International Financial Management P G Apte

1. CHAPTER - 4 The Balance of Payments International Financial Management P G Apte

2. What is the Balance of Payments? • The Balance of Payments of a country is a systematic, double-entry accounting record of all economic transactions during a given period of time between the residents of the country and foreign residents • Some Simple Rules of Thumb • All transactions which lead to an immediate or prospective payment from the Rest of the World (ROW) to the country should be recorded as credit entries. The payments themselves, actual or prospective, should be recorded as the offsetting debit entries. • All transactions which lead to an immediate or prospective payment to the ROW from the country should be recorded as debit entries. The payments themselves, actual or prospective, should be recorded as the offsetting credit entries.

3. A transaction which results in an increase in demand for or reduction in supply of foreignexchange is a debit entry while a transaction which results in an increase in the supply of or reduction in demand for foreign exchange is a credit entry. • Thus : Exports are credit entries; payments for exports increase our forex balance – a use of forex – balancing debit entries. Conversely, an import transaction is a debit entry while payment for imports is a credit entry.

4. Components of the BOP • Three Main Categories • The Current Account: Includes imports and exports of goods and services and unilateral transfers. • The Capital Account: All transactions leading to changes in foreign assets and liabilities of the country. • The Reserve Account: In this category only "reserve assets" are included. Further sub-categories within each main category.

5. The Current Account • Merchandise Trade • Merchandise trade should cover all transactions relating to tangible goods. Exports (+), Imports(-), Net Balance: Merchandise Trade Balance. • The valuation should be on f.o.b. basis so that international freight and insurance are treated as distinct services and not merged with the value of the goods themselves. • Contra-entries in capital account unless barter trade.

6. The Current Account • Invisibles The invisibles account includes services such as transportation and insurance, bpo services, consultancy services, income payments and receipts for factor services - labour and capital - and unilateral transfers. • Services rendered to ROW (+); Services bought from ROW (-);Transfers received (+), transfers given (-). • Net Balance: Balance on Invisibles Account • Contra-entries in Capital Account Merchandise Trade Balance + Invisibles Balance = Current Account Balance

7. The Capital Account • Banking, Government, Other Records changes in foreign assets and liabilities. Capital inflows are credits, outflows are debits. Hence increase in foreign assets or reduction in liabilities are debits; reduction in foreign assets or increase in liabilities are credits. Loans raised, portfolio investments by foreigners, direct inward investment – credits Loans repaid, investments by residents abroad, disinvestment by foreigners – debits. Net Balance : Capital Account Balance

8. The Reserve Account • Other Accounts and Forex Reserves • The IMF account contains purchases (borrowings) and repurchases (repayments) from the IMF. Former are credits, latter debits. • The Foreign Exchange Reserves account records increases (debits) and decreases (credits) in reserve assets (RBI's holdings of gold and foreign exchange, SDRs) * (Current+Capital) Account Balance (+) implies reserves increase, reserve account (-) * (Current+Capital) Account Balance (-) implies reserves decrease, reserve account (+)

9. Meaning of “Deficit” and “Surplus”in the Balance of Payments • In a double-entry accounting statement total credit entries must equal total debit entries. • The terms “Deficit" or “Surplus" cannot then refer to the entire BOP but must indicate imbalance on a subset of accounts included in the BOP • In popular parlance, BOP deficit or surplus refers to deficit or surplus on current account. • An economically meaningful distinction is between “autonomous” and “compensating” transactions. Balance on autonomous transactions- “above the line”; on compensating transactions- “below the line”

10. Meaning of “Deficit” and “Surplus”in the BOP • Several concepts of "balance" have evolved • Trade Balance:This is the balance on the merchandise trade account. • Balance on Goods and Services:This is the balance between exports and imports of goods and services. • Current Account Balance: This is the net balance on the entire current account.

11. Meaning of “Deficit” and “Surplus”in the BOP • Balance on Current Account and Long Term Capital: This is sometimes called Basic Balance. This is supposed to indicate long term trends in the BOP, the idea being that while short term capital flows are highly volatile, long term capital flows are of a more permanent nature and indicative of the underlying strengths or weaknesses of the economy.

28. Capital Flows Capital flows during 2006-07 were substantially higher than a year ago, led by foreign direct investment (FDI) flows, on the back of strong growth prospects and buoyant investment demand. FDI inflows at US $ 16.4 billion during April-January 2006-07 were substantially higher than the inflows in the corresponding period of the previous year. FDI was channeled mainly into financial services, manufacturing, banking services, information technology services and construction. Mauritius, the US and United Kingdom remain the dominant sources of FDI to India. Outward direct investment from India also exhibited a significant rise to US $ 8.7 billion during April-December 2006 from US $ 1.9 billion a year ago due to some large overseas acquisitions by Indian corporates.

29. Capital Flows 2008-09 During 2008-09 so far capital flows have remained volatile. Net capital flows during 2008-09 so far were lower than those in the corresponding period of 2007-08, mainly on account of outflows by foreign institutional investors (US $ 7.3 billion) during 2008-09 (up to October 10, 2008) in contrast to net FII inflows (US $ 18.9 billion) during the corresponding period of 2007-08. On the other hand, net FDI flows into India were placed higher at US $ 16.7 billion during April-August 2008 as compared with US $ 8.5 billion during April-August 2007.

30. The funds raised through issuances of ADRs/GDRs abroad were at US $ 1.1 billion during April-August 2008 (US $ 2.8 billion in April-August 2007). NRI deposits recorded a net inflow of US $ 273 million during April-August 2008 mainly due to inflows under the rupee deposit accounts as against a net outflow (US $ 168 million) during April-August 2007. With net capital flows being higher than the current account deficit, the overall balance of payments recorded a surplus of US $ 2.2 billion during the first quarter of 2008-09 (US $ 11.2 billion in the first quarter of 2007-08).

32. Capital Flows (US $ billion) Components 2008-09 2009-10 (April-March) (January-June) Foreign Direct Investment FDI into India 35.0 10.0 FDI Abroad 17.5 7.4 FIIs (net) -15.0 5.6 ADRs/GDRs 1.2 0.06 External Aid (Net) 2.6 0.88 ECB (Net) 8.2 1.50 Short-term Trade Credits (Net) -5.8 -8.6 NRI Deposits (Net) -7.7 -10.6 Source: RBI

41. INDIA’S FOREIGN EXCHANGE RESERVES

47. Why BOP Statistics Are Important • BOP statement contains useful information for financial decision makers. • In the short run, BOP deficits or surpluses may have an immediate impact on the exchange rate • When exchange rates are market determined, BOP figures indicate excess demand or supply for the currency and the possible impact on the exchange rate • May signal a policy shift on the part of the monetary authorities of the country, unilaterally or in concert with its trading partners

48. BOP and the Macroeconomy • Persistent imbalance- exchange rate changes and/or policy responses. • Reserve loss, not sterilized, leads to monetary contraction, higher interest rates, economic slowdown • Reserve gain leads to monetary expansion, lower interest rates, economic upturn • No intervention leads to exchange rate depreciation or appreciation – quantity impacts on exports, imports thereby other sectors • Excessive imbalance (-), may lead to crises/panics.