Balance_of_Payments

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Balance of Payments : 

Balance of Payments

Definition: 

Definition Balance of payments is a statement listing receipts and payments in international transactions of a country. It is based on the concept of double entry book keeping. Where credit balance shows the receipt of foreign exchange and debit balance shows the outflows or payments of foreign exchange and debit and credit balance equal if the various entries are done properly. Disequilibrium does occurs but not from accounting point of view.

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Receipts and Payments are divided into two heads: Current Account and Capital Account

Current Account Transactions: 

Current Account Transactions Current Account Receipts Export of Goods Invisibles Non monetary movement of gold

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Current Account Payments Import of goods Invisibles Non monetary movement of gold

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Export of goods effects flow of foreign exchange into the country, while import of goods causes outflow of foreign exchange from the country. The difference between the two is known as balance of trade. If Exports > Imports balance of trade is Surplus If Imports > Exports balance of trade is Deficit

Invisibles: 

Invisibles Includes receipts and payments on account of: Trade in services such as travel and tourism, transport etc. Investment income such as interest and dividend etc. Unilateral transfers like : pensions, remittances, gifts or any other transfers for which no services are being rendered

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Non monetary sale and purchase of gold is being done for industrial purpose that is shown in the current account either separately or with the trade in merchandise. If Credit > Debit current account is surplus If Debit > Credit current account is deficit

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Credit Debit Balance A. Current Account Merchandise import 120 Merchandise export 100 Balance of Trade -20 Invisibles Services (Net) 4 Unilateral Transfers (Net) 2 Investment Income (Net) 1 Balance of Current Account -15

Lets Solve: 

Lets Solve Find out (a) the balance of trade and (b) balance of current account, if: Inflow on account of services 1000 Outflow on account of services 800 Outflow of dividend royalty etc. 1100 Inflow of dividend etc. 560 Export of goods 10000 Import of goods 12000 Remittances 1200

Capital Account Transactions: 

Capital Account Transactions Capital account transactions on the other hand, comprise log term and short term inflow and outflow of funds under the capital account receipt and payment heads. Long term are for more than a year Short term for less than a year

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Credit side of capital account Official and private borrowing from abroad net of repayments Direct and portfolio investment Short term investments into the country It also records the bank balances of the non – residents held in the country

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Debit side of capital account Dis-investment of capital invested into the country Country’s investment abroad Loans given to a foreign government or a foreign party Bank balance held abroad

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When the addition of credit side of the capital account adding up with the credit side of the current account is compared with the addition of debit side of capital account and debit side of current account the difference is known as basic balance which may be either negative or positive.

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Credit Debit Balance A. Current Account Merchandise import 120 Merchandise export 100 Balance of Trade -20 Invisibles Services (Net) 4 Unilateral Transfers (Net) 2 Investment Income (Net) 1 Balance of Current Account -15 B. Capital Account Long term: Direct investment abroad 11 Direct foreign investment inflow 18 Portfolio Investment (Net) 9 Loans official and private net of repayments 12 Basic Balance -5

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Balancing of capital account is not complete with the basic balance. The debit and credit sides of the short term capital account transactions are added to their respective sides and then the capital account is balanced.

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Credit Debit Balance A. Current Account Merchandise import 120 Merchandise export 100 Balance of Trade -20 Invisibles Services (Net) 4 Unilateral Transfers (Net) 2 Investment Income (Net) 1 Balance of Current Account -15 B. Capital Account Long term: Direct investment abroad 11 Direct foreign investment inflow 18 Portfolio Investment (Net) 9 Loans official and private net of repayments 12 Basic Balance -5 Short term: Holdings with banks 4 Other short term transactions 3 Balance of capital account 11

Problem: 

Problem Find out the balance of capital account, if: Inflows of loans: 2000 Repayment of loans: 2150 FDI inflow: 7000 FDI outflow: 1500 FII’s investment in India: 500 Short term movement of funds: -200

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After balancing the capital account, errors and omissions are mentioned. Finally, the two sides are compared. The difference is known as overall balance. Errors and omissions, collectively termed as statistical discrepancy arise for different reasons like:

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Difficulties involved in collecting balance of payment data. Different sources of data that sometimes differ in approach Also movement of capital may precede or follow the transactions that they are supposed to finance Certain figures are based on estimates

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Lastly errors and omissions may arise due to unrecorded illegal transacctions.

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Credit Debit Balance A. Current Account Merchandise import 120 Merchandise export 100 Balance of Trade -20 Invisibles Services (Net) 4 Unilateral Transfers (Net) 2 Investment Income (Net) 1 Balance of Current Account -15 B. Capital Account Long term: Direct investment abroad 11 Direct foreign investment inflow 18 Portfolio Investment (Net) 9 Loans official and private net of repayments 12 Basic Balance -5 Short term: Holdings with banks 4 Other short term transactions 3 Balance of capital account 11 C. Errors and Omissions -1 Overall Balance (A + B + C) -5

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When the overall balance is found to be in deficit, the monetary authorities arrange for capital flows to cover up the deficit. Such inflows may take the form of official borrowings or purchases from the International Monetary Fund, from this point of view, the capital inflows are divided into two parts:

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Autonomous and Accommodating Inflows Accommodating cash inflow is the inflow of funds on capital account for meeting the overall balance of payments deficit. While autonomous capital flows takes place regardless of such considerations.

Official Reserves Account: 

Official Reserves Account Held by the monetary authorities of a country. Consists of monetary gold, SDR allocations by the IMF, and foreign currency assets. The foreign currency assets are held in the form of balances with foreign central banks and investment in Foreign Govt. Securities. If the overall BOP is surplus it gets added to the official reserves account and vice versa.

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Credit Debit Balance A. Current Account Merchandise import 120 Merchandise export 100 Balance of Trade -20 Invisibles Services (Net) 4 Unilateral Transfers (Net) 2 Investment Income (Net) 1 Balance of Current Account -15 B. Capital Account Long term: Direct investment abroad 11 Direct foreign investment inflow 18 Portfolio Investment (Net) 9 Loans official and private net of repayments 12 Basic Balance -5 Short term: Holdings with banks 4 Other short term transactions 3 Balance of capital account 11 C. Errors and Omissions -1 Overall Balance (A + B + C) -5 D. Official Reserves SDR allocations 3 Net official reserves 2 Overall Balance -5 Official reserves movement 5

Problem: 

Problem Find out the amount of foreign exchange reserves on 31/03/11 if: Foreign exchange reserves on 31/03/10: 70000 Balance of current account during 2010 -11 -5500 Balance of capital account during 2010 -11: 2200 Statistical discrepancy during 2010-11: -500

Equilibrium, Disequilibrium & Adjustment: 

Equilibrium, Disequilibrium & Adjustment Accounting Equilibrium : Since BOP is constructed on the basis of double-entry book keeping, credit is always equal to debit. If debit is greater than the credit, funds flow into the country that are recorded on the credit side off the capital account and the excess of debit is wiped out.

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Thus the concept of BOP is based on the concept of accounting equilibrium, i.e. Current Account + Capital Account = 0

Disequilibrium and Adjustment: 

Disequilibrium and Adjustment Disequilibrium and the Focus of Adjustment: In the economic sense, BOP equilibrium occurs when a surplus or deficit is eliminated from the BOP. But normally such equilibrium is not found. Rather it is disequilibrium in the BOP that is a normal phenomenon.

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If national income exceeds national spending, the excess amount will be invested abroad resulting in capital deficit. If national spending exceeds national income causes borrowings from abroad which would push the capital account into surplus. Disparity in national income and national spending influences the capital account via the current account also.

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If National Output > National Spending The difference manifests itself in export causing current account surplus. Surplus is invested abroad resulting in capital account deficit. If National Output < National Spending Deficit appears on the current accounts The country borrows to meet the current account deficit and the borrowing results in capital account surplus.

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Increase in the money supply raises the price level, exports turn uncompetitive and fall of export earnings leads to deficit in the current account. Similarly, the higher prices of domestic goods make the price of imported goods competitive as a result of which imports rise and a deficit appears in the current account.

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If the currency of the country depreciates, exports become competitive and export earnings improve. On the other hand imports become costlier. If as a result, imports are restricted, the trade accounts balance will improve but if imports are not restrained, a deficit will appear on the trade account. In fact, the net effect depends upon how price-elastic is the demand for export and import.

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Any increase in the domestic interest rate causes capital inflow in search of higher returns and the capital account turns surplus. The reverse is the case when interest rate falls. Disequilibrium becomes a cause for concern when it is associated with the current account because it represents a shift in real income, and also because adjustments in this account is not very easy.

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If the balance of trade is in deficit zone and if the deficit is too large to be covered by the invisible trade surplus, a current account deficit will occur.

Correcting the deficit is not kids game?: 

Correcting the deficit is not kids game? Autonomous and accommodating capital flows are not so smooth. If deficit on current account continues to persist, the official reserves will be eroded. If the country borrows a large amounts to meet the deficit, it may fall into the vicious debt trap. That is why adjustment measures are primarily directed at correcting disequilibrium in the trade account.