A REPORT ON

BALANCE OF PAYMENTS

CONCEPT QUESTIONS
BALANCE OF PAYMENTS
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.
- Reserve Bank of India
The above definition can be summed up as following: - Balance of Payments is the summary
of all the transactions between the residents of one country and rest of the world for a given
period of time, usually one year.
The definition given by RBI needs to be clarified further for the following points:
A.

Economic Transactions

An economic transaction is an exchange of value, typically an act in which there is transfer of

title to an economic good the rendering of an economic service, or the transfer of title to
assets from one economic agent (individual, business, government, etc) to another. An
international economic transaction evidently involves such transfer of title or rendering of
service from residents of one country to another. Such a transfer may be a requited transfer
(the transferee gives something of an economic value to the transferor in return) or an
unrequited transfer (a unilateral gift). The following are the basic types of economic
transactions that can be easily identified:
1.

Purchase or sale of goods or services with a financial quid pro quo cash or a
promise to pay. [One real and one financial transfer].

2.

Purchase or sale of goods or services in return for goods or services or a barter

transaction. [Two real transfers].

3.

An exchange of financial items e.g. purchase of foreign securities with payment in

cash or by a cheque drawn on a foreign deposit. [Two financial transfers].

4.

A unilateral gift in kind [One real transfer].

5.

A unilateral financial gift. [One financial transfer].

B.

Resident

The term resident is not identical with citizen though normally there is a substantial
overlap. As regards individuals, residents are those individuals whose general centre of
interest can be said to rest in the given economy. They consume goods and services;
participate in economic activity within the territory of the country on other than temporary
basis. This definition may turnout to be ambiguous in some cases. The Balance of Payments
Manual published by the International Monetary Fund provides a set of rules to resolve
such ambiguities.
As regards non-individuals, a set of conventions have been evolved. E.g. government and
non profit bodies serving resident individuals are residents of respective countries, for
enterprises, the rules are somewhat complex, particularly to those concerning unincorporated
branches of foreign multinationals. According to IMF rules these are considered to be
residents of countries in which they operate, although they are not a separate legal entity from
the parent located abroad.
International organisations like the UN, the World Bank, and the IMF are not considered to
be residents of any national economy although their offices are located within the territories
of any number of countries.
To certain economists, the term BOP seems to be somewhat obscure. Yeager, for example,
draws attention to the word payments in the term BOP; this gives a false impression that the
set of BOP accounts records items that involve only payments. The truth is that the BOP
statements records both payments and receipts by a country. It is, as Yeager says, more
appropriate to regard the BOP as a balance of international transactions by a country.
Similarly the word balance in the term BOP does not imply that a situation of comfortable
equilibrium; it means that it is a balance sheet of receipts and payments having an accounting
balance.
Like other accounts, the BOP records each transaction as either a plus or a minus. The general
rule in BOP accounting is the following:a)

If a transaction earns foreign currency for the nation, it is a credit and is recorded as
a plus item.

b)

If a transaction involves spending of foreign currency it is a debit and is recorded as

a negative item.

The BOP is a double entry accounting statement based on rules of debit and credit similar to
those of business accounting & book-keeping, since it records both transactions and the
money flows associated with those transactions. Also in case of statistical discrepancy the
difference amount is adjusted with errors and omissions account and thus in accounting sense
the BOP statement always balances.
The various components of a BOP statement are:
A.
B.
C.
D.
E.
F.

Current Account
Capital Account
IMF
SDR Allocation
Errors & Omissions
Reserves and Monetary Gold

BALANCE OF TRADE
Balance of trade may be defined as the difference between the value of goods and services
sold to foreigners by the residents and firms of the home country and the value of goods and
services purchased by them from foreigners. In other words, the difference between the value
of goods and services exported and imported by a country is the measure of balance of trade.
If two sums (1) value of exports of goods and services and (2) value of imports of goods and
services are exactly equal to each other, we say that there is balance of trade equilibrium or
balance; if the former exceeds the latter, we say that there is a balance of trade surplus; and if
the later exceeds the former, then we describe the situation as one of balance of trade deficit.
Surplus is regarded as favourable while deficit is regarded as unfavourable.
The above mentioned definition has been given by James. E. Meade a Nobel Prize British
Economist. However, some economists define balance of trade as a difference between the
value of merchandise (goods) exports and the value of merchandise imports, making it the
same as the Goods Balance or the Balance of Merchandise Trade. There is n doubt that
the balance of merchandise trade is of great significance to exporting countries, but still the
BOT as defined by J. E. Meade has greater significance.

Regardless of which idea is adopted, one thing is certain i.e. that balance of trade is a national
injection and hence it is appropriate to regard an active balance (an excess of credits over
debits) as a desirable state of affairs. Should this then be taken to imply that a passive trade
balance (an excess of debits over credits) is necessarily a sign of undesirable state of affairs in
a country? The answer is no. Because, take for example, the case of a developing country,
which might be importing vast quantities of capital goods and technology to build a strong
agricultural or industrial base. Such a country in the course of doing that might be forced to
experience passive or adverse balance of trade and such a situation of passive balance of
trade cannot be described as one of undesirable state of affairs. This would therefore again
suggest that before drawing meaningful inferences as to whether passive trade balances of a
country are desirable or undesirable, we must also know the composition of imports which
are causing the conditions of adverse trade balance.

BALANCE OF CURRENT ACCOUNT

BOP on current account refers to the inclusion of three balances of namely Merchandise
balance, Services balance and Unilateral Transfer balance. In other words it reflects the net
flow of goods, services and unilateral transfers (gifts). The net value of the balances of visible
trade and of invisible trade and of unilateral transfers defines the balance on current account.
BOP on current account is also referred to as Net Foreign Investment because the sum
represents the contribution of Foreign Trade to GNP.
Thus the BOP on current account includes imports and exports of merchandise (trade
balances), military transactions and service transactions (invisibles). The service account
includes investment income (interests and dividends), tourism, financial charges (banking and
insurances) and transportation expenses (shipping and air travel). Unilateral transfers include
pensions, remittances and other transfers for which no specific services are rendered.
It is also worth remembering that BOP on current account covers all the receipts on account
of earnings (or opposed to borrowings) and all the payments arising out of spending (as
opposed to lending). There is no reverse flow entailed in the BOP on current account
transactions.

BASIC BALANCE
The basic balance was regarded as the best indicator of the economys position vis--vis other
countries in the 1950s and the 1960s. It is defined as the sum of the BOP on current account
and the net balance on long term capital, which were considered as the most stable elements
in the balance of payments. A worsening of the basic balance [an increase in a deficit or a
reduction in a surplus or even a move from the surplus to deficit] was seen as an indication of
deterioration in the [relative] state of the economy.
The short term capital account balance is not included in the basic balance. This is perhaps
for two main reasons:
a)

Short term capital movements unlike long term capital movements are relatively
volatile and unpredictable. They move in and out of the country in a period of less than a
year or even sooner than that. It would therefore be improper to treat short term capital
movements on the same footing as current account BOP transactions which are extremely
durable in nature. Long term capital flows are relatively more durable and therefore they
qualify to be treated along side the current account transactions to constitute basic
balance.

b)

In many cases, countries dont have a separate short term capital account as they
constitute a part of the Errors and Omissions Account.

A deficit on the basic balance could come about in various ways, which are not mutually
equivalent. E.g. suppose that the basic balance is in deficit because a current account deficit is
accompanied by a deficit on the long term capital account. The long term capital outflow will,
in the future, generate profits, dividends and interest payments which will improve the
current account and so, ceteris paribus, will reduce or perhaps reduce the deficit. On the other
hand, a basic balance surplus consisting of a deficit on current account that is more than
covered by long term borrowings from abroad may lead to problems in future, when profits,
dividends etc are paid to foreign investors.

THE OFFICIAL SETTLEMENT CONCEPT

An alternative approach for indicating, a deficit or surplus in the BOP is to consider the net
monetary transfer that has been made by the monetary authorities is positive or negative,
which is the so called settlement concept.
If the net transfer is negative (i.e. there is an outflow) then the BOP is said to be in deficit, but
if there is an inflow then it is surplus. The basic premise is that the monetary authorities are
the ultimate financers of any deficit in the balance of payments (or the recipients of any
surplus). These official settlements are thus seemed as the accommodating item, all other
being autonomous.
The monetary authorities may finance a deficit by depleting their reserves of foreign
currencies, by borrowing from the IMF or by borrowing from other foreign monetary
authorities. The later source is of particular importance when other monetary authorities hold
the domestic currency as a part of their own reserves. A country whose currency is used as a
reserve currency (such as the dollars of US) may be able to run a deficit in its balance of
payments without either depleting its own reserves or borrowing from the IMF since the
foreign authorities might be ready to purchase that currency and add it to its own reserves.
The settlements approach is more relevant under a system of pegged exchange rates than
when the exchange rates are floating.
THE CAPITAL ACCOUNT
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.
It is often useful to make distinctions between various forms of capital account transactions.
The basic distinctions are between private and official transactions, between portfolio and
direct investment and by the term of the investment (i.e. short or long term). The distinction
between private and official transaction is fairly transparent, and need not concern us too
much, except for noting that the bulk of foreign investment is private.
Direct investment is the act of purchasing an asset and the same time acquiring control of it
(other than the ability to re-sell it). The acquisition of a firm resident in one country by a firm
resident in another is an example of such a transaction, as is the transfer of funds from the

parent company in order that the subsidiary company may itself acquire assets in its own
country. Such business transactions form the major part of private direct investment in other
countries, multinational corporations being especially important. There are of course some
examples of such transactions by individuals, the most obvious being the purchase of the
second home in another country.
Portfolio investment by contrast is the acquisition of an asset that does not give the purchaser
control. An obvious example is the purchase of shares in a foreign company or of bonds
issued by a foreign government. Loans made to foreign firms or governments come into the
same broad category. Such portfolio investment is often distinguished by the period of the
loan (short, medium or long are conventional distinctions, although in many cases only the
short and long categories are used). The distinction between short term and long term
investment is often confusing, but usually relates to the specification of the asset rather than
to the length of time of which it is held. For example, a firm or individual that holds a bank
account with another country and increases its balance in that account will be engaging in
short term investment, even if its intention is to keep that money in that account for many
years. On the other hand, an individual buying a long term government bond in another
country will be making a long term investment, even if that bond has only one month to go
before the maturity. Portfolio investments may also be identified as either private or official,
according to the sector from which they originate.
The purchase of an asset in another country, whether it is direct or portfolio investment,
would appear as a negative item in the capital account for the purchasing firms country, and
as a positive item in the capital account for the other country. That capital outflows appear as
a negative item in a countrys balance of payments, and capital inflows as positive items,
often causes confusions. One way of avoiding this is to consider that direction in which the
payment would go (if made directly). The purchase of a foreign asset would then involve the
transfer of money to the foreign country, as would the purchase of an (imported) good, and so
must appear as a negative item in the balance of payments of the purchasers country (and as
a positive item in the accounts of the sellers country).
The net value of the balances of direct and portfolio investment defines the balance on capital
account.

ACCOMMODATING & AUTONOMOUS CAPITAL FLOWS

Economists have often found it useful to distinguish between autonomous and
accommodating capital flows in the BOP. Transactions are said to Autonomous if their value
is determined independently of the BOP. Accommodating capital flows on the other hand are
determined by the net consequences of the autonomous items. An autonomous transaction is
one undertaken for its own sake in response to the given configuration of prices, exchange
rates, interest rates etc, usually in order to realise a profit or reduced costs. It does not take
into account the situation elsewhere in the BOP. An accommodating transaction on the other
hand is undertaken with the motive of settling the imbalance arising out of other transactions.
An alternative nomenclature is that capital flows are above the line (autonomous) or below
the line (accommodating). Obviously the sum of the accommodating and autonomous items
must be zero, since all entries in the BOP account must come under one of the two headings.
Whether the BOP is in surplus or deficit depends on the balance of the autonomous items.
The BOP is said to be in surplus if autonomous receipts are greater than the autonomous
payments and in deficit if vice a versa.
Essentially the distinction between both the capital flow lies in the motives underlying a
transaction, which are almost impossible to determine. We cannot attach the labels to
particular groups of items in the BOP accounts without giving the matter some thought. For
example a short term capital movement could be a reaction to difference in interest rates
between two countries. If those interest rates are largely determined by influences other than
the BOP, then such a transaction should be labelled as autonomous. Other short term capital
movements may occur as a part of the financing of a transaction that is itself autonomous
(say, the export of some good), and as such should be classified as accommodating.
There is nevertheless a great temptation to assign the labels autonomous and
accommodating to groups of item in the BOP. i.e. to assume, that the great majority of trade
in goods and of long term capital movements are autonomous, and that most short term
capital movements are accommodating, so that we shall not go far wrong by assigning those
labels to the various components of the BOP accounts. Whether that is a reasonable
approximation to the truth may depend in part on the policy regime that is in operation. For
example what is an autonomous item under a system of fixed exchange rates and limited

capital mobility may not be autonomous when the exchange rates are floating and capital may
move freely between countries.

BALANCE OF INVISIBLE TRADE

Just as a country exports goods and imports goods a country also exports and imports what
are called as services (invisibles). The service account records all the service exported and
imported by a country in a year. Unlike goods which are tangible or visible services are
intangible. Accordingly services transactions are regarded as invisible items in the BOP. They
are invisible in the sense that service receipts and payments are not recorded at the port of
entry or exit as in the case with the merchandise imports and exports receipts. Except for this
there is no meaningful difference between goods and services receipts and payments. Both
constitute earning and spending of foreign exchange. Goods and services accounts together
constitute the largest and economically the most significant components in the BOP of any
country.
The service transactions take various forms. They basically include 1) transportation,
banking, and insurance receipts and payments from and to the foreign countries, 2) tourism,
travel services and tourist purchases of goods and services received from foreign visitors to
home country and paid out in foreign countries by home country citizens, 3) expenses of
students studying abroad and receipts from foreign students studying in the home country, 4)
expenses of diplomatic and military personnel stationed overseas as well as the receipts from
similar personnel who are stationed in the home country and 5) interest, profits, dividends
and royalties received from foreign countries and paid out to foreign countries. These items
are generally termed as investment income or receipts and payments arising out of what are
called as capital services. Balance of Invisible Trade is a sum of all invisible service
receipts and payments in which the sum could be positive or negative or zero. A positive sum
is regarded as favourable to a country and a negative sum is considered as unfavourable. The
terms are descriptive as well as prescriptive.

BALANCE OF VISIBLE TRADE

Balance of visible trade is also known as balance of merchandise trade, and it covers all
transactions related to movable goods where the ownership of goods changes from residents

to non-residents (exports) and from non-residents to residents (imports). The valuation should
be on F.O.B basis so that international freight and insurance are treated as distinct services
and not merged with the value of goods themselves. Exports valued on F.O.B basis are the
credit entries. Data for these items are obtained from the various forms that the exporters
have fill and submit to the designated authorities. Imports valued at C.I.F are the debit
entries. Valuation at C.I.F. though inappropriate, is a forced choice due to data inadequacies.
The difference between the total of debits and credits appears in the Net column. This is the
Balance of Visible Trade.
In visible trade if the receipts from exports of goods happen to be equal to the payments for
the imports of goods, we describe the situation as one of zero goods balance. Otherwise
there would be either a positive or negative goods balance, depending on whether we have
receipts exceeding payments (positive) or payments exceeding receipts (negative).

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 and because
these cannot, therefore, ordinarily have equal entries for debits and credits. The entry for net
errors and omissions often reflects unreported flows of private capital, although the
conclusions that can be drawn from them vary a great deal from country to country, and even
in the same country from time to time, depending on the reliability of the reported
information. Developing countries, in particular, usually experience great difficulty in
providing reliable information.
Errors and omissions (or the balancing item) reflect the difficulties involved in recording
accurately, if at all, a wide variety of transactions that occur within a given period of (usually
12 months). In some cases there is such large number of transactions that a sample is taken
rather than recording each transaction, with the inevitable errors that occur when samples are
used. In others problems may arise when one or other of the parts of a transaction takes more
than one year: for example wit a large export contract covering several years some payment
may be received by the exporter before any deliveries are made, but the last payment will not
made until the contract has been completed. Dishonesty may also play a part, as when goods
are smuggled, in which case the merchandise side of the transaction is unreported although

payment will be made somehow and will be reflected somewhere in the accounts. Similarly
the desire to avoid taxes may lead to under-reporting of some items in order to reduce tax
liabilities.
Finally, there are changes in the reserves of the country whose balance of payments we are
considering, and changes in that part of the reserves of other countries that is held in the
country concerned. Reserves are held in three forms: in foreign currency, usually but always
the US dollar, as gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF. Note
that 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.
The changes in the countrys reserves must of course reflect the net value of all the other
recorded items in the balance of payments. These changes will of course be recorded
accurately, and it is the discrepancy between the changes in reserves and the net value of the
other record items that allows us to identify the errors and omissions.

UNILATERAL TRANSFERS
Unilateral transfers or unrequited receipts, are receipts which the residents of a country
receive for free, without having to make any present or future payments in return. Receipts
from abroad are entered as positive items, payments abroad as negative items. Thus the
unilateral transfer account includes all gifts, grants and reparation receipts and payments to
foreign countries. Unilateral transfer consist of two types of transfers: (a) government
transfers (b) private transfers.
Foreign economic aid or assistance and foreign military aid or assistance received by the
home countrys government (or given by the home government to foreign governments)
constitutes government to government transfers. The United States foreign aid to India, for
BOP 9but a debit item in the US BOP). These are government to government donations or
gifts. There no well worked out theory to explain the behaviour of this account because these
flows depend upon political and institutional factors. The government donations (or aid or
assistance) given to government of other countries is mixed bag given for either economic or
political or humanitarian reasons. Private transfers, on the other hand, are funds received
from or remitted to foreign countries on person to person basis. A Malaysian settled in the
United States remitting $100 a month to his aged parents in Malaysia is a unilateral transfer

inflow item in the Malaysian BOP. An American pensioner who is settled after retirement in
say Italy and who is receiving monthly pension from America is also a private unilateral
transfer causing a debit flow in the American BOP but a credit flow in the Italian BOP.
Countries that attract retired people from other nations may therefore expect to receive an
influx of foreign receipts in the form of pension payments. And countries which render
foreign economic assistance on a massive scale can expect huge deficits in their unilateral
transfer account. Unilateral transfer receipts and payments are also called unrequited transfers
because as the name itself suggests the flow is only in one direction with no automatic
reverse flow in the other direction. There is no repayment obligation attached to these
transfers because they are not borrowings and lendings but gifts and grants exchanged
between government and people in one country with the governments and peoples in the rest
of the world.

ILLUSTRATE THE ITEMS WHICH FALL UNDER CAPITAL ACCOUNT AND

CURRENT ACCOUNT WITH EXAMPLES.

1.

Credits
Current Account
Merchandise Exports (Sale of Goods)

2.

Invisible Exports (Sale of Services)

a.
b.
c.

Transport services sold abroad

Insurance services sold abroad

Foreign tourist expenditure in
country
d.
Other services sold abroad

Debits
Current Account
1.
Merchandise Imports (purchase of
Goods)
2.
Invisible Imports (Purchase of
Services)
a.
Transport services purchased
from abroad
b.
Insurance services purchased
c.
Tourist expenditure abroad
d.

Other services purchased from

abroad
Incomes received on loans and
e.
Income paid on loans and
investments abroad.
investments in the home country.
3. Unilateral Transfers
3. Unilateral Transfers
a. Private remittances received from
a. Private remittances abroad
abroad
b. Pension payments received from
b. Pension payments abroad
abroad
c. Government grants received from
c.
Govern
abroad
ment grants abroad.
Capital Account
Capital Account
3.
Foreign long-term investments in the 3.
Long-term investments abroad (less
home country (less redemptions and
redemptions and repayments)
e.

repayments)
a.
Direct investments in the
home country
b.
Foreign investments in
domestic securities
c.
Other investments of
foreigners in the home country
d.
Foreign Governments loans
to the home country.
4.
Foreign short-term
investments in the home country.

a.

Direct Investments abroad

b.

Investments in foreign
securities
c.
Other investments abroad
d.

Government loans to foreign

countries
4.
Short-term investments
abroad.

CAPITAL ACCOUNT CONVERTIBILITY (CAC)

While there is no formal definition of Capital Account Convertibility, the committee under
the chairmanship of S.S. Tarapore has recommended a pragmatic working definition of CAC.
Accordingly CAC refers to the freedom to convert local financial assets into foreign financial
assets and vice a versa at market determined rates of exchange. It is associated with
changes of ownership in foreign / domestic financial assets and liabilities and embodies the
creation and liquidation of claims on, or by, the rest of the world. CAC is coexistent with
restrictions other than on external payments. It also does not preclude the imposition of
monetary / fiscal measures relating to foreign exchange transactions, which are of prudential
nature.
Following are the prerequisites for CAC:
1.

Maintenance of domestic economic stability.

2.

Adequate foreign exchange reserves.

3.

Restrictions on inessential imports as long as the foreign exchange position is not very
comfortable.

4.

Comfortable current account position.

5.

An appropriate industrial policy and a conducive investment climate.

6.

An outward oriented development strategy and sufficient incentives for export

growth.

DESCRIPTIVE QUESTIONS
DISCUSS THE RELEVANCE / IMPORTANCE OF THE BOP STATEMENTS?
BOP statistics are regularly compiled, published and are continuously monitored by
companies, banks and government agencies. A set of BOP accounts is useful in the same way
as a motion picture camera. The accounts do not tell us what is good or bad, nor do they tell
us what is causing what. But they do let us see what is happening so that we can reach our
own conclusions. Below are 3 instances where the information provided by BOP accounting
is very necessary:
1.

Judging the stability of a floating exchange rate system is easier with BOP as the
record of exchanges that take place between nations help track the accumulation of
currencies in the hands of those individuals more willing to hold on to them.

2.

Judging the stability of a fixed exchange rate system is also easier with the same
record of international exchange. These exchanges again show the extent to which a
currency is accumulating in foreign hands, raising questions about the ease of defending
the fixed exchange rate in a future crisis.

3.

To spot whether it is becoming more difficult for debtor counties to repay foreign
creditors, one needs a set of accounts that shows the accumulation of debts, the repayment
of interest and principal and the countries ability to earn foreign exchange for future
repayment. A set of BOP accounts supplies this information. This point is further
elaborated below.

The BOP statement contains useful information for financial decision makers. In the short
run, BOP deficit or surpluses may have an immediate impact on the exchange rate. Basically,
BOP records all transactions that create demand for and supply of a currency. When exchange
rates are market determined, BOP figures indicate excess demand or supply for the currency
and the possible impact on the exchange rate. Taken in conjunction with recent past data, they
may conform or indicate a reversal of perceived trends. They also signal a policy shift on the
part of the monetary authorities of the country unilaterally or in concert with its trading
partners. For instance, a country facing a current account deficit may raise interest to attract
short term capital inflows to prevent depreciation of its currency. Countries suffering from
chronic deficits may find their credit ratings being downgraded because the markets interpret
the data as evidence that the country may have difficulties its debt.

BOP accounts are intimately with the overall saving investment balance in a countrys
national accounts. Continuing deficits or surpluses may lead to fiscal and monetary actions
designed to correct the imbalance which in turn will affect exchange rates and interest rates in
the country. In nutshell corporate finance managers must monitor the BOP data being put out
by government agencies on a regular basis because they have both short term and long term
implications for a host of economic and financial variables affecting the fortunes of the
company.

IN THE ACCOUNTING SENSE THE BOP ALWAYS BALANCES!

The BOP is a double entry accounting statement based on rules of debit and credit similar to
those of business accounting & book-keeping, since it records both transactions and the
money flows associated with those transactions. For instance, exports (like sales of a
business) are credits, and imports (like the purchases of a business) are debits. As in business
accounting the BOP records increases in assets (direct investment abroad) and decreases in
liabilities (repayment of debt) as debits, and decreases in assets (sale of foreign securities)
and increases in liabilities (the utilisation of foreign goods) as credits. An elementary rule that
may assist in understanding these conventions is that in such transactions it is the movement
of a document, not of the money that is recorded. An investment made abroad involves the
import of a documentary acknowledgement of the investment, it is therefore a debit. The
BOP has one important category that has no counter part or at least no significant counter part
in business accounting, i.e. international gifts and grants and other so called transfer
payments.
In general credits may be conceived as receipts and debits as payments. However this is not
always possible. In particular the change in a countrys international reserves in gold and
foreign exchange is treated as a debit if it is an increase and a credit if it is a decrease. The
procedure is to offset changes in reserves against changes in the other items in the table so
that the grand total is always zero, (except for errors and omissions).
A transaction entering the BOP usually has two aspects and invariably gives rise to two
entries, one a debit and the other a credit. Often the two aspects fall in different categories.
For instance, an export against cash payment may result in an increase in the exporting
countrys official foreign exchange holdings. Such a transaction is entered in the BOP as a
credit for exports and as a debit for the capital account. Both aspects of a transaction may

sometimes be appropriate to the same account. For instance the purchase of a foreign security
may have as its counter part reduction in official foreign exchange holdings.
Thus it is clear that if we record all the entries in BOP in a proper way, debits and credits will
always be equal. So that in accounting sense the BOP will be in balance.

DETAILED OUTLINE OF THE BOP STATEMENT & SUB ACCOUNTS

Balance of Payments is the summary of all the transactions between the residents of one
country and rest of the world for a given period of time, usually one year. A BOP statement
(revised) includes the following sub accounts, as shown in the table below.
Items

Credits

G.

Current Account
Merchandise
a. Private
b. Government
2. Invisibles
a. Travel
b. Transportation
c. Insurance
d. Investment Income
e. Government (not included elsewhere)
f. Miscellaneous
3. Transfer Payments
a. Official
b. Private
Total Current Account (1+2+3)
1.

H.

Capital Account
2. Private
a.
b.
3. Banking
4. Official
a. Loans
b. Amortisation
c. Miscellaneous
Total Capital Account (1+2+3)
I.
J.
K.
L.

Long Term
Short Term

IMF
SDR Allocation
Capital Account, IMF & SDR Allocation (B+C+D)
Total Current Account, Capital Account, IMF & SDR
Allocation (A+E)

Debits

Net

M.
N.

Errors & Omissions

Reserves and Monetary Gold

Current Account
The current account includes all transactions which give rise to or use up national income.
The current account consists of two major items, namely, (a) merchandise export and imports
and (b) invisible imports and exports.
Merchandise exports i.e. sale of goods abroad, are credit entries because all transactions
giving rise to monetary claims on foreigners represent credits. On the other hand,
merchandise imports, i.e. purchase of goods abroad, are debit entries because all transactions
giving rise to foreign money claims on the home country represent debits. Merchandise
exports and imports form the most important international transactions of most of the
countries.
Invisible exports i.e. sale of services, are credit entries and invisible imports i.e. purchase of
services are debit entries. Important invisible exports include sale abroad of services like
insurance and transport etc. while important invisible imports are foreign tourist expenditures
in the home country and income received on loans and investment abroad (interests or
dividends).
Transfers payments refer to unrequited receipts or unrequited payments which may be in cash
or in kind and are divided into official and private transactions. Private transfer payments
cover such transactions as charitable contributions and remittances to relatives in other
countries. The main component of government transfer payments is economic aid in the form
of grants.
Capital Account
The capital account separates the non monetary sector from the monetary one, that is to say,
the trading or ordinary private business element in the economy together with the ordinary
institutions of central or local government, from the central bank and the commercial bank,
which are directly involved in framing or implementing monetary policies. The capital
account consists of long term and short term capital transactions. Capital outflow represents
debit and capital inflow represent credit. For instance, if an American firm invests rupees 100

million in India, this transaction will be represented as a debit in the US BOP and a credit in
the BOP of India.
Other Accounts
The IMF account contains purchases (credits) and repurchases (debits) from the IMF. SDRs
Special Drawing Rights are a reserve asset created by the IMF and allocated from time to
time to member countries. Within certain limitations it can be used to settle international
payments between monetary authorities of member countries. An allocation is a credit while
retirement is a debit. The Reserve and Monetary Gold account records increases (debits) and
decreases (credits) in reserve assets. Reserve assets consist of RBIs holdings of gold and
foreign exchange (in the form of balances with foreign central banks and investment in
foreign government securities) and governments holding of SDRs. Errors and Omissions is a
statistical residue. Errors and omissions (or the balancing item) reflect the difficulties
involved in recording accurately, if at all, a wide variety of transactions that occur within a
given period of (usually 12 months). It is used to balance the statement because in practice it
is not possible to have complete and accurate data for reported items and because these
cannot, therefore, ordinarily have equal entries for debits and credits.

HOW WILL YOU IDENTIFY A DEFICIT OR SURPLUS IN BALANCE OF

PAYMENTS? / MEANING OF DEFICIT AND SURPLUS IN THE BALANCE OF
PAYMENTS.
If the balance of payment is a double entry accounting record, then apart from errors and
omissions, it must always balance. Obviously, the terms deficit or surplus cannot refer to
the entire BOP but must indicate imbalance on a subset of accounts included in the BOP. The
imbalance must be interpreted in some sense as an economic disequilibrium.
Since the notion of disequilibrium is usually associated within a situation that calls for policy
intervention of some sort, it is important to decide what is the optimal way of grouping the
various accounts within the BOIP so that an imbalance in one set of accounts will give the
appropriate signals to the policy makers. In the language of an accountant e divide the entire
BOP into a set of accounts above the line and another set below the line. If the net
balance (credits-debits) is positive above the line we will say that there is a balance of
payments surplus; if it is negative e will say there is a balance of payments deficit. The net

balance below the line should be equal in magnitude and opposite in sign to the net balance
above the line. The items below the line can be said to be a compensatory nature they
finance or settle the imbalance above the line.
The critical question is how to make this division so that BOP statistics, in particular the
deficit and surplus figures, will be economically meaningful. Suggestions made by economist
and incorporated into the IMF guidelines emphasis the purpose or motive a transaction, as a
criterion to decide whether a transaction should go above or below the line. The principle
distinction between autonomous transaction and accommodating or compensatory
transactions. Transactions are said to Autonomous if their value is determined independently
of the BOP. Accommodating capital flows on the other hand are determined by the net
consequences of the autonomous items. An autonomous transaction is one undertaken for its
own sake in response to the given configuration of prices, exchange rates, interest rates etc,
usually in order to realise a profit or reduced costs. It does not take into account the situation
elsewhere in the BOP. An accommodating transaction on the other hand is undertaken with
the motive of settling the imbalance arising out of other transactions. An alternative
nomenclature is that capital flows are above the line (autonomous) or below the line
(accommodating). The terms balance of payments deficit and balance of payments
surplus will then be understood to mean deficit or surplus on all autonomous transactions
taken together.
The other measures of identifying a deficit or surplus in the BOP statement are:
Deficit or Surplus in the Current Account and/or Trade Account.
The Basic Balance which shows the relative deficit or surplus in the BOP.

A DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR UNDESIRABLE!

The basic balance was regarded as the best indicator of the economys position vis--vis other
countries in the 1950s and the 1960s. It is defined as the sum of the BOP on current account
and the net balance on long term capital, which were considered as the most stable elements
in the balance of payments.
A worsening of the basic balance [an increase in a deficit or a reduction in a surplus or even a
move from the surplus to deficit] is seen as an indication of deterioration in the [relative] state

of the economy. Thus it is very much evident that a deficit in the basic balance is a clear
indicator of worsening of the state of the countrys BOP position, and thus can be said to be
undesirable at the very outset.
However, on further thoughts, a deficit in the basic balance can also be understood to be
desirable. This can be explained as follows: A deficit on the basic balance could come about
in various ways, which are not mutually equivalent. E.g. suppose that the basic balance is in
deficit because a current account deficit is accompanied by a deficit on the long term capital
account. This deficit in long term capital account could be clearly observed in a developing
countrys which might be investing heavily on capital goods for advancement on the
agricultural and industrial fields. This long term capital outflow will, in the future, generate
profits, dividends and interest payments which will improve the current account and so,
ceteris paribus, will reduce or perhaps reduce the deficit.
Thus a deficit in basic balance can be desirable as well as undesirable, as it clearly depends
upon what is leading to a deficit in the long term capital account.

SHORT NOTES
BALANCE OF PAYMENTS
(Refer to Concept Questions)

CURRENT ACCOUNT
The current account records exports and imports of goods and services and unilateral
transfers. Exports whether of goods or services are by convention entered as positive items in
the account. Imports accordingly are entered as negative items. Exports are normally
calculated f.o.b i.e. cost from transportation, insurance etc are not included whereas imports
are normally calculated c.i.f. i.e. transportation, insurance cost etc are included.
In many cases the payment for imports and exports will result in transfer of money between
the trading countries. For example a UK firm importing a good from US may settle its debt
by instructing its UK bank to make a payment to the US account of the exporter. This is not

necessarily the case however. If the UK firm holds a bank account in the US, then it may
make payment to the US exporter from that account. In the former case the financial side of
the transaction will appear in the UK BOP account as part of the net change in UK foreign
currency reserves. In the later it will appear as the part of the capital account since the UK
firm has reduced its claims on the US bank.
BOP accounts usually differentiate between trades in goods and trade in services. The balance
of imports and exports of the former is referred to in the UK accounts as the balance of
visible trade in other countries it may be referred to as the balance of merchandise trade, or
simply as the balance of trade. The net balance of exports and imports of services is called the
balance of invisible trade in the UK statistics.
Invisible trade is a much more heterogeneous category than is visible trade. It helps in
distinguishing between factor and non-factor services. Trade in the later of which shipping,
banking and insurance services and payments by residents as tourists abroad are usually the
most important, is in economic terms little different from trade in goods. That is, exports and
imports are flows of outputs whose values will be determined by the same variables that
would affect the demand and supply for goods. Factors services, which consist in the main of
interest, profits and dividends, are on the other hand payments for inputs. Exports and
imports of such services will depend in large part on the accumulated stock of past
investment in and borrowing from foreign residents.
Unilateral transfer forms a major part of the current account. It refers to unrequited receipts or
unrequited payments which may be in cash or in kind and are divided into official and private
transactions. Unilateral transfers or unrequited receipts, are receipts which the residents of a
country receive for free, without having to make any present or future payments in return.
Receipts from abroad are entered as positive items, payments abroad as negative items.
The net value of the balances of visible trade and of invisible trade and of unilateral transfers
defines the balance on current account.

CAPITAL ACCOUNT
(Refer to Concept Questions)

OFFICIAL RESERVES ACCOUNT

Official reserve account forms a special feature of the capital account. This account records
the changes in the part of the reserves of other countries that is held in the country concerned.
These reserves are held in three forms: in foreign currency, usually but not always the
US dollars, as gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF.
Note that the reserves do not have to be held by the country. Indeed most of the countries
hold a proportion of the reserves in accounts with foreign central banks.
The IMF account contains purchases (credits) and repurchases (debits) from the IMF. SDRs
Special Drawing Rights are a reserve asset created by the IMF and allocated from time to
time to member countries. Within certain limitations it can be used to settle international
payments between monetary authorities of member countries. An allocation is a credit while
retirement is a debit. The Reserve and Monetary Gold account records increases (debits) and
decreases (credits) in reserve assets. Reserve assets consist of RBIs holdings of gold and
foreign exchange (in the form of balances with foreign central banks and investment in
foreign government securities) and governments holding of SDRs.
The change in the reserves account measures a nations surplus or deficit on its current and
capital account transactions by netting reserve liabilities from reserve assets. For example, a
surplus will lead to an increase in official holdings of foreign currencies and/or gold; a deficit
will normally cause a reduction in these assets.
For most of the countries, there is a correlation between balance-of-payments deficits and
reserve declines. A drop in reserves will occur, for instance, when a nation sells gold to
acquire foreign currencies that it can use to meet the deficit in the balance of payments.

BIBLIOGRAPHY
Balance of Payments
- Paul Madson
International Financial Management
- P G Apte
International Economics
- Lindert
International Economics
- Francis Chernuliam
International Economics
- C P Kindelberger
International Economics
- Geoffrey Reed
International Economics
- H G Mannur