Balance of Payments: Balance of Payments: Definitions and ConceptsDefinitions and Concepts

OutlineOutline

Importance of the BoP AccountingImportance of the BoP AccountingMeaning and Definition of the BoPMeaning and Definition of the BoPBoP AccountsBoP AccountsConcepts of the BoP AccountingConcepts of the BoP Accounting

Importance of the BoP AccountingImportance of the BoP AccountingTo select correct monetary, Fiscal and exchange To select correct monetary, Fiscal and exchange rate policies we need a deep understanding how rate policies we need a deep understanding how the international macroeconomic system works. the international macroeconomic system works. In this regard, understanding of the Balance of In this regard, understanding of the Balance of payment account is useful.payment account is useful.The Balance of accounts tells us what is good or The Balance of accounts tells us what is good or bad and what causes whatbad and what causes whatThe balance of payment accounting helps us to The balance of payment accounting helps us to judge the stability of the exchange rate systemjudge the stability of the exchange rate systemThe BoP Accounting gives an idea about the The BoP Accounting gives an idea about the international status of the country.international status of the country.

Meaning and Definition of the Meaning and Definition of the Balance of PaymentBalance of Payment

The balance of payments of a country is a The balance of payments of a country is a systematic record of all economic transactions systematic record of all economic transactions between resident of that country and the rest of between resident of that country and the rest of the world during a given period of time.the world during a given period of time.Each transaction of BoP has two sides.Each transaction of BoP has two sides.A credit is an outflow of value for which an A credit is an outflow of value for which an offsetting inflow of value or payment is due to this offsetting inflow of value or payment is due to this country.country.A debit is an inflow of value for which resident of A debit is an inflow of value for which resident of the country has to make payments.the country has to make payments.

BoP AccountsBoP Accounts

Goods AccountsGoods AccountsServices AccountsServices AccountsUnilateral Transaction AccountsUnilateral Transaction AccountsShort term capital accountsShort term capital accountsLong term capital accountsLong term capital accountsInternational Liquidity accounts International Liquidity accounts

BoP AccountsBoP AccountsGoods Accounts:Goods Accounts:– It include the value of merchandised exports and the It include the value of merchandised exports and the

value of the merchandised importsvalue of the merchandised imports– The items of this accounts are called visible items of The items of this accounts are called visible items of

the BoP.the BoP.– If the receipts from the exports are equal to imports – If the receipts from the exports are equal to imports –

we have zero goods balancewe have zero goods balance– If the receipts from the exports are greater than If the receipts from the exports are greater than

imports – we have postive/favourable goods balanceimports – we have postive/favourable goods balance– If the receipts from the exports are less than imports – If the receipts from the exports are less than imports –

we have negative/unfavourable goods balancewe have negative/unfavourable goods balance

Services AccountServices AccountThe services account records all the services The services account records all the services imported and exported by the country during the imported and exported by the country during the yearyearServices are intangibleServices are intangibleThey are invisible in the sense that they are not They are invisible in the sense that they are not recorded at the port.recorded at the port.The services transaction basically included:The services transaction basically included:– Transportation, banking and insuranceTransportation, banking and insurance– Tourism and travel servicesTourism and travel services– Expenses of students studying abroadExpenses of students studying abroad– Expenses of diplomatic and military expensesExpenses of diplomatic and military expenses– Interest, profit and dividends Interest, profit and dividends

Unilateral Transfer AccountsUnilateral Transfer Accounts

This accounts includes all gifts and grants This accounts includes all gifts and grants to foreign countries.to foreign countries.Unilateral transfers consists of two types Unilateral transfers consists of two types of transfers:of transfers:– Government transfersGovernment transfers– Private transfers Private transfers

Long Term Capital AccountsLong Term Capital Accounts

Any capital that moved in or out of the Any capital that moved in or out of the country for period of one year or more is country for period of one year or more is regarded as long term capital movement.regarded as long term capital movement.They include following types:They include following types:– Private direct investmentPrivate direct investment– Private portfolio investmentPrivate portfolio investment– Government loans to foreign countriesGovernment loans to foreign countries

Short Term Capital AccountsShort Term Capital AccountsBank deposits and other short term payments Bank deposits and other short term payments and credit arrangements fall into this categoryand credit arrangements fall into this categoryThe vast majority of the short term capital The vast majority of the short term capital transaction basically represents bank transfers transaction basically represents bank transfers that finance trade and commerce.that finance trade and commerce.Ex. If Malaysian exporter exports rubber worth of Ex. If Malaysian exporter exports rubber worth of $5 million to an importer in US, it represents $5 million to an importer in US, it represents credit of $5 million in Goods a/c. However, if the credit of $5 million in Goods a/c. However, if the US importer deposits $5 million in to the bank US importer deposits $5 million in to the bank a/c of Malaysian in US, it would be treated in a/c of Malaysian in US, it would be treated in short term capital a/cshort term capital a/c

International Liquidity AccountInternational Liquidity Account

Record the net changes in the foreign Record the net changes in the foreign reserves.reserves.This account lists internationally This account lists internationally acceptable means of settling international acceptable means of settling international obligations.obligations.

International Liquidity A/CInternational Liquidity A/CSN Account Credit Debit1 Goods Account 1500 8002 Services Account 500 14003 Unilateral Account 100 1204 Long term Capital

Account 900 400

5 Short Term Capital Account

500 630

6 International Liquidity Account

-- 150

Total 3500 3500

International Liquidity A/CInternational Liquidity A/CWhen the total receipt exceeds the total When the total receipt exceeds the total payments, there is a net BoP surplus amounting payments, there is a net BoP surplus amounting to 150 million. This sum is entered in the to 150 million. This sum is entered in the international liquidity account in the debit side international liquidity account in the debit side either through following actions;either through following actions;– Purchase or import of gold of 150 millionPurchase or import of gold of 150 million– Net addition to accumulation of foreign Net addition to accumulation of foreign

reserves of 150 millionreserves of 150 million– Capital lending to other country of that volume. Capital lending to other country of that volume.

International Liquidity A/CInternational Liquidity A/CSN Account Credit Debit1 Goods Account 800 15002 Services Account 1400 5003 Unilateral Account 120 1004 Long term Capital

Account 400 900

5 Short Term Capital Account

630 500

6 International Liquidity Account

150 --

Total 3500 3500

International Liquidity A/CInternational Liquidity A/CIn the above case, the sum of debit In the above case, the sum of debit payment exceeds the credit resulting a payment exceeds the credit resulting a deficit case.deficit case.This deficit of 150 million is financed by;This deficit of 150 million is financed by;– Selling or exporting Gold worth of 150 millionSelling or exporting Gold worth of 150 million– Drawing down upon the past accumulated Drawing down upon the past accumulated

foreign reserves equal to the sum of 150 foreign reserves equal to the sum of 150 millionmillion

– Borrowing capital the sum of 150 million from Borrowing capital the sum of 150 million from IMF.IMF.

Balance of Payments ConceptsBalance of Payments ConceptsMajor Accounts Credit Debit Net Surplus/Deficit

1 Goods Account 200 180 20

2 Services Account 100 250 -150

A Balance of Trade (1+2) 300 430 -130

3 Unilateral Transfer Account 300 120 180

B BoP on Current A/C (1+2+3) 600 550 50

4 Long term Capital A/C 150 120 30

C Basic Balance(1+2+3+4) 750 670 80

5 Short term capital A/C 50 40 10

D BoP on Capital A/C (4+5) 200 160 40

E Overall Balance of payment (B+D) 800 710 90

6 International Liquidity A/C 90

F Balance of Payments Accounting Balance

800 800 0

Balance of payments ConceptsBalance of payments Concepts

Balance of Trade: The difference between Balance of Trade: The difference between the value of goods and services exported the value of goods and services exported and imported by a country.and imported by a country.This can be surplus, deficit or balancedThis can be surplus, deficit or balancedIs it the deficit in the balance of trade is Is it the deficit in the balance of trade is always bad?always bad?Not necessarily.Not necessarily.

Balance of payments ConceptsBalance of payments ConceptsBalance of Payments on current account: (1+2+3) Balance of Payments on current account: (1+2+3) balances.balances.Trade balance+ service balance + unilateral balanceTrade balance+ service balance + unilateral balanceTrade balance + transfer balanceTrade balance + transfer balanceBalance of payment on the current A/C referred as Net Balance of payment on the current A/C referred as Net foreign investmentforeign investmentThe sum represents contribution of foreign trade to GNP.The sum represents contribution of foreign trade to GNP.It is to be noted that BoP on current A/C covers all It is to be noted that BoP on current A/C covers all receipts on account of earnings (opposed to borrowings) receipts on account of earnings (opposed to borrowings) and all payments of spending (as opposed to lending. and all payments of spending (as opposed to lending. There is no reverse flow in this account.There is no reverse flow in this account.

Balance of payments ConceptsBalance of payments ConceptsBoP on Capital Account:BoP on Capital Account:All the transactions involving inward or outward All the transactions involving inward or outward movement of capital and investment are included in this movement of capital and investment are included in this account.account.It is useful to understand that DCs are net exporter of It is useful to understand that DCs are net exporter of capital and LDCs are net importer of the capital.capital and LDCs are net importer of the capital.So, LDCs will enjoy surplus and DCs will have deficits.So, LDCs will enjoy surplus and DCs will have deficits.This account deals with the borrowings and lending.This account deals with the borrowings and lending.Is the surplus in the capital account is good?Is the surplus in the capital account is good?Not necessarily.Not necessarily.Surplus in the capital account will results deficit in the Surplus in the capital account will results deficit in the current account.current account.

Balance of payments ConceptsBalance of payments ConceptsBasic Balance: Current A/C + Long term Basic Balance: Current A/C + Long term capital A/Ccapital A/C

Balance of payments ConceptsBalance of payments Concepts

Overall BoP: (current a/c + capital a/c)Overall BoP: (current a/c + capital a/c)We must not know the amount of overall We must not know the amount of overall BoP surplus or deficit but the location.BoP surplus or deficit but the location.If the overall BoP surplus is caused by If the overall BoP surplus is caused by current account and not capital account, current account and not capital account, the surplus may be goodthe surplus may be goodIf the overall deficit is caused by current If the overall deficit is caused by current a/c, and not by capital a/c, deficit is bad.a/c, and not by capital a/c, deficit is bad.

Balance of payments ConceptsBalance of payments Concepts

In the accounting sense, the balance of In the accounting sense, the balance of payments must always balance.payments must always balance.Then what is the meaning of deficit and surplus Then what is the meaning of deficit and surplus in the balance of payments?in the balance of payments?If there is no imbalalnce, then what is the If there is no imbalalnce, then what is the meaning of disequilibrium in BoP?meaning of disequilibrium in BoP?Why do countries talk about the BoP adjustment Why do countries talk about the BoP adjustment and BoP settlements?and BoP settlements?

Autonomous and Accommodating Autonomous and Accommodating TransactionsTransactions

The distinction in made to understand the The distinction in made to understand the concepts of surplus and deficitsconcepts of surplus and deficitsAn autonomous transaction take place An autonomous transaction take place regardless of the size of the other items in the regardless of the size of the other items in the BoPBoPBorrowing – long term capital A/CBorrowing – long term capital A/CInterest payments – services A/CInterest payments – services A/CForeign aid – unilateral A/CForeign aid – unilateral A/CExport of goods – goods A/CExport of goods – goods A/C

Autonomous and Autonomous and Accommodating TransactionsAccommodating TransactionsAll the above transactions arise out of All the above transactions arise out of autonomous economic activities autonomous economic activities regardless or independent of BoP situation regardless or independent of BoP situation of the country.of the country.On the other hand the accommodating On the other hand the accommodating transaction take place on account of BoP transaction take place on account of BoP situation in the country and are the cause situation in the country and are the cause of BoP situationof BoP situation

Autonomous and Autonomous and Accommodating TransactionsAccommodating TransactionsExample 1: South Africa exporting Gold and Example 1: South Africa exporting Gold and Indian exporting Gold.Indian exporting Gold.Result of the BoP situation Vs. cause of the BoP Result of the BoP situation Vs. cause of the BoP situationsituationExample 2: Malaysia borrowed to construct Example 2: Malaysia borrowed to construct bridge vs. Malaysia borrowed from WB to settle bridge vs. Malaysia borrowed from WB to settle depositsdepositsEntry in the current A/C and capital A/C are Entry in the current A/C and capital A/C are considered as autonomous transactionconsidered as autonomous transactionEntry in the international liquaidity A/C are Entry in the international liquaidity A/C are accommodating transaction.accommodating transaction.

Autonomous and Autonomous and Accommodating TransactionsAccommodating TransactionsThe distinction lies in the question whether the The distinction lies in the question whether the transaction has caused the BoP situation or is transaction has caused the BoP situation or is the cause of the BoP situation.the cause of the BoP situation.If autonomous credit = autonomous debit -> no If autonomous credit = autonomous debit -> no surplus or deficitsurplus or deficitIf autonomous credit > autonomous debit -> If autonomous credit > autonomous debit -> surplus in BoPsurplus in BoPIf autonomous credit < autonomous debit -> If autonomous credit < autonomous debit -> deficitdeficit

Surplus or Deficit in BoPSurplus or Deficit in BoP

The sum of the accommodating The sum of the accommodating transaction entered as credit in the transaction entered as credit in the international liquidity A/C -> Deficit in BoPinternational liquidity A/C -> Deficit in BoPSimilar entry in the debit side of the Similar entry in the debit side of the international liquidity A/C -> surplus in BoPinternational liquidity A/C -> surplus in BoPIf international liquidity A/C shows zero If international liquidity A/C shows zero entry -> equilibrium in BoPentry -> equilibrium in BoP

Balance and EquilibriumBalance and Equilibrium

Balance is a book keeping concept and Balance is a book keeping concept and Equilibrium is a meaningful economic concept.Equilibrium is a meaningful economic concept.Balance is always present.Balance is always present.Equilibrium is there only when autonomous Equilibrium is there only when autonomous credits are equal to autonomous debitscredits are equal to autonomous debitsSo balance and equilibrium or imbalance and So balance and equilibrium or imbalance and disequilibrium can not be used interchangeably.disequilibrium can not be used interchangeably.There can be disequilibrium with the presence of There can be disequilibrium with the presence of balance in the BoP accounts.balance in the BoP accounts.

Location and DurationLocation and DurationWhether deficit in BoP is always bad and surplus Whether deficit in BoP is always bad and surplus is always good?is always good?To analyze whether surplus is always good and To analyze whether surplus is always good and deficit is always bad, we need to explore to deficit is always bad, we need to explore to aspects of BoP disequilibrium.aspects of BoP disequilibrium.Surplus in current A/C is good (earning capacity)Surplus in current A/C is good (earning capacity)Surplus in capital A/C is not necessarily good Surplus in capital A/C is not necessarily good sign (represents the borrowing status/capacity)sign (represents the borrowing status/capacity)Dificit in the current A/C is bad.Dificit in the current A/C is bad.Capital A/C deficit is not necessarily bad Capital A/C deficit is not necessarily bad (lending)(lending)

Location and DurationLocation and DurationCurrent A/C deficit of a short term duration can Current A/C deficit of a short term duration can be corrected through capital A/C borrowing.be corrected through capital A/C borrowing.It is true that surplus is unquestionably good?It is true that surplus is unquestionably good?Temporary surpluses are good if the surpluses Temporary surpluses are good if the surpluses are to a) offset capital A/C deficit, b) to pay off are to a) offset capital A/C deficit, b) to pay off old debtsold debtsIf the country is operating with persistent If the country is operating with persistent surplus, it results in a) accumulation of foreign surplus, it results in a) accumulation of foreign exchange reserves -> money supply -> inflationexchange reserves -> money supply -> inflation

Location and DurationLocation and Duration

If the country is operating with persistent If the country is operating with persistent surplus, it results in b) exchange rate surplus, it results in b) exchange rate appreciation ->exports are less competitive, appreciation ->exports are less competitive, import expansion and export contraction.import expansion and export contraction.Precise result depends on the deferent policies.Precise result depends on the deferent policies.In any case, persistent surplus do not produce In any case, persistent surplus do not produce healthy effects on the country.healthy effects on the country.So, BoP surpluses are not good as well as So, BoP surpluses are not good as well as deficits.deficits.

BOP settlement and AdjustmentBOP settlement and Adjustment

If we have a deficit/ surplus in the current/ capital A/c If we have a deficit/ surplus in the current/ capital A/c resulting out of the autonomous transactions, then we resulting out of the autonomous transactions, then we “settle”“settle” this deficit or surplus by accommodating this deficit or surplus by accommodating payments/receipts , so as to produce BOP balance in payments/receipts , so as to produce BOP balance in the accounting sense.the accounting sense.This is a process of This is a process of BOP settlement.BOP settlement.This settlement is temporary or the fire so as to speak, This settlement is temporary or the fire so as to speak, has extinguished, but the house is still not has extinguished, but the house is still not reconstructed.reconstructed.But, on the other hand, if we control the deficit/surplus But, on the other hand, if we control the deficit/surplus by controlling the forces which results in imbalance, by controlling the forces which results in imbalance, then it is called then it is called Adjustment Adjustment in the BOP.in the BOP.

BOP settlement and AdjustmentBOP settlement and Adjustment

BOP adjustment takes place only when we BOP adjustment takes place only when we produce balance in the autonomous transactionproduce balance in the autonomous transaction when accounting balance is produced with the when accounting balance is produced with the help of accommodating transactions.help of accommodating transactions.– Settlement.Settlement.

When balance is produced without the help of When balance is produced without the help of accommodating transactions, there is BOP accommodating transactions, there is BOP adjustment.adjustment.Adjustment is more desirable than settlement.Adjustment is more desirable than settlement.

Full Employment Equilibrium or True Full Employment Equilibrium or True BalanceBalance

When the sum of accommodating transactions When the sum of accommodating transactions are zero, there is equilibrium in the BOP.are zero, there is equilibrium in the BOP.However, it is possible that such a equilibrium However, it is possible that such a equilibrium may be achieved bymay be achieved by– (a) Imposing trade and payment restrictions(a) Imposing trade and payment restrictions

Import quota, import tariff, export dutiesImport quota, import tariff, export dutiesRestrictions on foreign travelRestrictions on foreign travelExchange rate support policies and other monetary and Exchange rate support policies and other monetary and fiscal policy applications,fiscal policy applications,

– (b) By causing internal imbalance:(b) By causing internal imbalance:Causing inflation and unemployment in the economy.Causing inflation and unemployment in the economy.

Full Employment Equilibrium or True BalanceFull Employment Equilibrium or True Balance

If BOP equilibrium is attained by causing either (a) or If BOP equilibrium is attained by causing either (a) or (b) or both, then it is not considered true balance, or (b) or both, then it is not considered true balance, or full employment equilibrium.full employment equilibrium.But equilibrium in the BOP is considered to be true or But equilibrium in the BOP is considered to be true or full employment, if the balance is achieved without (a) full employment, if the balance is achieved without (a) the use of commercial policies and (b) inflation or the use of commercial policies and (b) inflation or deflation.deflation.True balance is inconsistent with the existence of True balance is inconsistent with the existence of commercial policy and internal imbalance.commercial policy and internal imbalance.““External balance” must be consistent with “internal External balance” must be consistent with “internal balance” on the one hand and “free trade” of goods balance” on the one hand and “free trade” of goods and services, and factor flows on the other.and services, and factor flows on the other.

BOP and Economic PolicyBOP and Economic PolicyWhen BOP is in disequilibrium, one can talk When BOP is in disequilibrium, one can talk about suggested economic policy in relation to about suggested economic policy in relation to a given BOP situation of a country.a given BOP situation of a country.For example: If a country has a deficit and an For example: If a country has a deficit and an accommodating capital inflow, accommodating capital inflow, – It must try to implement measures aimed at It must try to implement measures aimed at

reducing the deficitreducing the deficit– But if there is surplus in BOP and a corresponding But if there is surplus in BOP and a corresponding

accommodating capital outflow, it may not take accommodating capital outflow, it may not take immediate measures.immediate measures.

To understand the nature of deficit, we have to judge it To understand the nature of deficit, we have to judge it against the background of the general economic policy against the background of the general economic policy of a country and policy options of the country.of a country and policy options of the country.If the country is already pursuing tight monetary and If the country is already pursuing tight monetary and fiscal policy and has tariff and import control, but yet it fiscal policy and has tariff and import control, but yet it has serious deficits, it may be very difficult for such a has serious deficits, it may be very difficult for such a country to get rid of its deficits.country to get rid of its deficits.We need to know about actual and potential deficits.We need to know about actual and potential deficits.

The actual deficit that has appeared on the surface is The actual deficit that has appeared on the surface is in that case much smaller than the potential deficits, in that case much smaller than the potential deficits, that could have surfaced that could have surfaced – But has indeed been suppressed by tight domestic and But has indeed been suppressed by tight domestic and

foreign trade economic policies of the country.foreign trade economic policies of the country.– The possibility of pursuing a more restrictive policy to close The possibility of pursuing a more restrictive policy to close

the actual deficit may no longer exist for the country which the actual deficit may no longer exist for the country which has already experiencing upper limit.has already experiencing upper limit.

If the economy is already experiencing politically If the economy is already experiencing politically unacceptable levels of high unemploymentunacceptable levels of high unemployment– It is almost impossible to try to cut down BOP deficits by It is almost impossible to try to cut down BOP deficits by

pursuing still contractionary monetary, fiscal and other pursuing still contractionary monetary, fiscal and other policies.policies.

– In such situation, only international capital flows can play In such situation, only international capital flows can play vital role in equilibrating the BOPvital role in equilibrating the BOP

It is left to the ingenuity of the country’s It is left to the ingenuity of the country’s planners and policy makers to adopt ways and planners and policy makers to adopt ways and means of converting accommodating capital means of converting accommodating capital imports of short term nature into planned long imports of short term nature into planned long term autonomous capitals imports.term autonomous capitals imports.