Balance of payments ( BOP ) - component and difference between capital account and current account .

Balance of payments (BOP)

The balance of payments (BOP) refers to the systematic record of all the financial and economic transactions made by the residents of the country with the rest of the world. It is the summary of all the financial transactions made by the individuals, corporate firms, and the government etc. It includes all the external visible and non-visible financial transactions of the country.

The BOP of a country gives information about its ability to pay for its imports. It gives information about the position of the country with respect to issues like currency crisis, capital flows and its impact on the economy etc. It also gives valuable insights into its economic output which is required for its economic growth.

What is the balance of trade (BOT)?

The BOP should not be confused with Balance of trade (BOT). BOT is different from the balance of payment of a country. The balance of trade shows the difference between the country s monetary value of exports and imports (visible trade) for a given period of time. It is usually the largest component of any country's BOP.

The balance of trade is also known as trade balance, international trade balance, net exports or commercial balance etc. If a country exports more than its imports then it will have a positive balance or trade surplus. However, if imports are greater than its exports, the country will have a trade deficit or negative balance.

The economic transactions of a country include all the inflows and outflows during a financial year. The inflows and outflows form the part of the balance of payment.

Inflow of money (foreign receipts)

The foreign receipts include the inflows from external earnings and external borrowings.

·     Source of earnings: It includes the merchandise exports, services exports, private transfers and remittances, Gifts and Aids from foreign sources, money earned from interest, dividends, and royalties etc.

·     Source of borrowings: the borrowings include Foreign Direct Investments (FDI), foreign portfolio investments (FPI), external commercial borrowings, NRI deposits, loans taken by the government from external sources etc.

Outflow of money (foreign payments)

·     Spendings: it includes spending on merchandise imports, service imports, remittances sent to their home countries by foreign nationals, gifts, and grants given to foreign countries, interest, dividends and royalties etc paid to the foreign countries etc.

·     Lendings: it includes Foreign Direct Investment made by Indian companies in foreign countries, Foreign Portfolio Investment made by the Indian citizens, short term deposits made by Indian residents in foreign countries, the loans given by the Indian government to the foreign governments etc.

Components of the Balance of payments (BOP)

The components of the balance of payment are:

·     Current account: It includes the financial transactions dealing with the export and import of goods, services, unilateral transfers, investment income etc.

·     Capital account: It includes the financial transactions dealing with assets such as foreign direct investment, foreign portfolio investment, foreign loans etc.

·     Official reserve transactions:It conducted by the central bank in case of the BOP deficit or BOP surplus.

·     Errors and omissions: It is the element of BOP (other than the current account and the capital account) which refers to the balancing items reflecting the inability to record all the international financial transactions.

Autonomous and accommodating transactions

All the transactions under the current account and the capital account are known as autonomous transactions. This is because these transactions are done solely on the basis of profit motives without taking into consideration the status of the Balance of payments. Autonomous transactions are also known as above the line elements in the Balance of payments.

The accommodating transactions depend upon the status of the Balance of payments. These transactions are determined by the consequences of the autonomous transactions on the BOP. The accommodating transactions are also known as below the line elements in the Balance of payments. The official reserve transactions are an example of accommodating transactions.

Current Account transactions

It includes all the transactions for exports and imports of goods, services, unilateral transfers and investment income etc. The receipts from the exports of goods, services, investment income, and unilateral transfers are shown as positive items or credit in the current account. Whereas the payments made for the import of goods, services, investment income sent abroad and unilateral payments are shown as negative items or debit in the current account. The balance on current account refers to the net value of these credits and debits.

When the net value of these transactions is negative, then it leads to the current account deficit (CAD). While if the net value of all these transactions is positive then it is known as current account surplus. The current account shows the income generated from the foreign sources.

Components of the current account

The major components of the current account are as follows:

·     Merchandise transactions or the visible trade (export and import of goods): the major part of foreign trade transaction include the export and import of a country. Payments made for the import of goods from other countries are shown as a negative side or debit items, and the receipts from the export of goods to other countries are shown as positive items. The balance of these exports and imports is called as the balance of trade or the merchandise trade balance. If the imports are more than exports, it will lead to trade deficit; while if the exports are more than imports, it will lead to a trade surplus. India has experienced consistent trade deficits except for the two years in the 1970s.

·     Invisible trade (the export and import of services): it includes the export and import of services such as Information Technology services, banking, insurance and consultancy services offered to foreign countries, BPO, tourism, outsourcing etc. The export of services is shown as a credit in the current account, while the import of services is shown as a debit to the current account. Since the export and import of services are invisible, they are known as invisible trade.

·     Unilateral or unrequited transfers (one sided transactions): the unilateral or unrequited transfers are one way transfer which include gifts and donations, personal remittances, foreign aid, charitable donations, withdrawal of NRI deposits locally etc. The inward transfers are shown as a credit to the current account and the outward remittances are shown as a debit to the current account.

·     Income receipts and payments (investment income): it refers to the income from the investments made in the foreign countries, profits from the subsidiaries of companies located abroad, interest earned from loans and investments abroad, dividend income from the shares in the foreign companies etc. If the income is received from foreign sources, it is shown as a credit to the current account and if the payments are made to the residents of foreign countries, then it is shown as a debit to the current account.

Capital account transactions:

Capital account refers to the record of all the transactions of the capital inflows and capital outflows which affect a country's foreign assets and liabilities. It deals with all the international capital trade transactions between the residents of one nation with other. The capital account shows net the changes in the ownership of a country's assets and liabilities. For example, if an Indian citizen buys a property in a foreign country it will be shown as a debit in the capital account.

The capital account components include foreign investment such as FDI and FPI, immovable properties, intangible assets trade credits, borrowings from other countries, banking capital, changes in the foreign exchange reserve etc. The NRI deposits, Special Drawing Rights, funds held in foreign countries etc are also included in the capital account. The capital account is concerned with the claims and liabilities of financial nature regardless of the time period.

The capital account is used for financing deficits in the current account or absorbing any surplus of the current account. As the capital account deals with financial transfers, it does not have any direct impact on the output, income and the employment of the nation.

Components of capital account

·     Borrowing and lendings from foreign countries: it includes the financial transactions related to borrowing money from foreign countries by the private sector companies or individuals, government etc. The receipts from abroad which include the repayment of loans from the foreign citizens etc are shown as a credit in the capital account. The financial transactions dealing with lending to abroad by the private sector companies, individuals and the government, and the repayment of loans taken from foreign countries is shown as a debit in the capital account.

·     Investments to and from the foreign countries: the investments from the foreign countries in the Indian companies, government bonds, real estate etc in India are shown as a credit in the capital account as they lead to the inflow of foreign exchange. The investments made by the Indian residents in the stocks and shares of companies abroad, government bonds, real estate etc are shown as a debit in the capital account as they lead to the outflow of foreign exchange.

·     Foreign direct investment (FDI): when the foreign residents buy Indian capital assets such as companies, industrial complexes, machines etc, it is shown as a credit to the capital account. The FDI investment made by Indians in the foreign countries is shown as a debit in the capital account.

·     Foreign portfolio investment (FPI): when the foreign residents purchase stocks, government bonds, corporate securities etc, then these transactions are shown as a credit to the capital account. When the Indian residents purchase securities and bonds in foreign countries, it is shown as a debit in the capital account.

·     Changes in the Foreign Exchange Reserves: the foreign exchange reserves are the financial assets held by the central bank (RBI for India) of the country. These reserves serve as financing item in the Balance of payments. Any withdrawal from the foreign exchange reserves is shown as credit, while any addition in the reserves is shown as a debit in the capital account. The changes in foreign exchange reserves is shown in the BOP account and not the actual foreign exchange reserves .

Balance on the capital account

The net value of all the credits and debits as mentioned above gives the balance on the capital account. When the credit items are more than the debit items, it leads to capital account surplus and indicates the net inflow of capital in the country. When the debit items are more than the credit items then it leads to a deficit in the capital account which indicates the net outflow of capital from the country.

Balance of payments (BOP) = Current account + Capital account =0

Current account deficit

Current account deficit refers to a situation when the value of goods and services imported by a country exceeds the value of goods and services exported by it. In other words, it simply means that a country imports more than what it exports.

This current account deficit is paid through surplus in the capital account i.e through surplus foreign investments or foreign loans or through the forex reserves. When foreign exchange reserves fall below the critical level, the country faces the balance of payment crisis.

Impact of current account deficit

·     The impact of the current account deficit depends upon the manner in which this deficit is financed. If it is financed through loans and borrowings from foreign countries, it becomes unsustainable in the long run because large borrowings ultimately leads to high interest payments in the future.

·     The financing of CAD through hot money such as foreign Institutional Investment (FII) is also risky as when the confidence of market falls, the hot money flows out quickly leading to rapid depreciation of currency as happened during the East Asian crisis.

·     Running CAD means the claims of foreigners are increasing in the countries assets which could be redeemed by them at any point of time.

·     However, the impact of CAD may not be necessarily negative as CAD during the period of inward investment through FDI can create jobs and growth in the economy. This improves the health of the country's economy and the country will be able to pay its debts back.

·     The developing countries usually run CAD for buying capital goods, and later they export the consumer goods for repaying their debts.

·     A moderate CAD of around 2% of GDP is stable for the economy and can be helpful in long run to improve its productivity.

Difference between them

Twin deficit

When a country faces a current account deficit and fiscal deficit at the same time it is known as twin deficits. Both these deficits reinforce each other and high fiscal deficit usually leads to a high current account deficit and vice versa.

The balance of payment (BOP) crisis of 1991 in India

The balance of payment crisis occurs when there are insufficient capital account surplus and foreign exchange reserves for financing the current account deficit.

·     India faced the BOP crisis in 1991 due to factors such as the Gulf War which increased the oil prices. The disintegration of USSR also negatively impacted India's exports contributing to the BOP crisis.

·     The value of Indian rupee fell and the Reserve Bank of India sold its forex reserves for making the balance of payment zero. Since the RBI did not had enough forex reserves, India had to pledge 65 tons of gold for getting foreign loans to make the balance of payment zero.

·     India liberalized its economy after 1991, and now the Reserve Bank of India holds forex reserves of around $400 billion.