CHAPTER V

BALANCE OF PAYMENTS
ABID RAHMAN K A
Guest Faculty
Dept of Economics
Sullamussalam science College Areekode
 Module v
Balance of Payments:
• Balance of Trade
• Balance of Payments - Structure of balance of
payments
• Equilibrium and disequilibrium in BOP
• Measures to correct BOP disequilibrium – India‘s
BOP since 1991
• International financial flows – FDI & FPI
• Currency Convertibility
• IMF-Role and Functions.
 Balance of trade (BOT)
• Balance of trade (BOT) is the difference between
the value of a country's exports and the value of
a country's imports for a given period.
• Balance of trade is the largest component of a
country's balance of payments (BOP).
• The balance of trade is also referred to as the
trade balance, the international trade balance,
commercial balance, or the net exports.
• The balance is calculated as the value
of exports less the value of imports. If the figure
is positive then this is a surplus; it is negative then
it is a deficit
 Visible and Invisible
• The visible trade balance (merchandise trade balance)
is that part of the balance of trade figures that refers
to international trade in physical goods, but not trade
in services.
• The invisible balance or balance of trade on services is
that part of the balance of trade that refers to services
and other products that do not result in the transfer of
physical objects. Examples include consulting services,
shipping services, tourism, and patent license
revenues. This figure is usually generated by tertiary
industry. The term 'invisible balance' is especially
common in the United Kingdom
 Balance of Payment (BOP)
• Balance of Payment (BOP) is a summary statement of
all economic transactions of the residents of a nation
with the residents of Rest of the World (ROW) during a
particular period of time.
• BOP is recorded usually for a Calendar year.
• In other words B O P is a systematic statistical
statement or record of the character and dimensions of
the country’s economic relationship with the rest of
the world. Balance of payments is integral parts of
national accounts for an open economy.
 Balance of Payment (BOP)
• The main purpose of the Balance of Payment is to inform the
Government of the international economic position of the
nation and to help in formulating its of monitory, fiscal and
trade policies.
• The Foreign Governments also use the Balance of Payment
accounts for the purpose of formulating trade relation with
other countries.
• The Balance of Payment account have significant role in an
open economy. An open economy is one which has economic
relations with the rest of the world.
• An economic transaction is an exchange of value, involving a
payment or receipts of money in exchange of a good, a service
or an asset for which payment is made between the resident of
a country with resident of the rest of the world.
• Some goods are transferred to other as a gift, without
expecting payment known in economics as the transfer
payments or unilateral transfers.
 Balance of Payment (BOP)
• An international economic transaction is systematically
recorded in the books of accounts of balance of payments.
• Balance of payments are maintained in a ‘Double entry
book keeping principle’. Under such principle each
transaction is the balance of payments is entered as a
Credit or a Debit entry.
• A ‘Credit entry’ in Balance of Payments refers to an inflow
or that transaction is the one that shows a receipt of funds
from the rest of the world.
• A ‘Debit entry’ Balance of Payments refers to an outflow or
that transaction is the one that shows a payment of funds
to the rest of the world.
• According to the Double entry book keeping principle, for
each Debit entry a corresponding Credit entry is made to
keep the balance of payment always in balance.
 BOT BOP
Balance of Trade is defined as Balance of Payment includes not only import
'difference between export and import and export of goods and services but also
of goods and services' financial / capital transfer.

BOT = Net Earning on Exports - Net BOP = Current Account + Capital Account + or -
payment made for imports Balancing item ( Errors and omissions)

If export is more than import, at that Balance of Payment will be favorable, if the
time, BOT will be favorable. If import is country has surplus in current account for
more than export, at that time, BOT paying your all past loans in her capital
will be unfavorable. account. Balance of payment will be
unfavorable, if country has current account
deficit.
Need not be in balance always BOP to be in balance always.
Following are main factors which affect Following are main factors which affect
a) cost of production a) Conditions of foreign lenders.
b) availability of raw materials b) Economic policy of Govt.
c) Exchange rate c) all the factors of BOT
d) Prices of goods manufactured at
home
BOP Accounting/Structure of BOP
• Balance of Payment Accounts consists of the
two sub accounts. They are Current account
and Capital Account.
• Current account includes visible items
(commodities) and Invisible items (Services).
• Capital account consists of long term and
short term capital flows..
 THE CURRENT ACCOUNT
• In economics, a country's current account records the value
of exports and imports of both goods and services and
international transfers of capital.
• Current account measures the nation's earnings and
spending abroad and it consists of the balance of trade,
net primary income or factor income (earnings on foreign
investments minus payments made to foreign investors)
and net unilateral transfers, that have taken place over a
given period of time.
• Both government and private payments are included in the
calculation. It is called the current account because goods
and services are generally consumed in the current period.
 THE CURRENT ACCOUNT
• The current account is calculated by adding up the 4 components of
current account: goods, services, income and current transfers.
• Goods : Being movable and physical in nature, goods are often traded
by countries all over the world.
• Services : When an intangible service is used by a foreigner in a local
land and the local resident receives the money from a foreigner, this is
also counted as an export, thus a credit.
• Income : A credit of income happens when an individual or a company
of domestic nationality receives money from a company or individual
with foreign identity
• Current transfers : Current transfers take place when a certain foreign
country simply provides currency to another country with nothing
received as a return. Typically, such transfers are done in the form of
donations, aids, or official assistance. Remittances from migrants are
part of the balance of current transfers.
 THE CAPITAL ACCOUNT
• Capital account records the net flow of
investment transaction into an economy. The
capital account reflects net change in
ownership of national assets.
• A surplus in the capital account means money
is flowing into the country. A deficit in the
capital account means money is flowing out of
the country, and it suggests the nation is
increasing its ownership of foreign assets.
 ERRORS AND OMISSIONS
• Errors and omissions, which reflect
transactions that have not been recorded for
various reasons and cannot be entered under
a standard heading, may cause Errors and
omissions.
OFFICIAL RESERVES ACCOUNT
• The official reserves account measures the changes
in the official reserves and changes the foreign
official assets in the country during the year.
• Official reserves consist of gold, Special Drawing
Rights (SDRs) borrowed from the IMF, and holding
of foreign convertible currencies.
• The changes in the country’s reserves must reflect
he 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 reserved and the net value of the other
recorded items that allows identifying the errors
and omissions.
Accounting Treatment of Items (Debit
and Credit Items)
• Any item which gives rise to a sale of foreign
exchange (an inflow) is recorded as a credit
item (+) in the accounts e.g. export of goods
and services
• Any item which gives rise to the purchase of
foreign exchange (an outflow) is recorded as a
debit item (-) in the accounts e.g imports of
goods and services.
 EQUILIBRIUM AND DISEQUILIBRIUM IN THE
BALANCE OF PAYMENTS
• Balance of payments should always be in
equilibrium.
• Disequilibrium in the balance of payments of a
country appears either as a surplus or as a
deficit.
 BOP Disequilibrium
• BOP is a double entry accounting record, then
apart from errors and omissions, it must always
balance.
• The BOP deficit or surplus indicate imbalance in
the BOP.
• This imbalance is interpreted as BOP
Disequilibrium.
• A country’s balance of payments is said to be in
disequilibrium when its autonomous receipts
(credits) are not equal to its autonomous
payments (debits).
• BOP Deficit :A deficit or an unfavorable
balance exists when the value of autonomous
debit items exceeds the value of autonomous
credit items.
• BOP Surplus :A surplus or a favourable balance
exists when the value of autonomous credit
items exceeds the value of autonomous debit
items.
 Types of Disequilibrium
• Cyclical Disequilibrium: Disequilibrium caused by trade cycles
Terms of trade and growth of trade undergo a change as a result of
trade cycles. It affects BOP. It can be corrected by import-export
adjustment
• Secular Disequilibrium: When an economy undergoes intensive
changes, it causes secular or long term disequilibrium in the BOP
• Structural Disequilibrium : When structural changes take place in
some sectors of the economy, they effect import-export trade of
the country resulting in structural disequilibrium
• Fundamental Disequilibrium : When a country suffers chronic
disequilibrium in its BOP, then according to IMF it will be called
fundamental disequilibrium.
• Temporary Disequilibrium :Short term factors account for
temporary disequilibrium in BOP.
 Causes of Disequilibrium
• Economic factors
1.Structural changes in the economy
2.Changes in exchange rates (overvaluation / undervaluation)
3.Changes in the level of foreign exchange reserves
4.Cyclical fluctuations
5.Inflation / deflation Developmental expenditure undertaken
by developing countries, etc.
• Social factors –changes in tastes & preferences due to
demonstration affect, population growth rate, rate of
urbanization, etc.
• Political factors – The political factors may include – political
stability / instability in a country, war, change in diplomatic
policy, etc.
MEASURES TO CORRECT BALANCE OF PAYMENT
DISEQUILIBRIUM
1. Deflation
• Deflation is the classical medicine for correcting the deficit in the balance
of payments.
• Deflation refers to the policy of reducing the quantity of money in order to
reduce the prices and the money income of the people.
• This is done by the central bank of the country through raising the bank
rate, by selling the securities in the open market and by other methods
can reduce the volume of credit in the economy which will lead to a fall in
prices and money income of the people.
• Fall in prices will stimulate exports and reduction in income checks
imports.
• Thus, deflationary policy restores equilibrium to the balance
• (a) by encouraging exports through reduction in their prices and
• (b) by discouraging imports through the reduction in incomes at home.
Moreover, a higher interest rate in the domestic market will attract foreign
funds which can be used for correcting disequilibrium.
MEASURES TO CORRECT BALANCE OF PAYMENT
DISEQUILIBRIUM
2. Depreciation
• Another method of correcting disequilibrium in the balance of
payments is depreciation or appreciation of the exchange rate.
• Deprecation means a fall in the rate of exchange of one currency
(home currency) in terms of another (foreign currency).
• An appreciation on the other hand is the rise in the value of a
currency relative to the foreign currency.
• Depreciation helps a country to achieve a favorable balance of
payments by checking imports and stimulating exports.
3. Devaluation
• Devaluation refers to the official reduction of the external values of a
currency.
• Thus, devaluation serves only as an alternative method to
depreciation. Both the methods imply the same thing, i.e., decrease
in the value of a currency in terms of foreign currencies.
• Both the methods can be used to produce the same effects; they
discourage imports, encourage exports and thus lead to a reduction in
the balance of payments deficit.
MEASURES TO CORRECT BALANCE OF PAYMENT
DISEQUILIBRIUM
4. Exchange Control:
• Exchange control is the most widely used method for correcting
disequilibrium in the balance of payments. Exchange control refers to
the control over the use of foreign exchange by the central bank.
• Under this method, all the exporters are directed by the central bank
to surrender their foreign exchange earnings.
• Foreign exchange is rationed among the licensed importers. Only
essential imports are permitted. Rather it may aggravate these causes
and thus may create a more basic disequilibrium.
• In short, exchange control does not provide a permanent solution for
a chronic disequilibrium.
5. Tariffs
• When tariffs are imposed, the prices of imports would increase to the
extent of tariff. The increased prices will reduced the demand for
imported goods and at the same time induce domestic producers to
produce more of import substitutes.
• Non-essential imports can be drastically reduced by imposing a very
high rate of tariff.
MEASURES TO CORRECT BALANCE OF PAYMENT
DISEQUILIBRIUM
6. Quotas
• Under the quota system, the government may
fix and permit the maximum quantity or value
of a commodity to be imported during a given
period.
• By restricting imports through the quota
system, the deficit is reduced and the balance
of payments position is improved.
 TRENDS IN INDIA’S BOP POST AND
PRE REFORM PERIODS
• High earnings from invisibles : The positive earnings from
invisibles covered a subpart of the trade deficit with the
result that the account deficit was reduced significantly.
• Rise in external commercial borrowing: External
commercial borrowings have been an important source of
funds for the government
• Non-Resident deposits: The non-resident deposits add to
the capital account of BOP.
• Role of Foreign Investment: Foreign investment is
constituted of (1)foreign direct investment and (2) portfolio
investment. portfolio investment, in turn consists of (a)
foreign institutional investment and (b) euro equities and
others
 Reasons for Adverse BOP
• Rising level of imports
• High demand for consumer goods
• Increasing defence expenditure
• Rising external debt
• Inflationary pressure
• Rising price of petroleum products
 International Financial Flows
• It refers to the movement of capital across the
nation
• This may be inflow or outflow of capital
• Foreign Direct Investment (FDI)
• Foreign Portfolio Investment
 Foreign Direct Investment (FDI)
• Foreign direct investment is an investment in a
business by an investor from anther country for which
the foreign investor has control over the company
purchased.
• It is also defined as cross border investment made by a
resident in one economy in an enterprise in another
company.
• FDI is direct investment into production in a country by
a company located in another country ,either by buying
a company in the target country or by expanding
operations of an existing business in that country.
 MOTIVE for FDI
• Resource seeking:-looking for resources at a
lower real cost.
• Market seeking:-secure market share and sales
growth in target foreign market.
• Efficiency seeking:-seeks to establish efficient
structure through useful factors ,cultures, policies
or markets.
• Strategic asset seeking:-seeks to acquire assets in
foreign farms that promote corporate long term
objectives.
 BENEFITS OF FDI
• Improve foreign exchange position of the country.
• Employment generation and increase in
production.
• Help in capital formation by bringing fresh capital.
• Helps in transfer of new technologies and
management skill.
• Helps in increase exports.
• Increases tax revenues.
 DISADVANTAGES OF FDI
• Domestic companies fear that they may lose their
ownership.
• Small companies fear that they may not be able
to compete with world class large companies.
• Foreign companies invest more in machinery and
intellectual property than in wages of the local
people.
• Government has less control over the functioning
of such companies as they usually work as wholly
owned subsidiary of an overseas company.
Foreign portfolio investment (FPI)
• Foreign portfolio investment (FPI) refers to the
purchase of securities and other financial assets
by investors from another country. Examples of
foreign portfolio investments include stocks,
bonds, mutual funds, exchange traded
funds, American depositary receipts (ADRs),
and global depositary receipts (GDRs).
Motives
• It earn quick higher returns from abroad
• Higher yield and lower risk
 Currency Convertibility
• Currency convertibility is the ease with which a
country's currency can be converted into gold or
another currency.
• Currency convertibility is important for international
commerce as globally sourced goods must be paid for
in an agreed upon currency that may not be the
buyer's domestic currency.
• When a country has poor currency convertibility,
meaning it is difficult to swap it for another currency or
store of value, it poses a risk and barrier to trade with
foreign countries who have no need for the domestic
currency.
 IMF
• The International Monetary Fund, or IMF,
promotes international financial stability
and monetary cooperation.
• It also facilitates international trade, promotes
employment and sustainable economic
growth, and helps to reduce global poverty.
• The IMF is governed by and accountable to its
190 member countries.
 Founding and mission
• The IMF was conceived in July 1944 at the United
Nations Bretton Woods Conference in New Hampshire,
United States.
• The 44 countries in attendance sought to build a
framework for international economic cooperation and
avoid repeating the competitive currency devaluations
that contributed to the Great Depression of the 1930s.
• The IMF's primary mission is to ensure the stability of
the international monetary system—the system of
exchange rates and international payments that
enables countries and their citizens to transact with
each other.
 Objectives of IMF
• International Monetary Co-Operation
• Ensure Exchange Stability
• Balanced Growth of Trade
• Eliminate Exchange Control
• Multilateral Trade and Payments
• Balanced Growth
• Correction of BOP Maladjustments
• Promote Investment of Capital
 Organisation of IMF
• The IMF, which started functioning in March 1947, is an
autonomous organisation and is affiliated to U.N.O. As
per Fund Agreement, the headquarters of the IMF
should be located in that country which usually possess
the highest quota of capital of the IMF. Accordingly, the
head office of IMF is located at Washington. At the
initial stage, the IMF had 30 countries as its members.
Later, as on April 30, 1986, the total membership of the
IMF rose to 149.
• IMF is rested on two bodies:
• (a) Board of Governors and
• (b) Board of Executive Directors.
 Function of IMF
1. Exchange Stability
2. Eliminating BOP Disequilibrium
3. Determination of Par Value
4. Stabilize Economies
5. Credit Facilities
6. Maintaining Balance Between Demand and Supply of
Currencies
7. Maintenance of Liquidity
8. Technical Assistance
9. Reducing Tariffs
10. General Watch