bop

1. Chapter 3
The Balance of Payments

2. 3-2
The Balance of Payments
• International business transactions occur
in many different forms over the course
of a year.
• The measurement of all international
economic transactions between the
residents of a country and foreign
residents is called the balance of
payments (BOP).

3. 3-3
The Balance of Payments
• BOP data is important for government policymakers
and MNEs as it is a gauge of a nations competitiveness
or health (domestic and/or foreign).
• For a MNE both home and host country BOP data is
important as:
– An indication of pressure on a country’s foreign
exchange rate
– A signal of the imposition or removal of controls in
various sorts of payments (dividends, interest,
license fees, royalties and other cash disbursements)
– A forecast of a country’s market potential
(especially in the short run)

4. 3-4
Typical BOP Transactions
• Each of the following represents an international
economic transaction that is counted in and captured in
the India’s BOP:
– An Indian subsidiary of a foreign MNE acts as a distributor
for the MNEs products in the Indian market
– An India based firm, manages the construction of a major
water treatment facility in a foreign country
– The Indian subsidiary of a foreign firm pays profits
(dividends) back to a parent in its home (foreign) country
– The Indian government finances the purchase of defence
equipment for a foreign ally

5. 3-5
Fundamentals of BOP Accounting
• The BOP must balance.
• It cannot be in disequilibrium unless
something has not been counted or has
been counted improperly.
• Therefore it is incorrect to state that the
BOP is in disequilibrium.

6. 3-6
Fundamentals of BOP Accounting
• There are three main elements of the actual process of
measuring international economic activity:
– Identifying what is and is not an international
economic transaction
– Understanding how the flow of goods, services,
assets, and money create debits and credits to the
overall BOP
– Understanding the bookkeeping procedures for
BOP accounting
• It is a daunting task to measure all international
transactions that take place in and out of a country over
a year.

7. 3-7
The BOP as a Flow Statement
• The BOP is often misunderstood as many people infer
from its name that it is a balance sheet, whereas in fact
it is a cash flow statement.
• By recording all international transactions over a
period of time such as a year, it tracks the continuing
flows of purchases and payments between a country
and all other countries.
• It does not add up the value of all assets and liabilities
of a country on a specific date (as an individual firm’s
balance sheet would do).

8. 3-8
The BOP as a Flow Statement
• Two types of business transactions
dominate the balance of payments:
– Exchange of Real Assets
– Exchange of Financial Assets
• Although assets can be identified as
belonging to distinct groups, it is easier
to think of all assets simply as goods that
can be bought or sold (a clock versus a
bond).

9. 3-9
The Accounts of the BOP
• The BOP is composed of two primary
sub accounts, the Current Account and
the Capital/Financial Account.
• In addition, the Official Reserves account
tracks government currency transactions.
• A fourth account, the Net Errors and
Omissions account is produced to
preserve the balance of the BOP.

10. 3-10
The Current Account
• The Current Account includes all international
economic transactions with income or payment flows
occurring within one year, the current period. It
consists of the following four subcategories:
– Goods trade and import of goods
– Services trade
– Income
– Current transfers
• The Current Account is typically dominated by the first
component which is known as the Balance of Trade
(BOT) even though it excludes service trade.

11. 3-11
India’s Trade Balance & Balance
on Payments April-March 2004-05 (millions of US$)
Source: Economic Survey, Government of India 2005.
India's Balance of Payments: April-March 2004-05
(US $ million)
April-March 2004-05 April-March 2003-04
Exports 80,832 64,723
Imports 118,961 80,177
Trade Balance -38,129 -15,454
Invisibles, net 31,697 26,015
Current Account -6432 10,561
Capital Account* 32,592 20,860
Change in Reserves# -26,159 -31,421
(- Indicates increase)
*: Including errors and omissions. #: On BoP basis excluding valuation.

12. 3-12
The Current Account
• The deficits in the BOT of the past decade have
been an area of considerable concern for India.
Current account slipped into a modest deficit of
US $ 6.4 billion after a three-year span of
continuous surpluses.
• However merchandise export growth in the
period was significantly above the target (16 per
cent growth) set by Ministry of Commerce and
Industry.
• Sharp rise of 48.4 per cent in merchandise import
payments - oil import bill up by 45.1 per cent;
non-oil import payments higher by 49.5 per cent.

13. 3-13
The Current Account
• Volume growth of POL imports moderated to
5.5 per cent but average Indian basket of
international crude prices rose 40 per cent from
US $ 27.8 per barrel in 2003-04 to US $ 38.9
per barrel in 2004-05.
• Invisible receipts up by 46.3 per cent due to
significant growth in travel, transportation,
software exports and other professional and
business services.
• Sustained buoyancy in travel receipts reflected
a rise of 25 per cent in international tourist
traffic to India.

14. 3-14
The Current Account
• Private transfers, comprising primarily
remittances from Indians working abroad.
• Invisible payments grew sharply (69.8 per
cent) on account of surge in outbound tourist
traffic, payments for transportation and
business services such as business and
management consultancy, engineering,
technical and distribution services.

15. 3-15
The Capital/Financial Account
• The Capital Account of the balance of
payments measures all international economic
transactions of financial assets. It is divided
into two major components:
– The Capital Account
– The Financial Account
• The Capital Account is minor (in magnitude),
while the Financial Account is significant.
• Net capital flows for India remained buoyant
due to surge in both debt and non- debt
inflows.

16. 3-16
The Financial Account
• Financial assets can be classified in a
number of different ways including the
length of the life of the asset (maturity)
and the nature of the ownership (public
or private).
• The Financial Account, however, uses a
third method. This focuses on the degree
of investor control over the assets or
operations.

17. 3-17
The Financial Account
• The Financial Account consists of three
components;
– Direct Investment – in which the investor exerts
some explicit degree of control over the assets
– Portfolio Investment – in which the investor has no
control over the assets
– Other Investment – consists of various short-term
and long-term trade credits, cross-border loans,
currency deposits, bank deposits and other A/R and
A/P related to cross-border trade

18. 3-18
Direct Investment
• This is the net balance of capital dispersed from and
into India for the purpose of exerting control over
assets.
• Net FDI into India up on favourable investment
climate; outward FDI surged as liberalised investment
regime spurred search for new markets, takeovers and
natural resources .
• The source of concern over foreign investment in any
country focuses on two topics: control and profit.
• Some countries possess restrictions on foreigners may
own in their country.
• The general rule or premise is that domestic land,
assets and industry should be owned by residents of the
country.
• Concerns over profit stem from the same argument.

19. 3-19
Portfolio Investment
• Positive FII flows since August 2004 cumulated into
surge in Q3 and Q4, on the back of positive growth
outlook, improved corporate performance and
attractive valuations.
• The purchase of debt securities across borders is
classified as portfolio investment because debt
securities by definition do not provide the buyer with
ownership or control.
• Portfolio investment is motivated by a search for
returns rather than to control or manage the investment.

20. 3-20
Current Account Balances for India, 2002-2005
(billions of US$)
Source: Economic Survey,Govt Of India , 2005.
Movement in Current Account Balance
-12
-9
-6
-3
0
3
6
9
12
Apr-Jun
2003
Jul-Sep
2003
Oct-Dec
2003
Jan-Mar
2004
Apr-Jun
2004
Jul-Sep
2004
Oct-Dec
2004
Jan-Mar
2005
US$billion
Trade balance Invisible balance
Current Account balance

21. 3-21
Capital Account Balances for the
India,2004-05(billions of US$)
Net Capital Flows: April-March 2004-05
(US $ million)
Components
April-March April-March January-March January-March
2004-05 2003-04 2005 2004
Foreign Direct Investment 3,033 3,420 592 929
Portfolio Investment 8,908 11,356 3,807 3,733
External Assistance 1,922 -2,742 1,250 -942
External Commercial Borrowings 5,948 -1,526 2,146 1,898
NRI Deposits -1,067 3,642 241 -96
Other Banking Capital 5,071 2,589 2,680 476
Short-term Credits 3,791 1,420 829 -946
Others 4,570 2,383 808 -1,062
Total 32,176 20,542 12,353 3,990
Note: FDI consists of equity under Government (SIA/FIPB) and RBI routes, acquisition of shares of
Indian companies by non-residents, equity capital of unincorporated bodies, reinvested earnings
and other capital of FDI entities. Portfolio investment consists of net inflow of funds on account of
investment by FIIs and amount raised by Indian companies through ADRs/GDRs.

22. 3-22
Net Errors & Omissions/Official
Reserves Accounts
• The Net Errors and Omissions account ensures that the
BOP actually balances.
• The Official Reserves Account is the total reserves held
by official monetary authorities within the country.
• These reserves are normally composed of the major
currencies used in international trade and financial
transactions (hard currencies).
• The significance of official reserves depends generally
on whether the country is operating under a fixed
exchange rate regime or a floating exchange rate
system.

23. 3-23
India’s Foreign Exchange Reserves
Accretion to India's Foreign Exchange Reserves
-1
1
3
5
7
9
11
13
15
April-June July-September October-December January-March
US$billion
2003-04 2004-05

24. 3-24
The BOP in Total — Surplus
• A surplus in the BOP implies that the
demand for the country’s currency
exceeded the supply and that the
government should allow the currency
value to increase – in value – or
intervene and accumulate additional
foreign currency reserves in the Official
Reserves Account.

25. 3-25
The BOP in Total — Deficit
• A deficit in the BOP implies an excess
supply of the country’s currency on
world markets, and the government
should then either devalue the currency
or expend its official reserves to support
its value.

26. 3-26
Capital Mobility
• The degree to which capital moves freely
across borders is critically important to a
country’s balance of payments.
• While capital has not always been free to
move in and out of a country, it clearly
has increased over the past few years.

27. A Stylized View of Capital Mobility
in Modern History
Source: “Globalization and Capital Markets,” Maurice Obstfeld and Alan M. Taylor, NBER Conference Paper, May 4-5, 2001, p. 6.
Low
High
Capital Mobility
18801860 1900 1920 1940 1960 1980 2000
•
•
•
• •
••
•
• •
•
•1880
1900
1914
1929
1860
19251918
1945
1960
1971
1980
2000
Bretton Woods
1945-1971
Interwar, 1914-1945
Float
1971-2000
Gold Standard
1880-1914

28. 3-28
Capital Mobility
• The authors argue that the post-1860 era can be
subdivided into four distinct periods with regard to
capital mobility.
– 1860-1914 – continuously increasing capital mobility as the
gold standard was adopted and international trade relations
were expanded
– 1914-1945 – global economic destruction, isolationist
economic policies, negative effect on capital movement
between countries
– 1945-1971 – Bretton Woods era say a great expansion of
international trade
– 1971-2002 – floating exchange rates, economic volatility,
rapidly expanding cross-border capital flows

29. 3-29
Capital Flight
• Although no single definition of capital flight
exists, it has been characterized as occurring
when capital transfers by residents conflict
with political objectives.
• Many heavily indebted countries have suffered
capital flight, compounding their debt service
problems.
• Capital can be moved via international
transfers, with physical currency, collectables
or precious metals, money laundering or false
invoicing of international trade transactions.

30. 3-30
Capital Account Convertibility in
India
• CAC allows anyone to freely move from local
currency into foreign currency and back.
• CAC is widely regarded as one of the
hallmarks of a developed economy.
• It is also seen as a major comfort factor for
overseas investors since they know that
anytime they change their mind they will be
able to re-convert local currency back into
foreign currency and take out their money.

31. 3-31
Tarapore Committee for Capital
Account Convertibility in India
• In India, the Tarapore committee had laid down
a three-year road-map ending 1999-2000 for
CAC.
• It also cautioned that this can be done earlier or
could be delayed depending on the success
achieved in establishing certain pre-conditions
— primarily fiscal consolidation, strengthening
of the financial system and a low rate of
inflation.
• With the exception of the last, the other two
pre-conditions have not yet been achieved.

32. 3-32
Tarapore Committee for Capital
Account Convertibility in India
• The Committee stressed that
implementation of measures towards
CAC should be sequenced along with the
authorities making an assessment of the
progress towards the attainment of the
preconditions/ signposts stipulated for
the relevant year and depending on this
assessment the implementation of
measures could be accelerated or
decelerated.

33. 3-33
Tarapore Committee for Capital
Account Convertibility in India
• The Committee recommends that interest
rates should be fully deregulated and there
should be total transparency to ensure that
there are no formal interest rate controls.
• RBI should be given freedom to use the
instruments at. its command- to attain the
medium-term inflation target.
• It also recommends that the RBI should have
a Monitoring Exchange Rate Band of +/- 5.0
per cent around the neutral Real Effective
Exchange Rate (REER).

34. 3-34
Tarapore Committee for Capital
Account Convertibility in India
• Committee recommends that thefinancialinstitutions
should also be made to function with a targeted
mandate to reduce the quantum of NPAs within a
time-bound programme.
• The size of the current account deficit (CAD) which
can be sustained without encountering external
constraint is a function of the degree of openness of
the economy which can be defined in terms of the
ratio of current receipts (CR) to GDP.
• In the context of a move to CAC, capital flows
would have a more significant effect on the balance
of payments and conventional indicators in terms of
import cover do not provide a good indicator of the
adequacy of reserves.