Balance of Payment

In which sub-account and on which side of the Balance of Payment

account will foreign investment in India be recorded? Explain why?
What will be the effect of foreign investment on India’s exchange rate?
Explain the reason.
 We now begin our examination of the monetary aspects of international
economics, or international finance, and the commodity prices are
expressed in terms of domestic and foreign currency units.
 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.
 BOP may confirm trend in economy’s international trade and exchange rate
of the currency. This may also indicate change or reversal in the trend.
 This may indicate policy shift of the monetary authority (RBI) of the
country.
 The export of goods and services, as well as primary income, secondary income,
and capital transfers receivable from abroad are classified as credit transaction.
 whereas imports of goods and services, as well as primary income, secondary
income, and capital transfers payable to foreign residents are classified as debit
transactions.
 Net lending (+) from current- and capital-account transactions occurs when the
total credits exceed the total debits in the nation’s current and capital accounts.
 Net borrowing (−) from current- and capital- account transactions occurs
when the total debits exceed the total credits in the nation’s current and capital
accounts.
 The various components of a BOP statement

 Current Account
 Capital Account
 IMF
 SDR Allocation
 Errors & Omissions
 Reserves and Monetary Gold
Current Account
 BOP on current account refers to the inclusion of three balances of namely – Merchandise
balance, Services balance and Unilateral Transfer balance.
 It includes several sub-components:
 Goods Balance: This accounts for the value of physical goods (exports and imports) traded
between a country and its trading partners. It is often referred to as the trade balance.
 Services Balance: This component includes international transactions in services, such as
tourism, transportation, financial services, and business services.
 Income Balance: The income balance reflects earnings from investments, including income
received by residents from foreign investments (such as dividends and interest) and income
earned by foreign residents from investments within the country.
 Current Transfers: This sub-component includes unilateral transfers of money or goods
between countries, such as foreign aid, remittances from overseas workers, and grants.
 The current account, therefore, provides information about a country's trade balance (whether it
has a trade surplus or deficit) and its net income from international transactions.
Capital Account
 The capital account records all international transactions that involve a resident of the
country concerned with changing either his assets 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 includes:
 Foreign Direct Investment (FDI): The purchase or sale of physical assets, like factories
or businesses, by foreign entities in the country and vice versa.
 Portfolio Investment: Transactions involving financial assets like stocks and bonds,
typically involving non-controlling ownership.
 Other Investments: Transactions in financial assets and liabilities that do not fall into the
categories of FDI or portfolio investment, including loans and currency deposits.
 Capital Transfers: These are one-time transfers of ownership, such as debt forgiveness or
the transfer of ownership of fixed assets.
Capital Account
BOP is always in Balances
 The BoP is essentially a structured accounting system that ensures that the
accounting equation remains balanced at all times.
1. Double-Entry Accounting: The BoP follows the principles of double-entry
accounting, which is a fundamental accounting concept. In double-entry
accounting, every financial transaction has two equal and opposite entries—
one on the credit side and one on the debit side. This system ensures that the
accounting equation stays in balance.
2. Recording of International Transactions: When international transactions
occur, they are recorded in the BoP in a way that reflects their economic
impact on a country. These transactions are categorized into the current
account, capital account, depending on their nature. For example, exports are
recorded as a credit entry in the current account, while imports are recorded as
a debit entry.
3. Balance of Payments Identity: The BoP is governed by the balance
of payments identity, which is an accounting identity stating that the
sum of the current account balance, the capital account balance, must
always equal zero.
4. International Economic Equilibrium: From an economic
perspective, the BoP always balances because, in the absence of
errors and omissions, all international transactions involve an
exchange of economic value between countries. For every credit
(inflow) recorded in the BoP, there is a corresponding debit (outflow)
that represents the reciprocal transaction in another country.
5. Errors and Omissions: In practice, there may be some minor
discrepancies in the BoP due to data collection and reporting issues,
but these discrepancies are typically categorized as "errors and
omissions." These discrepancies are relatively small and do not
significantly affect the overall balance of the BoP.
India’s BOP
Disequilibrium in BOP
 Balance of Payments (BOP) disequilibrium refers to a situation where a
country's international transactions result in an imbalance between its receipts
and payments.
1. Trade Disequilibrium: A trade deficit occurs when a country imports more
than it exports, and a trade surplus occurs when it exports more than it
imports.
2. Current Account Disequilibrium: The current account includes the trade
balance along with income from abroad (such as interest, dividends, and
remittances) and unilateral transfers (gifts, grants, and foreign aid).
3. Capital Account Disequilibrium: Disequilibrium in the capital account can
result from fluctuations in capital flows, such as a sudden outflow of foreign
investment.
India’s Trade Deficit in last 10 years
Causes of Disequilibrium
Balance of Payments (BOP) disequilibrium can be caused by a variety of factors, both
internal and external to a country's economy.
 Trade Imbalances: various reasons, of trade imbalances including differences in
production costs, changes in exchange rates, and shifts in global demand and supply.
 Exchange Rate Movements: Exchange rate fluctuations can affect a country's BOP.
A depreciation of the domestic currency can make exports more competitive but can
also increase the cost of imports, potentially affecting the trade balance.
 Global Economic Conditions: Changes in the global economy can impact a country's
BOP. For example, a global recession can reduce demand for a country's exports,
leading to a trade deficit. Conversely, a strong global economy can boost demand for
exports, resulting in a trade surplus.
 Domestic Economic Factors: A country's domestic economic conditions, such as
inflation, interest rates, and income levels, can affect its BOP. High inflation, for
instance, may reduce a country's competitiveness by raising production costs.
 Interest Rates: Higher interest rates in one country may attract foreign capital,
causing a capital account surplus.
 Government Policies: Government policies related to trade, fiscal spending, and
monetary policy can impact a country's BOP.
 Speculative Capital Flows: Sudden inflows or outflows of speculative capital can
affect exchange rates and the financial account.
 External Shocks: External shocks such as natural disasters, geopolitical events, or
global financial crises can disrupt a country's BOP by affecting its trade, investment,
and financial flows.
 Terms of Trade: A decline in the terms of trade, where export prices fall relative to
import prices, can lead to a trade deficit.
 Capital Flight: Political instability or economic uncertainty can lead to capital flight,
where residents and foreign investors withdraw their capital from a country, causing
a sudden BOP crisis.
 Government Interventions: Central bank interventions in foreign exchange markets
to maintain a fixed exchange rate or defend the currency can impact the BOP by
affecting foreign exchange reserves.
 Structural Factors: Long-term structural issues within an economy, such as
inadequate infrastructure, an aging population, can contribute to persistent BOP
imbalances.
Method of correction of BOP disequilibrium
Correction of BOP
disequilibrium

Automatic Deliberate
correction measures

Monetary
measures Miscellaneous Trade measures

1. Foreign loans Export promotion

2. Incentives for
foreign investments 1. Abolition/reduction
1. Monetary
3. Tourism of export duties
contraction/ expansion
development 2. Export subsidies
2. Exchange control
4. Incentives for 3. Export incentives
foreign remittances
5.Import substitution Import control
Monetary Policy:
• Interest Rate Changes (for Deficit or Surplus Correction): Adjusting
interest rates can influence capital flows. Raising interest rates can attract
foreign capital and reduce imports, while lowering rates can stimulate
domestic demand and potentially increase imports.
 Exchange Rate Adjustment:
• Currency Depreciation (for Deficit Correction): A country with a BOP
deficit can allow its currency to depreciate in the foreign exchange market.
This can make its exports cheaper and imports more expensive, potentially
boosting exports and reducing imports.
• Currency Appreciation (for Surplus Correction): Conversely, a country
with a BOP surplus can allow its currency to appreciate. This can make
imports cheaper and exports more expensive, potentially reducing exports
and increasing imports.
 2. Trade Policies:
• Tariffs and Import Restrictions (for Deficit Correction):
Imposing tariffs or other import restrictions can reduce the
quantity of imports and promote domestic production, helping to
correct a trade deficit.
• Export Promotion (for Surplus Correction): Governments can
provide incentives to boost exports, such as export subsidies, tax
breaks, or marketing support.
Miscellaneous Measure
 Structural Reforms:
• Long-term Measures (for Structural Disequilibrium Correction): Addressing
structural issues in the economy, such as improving infrastructure, enhancing
competitiveness, and encouraging innovation, can help correct chronic BOP
imbalances.
 Negotiations and International Agreements:
• Bilateral or Multilateral Agreements (for Surplus or Deficit Correction):
Negotiating trade agreements or currency arrangements with other countries can
help rebalance the BOP. For example, a country with a surplus might agree to
increase imports from its trading partners.
 Foreign Aid and Assistance:
• Foreign Aid (for Deficit Correction): In the case of developing countries, foreign
aid and assistance can help finance deficits by providing additional financial
resources.
 Foreign Direct Investment (FDI):
• Encouraging FDI (for Deficit or Surplus Correction): Attracting foreign direct
investment can bring in capital and create jobs, potentially addressing BOP issues.
 Questions
 Where are borrowings from abroad recorded in the Balance of payment account
and why?
 The Balance of trade shows a deficit of Rs.300 crores. The value of exports
are Rs.500 crores. What is the value of imports?
 In which sub-account and on which side of the Balance of Payment account will
foreign investment in India be recorded? Explain why?
 What will be the effect of foreign investment on India’s exchange rate? Explain
the reason.
 Give examples of 4 invisible items of the Balance of payment account.
 A country export goods worth Rs. 600 crores, whereas, its imports amounted to
Rs. 700 uores. Calculate the volume of balance of trade and indicate its narue.
 Describe two methods to correct a disequilibrium in the Balance of Payment.
 Explain the difference between Balance of Trade and Balance of Payment, with
refernce to their componenet and implication.