Composition of Balance of Payments(BoP)

Yashonidhi Shukla
Division A

Roll No. 59

According to the Reserve Bank of India, The balance of payments of a country is a systematic
record of all economic transactions between the residents of a country and the rest of the world.
It presents a classified record of all receipts on account of goods exported, services rendered
and capital received by residents and payments made by them on account of goods imported and
services received and capital transferred to non-residents and foreigners. It reflects all
payments and liabilities to people outside the country and all payments and obligations received
from people outside the country. The BOP accounts summarize international transactions for a
specific period, usually a year, and are prepared in a single currency, typically the domestic
currency for the country concerned. Sources of funds for a nation, such as exports or the receipts
of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for
imports or to invest in foreign countries, are recorded as negative or deficit items. Balance of
payments (BoP) is a major indicator of a countrys status in international trade. In this, double
entry book keeping system is followed where the credit side shows the receipt of foreign
exchange from abroad and the debit side shows the payments in foreign exchange to foreign
residents.
Balance of Payments (BoP) statistics systematically summaries the economic transactions of an
economy with the rest of the World for a specific period. It is also an important indicator of
pressure on a countrys foreign exchange rate. It helps to forecast a countrys market potential,
especially in the short run. Changes in a countrys Balance of Payment may signal an imposition
or removal of controls over payment of dividends and interest, license fees, royalty fees, or other
cash disbursements to foreign firms or investors.

Balance of payment (BoP) comprises of:1.

2.
3.
4.
5.

Current account
Capital account
Errors and omissions
Official Reserves Account.
Unilateral Transfer Account

1. Current Account:- This is the countrys trade in goods and services in the current period.

This is record of a countrys trade in goods and services in the current period.
CA = Exports (X) Imports (M).
It is divided into 4 sub-categories:
1.
2.
3.
4.

Goods trade
Services trade
Income
Current transfers
The sum of the four sub-categories = CA balance

Goods Trade, i.e., the sale of goods abroad, are credit entries because all transactions giving rise
to monetary claims on foreigners represent credits. On the other hand, goods imports, i.e.
purchase of goods from abroad, are debit entries because all transactions giving rise to foreign
money claims on the home country represent debits. Merchandise imports and exports form the
most important international transaction of most of the countries .Invisible exports, i.e., services
trade, are credit entries and invisible imports, i.e. Purchases of services, are debit entries.
Important invisible exports include the sale abroad of such services as transport, insurance, etc.,
foreign tourist expenditure abroad and income paid on loans and investments (by foreigners)in
the home country form the important invisible entries on the debit side.

Theoretically, the balance should be zero, but in the real world this is improbable, so if the
current account has a surplus or a deficit, this tells us something about the government and state
of the economy in question, both on its own and in comparison to other world markets.

A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how
much a country is saving as opposed to investing. What this means is that the country is
providing an abundance of resources to other economies, and is owed money in return. By
providing these resources abroad, a country with a CAB surplus gives other economies the
chance to increase their productivity while running a deficit. This is referred to as financing a
deficit.

Current Account Surplus (In Billion US $)

250
200
Current Account Surplus
(In Billion US $)

150
100
50
0
Germany

China

Saudi Arabia

Kuwait

A deficit reflects government and an economy that is a net debtor to the rest of the world. It is
investing more than it is saving and is using resources from other economies to meet its domestic
consumption and investment requirements. For example, let us say an economy decides that it
needs to invest for the future (to receive investment income in the long run), so instead of saving,
it sends the money abroad into an investment project. This would be marked as a debit in the
financial account of the balance of payments at that period of time, but when future returns are
made, they would be entered as investment income (a credit) in the current account under the
income section.
A current account deficit is usually accompanied by depletion in foreign-exchange assets because
those reserves would be used for investment abroad. The deficit could also signify increased
foreign investment in the local market, in which case the local economy is liable to pay the
foreign economy investment income in the future.

Current Account Deficit (In US Billion $)

500
450
400
350
300

Current Account Deficit (In

US Billion $)

250
200
150
100
50
0
U.S.A United Kingdom India

Canada

France

It is important to understand from where a deficit or a surplus is stemming because sometimes

looking at the current account as a whole could be misleading.
Current Account Convertibility in India, In Current Account can be converted into Foreign
Currency (E.g. $) and Vice-versa. It is freely permitted in India by Reserve Bank of India.

2.

Capital account (KA):- This includes all short- and long-term transactions pertaining to
financial assets. A = Capital Inflow (Credit) Capital outflow (Debit).

The two main components:

1. Capital account.
2. Financial account (direct, portfolio, other).

KA balance = Sum of capital account and financial account.

The Capital Account consists of short- terms and long-term capital transactions A capital outflow
represents a debit and a capital inflow represents a credit. For instance, if an American firm
investsRs.100 million in India, this transaction will be represented as a debit in the US balance of
payments and a credit in the balance of payments of India. The payment of interest on loans and

dividend payments are recorded in the Current Account, since they are really payment s for the
services of capital. As has already been mentioned above, the interest paid on loans given by
foreigners of dividend on foreign investments in the home country are debits for the home
country, while, on the other hand, the interest received on loans given abroad and dividends on
investments abroad are credits
Capital Account Convertibility In India, Partial Capital Account convertibility is there, i.e. up to
$200,000 is allowed by Reserve bank of India .Up to $500 million the bank need not to take
permission from RBI for Foreign Loan.
Financial account includes:Transactions in the external assets and liabilities of an economy constitute another significant
category of the balance of payments statistics. Short and long-term international financial flows
of the private and public sector are followed under this account. The financial flows, which are
an integral part of the international economic transactions, basically cover all transactions
associated with the change of ownership in external financial assets and liabilities of an
economy. According to the type of the financial flows, the Financial Account is classified as
follows;
i. Direct Investment
ii. Portfolio Investment
iii. Financial Derivatives
iv. Other Investment
v. Reserve Assets.

i. Direct Investment:Direct investment is the category of international investment that reflects the objective of a
resident entity in one economy obtaining a lasting interest in an enterprise resident in another
economy. Direct investment definition requires that direct investor should have an ownership of
10 percent or more of the ordinary shares or the voting power in the management of an
enterprise. Being recorded on a directional basis (residents direct investment abroad and
nonresidents direct investment in the reporting economy), the major components of the direct
investment item are Equity Capital, Reinvested Earnings, and Other Capital:
Equity Capital refers to the investment of a direct investor for the establishment of a new
enterprise outside the economy in which the investor is located or the acquisition of the share of

ownership in an existing enterprise, Reinvested Earnings refers to direct investors share of

earnings not distributed as dividends and added to the equity capital,
Other Capital refers to investment associated with the borrowing and lending of funds between
direct investors and their subsidiaries, branches and associates.
ii) Portfolio Investment
The portfolio investment, which is briefly defined as investment on securities, generally includes
equity securities and debt securities in the form of bills and bonds issued by public and private
institutions as well as money market instruments. There are significant differences between
direct investment and portfolio investment, the most important being the issue of management
and control. In the case of direct investment, investors expect to have an effective voice in the
management and control of the enterprise. However, portfolio investors provide funds for the
resident enterprise from international capital markets without having an effective voice in
management. Also in addition to the investment capital, direct investors may provide production
technology and management skills to the direct investment enterprise. On the other hand, the
portfolio investor provides only capital to the enterprise. The portfolio investment sub items,
classified under assets and liabilities, are equity securities and debt securities.
iii) Financial Derivatives
Financial derivatives are financial instruments that are linked to an underlying asset
that may be purchased or sold in their own right. Derivatives are conducted by
binding contracts in which the terms of future transactions are determined at
present. There are two main types of financial derivative contracts: forward-type and
options-type.
iv) Other Investment
All the other financial transactions, not covered by direct investment, portfolio
investment, financial derivatives and reserves are included in this category.
Similar to the portfolio investment, it is classified on an asset/liability basis according
to the type and institutional sector as follows:

Trade credits (credits extended for exports or imports)

Loans
Currency and deposits
Other assets and liabilities.

v) Reserve Assets
Reserve Assets include;

Monetary Gold
Special Drawing Rights (SDRs)
Reserve Position in the Fund
Foreign Exchange Holdings
Other claims

3. Net Omission:The balance of payments is constructed as an accounting system, in which each transaction is
recorded twice with two opposite signs (credit and debit entries). That is, the Current
Account and the Capital and Financial Account should always be equal in absolute values
since each transaction is recorded as credit and debit entries with equal values. In practice,
however, this theoretical consequence occurs rarely. The collection of data from different
sources leads to differences in valuation, measurement and time of recording; as a result,
these differences are reflected in Net Errors and Omissions item as residual. Here are
examples: The physical movement of goods is recorded on the basis of customs documents,
while records regarding the payments are provided from banks reports. The value of these
records may differ causing unequal entries to the related items. Assuming that the exported
goods are invoiced as 100 units in custom documents, and 70 units of this total amount are
deposited to the exporters account in a resident bank, while the remaining 30 units are kept
in a deposit account abroad; the remaining 30 units is recorded under Net Errors and
Omissions item since it will not be reflected in resident banks records. However, the change
in resident nonbank sectors deposit accounts abroad is obtained from the Bank for
International Settlements (BIS) statistics and reflected under the Other
Investment/Assets/Currency and Deposits/Other Sectors item.

4. Official Reserves Account.

Official reserves represent the holdings by the government or official agencies of the
means of payment that are generally accepted for the settlement of international claims.
5. Unilateral Transfer Account

Unilateral transfers is another terms for gifts. These unilateral transfers include private
remittances, government grants, disaster relief, etc. Unilateral payments received from
abroad are credits and those made abroad are debits.