Trade in services such as travel and tourism, transport, etc.
• Investment income, such as, interest and dividend, etc. and
• Unilateral transfers include pension, remittances, gifts and other
transfers for which no specific services are rendered. They are unilateral
transfers because they represent flow of funds only in one direction, that
is, the direction of payment.
• Movement of gold – may be monetary or non-monetary.
– Monetary movement is the sale or purchase that influences the international
monetary reserves.
– Non-monetary sale and purchase of gold is done for industrial purposes that is
shown in the current account.
• If the credit side of the current account is greater than the debit side – there is a surplus
balance.
• If the debit side of the current account is greater than the credit side – there is a deficit
balance.
• The current account shows the net amount a country is earning balance of trade (net
earnings on exports minus payments for imports), factor income (earnings on foreign
investments minus payments made to foreign investors) and cash transfers.
• So, BOP on current account refers to the inclusion of 3 balances:
– Merchandise balance,
– Services balance and
– Unilateral Transfer balance (gifts)

• Where, CA: current account, X and M: export and import of goods and services
respectively, NY: net income from abroad; NCT: net current transfers - The net value of
the balances of visible trade and of invisible trade and of unilateral transfers defines the
balance on current account.

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 • BOP on current account is also referred to as Net Foreign Investment because the sum
represents the contribution of Foreign Trade to GNP.
Structure of Current Account
Transactions Credit Debit Net Balance
1. Merchandise Export Import -
2. Foreign Travel Earning Payment -
3. Transportation Earning Payment -
4. Insurance (Premium) Receipt Payment -
5. Investment Income Dividend Receipt Dividend Payment -
6.Government (purchase Receipt Payment -
of goods & services)
Current A/C Balance - - Surplus (+) or Deficit (-)

2. Capital Account Transactions

• 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.
• Capital account receipts and payments comprise long-term and short-term inflow and
outflow of funds.
• Credit side records the official and private borrowing from abroad net of payments,
direct and portfolio investment and short-term investments into the country. It records the
bank balances of the non-residents held in the country.
• Debit side includes dis-investment of capital invested into the country, the country’s
investment abroad, loans given to a foreign government or a foreign party and the bank
balances held abroad.
• Long-term transactions involve maturity periods of over 1 year (an individual buying a
long term government bond in another country).
• Long term capital movement includes:
– Investments in shares, bonds, physical assets, etc.
– Amortization (repayment) of capital

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 • Short-term flows are effected for 1 year or less (a firm or individual that holds a bank
account with another country and increases its balance in that account).
• Short term capital movement includes:
– Purchase of short term securities
– Speculative purchase of foreign currency
– Cash balances held by foreigners
– Net balance of current account
Various Forms of Capital Account Transactions
• Direct investment is the act of purchasing an asset and the same time acquiring control
of it. Ex: The acquisition of a firm resident in one country by a firm resident.
• Portfolio investment by contrast is the acquisition of an asset that does not give the
purchaser control. Ex: Purchase of shares in a foreign company or of bonds issued by a
foreign government or Loans made to foreign firms or governments come into the same
broad category.
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.
3. Official Reserves Account
• Official reserves are held by the monetary authorities of a country.
• Reserves are held in 3 forms: in foreign currency, usually but always the US dollar, as
gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF.
• Foreign currency assets are normally held in the form of balances with foreign central
banks and investment in foreign government securities.
• 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.
• If the overall balance of payments is surplus, the surplus amount adds to the official
reserves account but if the overall balance of payments is deficit, the official reserves
account is debited by the amount of deficit.