Balance of Payments

Balance of Payments-

• The balance of payments (BoP) is a record of all the economic transactions in goods, services, and assets that take place between a country's residents and the rest of the world over a specific period, usually one year.

• It is a type of Double entry accounting system ( Each transaction is entered on the credit and debit side of the balance sheet).

• It includes all transactions, visible as well as invisible.

Some Basic terms-

Visible items -

• It  include all types of physical goods exported and imported

Invisible items -

• It include all those services whose export and import are not visible. e.g. transport services, medical services etc.

Importance of Balance Of Payments-

1.The Balance of Payments is an important tool that provides detailed information on a country's economic and financial transactions.

2.It provides important information to understand and analyze the economic dealings of one country with the other.

3.The balance of payments (BOP) is a system used to track all transactions that impact the demand for and supply of a currency.

4.It helps the government on trade and fiscal policies.

5.It helps to give information about international economic trend.

The various components of a BOP statement

1.Current Account

2.Capital Account

3.Reserve Account

4.Errors & Omissions

1.Current Account

• The current account is a record of a country's international transactions, including the value of goods and services exported and imported, as well as transfer payments.

It is Further divided into 2 parts-

A.Balance of Visibles

B.Balance of Invisibles

A.Balance of Visibles-

• It  include all types of physical goods exported and imported and there difference is called as Balance of Visible.

• It is also known as Balance of Trade.

• Export and Import of Capital goods like Machinery etc. are also included in it.

Trade surplus-

• If Exports are more than Imports than it is called as Trade Surplus

Trade Deficit-

• If Exports are less than Imports than it is called as Trade Surplus.

• In India Balance of Trade is Negative because India has more portion of imports rather than Exports therefore we have Trade Deficit

Difference Between Balance of Payments and Balance of Trade

B.Balance of Invisibles-

• It include all those services whose export and import are not visible.

For Example-

• Transfer payments like Gift and Remittances.

• Profit ,Interest and Dividend received for the Invest made abroad.

• Export and Import of Services like Medical services,Transportation services etc.

Balance of invisibles is Positive in India because we have Net exporter of services to the world

Balance of Current account

• Balance of current account is the difference of Balance of Visibles and Balance  of Invisibles.

• In India Balance of Invisibles is more Negative therefore overall we have Deficit in Current account which is also called as Current Account Deficit.

• If this figure had been a positive number, there would have been a current account surplus

2.Capital Account-

• The capital account refers to all international transactions involving a resident of a country and a resident of another country.
• Transactions recorded in the capital account reflect changes in stock, specifically assets and liabilities.
• These transactions involve the exchange of assets and liabilities between residents of different countries.
• The capital account is a vital component of a country's balance of payments, which records all financial transactions between a country and the rest of the world.
• The capital account is divided into two categories: capital transfers and acquisitions/disposals of non-produced, non-financial assets.

It is further divided as follows-

1.1 Foreign Investments

1.2 Loans

1.3 Banking Capitals

1.1 Foreign Investments

It is further divided into Two parts

Foreign Direct Investment and Foreign Institutional Investment

A.Foreign Direct Investment(FDI)

• When a company invests in another company in a foreign land, the investment is said to be a foreign direct investment (FDI)" is a commonly accepted definition of FDI.

Types of FDI-

Classification on the basis of Type of Investment

Horizontal FDI-

• In this there is investment of funds in a foreign company belonging to the same industry as that owned or operated by the FDI investor

Vertical FDI-

• Vertical FDI refers to a business strategy where a company expands its operations to another country by integrating or acquiring a supplier or distributor in a different level of the supply chain.

Conglomerate FDI-

• Under the type of FDI, a business undertakes unrelated business activities in a foreign country.

Platform FDI- 

• In this case  a business expands into another country but the output from the business is then exported to a third country.

Greenfield investment-

• In this case a company builds its own, brand new facilities from the ground up I.e. from zero

Brownfield investment -

• It happens when a company purchases or leases an existing facility.

Routes of FDI in India-

Automatic Route-

• In this route there is no prior approval of government for investment in the country.

Government Route-

• Though this route investment is made in those sectors in which permission of government is required.

Features of FDI-

• Any foreign investment equal to or greater than 10% in listed companies is considered as FDI.

• Any investment in Unlisted entity is considered as FDI.

• In FDI, the foreign entity has a say in the day-to-day operations of the company.

• If holding in listed companies goes below 10% by foreign entity than also it will be considered as FDI.

Sectors where FDI is prohibited 

• Atomic Energy Generation.

• Agricultural or Plantation Activities ( exceptions like horticulture, fisheries, tea plantations, Pisciculture, animal husbandry, etc.).

• Nidhi Company.

• Investment in Lotteries.

• Investment in Chit Funds.

• Trading in TDR’s.

• Investments in Any Gambling or Betting businesses.

• Investments in Housing and Real Estate (except townships, commercial projects, etc.).

• Investments in Cigars, Cigarettes, or any related tobacco industry

B.Foreign Portfolio Investment (FPI)

It involves an investor buying foreign financial assets. It involves an array of financial assets like fixed deposits, stocks, and mutual funds.

Types of FPI-

Category I or Low Risk-

• Investors falling under the category of Low Risk or Category I comprise of those from the government sector, including central banks, governmental agencies, and international or multilateral organizations/agencies.

Category II or moderate-risk-

• This includes mutual funds, insurance firms, banks, and pension funds among others.

Category III-

• Category III comprises of entities and individuals that are not eligible for the first two categories. This includes endowments, charitable societies, charitable trusts, foundations, corporate bodies, trusts, and individuals.

Regulation-

They are regulated by Securities and Exchange Board of India (SEBI)

Difference between FDI & FPI

C.Investments through Depository receipts

Depository Receipt-

A depository receipt (DR) is a type of negotiable financial security that allows investors to hold shares in a foreign public company.

It is divided as follows-

American Depositary Receipt (ADR)

• It is listed only on American stock exchanges (i.e., NYSE, AMEX, NASDAQ) and can only be traded in the U.S.

European Depositary Receipt (EDR)

• The European Depositary Receipt (EDR) is a financial instrument that is comparable to American Depositary Receipts (ADRs). Just like ADRs, EDRs are only traded on European stock exchanges and can solely be traded within Europe.

Global Depositary Receipt (GDR)

• The term "Global Depositary Receipt" refers to a type of depositary receipt that represents shares of a foreign company. Essentially, any depositary receipt that does not originate from the investor's home country can be classified as a GDR.

Indian Depository Receipt (IDR)

• An Indian Depository Receipt (IDR) is a financial instrument that represents ownership of shares in a foreign company, denominated in Indian Rupees. It is structured as a depository receipt and is similar to global depository receipts. The IDR provides Indian investors with an opportunity to invest in foreign companies without having to directly purchase shares on foreign stock exchanges.

Advantages of Depositories Receipts

• Liquidity for Investors.

• Exposure to international securities.

• Additional sources of capital.

• Less international regulation.

Disadvantages of DRs

• Risk of Foreign Exchange Rate.

• Higher administrative and processing fees, and taxes.

• Restriction placed by local governments

1.2 Loans-

It includes international borrowing by Government and Private sector of India

It is further divided into following parts-

External Commercial Borrowings (ECB)-

• It refer to commercial loans [in the form of bank loans, buyers’ credit, suppliers’ credit, securitised instruments (e.g. floating rate notes and fixed rate bonds) availed from non-resident lenders with minimum average maturity of 3 years.

• It can be availed through Automatic route and Government route

External Assistance-

• These are international assistance in form of concession like borrowings from IMF,World banks etc.

Trade credit-

• Trade credit refers to a form of commercial funding that permits a purchaser to procure goods or services and settle the supplier's invoice at a predetermined date in the future.

• Residents of India are only eligible for this credit.

1.3 Banking Capitals-

• It includes international transactions by Commercial and co-operative banks

It includes-

• Foreign currency Non-resident account.

• Non-Resident External Rupee Account.

• Non - Resident Ordinary Rupee Account.

Errors and Omissions

• The category of "Errors and Omissions" pertains to reporting discrepancies in transactions.
• This type of entry acts as a balance to offset overstated or understated components.
• Leads and lags in reporting can contribute to errors and omissions.

Autonomous and Accommodating Transactions

Autonomous Transactions-

• Autonomous international economic transactions are those made independently of the state of the balance of payments (BoP), often motivated by profit.
• These transactions are referred to as "above the line" items in the BoP.
• A surplus or deficit in the balance of payments is determined by whether autonomous receipts exceed autonomous payments (resulting in a surplus) or vice versa (resulting in a deficit).

Accommodating transactions

• Accommodating transactions are determined by the net consequences of autonomous items, such as whether the Balance of Payments (BoP) is in surplus or deficit.
• Official reserve transactions are viewed as the accommodating item in the BoP, with all other transactions being autonomous.
• Below the line items refer to transactions that are not classified as part of the BoP, but are still significant in determining a country's economic health.

Disequilibrium of Balance of Payment-

When a country’s current account is at a deficit or surplus, its balance of payments (BOP) is said to be in disequilibrium

Types of Disequilibrium of Balance of Payment

1.Cyclical Disequilibrium-

• The occurrence of cyclical disequilibrium in the Balance of Payments (BOP) is due to variations in the business cycle or trade cycle, which can take different routes and exhibit distinct patterns in various countries.

2.Secular Disequilibrium-

• It may be caused by changes in several dynamic forces or factors such as capital formation, population growth, technological changes etc.

3.Structural Disequilibrium-

• Structural disequilibrium occurs when changes in a few sectors of the economy create imbalances in the overall structure.

• Political disturbances, strikes, lockouts, etc are such examples

4.Short run Disequilibrium-

• Disequilibrium caused on a temporary basis for a short period, say one year is called short run disequilibrium.

5.Fundamental Disequilibrium-

• Dynamic factors are often the cause of fundamental disequilibrium, which can result in a chronic deficit in the balance.

Causes of Disequilibrium in Balance of Payment

• Huge Developmental and Investment Programmes by government.

• Huge External Borrowings.

• Rapid increase in population.

• Short fall in the exports.

• Natural Calamites and structural changes in the economy

Measures to Correct Disequilibrium in Balance of Payment

A.Monetary Measures- 

• Effective Monetary policy by Government-The Central Bank may expand or contract the money supply in the economy through appropriate measures which will affect the prices.

• Focus on Effective Fiscal policy by the government-Depending upon the situation governments expenditure may be increased or decreased.
• By reducing the value of the domestic currency, government can correct the disequilibrium in the BOP in the economy I.e. Depreciation.

• Devaluation refers to the deliberate reduction of the exchange value of a country's official currency. The main effect of devaluation is that it makes a country's exports less expensive and its imports more expensive, leading to a reduction in the balance of payments (BOP) deficit.

• Controlling Export and import in the country.

B.Non- Monetary measures

It includes-

• Measures to Enhance export in the country like: export duties may be reduced to boost exports ; cash assistance, subsidies can be given to exporters to increase exports.

• Import Substitutes Steps may be taken to encourage the production of import substitute.

• Encouragement of Foreign investment in India to increase self sufficiency in India

Current Account and Capital Account Convertibility

Currency convertibility refers to the ability to convert a country's domestic currency, such as the Indian rupee, into other foreign currencies without restrictions or limitations.

Current account convertibility -

• Current account convertibility refers to the freedom to convert domestic currency for current account transactions, as well as the freedom to convert currencies for unilateral transfers such as gifts and donations, and to pay and receive interest and dividends.
• India has had full current account convertibility since August 20, 1993.

Capital Account Convertibility-

• Capital account convertibility refers to the freedom to convert domestic currency for capital account transactions.
• The Tarapore Committee, in 2006, defined capital account convertibility as the ability to convert local financial assets into foreign financial assets and vice versa.

In India Capital account is partially convertible or we can say It is convertible with some restrictions and these restrictions are as follows-

(i) Indian corporates are allowed full convertibility in the automatic route upto $ 500 million overseas ventures (investment by Ltd. companies in foreign countries allowed) per annum.

(ii) Indian corporate are allowed to prepay their external commercial borrowings (ECBs) via automatic route if the loan is above $ 500 million per annum.

(iii) Individuals are allowed to invest in foreign assets, shares, etc., upto the level of $ 2,50,000 per annum.

(iv) Unlimited amount of gold is allowed to be imported (this is equal to allowing full convertibility in capital account via current account route, but not feasible for everybody) which is not allowed now

Advantages of Capital account Convertibility

• Reduction in transaction cost due to free rupee convertibility.

• Improvement in savings and investments which effectively accelerates growh.

• It will Increase liquidity in Financial Markets.

• It will enhance Employment and Business Opportunities.

• It will provide Better Access to a Variety of Goods and Services.

• It will increase the  Access to Foreign Capital.

Disadvantages of Capital account Convertibility

• A rising, unregulated rupee makes Indian exports less competitive in the international markets.

• When market currency rates are greater than government fixed exchange rates, import prices rise and Cost-push inflation occurs.

• It can expose the economy of country to global economic vulnerabilities.

• Businesses can easily raise foreign debt, but they are prone to the risk of high repayments if exchange rates become unfavorable.

Important one liner Question and answers on Balance of Payments.

What is the Balance of Payments?

The Balance of Payments (BoP) is a record of all economic transactions in goods, services, and assets that take place between a country's residents and the rest of the world over a specific period, usually one year.

What is Double-entry accounting system in Balance of Payments?

Double-entry accounting system in Balance of Payments means that each transaction is entered on the credit and debit side of the balance sheet.

What does the Balance of Payments include?

The Balance of Payments includes all transactions, visible as well as invisible.

What are Visible items in the Balance of Payments?

Visible items include all types of physical goods exported and imported.

What are Invisible items in the Balance of Payments?

Invisible items include all those services whose export and import are not visible, e.g. transport services, medical services, etc.

Why is the Balance of Payments important?

The Balance of Payments is an important tool that provides detailed information on a country's economic and financial transactions.

What information does the Balance of Payments provide?

The Balance of Payments provides important information to understand and analyze the economic dealings of one country with the other.

What is the purpose of the Balance of Payments?

The Balance of Payments is a system used to track all transactions that impact the demand for and supply of a currency.

How does the Balance of Payments help the government?

The Balance of Payments helps the government on trade and fiscal policies.

What information does the Balance of Payments provide about international economic trends?

The Balance of Payments helps to give information about international economic trend.

What are the various components of a BOP statement?

The various components of a BOP statement are the Current Account, Capital Account, Reserve Account, and Errors & Omissions.

What is the Current Account in the Balance of Payments?

The Current Account is a record of a country's international transactions, including the value of goods and services exported and imported, as well as transfer payments.

What are the two parts of the Current Account?

The two parts of the Current Account are the Balance of Visibles and the Balance of Invisibles.

What is the Balance of Visibles?

The Balance of Visibles includes all types of physical goods exported and imported and their difference is called as Balance of Visible. It is also known as the Balance of Trade. Export and import of capital goods like machinery, etc., are also included in it.

What is Trade surplus in the Balance of Payments?

If Exports are more than Imports, it is called a Trade Surplus.

What is Trade Deficit in the Balance of Payments?

If Exports are less than Imports, it is called a Trade Deficit.

Why does India have a Trade Deficit?

India has a Trade Deficit because India has more portion of imports rather than exports.

What is the Balance of Invisibles?

The Balance of Invisibles includes all those services whose export and import are not visible, such as transfer payments like gifts and remittances, profit, interest and dividend received for the investment made abroad, export and import of services like medical services, transportation services, etc.

Why is the Balance of Invisibles Positive in India?

The Balance of Invisibles is Positive in India because we have a net exporter of services to the world.

What is the Capital Account in the Balance of Payments?

The Capital Account refers to all international transactions involving a resident of a country and a resident of another country.