INTERNATIONAL FINANCIAL MANAGEMENT

ASSIGNMENT ON

BALANCE OF PAYMENTS

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WHAT IS BALANCE OF PAYMENT?
The balance-of-payments accounts of a country record the payments and receipts of the residents of the country in their transactions with residents of other countries. If all transactions are included, the payments and receipts of each country are, and must be, equal. Any apparent inequality simply leaves one country acquiring assets in the others. For example, if INDIANS buy automobiles from Japan, and have no other transactions with Japan, the Japanese must end up holding RUPEES, which they may hold in the form of bank deposits in INDIA or in some other INDIAN investment. The payments Indians make to Japan for automobiles are balanced by the payments Japanese make to Indians. individuals and institutions, including banks, for the acquisition of Rupee assets. Put another way, Japan sold India automobiles, and INDIA sold Japan rupees or Rupee-denominated assets such as treasury bills .
Although the totals of payments and receipts are necessarily equal, there will be inequalities—excesses of payments or receipts, called deficits or surpluses—in particular kinds of transactions. Thus, there can be a deficit or surplus in any of the following: merchandise trade (goods), services trade, foreign investment income, unilateral transfers (foreign aid), private investment, the flow of gold and money between central banks and treasuries, or any combination of these or other international transactions.
Many different definitions of the balance-of-payments deficit or surplus have been used in the past. Each definition has different implications and purposes. Until about 1973 attention was focused on a definition of the balance of payments intended to measure a country’s ability to meet its obligation to exchange its currency for other currencies or for gold at fixed exchange rates. To meet this obligation, countries maintained a stock of official reserves, in the form of gold or foreign currencies that they could use to support their own currencies. A decline in this stock was considered an important balance-of-payments deficit because it threatened the ability of the country to meet its obligations. But that particular kind of deficit, by itself, was never a good indicator of the country’s financial position. The reason is that it ignored the likelihood that the country would be called on to meet its obligation and the willingness of foreign or international monetary institutions to provide support.
When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counter-balanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries.
While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted. The term "balance of payments" often refers to this sum: a country's balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a certain amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter.
Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country's currency and other currencies. Then the net change per year in the central bank's foreign exchange reserves is sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a managed float where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange rate). With a pure float the central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the central bank's foreign exchange reserves do not change.
ANALYSIS of Balance of payments
The two principal parts of the BOP accounts are the current account and the capital account.
The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers.
The capital account records the net change in ownership of foreign assets. It includes the reserve account (the foreign exchange market operations of a nation's central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account).
The Financial Account
In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented.

Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

The Balancing Act
The current account should be balanced against the combined-capital and financial accounts. However, as mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies. When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account. If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded.

When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP.
The IMF definition
The International Monetary Fund (IMF) defines the BOP accounts, which is also used by the Organization for Economic Cooperation and Development (OECD), and the United Nations System of National Accounts (SNA) as follows.
“The main difference in the IMF's terminology is that it uses the term "financial account" to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, form a small part of the overall capital account.[6] The IMF separates these transactions out to form an additional top level division of the BOP accounts. Expressed with the IMF definition, the BOP identity can be written:

The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading sub-divisions, which are: * The goods and services account (the overall trade balance) * The primary income account (factor income such as from loans and investments) * The secondary income account (transfer payments)
Conceptual Framework of the Balance of Payments
The Reserve Bank of India (RBI) is responsible for compiling the balance of payments for India. The RBI obtains data on the balance of payments primarily as a by-product of the administration of the exchange control. In accordance with the Foreign Exchange Management Act (FEMA) of 1999, all foreign exchange transactions must be channeled through the banking system, and the banks that undertake foreign exchange transactions must submit various periodical returns and supporting documents prescribed under the FEMA. In respect of the transactions that are not routed through banking channels, information is obtained directly from the relevant government agencies, other concerned agencies, and other departments within the RBI. The information is also supplemented by data collected through various surveys conducted by the RBI. Data are prepared on a quarterly basis and are published in the Reserve Bank of India Bulletin.

Components of the INDIAN Balance of Payments

1. Current Account - Under this are included imports and exports of goods and services and unilateral transfers of goods and services

The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account.

Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports.

Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received

Goods
The RBI compiles data on merchandise transactions mainly as a by-product of the administration of exchange control. Data on exports are based on export transactions and the collection of export proceeds as reported by the banks. In the case of imports, exchange control records cover only those imports for which payments have been effected through banking channels in India. Information on payments for imports not passing through the banking channels is obtained from other sources, primarily government records and borrowing entities in respect of their external commercial borrowing. Since 1992-93, the value of gold and silver brought to India by returning travelers has been added to the imports data with a contra-entry under current transfers, other sectors. Exports are recorded on an f.o.b. basis, whereas imports are recorded c.i.f. The Fund adjusts imports, for publication in this yearbook, to an f.o.b. basis by assuming freight and insurance to be 10 percent of the c.i.f. value.
Services
Under the exchange control rules, authorized dealers (i.e., banks authorized to deal in foreign exchange) are required to report details in respect of transactions, other than exports, when the individual remittances exceed a stipulated amount. For receipts below this amount, the banks report only aggregate amounts without indicating the purpose of the incoming remittance. The balance of payments classification of these receipts is made on the basis of the Survey of Unclassified Receipts conducted by the RBI. This sample survey is conducted on a biweekly basis.

Transportation
This category covers all modes of transport and port services; the data are based mainly on the receipts and payments reported by the banks in respect of transportation items. In addition to the exchange control records, the survey of unclassified receipts is also used as a source. These sources are supplemented by information collected from major airline and shipping companies in respect of payments from foreign accounts. A benchmark Survey of Freight and Insurance on Exports is also used to estimate freight receipts on account of exports.

Travel
Travel data are obtained from exchange control records, supplemented by information from the surveys of unclassified receipts. The estimates of travel receipts also use the information on foreign tourist arrivals and expenditure, received from the Ministry of Tourism as a cross-check of the exchange control and survey data.

The insurance category covers all types of insurance (i.e., life, nonlife, and reinsurance transactions). Thus, the entries include all receipts and payments reported by the banks in respect of insurance transactions. In addition to information available from exchange control records, information in the survey of unclassified receipts is also used. The benchmark survey of freight and insurance is used to estimate insurance receipts on account of exports. Other services also cover a variety of service transactions on account of software development, technical know-how, communication services, management fees, professional services, royalties, and financial services. Since 1997-98, the value of software exports for onsite development, expenditure on employees, and office maintenance expenses has been included in other services. Transactions in other services are captured through exchange control records and the survey of unclassified receipts, supplemented by data from other sources. For example, information on issue expenses in connection with the issue of global depository receipts and foreign currency convertible bonds abroad is obtained from the details filed by the concerned companies with the Foreign Exchange Department, RBI.
Income
Information on investment income transactions is obtained from exchange control records and foreign investment surveys, supplemented by information available from various departments of the RBI. Interest payments on foreign commercial loans are also reported under the RBI Foreign Currency Loan reporting system. The data on reinvested earnings of foreign direct investment companies are based on the annual Survey of Foreign Liabilities and Assets, conducted by the RBI. Details of investment income receipts on account of official reserves are obtained from the RBI's internal records. Interest accrued during the year and credited to nonresident Indian deposits is also included under this category.

Current transfers
The data are obtained from the Controller of Aid Accounts and Audit, government of India, whereas data on PL-480 grants are obtained from the U.S. Embassy in India.

Other sectors
Transactions relating to workers' remittances are based on the information furnished by authorized dealers regarding remittances received under this category, supplemented by the data collected in the survey of unclassified receipts regularly conducted by the RBI. Redemption, in India, of nonresident dollar account schemes and withdrawals from nonresident rupee account schemes has been included as current transfers, other sectors since 1996-97.

2. The Capital Account

The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets (assets such as equipment used in the production process to generate income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to fixed assets.

The Capital Account consists of short- terms and long-term capital transactions A capital outflow represents a debit and a capital inflow represents a credit. For instance, if an American firm invests Rs.100 million in India, this transaction will be represented as a debit in the US balance of payments and a credit in the balance of payments of India. The payment of interest on loans and dividend payments are recorded in the Current Account, since they are really payments for the services of capital. As has already been mentioned above, the interest paid on loans given by foreigners of dividend on foreign investments in the home country are debits for the home country, while, on the other hand, the interest received on loans given abroad and dividends on investments abroad are credits.

3. The Financial Account

In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented.

Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

Direct investment
Basic data are obtained from the exchange control records, but information on noncash inflows and reinvested earnings is taken from the Survey of Foreign Liabilities and Assets, supplemented by other information on direct investment flows. Up to 1999/2000, direct investment in India and direct investment abroad comprised mainly equity flows. From 2000/2001 onward, the coverage has been expanded to include, in addition to equity, reinvested earnings, and debt transactions between related entities. The data on equity capital include equity in both unincorporated business (mainly branches of foreign banks in India and branches of Indian banks abroad) and incorporated entities. Because there is a lag of one year for reinvested earnings, data for the most recent year (2003/2004) are estimated as the average of the previous two years. However, as intercompany debt transactions were previously measured as part of other investment, the change in methodology does not make any impact on India's net errors and omissions.

Portfolio investment
Basic data are obtained from the exchange control records. These are supplemented with information from the Survey of Foreign Liabilities and Assets. In addition, the details of the issue of global depository receipts and stock market operations by foreign institutional investors are received from the Foreign Exchange Department, RBI.

Other investment
Most of the information on transactions in other investment assets and liabilities is obtained from the exchange control records, supplemented by information received from the departments of the RBI and various government agencies. Entries for transactions in external assets and liabilities of commercial banks are obtained from their periodic returns on foreign currency assets and rupee liabilities. Data on nonresident deposits with resident banks are obtained from exchange control records, the survey of unclassified receipts, and information submitted by the relevant banks to the RBI.

Reserve assets
Transactions under reserve assets are obtained from the records of the RBI. They comprise changes in its foreign currency assets and gold, net of estimated valuation changes arising from exchange rate movement and revaluations owing to changes in international prices of bonds/securities/gold. They also comprise changes in SDR balances held by the government and a reserve tranche position at the IMF, also net of revaluations owing to exchange rate movement.

4. Net errors and omissions
This is the last component of the balance of payments and principally exists to correct any possible errors made in accounting for the three other accounts. These errors are common to occur due to the complexity of the calculations and difficulty in obtaining measurements.
Omissions are rarely used usually by governments to conceal transactions.They are often referred to as "balancing items".

5. Reserve Account
The official reserve account records the change in stock of reserve assets (also known as foreign exchange reserves) at the country's monetary authority . Frequently, this is the responsibility of a government established central bank. Reserves include official gold reserves, foreign exchange reserves, IMF Special Drawing Rights (SDRs), or nearly any foreign property held by the monetary authority all denominated in domestic currency. Changes in the official reserve account equal the differences between the capital account and current account (and errors & omissions) by accounting identity and are mostly composed of foreign exchange interventions and deposits into international organizations such as the IMF; the magnitude of these changes will depend upon monetary policy and government mandate.
According to the standards published by the IMF in the IMF Balance of Payments Manual, net decreases of official reserves indicate that a country is buying its domestic assets, usually currency then bonds, to support its value relative to whatever asset, usually a foreign currency, that they are selling in exchange. Countries with large net increases in official reserves are effectively attempting to keep the price of their currency low by selling domestic currency and purchasing foreign currency, increasing official reserves.

THE CURRENT INDIAN BALANCE OF PAYMENT
On September 30, 2011, the Reserve Bank of India (RBI) published India’s balance of payments (BoP) using a new presentation format. The format improves the presentation of India’s BoP by aligning with international best practices. A major part of the BoP report has been compiled based on the IMF’s latest BoP Manual (BPM6) starting from the first quarter of the fiscal year 2010-2011 (April-June 2010), officially replacing the previous BPM5 format.
India’s Balance of Payments (BPM6)

Chart provided by: CEIC Data
During the quarter of April-June 2011, the trade deficit rose by 9.7% to USD 35.4 billion, despite a sharp increase in exports relative to imports. Export goods recorded growth of 47.1% year-on-year (YoY), and imports registered a 33.2% YoY growth during the quarter. In absolute terms, the trade deficit increased by USD 3.1 billion from USD 32.3 billion in the corresponding quarter previous year. Meanwhile, net exports of services rose by 19.1% in the quarter, mainly due to higher growth in receipts led by the transportation, construction, insurance and pension, telecommunication, computer and information sectors.
Driven by higher commodity prices, the current account deficit (CAD) widened by 17.4% YoY to USD 14.1 billion during the first quarter of the current fiscal year. This wider CAD was financed by an overall capital and financial accounts surplus in excess of USD 15.4 billion during the same period. Mainly due to increasing net foreign direct investment (FDI) inflows to India, net financial inflows increased 20.4% to USD 15.7 billion in the quarter compared to the previous year. FDI inflows increased to USD 7.2 billion during the first quarter of fiscal year 2011-2012 as compared to USD 2.9 billion last year. There was a net accretion to foreign exchange reserves to the tune of USD 5.4 billion reflecting depreciation of the U.S. dollar against major international currencies during the quarter.
The RBI’s latest presentation of the trade deficit patterns is decomposed into specific current account components with detailed breakdowns on trade of goods, services, and income transfers. In line with current international standards, the new BPM6 classifications enhance India’s BoP statistics with more detail and better cross-country comparisons.
When Balance of Payments Really Matters

A balance of payment crisis can occur when a nation is highly indebted and can neither pay for its imports or exports, nor can it borrow to pay off previous debts. This phenomenon usually begins with an influx of foreign investment capital that creates an economic boom. However, as the borrowed or invested capital runs thin, and with few dollars flowing in on the balance of trade, the creditors start to take profits, and the country is often left indebted, but with very little real income to cover its debts.

Likewise, no creditors are willing to lend it more money to make good on immediate liabilities, since they are mostly interested (at this point) in recouping their original investment.

Balance of payment crises can happen virtually overnight. The United States, which runs one of the largest current account deficits, but is still regarded as a highly stable nation, could fall into a crisis at any minute should its creditors, namely China and Japan, decide they are no longer interested in buying up more debt. While these types of situations are extreme and happen most frequently in developing nations, they can and do happen in the developed world.

To combat current account deficits, the affected country usually turn to inflation to solve their immediate worries. The result is a precipitous decline in currency values and massive global sell off of the individual currency. This happened most recently in the 1990s during the Asian currency crisis, where whole governments plunged into bankruptcy in a matter of weeks. As a forex trader, it is paramount to understand the balance of payments, which belies the precarious situation each currency faces.