4 Balance of Payments

CON TEXT
In the realm of international finance, one of the most heavily used data sources is an

accounting statement known as the balance of payment, which records the economic

transactions between the residents and government of a particular country and the
chapter
residents and the governments of the rest of the world during a given period of time,

usually a year. For governments, the BOP provides valuable information for the conduct

of economic and fiscal policy. For irms and individuals, it provides clues about
expectations for such matters as the volume of trade and capital Hows, the movement

of exchange rate and he profitable course of economic policy. The present chapter

gives much emphasis to explaining and interpreting the BOP.

CONTENT
• Introduction • Summary
• Solved Problems
Balance

Debits
of

and
Payments

Credits
Accounting
• Review Questions

Project Work
• Balance of Payments Statement
Case
• Debit and Credit Entries
• Annexure

INTENT
A country's balance of payments affects the value of its currency, its ability to obtain

currencies of other countries and its policy towards foreign investment. The present

chapter first gives an overview of the BOP-and then goes on to discuss the various

accounting rules regarding the recording of all types of international transactions that a

country consummates over a certain period of time. The chapter then discusses the

three sections in which the BOP statement can be divided the current account, the

capital acCcount and the official reserve account. The discussion here is useful for an

MNC since the MNC can be affected by changes in a country's current account and

capital account positions over a period of time. Various solved problems are discussed

which help the students to clearly understand the technique of recording the transactions

in a BOP statement and also help them to prepare a BOP statement. An appendix

to this chapter gives the BOP position of India in the 1990s.

 76 • Intermational Financial Management

Introducetion
transactions
The Balance the economic berween
of Paymnents (BOP)is an accounting system that
records of the
rest of
the residents
and governments
the residentsand government a particular country and include exports and

of
transactions
the world during a certain period of time, usually a year.
Economic transfer payments and
and other
gifts
imports goods and services, capital inflows and outflows, valuable
of
the BOP provides information

changes in a country's international reserves. For the governments, clues about expectations
ir provides
and individuals, flows, the movement
for the conduct of economic policy, For firms

of
oftrade and
capital

relating to such matters as the volume of different types

and the probable course of cconomic policy.

Cxchange rates to investors, multinational
important the value of ity
is
payments
it affects
In particular, a country's own balance of officials
because
government macroeconomic varíables
companies, business managers, consumers and inportant
and also influences and exchange rate. The
investments scenario
currency, its policy towards forcign employment
levels, of a country.
price
like gross national product, interest rates, the BOP position

also takes into account

of a country payments for predicting
monetary and fiscal policy balance of
in a forcign country's debts and dividend
of foreign
International may be interested the payment as much
managers
imports, is not likely
to import
regarding Cxports, deficit
the country's overall ability balance
of payments may signal
BOP
country cxperiencing
a severe in a countrys
remittances. A
and continuing deficits to foreign
Persistent disbursements
a surplus position. interest fees
or other cash on a
as it would in dividends and pressure
payments of of the likely
over important indicator
future problems of payments is an trading wich
the balance which tirms
Also, gains or losses
firms or investors. resultant foreign exchange
and the
foreign exchange rate
country's
place between
are likely to face. that have taken
that country all the transactions and
of a country summarises refers to exports
The balance of payments usually a year. The word
transactions
aid and
in a given period, and government
and foreigners funds; remittances;
its residents
lending and borrowing of including
and services; and business enterprises,
imports of goods includes all individuals government
The term residents as well as
expenditures. within a country's borders,
permanently residing economic
military
that are the totality of a country's
institutions,
financial
the balance of payments reflects and sale of
words, of services, its purchase
at all levels. In other its exchange
agencies
world: its trade in goods, expenditures
the
relations with the rest of as foreign aid, military
transactions how
and such important governmental the volume of these transactions,
assets;
financial
Certain forces determine are
payment of reparation. and what policies
abroad and the arise when
they fail to balance
what problems
into balance,
they are brought
to deal with those
problems.
available

Balance ofPayments Accounting to the principle of double entry bookkeeping.

the BOP conforms
and credit entries of
accounting statements, equal
Like other
transaction should produce debit
This means that every nor a balance
international

to mention here that

BOP is neither an incomestatement
magnitude. It is important assets, liabilities and net worth
statement that reflects changes
in
and uses of funds
sheet. It is a sources net worth represent
time. Decreases in assets
and increases in liabilities or
during a specified period of worth represent debits or
in liabilities or net
credits or sources
of funds. Increases in assets and decreases of goods and
sources of funds include exports
context of international transactions,
uses of funds. In the and loans from
transfers received from abroad
unilateral
services, investment and interest earnings,
to foreign investors,
of goods and services, dividends paid
foreigners. Uses of funds include imports with the
and increase in reserve assets. In accordance
transfer payments abroad, loans to foreigners
and uses should always match.
principle of double entry bookkeeping, sources
 Chapter 4 Balance of Pryments• 77

However, if expenditure abroad by

residents of one nation exceeds what theresidents
of that
nation can carn or otherwise reccive from abroad,
that nation is supposed to have a "deficit in its
balance of payments. If a nation reccives
from abroad more than it spends, then the nation
incurs a
"surplus". BOP accounts show the size of any surplus or deficit which
a nation can have and also
indicate the manner in which a deficit was
financed or the proceeds of a surplus invested.

Debits and Credits

Since the balance of payments statement is
based on the principle of double entry bookkeeping cvery
credit in the account is balanced by a
matching debit and vice versa. The following
section now explains,
with examples, the BOP accounting principles
regardingdebits and credíts. These principles are logically
consistent, though they may be a little confusing
sometimes.
A country earns exchange on some transactions
forcign
and expends foreign exchange on others
when it deals with the of the world. Credit transactions
rest
are those that carn foreign exchange and are
recorded in the balance of payments with a plus (+) sign.
Selling either real or financial assets or services
to nonresidents is a credit
transaction. For example, the export of Indian made
goods earns foreign
exchange for us and is, hence, a credit transaction.
Borrowing abroad also brings in foreign exchange
and is recorded as a credit. An increase in
accounts payable due to foreigners by Indian residents has the
same BOP effect as more formal borrowing in the world's capital
market. The sale to a foreign resident
of a service, such as an airline trip on Air India or 'hotel
booking in an Indian hotel, also earns foreign
exchange and is a credit transaction.

Transactions that expend or use foreign up

exchange are recorded as debits and are entered with a
minus (-) sign. The best example here
of import of goods and services from foreign countries.
is
When
Indian residents buy machinery from US or perfumes from France, foreign exchange
is spent and the
import is recorded as a debit. Similarly, when Indian residents purchase
foreign services, foreign exchange
is used and the entry is recorded as a debit.

The BOP's accounting principles regarding debits and credits can be summarised as follows.
1
Credit Transactions (+) are those that involve the of payment from
receipt foreigners. The following
are some of the important credit transactions

a.
Exports of goods or services

b Unilateral transfers (gifts) received from foreigners

c. Capital inflows
2. Debit Transactions (-) are those that involve the payment of foreign exchange i.e., transactions
that expend The
foreign exchange. following are some of the important debit transactions

Import of goods and services

b Unilateral transfers (or gifts) made to foreigners

C. Capital outflows

Let us now analyse the two terms capital inflows and capital outflows - in a litde more detail.
Capital Inflows can take either of the two forms
a. An increase in foreign assets of the nation
b. A reduction in the nation's assets abroad

For Example,

A US resident purchases an Indian stock. When a US resident acquires a stock in an Indian

company, foreign assets in India go up. This is a capital inflow to India because it involves the
receipt of a payment from a foreigner.
 78 Intemational Financial Management

Indian assets abroad decrease. This

When an Indian resident sells a foreign stock,
transaction
to India because it involves receipt of a payment from a foreigner.
capital inflow

Capital Outflows can also take any of the following forns

An increase in the nation's assets abroad

b A reduction in the foreign assets of the nation

Both the above transactions involve a payment to foreigners and are capital outflows.

For Example.
The transaction results in an
Purchase of a UK treasury bill by an Indian rcsident. increase in the
assets abroad and is a debit transaction since it involves a payment to foreigners.
Indian

reduces foreign assets in India

Sale by a US firm of an Indian subsidiary. Thc transaction
and is
entered as a debit transaction.

Balance ofPayments Statement

all types of international transactions thar a
The balance of payment statement records country

consummates over a certain period of time.

It is divided into three sections:

I. The Current Account

I/ The Capital Account

III. The Official Reserve Account.

THE CURRENT ACCOUNT

the merchandise trade balance. rhe
current account typically divided into three sub-categories;
The is

services balance and the balance on unilateral transfers. Entries in this account are current in value as

A in the current account represents an inflow of funds

they do not give rise to future claims. surplus

while a deficit represents an outflow of funds.

The balance of merchandise refers to the balance berween exports and imports of tangible
trade

goods such as automobiles,computers, machinery and so on. A favourable balance of merchandise

occurs when exports are greater in value than imports. An unfavourable balance
of
trade (surplus)

merchandise trade (defici) occurs when imports exceed exports. Merchandise exports and impors
are the largest single component of total international payments for most countries.

b. Services represent the second category of the current account. Services include interest payments,
shipping and insurance fees, tourism, dividends and military [Link] trades in services

are sometimes called invisible trade.

C Unilateral transfers are gifts and grants by both private parties and governments. Private gifts and
grants include personal gifts of all kinds and also relief organisation shipments. For example,
money sent by immigration workers to their families in their native country represents private

transfer. Government transfers include money, goods and services sent as aid to other countries.

For example, if the United States government provides relief to a developing country as part of its

drought-relief programme, this would represent a unilateral government transfer.

Unlike other accounts in the BOP unilateral transfers have only one-directional flow without
offsetting flows. For double entry bookkeeping, unilateral transfers are regarded as an act of buying
goodwill from the recipient.
 Chapter 4 Balance of Psyments 79

THE CAPITAL ACCOUNT

The capital account is an accounting measure of the total domestic currency value of financial transactions

between domestic residents and the rest of the world over a period of time. This account consists of
loans, investments,other transfers of financial assets and the creation of labilities. It includes financial

transactions associated with international trade as well as flows associated with portfolio shifts involving

the purchase of foreign stocks, bonds and bank deposits.

A country's current account deficit must be paid for either by borrowing from foreigners or by selling

off past foreign investment. In the absence of the government reserve transaction, acurrent account surplus

cquals a capital account deficit and a current account deficit equals a capital account surplus. Thar is, the

current account balance must be cqual to the capital account balance but with the opposite sign.

The capital account can be divided into three categories: direct investrnent, portfolio investment
and other capital flows.

Direct investment occurs when the inves tor acquires equity such as purchases of stocks, the
acquisition of entire firms, or the establishment of new subsidiaries.

Foreign Direct Investment (FD) generally takes place when firms tend to take advantage of various
market imperfections. Firms also undertake foreign direct investments when the expected returns

from foreign investment exceed the cost of capital, allowing for foreign exchange and political

risks. The expected returns from foreign profits can be higher than those from domestic projects

due to lower material and labour costs, subsidised financing, investment tax allowances, exclusive
access to local markets ,.
etc For example, many US firms are engged in direcr investment in

foreign countries. Coca-Cola has built bottling facilities all over the world.
b. Portfolio investments represent sales and purchases of foreign financial assets such as stocksand
bonds that do not involve a transfer of management control. A desire for return, safety and liquidity

in investments is the same for international and domestic portfolio investors. International portfolio

investments have specifically boomed in recent years due to investors desire to diversify risk globally.

Investors generally feel that they can reduce risk more effectively if they diversify their portfolio

holdings internationally rather than purely domestically. In addition, investors may also benefit

from higher expected returns from some foreign markets.

C. Capital flows represent the of capital account and represent claims
third category
with a maturity of less than one Such claims include bank deposits, short-term loans, short
year.

term securities, money market investments and so forth. These investments are quite sensitive to
both changes in relative interest rates between countries and the anticipated change in the exchange
the interest in India, with other variables remaining constant, India
rate. For example, if rates rise

inflows as investors would like to deposit or invest in India to take advantage

will experience capital
of the higher interest rate. But if the higher interest rate is accompanied by an expected depreciation
of the Indian rupee, capital inflows to India may not materialise.

short-term
Short-term flows are of two types: non liquid short-term capital and liquid
capital
bank loans and other short-term funds that are
capital. Non-liquid short-term capital flows include
Liquid short-term capital flows represent claims such as
very difficult to liquidate quickly without loss.

demand deposits and short-term securities that are easy to liquidate with mìnimum or no loss.

accounts change for two specific reasons: compensating adjustments and

Short-term capital

adjustments or accommodating adjustments are short-term capital

autonomous adjustments. Compensating
merchandise trade, services, unilateral transfers and investments.
movements induced by changes due to

other items in the balance of payments. Autonomous

These compensating accounts change so as to finance

due to differences in interest rates and also expected changes

adjustments are short-term capital movements
Autonomous changes take place for purely economic reasons.
in foreign exchange rate among nations.
 80 International Financial Management

THE OFFICIAL RESERVE ACCOUNT

reserve account
government owncd asscts, The
Official official
rescrves are represents
country (e.g., the Reserve Bank of
only purchases and sales by the central bank of the Inndia). The

or surplus in the balance of payme

nccessary to account for the deficit
Changes in official reserves are
bank have to either run down its f
For example, if a country has a BOP deficit, the central will

from foreign central bant

reserve assets such as gold, foreign exchange and SDRs or borrow fresh

acquire additional reserve

a BOP surplus, its central bank will cither
However, if a country has
from foreigners or retire some of its foreign debts.
$ billion).
Exhibit 4.1 presents a summaryof the US balance of payments (in

e x h ibi t 4.1
Credit Debit

Current Account
832.86
1 Exports
502.73
1.1 Merchandise
172.29
1.2 Services
157.84
1.3 Factor income
-954.42
2 Imports
-669.09
2.1 Merchandise
-128.01
2.2 Services
-157.32
2.3 Factor income
-34.12
3 Net unilateral transfer
-18.42
3.1 Private transfer
-15.70
3.2 Official transfer
current account -155.68
Balance on
[1+2+3]

Capital Account
4 Direct investment 1.64

5 Portfolio investment 33.43

6. Other capital 112.12

Balance on capital account 147.19

(4+5+6]
7 Statistical discrepancy -33.25
Overall balance -41.74

Official Reserve Account

8 US official reserve assets 5.34

9. Foreign official reserve assets 36.40
Balance of reserve transactions 41.74

Source: IMF, International Financial Statistics.

Debit and Credit Entries

The Balance of Payment of a country is classified into three well-defined categories- the Current
Account, the Capital Account and che Official Reserves Account.

The Current account measures the net balance resulting from merchandise trade, service trade,
investment income and unilateral transfers and reflects the country's current competitiveness in
 Chapter 4 Balance of Payments 81

international markets. The rules for recording a transaction as debit and credit in che current
account are:

Deblt (Outflow) Credit (Inflow)

Goods Buy Sell

Services Buy Sell

Investment Income Pay Receive

Unilateral transfers Give Receive

The Capital account in the BOP records the capital transactions - purchases and sales of assets

between residents of one country and those of other countries. Capital account transactions can be
divided into two categories. Foreign direct investment and portfolio investment. Portfolio investments

are of two types short-term and long-term.

Short-term portfolio investments are financial instruments with maturities of one year or less e.g.,

time deposits, certificate of deposit held by residents of a country in foreign banks or by foreigners in

domestic banks, commercial paper etc.

Long-term portfolio investments are stocks, bonds and other financial instruments issued by private

and public organisations that have maturities greater than one year and are held for purposes other than

control. The rules for doubly entry recording here are as follow:

Credit (Inflow)
Debit (Outflow)

Portfolio Receiving a payment from a foreigner Making a paymernt to a foreigner

(short-term) Sellinga domestic short-term asset

a short-term asset

to
Buying
a foreigner

Selling a short-term foreign asset

Buying back a short-term domestic
asset from foreign owner acquired previously
its
Buying a long-term foreign asset (not Selling a domestic long-term asset

to
Portfolio
of control a foreigner (not for purpose of control)
(long-term) for purpose

long-term domestic Selling a long-tern foreign asset

Buying back a

asset from foreign owner (not for acquired previously (not for purposes
its
purpose of control) of control)

Buying a foreign asset for purpose of Selling a long-term foreign asset

Foreign direct investment
acquired previously (not for purposes
control
of control)

Buying back from foreign owner a Selling a foreign asset previously

its
of control
domestic asset previously acquired for acquired for purposes

purposes of control

ILLUSTRATION 1

the cffect that they have on the balance ofpayments.

The following transactions can help us to understand

Rs 4,00,000 worth of machinery to a US company.

i. Merchandise Trade: An Indian company sells
machinery in 30 days. In this transaction, merchandise exports are
The US company pays for the At the same time,
India with an increase in its claims
on foreigners.
credited because they provide
investment abroad, i.e., an increase in its account
the Indian exporter should increase its short-term
investment represents a use of funds or a debit entry.
receivable. This short-term

(debit) Rs 4,00,000
Liquid short-term capital
(credit)
Rs 4,00,000
Exports
 82 International Fnancial Management

such as tourist
ii.
bervices: Services non-merchandise transactions
represent expenditures.
in UK. She cashes Rs 3,00,000 worth
woman who visits ber husband of Cond
an Indian herInd
UK Before she returns to India,
she spends Rs 3,00,000
traveller's cheques ata hotel, in UK
travel services from
UK in the amount of Rs 3,00,000, Inreturn
India received for
this casc,
rupees.
The services
banks now have Rs 3,00,000 worth provided

of
services, UK
tourist
in deposits of UK banks in Indian
use of funds. The resulting
increases banks
a
are clearly
the Indian balance reprmy

of
will appcar in payments as
a source of funds. This transaction follows

Rs 3,00,000 (debit)
Tourist expenditure
Rs 3,00,000 (credit)

Liquid short-term capital

by domestic residents to foreign residents
account covers gifts or pfs
iii. Transfer: This
Unilateral
Assume that the US Red Cross sends
to foreign governments.
the domestic government the
reflects the
nature

of
flood India. The term "transfer"
relief goods to transaction: e
worth of
the US sends its goods to India, his
nothing in return. Because transacie
States receives
United
transfers should be debited. The
States. Thus,
these
sale o
reduces the real assets of the United
by the United States represents exports and these exports are cred
unilateral transfer of products
in the US balance of
payments as follows
The flood relief shipments appear
$10,000 (debit)
Transfer payments
$10,000 (credit)
Exports
and outflow of capital commitments whose
This account shows inflow
maturity
iv. Long-term Capital: rhe
without significant control of
in financial assets
than one year. It covers investments
is longer
in real assets or financial assets with significant Conrol.t
The account also investmentscovers
assets.
yen 60,000 worth of UK bonds and pays for
it with

assets. Assume that Japanese purchases

a
real
apanese now owns a UK bond, while UK owns Japanee
cheque drawn on an account. The
UK bond increases Japan's portfolio of bank investments
in

deposits. Since the acquisition of the

investments must be debited. At the same time, the yen balanre

foreign countries, the portfolio

Japanese to foreigners. Hence, Japan's shorr-tem
owned by UK, represents an increase in liabilities

This transaction will appear in Japan's balance of payments as follows

capital should be credited.

investments yen 60,000 (debit)

Portfolio

yen 60,000 (credit)

Liquid short-term capital

short-term liabilities are flows of funds that

are not
V Non-liquid Short-term Capital: Non-liquid
that a US
non-liquid short-term liabilities. Suppose
bank
normally resold. Bank loans represent
US purchasing power, the US non
lends $30,000 to a Canadian firm. Since this loan reduces
At the same time, the bank creates or increases a

liquid short-term liabilities must be debited.

firm through its loan. Because chis loan increases US short-term

deposit balance for the foreign
the short-term liabilities should be credited.
In the US balance of

liabilities t foreigners, liquid

payments, this transaction will appear as follows

Non-liquid short-term capital

$30,000 (debit)

Liquid short-term capital $30,000 (credit)

ILLUSTRATION 2
i.
An Indian firm exports Rs 80,000 worth of goods to be paid in three months.
Debit Credit

Short-term capital outflow Rs 80,000

Merchandise exports Rs 80,000

 Chapter 4 Balanca of Pyments 83

Short-term capital outflow is debited because it represents an increase in Indian assets abroad
while merchndise expon is credited since this will iead to a receipt of payment fram foreigners.

ii. An lndian resident visits UK and spends Rs 1,00,000 on hotel and meals and so on.

Debit Credit

Travel services Rs 1,00,000

Short-term capital inflow Rs 1,00,000

Travel services are debited for Rs 1,00,000 because the transaction here is similar to an Indian
import. The payment itself is then entered as a short-term credit because it represents an increase

in foreign assets in India.

i. An Indian resident purchases foreign stock for Rs 50,000 and pays for it bry increasing the foreign
bank balances in India.

Debit Credit

Long-term capital outflow Rs 50,000

Short-ternm capital inflow Rs 50,000

Purchase of foreign stock increases Indian assets abroad and thus long-term capital ourflow is

debited. Short-term capital inflow is credited because the increase in foreign bank balance in India

represents an increase in foreign assets in India.

A foreign investor purchases Rs 70,000 worth of Indian treasury bills and pays by drawing down
his bank balance in India by an equal amount.

Debit Credit

Short-term capital outflow Rs 70,000

Short-term capital inflow Rs 70,000

Short-term capital outflow is debited because it represents a reduction in foreign bank balances in

India while short-term capital inflow is credited since it represents a purchase of Indian treasury

bills by a foreigner.

V. US government gives a US bank balance of $10,000 to the government ofa developing nation as
part of the US aid programme.
Debit Credit

Unilateral transfers $10,000

Short-term capital inflow $10,000

Unilateral transfers are debited since extending aid involves a US paymentto foreigners. Short
term capital inflow is credited because it represents an increase in foreign claims of foreign assets in the
US.

ILLUSTRATION 3
Record the following transactions and prepare the balance of payments statement.

a. A USfirm exports $1,000worth of goods to be paid in six months.

b. A US resident visits London and spends $400 on hotel, meals and so on.
 84 International Financial Mansgement

narion
of a developing
C.
US government gives a US bank balance of $200 to the government

of the US aid programme. the foreign bank

by increasing
pays for it
d. A US resident purchases foreign stock fot $800 and
balances the down his
in US.
pays by drawing
bills and
treasury
A foreign investor purchases $600 United
States

of
in the United States by an equalamount.
bank balances

Solution
Credit ()
Debit (-)

(in $)

1,000
1.000
Short-term capital outflow

Merchandise Exports
400 400
purchased from foreigners
b. Travel services
capital inflow
Short-term 200
200
Unilateral transter made
c.
capital inflow
Short-term 800
800
capital outflow
d. Long-term
capital inflow
Short-term
600
capital outflow
e. Short-term in 600
bank balances
in foreign
(The reduction
inflow)
capital
the US short-term
inflow
Short-term capital
US treasury bills by a foreigner)
(The purchase of
transactions of United Scates
are all the international
these five transactions
Ir we assume that

the US balance of payments is as follows

during the year,

Credit (+)
Debit ()
(in $)
(in $)

1,000
Merchandise

Services 400

Unilateral transfers 200

800
Long-term capital

Short-term
400
capital, Net

1400 1400

The net short-term capital credit balance of $400 is obtained by adding togecher the five short
term capital entries (-$1,000, s400, $200, $s00, S600, -S600) examincd separately. Total debits
cqual total credits because of double entry bookkeeping.

ILLUSTRATION 4
Comprehensive Exercises on Balance of Payments Accounting
Given below is a series of transactions between country A and country B (che rest ofthe world). Assume
the point of view of country A and that A's currency is dollars (S). Do the following

1. Indicate the accounts to be debited and credited in cach transaction.

2. Enter these transactions in the appropriate "T accounts".

 Chpter 4 Balmce of Pnyments 85

3. Prepare the balance of payments for country A. Asume that all the short term capiral movements
are of a compensating nature.

Transactions

1. a A exports goods to B for $1,000. B'% importers sign a bill of exchange for the goods they
imported from A.

b. As exporters discount the bill of exchange with their bank which, in turn, keeps the bill unril

maturity (Assume 10% discount).

c. On the bill's maturity, A's bank reccives payment for the bill in B's currency (as it was
originally drawn). A's bank deposits B's currency in B's bank. The interest accrued on the bill

is $50.

2. A imports goods from B for $800 and A's importers pay B's cxporters for the S800 with a loan in

B's currency which they get from As bank.

3. A resident of country A, MrX goes on vacation to country B. He spends all the money he had with
him, $5,000, for services received while on his vacation in country B.

4. Mr X is lucky, however, because on the last day of his vacation he finds in the street a purse with

$100 in B's currency. He brings the money home and declares his finding to custom authorities.

5 Another resident of A who has migrated from B to A few years ago decides to send $100to his

family. His father uses this money to buy a bond from another citizen of A.

6 A businessman of A, Mr Y decides to build a subsidiary plant in B. Therefore, he ships to B all

necessary materials for this purpose, which cost $50,000.

7. Mr Y very soon finds out that he needs another $20,000 for the completion of the plant. Thus, he
issues bonds on the parent company for this amount and sells them to the citizens of B.
8. Mr Y makes $10,000 profit during the first year of operation which Mr Y uses to enlarge his
business in B. A's citizens are very impressed by the successful operation of Mr Ysplant in B.

Therefore, A's citizens buy from B's citizens half of the bonds issued by Mr Y.

9. Aresident of B, Mr Z, migrates to A. His only property is $1,000 in B's currency, which he carries

with him to A and his house in B which he rents to a friend for $100 a month. The house is worth

$8,000. No rent payment, however, has been received.

10. Mr zdecides to sell his house to his friend for $8,000. The payment is arranged as follows:
$4,000 in cash and $4,000 in five years. Mr Z deposits this money with his old bank in B.

(Everything here is in terms of B's currency).

11. Mr Z, howevet, thinks he should give back to the church of his village $1,000. Therefore, S1,000
is transferred from Mr Z's account in B's bank to the account of the church.

12. Bis a producer of gold. During the period of time for which the balanceof payments is complered.
$1 million worth of gold. Half of this is consumed at home. However, 20% is sold
to
B produces
As central bank and 10% is exported to A for industrial use. For the amountof gold exported to

A, B accepts a deposit with the central bank of country A.

A,Mr M, who Ba long time ago, out that he has inherited

13. A citizen of migrated there from finds

The property of a farm worth $2,000 and a deposit of $1,000

the property of his uncle. consists

in B's bank.

M money with B's bank but he buys a designers dress of $200 which he sends to his
14. Mr keeps the
sister in B as a gift. The dress is purchased in A with A's currency.
86 International Financil Management

B' bank to
deposit in buy
and his
15. Finally, Mr M sells the farm for $2,000. He uses the proceeds

bonds issucd by B's government. which costs $500 and acheque

of a watch
gift consists
16. Mr M makes a gift to his brother in [Link]
A with A's currency.
is purchased in country
for $[Link] watch

by $1000. Short-
Solution to credit exports
we have

goods worth $1000, The entries

are
1. a. As country A has cxported
by $1000 simultaneously.
term claims on foreigners is debited Debit Credit

S1,000
Short-term claim on forcigners $1,000
is no effecr on the
bank, there
Exports and his own local
exporter
between the
b. As this is an agreement
Exchange) bu
balance of payments. clain (Bill of
of one short-term entry are on
rhe
the substitution and the credit
C. This transaction
represents both the debit accounr Th.
in B's bank).
Therefore. to the interest
another (an account of interest accrued is credited
Also, the amount
same account.
entries are
Debit Credit

$1000
of Exchange)
(Bill
claims on foreigners
Short-term bank) $1000
(Account in B's
Short-term
claim on foreigners $50
(on of Exchange)
Interest
Bill
$50
on (interest) Thus.
foreigners in B's currency.
paid with a loan
Short-term claim
worth $800. This
is

2. A has imported goods short-term claims.

Now country
imports account and
crediting

entry will be debit of

accounting Debit Credit

$800
(B's) currency
Short-term claims on foreigner's
$800
Imports in B, there is an
X spends this currency
is a liability for A. Thus, when a resident from foreigners. Thus
3. A's currency services received
This is in exchange for
in liabilities (short-term).
increase
the entries are:
Debit Credit

$5000
(A's currency)
Short-term liabilities
$5000
Services received from foreigners
an increase in short-term
$100 Thus, this represents
4 Mr X finds a purse with in B's currency.
therefore, are
be treated as a gift from foreigners. The entries
claims on foreigners and can

Debit Credit

on foreigners (B's currency) $100

Short-term claims
$100
Gift from foreigners
This money is used to buy a bond froma citizen of A. The
5. The $100 represents a gift to foreigners.

entries are

Debit Credit
$100
Gift to foreigners

Long-term liabilities to foreigners (bill or bond) $100

 Chapter 4 Balance of Pryments 87

6. Mr Y of country A is making a subsidiary plant in countryB with an investment of $50,000

worth of goods which he ships to B,This is cquivalent to an export of goods worth US $50,000
and the balancing entry is an increase in long-term claims. The entries therefore, are

Debit Credit

Long-term claims on foreigners $50,000

Exports $50,000
7. Another $20,000 is needed for completion of the plant. Bonds on the parent companyare issued

on company B'* citizens. This represents an increase of long term liabiliries of country A balanced
by an increase in short-term claims (due to citizens of B buying the bonds). As this amount raised
is investedthe plant in country B, this represents
in an increase in direct investment in foreign
countries balanced by a decrease in short-term [Link] entries are

Debit. Credit

Long-term liabilities to forcigners (bonds issucd) $20,000

Short-term claims from foreigners (B's currency for
bonds) $20,000
Direct investment in foreign countrics $20,000
Short-term claims on forcigners (B's currency) $20,000
8.
Mr Y makes a profit of $10,000 which he uses to enlarge his business in B. This represents a direct

investment in country B. The balancing entry will be profits for foreigners.

As citizens of A buy $10,000 worth of bonds from B's citizens, this represents decrease in long
term liabilities (bonds) countered by increase in short-term liabilities (assuming A's currency is

used). The entries are

Debit Credit

Direct investment in foreign countries $10,000

Profits S10,000
Long-term liabilities (bonds) $10,000
Short-term liabilities (A's currency) $10,000
9. When Mr Z migrates from B to A, the currency that he brings ($100) beco mes a short-term claim

on foreigners. This is balanced by an equivalent credit entry on gifts from foreigners.

Also, the house represents a long-term claim on foreigners. This is also balanced by a credit entry

on gifts from foreigners. The entries are

Debit Credit

Short-term claim on foreigners (B's currency) $1000

Long-term claim on foreigners (fixed asset) $8000
Gift from foreigners $9000

10. On slling the house, there is a sale of fixed assets, i.., a long-term claim (fixed asset) has been
converted to a short-term claim (B's account) and a long-term claim (promise).The entries are
Debit Credit

Long-term claim on foreigners (fixed asset) $8000

Short-term claim on foreigners (account in B's bank) $4000

on foreigners (promise) $4000
Long-term claim
88 International Financial Management

11. This represents a gift to foreigners. The entries are

Debit Credit

Gift to foreigners
S1000
S1000
Short-term claim on foreigners (account in B) of
A asks for $300,000worth gold
in
12. B produces gold worth $1 million. Out of this, country representsan
increase
use), This
industrial
($200,000 to
A's
central bank and $100,000 for Ihe entries are
liability increase.
of A (a debit entrv) balanced by short-term

official gold reserves

Credit
Debit

S200,000
Official gold reserves
S100,000
Imports (gold)
$300,000
Short-term liabilities to forcigners

The entrics are

represents gift from foreigners.
13. This again
Credit
Debit
$3000
Gift from foreigners
bank)
$1000
(money in B's
Short-term claim on foreigners
$2000
(fixed assets)
Long-term claim on foreigners
not be recorded in the BOP statement.
will
of this gift tohis sister, this
14. As there is no record
are
claim into another. The entries
the conversion of one long-term
15. This represents
Debit Credit

$2000
(fixed asset)
claim on foreigners
Long-term $2000
on foreigners (bonds)
Long-term claim
figures inthe BOP
However, the gift by cheque
the watch goes unrecorded.
16. Again the gift of
The entries are
statement.

Debit Credit

$100
Gift to foreigners
$100
liabilities to foreigners
Short-term
are as shown below:
The T accounts for the above transactions

Exports

Debit Credit

Exports $1000
Plant $50000

Balance cld $51,000

$51,000 $51,000
 Chapter & Bne of Pmnt 89

Imports

Debit Credt

Import S800

Import (gold) $100,000

Balance cdd $ 100,800

$100,800 S100,800

Short-term Claims on Foreigners

Dcbit Credit

Exports S1000 Setling of Bill of Exchange $1000

Account in B's bank $1000
Interest $50
Gift $100 Imports $800
Bonds $20,000 Bonds S20,000
Gift $1000
Sale of Fixed Asset $4000
Gift S1000 Gift to foreigners S1000
Balance cld $5350
$28,150 $28,150
IV Short-term Liabilities

Debit Credit

Expenditure in foreign

country S5000
Purchase of bonds S10,000

Deposit in exchange

of gold $300,000
Gift to foreigners
S100

Balance cld $315,100

$315,100 $315,100
90 International Financial Management

V
Long-term Claims

Credit
Debit

Setting of plant $50,000

$8,000
Sale of fxed asset
Gift from foreigners $8,000

Promisc onsale of

Fixed assct $4,000

Gift from forcigners $2,000

$2,000
Sale of Fixed asset
Purchase of bonds $2,000
$56,000
Balance cld

S66,000
$66,000
to Foreigners
VI Services Payments
Credit
Debit
$5000
Balance dd
$5000
Exports by X $5000
$5000
Service Received
VII
Credit
Debit
$50
Interest

Profits
S10,000

Balance cld 10,050

S10,050
$10,050

Unilateral Transfers
VIII
Credit
Debit

Gift S100
Gift $100
$1000 Gift $9,000
Gift
$100 Gift $3,000
Gift

balance cld $10,900

$12,100 $12,100

Direct Investments
IX
Debit Credit

plant $20,000
Completion
$10,000 Balance b/d $30,000
Expansion
$30,000 $30,000
 Chapter 4 Rlae f Prments 91

Official Reserves

Debit Credit

Oicial gold reserves$ 200,000

Balance cld $200,000
$200,000 $200,000
Long-term Liabilities

Debit Credit

Bond $100
Bond S20,000
Bond (repurchase) $10,000
Balance cld $10,100
$20,100 $20,100

Balance of Payments Statement

Current Account

Merchandise account

Exports $51,000
Imports -$100,800
Balance $ -49,800
Service account

Receipts $10,050
Payments -$5,000

Balance $5,050
Balance on goods and services -$44,750

Unilateral Transfers

Gifts received $12,100

Gifts to foreigners $1,200
Balance $10,900 $10,900
Current account balance -$33,850

Capital Account

Long-term capital flows

Direct investments abroad -$30,000

Long-term claims -$56,000

Long-term liabilities -$10,100

Balance on long-term capital $75,900

92 International Financil Management

Short-term capital flows

Short-term claims -$5350

Short-term liabilities $315,100
Balance onshort-term capital
$309,750
|$233,85
Capital account balance

Overall balance |$200,000

Oficial Reserves account

Gold imports -$200,000

Balance on official reserves -$200,00

Capital Account Convertibility (CAC)

The Tarapore committee set up by thc Reserve Bank of India (RBI) inFebruary 1997 o g0 inte 4

issue of CAC gave the following definition of Capital Account Convertibility. Capital Account

can be defined as the freedom to convert local financial assets into foreign financial
Convertibility

and vice versa at market determined rates of exchange for any purpose whatsoever, withour
needing amy

permission from the government. This means one can import or export goods or receive or mal
that

CAC allows anyone to freely move from local currency into

payments for services rendered. foreign
ad
currency and back. It is associated with changes of ownership in foreign/domestic
financial assets

and liquidation of claims on, or by, the rest of the world

liabilities and embodies the creation

What is capital account convertibility?

account transactions that lead to changes in rhe
In a country's balance of payments, the capital features

overseas financial assets and liabilities. These include investments abroad and inward capital flows. A

account is one of the two standard

capital components of a nation's balance of payments; the other

component being the current account, which refers to goods and services, income, and current transfers.

Capital account convertibility as mentioned carlier implies the freedom to convertdomestic financial

assets into overseas financial assets at market determined rates. It can also imply conversion of overseas
financial assets into domestic financial assets. Broadly, itwould mean freedom for firms and residents to

freely buy into overseas assets such as equity, bonds, property and acquire ownership of overseas firms

besides, free repatriation of proceeds by foreign investors.

Why CAC? Capital account convertibility is considered to be one of the major features ofa developed
economy as it helps attract foreign investment. It offers foreign investors a lot of comfort as they can re
convert local currency into foreign currency anytime they want to and take their money away. CAC
allows freedom to make investment in foreign equity, extend loans to foreigners, and buy real estate in

foreign lands and vice-versa. India presently has current account convertibility, which means that foreign

exchange is easily available for import and export for goods and service and is almost wholly free for
current account transactions like trade, tourism, travel, education abroad and in India, and remitances

into and out of India for purchasing health-care products. Complete capital account convertibility of

the rupee will imply that there will be no restrictions and no questions asked for capial flows outside
India.

CAC is a debatable issue. The benefits of Capital Account Convertibility are that it results in the

most efficient allocation of capital and opens up the economy in terms of capital inflows and outflows.
Foreign fund inflows to the country. also become easier thus increasing the availability of large capital
stock. It also offers countries better access to global markets, besides resulting in the emergence of
deeper and more liquid markets. Capital account convertibility is also stated to bring with it greater
discipline on the part of governments in terms of reducing excess botrowings and rendering fiscal
discipline.

However, following the East Asian crisis, World Bank has said that embracing CAC without
necessary precautions could be absolutely disastrous. It has been also elaborated that the risks involved
in fuller capital account convertibility are much more that the fruits we get from it. The volariliry in
exchange and the wake of
interest rates in capital inflows can lead to unsound funding and large un
hedged foreign liabilities. This is especially so for economies that goes in for a free-fAloat withoutr following
prudent macro-economic policies, and ensuring financial reforms.

Yet, fuller convertibility on capital account can be a step towards creating opportunities in achiering
more goals of cconomic policies

Summary
The balance of payments is a double entry accounting The BOP conforms to the principle of doubie entry
system that records the cconomic transactions between bookkeeping. Every international transaction is

the residents and government of a particular country recorded as debt

a and credit entry of equal magniade
and the residents and governments of the rest of the The BOP is a sources and uses of funds statement thar

world during a certain period of time, usually a year.

reflects changes in assets, liabilities and net worth
during a specified period of time.
The key components of the balance of payments are
the current account and the capital account. The A country's international capital Aows are affected by
factors that influence direct foreign investment or
current account represents a broad measure of the
portfolio investments. FDI generally takes place when
country's international trade balance. The capital firms tend to take advantage of various market
account is a measureof the country's long-term and imperfections. Portfolio investments represents sales
short-term capital investments, including direct foreign and purchase of foreign financial assets that do not
investment and portfolio investment. involve a transfer of management control.

Solved Problems
1. Briefly explain the balance of payments statement. net errors and omissions is included in the capital
and financial account.
Ans. The balance ofpayment is divided into two groups of
accounts. The current account records transactions in 2. Whydo discrepancies arise in the balance of payment
good and services, in come and current transfers. The statement?

capital and financial account records capital transfers;

Ans. Discrepancies may arise in the balance of payments
the acquisition or disposal of non-produced, non because there is no single source for balance of
financial assets (such as patents); and transactions in
payments data and no wayto ensure that data from
financial assets and liabilities. Gross international
different sources are fully consistent. Sources indude
reserves are recorded in a third set of accounts, the
customs data, monetary accounts of the banking
international investment position, which records the
system, external debt records, information provided
stocks of assets and liabilities.
by enterprises, surveys to estimate service transactions
The balance of payments is a double entry and foreign exchange records. Diferences in recording
accounting system that shows all flows of goods and
methods,for example, in the tùming of transactions,
services into and outofan economy; all transfers that in definitions of residence and ownershipand in the

are the counterpart of real resources or financial claims exchange rate used to value transactions contribute to
provided to or by the rest of the world without a
net errors and [Link] addition, smugglingand
quid pro quo, such as grants; and all
donations, other illegal or quasi-legal transactions may be
changes in residents' on and liabilities to
cdaims unrecorded or misrecorded.
nonresidents that arise from economic transactions.

All transactions are recorded twice: once as a credit

3. How are capital account converibility and current

account convertibility different?

and once as a debit. In principle, the net balance
should be zero bu, in practice, the accounts often Ans. Current account convertibility allows free inflows and
do not balance. In these cases a balancing item called outflows for all purposes other than for capital
94 International Financial Management

for export
foreign currency)
goods and \

of
purposes such as investments and loans. In other
dollars for import of goods and services
anÀ

- Pay
words,it alows residents to make and receive trade accesssforeign services,
make
sundry remittances, currency
other for
related payments reccive dollars (or any medial Itreatment and
studies abroad, gifts, travel
etc.

Review Questions An American autocornpany decides to

1. and uses of the balance of an build
What are the implications assembly Hong Kong, The
plant

in
American
payments statement? ships $4,,000 worth of
auto company
material
2. What is mncant by thc balance payments? In what this purpose to Hong Kong,
for

of
way is the balance of payments a summary statement? The American auto o company finds itt
involved in measuring
Inwhat way is the time clement
to increase
its investrment by
S2,500
necessary
forthe
a nation's balance payment? completion the plant. sells
$2,500

It
of
worh

of
What is a credit and a debit transaction?

of
3. transaction its bonds to the citizens ofHong Kong.
broad categories of international
Which are the citizen buys Korean
and as debits? An American government
classificed as credits
transactions bonds for $3,000 in cash.
the United States and
4 A series of transactions between

are given below.

h ASouth African gold producer sels $1.20
the rest of the world
a British worth ofgold to the Federal Reserve System af
to
An American companyexports goods States.
the United
company for $2,000. The British company signs
bill ofexchange for its imports. With the help of theabove transactions
a
ships $3,000 worth of
Record each transaction as debit and credit.
b An Italian-American

goods to his relatives in Italy.

Prepare the balance payment for the US

of
of
An American company imports $500 worth Why is useful to examine a countrys balance of
5 it
from Canada. The American company rd
goods How does it differ from balane

of
payments data?
with a loan in Canadian
pays for the merchandise payments of a country
6. What does the balance of
currency.
goes on vacation to Mexico. demonstrate? How can you use the balance of

An American citizen

before he returns to the payments in determining what will happen to the

He spends $5,000
States. value ofa currency?
United

Project Work
Is India also facing current-account deficit? Discussin
1 Identify a few nations that have been facing a

detail.
What are the long
current account deficit.
term consequences for the nations which face a current 2 Analyze the impact that the Global Slowdown has

account deficit. Analyze the implications in detal for had on Indias BOP in the last few years. Has it been
the countries chosen. favourable?