Components of Balance of Payments

Balance of Payments refers to the systematic and summary record of a country’s economic and financial transactions with the rest of the world, over a period of time. In a layman’s language, anything that affects the financial and accounting entries of a country with respect to the rest of the world is counted in Balance of Payments. Knowledge about BoP provides a good basis for developing an understanding of economic issues like currency crises, the impact of capital flows, economic position of a country etc.

Components of BoP

The three main components of BoP:

• Current Account
• Capital Account
• Official Reserve Transactions

The current account includes all the transactions related to export and import of goods and services, investment income, and unilateral transfers (remittances, gifts, grants etc.). The capital account includes all international asset transactions (FDI, FPI etc.). The official reserve transactions are conducted by central banks like RBI whenever there is BoP deficit or BoP surplus. These transactions are conducted in the form of international reserve assets, such as gold and major international currencies. The sum of the three BoP components should be zero.  There is another element in BoP that is ‘Errors and Omissions’, which is the balancing item reflecting our inability to record all international transactions accurately.

BoP = Current Account + Capital Account + Official Reserve Transactions + Errors and Omissions = 0

Generally, when the joint of sum of current account and capital account of BoP is negative, it is referred as ‘BoP deficit’. When the term ‘BoP deficit’ is used, we leave aside the official reserve transactions.  Similarly, ‘BoP surplus’ means there is surplus in the joint sum of current account and capital account of BoP. Whenever we use the terms BoP Equilibrium and BoP Disequilibrium, we consider only current account and capital account.

Autonomous and Accommodating Transactions

All the included transactions under current account and capital account are called as autonomous transactions because they are done with business or profit motives without considering the status of BoP (whether it is surplus or deficit). Autonomous transactions are also called as ‘above the line’ items in BoP. The accommodating transactions are determined by the net consequences of autonomous transactions, that is, they depend on the status of BoP. These accommodating transactions are also called as ‘below the line’ items in BoP. Examples of accommodating transactions are official reserve transactions.

Current Account Transactions

Current Account transactions include all transactions of export and import of goods and services, investment income, and unilateral transfers. If the sum of all these transactions is negative then it is called as current account deficit (CAD) whereas if the sum is positive it is called current account surplus.

Exports and imports of goods (visible trade)

When we export goods, we credit money to the current account. When we import goods, we debit money from the current account.  The difference between export and import is called merchandise Trade Balance. If exports are more than imports there will be trade surplus and if imports are more than exports there will be trade deficit. Except for two years in the 1970s, India has a trade deficit consistently.

Export and Import of Services (invisible trade)

When we export services, we again credit money to the current account. When we import the services, we debit money from the current account. Now, export of services has two meanings. One is that we provide service to the foreign nationals in their own land and another is that foreigners come to our country and we provide service to them here. Both have same meaning. Like in tourism, the tourists come to India and whatever we earn from their tourism activity is also deemed to be a service export. But since we cannot see this export taking place, we call it Invisible Export. India is slowly becoming a service oriented economy, so invisible exports are slated to play very important role in the years to come. Following are examples of Invisible exports and imports:

• Money spent on travel by tourists
• Tuition paid to universities by international students
• Banking, Insurance, Consulting services in foreign land
• Royalties and license fee paid for use of copyright or patent

Please note that Outsourcing is basically getting service from abroad. So, it is a service import or invisible import, which would be a debit entry in the current account. Even if you outsource goods, it would mean import of goods.

Investment income

Investment income includes any income made from investing abroad, profits from business activities of subsidiaries located abroad, interest received from investment and loans abroad, and dividends from owing shares in overseas companies. If we receive interest, dividends and other incomes from abroad, it will be a credit entry in the current account. Similarly, if we pay the interest, dividends and other expenditures to abroad, it will be debit entry from the current account.

Unilateral transfers

Unilateral transfers include foreign aid, personal gifts sent to friends and relatives abroad, donations, charitable donations, and international remittances, withdrawal/redemption of NRI deposits locally etc. Whenever there is inward remittance, it will be credited to the current account and outward remittances will be debited from the current account. The same is valid for pensions also. If a foreigner living in India is getting pension from his own country here, it would be credited to current account and vice versa.

Capital Accounts Transactions

The capital account transactions include all transactions which alter the assets or liabilities, including contingent liabilities, outside India of persons resident in India. Similarly, it includes transactions which alter assets and liabilities in India of persons resident outside the India. The assets and liabilities include securities, immovable properties, foreign currency, lending or borrowing in foreign currency or rupees, intangible assets, trade credits etc. Current Account items can be categorised based on maturity as short term or long term flows, based on instrument type as debt or non-debt instrument. NRI deposits from part of capital accounts. Other capital account items includes leads and lags in exports, special drawing rights (SDR) allocation, funds held abroad, advances received pending issue of shares under FDI and other capital not included elsewhere (n.i.e).

Foreign Direct Investment

When foreigners purchase the Indian capital assets such as factories, machines, companies, we credit the money to the capital account. If Indians make FDI investment abroad, we debit the money from the capital account.

Portfolio Investment

When foreigners purchase the Indian securities such as stocks, bonds, CDs, money-market accounts, the money is credited to capital Account. When Indians purchase the foreign securities abroad, the money is debited from the capital Account.

Other items of Capital Account

When there is an increase in loans & trade credits to Indian residents by foreigners, the money will be credited to financial account and vice versa. Loans can be in the form of external assistance, external commercial borrowings and trade credits.