Balance of Payments

• The balance of payments (BoP) is an account statement which holds the summation of all international transactions a country has had with other nations.
• It gives an idea about the country’s performance in trade, in attracting foreign capital and the impact on the foreign exchange reserve of a country. It also tells us whether the country saves enough to pay for its imports. It also reveals whether the country produces enough economic output to pay for its growth.
• As per the balance of payments manual of the IMF, BoP comprises current account, capital account, errors and
  omissions, and change in foreign exchange reserves.
• A balance of payments deficit means the country imports more goods, services, and capital than it ex[ports. Hence the country must borrow from other countries to pay for its imports.
• A balance of payments surplus means the country exports more than it imports. Government and residents of the country are savers. They provide enough capital to pay for all domestic production. They have disposable reserves which they might even lend outside the country.

Components of Balance of Payments:

Current Account:

• The current account is a country’s trade balance plus net income and direct payments. It reflects trade position of the country. The current account also measures international transfers of capital.
• The trade position of the country is reflected by the current account. It shows the merchandise exports and imports and also the transfers and grants.
• A current account is in balance when the country’s residents (people, government and businesses) have enough reserves to fund all purchases in the country.
• In India, we have always had a current account deficit.
• The current account is divided into four components: trade, net income, direct transfers of capital and asset income.
• Trade:Trade in goods and services is the largest component of the current account. Hence a trade deficit  is enough to create a current account deficit.
• Net Income: Net income is an income received by the country’s residents minus income paid to foreigners. The two sources of income received by residents are i)  income from asset hold overseas and interest, dividends from an investment held overseas. ii) income earned by a country’s residents who work overseas. The two sources of income paid to foreigners are i)  income from asset held in the country and interest, dividends from an investment held in the country. ii) income earned by a foreigner who works in the country. If the income received by a country’s individuals, businesses and government from foreigners is more than the income paid out, then net income is positive (surplus). If it is less, then net income is negative (deficit).
• Direct Transfers: This includes remittances from workers to their home country.  Direct transfers also include a government’s direct foreign aid, foreign direct investment, and the direct transfer is bank loans to foreigners.
• Asset Income: This is composed of increases or decreases in assets like bank deposits, the central bank, and government reserves, securities and real estate. The asset income includes country’s liabilities to foreigners such as deposits of foreign residents at the country’s banks, loans made by foreign banks abroad to domestic banks, foreign private purchases of a country’s government bonds, sales of the securities made by a nation’s businesses to foreigners. FDI, such as reinvested earnings, equities, and debt. Other debts owed to foreigners. Assets, like those described, held by foreign governments. Net shipments of the country’s currency to foreign governments.

Capital Account:

• The former balance of payments capital account has been redesignated as the capital and financial account as per the fifth edition of Balance of Payments Manual(IMF). The revised account has two major components:
  – The Capital Account and The Financial Account

• Capital Account:

  • The investment part of the international transactions is included in the capital account. The major components of the capital account are (a) capital transfers and (b) acquisition/disposal of non produced, nonfinancial assets. This is further categorized into equity and debt investment.
  • The money of a foreign institutional investor (FII) and Foreign Direct Investment (FDI) are a part of the equity investments. Debt investments include the External Commercial Borrowings (ECBs), money deposited in banks by non-resident Indians and trade credits.

• Financial Account:

  • The financial account records an economy’s transaction in external financial assets and liabilities. The components of account are classified according to the type of investment or by functional subdivision ((a) direct investment, (b) portfolio investment, (c) other investment,(d) reserve assets

Official Reserve Account:

• The official reserve account is a part of the capital account, are the foreign currency and securities held by the central bank of a country and used to balance the payments from year-to-year.
• The reserves increase in case of a trade surplus and decrease when there is a trade deficit.
• The central banks use it to change the exchange rate to what the government perceives as more favourable.
• The difference between the current account and the capital account of a country is reflected in the change in the foreign exchange reserves of that country.

Foreign Exchange Reserves:

• Foreign exchange reserves are the foreign currencies held by a central bank.
• The foreign exchange reserve comprises Special Drawing Rights (SDRs), Foreign Currency Assets (FCA) and Reserve Tranche Position (RTP) at the IMF. The level is determined largely by the central bank’s open market operations in the Forex exchange market to even out the volatility in exchange rates and its valuation changes
  according to the movement of the dollar against the other major currencies.
• These reserves are accumulated when the central bank absorbs excess foreign exchange flows through intervention in the foreign exchange market and through the receipt of aid and interest payments.
• The International Bank for Reconstruction and Development (IBRD), International Development Association (IDA) and Asian Development Bank (ADB) funding also add to the foreign exchange reserves.
• Foreign currency assets are maintained in key international currencies such as the US dollar, pound sterling, euro, yen and Australian dollar.

Reasons for Holding Foreign Exchange Reserves:

• Countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate.
• Countries with a floating exchange rate system use reserves to keep the value of their currency lower than the dollar. Reserve Bank of India buys U.S. Treasuries to keep its value of rupee lower than the dollar. This keeps India’s exports relatively cheaper, boosting trade and economic growth.
• To maintain the liquidity in case of an economic crisis. For example, a natural calamity may temporarily suspend local exporters’ ability to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the central bank uses the reserve to fund imports. The central bank supplies foreign currency to keep markets steady. It also buys the local currency to support its value and prevent inflation.
• To provide confidence. The central bank assures foreign investors that it’s ready to take action to protect their investments.
•  It is needed to make sure a country will meet its external obligations like international payments,  commercial debts, financing of imports and to absorb any unexpected capital movements.
• To fund sectors, such as infrastructure.
• To boost returns without compromising safety. They do that by diversifying their portfolio. They also hold gold and other safe, interest-bearing investments.

Relationship between Current Account, Capital Account and Official Reserve Account and Balance of Payments:

• The current account and the capital account should balance because every transaction is recorded as both a credit and a debit in double-entry accounting and since credits must equal debits and the balance of payments is equal to credits minus debts, the sum of the balance of payments statements should be zero.
• Current account deficit is when payments exceed receipts from the trade of goods & services, transfers, and net income.  It indicates a country is borrowing and is a net debtor to the rest of the world. A current account deficit is when a country’s government, businesses, and individuals import more goods, services and capital than it exports.
• A deficit in the current account leads to depletion of foreign currency assets as these assets are used as a source to fund deficit which forms part of the capital account. Depletion of foreign currency assets reduces money supply which in turn results in liquidity issues.
• If the payments are more than the receipts under the current account, there will be a deficit. If the receipts are more than the payments, the current account will show a surplus. Thus, any surplus in the current account of a country is offset by a net outflow of a country (net export of capital), and any deficit in the current account is offset by a net inflow of capital (or net import of capital). In such a situation, the current account balance is equal to the capital account balance so that the country’s BoP achieves equilibrium in the absence of the official reserve account. For example, during a particular year, the exports and imports of India were $ 600 billion and $ 450 billion, respectively. The surplus on the current account was $ 150 billion. There was, thus, a net capital outflow of $ 150 billion. The surplus on the current account was exactly matched by the deficit in the capital account and, therefore, the balance of payments was in equilibrium.
• A country may take various measures in order to balance its current account deficits. Such measures include the issuance of securities like bonds or equity stocks and, the sale of some of its business operations abroad. If a country acquires some surplus in her current account transaction, it may buy foreign assets, including financial assets. The balance of payment on current account, thus, results in changing strategies in respect of capital assets.
• A country that produces more than it consumes will save more than its domestic investment. This will result in a net capital outflow. Conversely, a country that spends more than its produce will invest domestically more than it saves and has a net capital inflow.
• Net capital outflows (capital account surplus) would result in an increase in official reserves and net capital inflows (capital account surplus) would result in a decrease in official reserves. Hence, the sum of the current account balance, capital account balance, and the official reserve account balance are always zero.
• BOP = Current Account Balance + Capital Account Balance – Official Reserve Account = 0