What is the “Balance of Payments”?

4 comments Written on September 4th, 2014 by
Categories: Concepts

You’ve heard of the current account deficit and all that. But what, really, is the concept?

Here’s a primer.

Every country has to deal with other countries.

  • It will trade in physical goods where things are transported from one country to the other. This typically happens through ports (sea, air) or over land.
  • It will trade in services when people in one country provide services to people in the other, and are paid for it. The services could be performed remotely (such as over the internet), or locally (such as an Indian travel agent charging fees to organize a tour for a group of people coming from Germany)
  • Workers from a country who have gone abroad will send back money (remittances or transfers).
  • There’s “income” such as foreign companies sending money to pay salaries to their Indian branch employees, investment income such as dividends earned by residents on their investments abroad, and so on.

All of this, you might see, is money that typically comes into a country (or goes out) but has no “obligation” to return. It’s like if you go pay a barber for a haircut, you don’t consider that the barber owes you something because you paid him or left your hair behind. The money is the barber’s, to use as he chooses, and you needn’t figure in his future plans.

Think of this as a “current” account. If what a country gets from abroad (credit) is less than what it pays out (debit), then you have what is called a Current Account Deficit. Otherwise, you have a Current Account Surplus.

The Capital Account

A capital transaction is when you use your money to buy an asset abroad, or when someone abroad transfers money to buy an asset in your country. This is what comes under a Capital Account.

Together the Capital and Current Accounts make the Balance of Payments.

We’ll divide the current account into a financial capital transaction (where you buy financial assets like fixed deposits, or shares, or bonds) and non-financial capital transaction (where you buy stuff that’s not financial, like a house or such).

The latter, the non-capital-financial-transaction, is what the IMF calls the Capital Account.

The former, or the Financial Account consists of:

  • Foreign Direct Investment where businesses abroad will create or buy into businesses inside a country with the goal of operating them or with a “strategic” focus.
  • Foreign Portfolio Investment where investors from abroad buy into companies’ shares or bonds largely to participate financially only (no strategic input), and to benefit from either rising prices of securities or from dividends/interest.
  • You might have Non Resident Deposits from a country’s citizens who went abroad and want to deposit money in their home country. (This is a form of portfolio investment, agreed)
  • Local companies may borrow from abroad.
  • The central bank will either buy incoming foreign currency or sell it, thus changing the “forex reserve” of the country.
  • There’s a lot of the little stuff we just call ‘Other’.

It’s All A Zero Sum Game

The concept of a Balance of Payments is that the Current Account, the Capital Account and the Financial Account will cancel out each other. The Current Account is, by definition, financed by the Capital/FInancial Accounts.

In India the RBI releases this information on a regular basis, every quarter. The Current Account Deficit is a particular source of worry, because it had been widening and can result in a serious correction in the dollar-rupee equation - which it did, in 2013.

Here’s the data, as of 2014 (Jun quarter).

We’ve created a “waterfall’ model for you to understand this concept better:

image

That is:

  • In the quarter, we net imported $34.6 billion of physical goods
  • we exported $17.06 billion of services (mostly IT service exports)
  • We saw an income payout of $6.3 billion (interest, dividends and the like)
  • There were transfers/remittances from workers abroad, of $16 bn
  • The net Current Account showed a Deficit of $7.837 billion.

And then, here’s how the Balance of Payments works (the big pieces)

image

As you can see, the Green elements add to the balance, while the red elements subtract from it.

  • FDI and FPI (Direct and Portfolio Investment from foreigners) added over $22 billion in the quarter, and NRI’s chipped in with $2.4 billion.
  • RBI bought $11.2 billion , which, as BoP goes, is a subtraction from the BoP. (Forex reserves went up by that much)
  • Our Current Account and Net Borrowing were more than well financed by the FDI and FPI coming in. This quarter in particular! (This is how India has been, and how the US has been as well)

We hope this helps you understand the Current and Capital Account, and the Concept called the Balance of Payments. 

Here are three videos you may like, that are by Khan Academy, on the concept. This is marginally different for India, but we hope it will help you understand things better.

Related Posts Plugin for WordPress, Blogger...
About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@capitalmind.in.

4 comments “What is the “Balance of Payments”?”

Wonderfully explained Deepak!

Very beautifully explained.

i knew it but nicely explained …please pick up more topics like MOney supply…ROLE OF GOLD …OIL IMPORTS etc…

Very informative….


Leave a Reply