Balance of Payments:A Note

 

Countries rarely can exist in isolation. There is certain degree of interdependence across countries. Hence cross border transactions are a norm. these transactions manifest in many ways. There would be export of goods in exchange for which foreign currency is received. There are import of goods which have to be paid in foreign currency. There are remittances from domestic residents who would be currently working abroad. There would be banking transactions across border. Firms would invest in assets overseas. All these transactions that have an element of cross-border interaction are recorded in a statement what is popularly as balance of payments. Thus as is obvious, balance of payments (BoP) points to the records of all cross border transactions undertaken by a country in a given period of time. This might be prepared monthly, quarterly, half-yearly or annually.

 

Scenarios wherein demand for domestic currency exceeds that of the supply of domestic currency results in a surplus in the BoP. On the other hand, the situation wherein the supply of domestic currency is in excess of demand for domestic currency results in the BoP reporting a deficit. Balance of Payments is presented in a format suggested by the IMF to maintain uniformity across countries thus enabling cross country comparisons. It would be thus interesting to have glance at a typical BoP statement. A statement for BoP comprises of two components, the first the current account and the second, the capital account. The current account transactions are sought to be balance by the capital account transactions. The entry system follows a double-entry model of credit and debit something inherent in the accounting practices.

 

The current account comprises of all transactions that have an underlying consideration, all transactions that are unilateral transfers and those transfers wherein there is an income earned or expended. The first entry in a current account would be the merchandise trade. The export and import of goods would indicate what is termed the trade balance. A negative trade balance would indicate the domestic country has imports in excess of exports thus needing more foreign exchange. This foreign exchange would have to be compensated by the services exports or paid towards services imports. The service exports usually are termed invisibles. The balance of goods and services export and imports would point towards the X-M component in aggregate demand identity. Yet this goods and services balance might be negative thus alternate sources to compensate for the deficit and keep the current account balance in positive. These would take form of unilateral transfers. The unilateral transfers comprise among other things the remittances back home. To many countries with strong diaspora, these remittances are the ones which drive the economy. the unilateral transfers also comprise of charity. Many charitable organizations do give grants to poorer countries thus contributing to the current account. Incomes earned by the residents from services abroad or income paid to overseas residents for services rendered domestically, would comprise the third element of the current account balance. If the aggregate current account balance is negative, it is termed as current account deficit else it is known as current account surplus. Current account deficits have to be balanced by capital account surplus.

 

The capital account under a new nomenclature is known as financial and capital account. Yet the old convention is still followed in many instances. All entries which have a charge on them are included in the capital account. The most important and the critical component is of course what is termed as foreign direct investment (FDI) and foreign portfolio investment (FPI) but more popularly called FII. The FDI is an outcome of an asset creation. Since it involves creation of assets, it is stable and long term. It includes greenfield plants, expansion of existing capacity and mergers and acquisitions. FII on the other hand are about cross border exercise of speculative motive of money. The objective for the portfolio investors is not management control but to earn a return on their excess funds. Given the money follows the returns, it is volatile. The money is moved across border within matter of minutes following the path of highest returns. The policies on FDI and FII usually follow the need to raise global funds if there exists a current account deficit. A current account surplus on the other hand entails a capital account deficit. Implied is a large scale FDI outwards. The second component is the debt component both sovereign debt and corporate debt. The external commercial borrowings, the government debt, government borrowings from overseas all are part of the same. The cross border banking transaction and acquisition of financial assets and liabilities also constitute the financial and capital account. If the capital account too is unable to bridge the gap of current account deficit, the country would not have money to pay for imports, thus having to seek refuge in international institutions like International Monetary Fund (IMF) to tide over the BoP crisis. Alternatively, the countries might have to pawn their gold reserves to raise funds from overseas.

 

The net of current account and capital account surplus constitute the total foreign exchange reserves of the economy. High current account surplus countries invest overseas through sovereign wealth funds or through direct investment overseas or lend money thus mobilising monetary influence.  Those with current account deficit would basically build cases for more investment from overseas inwards to shore up their capital account balances thus accumulating foreign exchange reserves. The foreign exchange reserves can be used for multiple purposes. They can serve in terms of retiring the fiscal deficit. However the cost benefit analysis is skewed towards cost, hence something that governments keep resisting the temptations. Foreign exchange reserves are the source for sovereign wealth funds which earn returns through overseas investments. Foreign exchange reserves also come in handy for government assistance abroad. Many governments do lend to overseas agents. In many ways they are building sources of influence. These reserves are used also for grants to overseas countries. Yet the number of countries who have reserves to be sourced towards grants or lending assistance would obviously be limited. The balance of payments have however significant influence on the domestic policy in terms of inflation, interest rates as also fiscal deficit. There are strong linkages between fiscal and current account deficit. Of course, this needs a separate engagement, something for the future posts.