Balance of Payments — Notes

The balance of payments is a systematic record of all economic transactions of the residents of a country with the rest of the world during a period, usually a financial year. It is a flow statement kept by double entry: every receipt has a matching payment entry.

Structure: (1) current account; (2) capital account; (3) errors and omissions (a statistical adjustment); (4) change in official reserves of the central bank.

Receipts (credit, +) bring foreign exchange in; payments (debit, −) take it out.

Records transactions that do not change a country's assets or liabilities with the rest of the world.

1. Goods (visible trade): exports and imports of merchandise. Balance of trade = exports of goods − imports of goods.
2. Services: travel, transport, software, banking, insurance.
3. Income: compensation of employees and investment income (interest, dividends, profit).
4. Transfers: receipts or payments with nothing given in return: remittances, gifts, grants.

Items 2–4 are invisibles. Current account balance = balance of trade + net invisibles. A current account deficit means payments exceed receipts on these items.

Records transactions that change the assets or liabilities of residents with the rest of the world.

• Foreign direct investment (FDI): a lasting, controlling stake in an enterprise.
• Portfolio investment (FPI): shares and bonds bought without control.
• External borrowings: commercial loans and official assistance.
• Banking capital: deposits such as those of non-resident Indians.

Inflows (borrowing, foreign investment into India) are receipts; outflows (lending abroad, investing abroad, repaying loans) are payments. Interest on a loan is income (current account); only the loan itself is capital.

• Autonomous transactions are undertaken for a motive of their own (profit, trade, consumption), independent of the BoP position: "above the line".
• Accommodating transactions are undertaken to cover the gap in autonomous items: "below the line", e.g. sale of reserves or borrowing from the IMF.

BoP deficit: autonomous payments > autonomous receipts → official reserves fall (or the country borrows). BoP surplus: autonomous receipts > autonomous payments → reserves rise.

In the accounting sense the BoP always balances, because accommodating items and errors and omissions close any gap. "Deficit" and "surplus" therefore describe autonomous items.

Worked check (imagined Islandia, USD million): trade −1,700; invisibles +2,300; current account +600; capital +1,000; overall surplus 1,600, so reserves rise.

The foreign exchange rate is the price of one unit of foreign currency in domestic currency (e.g. ₹ per USD). A rise in this rate means the rupee is weaker.

• Fixed (pegged): set by the government or central bank, defended by buying and selling foreign currency. Merits: certainty, little speculation, policy discipline. Demerits: needs large reserves; the rate may be set wrongly; sudden devaluations.
• Flexible (floating): set by demand and supply without intervention. Merits: automatic adjustment, few reserves needed, monetary policy free for domestic aims. Demerits: uncertainty, speculation, imported inflation after sharp depreciation.
• Managed floating ("dirty floating"): market-determined, with central bank intervention to curb sharp swings. India moved from a pegged rate to a market-determined rate in stages in the early 1990s and follows managed floating.

Terms: devaluation and revaluation (official, fixed system); depreciation and appreciation (market, flexible system).

Demand for foreign exchange comes from imports of goods and services, travel and study abroad, investment and lending abroad, gifts sent abroad and loan repayments. It slopes downward: at a higher rate, imports are dearer, so less is demanded.

Supply of foreign exchange comes from exports, foreign tourists, remittances, foreign direct and portfolio investment and loans from abroad. It usually slopes upward: at a higher rate, exports are cheaper for foreigners, so more is supplied.

Equilibrium: the rate at which quantity demanded = quantity supplied. Excess demand pushes the rate up; excess supply pushes it down.

Shifts: demand rises (or supply falls) → rate rises → rupee depreciates. Supply rises (or demand falls) → rate falls → rupee appreciates. Speculation can shift demand by itself: expecting depreciation, traders buy dollars now.