Balance of Payment

The balance of payments (BOP) is an accounting of a country's international

transactions for a particular time period.

Any transaction that causes money to flow into a country is a credit to its BOP
account, and any transaction that causes money to flow out is a debit.

The BOP includes the

i) current account, which mainly measures the flows of goods and services;
ii) the capital account, which consists of capital transfers and the acquisition
& disposal of non-produced, non-financial assets; and
iii) iii) the financial account, which records investment flows.
The balance of payments is an accounting of a country's international
transactions over a certain time period, typically a calendar quarter or year.

It shows the sum of the transactions—purely financial ones, as well as those

involving goods or services—between individuals, businesses and government
agencies in that country and those in the rest of the world.
Every international transaction results in a credit and a debit.

Transactions that cause money to flow into a country are credits, and
transactions that cause money to leave a country are debits.

Ex: if someone in England buys a South Korean stereo, the purchase is a debit
to the British account and a credit to the South Korean account.
Current Account

The current account is composed of four sub-accounts:

 Merchandise trade Until mid-1993, this was the figure that was used when
the "balance of trade" was reported in the media.

 Services include tourism, transportation, engineering and business services,

such as law, management consulting and accounting.
 Income receipts include income derived from ownership of assets, such as
dividends on holdings of stock and interest on securities.

 Unilateral transfers represent one-way transfers of assets, such as worker

remittances from abroad and direct foreign aid. In the case of aid or gifts, a
debit is assigned to the capital account of the donor nation.
Capital Account
The capital account has two sub-accounts:

 Capital transfers capital transfers include the transfer of title to fixed assets
and the transfer of funds linked to the sale or acquisition of fixed assets, gift
and inheritance taxes, death duties, uninsured damage to fixed assets and
legacies.

 Acquisition and disposal of non-produced & non-financial

assets represent the sales and purchases of non-produced assets, such as the
rights to natural resources, and the sales and purchases of intangible assets,
such as patents, copyrights, trademarks, franchises and leases.
The Financial Accounts
A country's financial account is broken further down into two sub-accounts:

• the domestic ownership of foreign assets and

• the foreign ownership of domestic assets.

If the domestic ownership of foreign assets portion of the financial account

increases, it increases the overall financial account. If the foreign ownership of
domestic assets increases, it decreases the overall financial account.
A. Current Account Credit Debit Net

I Merchandise
II Invisible
•Travel
•Transportation
•Insurance
•Investment income
•Employee compensation
•Govt. not elsewhere classified
•Miscellaneous
•Transfer payments
a. Official
b. Private
Total Current Account(I+II)
B. Capital Account
1.Foreign Investment (a +b)
a. In India
i. Direct
ii. Portfolio
b. Abroad
2.Loans
3.Banking Capital
4. Rupee Debt Service
5. Other capital
Total Capital Account(1 to 5)
Overall Balance
Deficit and Surplus
In theory, the current account should balance with the capital plus the financial
accounts. The sum of the balance of payments statements should be zero.
What is the importance of the Balance of Payments in India?
The importance of the balance of payment in India can be determined from the
following points
• It monitors the transactions of all imports and exports of services and goods
for a given period

• It helps the government to analyse a particular industry export growth

potential and formulate to sustain it

• It gives the government a comprehensive perspective on a different range

of imports and exports tariffs.
What is the difference between the balance of trade and the balance of
payments?
What are the sources of supply of foreign exchange?
The sources of supply of foreign exchange are:
• Purchase of goods and services by foreigners
• FDI into our country
• Inflow by the NRIs settled in foreign countries
• Speculative purchase of home currency by foreigners
What Is Disequilibrium?
Disequilibrium is a situation where internal and/or external forces prevent
market equilibrium from being reached or cause the market to fall out of
balance.

Disequilibrium is also used to describe a deficit or surplus in a

country’s balance of payments.
Disequilibrium in Action
Below is a hypothetical graph depicting supply and demand in the market for
wheat. As the graph shows, the price at P e is the single price that incentivizes

both farmers (or suppliers) and consumers to engage in an exchange. At P e,

there is a balance in the supply and demand for wheat.
Correcting Disequilibrium in the Balance of Payments:
When the visible and invisible exports of a country are less than all her
imports (or the imports exceed the exports) over a long period and the
difference is big, steps have to be taken to bridge the gap.
A number of methods are used.
They are:

1) Import restrictions and Export promotion. Imports can be checked

either by total prohibition, or by levying import duties, or by a quota system.

2) Adopting of measures of import substitutions

3) Deflation:
Another method is deflation. Under this method, total money income in the
economy is sought to be reduced, so that the aggregate demand in the country
falls.

4) Exchange control:
Deflation brings disastrous consequences in the form of depression and
widespread unemployment.
5) Devaluation:
A very common method of correcting an adverse balance of payments is the
devaluation of the home currency. The devalued currency falls in value
against foreign currencies so that the foreigners have to pay less in terms of
their own currencies for our goods.

The success of devaluation in improving the balance of trade, and through it

the balance of payments depends upon the demand elasticity’s of imports and
exports of the devaluing country.
Similarly, if her export demand is inelastic, then, after devaluation, lesser
amount will be spent by the foreigners thereby affecting adversely the balance
of payments of the devaluing country.

However, if her demand for exports is elastic then with a fall in the prices of
the exports as a result of devaluation, more will be purchased by the
foreigners, which, in turn, will help in restoring the equilibrium in her balance
of payments.
What Is Purchasing Power Parity (PPP)
One popular macroeconomic analysis metric to compare economic
productivity and standards of living between countries is purchasing power
parity (PPP). PPP is an economic theory that compares different countries'
currencies through a "basket of goods" approach.

Purchasing power is the power of money expressed by the number of goods or

services that one unit can buy.

According to this concept, two currencies are in equilibrium—known as the

currencies being at par—when a basket of goods is priced the same in both
countries, taking into account the exchange rates.
 USA USD/CHF Switzerland
1/1/1999 A basket cost $ 100 2.00 Same basket cost CHF
200
31/12/99 Basket cost $ 108 1.9074 The basket costs CHF
206
Calculating Purchasing Power Parity
The relative version of PPP is calculated with the following formula:
S=P1/ ​P2​​

where:
S= Exchange rate of currency 1 to currency 2
P1​= Cost of good X in currency 1
P2​= Cost of good X in currency 2
Pairing Purchasing Power Parity With Gross Domestic Product
• Gross domestic product (GDP) refers to the total monetary value of the
goods and services produced within one country.

• Nominal GDP calculates the monetary value in current, absolute terms.

• Real GDP adjusts the nominal gross domestic product for inflation.

However, some accounting goes even further, adjusting GDP for the PPP
value. This adjustment attempts to convert nominal GDP into a number more
easily comparable between countries with different currencies.
To better understand how GDP paired with purchase power parity works,
suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an
identical shirt in Germany.

To make an apples-to-apples comparison, we must first convert the €8.00 into

U.S. dollars. If the exchange rate was such that the shirt in Germany costs
$15.00, ( 1 € = 1.875$)
the PPP would, therefore, be 15/10, or 1.5.

In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to
obtain the same shirt in Germany buying it with the euro.
Drawbacks of Purchasing Power Parity

1 Transport Costs Goods that are unavailable locally must be imported,

resulting in transport costs. These costs include not only fuel but import duties
as well. Imported goods will consequently sell at a relatively higher price than
do identical locally sourced goods.

2 Tax Differences Government sales taxes such as the value-added

tax (VAT) can spike prices in one country, relative to another.
3 Government Intervention Tariffs

4 Non-Traded Services (insurance, utility costs, and labor costs) are

unlikely to be at parity internationally.

5 Market Competition Goods might be deliberately priced higher in a

country. In some cases, higher prices are because a company may have
a competitive advantage over other sellers. The company may have a
monopoly or be part of a cartel of companies that manipulate prices,
keeping them artificially high.
Relative Purchasing Power Parity (RPPP)

• It is an expansion of the traditional purchasing power parity (PPP) theory to

include changes in inflation over time.

• RPPP suggests that countries with higher rates of inflation will have a
devalued currency.

• According to relative purchasing power parity (RPPP), the difference

between the two countries’ rates of inflation and the cost of commodities
will drive changes in the exchange rate between the two countries.
The relative version of PPP is calculated with the following formula:
S=k(P1/ ​P2)

USA USD/CHF Switzerland

1/1/2000 A basket cost $ 100 1.6660 Same basket cost CHF 200

31/12/2000 Basket cost $ 108 1.5889 The basket costs CHF 206
 USA USD/CHF Switzerland

1/1/2000 A basket cost $ 100 1.6660 Same basket cost CHF 200 (=120.05$)

31/12/2000 Basket cost $ 108 1.5889 The basket costs CHF 206 (=$129.65)
With k = 1.20. price level in Switzerland is 20% higher than what is required by absolute PPP
but it is so in both periods

In the above example, the US and the Swiss inflation rates are respectively 8% & 3%. The
percentage appreciation of the Swiss franc is 4.63% (1.666-1.5889)/1.666. Thus result is
known as relative PPP. In other words, it says that the proportionate (or %) change in
exchange rate between 2 currencies A& B between two points of time equals the difference
in the inflation rates in the two countries over the same time interval.
Example of Relative Purchasing Power Parity
Suppose that over the next year, inflation causes average prices for goods in
the U.S. to increase by 3%. In the same period, prices for products in Mexico
increased by 6%. We can say that Mexico has had higher inflation than the
U.S. since prices there have risen faster by three points.

According to the concept of relative purchase power parity, that three-point

difference will drive a three-point change in the exchange rate between the
U.S. and Mexico. So we can expect the Mexican peso to depreciate at the rate
of 3% per year, or that the U.S. dollar should appreciate at the rate of 3% per
year.
Nominal Exchange Rates versus Real Exchange Rates
The nominal exchange rate is the rate at which currency can be exchanged. If
the nominal exchange rate between the dollar and the lira is 1600, then one
dollar will purchase 1600 lira.

Exchange rates are always represented in terms of the amount of foreign

currency that can be purchased for one unit of domestic currency. Thus, we
determine the nominal exchange rate by identifying the amount of foreign
currency that can be purchased for one unit of domestic currency.
While the nominal exchange rate tells how much foreign currency can be
exchanged for a unit of domestic currency,

the real exchange rate tells how much the goods and services in the domestic
country can be exchanged for the goods and services in a foreign country.

The real exchange rate is represented by the following equation: real exchange
rate = (nominal exchange rate X domestic price) / (foreign price).
Let's say that we want to determine the real exchange rate for grapes between
the US and Italy. We know that the nominal exchange rate between these
countries is 1600 lira per dollar. We also know that the price of grapes in Italy
is 3000 lira and the price of grapes in the US is $6. Remember that we are
attempting to compare equivalent types of grapes in this example.

In this case, we begin with the equation for the real exchange, rate of real
exchange rate = (nominal exchange rate X domestic price) / (foreign price).
Substituting in the numbers from above gives real exchange rate = (1600 X
$6) / 3000 lira = 3.2 basket of Italian grapes per basket of American grapes.
By using both the nominal exchange rate and the real exchange rate, we can
deduce important information about the relative cost of living in two
countries.

While a high nominal exchange rate may create the false impression that a
unit of domestic currency will be able to purchase many foreign goods, in
reality, only a high real exchange rate justifies this assumption.