Balance of Payments

The One Thing

The Balance of Payments provides a comprehensive record of a country’s economic transactions with the rest of the world, including trade, income, transfers and capital flows. Surpluses, deficits and exchange-rate movements reflect the interaction of these transactions with foreign-exchange demand, capital movements and central-bank policy, particularly under a managed floating exchange-rate system.

Who and What

• Balance of Payments: A systematic record of all economic transactions between the residents of a country and residents of other countries during a given period, usually one year. It is mainly divided into the current account, capital account and financial transactions.
• Balance of Trade: The difference between the value of merchandise exports and merchandise imports. It excludes services and transfer payments.

Balance of Trade = Value of merchandise exports − Value of merchandise imports.

• Current Account: Records trade in goods, trade in services, income receipts and payments, and unilateral transfers.

Current Account Balance = Balance of Trade + Net Invisibles. Net invisibles include net services, net income and net transfers.

• Visible Items: Physical goods exported and imported, such as machinery, petroleum and agricultural products.
• Invisible Items: Non-physical transactions, including services, income flows and transfers, such as tourism, transport, software services, interest and remittances.
• Capital Account: Records transactions involving changes in foreign assets and liabilities, including foreign investment, loans and banking capital.
• Foreign Direct Investment: Investment by a foreign entity in a domestic business to obtain a lasting interest or significant control.
• Portfolio Investment: Investment in shares, bonds or other financial securities without obtaining controlling ownership of the enterprise.
• Autonomous Transactions: Transactions undertaken for economic or business motives, such as exports, imports, investment and borrowing, rather than to correct a Balance of Payments imbalance.
• Accommodating Transactions: Transactions undertaken to balance a deficit or surplus, such as changes in official foreign-exchange reserves by the central bank.
• Balance of Payments Surplus: A situation in which autonomous foreign-exchange receipts exceed autonomous payments, leading to an increase in official reserves or upward pressure on the domestic currency.
• Balance of Payments Deficit: A situation in which autonomous foreign-exchange payments exceed autonomous receipts, leading to a fall in official reserves or downward pressure on the domestic currency.
• Exchange Rate: The price of one currency expressed in terms of another. For example, if 1 US dollar equals 83 Indian rupees, the quotation is ₹83 per US dollar.
• Foreign Exchange Market: The market in which different national currencies are bought and sold. It is influenced by demand for imports, demand for exports, foreign investment, interest rates, inflation, expectations and government policy.
• Fixed Exchange Rate: A system in which the government or central bank maintains the currency’s value at an officially announced level.
• Flexible or Floating Exchange Rate: A system in which the currency’s value is mainly determined by demand and supply in the foreign exchange market.
• Managed Floating Exchange Rate: A system in which market forces generally determine the exchange rate, while the central bank intervenes to moderate sharp or undesirable movements.
• Depreciation: A fall in the value of a currency under a flexible or managed floating exchange-rate system.
• Appreciation: A rise in the value of a currency under a flexible or managed floating exchange-rate system.
• Devaluation: An official reduction in the value of a currency under a fixed exchange-rate system.
• Revaluation: An official increase in the value of a currency under a fixed exchange-rate system.
• Foreign Exchange Reserves: External assets held by the central bank, including foreign currencies, gold and reserve-related international assets. They are used for external payments and exchange-rate intervention.
• Current Account Convertibility: The freedom to convert domestic currency into foreign currency for current transactions, including trade in goods and services, income payments and transfers.
• Capital Account Convertibility: The freedom to convert domestic financial assets into foreign financial assets, and vice versa, for investment and borrowing transactions.
• Credit Entry: A transaction that brings foreign exchange into the country. Examples include exports of goods and services, foreign investment received, foreign loans received and remittances received.
• Debit Entry: A transaction involving an outflow of foreign exchange. Examples include imports of goods and services, investment abroad, loans given to foreigners, interest paid abroad and remittances sent abroad.
• Errors and Omissions: An accounting item included because complete and accurate data on international transactions may not be available.

Causes and Consequences

• The Balance of Payments records all international transactions rather than only merchandise trade. Consequently, a country’s external position must be assessed through the current account, capital account, financial transactions and related balancing entries.

• The basic Balance of Payments identity is:

Current Account Balance + Capital and Financial Account Balance + Errors and Omissions = Overall Balance. In accounting terms, the Balance of Payments always balances because a deficit or surplus is matched by changes in official foreign-exchange reserves and other balancing entries.

• When current receipts exceed current payments, a current account surplus occurs. When current payments exceed current receipts, a current account deficit occurs. A current account deficit does not necessarily indicate an overall Balance of Payments crisis if it is financed by stable and sufficient capital inflows.

• A Balance of Payments surplus occurs when autonomous foreign-exchange receipts exceed autonomous payments. This may produce an accumulation of foreign-exchange reserves and appreciation pressure on the domestic currency.

• A Balance of Payments deficit occurs when autonomous foreign-exchange payments exceed autonomous receipts. It may be financed by using foreign-exchange reserves, borrowing from abroad, attracting capital inflows or allowing the domestic currency to depreciate.

• A persistent and large deficit can place pressure on foreign-exchange reserves, increase external borrowing and weaken confidence in the domestic currency. Corrective policies may include promoting exports, reducing unnecessary imports, attracting suitable capital inflows, improving competitiveness and maintaining adequate reserves.

• Under a floating exchange rate, an increase in demand for foreign currency tends to depreciate the domestic currency, while an increase in the supply of foreign currency tends to appreciate it.

• Currency depreciation makes exports relatively cheaper for foreigners and imports more expensive for domestic residents. Currency appreciation makes imports relatively cheaper and exports relatively more expensive in foreign markets. The final effects depend on demand conditions and time lags.

• In a managed floating system, the central bank can buy foreign currency to prevent excessive appreciation or sell foreign currency to prevent excessive depreciation. Managed floating therefore combines the adjustment benefits of market-determined exchange rates with limited intervention to reduce excessive volatility.

• A surplus or deficit in one part of the Balance of Payments should not be judged in isolation. Its composition, duration and method of financing determine whether it is economically sustainable. A current account deficit is more sustainable when financed by productive and stable capital inflows that support future income and repayment capacity.

• The Balance of Payments is a flow statement because it records transactions occurring during a period. By contrast, foreign-exchange reserves and external debt are stock variables measured at a point in time.

• The distinction between current account convertibility and capital account convertibility concerns the type of transaction permitted. Current account convertibility relates to trade, income and transfers, whereas capital account convertibility relates to investment and borrowing transactions.

What Gets Asked

• Distinguish between the Balance of Payments and the Balance of Trade, explaining why the Balance of Payments provides a broader account of international economic activity.
• Explain the composition of the current account, including visible items, invisible items, net services, net income and net transfers.
• Use the equations Balance of Trade = Value of merchandise exports − Value of merchandise imports and Current Account Balance = Balance of Trade + Net Invisibles to analyse external transactions.
• Compare autonomous transactions with accommodating transactions, and explain how a Balance of Payments surplus or deficit affects official foreign-exchange reserves.
• Explain how demand and supply in the foreign exchange market affect depreciation and appreciation, using the quotation ₹83 per US dollar as an example of exchange-rate measurement.
• Evaluate managed floating in comparison with fixed and flexible exchange-rate systems, including the central bank’s purchase and sale of foreign currency to moderate excessive exchange-rate movements.