The document discusses the balance of payments (BOP) and its relationship to key macroeconomic variables. It defines BOP as a systematic record of economic transactions between residents of a country and foreign countries. The BOP includes current account, capital account, and financial account balances. It interacts with GDP, exchange rates, interest rates, and inflation. A BOP deficit or surplus can impact the exchange rate, and central banks may intervene to address imbalances. Inflation can also negatively affect the BOP by impacting export competitiveness and demand for a country's currency.

1. Module 2
What is Balance of Payments? Explain its relationship with the different economic
variables. – July 2018
What is BOP? How is it calculated? List the important components included in
calculation of BOP – July 2017
Explain the different types of accounts maintained under BOP with its components-
July 2016

2. Balance of Payment
• The balance of payments is a statistical report that in a
systematic way includes a summary of data on economic
transactions between residents of a given country and the
residents of other countries (non-residents) for a certain
period of time.
• The balance of payments plays the role of the macroeconomic
model that systematically reflect economic transactions which
is carried out between the national economy and the
economies of other countries.

3. BalanceofPayments (BOP)
“Asystematicrecordof all
economictransactions
between the residentsof
the reporting countryand
residentsof foreign
countries.”

4. Accounting Principles in BOP
 Summary of a country’s net international Transactions
 Double entry accounting principles
 For every transaction two entries must be made, one debit and
• credit
 The debits will be equal to credits and the BOP will always “balance”, setting aside
errors and omissions
 Following principles can be considered as the guidelines for accounting for BOP
1. Credit all transactions which lead to an immediate or prospective payment form the rest of the
world (ROW i.e. non- residents), to
the residents of the country which receive payments
• Or Credit items represent international receipts
2. Debit all transactions which lead to an immediate or prospective payment by the residents of
the country to the residents of the rest of the world(ROW)
• Or Debit items represent international payments

5. 3. Debit a transaction which results in an increase
in demand for foreign exchange or decrease in
supply of foreign exchange
4. Credit all transactions which result in an
increase in supply of foreign exchange or
decrease in demand for foreign exchange
• Thus, an increase in foreign assets or decrease
in foreign liabilities(use of foreign exchange by
residents of the country – reduces supply or
increases demand for foreign exchange) is a
debit item – capital outflow and loan repayment
etc., is a debit item
• While capital inflow, receipt of loan by
residents from the ROW is a credit item.

6.  Credit items (+) are funds flowing into a country
– Exports of goods and services,
– Investment income on foreign assets owned
by domestic residents,
– Transfers to domestic residents
– Net purchases of domestic assets by foreign residents
 Debit items (–) are funds flowing out of a country
– Imports of goods and services,
– Investment payments on domestic assets owned
by foreign residents
– Transfers to foreign residents,
– Net purchases of foreign assets by domestic
residents.

7. • From the above it can be understood that
• When goods are exported, there will be a credit for
outflows of goods on current account and a
corresponding debit entry for claim on a foreign company
or country or increase in foreign assets or claims of
foreigners
• Similarly, on imports, goods will appear on the debit side
of current account credit is given for increase in foreign
liabilities, reduction for foreign assets or outflow of funds
or claims of the country
• Thus, for every debit or credit in the current account there
will be an equivalent credit or debit in the capital account
and vice versa

8.  However, in case of unilateral payments or receipts like
donations, gift, etc., there is no corresponding payment
or change in assets or liabilities position
 In this case the contra entry will be the goods outflow from
the country to the other country. Thus, always it is not
possible to match all debits will credits due to difference in
sources and timings.
 Discrepancy then arises, which necessitates a
balancing entry known as errors and omissions

9. Valuation and Timings
 Transactions are to be recorded at their values
 Different values or prices – market prices,
wholesale prices, retail prices, cost prices etc.
 Further, for comparing the prices and BOP of
different countries there must be a uniform practice
for valuation
 IMF recommends, the use of MARKET PRICES
defined as “ the price paid by a ‘willing buyer’ to a
‘willing seller’, where the buyer and seller are
‘independent parties’ and the transactions are solely
governed by commercial considerations

10. • Always it is difficult to follow these guidelines
• In this case either FOB (Free on Board) or CIF (Cost,
Insurance and Freight) valuations can be followed IMF
recommends FOB, because the latter also include
• transportation and insurance costs
• In India, exports are valued at FOB and imports are valued
at CIF prices (Apte. p. 77)
• Exchange rate also create problems, theoretically the
exchange rate at the time of the transaction is to be
considered but, in practice, for transactions of a month,
average exchange rate for the month is used (ibid)
• Similarly time of recording the transaction also create
problems
• When exports and imports are to be recorded?
• Uniform policy should be followed, Exports are recorded
when it is cleared by customs and imports on payment

11. Components of BOP
1. CurrentAccountBalance
 BOP on current account is a statement of actual
receipts and payments in short period.
 It includes the value of export and imports of both
visible and invisible goods. There can be either surplus
ordeficit in currentaccount.
 The current account includes:- export & import of
services, interests, profits, dividends and unilateral
receipts/payments from/toabroad.

12. 2. Capital AccountBalance
 It is difference between the receipts and payments on
account of capital account. It refers to all financial
transactions.
 The capital account involves inflows and outflows relating to
investments, short term borrowings/lending, and medium
term to long term borrowing/lending.
 Therecanbe surplus or deficit in capital account.
 It includes: - private foreign loan flow, movement in banking
capital, official capital transactions, reserves, gold
movement etc.

13. 3. Overall BOP-:
Total of a country’s current and capital account is reflected in
overall Balance of payments. It includes errors and omissions
and official reservetransactions.
The errors may be due to statistical discrepancies & omission
may be due to certain transactions may not be recorded.
For e.g.: Aremittance by an Indian working abroad to India may
not yet recorded, or a payment of dividend abroad by an MNC
operating in India may not yet recorded or soon.
The errors and omissions amount equals to the amount
necessaryto balance both the sides

14. Causes of Disequilibrium
1. Natural causes–e.g. floods, earthquake etc.
2. Economiccauses–e.g.Cyclical Fluctuations, Inflation,
Demonstration Effectetc.
3. Political causes–e.g. international relation, political
instability, etc.
4. Social factors –e.g. changein taste and preferences etc.

15. BOP Surplusand Deficit
• BOP Surplus-Animbalancein anation's
balanceof paymentsin whichpayments
madebythe countryare lessthan payments
receivedbythe country.Thisisalsotermed
asfavorable balanceofpayments.
• BOP Deficit- Animbalancein anation's
balanceof paymentsin whichpayments
madebythe countryexceedpayments
receivedbythe country.Thisisalsotermed
asunfavorable balanceofpayments.

16. Disequilibrium In The Balance Of
Payments
A disequilibrium in the balance of payment
means its condition of Surplus Or deficit
 A Surplus in the BOP occurs when Total
Receipts exceeds Total Payments. Thus,
BOP= CREDIT>DEBIT
 A Deficit in the BOP occurs when Total
Payments exceeds Total Receipts. Thus,
BOP= CREDIT<DEBIT

17. INDIA'S BALANCE OF
PAYMENT
 A country, like India, which is on the path of
development generally, experiences a deficit balance
of payments situation.
 This is because such a country requires imported
machines, technology and capital equipment's in
order to successfully launch and carry out the
programme of industrialization

18. REASONS FOR POOR
PERFORMANCE OF INDIA’S
EXPORT TRADE
• There are Several reasons for India’s Poor
performance. Some off them are:
I.Export - Related Problems :-
1.High Prices :-
• As compared to other Asian Countries the price
of Indian goods is high. Prices are high due to
documentation formalities, high transaction
costs & also to make higher profits.
2. Poor - Quality :-
• Many Indian exporters do not give much
importance to quality control, so their products
are of poor quality. Due to low quality many
times Indian goods are rejected & sent back to
India by foreign buyers.

19. 3.Poor Negotiation Skills :- Indian exporters lack Negotiation
Skills due to poor training in Marketing. They fail to Convince
& induce the foreign buyers to place orders.
4.Inadequate Promotion :-For Export Marketing, Promotion is
important. Many Indian Exporters do not give much
importance to promotion. A good no. of Indian exporters are
not professional in advertising & Sales promotion. They do not
take part in trade fairs & exhibitions.
5.Poor follow-up of sales :-Indian exporters are ineffective in
providing after- sale-service. They do not bother to find out the
reactions of buyers after sale. This results in poor performance
of India’s export trade.

20. II. General Causes
1.Good Domestic Market
•Sellers find a ready market for their goods within
the country, so they do not take parts to get orders
from overseas markets.
2.Number of formalities
•There are number of documentation & other
formalities due to which the some marketers do
not enter the export field. So there is a need to
simplify formalities.

21. 3. Problem of Trading Blocs
• Trading blocs reduce trade barriers on member nations, but they
impose trade barriers on non-members. As India is not a member
of some powerful trading blocs, it has to face some problems.
4. NegativeAttitude
• Some of the overseas buyers have a negative attitude towards
Indian goods. They feel that Indian goods are inferior goods.
Thus there is a need to correct thisattitude.
5. Poor Infrastructure
• Indian infrastructure is poor. Indian exporters find it difficult to
get orders & also to deliver them at time.

22. Importance ofBalance Of
Payments
1. BOP records all the transactions that create demand for
and supply of a currency.
2. Judge economic and financial status of a country in the
short-term
3. BOP may confirm trend in economy’s international
trade and exchange rate of the currency. This may also
indicate change or reversal in the trend.
4. This may indicate policy shift of the monetary authority
(RBI) of the country.

23. Limitations of Balance of
Payments Accounts
1. Coverage of Transactions:
(i) Central Banks, Governments, and other Authorities:
Transactions of the central banks, governments and
international institutions pose conceptual and logical
problems regarding their inclusion.
• In effect, however, their transactions cover both varieties and
this poses a problem of estimating the overall BOP
surplus/deficit.
• Thus, for example, governments frequently enter into defence
deals or deals motivated by political considerations, and the
transactions of central banks (including those meant for
ensuring an orderly working of the foreign exchange market).

24. (ii) International Institutions:
• Similarly, international institutions are not residents of any
specific country, but their activities generate huge volumes of
inter-country transactions and their offices have to be located
somewhere.
(iii) Illegal Transactions:
• Illegal transactions like smuggling and transfer of funds
through Havana and other channels also pose their own
problems. Such transactions do not find a place in the official
BOP accounts.
• To some extent, they are also cancelled by compensatory
movements. But they add to the problems of (a) inadequate
coverage and (b) discrepancy in data.

25. 2. Classification of Items:
• For revealing their accounting and economic significance,
external transactions of a country should be aggregated into
categories which the authorities consider appropriate and
relevant. However, there is no classification which can be
rated as an ideal one for all countries and for all times.
3. Agreements and their Implementation:
• There is a time gap between legal agreements which govern
the international flow of goods, services and capital funds, and
the actual implementation of these agreements.
Consequently, a sizeable portion of external transactions of a
country are spread over two or more BOP time intervals.

26. 4. Valuation:
• By their very nature, external transactions of a country cannot
be aggregated in physical units; they have to be converted into
monetary equivalents. This poses some problems of its own
like the following:
• Conventionally, an import is valued c.i.f. (that is, its value is
recorded inclusive of the “cost, insurance and freight”).
• In contrast, an export is valued f.o.b. (that is, free on board or
at the price which the exporter receives). Consequently, there
is an inherent tendency for the value of world imports to
exceed the value of world exports.

27. Relationship of BOP with other economic
variables/ The BOP Interaction with Key
MacroeconomicVariables
• A nation’s balance of payments interacts with
nearly all of its key macroeconomic variables
• Interacts means that the BOP affects and is
affected by such key macroeconomic factors as:
– Gross Domestic Product (GDP)
– The exchange rate
– Interest rates
– Inflation rates

28. The BOP and GDP
• In a static (accounting) sense, a nation’s GDP can be
represented by the following equation:
• GDP = C + I + G + X – M

29. The BOP and
GDP
X–M=thecurrentaccount balance
• The variables from the formula on the
previous page are defined as:
C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services

30. The BOP and Exchange Rates
• A country’s BOP can have a significant impact on the
level of its exchange rate and vice versa
• The relationship between the BOP and exchange rates
can be illustrated by use of a simplified equation that
summarizes BOP Data (see next slide)

31. The BOP and Exchange
Rates
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
Where:
X = exports of goods and services
M = imports of goods and services
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
FXB = official monetary reserves
Current Account Balance
Capital Account Balance
Financial Account Balance
1-31

32. The BOP and Exchange
Rates
1-32
• Fixed Exchange Rate Countries
– Under a fixed exchange rate system, the
government bears the responsibility to ensure that
the BOP is near zero
• Floating Exchange Rate Countries
– Under a floating exchange rate system, the
government has no responsibility to peg its foreign
exchange rate
• Managed Floats
– Countries operating with a managed float often find
it necessary to take action to maintain their desired
exchange rate values.

33. The BOP and Interest
Rates
•
•
• Apart from the use of interest rates to intervene in the
foreign exchange market, the overall level of a country’s
interest rates compared to other countries does have and
impact on the financial account of the BOP
Relatively low real interest rates should normally
stimulate an outflow of capital seeking higher rates
elsewhere
However, in the case of the U.S., the opposite has
occurred due to perceived growth opportunities and
political stability – allowing it to finance its large fiscal
deficit

34. The BOP and Inflation
• Inflation affects balance of payments position through changes in
exchange rate between home currency and foreign currency.
• Suppose price rises in country A. So the price of goods sold there will
rise. If it is exported to country B, the people have to pay more for
their imports from country A. As a result people will not purchase
products from country A.
• With less demand A’s exports will decline. Further with less export
foreigners will demand currency of A less to pay for its products.
With decline in demand in foreign exchange market exchange value
of A’s currency will come down in relation of currency of other
countries.
• Now A has to pay more for its imports from abroad. With less export
and more import prices there will be Balance of Payments
difficulties as country A cannot pay for its imports.
• Thus inflation affect country’s economy and it should be kept in
check.