Balance of Payment - CBSE Notes for Class 12 Macro Economics (2024)

January 18, 2024 by Sastry CBSE

Balance of Payment – CBSE Notes for Class 12 Macro Economics

Introduction

This chapter gives a detailed account of balance of payment of an economy, it structure and categorisation into current and capital account. Thereafter explaining balance of trade and its differences with the balance of payment, autonomous items, accommodating items and their differences, disequilibrium in balance of payment.

Balance Of Payment, Its Structure And Components

1. The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of the foreign countries during a given period of time.
Note: Economic transactions are the transactions which cause transfer of value. In the context of foreign transactions value is transferred by the residents of one country to the residents of other country. Example: when exports of goods or services are made by country A to country B, value (= export receipts) is transferred by country B to country A. Between the countries, value is transferred in terms of foreign exchange (i.e. payments are received and made in terms of foreign exchange).
2. Structure of balance payment accounting
(a) Transactions are recorded in the balance of payments accounts in double-entry book keeping.
(b) Each international transaction undertaken by country will results in a credit entry and debit entry of equal size.
(c) As international transactions are recorded in double entry accounting, the BOP accounting must always balance i.e., total amount of debits must be equal to total amount of credits.
(d) The balancing item Errors and omissions must be added to “balance” the BOP accounts.
(e) By convension, debit items and credit items are entered with a minus sign and plus sign respectively.
(f) Transactions in BOP are classified into the following five major categories:
(i) Goods and services account (ii) Unilateral transfer account
(iii) Long-term capital account (iv) Short-term private capital account
(v) Short-term official capital account
For each of these given categories, specific types of transactions are shown as debits or credits. This is shown in below table:


The above five categories are also divided into the following two major categories of accounts in the BOP account statement:
3. Current Account (Category-I, Category-II):
(a) Meaning: Current account records imports and exports of goods and services and unilateral transfers.
(b) Components of Current Account: The main components of Current Account are:
(i) Export and Import of Goods (Merchandise Transactions or Visible Trade):
A major part of transactions in foreign trade is in the form of export and import of goods (visible items). Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items). Balance of these visible exports and imports is known as balance of trade (or trade balance).
(ii) Export and Import of Services (Invisible Trade): It includes a large variety of non-factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services. Services are generally of three kinds: (a) Shipping, (b) Banking, and (c) Insurance. Payments for these services are recorded on the negative side and receipts on the positive side.
(iii) Unilateral or Unrequisted Transfers to and from abroad (One sided Trans¬actions): Unilateral transfers include gifts, donations, personal remittances and other ‘oneway’ transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side.
(iv) Income receipts and payments to and from abroad: It includes investment income in the form of interest, rent and profits.
4. Capital Account (Category-Ill, Category-IV, Category-V):
(a) Meaning: Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government.
(b) Components of Capital Account: The main components of capital account are:
(i) Loans: Borrowing and lending of funds are divided into two transactions:
• Private Transactions
-> These are transactions that are affecting assets or liabilities by individuals, businesses, etc. and other non-government entities. The bulk of foreign investment is private.
-> For example, all transactions relating to borrowings from abroad by private sector and similarly repayment of loans by foreigners are recorded on the positive (credit) side.
-> All transactions of lending to abroad by private sector and similarly repayment of loans to abroad by private sector is recorded as negative or debit item.
• Official Transactions
-> Transactions affecting assets and liabilities by the government and its agencies.
-> For example, all transactions relating to borrowings from abroad by government sector and similarly repayment of loans by foreign government are recorded on the positive (credit) side.
-> All transactions of lending to abroad by government sector and similarly repayment of loans to abroad by government sector is recorded as negative or debit item.
Private and official transactions borrowing are of two components:
(i) Commercial borrowings, referring to borrowing by a country (including government and private sector) from international money market. This involves market rate of interest without considerations of any concession, (ii) Borrowings as External Assistance, referring to borrowing by a country with considerations of assistance. It involves lower rate of interest compared to that prevailing in open market.
(ii) Foreign Investment (Investments to and from abroad): It includes:
• Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange.
• Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad are recorded on the negative (debit) side as they lead to outflow of foreign exchange.
‘Investments to and from abroad’ includes two types of investments:
-> Foreign Direct Investment (FDI)
It refers to purchase of an asset in rest of the world, such that it gives direct control to the purchaser over the asset.
For example, (i) acquisition of a firm in the domestic country by a foreign country’s firm (ii) transfer of funds from the parent company abroad to the subsidiary company in the domestic country.
-> Portfolio Investment
Portfolio Investment refers to the purchase of financial asset by the foreigners that does not give the purchaser control over the asset. A foreign Institutional Investment (FII) is also a part of portfolio investment.
For instance, purchase of shares of a foreign company, purchase of foreign government’s bonds, etc. are treated as portfolio investments.
(iii) Change in Foreign Exchange Reserves
• The foreign exchange reserves are the financial assets of the government held in
• central bank. A change in reserves serves as the financing item in India’s BOP.
• So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side.
• It must be noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’.

Balance Of Payments And Its Types

1. Balance: It means difference between the sum of credits and sum of debits. The BOP account records three balances:
(a) Balance of trade
(b) Balance on current account
(c) Balance on capital account
2. Balance of trade: The term “balance of trade” denotes the difference between the exports and imports of goods in a country. Balance of trade refers to the visible items only. It is the difference between the value of merchandise (goods) exports and imports.
Balance of Trade = Export of visible goods – Import of visible goods.
3. Balance on current account: It is the difference between sum of credits and sum of debits on current account.
Balance on Current Account = Sum of credits on current account – Sum of debits on current account
4. Balance on capital account: It is the difference between sum of credits and sum of debits on capital account.
Balance on capital account = Sum of credits on capital account – Sum of debits
on capital account

Autonomous And Accommodating Items, Deficit In Balance Of Payment And Disequilibrium In Balance Of Payment

1. Autonomous items
(a) Autonomous items refer to those international economic transactions in the
current account and capital account which take place due to some economic motive such as profit maximisation.
(b) These transactions are independent of the state of BOP account.
(c) These items are also known as ‘above the line items’.
(d) For example, if a foreign company is making investments in India with the aim of earning profit, then such a transaction is independent of the country’s BOP situation.
2. Accommodating items
(a) Accommodating items refer to the transactions that are undertaken to cover deficit or surplus in autonomous transactions, i.e., such transactions are determined by net consequences of autonomous transactions.
(h) These items are also known as ‘below the line items’.
(c) For example, if there is a current account deficit in BOP, then this deficit is settled by capital inflow from abroad. The sources used to meet a deficit in BOP, are: (i) Foreign exchange reserves; (ii) Borrowings from IMF or foreign monetary authorities.
3. Deficit in BOP
(a) The balance of payments of a country is a systematic record of all economic transactions between the residents of foreign countries during a given period of time.
(b) The transaction in the balance of payment account can be categorized as autonomous transactions and accommodating transactions.
(c) Autonomous transactions are transactions done for some economic consideration such as profit.
(d) When the total inflows on account of autonomous transactions are less than total outflows on account of such transactions, there is a deficit in the balance of payments account.
(e) Suppose, the autonomous inflow of foreign exchange during the year is $500, while the total outflow is $600. It means that there is a deficit of $100.
4. Disequilibrium in Balance of Payments: There are a number of factors that cause disequilibrium in the balance of payments showing either a surplus or deficit. These causes are:
(a) Economic Factors
(i) Large scale development expenditure that may cause large imports.
(ii) Cyclical fluctuations in general business activity such as recession or depression.
(iii) High domestic prices may result in imports.
(b) Political Factors: Political factors instability may cause large capital outflows and hamper the inflows of foreign capital.
(c) Social Factors: Changes in tastes, preference and fashions of the people bring disequilibrium in BOP by inflowing imports and exports.

Words that Matter

1. Balance of payment: The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of the foreign countries during a given period of time.
2. Current account: It records imports and exports of goods and services and unilateral transfers.
3. Capital account: Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government.
4. Foreign Direct Investment: It refers to purchase of an asset in rest of the world, such that it gives direct control to the purchaser over the asset.
5. Portfolio Investment: It refers to the purchase of financial asset by the foreigners that does not give the purchaser control over the asset.
6. Balance: It means difference between the sum of credits and sum of debits.
7. Balance of trade: The term “balance of trade” denotes the difference between the exports and imports of goods in a country. Balance of trade refers to the visible items only.
8. Balance on Current Account: It is the difference between sum of credits and sum of debits on current account.
Balance on Current Account = Sum of credits on current account – Sum of debits on current account
9. Balance on Capital Account: It is the difference between sum of credits and sum of debits on capital account.
Balance on capital account = Sum of credits on capital account – Sum of debits
on capital account
10. Autonomous items: It refer to those international economic transactions in the current account and capital account which take place due to some economic motive such as profit maximisation.
11. Accommodating items: It refer to the transactions that are undertaken to cover deficit or surplus in autonomous transactions, i.e., such transactions are determined by net consequences of autonomous transactions.

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