CBSE 12 Macro Economics Chapter 12-Balance of Payments

 CBSE 12 Macro Economics Chapter 12-Balance of Payments notes in English medium for GMSSSS and CBSE schools.

Chapter 12 Balance of Payments

1. Balance of Payment (BoP) meaning-

Balance of payments (BOP) is a statement of accounts showing all monetary transactions (or economic transactions) of a country with the rest of the world during a financial year. These transactions may be made by the individuals, firms and the government of a country.

According to Kindle Berger, “The balance of payment of a country is a systematic record of old economic transactions between its residents and residents of foreign countries.”

In other words, BoP is a statement of the monetary transactions related to:

(i) Export and import of goods- It is also known as 'merchandise or visible trade'. The goods are visible and goods can be seen i.e. tangible items.

(ii) Export and import of services- It is called 'invisible trade' because services are not visible and Services cannot be seen i.e. intangible items.

(iii) International sale and purchase of financial assets- These assets include stocks and bonds.

(iv) international sale and purchase of real assets- Real assets are like plant and machinery etc.

There is a inflow of foreign exchange into the country when we export goods and services or when the foreigners invest in our financial or real assets. On the same time, there is a outflow of foreign exchange from our country to rest of the world when we import goods and services or when our residents invest in the financial or real assets of other countries. BOP accounts record all receipts and payments of foreign exchange. Receipts are recorded as credit items, while payments are recorded as debit items. So, BoP accounts reflect performance of our economy in relation to rest of the world.

 

2. COMPONENTS OF BoP ACCOUNT

BoP accounts include:

(i)              Current Account

(ii)            Capital Account

(iii)          Official Reserves Account.

(i) Current Account

Current account is it that account which records imports and exports of goods and services and unilateral transfers. Current account is a record of receipt and payment of foreign exchange transactions which do not impact asset-liability status of a country in relation to rest of the world. Liabilities or assets of a country (in relation to rest of the world) are neither raised nor reduced. In other words, current account transactions do not give rise to 'future claims’.

 Components of Current Account-

Components of Current account Bop

The main components/items of Current Account of BoP are as under:

(i) Export and Import of Goods-

Export and import of goods is treated as 'merchandise' or visible trade. This is a visible trade because goods are tangible (material) and therefore, can be seen while crossing the borders. Example: Export or import of mobile phones.

(ii) Export and Import of Services-

Export and import of services is treated as 'invisible trade'. This is because services are not tangible (material) and therefore, cannot be seen while crossing the borders. Example: IT service.

Services are further classified as: factor services and non-factor services

(a) Factor Services-

Factor services are those which generates factor payments or factor income. In the BoP accounts, monetary transactions related to factor incomes are split as: (i) investment income, and (ii) compensation of employees. Investment income includes income on account of rent, interest and profit.

Factor Incomes = Compensation of employees+Investment income (rent + interest + profit)

 (b) Non-factor Services-

Non-factor services include all services, other than factor services. For example-Insurance and banking services. Monetary transactions related to non-factor services are recorded as receipts for exports and as payments for imports.

 

(iii) Current Transfers

Current transfers refer to one sided 'transfers for free'. These are unilateral transfers made by way of gifts, grants and remittances by the residents settled Abroad. In the BoP accounts, current transfers are treated as an element of invisibles items. These items are only one sided transfers.

 

From above explanation we can conclude this-

(1) Trade Balance/Merchandise Balance = X-M

Trade balance is reflected as:

(a)  Trade Deficit when M > X

(b)  Trade Surplus when X > M

(ii) Goods and Services Balance Export of Goods

            = (Export of Goods and non-factor services) - (Import of  Goods and non-factor services)

= Trade balance + Balance on account of non-factor services

(iii) Invisibles Balance

= Balance on non-factor services

+ Balance on income (balance on factor services

+ Balance of current transfers

(iv) Current Account Balance

= Trade Balance + Invisibles Balance

Note-

1) While estimating trade balance, we consider goods only.

2) While estimating goods and services balance, we consider (i) goods, and (ii) non-factor services only.

3) While estimating invisibles balance, we consider (i) balance relating to non-factor services, (ii) balance relating to factor services (called balance on income), and (iii) balance on current transfers.

(ii) Capital Account

Capital account records receipts and payments of such transaction which cause a change in asset-liability status of a country in relation rest of the world. Liabilities or assets of a country in relation to rest the world, are either raised or reduced. In other words, capital account transactions lead to future claims.

Important Note-

The export and import of all types of goods (consumer good or capital goods-Plant and machinery etc.) is recorded as 'merchandise' or 'visible trade' in the current account of BOP. Thus, export and import of capital goods nothing to do with capital account of BOP.

 

Components of Capital Account

Two main components of capital account are:

(1) Borrowing, and (2) Foreign investment.

(1) Borrowing-

Borrowing can be split further as:

(i) External commercial borrowing-

External commercial borrowing is available at the market rate of interest in the international money market.

(ii) External assistance-

External assistance is available at the concessional rate of interest.

Borrowing from rest of the world raises our liability to rest of the world. But it is recorded as a 'credit item' in the capital account of BoP. The reason is all receipts of foreign exchange are recorded as credit items in the BoP accounts. Thus borrowing of rest of the world or say lending to rest of the world would be recorded as 'debit item' in the capital account, as it causes flow of foreign exchange from our country to rest of the world.

 

(2) Foreign Investment-

Foreign investment can also split further as:

(i) Portfolio Investment-

Portfolio Investment basically refers to foreign institutional investment (FII). It is investment by rest of the world in shares and bonds of the domestic companies.

(ii) Foreign Direct Investment (FDI).

Foreign Direct Investment relates to ownership of enterprises or in the domestic economies by rest of the world. Example: Walmart’s or amazon’s stores in India.

 

Other Components of Capital Account

Besides, borrowing and investment (Being principal components of capital account) there are other components, as under:

(3) NRI Deposits-

In the context of the Indian economy, 'NRI deposits is also a significant compnent of capital account.

Important Note-

It includes only such NRI deposits which are made in the domestic economy. The money sent by the NRIs to their families in India is to be treated as 'current transfers', and are to be recorded in current account of BOP. Only deposits held by NRI’s in the domestic economy are to be considered as a component of capital account.

 

4) Banking Capital (Other than NRI Deposits)

Banking capital is also significant component of capital account. It refers to 'foreign assets' held by the commercial banks.

 

(5) Short-term Trade Credit-

Short-term trade credit refers to account of purchases in the international market without making immediate payment. Repayment of short-term debt to rest of the world leads to outflow of foreign exchange to rest of the world. Accordingly, it is recorded in the capital account with a negative sign. Inward flow of foreign exchange from rest of the world is recorded with a positive sign.

Following is a flow chart presentation of the components of capital account BoP:

 

Components of Capital account Bop

(iii) Official Reserves Account (Indicating Reserves of Forex with the RBI)

RBI is the custodian of Forex reserves of the country. So the overall balance is finally reflected in the Official Reserves Account of the RBI and all Forex transactions in the country are routed through the RBI. If overall balance is positive, it causes increase in official reserves; if overall balance is negative, it causes decrease in official reserves.

Important Note-

Sometimes, Official Reserves Account is shown as a part of the capital account BoP, rather than a separate account. If official reserves are shown as a part of the capital account BOP, then BoP always balances. Increase in the official reserves is indicated by a negative (-) sign, while decrease is indicated by a positive (+) sign.

3- Equilibrium and Disequilibrium in BoP

BOP equilibrium state

when:

Current account balance + Capital account balance + Errors and omissions = 0

and there is no increase or decrease in official reserves of the central bank.

In case we ignore the element of errors and omissions, we can say that the BoP is in equilibrium state when:

Current account balance + Capital account balance = 0

and there is no movement (increase/decrease) of the official reserves.

Or

We can say that BOP is in a state of equilibrium when any negative balance in the current account is equally counterbalanced by a positive balance in the capital account, and there is no change in official reserves of the central bank.

Thus, in a state of BOP equilibrium inward flow of foreign exchange (on account of current account and capital account transactions) is exactly equal to the outward flow of foreign exchange, and there is no change in official reserves (of foreign exchange and gold) with the central bank of the country.

A disequilibrium in BoP occurs when the sum total of current account balance and capital account balance is not zero; instead it is either some positive value or some negative value. In case the sum of total of current account balance and capital account balance is some positive number, it indicates BoP Surplus. On the other hand, if the sum total of Current account balance and capital account balance is some negative number, it indicates BOP Deficit.

Thus, we have:

BoP Disequilibrium state-

Current account balance + Capital account balance is NOT equal to zero, and it causes the movement of official reserves. There are two outcome possible in this.

(i)              BoP Surplus-

Current account balance + Capital account balance is some positive number, pointing to net inward flow of foreign exchange, and leading to an increase in official reserves.

(ii)            BoP Deficit-

Current account balance + Capital account balance is some negative number, pointing to net outward flow of foreign exchange, and leading to a decrease in official reserves. Autonomous and Accommodating Items of BoP Account BoP transactions or items in BoP account are often classified as

 

Autonomous items and accommodating items.

Autonomous items refer to such BoP transactions which are undertaken with a view to making profits. It is due to these transactions that there is a BoP deficit/surplus.

Accommodating items, on the other hand, refer to such transactions which are undertaken by the central bank of a country with a view to correcting BoP imbalance and restoring Bop equilibrium.

Important note

Accommodating items do not cause any movement of goods and services across the borders. These relate only to the movement of official reserves with a view to correcting BOP imbalances.

Generally the accommodating items are not reflected as an element of BoP accounts. These are therefore called 'below the line' items, while autonomous items are called 'above the line' items. Thus, when Bop deficit/surplus is estimated, it is with reference to only the autonomous items or autonomous transactions of BOP.

Difference Between Autonomous and Accommodating items

Autonomous Items	Accommodating Items
(i) Autonomous items refer to such BOP transactions which are undertaken for considerations of profit.	(i) Accommodating items are free from the considerations of profit.
(ii) Autonomous items are the cause of BoP imbalance (BOP surplus or BoP deficit).	(ii) Accommodating items are meant to restore BOP balance. Or Accommodating items are meant to correct BoP imbalance.
(iii) Autonomous items may involve the movement of goods across the borders (like export and import of consumer goods or capital goods).	(iii) Accommodating items do not involve the movement of goods across the borders. These items only involve the movement of official reserves with the RBI.
(iv) Autonomous items are classified as 'above the line' items of BoP.	(iv) Accommodating items are classified as 'below the line items of BoP.

 

Significance of BoP Accounts

Significance of BoP accounts can be explained by following points-

1) Financial Status of the Domestic Economy-

BoP accounts reveal financial status of the domestic economy in relation to rest of the world. More borrowing reveals dependence on rest of the world. It points to backwardness of the domestic economy.

(2) Net Factor Income from Abroad-

BOP data offers information on net factor income from abroad. It is an important component of national income.

3) X-M (As a Component of AD)-

BOP accounts show exports and imports of a country. As we know, net exports (X-M) is an important component of AD (aggregate demand). Rise in 'X-M' leads to a rise in AD.

(4) Market Potential-

BOP accounts reflect market potential in the domestic economy. It is reflected by the size of foreign investment. Larger size of foreign investment points to high market potential in the economy.

5) Monetary and Fiscal Policies-

BoP performance of a country impacts its monetary and fiscal policies. In the event of greater inflow of foreign exchange from rest of the world, there is a pressure of demand for the domestic currency. This lead RBI to the formulation of its monetary policy. Likewise, poor-flow of foreign investment in the domestic economy, may indicate hard tax laws in the domestic economy. The government must account for it in the formulation of its fiscal policy.

 

In brief, By BoP accounts or BoP data reveals financial strength of a country in relation to rest of the world. For less developed countries like India, it plights the need for borrowing from rest of the world as well as the need for foreign investment.

 

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