BOP - DEFINITION

• The BOP of any Country is “a systematic

record of all economic transactions taking
place between the residents of a given
country (domestic country) and the residents
of the rest of the world in a given accounting
period (viz. a year)”
 BOP – Major Accounts
• The BOP statements basically include six
major accounts which are as follows:
• Goods Account
• Services Account
• Unilateral Transfers Account
• Long Term Capital Account
• Short Term Capital Account
• International Liquidity Account
 GOODS ACCOUNT
• It includes the value of merchandise exports
and the value of merchandise imports.
• These items of foreign exchange earnings and
spendings are called as “visible” items in the
BOP.
 SERVICE ACCOUNT
• The Service account includes
• Transportation, banking and insurance
receipts and payments from and to foreign
countries,
• Tourism, travel services and tourist purchases
of goods and services received from foreign
visitors to home country and paid out in
foreign countries by home country citizens,
 SERVICE ACCOUNT
• Expenses of students studying abroad and
receipts from foreign students studying in the
home country.
• Expenses of diplomatic and military personnel
stationed overseas as well as the receipts
from similar personnel from overseas who are
stationed in the home country,
 SERVICE ACCOUNT
• Interest, profits, dividends and royalties
received from foreign countries and paid out
to foreign countries.
 UNILATERAL TRANSFER ACCOUNT

• This account includes all gifts, grants and reparation

receipts and payments to foreign countries.
• Unilateral transfer consist of two types of transfers
• Government Transfers
• Private Transfers
• Unilateral transfer receipts and payments are also
called ‘unrequited transfers’ because the flow is only
in one direction.
 LONG TERM CAPITAL ACCOUNT
• Any capital that has moved in or out of the country
for a period of one year or more is regarded as long
term capital movement.
• The Long Term capital account includes the following
categories.
• Private Direct Investment: This type of capital
movement is induced by differences in profit rate
between the home country and the rest of the
world.
 LONG TERM CAPITAL ACCOUNT
• Private Portfolio Investment: This type of
movement in and out of a country is induced
by differences in interest rate, dividends or
rate of return on capital between the home
country’s financial assets and those of the
foreign nations.
• Government loans to foreign governments
 SHORT TERM CAPITAL ACCOUNT
• Short term capital items fall due on demand
or in less than one year
• The vast majority of short term capital
transactions basically represents bank
transfers that finance trade and commerce.
• It is generally clubbed with ‘errors and
omissions’ or ‘unrecorded transaction’.
 INTERNATIONAL LIQUIDITY ACCOUNT

• This account simply records net changes in

foreign reserves.
• International Liquidity account can be
understood by looking at the following
example in which BOP experiences a surplus.
 SURPLUS CASE
Credit Debit
(Receipts) (Payments)
1. Goods Account 1500 800
2. Services 500 1400
3. Unilateral Transfers 100 120
4. LTC 900 400
5. Errors & Omissions 500 630
6. IL 150
 SURPLUS CASE
• TOTAL BOP 3500 3500
• The logic of accounting for this sum of $150 million
as a debit of payment is that, this sum represents
either
• Purchase or import of gold worth $150 million; or
• Net addition to accumulation of foreign exchange
reserves of $150 million;or
• Capital lending in the sum of $150 million to other
countries on short or long term basis.
 IMPLICATIONS OF LARGE CAD
• The large Cad can be financed through
– Capital A/c Surplus – Debt Crisis
– Official reserve a/c – reducing FER- BOP crisis
The problem of persistent CAD can be avoided by pursuing the
following measures:-
1. Control Fiscal deficit: higher FD- Higher Inflation X
and M
2. Devaluation of domestic Currency
3. Increase in productivity
4. Reduced dependence on costly ECBs and encouraging FDI
 Exchange Rate Regimes and
Currency Convertibility
• Exchange Rate:- the rate at which currencies are
traded in the international market.
• The price of one currency in terms of another.
• It helps in estimating the price of a commodity,
which is quoted in terms of foreign currency in terms
of domestic currency.
• Price of a commodity in terms of domestic currency
= Price of commodity in foreign currency x Exchange
rate
• Spot exchange Rate vs Forward Exchange Rate
• SPOT ER: The exchange rate resulting from the foreign
exchange transactions in the current market, i.e., the market
where foreign exchange is quoted and traded for immediate
delivery and payment.
• Forward ER: It refers to an ER that is quoted and traded today,
but for delivery and payment on a specific future date.
• Forward price is determined by spot price and the interest
rate differential between the two countries. It can be higher
(at a premium) or lower than (at a discount) the spot price.
• Nominal ER vs Real ER
• Nominal ER is the rate at which one organization can
trade one currency with another currency. The ER
quoted at any particular time in the foreign exchange
market is the nominal exchange rate.
• Real ER is the nominal ER adjusted for the price level
is known as the real ER
• Real ER = Domestic Price level/ Foreign Price level x
Nominal ER
• Bilateral vs Effective ER
• All quoted Ers in the foreign market are bilateral ER as they
involve the currencies of only two countries.
• Bilateral ER, in a particular period , vary by different degree in
different directions. One Bilateral ER may be increasing,
whereas another one may be decreasing a particular period of
time. BILATERAL ERs in such a situation are inefficient in
expressing the average of effective ER faced by the domestic
country.
• An overall measure of the movement in the domestic
currency vis-a vis major currencies can be obtained by
calculating the Effective ER.
• To know the Effective ER the composite index
of weighted average of different bilateral ERs
faced by the country is used.
• The weights are either the shares of different
countries in the total trade or the shares of
exports to the different countries in the total
exports of the country in consideration.
• The composite index based on the trade
weights is referred to as the trade- weighted
• Exchange rate, whereas, that based on export
weights is referred to as the export-weighted
exchange rate.
• The Nominal Effective Exchange Rate(NEER) is
obtained by calculating the weighted average of the
bilateral nominal exchange rates.
• The Real Effective Exchange Rate(REER) is obtained
by estimating the weighted average of the bilateral
real effective exchange rate.
 ER regimes and Determination of ER
• The body of rules that govern the buying and
selling in the foreign ER market is referred to
as the ER regime.
• 3 types of ER Regimes
– Fixed ER Regime
– Managed flexibility Regime or Controlled Floating
– Fully flexible ER regime
• Fully Flexible ER System is determined by the
movements in the demand for and supply of
domestic currency in the foreign exchange
market. The movements in demand and
supply of Foreign exchange in turn are
dependent on the factors which affect the
international transactions in goods, services
and financial assets.
• There is a negative relationship between the
ER and the demand for the domestic currency.
• A shift in the demand curve can take place
when variables other than ER changes. For eg.
Increase in foreign income, changes in
foreigners preference towards domestic
goods, reduction in tariff barriers, , increase in
productivity, export subsidies, domestic price
level.
• Supply of domestic currency in international
market depends on demand for foreign goods
and services and financial assets by the
domestic participants.
• There is a positive relationship between the
ER and supply of domestic currency.
• Factors affecting Supply of domestic currency
 Advantages and Disadvantages of Flexible ER

• Advantages
– Self-correcting mechanism
– No speculation
– Independence of monetary policy
– Minimization of FER
• Disadvantages
– Volatility in the ER market
– Lack of Discipline
– Impact of domestic policy on the ER
 Fixed ER regime
• Under Fixed ER system the ER is fixed by the
Central Bank at a pre-announced ‘par’ value
that is changes only occasionally when the
existing rate can no longer be defended.
• Advantages and Disadvantages
– Advantages - Stability in ER, Discipline in policies
– Disadvantages – Persistent imbalances in BOP, no
independence in monetary policy, speculations,
large FER requirement.