CH 7

Balance of Payments
7
Balance of Trade
It is the difference between the value of goods exported and value of goods
imported.
BOT = Export value – Import value [Only Tangible/Visible goods]
Balance of Trade may be (i) surplus BOT (export > import) (ii) deficit BOT
(import > export) (iii) equilibrium BOT (export = import).
Balance of Payment
It is a statement that records all economic transactions of a country with
rest of the world. i.e.
(i) Visible items: It includes all types of physical goods exported & imported.
These are seen crossing the borders. eg. Machines and many other tangible goods.
(ii) Invisible items: Which include all types of services. These are invisible
like Banking Services, shipping services, insurance services, etc.
(iii) Unilateral transfers: These are one way transfers of money, goods or
services from one country to another. These are transfer for free e.g. gifts, grants,
donations, aid to flood victims, etc.
(iv) Capital transfers: Which are connected with capital receipts and capital
payments. These involves transfer of capital Assets.
Balance of Payment have two Accounts:
(i) Current Account in BOP
(ii) Capital Account in BOP
(i) Current Account in BOP
It is that account in BOP which records export and import of goods, services
and unilateral transfers.
Components of current account in a BOP:
(i) Export and import of goods: It records export and import of tangible
goods like Machineries etc. (visible items). All export of goods are recorded as
credit item or (+) items as these results inflow of foreign exchange in to our
country. While all import of goods are recorded as debit item or (–) items as these
results outflow of foreign exchange from our country.
(ii) Export & import of services: It records export and import of services i.e.
invisible items. Which is not seen as crossing the borders. Servics are split into
two components (i) factor services (ii) non factor services.
Factor services involve payments in terms of income like compensation of
employees. Non-factor services like shipping, insurance, banking, involve payments
in terms of revenue. So all export of services are recorded as credit item or (+) items
as these results inflow of foreign exchange where as all import of services are
recorded as debit item or (–) item because it results outflow of foreign exchange.
(75)
76 MACRO ECONOMICS
(iii) Unilateral transfers: It also records current transfers. It refers to

“transfer for free” these are unilateral transfers by way of gift, grant, donations
etc. So receipt of unilateral transfers are recorded as credit item or (+) items
because it results inflow of foreign exchange in to our country. Whereas payment
of unilateral transfers are recorded as debit item or (–) items because it results
outflow of foreign exchange from our country.
Net value of these 3 items ((i) visible (ii) invisible (iii) unilateral transfers) are
recorded as balance of current account in BOP.
(ii) Capital Account in BOP
It is that account of BOP which records all such transactions between
resident of a country and rest of the world which cause a change in Assets or
liabilities of the Resident of a country or its government.
Components of Capital Account in BOP
(i) Foreign Investment: It has two sub component:
(a) Foreign direct investment (FDI): It refers to the purchase of assets in
the rest of the world which allows control over that assets.
eg. Purchase of a firm by TATA in rest of the world. After purchase TATA has
full control over that firm.
(b) Portfolio investment (foreign institutional investment): It refers to
purchase of an asset in rest of the world, without having any control over that
asset.
eg. Purchase of some shares of a foreign company by TATA, FDI and Portfolio
investment are non-debt creating capital transactions.
FDI or portfolio investment by the non-residents in our country is recorded
as credit item or (+) items because it results inflow of foreign exchange in to our
country whereas, FDI or Portfolio investment by resident in rest of the world is
recorded as debit item or (–) items because it results outflow of foreign exchange
from our country.
(ii) Borrowings / Loans: It has two sub components.
(a) Commercial Borrowings: It refers to borrowings by a country (including
government & private sector) from international money market.
(b) Borrowing from international monetary fund (IMF): It refers to
borrowing by a country with consideration. It involves lower rate of interest as
compared to market rate.
All the borrowings are debt creating capital transactions loan from rest of
the world are recorded as credit side, (+) items because this leads to inflow of
foreign exchange in our country. Whereas loan to rest of the world is recorded as
debit side, (–) items because outflow of foreign exchange from our country.
(iii) Change in foreign exchange reserves: Foreign exchange reserves are
the financial assets held as reserve by a Central Bank in foreign currencies.
A change in foreign exchange reserve affects the balance of payments.
Any withdrawn from the reserve are considered as a credit item or (+) item
and any addition to these reserves are considered as a debit item or (–) item.
BALANCE OF PAYMENTS 77
Net value of these items (foreign investment and borrowings) is recorded as

balance in capital account.
Note: we can say that capital account do not record export and import of
capital goods like plant and machinry and consumer goods like milk, these are
recorded as merchandise and included in current account. Capital account
includes only such asset (like land and building as well as plant and machinery)
which remains within our country. But ownership changes by their international
sale and purchase. Capital account of BOP also includes monetary asset like
stocks and bonds. It also includes claims related to borrowing between the
trading partners.
Overall balance of BOP is sub total of (i) current A/C balance and (ii) capital
and account balance.
*Equilibrium in BOP: Current account bal + Capital account bal = 0.
There is no movement of official reserves of the Central Bank.
i.e. inflow of foreign exchange = outflow of foreign exchange.
*Disequilibrium in BOP: When current account Balance + Capital account
Balance is not equal to zero. (It may be +ve or –ve).
(i) Surplus BOP: Here autonomous receipts are more than the autonomous
payments.
(ii) Deficit BOP: Here autonomous receipts are less than the autonomous
payments.
*BOP is always balances, in case there is imbalance, it is corrected through
accommodating transactions.
Difference between Autonomous and Accommodating transactions.
Autonomous Transactions Accommodating Transactions
(i) Autonomous items refers to Accommodating items refer to
those international economic those transactions which take
transactions which occur due to place to cover deficit or surplus in
some economic motive such as autonomous transactions.
Profit Maximisation eg. import of e.g. withdrawal from foreign
machinery from Japan, FDI, etc. exchange reserve, loan from IMF,
etc. to maintain BOP.
(ii) These items are independent in These items are dependent in nature.
nature.
(iii) These item take place on both These items take place only on
current and capital account. capital account.
(iv) These tems are also known as These items are also known as “below
“above the line items” as they the line items” as they are recorded
are recorded as first item before as secondary item after calculating
calculating deficit or surplus in deficit or surplus in BOP.
BOP.
78 MACRO ECONOMICS
IMPORTANT QUESTIONS
Q.1. Where is “borrowings from abroad” recorded in balance of payment
accounts? Give reasons.
Ans. Borrowings from abroad are liability for the govt. of a country.
So it is to be recorded in capital account of BOP. It is also called plus item
because it leads to inflow of foreign currency in our country. So, it is to
be recorded at credit side of capital account in BOP.
Q.2. Where is sale of machinery to abroad is recorded in BOP account? Give
reasons.
Ans. Sale of machinery to abroad is recorded in current account of BOP as
visible item.
It is a tangible item and export of all tangible items leads to inflow of
foreign exchange in our country. It is a plus item in current account. So
it is to be recorded at credit side of current account in BOP.
Q.3. Are the following entered (i) on the credit side or the debit side and (ii)
in the current account or capital account in the balance of payments
account. You must give reason for your answer.
(i) Investments from abroad
(ii) Transfer of funds to relatives in abroad.
Ans. (i) Investment from abroad: It leads to inflow of foreign currency in to
the country. It is a plus item, recorded credit side of capital account in
BOP.
(ii) Transfer of funds to relatives abroad like gifts, donations, cash, etc.
are outflows in which no Consideration has been received. So it leads to
outflow of foreign currency from our country. It is debit item or minus
item recorded in debit side of current account in BOP. All transfers of
funds recorded in current account of BOP.
Q.4. Differentiate between Autonomous and Accommodating transactions in
BOP.
Q.5. What is meant be Current Account Deficit (CAD) and Current Account
Surplus (CAS)? State their significance.
Q.6. What is meant by Current Account. Briefly discuss its various components.
Q.7. What is meant by Capital Account? Briefly discuss its various components.
Q.8. Differentiate between Balance of Trade and Balance of Payments.
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Balance of Payments

(iii) Unilateral transfers: It also records current transfers. It refers to

Net value of these items (foreign investment and borrowings) is recorded as

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