13

International Balance of Payments

INTRODUCTION

An international transaction involves two different countries and is, therefore, in two different currencies. These transactions occur in many different forms over the course of a year. The measurement of all international economic transactions between the residents of a country and foreign residents is done with the help of a statement called the balance of payments (BOP) account. Government policymakers need such measures of economic activity to evaluate the general competitiveness of domestic industry, to set exchange-rate or interest-rate policies or goals, and for many other purposes. Individuals and businesses use various BOP measures to gauge the growth and health of specific types of trade or financial transactions by country and regions of the world against the home country.

 

International transactions take many forms. Each of the following examples is an international economic transaction that is counted and captured in a country's balance of payments.

• India imports automobile parts, which are manufactured in Japan.
• A US-based firm, Bechtel Corporation, is hired to manage the construction of a major water-treatment facility in the Middle East.
• The US subsidiary of a French firm, Saint-Gobain S.A., pays profits (dividends) back to the parent firm in Paris.
• Daimler AG, the well-known German automobile manufacturer, purchases a small automotive parts manufacturer outside Chicago, Illinois.
• An Indian tourist purchases a hand-blown glass figurine in Venice, Italy.
• The US Government provides grant financing of military equipment for its NATO military ally, Turkey.
• An Indian professor pays a fee of 400 euros to attend a conference in Amsterdam.

This is just a small sample of the hundreds of thousands of international transactions that occur each year. The balance of payments provides a systematic method for the classification of all of these transactions. There is one rule of thumb that will always aid in the understanding of BOP accounting: Watch the direction of the movement of money, in this case the foreign exchange.

The balance of payments is composed of a number of sub-accounts that are watched quite closely by groups as diverse as investors, politicians and boardrooms across the world. These groups track and analyse the two major sub-accounts, the current account and the capital account, on a continuing basis. Before describing these two sub-accounts and the balance of payments as a whole, it is necessary to understand the rather unusual features of how balance of payments accounting is conducted.

FUNDAMENTALS OF BALANCE OF PAYMENTS ACCOUNTING

A basic fundamental rule is that the balance of payments must balance. If it does not, something has not been counted properly. It is therefore improper to state that the BOP is in disequilibrium. It cannot be. The supply and demand for a country's currency may be imbalanced, but that is not the same thing. Sub-accounts of the BOP, such as the merchandise trade balance, may be imbalanced, but the entire BOP of a single country is always balanced.

There are three main elements to the process of measuring international economic activity: (1) identifying what is and is not an international economic transaction; (2) understanding how the flow of goods, services, assets and money creates debits and credits to the overall BOP; and (3) understanding the bookkeeping procedures for BOP accounting, called double entry.

Defining International Economic Transactions

Identifying international transactions is ordinarily not difficult. The export of merchandise, goods such as trucks, machinery, computers, telecommunications equipment, and so forth, is obviously an international transaction. Imports such as French wine, Japanese cameras and German automobiles are also clearly international transactions. But this merchandise trade is only a portion of the thousands of different international transactions that occur in any other country of the world each year.

Many other international transactions are not so obvious. The purchase of a glass figure in Venice by an Indian tourist is classified as a US merchandise import. In fact, all expenditures made by American tourists around the globe that are for goods or services (meals, hotel accommodations and so forth) are recorded in India's balance of payments as imports of travel services in the current account. The purchase of a US Treasury bill by a foreign resident is an international financial transaction and is dutifully recorded in the capital account of the US balance of payments. A rule of thumb, therefore, for identifying an international transaction is that it involves two different countries and is therefore in two different currencies.

The BOP as a Cash Flow Statement

The BOP is often misunderstood to be a balance sheet because of its name. The BOP is actually a cash-flow statement that records the flow of foreign exchange from all international transactions over a period of time. It is a statement that tracks the continuing flow of receipts and payments between a country and all other countries for different categories of international transactions. It is thus a record of the flow of foreign exchange and not a statement of the final value of all assets and liabilities of a country like a balance sheet of an individual firm.

There are two types of business transactions that dominate the balance of payments:

1. Real assets: The exchange of goods (for example, automobiles, computers, watches, textiles) and services (for example, banking services, consulting services, travel services) for other goods and services (barter) or for the more common type of payment, money.
2. Financial assets: The exchange of financial claims (for example, stocks, bonds, loans, purchases or sales of companies) in exchange for other financial claims or money.

Although assets can be separated by whether they are real or financial, it is often easier to simply think of all assets as being goods that can be bought and sold. An American tourist's purchase of a hand-woven area rug in a shop in Bangkok is not all that different from a Wall Street banker buying a British government bond for investment purposes.

BOP Accounting: Double-entry Bookkeeping

The balance of payments employs an accounting technique called double-entry bookkeeping. Double-entry bookkeeping is the age-old method of accounting in which every transaction produces a debit and a credit of the same amount simultaneously. It has to. A debit is created whenever an asset is increased, a liability is decreased, or an expense is increased. Similarly, a credit is created whenever an asset is decreased, a liability is increased, or an expense is decreased.

 

An example will clarify this process. An Indian retail store imports USD 52 million worth of consumer electronics from Japan. A negative entry is made in the merchandise-import subcategory of the current account for the amount of USD 52 million. Simultaneously, a positive entry of the same USD 52 million is made in the capital account for the transfer of a USD 52 million bank account to the Japanese manufacturer. Obviously, the result of hundreds of thousands of such transactions and entries should theoretically result in a perfect balance.

That said, it is now a problem of application, and a problem it is. The measurement of all international transactions in and out of a country over a year is a daunting task. Mistakes, errors and statistical discrepancies will occur. The primary problem is that although double-entry bookkeeping is employed in theory, the individual transactions are recorded independently. Current and capital account entries are recorded independent of one another, not together as double-entry bookkeeping would prescribe. It must then be recognized that there will be serious discrepancies between debits and credits, and the possibility in total that the balance of payments may not balance.

The next section describes the various balance of payment accounts, their meanings, and their relationships with each other.

TYPES OF BALANCE OF PAYMENTS ACCOUNTS

The balance of payments is composed of two primary sub-accounts, the current account and the financial or capital account. In addition, the official reserves account tracks government currency transactions, and a fourth statistical sub-account, the net errors and omissions account, is produced to create and keep the balance in the BOP. Table 13.1 gives an analytic presentation of the BOP account, while Table 13.2 gives a sample of India's overall balance of payments in 2010 as per the Reserve Bank of India.

 

Table 13.1 Analytic Presentation of the Balance of Payments Account

	Credits	Debits
Current account N.I.E.
Goods
Services
Primary income
Secondary income N.I.E.
Balance on current account N.I.E..
Capital account N.I.E.
Balance on capital account N.I.E.
Financial account N.I.E.
Direct investment N.I.E.
Portfolio investment N.I.E.
Financial derivatives and ESOs N.I.E.
Other investment N.I.E.
Balance on financial account N.I.E.
Balance on current, capital, and financial accounts N.I.E.
Reserves and related items
Reserve assets
IMF credit and loans
Exceptional financing
Total reserves and related items
Errors and omissions
Overall balance
Monetary movements

Current Account

The current account includes all international economic transactions with income or payment flows occurring within the current year. The current account consists of four subcategories:

 

1. Goods trade: This is the record of export and import of goods. Merchandise trade is the oldest and most traditional form of international economic activity. Although many countries depend on imports of many goods (as they should according to the theory of comparative advantage), they also normally work to preserve either a balance-of-goods trade or even a surplus.
2. Services trade: This is the export and import of services. Some common international services are financial services provided by banks to foreign importers and exporters, the travel services of airlines, and construction services of domestic firms in other countries. For the major industrial countries, this sub-account has shown the fastest growth in the past decade.
3. Income: This category is predominantly current income associated with investments that were made in previous periods. In a previous chapter you read that Japanese steel major Kobe Steel Ltd has established a marketing subsidiary in India. The profit made by this subsidiary that will be repatriated back to Japan as dividend is the current investment income. Wages and salaries paid to non-resident workers are also included in this category.
4. Current transfers: Transfers are financial settlements associated with the change in ownership of real resources or financial items. Any transfer between countries that is one-way, a gift, or a grant, is termed a current transfer. A common example of a current transfer would be funds provided by the United States Government to aid in the development of a less-developed nation. Transfers associated with the transfer of fixed assets are included in a new separate account, the capital account, which now follows the current account. The contents of what previously had been called the capital account are now included within the financial account.

 

Table 13.2 India's Overall Balance of Payments (USD million)

 

 

All countries possess some amount of trade, most of which is merchandise. Many smaller and less-developed countries have little in the way of service trade, or items that fall under the income or transfers sub-accounts.

The current account is typically dominated by the first component described—the export and import of merchandise. For this reason, the balance on trade (BOT), which is so widely quoted in the business press in most countries, refers specifically to the balance of exports and imports of goods trade only. For a larger industrialized country, however, the BOT is somewhat misleading because service trade is not included; and it may actually be fairly large as well.

Capital and Financial Account

The capital and financial account of the balance of payments measures all international economic transaction of financial assets. It is divided into two major components, the capital account and the financial account.

 

1. Capital account:   The capital account is made up of transfers of financial assets and the acquisition and disposal of non-produced or non-financial assets. The magnitude of capital transactions covered is a relatively minor amount, and will be included in principle in all the following discussions of the financial account.
2. Financial account:   The financial account consists of three components: direct investment, portfolio investment, and other asset investment. Financial assets can be classified in a number of different ways, including the length of the life of the asset (its maturity) and by the nature of the ownership (public or private). The financial account, however, uses a third way. It is classified by the degree of control over the assets or operations the claim represents: portfolio investment, where the investor has no control, or direct investment, where the investor exerts some explicit degree of control over the assets.

The three major sub-categories of India's capital account balance are direct investment, portfolio investment, and other long-term and short-term capital.

1. Direct investment: This is the net balance of capital flows into and out of a country for the purpose of exerting control over assets. For example, if an Indian firm either builds a new automotive parts facility in another country or purchases a company in another country, this would fall under direct investment in India's balance of payments accounts. When the capital flows out of the United States, it enters the balance of payments as a negative cash flow. If, however, foreign firms purchase firms in the United States (for example, India's), it is a capital inflow and enters the US balance of payments positively. Whenever 10 per cent or more of the voting shares in a company is held by foreign investors, the company is classified as an affiliate of a foreign company, and a foreign direct investment. Similarly, if investors hold 10 per cent or more of the control in a company outside their country, that company is considered the foreign affiliate of a domestic company.
2. Portfolio investment: Portfolio investment is capital invested in activities that are purely motivated by returns, rather than ones made in the prospect of controlling or managing the investment. Investments that are purchases of debt securities, bonds, interest-bearing bank accounts, and the like are only intended to earn a return. They provide no vote or control over the party issuing the debt. Purchases of debt issued by the government (Treasury bills, notes and bonds) by foreign investors constitute net portfolio investment in the United States. If a US resident purchases shares in a Japanese firm, but does not attain the 10 per cent threshold, it is considered a portfolio investment (and in this case an outflow of capital).
3. Other investment assets/liabilities: This final category consists of various short-term and long-term trade credits, cross-border loans from all types of financial institutions, currency deposits and bank deposits, and other accounts receivable and payable related to cross-border trade.

In current and financial account balance relationships, there is an inverse relationship between the current and financial accounts of the BOP account. This inverse relationship is not accidental. The methodology of the balance of payments, double-entry bookkeeping requires that the current and financial accounts be offsetting. Countries experiencing large current-account deficits “finance” these purchases through equally large surpluses in the financial account and vice versa.

Net Errors and Omissions

As noted before, because current account and financial account entries are collected and recorded separately, errors or statistical discrepancies will occur. The net errors and omissions account (this is the title used by the International Monetary Fund) makes sure that the BOP actually balances. Statistical discrepancies arise due to several reasons:

• They occur due to difficulties in data collection, as they come from several different sources.
• There may be leads or lags between actual transactions and their flow of funds.
• Certain figures such as earnings on travel and tourism are estimated on the basis of sample cases that may be defective, leading to errors.
• Errors and omissions also occur due to unrecorded illegal transactions, which may not be recorded in the official accounts.

Official Reserves Account

The official reserves account refers to the total currency and metallic reserves held by official monetary authorities within the country. These reserves are usually composed of the major currencies used in international trade and financial transactions (so-called “hard currencies” like the US dollar, German mark, and Japanese yen) and gold.

The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system. If a country's currency is fixed, this means that the government of the country officially declares that the currency is convertible into a fixed amount of some other currency. For example, for many years, the South Korean won was fixed to the US dollar as 484 won equal to 1 US dollar. It is the government's responsibility to maintain this fixed rate (also called parity rate). If for some reason there is an excess supply of Korean won on the currency market, to prevent the value of the won from falling, the South Korean government must support the won's value by purchasing won on the open market (by spending its hard currency reserves, its official reserves) until the excess supply is eliminated. Under a floating rate system, the government possesses no such responsibility and the role of official reserves is diminished.

THE BALANCE OF PAYMENTS IN TOTALITY

The BOP current account and capital account add up to the total BOP account, which must always balance as it is prepared on the double-entry principle. If debits on the current account exceed its credit-side transactions, a flow of funds on capital account is needed to wipe out the deficit. Thus, a deficit in the current account is always matched by a surplus in the capital account and vice versa. The BOP is, therefore, based on the concept of accounting equilibrium, according to which:

 

Current account + Capital account = 0

Balance of trade = Export of goods – Import of goods

Balance of current account = Balance of trade + Net earnings on invisibles

Balance of capital account = Foreign exchange inflow – Foreign exchange outflow (on account of foreign investment, foreign loans, banking transactions and other capital flows)

Balance of payments = Balance on current account + Balance on capital account + Statistical discrepancy

 

The BOP account may, thus, have either a surplus or a deficit. If it has a surplus, the amount may be utilized for repaying past loans such as those taken from the IMF, and the balance amount transferred to the official reserves account. However, if the overall account has a deficit, the monetary authorities may transfer funds from the official reserves account or officially borrow from the IMF. In other words, if capital inflows are meant for meeting the BOP deficit and getting it to balance, they are termed accommodating flows. On the other hand, if capital inflows take place of their own volition, such as an FDI inflow or repayment of a loan, they are termed autonomous flows. Thus, accommodating capital flows go “above the line” and autonomous capital flows go “below the line”.

 

 

The accounting balance is an ex post concept, which describes what actually happened over a specific past period. This often leads to an accounting disequilibrium when the two sides of the autonomous flows differ in size. In such cases, accommodating flows bring the BOP back into equilibrium. In other words, the BOP account does not always balance automatically; it may have to be brought into a state of equilibrium through policy-induced measures.

In economic terms, a BOP disequilibrium is a state of surplus or deficit, and equilibrium is the elimination of either of these. The normal situation for a BOP account is a state of disequilibrium, which is caused by the influence of external economic variables. These include:

1. National output and national spending: If national income exceeds national spending, the excess saving needs to be invested, and a part of it may be invested abroad. The outflow of funds on capital account represents a capital account deficit. Conversely, excess of national spending over national income makes it necessary for the economy to borrow from abroad, leading to a capital account surplus.
2. Money supply: An inflow of foreign capital increases money supply in a fixed exchange rate regime. This in turn causes inflation, making exports expensive and uncompetitive, and imports relatively cheaper. As a result, there is a decline in exports and an increase in the country's imports, leading to a trade deficit.
3. Exchange rate: If the exchange rate regime is floating, an inflow of capital causes the exchange rate to appreciate; the price of the domestic currency rises relative to the foreign currency. An outflow, on the other hand, causes an exchange rate depreciation that makes exports competitive and reduces imports, leading to a trade and current account surplus.
4. Interest rate changes: Rising domestic interest rates attract foreign capital flows leading to a capital account surplus. Conversely, low domestic interest rates cause an outflow of foreign capital and a deficit on capital account.

Let us understand this with an example—if an inflow on current account is matched by an outflow on capital account, the debit-side entry matches the credit entry, and the BOP is in equilibrium. Such flows are known as automatic, because they automatically work to bring the BOP account into a state of equilibrium. However, if the country has excessive imports, this reflects in current account deficit, as it leads to an outflow of foreign exchange. In such a situation, in the absence of a corresponding inflow of foreign exchange, the BOP will be in a state of disequilibrium. In order to bring it into equilibrium, the central bank could transfer foreign exchange reserves out of the official reserves account, or it may have to borrow funds to tide over its deficit. This assistance is usually taken from organizations such as the IMF. Such flows are known as accommodating flows.

Generally, disequilibrium is a cause for concern when it is associated with the current account. Contrary to common belief, however, a current account deficit is not a sign of ill health of the economy. It is merely an indicator of the fact that the country is importing capital (see the closing case). The deficit is a response to macroeconomic conditions such as excessive inflation, low productivity or inadequate savings, as discussed earlier. Countries with relatively high price levels, gross national products, interest rates and exchange rates as well relatively low barriers to imports and attractive investment opportunities are more likely to have current account deficits than other countries.¹

The meaning of the BOP has changed over the past 30 years. As long as most of the major industrial countries were still operating under fixed exchange rates, the interpretation of the BOP was relatively straightforward. A surplus in the BOP implied that the demand for the country's currency exceeded the supply, and that the government should then allow the currency value to increase (revalue) or to intervene and accumulate additional foreign currency reserves in the official reserves account. This would occur as the government sold its own currency in exchange for other currencies, thus building up its stores of hard currencies. A deficit in the BOP implied an excess supply of the country's currency on world markets, and the government would then either devalue the currency or expend its official reserves to support its value. But the transition to floating exchange rate regimes during the 1970s (described in Chapter 11) changed the focus from the total BOP to its various sub-accounts like the current and financial account balances. These are the indicators of economic activities and currency repercussions to come.

DIFFERENT APPROACHES TO ADJUSTMENT

Over time, different schools of thought have emerged with varied explanations for adjustments in the BOP account. These also reflect developments and changes in the international monetary and exchange rate system.

Classical Viewpoint

Classical economists viewed the BOP disequilibrium as a self-adjusting phenomenon. This viewpoint was prevalent during the days of the gold standard and based on the price-specie-flow mechanism, which stated that an increase in money supply raised domestic prices, causing exports to become uncompetitive and export earnings to drop. Simultaneously, imports became cheaper and the import bill increased. Taken together, this meant a trade account deficit for which there was an outflow of precious metal such as gold, which was the legal tender at the time. This led to a contraction of money supply and a consequent lowering of the price level and reversal of the trade situation. This view was reflected in the mercantilist doctrine that a persistent trade surplus was possible through trade protection and export promotion.

 

Figure 13.1 J-curve Effect

Elasticity Approach

This approach looked at BOP adjustment in terms of changes in the fixed exchange rate, through a devaluation or revaluation. This is turn depended on the elasticity of demand for exports and imports. This partial equilibrium approach considers everything constant except for the effects of changes in exchange rates on export or imports. It also assumed infinite elasticity of supply so that prices of exports in home currency do not increase with increase in demand; neither do prices of imports fall with a decline in imports. This viewpoint ignores the monetary effects of variation in exchange rates. Based on these assumptions, devaluation helps to improve the current account balance only if:

 

 

where E_m is the price elasticity of demand for imports and E_x is the price elasticity of demand for exports.

This implies that when elasticity of demand is greater than 1 as a result of devaluation, the imports will decline and export earnings increase, leading to a reduction in the trade deficit. However, if the trade partner also devalues his currency, the trade balance will initially get worse and then begin to improve after a period of time. This is known as the J-Curve effect. As shown in Figure 13.1, the trade balance moves deeper into the deficit zone before it improves and crosses into the surplus zone.

Keynesian Approach

This approach takes into account the income effect which was ignored under the elasticity approach. The income effect is the change in an economy's income which affects the demand for goods/services. There are three different viewpoints based on the Keynesian approach. One is the absorption approach, the second is the Mundell approach,² and the third is the new Cambridge school approach.³

Absorption Approach

This approach explains the relationship between domestic output and trade balance. It considers the trade balance to be a residual between what the economy produces and what it absorbs or uses domestically. According to this,

 

 

Where

Y = Total output

C= Consumption

G = Government expenditure

I = Investment expenditure

X – M = Net exports

 

Alternately:

 

 

Where A represents total domestic absorption.

Hence,

 

Mundell Approach

An alternate explanation given by Robert Mundell brings interest rates and capital account into the preceding discussion. According to this viewpoint, interest rates influence both income and balance of payments. Changes in interest rates affect both the current account and the capital account. A higher interest rate leads to an improvement in the current account as it lowers income. At the same time, a higher interest rate improves the capital account by attracting foreign investment flows. Both of these, in turn, affect the balance of payments position.

New Cambridge School Approach

This approach incorporates savings (S), investment (I), taxes (T) and government spending (G) and their impact on the trade account. It essentially states:

 

 

Where X denotes exports and M denotes imports.

Alternately, we may say:

 

 

or

 

 

The theory assumes that (S − I) and (T − G) are determined independently of each other and of the trade gap (X − M).

(S − I) is normally fixed as the private sector which has a fixed net level of saving. Therefore, the surplus or deficit in the balance of payments depends upon (T − G) and on (S − I) (which as explained earlier is a constant). Balance of payments adjustment, hence, depends on changes in (T − G).

Monetary Approach

The monetary school believes that BOP disequilibrium is a monetary and not structural phenomenon. Adjustment therefore requires changes in various monetary variables. The assumptions of this approach are as follows:

1. Demand for money, L, depends on domestic price level, P, and real income Y.

   L = kPY

2. Money supply, M, depends on domestic credit, D, and international reserves, R, and the money multiplier, m.

   M = (R + D)m

3. Domestic price level P depends on the foreign price level, p*, and the domestic price of foreign currency, E.

   P = Ep*

4. Demand for money equals supply for money because of equilibrium in the money market.
5. The process of adjustment depends on the exchange rate regime. In a fixed exchange rate regime, if demand for money exceeds supply of money, the deficit is met by inflow of foreign funds. The reverse happens if supply exceeds demand. This inflow and outflow influences the balance of payments. With prices and output constant, any increase in domestic credit leads to an outflow of foreign exchange as people import more to lower excessive cash balances. This leads to a deficit in the BOP. The reverse happens as domestic credit decreases, leading to an excess demand for money, and international reserves flow in, thereby improving the BOP.

In the floating exchange rate mechanism, the demand and supply of money adjust via changes in exchange rate. An increase in domestic credit by the central bank causes money supply and prices to increase. This leads to increased imports and a depreciation of the domestic currency till such time that supply of money equals its demand. The reverse happens when domestic credit is reduced.

Accommodating flows

Autonomous flows

Balance of payments account

Capital and financial account

Current account

Double-entry bookkeeping

International transaction

Official reserves account

1. Explain the term “balance of payments”.
2. What are the different components of a country's balance of payments account?
3. Explain the term “disequilibrium” in the context of a country's balance of payments.
4. What is the relationship between official reserves and a country's exchange rate?

1. The Indian rupee has been made convertible over a period of time through a gradual process of liberalization of controls over capital flows. The Reserve Bank of India tracks the flow of capital as monthly, quarterly and annual data. Using the Web link http://www.rbi.org.in/scripts/PublicationsView.aspx?id=13743, analyse the capital flows into India since 1990–91.
2. The RBI also maintains a record of India's balance of payments position over the years. Using the links http://www.rbi.org.in/scripts/PublicationsView.aspx?id=13728 and http://www.rbi.org.in/scripts/PublicationsView.aspx?id=13730, prepare a report on the significant changes in the country's balance of payments position since liberalization. You should especially focus on the financing of the current account deficit and its implications for the Indian economy.