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Subject Business Economics

Paper No and Title 5; Macroeconomic Analysis and Policy

Module No and Title 5; BALANCE OF PAYMENTS

Module Tag BSE_P5_M5

BUSINESS PAPER NO. : 5; MACROECONOMICS ANALYSIS AND POLICY

ECONOMICS MODULE NO. : 5; BALANCE OF PAYMENTS
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TABLE OF CONTENTS
1. Learning Outcomes

2. Introduction

3.Balance of Payments Account

3.1 Current Account

3.2 Capital Account

3.3 Errors and Omissions and Official Reserve Transactions

4. Balance of Payments Measurement in India

5. How is Current Account Deficit Financed?

6. Summary

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ECONOMICS MODULE NO. : 5; BALANCE OF PAYMENTS
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1. Learning Outcomes
After studying this module, you shall be able to

 Know the meaning of balance of payments

 Understand why countries maintain balance of payments accounts
 Learn about the components and structure of balance of payments account
 Understand why the balance of payments account must balance
 Learn how balance of payments account is recorded in India
 Learn how current account deficit may be financed

2. Introduction
As discussed in the earlier modules, the national income accounting framework of a nation
provides estimates of aggregate income and expenditure of a nation. Exports and imports of
goods and services are recorded within this framework. However, it does not give a complete
account of all the international economic transactions such as those involving real and financial
assets. A separate set of accounts are maintained by each country that record all international
transactions between the government and residents of a country and foreigners (including foreign
governments). These are known as the Balance of Payments (BOP) accounts. A thorough
understanding of BOP accounts is very important as the progress of each nation is increasingly
becoming dependent on how much it is integrated with the rest of the world.

The BOP account consists of two main components: Current Account and Capital Account. The
balance of payments account provides information on important aspects of a nation’s
international position, example, whether it is net debtor or a net creditor country. Such
information would be of interest to foreign investors, other trading countries and international
organizations. It is also useful for the government as it can formulate economic policies
accordingly. In what follows, these issues are discussed in detail.

3. Balance of Payments
Balance of Payments refers to a systematic record of a country’s economic transactions (both
trade and financial flows) with the rest of the world during a specific period (typically a year).
The BOP account has two main parts, the Current Account and the Capital Account, separated by
a line. Accordingly, the transactions are often referred to either as above the line (Current
Account transactions) or below the line (Capital Account transactions).

3.1 Current Account

The Current Account records transactions involving a country’s trade in goods and services
including factor services with the rest of the world and it records payments made to and received
from foreigners in this regard. Any transaction is recorded twice in the BOP Account. In general,
transactions involving the inflow of foreign exchange are recorded as a credit entry in the current

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account, with the corresponding debit entry appearing in the Capital Account. The Current
Account has three main components: the balance of trade in goods and services, net investment
income and net unilateral transfers. You may note that the transactions involving trade in
services, factor incomes and transfers are also referred to as Invisibles in the Current Account.
These are further discussed below:

1. The Balance of Trade in Goods and Services: the difference between exports and imports
of goods by a country is captured by balance of trade (often called merchandise trade
balance) in the Current Account. The balance of trade may be positive, negative or zero.
A positive balance of trade indicates that the country’s exports of goods exceed imports
and the country is said to have a surplus balance of trade in this case. When imports of
goods exceed exports, the country has a negative balance or trade deficit. The balance of
trade in services (part of invisibles) reflects the difference between a country’s service
exports and imports. It may also be positive or negative, depending on whether the
country is a net exporter or net importer of services. Services include shipping,
transportation, travel and tourism, banking, insurance, education, consulting and other
miscellaneous services such as (software).

As mentioned above, in the current account the value of exports is a credit (as the
exporters earn foreign exchange), representing an inflow of foreign exchange. While the
value of imports is a debit (as importers have to make payments in foreign exchange),
representing an outflow of foreign exchange. Movements in trade balance impact on the
demand and supply of foreign exchange with implications for the exchange rate
(especially under the flexible exchange rate regime).

2. Investment Income: The Indian residents may receive investment income, such as
dividends and interest, on the foreign assets they hold while foreign residents receive
investment income on the Indian assets they possess. The former is recorded as credit
while the latter is debit in BOP accounts. Example, dividend payments made by
multinational firms operating in India to their shareholders abroad would result in a
foreign exchange outflow and it would be recorded as a debit entry in the Current
Account. The net investment income from abroad is investment earnings from abroad by
Indians minus foreigner’s earnings from their assets based in India.

3. Unilateral Transfers: Overseas payments made without any quid pro quo such as
assistance by foreign governments during war or natural calamity (foreign aid), workers’
remittances (example, money sent by Indian workers employed abroad to their families in
India), personal gifts, donations etc. are recorded in the Current Account. The net
unilateral transfers are transfers received by Indians from abroad minus similar transfers
sent to foreigners from India. These transfers are generally negative for developed
countries such as the U.S. as it has very little restrictions on sending money out of the
country. Whereas, in many developing countries there is a net credit balance on unilateral
transfers, especially due to workers’ remittances which can be an important source of
foreign exchange earnings.

The balance on current account is the sum of the (a) balance on merchandise trade (b) balance on
invisibles (which comprises balance on services trade, net investment income and net transfers).
When total foreign exchange receipts on account of all the transactions recorded in the current

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account are greater than total payments, the country has a Current Account surplus. In case
foreign exchange payments exceed receipts, the country has a Current Account deficit.

It is interesting to note that a country could have a current account surplus even if it has a trade
deficit if net transfers from abroad are positive and extremely high. This could be true for many
countries that receive high transfers, for instance, India has one of the highest remittances
received from the rest of the world.

Using the national income identity we had learnt in the previous modules, we can show that when
a country’s aggregate income (GNP) exceeds its aggregate expenditure (C+I+G), it runs a current
account surplus (current account balance is positive).

GNP – (C+I+G) = (GDP+NFIA) – (C+I+G)

= [(C+I+G+X-M) +NFIA] – (C+I +G)
= (X-M) + NFIA
= Current Account Balance

The above identity indicates that a country with a current account deficit (surplus) is one for
which aggregate domestic absorption (C+I+G) exceeds (falls short of) aggregate income. A
country with a current account deficit is a net debtor as it has to borrow to bridge the gap between
income and expenditure. A country with current account surplus is a net lender. A current
account deficit may be financed by borrowing from the rest of the world or by reducing holding
of foreign assets.Financing of current account deficit is dealt with in detail in section 6 of this
Module.

3.2 Capital Account

The Capital Account of the Balance of Payments includes transactions below the line, as we have
mentioned above. Transactions involving cross-border purchase and sale of real and financial
assets are recorded in the Capital Account. All transactions are recorded twice, once as a credit
and once as a debit entry in the capital account. This captures the two aspects of each transaction.
For instance, purchase of a foreign asset by a domestic resident involves an asset import against
which there is a capital outflow (payment made by the domestic resident for the foreign asset).
The asset in question could be physical assets like land, factories, houses or financial assets like
stocks and bonds.

Broadly two types of capital flows are recorded in the capital account – debt creating and non-
debt creating flows. When domestic firms borrow from foreign banks, the country experiences a
debt creating capital inflow, as this loan has to be repaid at a future date. However, foreign firms
investing in the domestic country (example, foreign direct investment or FDI) involves a non-debt
creating capital inflow, as this does not create any commitment for repayment for the recipient
nation.

Another way of classifying capital flows is by the duration involved. For instance, foreign
institutional investors (FIIs) purchasing domestic stock, involves a short term capital inflow. Such
investment in company stocks and bonds by foreigners is referred to as foreign portfolio
investment. The FIIs may sell the shares and withdraw their funds at short notice. Such
withdrawal of foreign funds would involve a capital outflow. Typically, investment by foreign

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firms in country’s production sector involves longer term capital inflows that are not likely to be
withdrawn as fast as investment in the financial sector.

When capital inflows exceed capital outflows, the country has a capital account surplus. In the
reverse case, when outflows exceed inflows it has a capital account deficit.

3.3 Errors and Omissions and Official Reserve Transactions

In principle, as each transaction is recorded twice (once as a debit entry and once as a credit of the
equivalent amount) under the double entry system of bookkeeping, the balance of payment
always balances. However, in practice this never happens largely due to data availability
problems that arise due to the time lags involved in the international transactions. For instance,
data on exports may be collected at the time the goods are shipped from the country. However,
the payments for exports are made nine months later and may not be recorded in the BOP of that
year. Therefore, in order to balance the BOP account an item for errors and omissions is
included.

You may wonder about the above point. If the Balance of Payments always balances (allowing
for errors and omissions), then why do we talk about a country running BOP surplus or a BOP
deficit?

The BOP surplus or deficit refers to the sum of current account and capital account balances. In
case a country has a current account deficit (of say, $10,000), but a capital account surplus that is
larger in magnitude (say, $12,000), then it has a BOP surplus (of $2000). Similarly, when there is
a current account deficit and a capital account deficit (or a capital account surplus smaller in
magnitude than the current account deficit), the country experiences a BOP deficit.

To further understand the implications of a BOP surplus or deficit, note that the capital account
essentially includes two kinds of transactions:

1. Transactions among government agencies and private individuals; and

2. Buying and selling of foreign currency by the country’s central bank. These are recorded
separately and are known as the Official Reserve Transactions (ORT)

With a BOP surplus, there is a corresponding addition to the stock of foreign exchange reserves
maintained by the central bank. Such an addition to foreign exchange reserves appears with a
negative sign in the BOP, as it is equal in magnitude but opposite in sign to BOP surplus, hence
ensuring that overall the BOP is in balance. Similarly, when there is a BOP deficit, there is a
depletion of the central bank’s foreign exchange reserves (that appears with a positive sign in the
capital account of the BOP).

In this sense the overall balance of payments must balance. That is, the sum of balance in current
account, private capital account (including errors and omissions) and official reserve transactions
must always balance i.e. must be zero. That is,

BOP = Current Account + Capital Account + Official Reserve Transactions  0

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4. Balance of Payments Measurement in India

In India, Reserve Bank of India (RBI) is responsible for compiling and disseminating the BOP
statistics. These are maintained on the guidelines of International Monetary Fund (IMF).Balance
on current account is reported quarterly. However, merchandise trade balance is reported
monthly. The data on merchandise trade is collected from both Directorate General of
Commercial Intelligence and Statistics (DGCI&S) and RBI.

To illustrate the BOP account further, Table 1 presents India’s balance of payments from 2010-11
to 2012-13.

Table 1: Key Components of India’s Balance of Payments, 2010-13

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Source: RBI

As explained earlier, BOP consists of current account, capital account, errors and omissions and
change in foreign exchange reserves. The current account includes merchandise (exports and
imports) and invisibles. The invisibles consistsof services, incomes and transfers. The
merchandise imports are greater than exports (in the three years presented) indicating a negative
trade balance or a trade deficit.

The capital account includes foreign investment (both FDI and FII), loans (external assistance,
external commercial borrowing and trade credit) and banking capital (includes NRI deposits). All
the components of capital account appear with a positive sign, indicating a capital account
surplus. The capital account surplus is computed by summing the items from A to E.

The overall balance of payments is the sum of current and capital account (item V in Table 1). It
is positive in the year 2010-11 and 2012-13 while negative in 2011-12. The positive overall
balance has resulted in 2010-11 and 2012-13 as capital account surplus exceeds current account
deficit. As a result there is an increase in foreign exchange reserves by the same amount, which is
shown by a negative sign in Reserves (Item VII in Table 1).Now that we have understood the
working of BOP account let us know the options available for a country to finance its current
account deficit (Item III).

5. How is Current Account Deficit Financed ?

We have seen that a country has a negative current account balance or current account deficit
(CAD) when its aggregate income is less than its aggregate expenditure. The problem of
financing the CAD essentially refers to the ways in which the country bridges this gap between
aggregate income and expenditure.

A CAD by itself may not be a cause of concern if the underlying reason for it is linked to high
levels of spending on productive investments (I). Such investments are likely to enhance
productive capacity of the economy and hence create capacity to export and reduce the deficit in
the long run. However, if the CAD is high due to unproductive expenditure on consumption, this
may be problematic in the medium to long run.In this case, the CAD might lead to growing
international debt burden without creating any condition to repay such debt via foreign exchange
earnings.

You may note that financing of the CAD essentially refers to the composition of capital flows and
reserve transactions (recorded in capital account) that offset the CAD. CAD may be financed by
net capital inflow into the country in various forms:

1. Foreign Direct Investment (FDI) – the foreign exchange can move into the country when
multinational companies intend to expand operation in the country. This could be done by
establishing new subsidiaries or by acquisition of already existing domestic firms. This is
a long term stable source of capital inflows.

2. Foreign Portfolio Investment (FPI) – the foreign exchange can move in when financial
institutional investors such as mutual funds, pension firms or other financial entities make

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financial investments by purchasing bonds, equities or other such financial assets. These
are short term capital flows that may be withdrawn at a short notice. As such this is a
volatile type of capital inflow.

3. External Borrowing – to finance its CAD, the country may borrow from foreign
governments or international agencies like IMF, World Bank etc. However, excessive
borrowing may lead to a crisis situation wherein countries find it difficult to repay foreign
debt. Several European nations like Portugal, Ireland, Greece and Spain have faced an
external debt crisis in recent times.

4. Foreign Asset Reserves – the country may reduce its holding of foreign assets to finance
CAD. This is usually through the sale of foreign currency by the central bank from its
stock of reserves.

The current account deficit may be therefore financed by foreign direct investment, foreign
portfolio investment, borrowing externally or depleting the stock of foreign assets.

6. Summary
 Balance of Payments refers to a systematic record of a nation’s economic transactions
with the rest of the world during a specific period
 The Current Account records transactions involving exports and imports of goods and
services, investment income and unilateral transfers
 Balance of Trade includes only imports and exports while balance of payments is much
wider and includes all receipts and payments in current and capital account
 Transactions in the Capital Account involve purchase and sale of all kinds of assets such
as debt or equity for a short or long period such as foreign investment consisting of
foreign direct investment (FDI) and portfolio investment by foreign institutional investors
(FII), loans (external borrowing, external commercial borrowing or trade credit) and
banking capital as well as real assets
 The BOP account is based on the basic accounting principle in which each transaction is
recorded twice (both on credit and debit sides)
 In India, Reserve Bank of India (RBI) is responsible for compiling and disseminating the
statistics in BOP account
 The negative current account balance or current account deficit (CAD) may be financed
by foreign direct investment, foreign portfolio investment, borrowing externally or
reducing the stock of foreign assets

BUSINESS PAPER NO. : 5; MACROECONOMICS ANALYSIS AND POLICY

ECONOMICS MODULE NO. : 5; BALANCE OF PAYMENTS