international trade and finance 2

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International Trade and finance

lecture no. 2

Prof. Mazahir saifee



Introduction

The government of every country keeps an account of economic transactions with other countries. Such anaccount of international transactions is useful for anumber of reasons. It provides useful information to

government regarding flow of goods and services andthe assets. It also enables the government to design anappropriate economic policy (e.g. trade policy,monetary policy, fiscal policy etc.). The record of alleconomic transactions of a country with the rest of the

world is known as balance of payment. In this chapter,we shall discuss the important issues related to balanceof payments.



Meaning of balance of payment

Balance of payments of a country as an annualstatement of accounts of all economictransactions, between the resident of the

country with the rest of the world (i.e. othercountries).

Balance of payment is summary statement of accounts of such receipts and payments.

All receipts and payments takes place inforeign exchange.



Characteristic Features of BOP

From the definition of balance of payments, following notablefeatures emerge:

1. Balance of payments is a summary of international transactions of

a country.2. International transactions arise on account of (a) flow of goods,(b) flow of services and flow of capital. Due to these flows,international receipts and payments take place.

3. Economic transactions as reflected in BOP take place between theresidents (normal residents) of a country and residents of foreigncountries.

4. Balance of payment is a flow concept. All the economic flows (e.g.flow of goods, flow of services and flow of capital) as shown inBOP are related to a certain time period usually a financial year.



Economic transactions in balance of

payments export and import of goods (or visible items of

trade).in this category, all types of physical goodsexported and imported are included. These are called

visible items because goods can be seen, touched andmeasured and are duly recorded at custom barriers.

Invisible Items. Invisible items of trade refer to alltypes of services given and received. These includeservices like shipping, banking, insurance, tourism etc.

There are invisible because services are not visible likephysical goods. Income from interest, dividend etc. alsofalls under this category.



Cont

Unilateral Transfers. Usually, an economic transaction involvespayment and receipt of foreign exchange in exchange of flow. Butsome economic flows between nations also ta ke place without anypayment which are called unilateral (one sided) payments ortransfer payments. Examples of this category are gifts received by

residents from foreigners, remittances sent by emigrants torelatives, war indemnities paid by a defeated country etc.

Capital Transfers. Capital transfers relate to capital receipts andcapital payments. These include borrowing capital repayments, saleof assets, change in stock of gold and reserve of foreign exchangeetc. these relate to movements of long term and short term capital

between nations. For example when the residents of a countrywant to borrow from other countries, we may say that they areimporting capital. Similarly when the residents of a country want toinvest in other countries, we may say that they are exportingcapital.



Structure (or components) of balance

of payments As discussed above, a balance of payments statement is a summary of a

nation's total economic transactions undertaken on international account.

It is unusually composed of two sections:

Current Account

Capital Account.

Current Account. current account is that account of BOP, which records

imports and exports of goods and services and unilateral transfers. It thus,

records the following three items

1. visible items of trade

2. invisible items and3. unilateral transfers transfers.

(Note. In India unilateral transfers are treated as part of invisible trade.)

Current account transactions are called account by actual transaction

because all the items included in it are actually transacted.



Items of Current Account

1. Exports and Imports of Visible Items orGoods. All visible goods (or material goods)which are exported and imported constitute

items of current account. The record of thesegoods is available with the ports.

2. Invisible Items (or Non-Material Goods orServices). These goods are invisible becausetheir record is not available with the ports.These items include the following:



Cont..

Transportation. Exports and imports of goods involvestransportation.Use of domestic transport by foreigners is knownas exports and use of foreign transport by natives is termed asimports

Services Rendered by CommercialUndertakings. Commercialundertakings such as shipping companies, banks, insurancecompanies,etc.which belong to the rest of the world give theirservices and the country also gives such services to the rest of theworld. These services form part of current account of the balanceof a payments.

Exports of Services. services of foreign experts are available by all

countries. The services' received from abroad are known asimports and services rendered to other countries are taken asexports. These services also form part of current account.



Cont

Traveling. Another invisible item of current account is traveling. Tourist of acountry visit foreign countries and foreigners can visit the country in connectionwith the business, health, education,pleasure,etc. the country visited by thetourist constitute exports for the visiting country and imports for the countryfrom which the tourist originates.

Investment Income. Rent, intrest

Donation and Gifts. Donation, gifts, etc. received from abroad by the natives areincluded under receipts and on the other hand donation, gifts, etc. given toother countries are treated as payments.

Government Transactions. Government of every country establishes embassies,offices of high commissioners and other missions abroad and spends a lot ontheir maintenance. Such expenditures are termed as payments and earning fromsuch sources known as receipts.

Miscellaneous. The miscellaneous or invisible items such as commission,advertisement, royalties, patent fees, rent, membership fees, etc. provided toabroad and received from abroad also form part of invisible items.

The above-mentioned items have their direct effect on country's income,output and employment.



Structure of balance of payment

account1.Current account

Credits (+) (receipts) Debits (-) (payments)

Exports Imports

Goods Goods

Services Services

Transfer payments Transfer payments



Items of capital accountCapital account is that account of BOP which records all such transactions

between the residents of a country and rest of the world which cause a change in

the asset or liability of the country. It concerns with capital transactions-all kinds of

short-term and long-term international capital transfers, gold and sale/purchase of

assets. It also deals with the payments of debts and claims. Main items of capital

account are listed below: -

Foreign Investment. It consists of direct foreign investment and portfolioinvestment. Foreign direct investment means purchasing an asset in other country

and at the same time acquiring control over it. For example a firm of a country

may set up a plant or acquirer a firm in another country. Portfolio investment on

the other hand, in the form of investment under which a firm/company of a

country purchases shares of a foreign company or buys bonds issued by foreign

governments. Under this form of investment, the firm does not have control over

the asset.

Private Loans. Private sector of the country' receives foreign loans which are

included under 'credit items' and their repayment is included under 'debit items'.

Movement of Banking Capital. Inflow of banking capital is shown under 'credit

items' and outflow of banking capital is shown under 'debit items'. However,

central bank is not included in banking capital.



Cont..

2. Capital account

Credits (+) (receipts) Debits (-) (payments)

(a) Borrowing from foreign

countries

(a) Lending to foreign

countries

(b) Direct investment by

foreign countries

(b) Direct investment in

foreign countries



Items under Monetary Movements Monetary movements consist of :-

Purchases and Re purchases from IMF. Purchases from IMF means

purchasing foreign currency from IMF and making payments in domestic

currency (say rupee). It is apart of loan from IMF because the country is

under obligation to buy back its currency by making payment in foreign

exchange. This is called repurchase .

Changes in Foreign Exchange Reserves. Foreign exchange reserves consist

of foreign currency, gold and SDR (Special Drawing Rights) with IMF. SDR is

a sort of currency issued by IMF. If a country has a deficit in its BOP, the

same can be met by withdrawing from foreign exchange reserves which is

recorded as credit item in BOP. An increase in the foreign exchange

reserves is shown as a debit item because it would cause outflow of

foreign exchange from the country to the foreign exchange reserve.

Miscellaneous. Besides above items, all other government capital receipts

(which also include the receipts of the central bank) are shown on 'credit

side', and payments on 'debit side'.



Difference between Current Account

and Capital Account

The balance of payments of a .country is divided intocurrent and capital accounts. The main points of differencebetween the two are as follows:

Current account records economic transactions relating to

exchange of goods and services and unilateral transferswhile capital account records capital transactions, e.g.borrowing and lending, sale and purchase of assets, changein' the stock of gold and foreign exchange.

Current account transactions are of flow nature, whilecapital transactions are of stock nature.

Current account transactions bring about a change in thecurrent level of a country's income, whereas capitaltransactions bring about a change in the capital stock of acountry.



Categories of balance

of payment There are three major categories of balance of payment accounts which

are explained below:

Balance of Trade (BOT). Balance of trade shows the balance of exports

and imports of visible items of trade. It is the difference between exports

and imports of goods. If exports of goods of a country are more than itsimports of goods, it has a favorable balance of trade or surplus in BOT. On

the other hand, if imports of goods are more than its exports of goods, it

has an unfavorable balance of trade or deficit in BOT. For example if India

exports goods for Rs. 10,000 crore and imports goods for Rs. 9,000 crore,

it has a surplus in its BOT of Rs. 1,000 crore. Thus,

Balance of Trade = Export of Goods - Imports of Goods

Remember, balance of trade does not include items of trade other than

visible items of trade. Specifically, it (BOT) does not include services.



Cont Balance of Current Account. It includes balance of trade, balance of

invisibles and balance of transfers.

Balance of current Account = Balance of Trade + Balance of Invisibles +Balance of Transfers

Net value of the three balances-balance of visible trade, balance of

invisible trade an balance of unilateral transfers is called balance oncurrent account.

Balance of Capital Account. Balance of capital account refers to thebalance of capital transfers, borrowing and lending, and sales from orpurchase of stocks of gold and foreign exchange. There are two types of capital flows included in the capital account. These are (i) autonomouscapital flows and (ii) accommodating capital flows. Autonomous capital

flows -are ordinary capital flows which are the outcome of economicconsiderations like earning of profits. On the other hand, accommodatingflows are specific. Such flows take place to bring BOP in equilibrium. Forexample, if there is deficit in current account of BOP, this deficit is settledby borrowing from other country or running down country's foreignexchange reserves by the government. Similarly a surplus in currentaccount must be matched by a deficit in the capital account.



Balance of payments always balances

In accounting sense, balance of payments of a country is always in

equilibrium. It is because of the reason that balance of payments is

prepared in terms of credits and debits based on the system of double

entry book-keeping. Under the system, each transaction gives rise to two

equal entries, one credit entry and the other debit entry. Thus, totalcredits and total debits are equal. Similarly, an international transaction

generates two equal entries, and, therefore, the sum of all international

receipts (credit items) are always equal to the sum of international

payments (debit items). Surplus on current account can lead to the grant

of loans to other countries by the government or it can lead to the

increase in the country's foreign exchange reserves. Contrary to it, a deficiton current account can be met by borrowing from abroad or by running

down country's foreign exchange reserves. The two sides, thus, necessarily

balance.

To illustrate the point that balance of payment always balances, a simply

hypothetical balance of payments statement can be given as under:



Disequilibrium in Balance of payment As we have studied that balance of payments always balances in the

accounting sense. The overall account of the balance of paymentsnecessarily balance or must always be in equilibrium. But, in the

functional sense there may be disequilibrium in the balance of payments

of a country. Now question arises: What is equilibrium or disequilibrium in

the balance of payments? When we talk of equilibrium or disequilibrium

in the balance of payments, we refer to that balance of the account

which do not include adjustments such as borrowing from International

Monetary Fund, use of SDRs, drawing from the foreign exchange

reserves held by the central bank, etc. While excluding these

adjustments items when there is neither deficit nor surplus, the balance

of payments is said to be in equilibrium. And when in this sense there is

either surplus or deficit, the balance of payments is said to be indisequilibrium. When a country is receiving more auto-nomous payments

from abroad than it has to make autonomous payments, it is considered

favorable balance of payments. Contrary to it, if a country makes more

payments that is autonomous spending) abroad what it receives,

(autonomous receipts) then the balance of payments is said to be

unfavorable.



Cont

Symbolically,

B=R-P

Where,

B stands for balance of payments

R stands for receipts from abroad

P stands for payments made abroad.

Favorable Balance of Payments

when R> P

Unfavorable Balance of Payments

when R< P



Difference between Equality and

Equilibrium In BOP

The equality in the BOP account refers to the

equality between the aggregate receipts from

and aggregate payments to other countries,

whereas equilibrium in BOP account implies the

equality between aggregate autonomous receipts

and aggregate autonomous payments.

Equality inBO

P account has no economicsignificance whereas equilibrium in BOP account

denotes economic stability of a country.



BasisBalance of Trade

Balance of Payments-

1. Meaning Balance of trade refers to the difference Balance of paymentS is a statement of

between exports and imports of goods all economic transactions between the

by a country in a year. residents of a country and rest of the

world during a year.

2. Concept It is a narrow concept as it is a compo- It is a wider concept

nent of balance of payments.

3. Natur e of Items It includes only visible items. It includes both visible and invisible

, items. It also includes unilateral and

capital transactions.

4. Natur e of It is only a partial record. Hence, it is It is. a complete record of economic

Recor d not a true indicator of economic relations transactions with the rest of the world.

with other countries. Hence, it provides a true picture of the

economy of a country with the rest of the

world.

5. Balance There may be surplus or deficit in BOT. BOP always balances in accounting

sense.



Causes of adverse BOP

Development programmers

Growth of population

Inflation

Huge international borrowing and lending Technological changes

Change in size of national income

Change in foreign exchange rates

Demonstration effect Natural factors

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