BOP and BOT.pdf

Unit 5: Open Economy and Macroeconomic Policy
St. Xavier’s College (Autonomous), Kolkata
MACROECONOMICS
Dr. Jayita Bit

How to measure openness of the
economy?
¨ If a country is engaged in transactions with any
other foreign country, then the concerned country
is considered to be an open economy.
¨ The degree of openness depends on the following:
1. The share of import and export (share of foreign
trade) as a proportion of total value of GDP.
n Greater the value à greater the degree of openness
(Widely used)
2. Value of import duties as proportion of total value of
imports
n Lesser the value à greater the degree of openness
2
Dr. Jayita Bit_St. Xavier's College (Autonomous), Kolkata

Openness of the economy refers to three
important factors:
1. Goods market openness: Trade of goods and
services across borders
(e.g. Trade of commodities)
2. Capital market openness: Trade of financial assets
across countries (only financial capital not physical
capital)
(e.g. Investors choosing between foreign and domestic assets, suppose
foreigner purchasing share of domestic company)
3. Factor market openness: Movement of factors of
production across national boundaries
(e.g. MNCs employing workers from different countries)
3 Dr. Jayita Bit_St. Xavier's College (Autonomous), Kolkata

The Balance of Payments (BoP)
4

The Balance of Payments (BoP)
¨ The Balance of Payments (BoP) is a systematic
record of all transactions between the economic
units of a country (households & firms) and the
rest of the world.
¨ The BoP of a country is a comprehensive
measure/statement of
¤ all the receipts of a country from rest of the world
(RoW) and
¤ all the payments by the country to the Rest of the
world (RoW).
5

The Balance of Payments (BoP) contd..
¨ The values are usually expressed
¤ either in terms of the domestic currency
¤ or in terms of Internationally/Universally accepted
currency like dollars ($)
¨ Classification of BoP:
¤ Current account (CA)
¤ Capital Account (KA)
6

Receipts and Payments of a country can
arise in four ways
7
Balance of
Payments (BoP)
Balance of Current
Account (CAB)
Balance of Trade
Trade in Visibles
(1) Export and
Import of Goods
Trade in Invisibles
(2) Export and
Import of Services
Unilateral
Transfers
(3) Gifts and
Grants
Balance of Capital
Account (KAB)
(4)Capital Inflow
and Outflow
Note: No obligations as Repayments
(That is why CA)
Note: Obligations as
Repayments
(That is why KA)

Balance in Current Account (CAB)
¨ CAB = Total Receipt – Total Payments
= (Receipts from Visible and invisible exports + Unilateral Receipts)
– (Payments for visible and invisible imports + Unilateral Payments)
or, CAB = Balance of Trade + Net Unilateral Transfers
Or, CAB = Value of Exports – Value of Imports + Net Transfers from Abroad
= Net Exports + Net Transfers from Abroad
If CAB > 0
à the country has current account surplus à favourable balance in CA
If CAB < 0
à the country has current account deficit à unfavourable balance in CA
If CAB = 0
à the country has current account balance

Balance of Trade (BoT) and Net Transfer from
Abroad
¨ Net Export is nothing but trade balance (BoT)
¤ BoT> 0 à Trade Surplus
¤ BoT< 0 à Trade Deficit
¤ BoT= 0 à Balance in Trade Balance
¨ If Net Transfer from Abroad > 0
¤ It implies that, foreign residents are transferring
less out of India (e.g. Gifts, Remittances) than
Indians are transferring from abroad.
9

Current account à No obligations
¨ Note that, all items in the current account of the
BoP have the characteristics that they do not
affect the assets and future liabilities of the
citizens and institutions of the country or it’s
government.
¨ These are current receipts and payments without
any implications in the future.
10

Balance in Capital Account (KAB)
¨ For Capital Account the transaction gives rise to
future claims such as acquiring foreign assets or
shares in companies located abroad.
¨ Note: Capital account transactions yield interest income for domestic
citizens and shareholders from next period onwards and this constitute a
part of current account transactions
Capital Accounts Balance (KAB)
= Receipt from sale of assets to foreigners
– spending on buying assets from foreigners
11

Balance in Capital Account (KAB)
12
Balance of Capital
Account (KAB)
A. Capital
Receipts
(i) Foreign
Investments
[1] Foreign Direct
Investment (FDI)
[2] Foreign Portfolio
Investment (FPI)
(ii) External
Borrowing
[1] Commercial
Borrowing
[2] As a form of
Aid
[3] In banks as
Fixed Deposits
(iii) Recovery of
External Loan
B. Capital Payments
(i) International
Investment
(ii) External
Lending
[1] Commercial
lending
[2] As a form of
Aid
[3] Capital
payments by the
banks

A. Capital Receipts: Components
(i) Foreign Investments
n [1] Foreign Direct Investment (FDI): In this case, the investor has real control over the
assets. e.g. If a foreigner sets up a factory in India or buys an Indian firm or purchases a
significant percentage of shares of an Indian company it is considered as FDI;
n [2] Foreign Portfolio Investment (FPI): Here the investors do not purchase significant
share of an Indian company. e.g. If a foreigner buys less than 10% of the shares of an
Indian Company, it is treated as FPI;
(ii) External Borrowing
n [1] Commercial Borrowing: Domestic country may borrow from abroad for commercial
purposes like opening up a factory and the loans taken on the rate of interest.
n [2] As a form of Aid: Domestic company borrowing from abroad in a situation of
economic crisis and the loan is taken on lower rate of interest.
n [3] In banks as Fixed Deposits: Some commercial banks in India are authorized by RBI
receive deposits in foreign currency. It can give fixed deposits in banks and this will also
be considered as investment from foreigners.
(iii) Recovery of External Loan: If foreign country pays back the loans which they had taken
earlier, flow of capital increases in the given year.

B. Capital Payments: Components
(i) International Investment: Investment in foreign countries in terms of
buying shares of foreign companies or buying any foreign assets.
(ii) External Lending: It can be of three types (similar to external barriers)
n [1] Commercial Lending: lending for commercial purpose
n [2] As a form of Aid: Lending as a formal aid (to help)
n [3] Capital payments by the banks: when the fixed deposits of the NRI
becomes matured for repayment and they are not renewed
14

Balance of Payment (BoP) of a country
¨ Export of visibles
¨ Export of invisibles
¨ Unilateral Receipts
¨ Capital Receipts
Inflow of foreign
currency (credit)
¨ Import of visibles
¨ Import of invisibles
¨ Unilateral Payments
¨ Capital Payments
Outflow of foreign
currency (Debit)
RECEIPTS PAYMENTS
15

Can there be any disequilibrium in the Balance
of Payment (BoP) of a country?
¨ In the accounting sense, there can not be any disequilibrium in the BoP. Any tendency
towards such inequality will be corrected by accommodating transactions. However in
economic sense, there is no reason to believe there cant be disequilibrium in the BoP.
¨ If receipts from the rest of the world (other than accommodating receipts) falls short
of payments to the RoW (other than accommodating payments), there will be BoP
deficit
i.e. If,
receipts from RoW (except accommodating receipts) <payments to the RoW (except
accommodating payments)
àThere will be BoP deficit
¨ If Payments to the rest of the world (other than accommodating payments ) falls short
of receipts from the RoW (other than accommodating receipts), there will be BoP
Surplus
i.e. If,
receipts from RoW (except accommodating receipts) > payments to the RoW (except
accommodating payments)
à There will be BoP Surplus

Can there be any disequilibrium in the Balance of
Payment (BoP) of a country? Contd…
¨ In economic sense, the BoP is in equilibrium only when,
autonomous payments to the RoW = autonomous receipts from RoW.
BoP in equilibrium when,
Total value of Receipts = Total value of payments
à Balance on CA and KA
Suppose there is imbalance in CA and KA
Imbalance in CA: 1) Surplus
2) Deficit
Imbalance in KA: 1) Surplus
2) Deficit
E.g. CA deficit = 60
KA surplus = 40
17
BoP Deficit of 20

Disequilibrium to Equilibrium in BoP of a country
(in Economic sense)
18
Disequilibrium in BoP
of a country
Deficit in BoP a/c
Equilibrium in BoP of a
country
Surplus in BoP a/c
Autonomous Receipts
are less than (<)
Autonomous Payments
Autonomous Receipts are
More than (>) Autonomous
Payments
Accommodating
Capital Receipts
Accommodating
Capital Payments

¨ Lack of foreign currencies
à Central Bank buys foreign
exchange from domestic
citizens & in return gives
domestic currencies
à BoP in balance because of
inflow of foreign
currencies
à Money Supply rises
¨ Excess supply of foreign
currencies
à Central Bank sells foreign
exchange to domestic
citizens & in return takes
domestic currencies
à BoP in balance because of
outflow of foreign
currencies
à Money Supply falls
BoP Deficit
Receipts < Payments
BoP Surplus
Receipts > Payments
19

Basic Accounting Rule of BoP
¨ Any transaction leading to a net receipt of foreign exchange creates a surplus
or credit in the corresponding account
¨ Any transaction leading to a net payment of foreign exchange creates a deficit
or debit in the corresponding account
¨ If, India’s Export > Import by India
èNet Export (NX) >0 è current account surplus
¨ If, India’s Export <Import by India
èNet Export (NX) <0 è current account deficit
¨ If Sales of Bonds to foreigners > Purchase of foreign bonds
(borrowing from abroad) > (lending to foreigners)
è Surplus in Capital account (KA) [reason: acquiring foreign currency]
¨ If Sales of Bonds to foreigners < Purchase of foreign bonds
(borrowing from abroad) < (lending to foreigners)
è Deficit in Capital account (KA) [reason: foreign currency depletion]
Hence, Surplus in KA à Net Inflow and Deficit in KA à Net Outflow

Basic Accounting Rule of BoP contd..
¨ When India borrows from abroad to fill up the gap between export and import, it’s
current account deficit is offset by capital account surplus
¨ Repayment of foreign Loan à Deficit in Capital account
[Reason: it involves payments (outflow) of foreign exchange]
¨ An increase in country’s foreign assets or A decrease in country’s foreign liability à
Debit Entry
¨ An increase in foreign asset à is a purchase or import of assets
à Hence ‘Imports’ in CA or KA carries a –ve (-) sign
à It is associated with payments to foreigners à Debit
¨ A decrease in country’s foreign assets or An increase in country’s foreign liability à
Credit Entry
¨ A decrease in foreign asset à is a sale or export of assets
à Hence ‘Exports’ in CA or KA carries a +ve (+) sign
à It is associated with receipts from foreigners à Credit

An important Identity
(Balance of Payment always balances)
¨ Asset Trade has two components:
A) Trade among private Citizens (Private capital Account)
B) Purchase and Sale by Central Bank of the country (Official Reserve
Transactions or ORT)
Given this we have,
Current account balance + Capital account balance + ORT = 0
Or, CAB + KAB + ORT = 0
Example: Suppose India exports iron ore to Japan.
Any three of the following will take place:-
A) There can be equal amount of import from Japan, such that, KAB=ORT=0;
B) Credit extended by Indian exporter to Japanese importer. à Capital outflow
from India àCAB>0 & KAB<0; ORT=0
C) Official intervention i.e. Japanese importer sells Yen to get INR. à CAB>0,
KAB=0, ORT<0 (RBI holding ‘Yen’, a foreign asset increases)
22

An important identity
(Balance of Payment always balances) contd..
¨ If importer gets INR by selling Yen to the bank of Japan, even then ORT<0 for India
[since Bank of Japan’s stock of INR decreases and it is a debit component in India’s capital
account(KA)]
¨ Alternatively, if we assume that foreign exchange is the only type of foreign asset the central
bank is holding,
¨ Note that,
¨ Hence,
¨ Surplus in BoP à increase in FER
àfall in ORT (affects monetary base) à Ms rises through money multiplier
¨ Deficit in BoP à decrease in FER
àrise in ORT (affects monetary base) à Ms falls through money multiplier

For each of the following transactions state to which account
(current/capital) in India’s BoP it belongs and whether it is a
surplus (credit) or Deficit (Debit) item. (Hint answers)
1. Purchase of South Korean Camera by an Indian Citizen.
Ans. Import of goods (visible) à Deficit (Debit) in Current account
2. Purchase of share of Indian Company by a German Mutual Find
Ans. Capital Inflow à Surplus (Credit) in capital Account
3. Govt. of India borrowing from US bank
Ans. Net Capital Inflow àSurplus(Credit) in capital account
4. Export of handmade cotton fabric from India to Australia
Ans. Export of goods à Credit (Surplus) in current account
5. An Indonesian tourist paying in cash for a stay in a hotel in Delhi
Ans. Export of services (Invisible) àCredit (Surplus) in current account
6. An Indian citizen purchases a house in Sao Paolo, Brazil
Ans. Spending on purchase of asset abroad from foreigners
à Deficit (Debit) in capital account
7. An US investor making a deposit in State Bank of India
Ans. Net Capital Inflow à Surplus (Credit) in Capital account

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