Balance of payments

10 C HAPTER (cid:1) (cid:7) (cid:7)(cid:10) (cid:15) (cid:2)(cid:3)(cid:2)(cid:4)(cid:5)(cid:6) (cid:8)(cid:9) (cid:2)(cid:11)(cid:12)(cid:6)(cid:4)(cid:13)(cid:14) (cid:12) (cid:7) (cid:7)(cid:5) (cid:6)(cid:2)(cid:4)(cid:16)(cid:4)(cid:17) (cid:2)(cid:4)(cid:18) (cid:8)(cid:12)(cid:10)(cid:8)(cid:4)(cid:6)(cid:4)(cid:13)(cid:14) The Balance of Payment (BOP) resident? What is a economic Accounts are an important aspect of the transaction? study of macro economy. In our four Resident of a country ordinarily sector circular flow diagram given in includes individuals, business units, Chapter 2, it has been shown that the government and their agencies. An external sector influences the working economic transaction is an exchange of of an open economy. Macroeconomic value: a process in which “there is phenomena cannot be confined with a transfer of title to an economic good, the particular economy. On the other hand, rendering of an economic service from open economies react sharply to events residents of one country to residents of that are occurring in the rest of world other countries.2 sector. In order to record the overseas Relation between National Income transactions of a country, the BOP and Balance of Payments accounts are maintained and they constitute an important part of the Economic activity usually generates two national income accounts. types of transactions that give rise to The BOP accounts are a summary international payments and receipts. of international transaction of a country Firstly, activities arising from production for a given period, that is a financial and sale of current output and secondly, year. ‘The balance of payments of a those arising from the purchase and sale country is a systematic record of all of existing assets, both real and financial. economic transactions between the Let us consider the first, which is residents of the reporting country and production and sale of current output. the residents of foreign countries during In an open economy, the expenditure of a given period of time’1. consumers, investors and government Here, are two questions that need in addition to the expenditure of to be answered. They are: who is a foreigners on the country’s exports 1 International Economics, Charles P. Kindleberger Homeward, Illinois, Irwin, p. 457. 2 ibid 140 INTRODUCTORY MACROECONOMICS generates the nation’s production of Balance of Payments takes into goods and services. The income account the exchange of both visible generated by this can be shown in the and invisible items. Hence, the balance following expression: of payments represents a better picture of a country’s economic transactions Y = C + I + G + X with the rest of the world than the This income is disposed off in the Balance of Trade. purchase of consumer goods and services (C), savings (S) and taxes (T). Add Structure of Balance of Payment the goods and services purchased from Accounting abroad by the domestic sectors, that is The transactions are recorded in the imports (M). Following expression gives balance of payments accounts in the way income is disposed off: double-entry book keeping.3 Each international transaction undertaken Y = C + S + T + M by the country will result in a credit According to national income entry and debit entry of equal size. As accounting, income generated must be international transactions are recorded equal to income disposed off. Therefore, in double-entry accounting, the BOP C + I + G + X = C + S + T + M accounting must always balance: that Simplifying this we obtain is, total amount of debits must equal total amount of credits. Of course, the I + X + G = S + T + M balancing item Errors and Omissions Here I, G and X are injections into must be included to ‘balance’ the BOP the income stream and S, T and M are accounts. By convention, debit items leakages there from. So, in equilibrium and credit items are entered with a planned injections must be equal to minus sign and plus sign respectively. total planned leakages. Transactions in BOP are classified Balance of Trade and Balance of into five major categories as given below: Payments 1. Goods and services account Balance of Trade takes into account only 2. Unilateral transfer account those transactions arising out of the exports 3. Long-term capital account and imports of goods (the visible items). It 4. Short-term private capital account does not consider the exchange of services 5. Short-term official capital Account rendered such as shipping, insurance and For each of these given categories, banking, payment of interest and dividend specific types of transactions are shown or expenditure by tourists which are also as debits or credits. This is shown in known as invisible items. Table 10.1.4 3 Double-entry book keeping is an accounting principle requiring funds that come in to be entered in an account that shows where they came from and also in an account that shows where they are put. Funds that go out are entered in an account that shows what they are spent on and also in an account that shows where they came from. 4 Dennis R. Appleyard and J. Field Homeward, International Economics, Illinois, Irwin 1992, p. 471. BALANCE OF PAYMENTS: MEANING AND COMPONENTS 141 Table 10.1: Classification on System of Debits and Credits in the Balance of Payments Accounts Debits (-) Credits (+) CATEGORY - I A. Imports of Goods A. Exports of Goods B. Imports of Services B. Exports of Services CATEGORY - II Unilateral Transfers (Gifts) made Unilateral transfers (Gifts) received CATEGORY - III A. Increase in long-term foreign assets A. Decrease in long-term foreign assets owned by home country private owned by home country citizens and citizens and government. government. B. Decrease in long-term home country B. Increase in long-term home country assets owned by foreign private assets owned by foreign private citizens and governments. citizens and governments. CATEGORY - IV A. Increase in short-term foreign assets A. Decrease in short-term foreign assets owned by home country private owned by home country private citizens. citizens. B. Decrease in short-term home country B. Increase in short-term home country assets owned by foreign private assets owned by foreign private citizens. citizens. CATEGORY - V A. Increase in short-term foreign assets A. Decrease in short-term foreign assets owned by home country government owned by home country government (official monetary authorities). (official monetary authorities). B. Decrease in short-terms home country B. Increase in short-term home country asset owned by foreign governments asset owned by foreign governments, (official monetary authorities). (official monetary authorities). Since there are two major categories Current Account of accounts in the BOP accounts The Current Account records imports statement, that is, current and capital and exports of goods and services and accounts, an explanation of current unilateral transfers. Exports, whether and capital account is in order at this of goods (steel, machinery, rice, etc.) or stage to understand their components. services (banking services, insurance 142 INTRODUCTORY MACROECONOMICS services, tourism services to foreign unilateral transfers is the balance on tourists in India, etc.) are entered as current account. positive items in the account. This is Capital Account because exports cause an inflow of foreign exchange into the country. The Capital Account records all Imports are recorded as negative items international transactions that involve in the account because imports cause a resident of the domestic country an outflow of foreign exchange from the changing his assets with a foreign country. resident or his liabilities to a foreign 1. BOP accounts differentiate between resident. The various forms of capital trade in goods and trade in services. account transactions are given below. The balance of exports and imports 1. Private transactions: These are of goods is called the balance of transactions that are affecting visible trade, and the balance of assets or liabilities by individuals, exports and imports of services is businesses, etc. and other non- called the balance of invisible trade. government entities. The bulk of The terms are used because goods foreign investment is private. are visible to the eye but services are 2. Official transactions: Transactions invisible to the eye. affecting assets and liabilities by the 2. Unilateral transfers or unrequited government and its agencies. transfers are receipts which 3. Direct investment: It is the act of residents of a country receive, or purchasing an asset and at the same payments that the residents of a time acquiring control of it (other country make without getting than the ability to re-sell it). An anything in return, i.e. receipts or example of such an investment is payments for which there is no quid the acquisition of a firm in one pro quo. Receipts from abroad are country by a firm in another entered as positive items and country. The transfer of funds from payments abroad are entered as the parent company abroad to the negative items. subsidiary company in the domestic Private unrequited transfers are country so that the subsidiary can gifts that domestic residents receive acquire assets in the domestic from or make to foreign residents. An country is another type of direct example of this would be Indians in investment. Such business Gulf countries sending back money to transactions form the major part of their relatives in India. Official private direct investment overseas. unrequited transfers is the receipt of or Similar transactions by individuals giving of foreign aid, from developed could be the purchase of a house countries or to developing countries. abroad, etc. The net value of balances of visible 4. Portfolio investment: It is the trade and of invisible trade and of acquisition of an asset that does not BALANCE OF PAYMENTS: MEANING AND COMPONENTS 143 give the purchaser control over the avoid taxes, or when smuggling asset. An example of such occurs, etc. investment is the purchase of shares 2. Official reserve transactions: All in a foreign company or of bonds transactions except those in this issued by a foreign government, or category may be termed as loans made to foreign firms or autonomous transactions. They are governments. so called because they are entered By convention, the purchase of an into with some independent motive, asset from another country appears as i.e. not with a view to bring their a negative item on the capital account consequences on the balance of for the purchasing country (there is payments or on the exchange rate. outflow of foreign exchange). Thus, In contrast to this, official reserve capital outflows are awarded a negative transactions are carried out by the sign and capital inflows are awarded a government and the central banks positive sign. in pursuit of some international The net value of the balances of economic policy objective; while direct and portfolio investment is called keeping an eye on such the balance on capital account. transaction’s effect on the BOP and the exchange rate. As a result such Other items in the Balance of Payments transactions are not autonomous. The remaining items that cannot be The first of these items is the categorised into the two preceding change in the domestic country’s categories constitute the other items in official reserve assets. These reserves the balance of payments. They are of a country are held in the form of included since the full balance of foreign currency or foreign currency payments account must balance. These securities, gold and Special Drawing items are as follows: Rights (SDR) with the IMF. SDR allows 1. Errors and omissions: These are to a country to avail of foreign exchange take into account the difficulty of in proportion to the quantum of the accurately recording all the wide country’s deposit of its currency with variety of transactions that take the IMF under the SDR scheme. The place in the accounting period. They changes in the country’s reserves may arise due to the presence of must reflect the net value of all other sampling of transactions rather items in the BOP. Reduction in these than recording each individual assets will be used to finance transaction (for example instead of expenditures abroad. Reductions recording each of a thousand exports of lemons, they may appear as a credit item in the BOP multiply an average lemon export (because their sale causes foreign figure by thousand), due to exchange inflow into the country). An dishonesty, i.e. businessmen increase in these reserves will appear under-reporting sales abroad to as a debit because purchasing assets 144 INTRODUCTORY MACROECONOMICS Table 10.1: India’s Balance of Payments The second of these transactions is the change in foreign official assets in Sl. Item 1990-91 2001-02 India. Foreign central banks will hold No part of their reserve assets in the form 1 Exports 18477 44915 of rupees. If foreign central banks 2 Imports 27915 57618 increase the amount of official reserve assets held in India it will appear as a 3 Trade Balance -9438 -12703 positive item because their purchase of 4 Invisibles (net) -242 14054 our rupee securities or rupees will (i) Non-factor services 980 4199 cause inflow of foreign exchange into (ii) Investment income -3752 -2654 India. The table 10.1 gives the components of India’s Balance of (iii) Private Transfers 2069 12125 Payments and changes over the last (iv) Official transfers 461 384 decade. 5 Current Account -9680 1351 Autonomous and Accommodating Balance Items 6 External assistance 2210 1204 In the discussion of these various (net) balances in BOP account, economists 7 Commercial 2248 -1147 use the terms such as autonomous borrowing (net) items, accommodating items, above the 8 IMF (net) 1214 0 line items and below the line items in 9 NR deposits (net) 1536 2754 the balance of payments. Let us explain their meaning. 10 Rupee debt service -1193 -519 Autonomous items in the BOP refer 11 Foreign investment 103 5286 to international economic transactions (net) of which that take place due to some economic (i) FDI (net) 97 3266 motive such as profit maximization. (ii) FIIs 0 1505 These transactions are independent of the state of the country’s balance of (iii) Euro equities 6 515 payments. These items are often called & others above the line items in the BOP. 12 Other flows (net) 2284 2828 The balance of payments is in deficit 13 Capital account 8402 10406 if the autonomous receipts are less than total (net) autonomous payments. This means 14 Reserve use 1278 -11757 that the foreign country has some net (-increase) claims against the domestic country. The BOP is in surplus if the Source: Economic Survey, 2002-03, autonomous receipts are greater than Government of India. autonomous payments. This means will cause an outflow of foreign that the domestic country has some net exchange. claims against the foreign country. BALANCE OF PAYMENTS: MEANING AND COMPONENTS 145 The monetary authorities may deficit. These causes are broadly finance a deficit by depleting their categorized into (a) Economic factors (b) reserves of foreign currencies, or by Political factors and (c) Social factors. borrowing from the IMF, or by Economic Factors borrowing from foreign monetary (cid:127) Large-scale development authorities. This will be shown as expenditure that may cause large decrease in reserves. The monetary imports. authority may deploy a surplus by purchasing foreign securities, foreign (cid:127) Cyclical fluctuations in general currency or gold. This appears as an business activity such as increase in reserves. recession or depression. Accommodating items in the BOP (cid:127) High domestic prices may result refer to transactions that occur because in imports. of other activity in the BOP, such as (cid:127) New sources of supply, new and government financing. Accommodating better substitutes to existing items are also referred to as below the products and changes in costs line items. The official settlements are will bring about a change in trade seen as an accommodating item in flows and hence BOP over a order to keep the BOP identity. The period of time. official settlements approach to the Political Factors balance of payments looks at the net monetary transfer that has been made Political instability may cause large by the monetary authorities in capital outflows and dampen the settlement. The assumption made in inflows of foreign capital. this approach is that the monetary Social Factors authority is the ultimate financier of any Changes in tastes, preference and deficit in the balance of payments or the fashions may affect imports and ultimate recipient of any surplus. exports. Note that the official settlements Balance of payments disequilibrium approach assumes importance in a is a serious issue for policy makers. A fixed exchange rate set-up. In a flexible chronic BOP deficit leads to rate set-up, much of the deficit and downgrading the economy in the world surplus will be automatically wiped out community. Domestic sectors also by an adjustment in the exchange rates, receive the impact of BOP deficit. Hence, leaving less settlement work for the the monetary authority of the country monetary authorities. concerned and the IMF undertake certain corrective measures to deal with Disequilibrium in Balance of the disequilibrium in the BOP. So, every Payments country in its economic agenda strives There are a number of factors that cause hard to perform well in its international disequilibrium in the balance of trade in order that it will not enter into payments showing either a surplus or problems of BOP disequilibrium. 146 INTRODUCTORY MACROECONOMICS SUMMARY (cid:1) Balance of Payment accounts is an integral part of the national income accounts. (cid:1) BOP accounts are maintained in a double-entry accounting structure. (cid:1) Overall balance of payments is important for economic policy. (cid:1) Disequilibrium in the BOP undermines the economic fundamentals of a nation. EXERCISES 1. Define Balance of Trade and Balance of Payments 2. Explain the five categories of classifying transactions. 3. Give the structure of Balance of Payment Accounts in India. 4. Explain the relationship between Balance of Payments and National income Accounts. 5. Define accommodating and autonomous items. 6. Explain the components of: (a) Current Account, and (b) Capital Account. 7. Describe the causes for disequilibrium in the BOP.