B. Bop_final

International Finance

1.Introduction:

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.

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.


2.The BOP Components

The various components of a BOP statement are:

A. Current Account

B. Capital Account

C. IMF

D. SDR Allocation

E. Reserves and Monetary Gold

F. Errors and omissions

Components of Balance of Payments

Balance of Payment is a standard double entry accounting record to capture all transactions of an economy with the Rest of the World.

It is a statistical statement showing:

a. Transactions in goods and services between an economy and rest of the world.

b. Changes of ownership and changes in country’s monetary, gold, SDRs, claims and liabilities to the rest of the world.

c. Unrequited transfers and counterpart entries that are needed to balance, in the accounting sense.


Items Credit Debit Net I] Current Account

1. Merchandise: -Private -Government2. Non-Monetary Gold Movement3. Invisibles

Total Current Account (1+2+3)

II] Capital Account

1. Private: -Long Term -Short Term

2. Banking3. Official -Loans -Amortization -Miscellaneous

Total Capital Account (1+2+3)

*Basic Balance

III] Reserves Account

1. IMF

2. SDR Allocation

3. Reserves and Monetary Gold

IV] Errors and Omissions

A. Structure of Current Account

1] Merchandise (Trade of Visible items)


-Private -Government

2] Non Monetary Gold Movement

3] Invisibles

- Trade in services - Investment income

- Government not classified elsewhere - Transfer Payments - Unilateral Payments

Total Current Account (1+2+3)

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.


Identify a deficit or a surplus in Current account.

Cr > Dr = surplus and visa versa

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).

Balance Of Trade

The difference between the value of goods and services exported and

imported by a country is the measure of balance of trade.

Non monetary gold movements:

Traditionally gold is treated as both a commodity and a financial asset. The

quantum of gold that is held by monetary authority as a part of International

reserves is classified as financial asset. All the other gold that is with residents is

commodity. While this commodity gold is traded by residents and non-residents, it

is recorded in this account which is a part of the Current Account. It is simply

import/ export transaction of gold by any one other than monetary authority. In

India Monetary authority is RBI.

Monetisation and Demonetisation of Gold: it may be observed

that :Reserves and Monetary Gold” part of Balance of Payments accounts for

monetary gold. Monetary authority might sometimes acquire gold from residents


to increase gold that forms part of international reserves. In this process

commodity category gets transferred to financial asset category. Hence it is a

debit to reserve account.

Non-Monetary Gold movements current account. This process is called as

Monetiasation of Gold. If it is reverse process i.e. monetary authority sells gold,

debiting Non Monetary Gold Movement and crediting “ Reserves” it is called

Demonetisation of Gold.

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.

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 country’s 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 lending’s but gifts and grants exchanged between government

and people in one country with the governments and peoples in the rest of the

world.

B. Structure of capital a/c

CAPITAL A/c

PRIVATE SECTOR CAPITAL FLOWS

OFFICIAL SECTOR CAPITAL FLOWS

BANKING SECTOR CAPITAL FLOWS


- LONG TERM

-SHORT TERM

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 firm’s country, and as a positive item in the capital account for the

other country. That capital outflows appear as a negative item in a country’s

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 net value of the balances of direct and portfolio investment defines the

balance on capital account.

The capital account consists of financial transactions that lead to changes

in foreign assets and liabilities of the economy. Increase in assets (decrease in

liabilities) is debit. Decrease in assets (increase in liabilities) is credit. It means

capital inflow is credit and capital outflow is debit.

The transactions are grouped by the institutional sector (banking,

government and private) and by term to maturity of the original claim.

1. Private Sector Capital Flows: This consists of loans received by private entities

(other than banks) in India from non-residents, investment by foreigners in

shares of Indian companies, repayment of loans to residents by non-residents,

repatriation of Indian investments abroad i.e. capital inflows, on credit side.

The capital outflows are recorded on the debit side such as investment by

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 purchaser’s

country (and as a positive item in the accounts of the seller’s country).

Identify a deficit or a surplus in Capital account.

Cr > Dr = surplus and visa versa


residents in shares abroad, investment by residents in foreign properties and

assets, repatriation of foreign investments in India, disbursement of loans to

non-residents. Short-term capital flows pertain to claims with maturities upto a

year, rest are long term capital flows.

2. Banking Capital: This covers changes in assets and liabilities of commercial

banks. This includes government banks, private banks as well as co-operative

banks that are authorized to deal in foreign exchange. Assets are the balances

held by foreign branches of Indian banks in India. Increase in assets is debit

and Increase in liabilities is credit. Decrease in assets is credit and decrease in

liabilities is debit.

3. Official Capital Flows: This includes transactions of Government of India (GOI)

and RBI that affect foreign financial assets and liabilities of Government of

India. In case of RBI, official reserve assets are excluded as they are covered

under “Reserves and Monetary Gold”. Even transactions of GOI with

International Monetary Fund are excluded and recorded separately.

The net balance between the debit and credit entries under the private

sector capital flows, Banking sector capital flows, Official sector capital flows

taken together is Capital account. If credits exceed debits, it is a surplus and if

debits exceed credits it is a deficit.

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.

Basic Balance

The basic balance was regarded as the best indicator of the economy’s position

vis-à-vis other countries in the 1950’s and the 1960’s. 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 don’t 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.

BASIC BALANCE- total of the credit column of both current A/c and capital

A/c and the totals of the debits of both these accounts.

CR DR Inflows outflows

(A) Current A/C xxx xxx

(B) Capital A/C xxx xxx

(A+B)Basic balance xx xxx

(C) Reserves xx xxx basic A/C surplus

BOP bal xx xx basic A/C deficit

C. D. E. The IMF, SDR & RESERVES AND MONETARY GOLD A/C.

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 RBI’s holdings of

gold and foreign exchange (in the form of balances with foreign central banks and

investment in foreign government securities) and government’s 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.

F. 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 (SDR’s) 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 country’s 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.

Illustrate the items which fall under capital account and current account

with examples.

CREDITS DEBITSCurrent Account Current Account

1. Merchandise Exports (Sale of Goods)

1. Merchandise Imports (purchase of Goods)

2. Invisible Exports (Sale of Services)

2. Invisible Imports (Purchase of Services)

a. Transport services sold abroad

a. Transport services purchased from abroad

b. Insurance services sold abroad

b. Insurance services purchased

c. Foreign tourist expenditure in country

c. Tourist expenditure abroad

d. Other services sold abroad

d. Other services purchased from abroad

e. Incomes received on loans and investments abroad.

e. Income paid on loans and investments in the home country.

3. Unilateral Transfers 3. Unilateral Transfers


a. Private remittances received from abroad

a. Private remittances abroad

b. Pension payments received from abroad

b. Pension payments abroad

c. Government grants received from abroad

c. Government grants abroad.

Capital Account Capital Account3. Foreign long-term investments

in the home country (less redemptions and repayments)

3. Long-term investments abroad (less redemptions and repayments)

a. Direct investments in the home country

a. Direct Investments abroad

b. Foreign investments in domestic securities

b. Investments in foreign securities

c. Other investments of foreigners in the home country

c. Other investments abroad

d. Foreign Governments’ loans to the home country.

d. Government loans to foreign countries

4. Foreign short-term investments in the home country.

4. Short-term investments abroad.

3. The 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 country’s 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.

4. Imp questions:

1. 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 country’s 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 country’s 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.

A DEFICIT IN THE BASIC BALANCE IS DESIRABLE OR UNDESIRABLE!

The basic balance was regarded as the best indicator of the economy’s

position vis-à-vis other countries in the 1950’s and the 1960’s. 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

In accounting sense BOP always balances.

Double entry accounting record to capture all transactions

Current A/C deficit are matched with capital A/C surplus and visa

versa

Reserves A/c


the country’s 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 country’s 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.

Numericals1. The following balance of payments information is available for a particular

economy:

Decline in foreign exchange reserves 500Long term Capital Inflow (net) 600Merchandise Exports 2,000Merchandise Imports 1,500Export of Services 3,000Import of Services 2,500

Calculate short-term capital account.

Solution:

From the above data balance in the current account is determined as follows

Particulars Credit (Inflow)

Debit (Outflow)

Merchandise Exports 2,000 -Merchandise Imports - 1,500

Export of Services 3,000 -Import of Services - 2,500

Total 5,000 4,000

Therefore, Credit – Debit = 5,000 - 4,000 = 1,000

Hence there is surplus on current account by Rs. 1,000/-

Now,


Change in foreign = Balance in Current + Balance in short term + Balance in long term Reserves Account capital account Capital Account

Surplus is denoted by ‘+’ sign while deficit by ‘-’ sign

Therefore solving by above formula we get,

-500 = 1000 + Balance in short term capital account + 600

-500 = 1600 + Balance in short term capital account

Therefore balance in short term capital account = -500-1600 = -2100

Hence short term capital account has net outflow or deficit of Rs. 2100/-.

2. The following data pertains to the balance of payment for India for the year 2000’

Particulars Rs. in croresGovernment loans from abroad 30Government loans to abroad 60Direct investment abroad 58FDI in the country 191Foreign short term loans investments in the country 60Short-term loans and investments abroad 451Private remittances abroad (Transfer of Payments) 85Private remittances from abroad 211

Calculate the balance on capital account in the balance of payments accounts of India

Solution:

Capital Account


Debit (Outflow)

Government loans from abroad 30 -Government loans to abroad - 60Direct investment abroad - 58FDI in the country 191 -Foreign short term loans investments in the country

60 -

Short-term loans and investments abroad - 451Total 281 569

Therefore, Credit – Debit = 281 – 569 = -288

Hence there is deficit on current account = 288

(Note: Private Remittances have not been included as they are the part of current

account of balance of payment)


3. The following balance of payments data are available for an economy:

Increase in foreign exchange reserves 450Short term Capital Outflow (net) 1,200Merchandise Exports 2,000Merchandise Imports 1,500Export of Services 2,700Import of Services 2,200

Determine the long-term capital account

Solution:

The balance in current is a follows:


Debit (Outflow)

Merchandise Exports 2,000 -Merchandise Imports - 1,500Export of Services 2,700 -Import of Services - 2,200

Total 4,700 3,700

Therefore, Credit – Debit = 4700 - 3700 = 1,000

Hence there is surplus on current account by Rs. 1000/-

Since,



450 = 1000 + (-1200) + Balance in long term capital account

Therefore balance in long term capital account = 450 – 1,000 + 1,200

= 650 = long term net inflow of

capital


4. Following details have been extracted from the balance of payments

statements of Fairland for the year 2000-2001

Transactions on Capital Account

FDI in Fairland 201Short-term loans given by Fairland 80Government loans given by Fairland 40Government loans received by Fairland 23Direct investment abroad (made by Fairland) 58Short-term loans raised by Fairland 68

It is also noticed that the balance of foreign exchange reserves as at the end of

2000-01 is exactly equal to the balance as at the beginning of 1999-2000.

Calculate the deficit on Current Account.

Solution:



Debit (Outflow)

FDI in Fairland 201 -Short-term loans given by Fairland - 80Government loans given by Fairland - 40Government loans received by Fairland 23 -Direct investment abroad (made by Fairland)

- 58

Short-term loans raised by Fairland 68 -Total 292 178

Therefore, Credit – Debit = 292 - 178 = 114

Hence there is surplus on current account = 114

In other words, there’s a deficit on current account: (-) 114

(Since there is no change in foreign exchange reserves, surplus on capital account

must have been equal to the deficit on current account)


5. You are given the following balance of payments data for the country X for

the calendar year 2000.

Particulars Millions of country X’s currency unit

Merchandise imports 18,191Merchandise exports 17,277Exports of services including travel and transportation

15,972

Imports of services including travel and transportation

12,464

Earnings on loans and investments from abroad 429Earnings of loans and investments in X by foreigner’s

1,054

Private remittances to abroad (transfers) 85Private remittances from abroad (transfers) 124Government loans to abroad 41Government loans from abroad 18Direct investments abroad 26FDI in X 134Short term loans and investments abroad 288Foreign short-term loans and investments in X 42

From the data given above, prepare a balance of payments (BoP) statement and

answer the following questions:

What is the trade balance on merchandise account?

What is the balance on current account?

What is the balance on long-term capital account?

What will be the entry against the item’s change in country X’s official

foreign exchange reserves’ in the BoP? Does this entry represent an

increase or decrease in the stock of foreign exchange reserves?


Solution:

Balance of Payments of country X for the year 2001

(All amounts in millions of country X’s currency unit)

Particulars Credit (Inflow) Debit (Outflow)

Current AccountMerchandise exports

Merchandise imports

Exports of services including travel and transportation


Earnings on loans and investments from abroad

Earnings of loans and investments in X by foreigner’s

Private remittances from abroad (transfers)

Private remittances to abroad (transfers)

17,277

-

15,972

-

429

-

124

-

-

18,191

-

12,464

-

1,054

-

85

Total 33,802 31,794Capital Account

Government loans to abroad

Government loans from abroad

Direct investments abroad

FDI in X

Short term loans and investments abroad

Foreign short-term loans and investments in X

18

134

42

41

26

288

Total 194 355

1. Trade Balance on Merchandise Account = Export – Import

= 17,277 – 18,191

= - 914

2. Balance on current account = 33,802 – 31,794


= 2,008

3. Balance on long term capital account = (18 + 34) – (41 + 26) = 152 – 67

= 85

4. Balance on Current Account = 2,008

Balance on Capital Account = 194 – 355 = -161

5. Overall Balance = Balance on Current + Balance on

Capital

Account Account

= 2,008 + (– 161) = 1,847

Therefore, change in country X’s official foreign exchange reserves = 1,847 millions.

Since the overall balance is favourable, this entry represents an increase in

the stock of foreign exchange reserves.


6. The following data pertains to the balance of payments for a country for

the year 2001.

Government loans from abroad 35Government loans to abroad 65Direct investment abroad 60Foreign direct investments in the country 193Foreign short-term loans investments in the country

65

Short-term loans and investments abroad 456Private remittance to abroad (transfers) 78Private remittances from abroad (transfers) 300

Calculate the balance on capital account in the balance of payments account of the country.

Solution:

Capital Account


Debit (Outflow)

Government loans from abroad 35 -Government loans to abroad - 65Direct investment abroad - 60FDI in the country 193 -Foreign short term loans investments in the country

65 -

Short-term loans and investments abroad - 456Total 293 581

Therefore, Credit – Debit = 293 – 581 = -288

Hence there is deficit in capital account = 288

(Note: Private Remittances have not been included as they are the part of current

account of balance of payment and we have been asked to calculate the balance

on capital account)


7. The following balance of payments data are available for an economy:

Increase in foreign exchange reserves 500Short-term capital outflow (net) 1,000Merchandise exports 1,800Merchandise imports 1,700Export of services 3,000Import of services 1,500

Determine the long-term capital account.

Solution:

The balance in current is a follows:


Debit (Outflow)

Merchandise Exports 1,800 -Merchandise Imports - 1,700Export of Services 3,000 -Import of Services - 1,500

Total 4,800 3,200

Therefore, Credit – Debit = 4,800 – 3,200 = 1,600

Hence there is surplus on current account by Rs. 1,600/-

Since,



500 = 1,600 + (-1,000) + Balance in long term capital account

Therefore balance in long term capital account = 500 – 1,600 + 1,000

= -100

Hence, long term net outflow of capital is 100


8. Following details have been extracted form the Balance of statement of 'x'

for the year 2000-2001


1. Foreign Direct Investment (In 'x') 1802. Short term loans given by 'x' 603. Government loans given by 'x' 364. Government loans received by 'x' 85. Direct Investment abroad (made by 'x') 826. Short term loans raised by 'x' 100

It is also noticed that the balance of foreign exchange reserves as at the end

of 2000-01 is exactly equal to the balance as at the beginning of 2000-01.

Calculate deficit on Current Account.

Solution:



Debit (Outflow)

Foreign Direct Investment (In 'x') 180 -Short term loans given by 'x' - 60Government loans given by 'x' - 36Government loans received by 'x' 8 -Direct Investment abroad (made by 'x') - 82Short term loans raised by 'x' 100 -

Total 288 178


Hence there is surplus on current account = 110

In other words, there’s a deficit on current account: (-) 100

(Since there is no change in foreign exchange reserves, surplus on capital account

must have been equal to the deficit on current account)


9. The following balance of payments information is available for an

economy.

1. Decline in foreign exchange reserves 3002. Long-term capital inflow (net) 6003. Merchandise exports 2,0004. Merchandise imports 1,5005. Export of services 3,0006. Import of services 2,500

Calculate the short-term capital account.

Solution:

From the above data balance in the current account is determined as follows


Debit (Outflow)

Merchandise Exports 2,000 -Merchandise Imports - 1,500

Export of Services 3,000 -Import of Services - 2,500

Total 5,000 4,000


Hence there is surplus on current account by Rs. 1000/-

Now,


Surplus is denoted by ‘+’ sign while deficit by ‘-’ sign


-300 = 1000 + Balance in short term capital account + 600

-300 = 1600 + Balance in short term capital account

Therefore balance in short term capital account = -300-1,600 = -1,900

Hence short term capital account has net outflow or deficit of Rs. 1,900/-.


10. You are given the following balance of payments data for country X f6r the calendar year 2001.

(Millions of country X’s currency unit)

Particulars AmountMerchandise imports 18,499Merchandise exports 17,484Exports of services including travel and transportation

15,972


12,464

Earnings of loans and investments from abroad 429Earnings of loans and investments in X by foreigner’s

1,054

Private remittances to abroad (transfers) 85Private remittances from abroad (transfers) 124Government loans to abroad 43Government loans from abroad 20Direct investments abroad 28FDI in X 126Short term loans and investments abroad 288Foreign short-term loans and investments in X 42

From the data given above, prepare a balance of payments (BOP) statement and

answer the following questions

1. What is the trade balance on merchandise account?

2. What is the balance on current account?

3. What is the balance on the long-term capital account?

4. What will be the entry against the item 'change in country X's official

foreign exchange reserves' in the BOP? Does this entry represent an

increase or decrease in the stock of foreign exchange reserves?


Solution:

Balance of Payments of country X for the year 2001

(All amounts in millions of country X’s currency unit)

Particulars Credit (Inflow) Debit (Outflow)

Current AccountMerchandise exports

Merchandise imports

Exports of services including travel and transportation


Earnings on loans and investments from abroad

Earnings of loans and investments in X by foreigner’s

Private remittances from abroad (transfers)

Private remittances to abroad (transfers)

17,484

-

15,972

-

429

-

124

-

-

18,499

-

12,464

-

1,054

-

85

Total 34,009 32,102Capital Account

Government loans to abroad

Government loans from abroad

Direct investments abroad

FDI in X

Short term loans and investments abroad

Foreign short-term loans and investments in X

20

126

42

43

28

288

Total 188 359

1. Trade Balance on Merchandise Account = Export – Import

= 17,484 – 18,499


= - 1015

2. Balance on current account = 34,009 – 32,102

= 1,907

3. Balance on long term capital account = (20 + 126) – (43 + 28) = 146 – 71

= 75

4. Balance on Current Account = 1,907

Balance on Capital Account = 188 - 359 = -171

11. Overall Balance = Balance on Current + Balance on

Capital

Account Account

= 1,907 + (– 171) = 1,736

Therefore, change in country X’s official foreign exchange reserves = 1,736

millions.

Since the overall balance is favourable, this entry represents an increase in

the stock of foreign exchange reserves.

You are required to find out the overall balance, showing clearly all the sub-balances from the following data.

(1) UC Corporation of the USA invests in India Rs. 3, 00,000 to modernize its Indians subsidiary.

(2) A tourist from Egypt buys souvenirs worth Rs. 3,000 to carry with him. He also pays hotel and travel bills of Rs. 5,000 to Delhi Tourist Agency.

(3) The Indian subsidiary of UC Corporation remits, as usual, Rs. 5,000 as dividends to the parent company in the USA.

(4) The Indian subsidiary of UC Corporation sells a part of its production in other Asians countries for Rs. 1, 00,000.

(5) The Indian subsidiary borrows a sum of Rs. 2, 00,000 (to be paid back in a year’s time) from German money market to resolve its urgent liquidity problem.


(6) The Indian company buys a machine for Rs. 1, 00,000 from Japan and 60% payment is made immediately; the remaining amount is to be paid after 3 years.

(7) An Indian subsidiary of French Company borrows Rs. 50,000 from the Indian public to invest in its modernization programme.

Solution:

Sr.no Sources Uses Nature1 3,00,000 Direct Foreign Investment.2 a. 3,000

b. 5,000

Goods exported.

Services (invisible) rendered.3 5,000 Dividend paid.4 1,00,000 Goods exported.5 2,,00,000 Short-Term borrowing.6

b. 40,000

a. 1,00,000 Equipments imported.

Increase in claim on India.6,48,000 1,05,000

BOP Statement

A. Current AccountGoods Accounts

Exports: Rs. 1, 03,000 (+)Imports: Rs. 1, 00,000 (-)

Balance: Rs. 3,000 (+)

Invisible AccountsPayments Received: Rs. 5,000(+)Payments Made : Rs. 5,000(-)

Balance : NIL

Current Account Balance: Rs. 3,000 (+)

B. Capital Account Foreign Direct Investment Inflow : Rs. 3, 00,000 (+) Outflow: Rs. NIL

Balance: Rs. 3, 00,000 (+) Portfolio Investment Inflow : Rs. 40,000 (+) Outflow: Rs. NIL

Balance: Rs. 40,000 (+)

Long-Term Capital Account: Rs. 3, 40,000 (+) (Foreign Direct Investment + Portfolio Investment)

Short-term borrowings


Inflow : Rs. 2,00,000 (+) Outflow: Nil

Balance: Rs. 2,00,000 (+)

Capital Account Balance: Rs. 5, 40,000 (+)

Overall Balance: Rs. 5, 43,000 (+)There is a net surplus of Rs 5, 43,000 in the balance of payments. This means,

there will be an increase of reserves by this amount.

Note: The transaction No.7 did not enter into the BOP Statement since this

transaction does not involve any foreign country. The entire transaction has taken

place in Indian rupees within India.


Case Study:

Prepare a BOP statement for France from the following data:

1. France export goods worth FFrs. 5000.

2. France import goods worth FFrs. 4000.

3. Expenditure of foreign tourist in France; FFrs. 2500.

4. France makes interest and dividend payments to foreigners; FFrs. 2000.

5. A France working in USA sends a cheque to his wife in Paris worth FFrs. 500.

6. A American Immigrant working in France remits money to his account in LA; FFrs. 1000

7. France Telecom invest in India; FFrs.4500.

8. IBM invests in France; FFrs.2000.

9. A France resident buys a German Treasury bond; FFrs.300.

10. A Swiss resident buys a France Treasury bond; FFrs.5000.

11. France borrows FFrs. 3800 for short-term.

12. A short-term loan advanced by BNP to a British resident; FFrs. 4000.

Solution:

Sr.no Sources Uses Nature

1 5,000 Exports

2 4,000 Imports

3 2,500 Exports

4 2,000 Imports

5 500 Unilateral transfer

6 1,000 Unilateral transfer

7 4,500 FDI

8 2,000 FDI

9 300 Portfolio investment

10 5,000 Portfolio investment

11 ---------- ------------ --------


12 3,800 Short-term borrowings

18,800 11,800


BOP Statement:

A. Current AccountGoods Accounts

Exports: Rs. 7,500 (+)Imports: Rs. 6,000 (-)

Balance: Rs.1, 500 (+)

Invisible AccountsPayments Received: Rs. 500 (+)Payments Made : Rs. 1,000(-)

Balance : Rs. 500 (-)


B. Capital Account

Foreign Direct Investment Inflow : Rs. 2,000 (+) Outflow: Rs. 4,500 (-)

Balance: Rs. 1,500 (-) Portfolio Investment Inflow : Rs. 5,000 (+) Outflow: Rs. 300 (-)


Long-Term Capital Account: Rs. 3,200 (+) (Foreign Direct Investment + Portfolio Investment)

Short-term borrowings Inflow : Rs. 3800 (+) Outflow: Nil


Capital Account Balance: Rs. 7,000 (+) Overall Balance: Rs. 8,000 (+)

There is a net surplus of Rs 8,000 in the balance of payments. This means, there will be an increase of reserves by this amount.

Note: The transaction No11 did not enter into the BOP Statement since this transaction does not involve any foreign country. The entire transaction has taken place in France currency within France.


Prepare a BoP statement for France from the following data:

1. France imports goods worth FFr 4,000.

2. Expenditure of foreign tourists in France FFr 2,500.

3. France makes interest and dividend payments to Foreigners FFr 2,000.

4. A French working in USA sends a cheque to his wife worth FFr 500.

5. A Bangladeshi immigrant working in France remits money to his account in

Dhaka FFr 1,000.

6. France Telecom invests in India FFr 4,500.

7. IBM invests in France FFrs 2,000.

8. A French resident buys a German treasury bond FFr 300.

9. A Swiss resident buys a French treasury bond worth FFr 5,000.


Balance of Payments Account for France

(Amounts in FFr)

Credit (Inflow of Funds)

Debit (Outflow of Funds)

Current Account Balance

Import of Goods

Exports of goods (Purchase made by foreign tourist)

Payment of Interests and dividends

Cash remittance by French working in U.S (Unilateral Transfer of Payments)

Transfer of Payments (by Bangladeshi immigrant working in France)

Investment Income

2,500

500

5,000

4,000

2,000

1,000

Total (1)8,000 7,000

Capital Account Balance

Foreign investments by France in India

Foreign Direct Investment (FDI) in France by IBM

Investment Abroad

2,000

4,500

300

Total (2) 2,000 4,800

Total Balance (1+ 2) 10,000 11,800

Therefore Balance of Payment = Credit – Debit = 10,000 – 11,800

= - 1800

Hence there is deficit in balance of payment of France by 1800 FFr which is

unfavourable.


Prepare a BOP statement for France from the following data:

1. France export goods worth FFrs. 5000.

2. France import goods worth FFrs. 4000.

3. Expenditure of foreign tourist in France; FFrs. 2500.

4. France makes interest and dividend payments to foreigners; FFrs. 2000.

5. A France working in USA sends a cheque to his wife in Paris worth FFrs.

500.

6. A American Immigrant working in France remits money to his account in

LA; FFrs. 1000

7. France Telecom invest in India; FFrs.4500.

8. IBM invests in France; FFrs.2000.

9. A France resident buys a German Treasury bond; FFrs.300.

10. A Swiss resident buys a France Treasury bond; FFrs.5000.

11. France borrows FFrs. 3800 for short-term.

12. A short-term loan advanced by BNP to a British resident; FFr. 4000.


Solution:

Sr.no Sources Uses Nature

1 5,000 Exports

2 4,000 Imports

3 2,500 Exports

4 2,000 Imports

5 500 Unilateral transfer

6 1,000 Unilateral transfer

7 4,500 FDI

8 2,000 FDI

9 300 Portfolio investment

10 5,000 Portfolio investment

11 ---------- ------------ --------

12 3,800 Short-term borrowings

18,800 11,800


BOP Statement:

C. Current Account

Goods AccountsExports: Rs. 7,500 (+)Imports: Rs. 6,000 (-)

Balance: Rs.1,500 (+)

Invisible AccountsPayments Received: Rs. 500 (+)Payments Made : Rs. 1,000(-)

Balance : Rs. 500 (-)


B. Capital Account

Foreign Direct Investment Inflow : Rs. 2,000 (+) Outflow : Rs. 4,500 (-)

Balance : Rs. 1,500 (-) Portfolio Investment Inflow : Rs. 5,000 (+) Outflow : Rs. 300 (-)

Balance : Rs. 4,700 (+)

Long-Term Capital Account: Rs. 3,200 (+) (Foreign Direct Investment + Portfolio Investment)

Short-term borrowings Inflow : Rs., 3800 (+) Outflow : Nil

Balance : Rs. 3,800 (+)

Capital Account Balance: Rs. 7,000 (+) Overall Balance : Rs. 8,000 (+)

There is a net surplus of Rs 8,000 in the balance of payments. This means, there

will be an increase of reserves by this amount.

Note: The transaction No11 did not enter into the BOP Statement since this transaction

does not involve any foreign country. The entire transaction has taken place in France

currency within France.

B. Bop_final

Documents

Transcript of B. Bop_final