Balance of Payment

Meaning of BOP
Bop is one of the oldest and most important
statistical statement for any country.
It is a systematic record of all the economic
transactions between the residents of one
country and the residents of the rest of the
world in a year.
Overall balance of payment is the sum of
balance of current account and the balance
of capital A/C.

 The balance of payment must always

balance in a book-keeping sense.
If there is surplus it adds to external
reserves of the country and if there is
a deficits, it reduces down the
external reserves of the country.

Definition
A record of all transaction made between
on e particular country and all other
countries during a specific period of time.
BOP compares the dollar difference of the
amount of exports and imports, including
all financial exports and imports.
A negative BOP means that more money
is flowing out of the country than coming
in, and vice versa.

 The BOP includes the current

account, which mainly measures
the flows of goods and services;
the capital account, which
consists of capital transfers and
the acquisition and disposal of
non-produced, non-financial
assets; and the financial
account, which records
investment flows.

Balance of Trade
In todays world, all countries import some goods and
services from other countries, and they also export certain
other goods and services which are surplus in their
country.
The difference between the value of goods and services
exported out of a country and the value of goods and
services imported into the country.
If a country has a balance of trade deficit, it imports more
than it exports, and if it has a balance of trade surplus, it
exports more than it imports.
The balance is said to befavorablewhen the value of the
exports exceeded that of the imports (i.e.exports exceed
imports), andunfavorablewhen the value of the imports
exceeded that of the exports (i.e. imports exceed exports).

What are the Factors That

Affect Balance of Trade
The cost of production (land, labour, capital, taxes, incentives, etc.) in the exporting
economy vis--vis those in the importing economy;
The cost and availability of raw materials, intermediate goods and other inputs;
Exchange rate movements;
Multilateral, bilateral and unilateral taxes or restrictions on trade;
Non-tariff barriers such as environmental, health or safety standards;
The availability of adequate foreign exchange with which to pay for imports; and
Prices of goods manufactured at home (influenced by the responsiveness of supply)

Table 4.1: Types of Trade

Type of
Trade

Phrase

Meaning

Source

Inter-industry

Either/or

Either imports or
exports in a given
sector of the
economy

Comparative
advantage

Horizontal
intra-industry

Both/and/
same

Both imports and

exports in a given
sector of the
economy at the same
stage of processing.

Product
differentiation

Vertical intraindustry

Both/and/
different

Both imports and

exports in a given
sector of the
economy at different
stages of processing.

Fragmentation
(comparative
advantage in
some instances)

Kenneth A. Reinert, Cambridge

University Press 2012

Basis of Difference

1. Definition

2. How Is It
Calculated?

3. When is it
considered as
Favourable or
Unfavourable?

Balance of Trade (BOT)

Balance of Trade is defined as 'difference

between export and import of goods and
services'
BOT = Net Earning on Exports - Net payment
made for imports

If export is more than

import, at that time, BOT will be favourable. If
import is more than export, at that time, BOT
will be unfavourable.

Balance of Payment (BOP)

Balance of Payment is defined as the 'flow of cash between

domestic country and all other foreign countries'. It includes not
only import and export of goods and services but also includes
financial capital transfer.
BOP = BOT + (Net Earning on foreign investment i.e. payments
made to foreign investors) + Cash Transfer + Capital Account +or Balancing Item
or
BOP = Current Account + Capital Account + or - Balancing item
( Errors and omissions)

Balance of Payment will be favourable, if the country has surplus in

current account for paying your all past loans in her capital account.
Balance of payment will be unfavourable, if country has current
account deficit and it took more loan from foreigners. After this, it
has to pay high interest on extra loan and this will make BOP
unfavourable.

4. Solution of
being
Unfavourable

To Buy goods and services

from domestic country.

To stop taking of loan from foreign countries.

5. Factors

Following are main factors which affect BOT

a) cost of production
b) availability of raw materials
c) Exchange rate
d) Prices of goods manufactured at home

Following are main factors which affect BOP

a) Conditions of foreign lenders.
b) Economic policy of Govt.
c) all the factors of BOT

CALCULATION OF BOP
Item
CURRENT ACCOUNTS
I.

Merchandise
i) Private
ii) Government

II. Invisibles
1. Travel
2. Transportation
3. Insurance
4. Investment
5. Government, not included elsewhere
6. Miscellaneous
7. Transfer payments
i) Official
ii) Private
A. TOTAL CURRENT ACCOUNT (I + II)

Credits

Debits

Net (Rs. Cr.)

CALCULATION OF BOP (CONTD)

Item
CAPITAL ACCOUNT
I.

Private
i) Long Term
ii) Short - Term

II. Banking
III. Official
i) Loans
ii) Amortization
iii) Miscellaneous

B. TOTAL CAPITAL ACCOUNT (I + II + III)

Credits

Debits

Net (Rs. Cr.)

CALCULATION OF BOP (CONTD)

Item
C. IMF
D. Special Drawing Rights (SDR) Allocation

E. Capital Account, IMF and SDR Allocation (B + C +

D)
F. Total Current Account, Capital Account, IMF and SDR
Allocation (A + E)
G. ERRORS AND OMMISSIONS
H. RESERVES AND MONETARY GOLD

Credits Debits Net (Rs. Cr.)

Structure of BOP
Current Accounta. Visible items of trade: the balance of export and
import of goods is called the balance of visible trade
e.g. Tea, Coffee etc
b. Invisible trade: the balance of exports and imports
of services is called the balance invisible trade e.g.
Shipping, insurance.
c. Unilateral Transfer: Unilateral transfer are receipts
which residents of a country make without getting
anything in return e.g Gift
The net balance of visible trade, invisible trade and of
unilateral transfer is the balance on current account.

2. Capital Account.
It records are international transactions that
involve a resident of the domestic country
changing his assets with a foreign resident or
his liabilities to a foreign resident.
Various forms of capital account transaction:
1. Private Transaction- there are transaction that
effect the liabilities and assets of individuals.
2. Official Transaction: transaction affecting
assets and liabilities by the govt and its
agencies.
3. Portfolio Investment: it is the acquisition of an
asset that does not give the purchaser control
over the asset.

4. Direct Investment: it is the act of

purchasing an asset and at the same time
acquiring control of it.
Other items in the balance of payments:1. Errors and Omissions: these may arise due
to the presence of sampling error or
dishonesty.
2. Official reserve transactions: All
transactions excepts those in the category
of autonomous transactions.

 Autonomous Items:- Autonomous items in

BOP refer to international economic
transactions that take place due to some
economic motive. Such as profit
maximization. These items are often called
above the line items in BOP

The BOP is in deficit if autonomous receipts

are less than autonomous payments. The
monetary authorities may finance a
deficits by depleting their reserves of
foreign currencies or by borrowing from the
IMF.

Equilibrium in BOP
The BOP equilibrium is defined as the
situation when trading among different
countries is such that the trading partners
remain debt free from each other over a
reasonable number of years. In other words,
the value of a countrys imports is equal to
the value of its exports.
The value of a countrys imports is equal to
the value of its export, in order to put this
into practice, the trading partners would
have to establish and meet numerical goals
for their exports and imports.

 BOP equilibrium occurs when induced bop

transaction those engineered by the
government to influence the nominal
exchange rate are zero. This implies that
autonomous receipts from exports and the
sale of securities abroad equal autonomous
payments for imports and the purchase of
securities from foreign residents.
Since changes in the stock of official reserves
of foreign exchange are the method used by
the authorities to fix or otherwise manipulate
the exchange rate, bop equilibrium requires
that the stock of foreign exchange reserves
be constant.

Devaluation and
Depreciation
Devaluation and Depreciation are the
two economic events that deal with
the value of your countrys currency.
Both of these situations cause the
value of your currency to drop versus
the rest of the world.
They have two different causes and
long term effects on your countrys
economy.

Devaluation
When a country makes a conscious decision to
lower its exchange rate in a fixed or semi fixed
exchange rate. Therefore, technically a
devaluation is only possible if a country is a
member of some fixed exchange rate policy.
For example in the late 1980s, the UK joined the
Exchange Rate Mechanism ERM. Initially the value
of the Pounds was set between say 3DM and
3.2DM. However, if the government thought that
was too high, they could make the decision to
devalue and change the target exchange rate to
2.7DM and 2.9DM.

 Devaluation happen in countries with

a fixed exchange rate. In a fixed rate
economy, the government decides
what its currency should be worth
compared with that of other
countries. The government pledge to
buy and sell as much of its currency
as needed to keep its exchange rate
the same.

 Devaluation is the reduction in the

value of the currency with respect to
the other monetary units. It
specifically implies officially lowering
of the value of a countrys currency
within a fixed exchange rate system,
by which the monetary authority
formally set a new fixed rate with
respect to a foreign reference
currency.

Depreciation
Depreciation happens in countries
with a floating exchange rate. A
floating rate means that the global
investment market determines the
value of a countrys currency. The
exchange rate among various
currencies change every day as
investors reevaluate new
information.

 When there is a fall in the value of a currency

in a floating exchange rate. This is not due to
a government decision, but due to supply and
demand side factors. If govt sold lots of
pounds they could help the depreciation.
For e.g. the dollar has depreciated in value
against the Euro during the last months. This
is due to the market forces, there is no fixed
exchange rate target for Euro and Dollar.
The problem is that in every day use people
talk about devaluation in the dollar, when
actually they technically speck of
depreciation in dollar.

Limitation of Devaluation
It is successful only when the
demand for exports and imports is
elastic.
It is successful only when other
country does not retaliate the same.
If both the countries go for the same
the effect is nil.
Though help correcting
disequilibrium, is considered to be a
weakness for the country.

Types of Disequilibrium in
the BOP
1. Structural Disequilibrium- it
takes place due to structural changes
in the economy affecting demand
and supply relations in commodity
and factor market. If the foreign
demand for a country product
declines due to the discovery of
cheaper substitutes abroad, then the
countrys export will decline causing
deficit.

2. Cyclical Disequilibrium- it is caused due

to changes in trade cycles, it is termed as
cyclical disequilibrium. It is possible that
different phases of trade cycle like
depression, prosperity, boom, recession may
disturb term of trade and cause
disequilibrium in bop. E.g during boom
period imports may increase due to increase
in demand for imported goods.
3. Technological Disequilibrium- the techno
change will give comparative advantage to
the innovating country leading to the
increase in exports or a decline in imports.

4. Short run Disequilibrium- caused

due to temporary basis for a short
period, say one year is called short
run Disequilibrium. This does not
pose a serious threat as it can be
overcome within a short run.

Measures to correct disequilibrium in BOP:

(i) Export promotion:
Exports should be encouraged by granting various bounties to manufacturers
and exporters. At the same time, imports should be discouraged by
undertaking import substitution and imposing reasonable tariffs.
(ii) Import:
Restrictions and Import Substitution are other measures of correcting
disequilibrium.
(iii) Reducing inflation:
Inflation (continuous rise in prices) discourages exports and encourages
imports. Therefore, government should check inflation and lower the prices
in the country.
(iv) Exchange control:
Government should control foreign exchange by ordering all exporters to
surrender their foreign exchange to the central bank and then ration out
among licensed importers.

(v) Devaluation of domestic currency:

It means fall in the external (exchange) value of
domestic currency in terms of a unit of foreign
exchange which makes domestic goods cheaper for
the foreigners. Devaluation is done by a government
order when a country has adopted a fixed exchange
rate system. Care should be taken that devaluation
should not cause rise in internal price level.
(vi) Depreciation:
Like devaluation, depreciation leads to fall in external
purchasing power of home currency. Depreciation
occurs in a free market system wherein demand for
foreign exchange far exceeds the supply of foreign
exchange in foreign exchange market of a country
(Mind, devaluation is done in fixed exchange rate
system.)

Recent development in foreign capital flow in

India
Capital flows contribute in filling the
resource gap in country like India where the
domestic savings are inadequate to finance
investment.
India requires approximately 500 billion US $
investment in infrastructure sector alone in
the next 5 years for sustaining present
growth rate of approximately 8-9 per cent.
Therefore, India need for capital in the form
of ECBs (External commercial borrowings)
and other foreign loans and aids.

 AUTOMATIC ROUTE
All items/activities for FDI investment up to
100% fall under the Automatic Route
except the following:
All proposals that require an Industrial License .
All proposals in which the foreign collaborator
has a previous venture/ tie up in India.
All proposals relating to acquisition of existing
shares in an existing Indian Company by a
foreign investor.
All proposals falling outside notified sectoral
policy/ caps or under sectors in which FDI is not
permitted.

 Foreign Direct Investment:

FDI is permitted under the Automatic Route
in items / activities in all sectors up to the
sectoral caps except in certain sectors
where investment is prohibited.
Investments not permitted under the
automatic route require approval from
Foreign Investment Promotion Board (FIPB).
The receipt of remittance has to be reported
to RBI within 30 days from the date of
receipt of funds and the issue of shares has
to be reported to RBI within 30 days from
the date of issue by the investee company.

FDI LIMITS
Banking - 74%
Non-banking financial companies - 100%
Insurance - 26%
Telecommunications - 74%
Private petrol refining - 100%
Construction development - 100%
Coal & lignite - 74%
Trading - 51%
Electricity - 100%
Pharmaceuticals 100%
Tourism - 100%
Mining - 74%
Advertising - 100%
Airports - 74%
Films - 100%
Domestic airlines - 49%

 Foreign Portfolio Investment:

FIIs: FIIs Investment by non-residents is permitted
under the Portfolio Investment scheme to entities
registered as FIIs and their sub accounts under
SEBI17(FII) regulations.
Investment by individual FIIs is subject to ceiling of
10 percent of the PUC (Pollution under Control) of the
company and limit for aggregate FII investment is
subject to limit of 24 percent of PUC of the company.
This limit can be increased by the company subject
to the sectoral limit permitted under the FDI policy.
The transactions are subject to daily reporting by
designated ADs (Authorized Dealers) to RBI for the
purpose of monitoring the adherence to the ceiling
for aggregate investments.

 Foreign Venture Capital Investors:

FVCIs (Foreign Venture Capital Investors)
registered with SEBI are allowed to invest
in units of venture capital funds any limit.
FVCI investment in equity of Indian venture
capital undertakings is also allowed. The
limit for such investments would be based
on the sectoral limits under the FDI policy.
FVCIs are also allowed to invest in debt
instruments floated by the IVCUs (In
Vacare Corporation-US). There is no
separate limit stipulated for investment in
such instruments by FVCIs.

 External Commercial Borrowings:

Under the Automatic Route, ECB up to US $ 500
million per borrowing company per financial year is
permitted only for foreign currency expenditure for
permissible end-uses of ECB. Borrowers in
infrastructure sector may avail ECB up to US $ 100
million for Rupee expenditure for permissible enduses under the Approval Route.
In case of other borrowers, the limit for Rupee
expenditure for permissible end-uses under the
Approval Route has been enhanced to US$ 50 million
from earlier limit of US $ 20 million. Entities in the
services sector, viz., hotels, hospitals and software
companies have been allowed to avail ECB up to
US $ 100 million, per financial year, for the purpose of
import of capital goods under the Approval Route.

 Investment by NRIs in Immovable

Properties:
The NRIs are permitted to freely acquire
immoveable property (other than agricultural
land, plantations and farmhouses). There are no
restrictions regarding the number of such
properties to be acquired.
The only restriction is that where the property is
acquired out of inward remittances, the
repatriation is restricted to principal amount for
two residential properties. There is no such
restriction in respect of commercial property. NRIs
are also permitted to avail of housing loans for
acquiring property in India and repayment of such
loans by close relatives is also permitted.