Balance of Payments (BoP)

IF & Trade
Batch 2010
 syllabus
• Balance of Payments
• International Monetary System
• An overview of International Financial
Markets
• Exchange Rate Determination and
Forecasting
BOP
 BOP
– http://rbidocs.rbi.org.in/rdocs/Content/docs/FS
BPS3031_Full.xls
 National Income Accounting
• GDP: National Spending = National Income
– Y=C+I+G+X–M
– Y = GDP; C = Consumption; I = Physical Investment; G =
Government Spending; X = Exports; M = Imports
– C + I + G = Domestic Absorption (spending on domestic output)
– (X – M) = Trade Balance = Net Exports
• Trade Balance = Nat’l Income less Domestic Absorption
– X – M = Y – (C + I + G)
• Trade Balance = Net Domestic Saving
– Y = C + Saving + Taxes = C + I + G + X – M
– X – M = (S – I) + (T – G)
– Trade Imbalances must be met with International Borrowing or
Lending, i.e., trade deficit  borrow from rest of world.
• Note  No Causation Implied!
 BOP
• The balance of payments of a country is a
systematic accounting record of all
economic transactions during a given
period of time between residents of the
country and residents of foreign countries
– Flow
 Balance of Payments
 The BOP is a statistical record of the flow of
all of the payments between the residents of
a country and the rest of the world in a given
year.
 Transactions are recorded on the basis of
double entry bookkeeping – by definition it
has to balance.
 Every “source” must have a “use”.

 The two main components are:

 Current Account
 Capital/Financial Account
 Accounting Principles in BOP
Capital Inflow
Sources of FX

CREDIT
Capital Outflow

Uses of FX

DEBIT
 Accounting Principles
1. Any transaction resulting in a payment to foreigners is
entered in the BOP accounts as a debit and is given a
negative sign.
2. Any transaction resulting in a receipt from foreigners is
entered as a credit and given a positive sign.
3. Current Account records transactions involving exports
and imports of goods and services
4. Capital Account records transactions involving the
purchase and sale of assets.
5. Double-Entry book keeping: Every international
transaction automatically enters twice, once as a credit
and once as a debit.
 Examples of Transactions
 Credit Transactions (+ve):
 Provision of goods and services to non-residents
 Income receivable from non-residents
 A decrease in foreign financial assets
 An increase in foreign financial liabilities
 Debit Transactions (-ve):
 Purchase of goods & services from non-residents
 Income payable to non-residents
 An increase in foreign financial assets
 A decrease in foreign financial liabilities
 Balance of Payments
• Record of Payments to & Receipts from
Foreign Entities
– Double-entry bookkeeping system.
• Every transaction has two entries – a credit (+)
and a debit (-)!
– Payment = Debit (-)
– Receipt = Credit (+)
– Multiple Accounts
• Current Account (CA) and Capital Account (KA)
– Is a summary (net) record of flows, not stocks
 1. Travel

BOP 2. Transportation
3. Insurance
a. Services 4. Govt not
Current account eslewhere
specified
Merchandise 5. miscellaneous

Invisibles b. Transfers Official

Private

c. income
1. Investment
income
2. Compensation to
Employees
Capital account
 BOP
r t f olio +
Current Account irec t; P o
a: D
nIndi
1. I
Capital Account 1. Foreign b r oad
2. A B anks I
Investments cial ties, NR
er
2. Loans (a+b-c) C omm , liabili
a. External a. s s ets
(a s its)
o
Assistance ( by 3. Banking capital dep
India, to India)
4. Rupee Debt o t hers
b.
b. Commercial Service
Borrowing (MT+LT)
5. Other Capital
c. Short term
Balance of Payments
 Current Account (CA)
 This is record of a country’s trade in goods and
services in the current period.
CA = Exports (X) – Imports (M)

 It is divided into 4 sub-categories:

 Goods trade
 Services trade
 Income
 Current transfers

 The sum of the four sub-categories = CA balance

 Capital Account (KA)
 This includes all short- and long-term
transactions pertaining to financial assets.
KA = Capital Inflow (cr) – Capital outflow
(dr)
 The two main components:
 Capital account.
 Financial account (direct, portfolio, other).

 KA balance = Sum of capital account and

financial account.
 Official Reserves
 Records the purchase or sale of official reserve assets
by the central bank. These assets include
 Commercial paper, Treasury bills and bonds
 Foreign currency
 Money deposited with the IMF
 This account shows the change in foreign exchange
reserves held by the central bank.
The Balance of
 Since the BOP must balance Payments Identity

CA + KA + RFX = 0
 CA + KA = – RFX
 For floating rate regime countries, such as the U.S., official
reserves are relatively unimportant.
 Statistical Discrepancy (E&O)
 The identity CA + KA = – RFX assumes that all
transactions are measured accurately.

 Inaccurate recording of transactions (errors & omissions),

results in the above equality not holding. For BOP to
balance,
CA + KA + E&O = – RFX
 Assuming changes in official reserves, errors are
approximately zero:
Current Account = (–) Capital Account
 This will hold approximately for floating rate countries
 Country A exported 500 worth
goods to country B
B
d in The balance in Exporter A
i
d pa country is an asset for Country
n
ya A and a liability for B Country
r enc
r
cu
inB
ice y
o
Inv rrenc BOP country A
cu
Country A Exporter gets his bank Cu.A/c Cr Dt
account credited with a bank in B
country Merchandise Ex 500
Cap. a/c
Normal a/c
Up in claims on 500
a Foreign Bank
Anchor the a/c
entry on claims
 Exchanged 300 worth Leather
goods for crude oil
BOP country A
Cu.A/c Cr Dt
Merchandise Ex 300
Merchandise Imports 300
Cap. a/c
 A bank in country A purchases B country Govt
securities and pays by drawing its correspondent
bank a/c in B country
BOP country A
Cu.A/c Cr Dt

Cap. a/c
Up in Foreign Bank holdings 200

Fall in Foreign Bank 200

deposits
 A country gifts medical supplies,
blankets..worth 150
BOP country A
Cu.A/c Cr Dt
Merchandise Ex 150
Unrequited transfers 150
Cap. a/c
 country A resident makes a gift of 50 in A’s currency to a
charitable organisation in B

BOP country A
Cu.A/c Cr Dt
Unrequited transfers 50

Cap. a/c
Increase in Foreign 50
Liabilities
 Example Transactions
• Record transactions in the following accounts
– CA: A = merchandise; B = services; C = invest. income; D =
Unilateral Transfers
– KA: E = Change in U.S. claims on foreign assets; F = Change in
foreign claims on U.S. assets
• U.S. firm sells $1m wheat to Romania, paid for out of
Romanian-owned deposit account in U.S.
– A (+), F(-):
• merchandise export is credit
• decrease in foreign-owned dollar deposits = K-out = decreased foreign
claims on U.S.
• U.S. tourist spends DM10,000 deposit in German bank while
traveling in Germany
– B(-), E(+)
• tourist spending abroad is service import ~ a debit
• decrease in U.S. claims on foreigners ~ K-in
 Example Transactions, cont.
• U.S. citizen receives DM10k interest payment from German bonds,
deposits in German bank
– C (+), E(-)
• U.S. citizen converts DM to US$ at German Bank
– E (+), F(-)
• debit = K-out = decrease foreign claims on U.S. (they gave up $)
• credit = K-in = decrease in U.S. claims on foreigners (we gave up DM)
• U.S. Bank loans US$ to German Bank
– F(+), E(-)
• debit = K-out = increase in U.S. claims on foreigner (future debt payments)
• credit = K-in = increase in foreign claims on U.S. (acquire $)
• German resident sells U.S Government Bond to French resident
– does not show on U.S. Balance of Payments!
• U.S. charity donates medicine to Nicaragua
– A (+), D(-): merchan. export, paid for by “gift” (unilateral transfer)
 Valuation and Timing
• Market Prices – willingness of parties
• F.O.B. Vs. C.I.F – former is preferred
• India’s exports are valued @ fob; imports
are cif
• Translation
• Timing : exports are recorded when
cleared by customs, imports when
payment is made - conventions
 Balance in BOP
• “imbalance” refers to disequilibrium
• Autonomous transactions arising from
normal business
• Accommodating transactions undertaken
with the motive of settling the imbalances
– funding deficits arising out of autonomous
transactions
 Balance in BOP
• Trade balance
• Balance in Goods & services
• Current account Balance
• Balance on CA and LT capital
 BOP in Total

 A surplus in the BOP implies that the demand for

the country’s currency exceeded the supply and
that the government should allow the currency
value to increase – in value – or intervene and
accumulate additional foreign currency reserves
in the Official Reserves Account.
 A deficit in the BOP implies an excess supply of
the country’s currency on world markets, and the
government should then either devalue the
currency or expend its official reserves to support
its value.
 Country faces current account
deficit…
• Policy shift by Govt to increase short term
interest rates to attract short term capital
inflow to prevent depreciation of currency
•Tighten credit & money supply and
make it difficult for domestic banks and
firms to borrow the home currency to
invest abroad; force exporters realise
export earnings quickly & bring it home
 INTERLINKAGES IN FINANCIAL
MARKETS
Cap Money Market Bullion
Market
inflation
interest rate currency

exchange rate

Commodity derivatives
 Balance in BOP
• Corporate Finance Managers monitor the
data on a regular basis to understand how
pressures in international market will
impact their firm in short term or long term
 Interpretation of Deficit and
Surplus
• This is a difficult issue. Ever wonder why economics
is called a “dismal science”? An account deficit
theoretically means that foreign goods are more
competitive and that perhaps national industries
aren’t making competitive products, which could
then signal recession, depression, or closure of
economies or business firms .
• A surplus, could theoretically mean there is excess
demand, that could trigger inflation and eventual
economic slowdown.
 Interpretation: Does it matter?
• Another group of people believe the
interpretations of deficit and surplus are
only good for politicians. They believe that
with globalization, the older interpretations
of deficit and surplus are becoming
meaningless.
 BOP & Macroeconomic Variables

A nation’s balance of payments

interacts with nearly all of its key
macroeconomic variables.
Interacts means that the BOP affects
and is affected by such key
macroeconomic factors as:
– Gross Domestic Product (GDP)
– Exchange rate
– Interest rates
– Inflation rates
 BOP & Exchange Rates

A country’s BOP can have a significant

impact on the level of its exchange rate
and vice versa.
The relationship between the BOP and
exchange rates can be illustrated by
use of a simplified equation that
summarizes the BOP (see next slide).
 BOP & Exchange Rates

(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:
X = exports of goods and services
Current Account
M = imports of goods and servicesBalance
CI = capital inflows Capital Account
CO = capital outflows Balance
FI = financial inflows Financial Account
FO = financial outflows Balance
FXB = official monetary reserves
 BOP & Exchange Rates

Fixed Exchange Rate Countries

– Under a fixed exchange rate system, the
government bears the responsibility to
ensure that the BOP is near zero.
Floating Exchange Rate Countries
– Under a floating exchange rate system,
surpluses/deficits influence exchange rate.
 Trade Balances & Exchange Rates

 A country’s import and export of goods and

services is affected by changes in exchange
rates.
 The transmission mechanism is in principle
quite simple: changes in exchange rates
change relative prices of imports and exports,
and changing prices in turn result in changes
in quantities demanded through the price
elasticity of demand.
 Theoretically, this is straightforward, in reality
global business is more complex.
Trade Balances & Exchange Rates
Thank You