International Finance

Lecture :5

Nature of Balance of payments

International finance is an area of study concerned with the balance of payments(BOP) and the international monetary system. Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. 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.

Components of BOP
The two principal parts of the BOP accounts are the current account , the capital account and reserves. 1. The current account ; shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports - payments for imports), factor income (earnings on foreign investments - payments made to foreign investors) and cash transfers. It is called the current account as it covers transactions in the "here and now" - those that don't give rise to future claims.

Components of BOP
The current account consists of a) marchandise trade: it receives more attention than any of the other accounta because this is where the imports and exports of goods are reported. These are often the largest single component of all international transection. In this A/C sales of goods to foreigners(exports)are reported as credits, ourchase of goods from overseas(imports) are recorded as debits. This payment can be made by either reducing current claims on foreigners or increasing foreign liabilities.

Components of BOP
b) services:

Its includes many payments such as freight and insurance on international shipment, tourist travel, profits and income from overseas ,personal expenditures by govt. civilian and militery personal overseas, payments for MGT fees, royalities film rental and constraction services.

All purchase of these services are recorded as debit while these services are similer to exports are recorded as credit.

Components of BOP
c) unrequited transfer: A balance of payments account that reports transactions which do not involve repayment or performance of any service. Sending food to any refugees by red cross, military pension by others countries etc.

Components of BOP
2. The Capital Account records the net change in ownership of foreign assets. It includes the reserve account (the foreign exchange market operations of a nation's central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The term "capital account" is also used in the narrower sense that excludes central bank foreign exchange market operations: Sometimes the reserve account is classified as "below the line" and so not reported as part of the capital account.

Components of BOP
3. Reserves: Reserves are used for bringing BOPaccounts into balance. Four major types of reserves available to monetary authorities in meeting BOP deficit. These are, monetary gold, special drawing rights, IMF reserve position, foreign exchange assets.

What is BOP Disequilibrium

Though the credit and debit are written balanced in the balance of payment account, it may not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of surplus.

What is BOP Disequilibrium

Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to foreigners. It arises when the effective demand for foreign exchange of the country exceeds its supply at a given rate of exchange. This is called an 'unfavourable balance'. Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a situation arises when the effective demand for foreign exchange is less than its supply. Such a surplus disequilibrium is termed as 'favourable balance'.

Causes of Disequilibrium in BOP

1. Population Growth

Most countries experience an increase in the population and in some like India and China the population is not only large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may increase as population increases.
2. Development Programmes Developing countries which have embarked upon planned development programmes require to import capital goods, some raw materials which are not available at home and highly skilled and specialized manpower. Since development is a continuous process, imports of these items continue for the long time landing these countries in a balance of payment deficit.

Causes of Disequilibrium in BOP

3. Demonstration Effect When the people in the less developed countries imitate the consumption pattern of the people in the developed countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the balance of payments. 4. Natural Factors Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial production in the country. The exports may decline while the imports may go up causing a discrepancy in the country's balance of payments.

Causes of Disequilibrium in BOP

5. Cyclical Fluctuations Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments.

6. Inflation An increase in income and price level owing to rapid economic development in developing countries, will increase imports and reduce exports causing a deficit in balance of payments.

Causes of Disequilibrium in BOP

7. Poor Marketing Strategies The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the developing countries have pushed them into huge deficits. 8. Flight Of Capital Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing countries may also shift their capital to developed countries to safeguard against political uncertainties. These capital movements adversely affect the balance of payments position.