UNIT-5(I)

BALANCE OF PAYMENTS
Meaning of balance of payments
Balance of payment is an accounting statement that provides a systematic record of all the
economic transactions, between residents of a country and the rest of the world, in a given
period of time.

Economic transactions
1. Visible items: These include all types of physical (tangible) goods which are exported
and imported.
2. Invisible item: It include services like shipping, banking, insurance etc. these items
cannot be seen, touched or measured.
3. Unilateral transfers: it includes gifts, personal remittances and other one-way
transactions.
4. Capital transfers: it include capital receipt like borrowing or sale of assets and capital
payments like capital repayments or purchase of assets.

Structure Of Balance Of Payments

Debit side any International transaction which results in outflow of foreign exchange is
recorded on the debit side in the balance of payment account (the current account and capital
account). It is given on negative sign. Examples
 Payments for imports of goods and services
 Purchase of financial assets (e.g share, debentures, bonds, etc.) In a foreign country.
 Transfer payments of a foreign country in the form of gift remittances etc.
Credit side any International transaction which leads to inflow of foreign exchange is recorded
on the credit side in the balance of payment accounts (the current account or the capital
account). It is given a positive sign. Examples
 Receipts on account of exports of goods and services
 Foreign investments
 Factor income earned from abroad
 Loans and grants from abroad

There are two main accounts of BOP current account and capital account.

Current account
Current accounts record all the transactions relating to export and import of goods and services
and unilateral transfers during a given period of time.
Components of current account
 Export and Import of goods(Visible trade): payment for import of goods is written on
the debit side and receipt from exports is shown on the credit side of balance of
payment account. It is also known as Balance of trade
  Export and Import of services(Invisible trade): it trade include both factor services and
non-factor services
o Factor services are those which lead to factor payments or factor income. Factor
income includes compensation of employees and investment income in the form
of rent, interest and profit..

o Non-factor income is net sale of service products like shipping, banking,

tourism, software services, etc.

Factor/Non-factor Income receipts from abroad are recoded on the credit side of
balance of payment account, while payments to abroad are recorded on the debit
side of balance of payment account.

 Unilateral transfers (one side transactions): unilateral transfer includes gift, donation,
personal remittance and other one-way transactions. These referred to those receipts
and payments, which take place without any services in return.

Balance on current account

Balance on current account has two component balance of trade and balance on invisibles.

Balance of trade it is the difference between the value of exports and imports of goods of a
country in a given period of time. It is also known as trade balance. Exports and imports of
goods is also called visible trade.

Balance BOT export of goods = import of goods

Surplus BOT export of goods > import of goods
Deficit BOT export of goods < import of goods

Balance of invisibles net invisible is the difference between the value of exports and value of
imports of invisibles of a country in a given period of time. INVISIBLE of BOP includes
services and unilateral transfers.

Current Account Balance

Receipts(Credit) on current account = Payments(Debit) on current account

Current Account Surplus(CAS)

Receipts(Credit) on current account > Payments(Debit) on current account
(It signifies that the nation is a lender to the rest of the world)

Current Account Deficit(CAD)

Receipts(Credit) on current account < Payments(Debit) on current account
(It signifies that the nation is a borrower to the rest of the world)

Balanced of current account:

Difference between balance of trade and balance of payments

Basis BOT BOP
Meaning Balance of trade is the Balance of payments is a
difference between visible summary statement of all
 exports and visible imports. economic transactions of a
country with the rest of the
world.
Components It record transaction related to It records transactions related to
goods only. goods as well as services.
Scope It is a narrow concept as it is BOP is a wider concept and it
only a part of BOP account includes BOT
Settlement It may be favourable or In accounting sense it is always
unfavourable kept balance

Basis Balance of trade Current account

Meaning Balance of trade is the Current accounts record all
difference between visible the transactions relating to
exports and visible imports. export import of goods and
services and unilateral
transfers during a given
period of time.

Components It record transaction related to It records transactions related to

goods only goods, services and unilateral
transfers.
Scope It is a narrow concept as it is Current account is a wider
only a part of BOP account concept and it includes BOT

The Capital Account

Capital account of BOP records all those transactions between the residents of a country and
the rest of the world, which causes a change in the assets or liabilities of the residents of the
country or its government.

Components of capital account

There are three components of capital account
1. Borrowings and lendings to and from abroad: all transactions relating to borrowings
from abroad by private sector and government sector are recorded on the credit side in
capital account.
All transactions of lending to abroad by private sector and government sector are
recorded on the debit side in capital account.

2. Investments to and from abroad: It includes:

Foreign direct investment (FDI): it refers to purchase of an asset, such that it gives
direct control to the purchaser over the asset. Example, purchase land.
Portfolio investment(FII): It refers to purchase of an asset, such that it does not give any
direct control over the asset to the purchaser. Example, purchase of shares.

Investments by rest of the world in India are recorded on the credit side in capital
account.
Investment by Indian residents in abroad are recorded on the debit side in capital
account.
 3. Change in foreign exchange reserves: The foreign exchange reserves are the financial
assets of the government held in the central bank. Any withdrawal from the reserves is
recorded in the credit side and any addition to these reserves is recorded on the debit
side in capital account

Capital account balance capital inflow = capital outflow

Surplus capital account capital inflow > capital outflow
Deficit capital account capital inflow < capital outflow

Basis Current account Capital account

Influence on the economy It record all the transactions It record all those transactions
relating to export and import between the residents of a
of goods and services and country and the rest of the
unilateral transfers during a world, which causes a change in
given period of time. the assets or liabilities of the
residents of the country or its
government.

Concept It is a flow concept It is a stock concept

Components visible trade, invisible trade, borrowings and lendings to and
unilateral transfers from abroad, Investments to and
from abroad , change in foreign
exchange reserves.

How is current account deficit (CAD) financed?

1. To correct current account deficit government sale asset, borrowing from abroad. Thus
any current account deficit must be financed by capital account surplus to make
equilibrium BOP without any change in official reserve.
2. Alternative, the country could use its reserve of foreign exchange in order to balance
any deficit in the BOP. The RBI sales foreign exchange in the foreign exchange market
when there is a deficit in BOP this is called official reserve sale.

Autonomous and accommodating items

Autonomous items refer to those international economic transactions which take place due to
some economic motive such as profit maximization for example FDI in India for profit motive.
Accommodating items referred to the transaction that are undertaken to cover deficit or
surplus in autonomous transactions. For example any deficit in current account settled from
capital account.
 Difference between autonomous items and accommodating items
Basis Autonomous items Accommodating items
Meaning Autonomous items refer to Accommodating items referred to
those international economic the transaction that are undertaken
transactions which take place to cover deficit or surplus in
due to some economic motive autonomous transactions
such as profit maximization
Effect on BOP These items are independent of These items are meant to maintain
the state of BOP account. the balance in BOP account.
Occurrence These items take place on both These items tale place only on
current and capital accounts capital account.
Alternative Name These items are also known as These items are also known as
‘above the line’ items ‘below the line’ items

Equilibrium And Disequilibrium Of BOP

EQUILIBRIUM BOP
Current account balance + capital account balance = 0

DISEQUILIBRIUM IN BOP

1. SURPLUS BOP
Current account balance + capital account balance = (+)

2. DEFICIT BOP
Current account balance + capital account balance = (-)

*In addition to current account and capital account, there is one more element on BOP
know as Errors and Omissions. It is the balancing item, which reflects the inability to record
all international transactions accurately.