III.

The Balance of Payments

Questions
1) Define balance of payments.
 ‘The statistical record of a country’s international transactions over a certain
period of time presented in the form of double-entry bookkeeping’
2) What are the major components of BOP? Explain each of the components in detail.
Current Account
 The current account monitors the flow of funds from goods and services trade
(import and export) between countries. Now this includes money received or
spent on manufactured goods and raw materials. It also includes revenue from
tourism, transportation receipts, revenue from specialized services (medicine,
law, engineering), and royalties from patents and copyrights.
Capital Account
 The capital account monitors the flow of international capital transactions.
These transactions include the purchase or disposal of non-financial assets (for
example, land) and non-produced assets. The capital account also includes
money received from debt-forgiveness and gift taxes. In addition, the capital
account records the flow of the financial assets by migrants leaving or entering a
country and the transfer, sale, or purchase of fixed assets.
Financial Account
 The financial account monitors the flow of funds pertaining to investments in
businesses, real estate, and stocks. It also includes government-owned assets
such as gold and Special Drawing Rights (SDRs) held with the International
Monetary Fund (IMF). In addition, it includes foreign investments and assets
held abroad by nationals. Similarly, the financial account includes a record of the
assets owned by foreign nationals.

3) Why would it be useful for a company to examine the BOPs of countries in which it
has operations?
 It would be useful to examine a country’s BOP for at least two reasons. First,
BOP provides detailed information about the supply and demand of the
country’s currency. Second, BOP data can be used to evaluate the performance
of the country in international economic competition. For example, if a country
 is experiencing perennial BOP deficits, it may signal that the country’s industries
lack competitiveness.
4) India has experienced continuous current account deficits for the past several
decades. What do you think are the main causes for the deficits? What would be
the consequences of continuous U.S. current account deficits on the Indian
economy?
 Japan's continuous current account surpluses may have reflected a weak yen
and high competitiveness of Japanese industries. Massive capital exports by
Japan prevented yen from appreciating more than it did. At the same time,
foreigners' exports to Japan were hampered by closed nature of Japanese
markets. Continuous current account surpluses disrupt free trade by promoting
protectionist sentiment in the deficit country. It is not desirable especially when
it is brought about by the mercantilist policies.
5) In contrast to India, China has realized continuous current account surpluses and
accumulated reserves touching a peak of $4 trillion. What could be the main
causes for these surpluses? Is it desirable to have continuous current account
surpluses?
Causes of China’s surplus:
1. The high saving rate of the Chinese households by reference to cultural factors of
East Asia and underdeveloped social welfare systems.
2. The role of the demographic transition. China has been implementing a family-
planning policy since the 1970s.
3. Migration of manufacturing factories to China in recent years, together with their
trade surpluses.
4. An undervalued currency could plausibly cause a current-account surplus, since a
depressed exchange rate encourages exports and discourages imports.
 Continuous current account surpluses disrupt free trade by promoting
protectionist sentiment in the deficit country. It is not desirable especially when
it is brought about by the mercantilist policies.
 This was possible due to a high level of government intervention. The influx of
foreign funds put pressure on the yuan to appreciate. To combat this pressure,
the People’s Bank of China bought up most of the foreign currency that entered
the country, leading to a swelling of the nation’s foreign exchange reserves.

6) Comment on the following statement: “Since India imports more than it exports, it
is necessary for India to import capital from foreign countries to finance its current
account deficits”.
  The statement pre-supposes that the India current account deficit causes its
capital account surplus. In reality, the cause may be running in the opposite
direction: India capital account surplus may cause the country’s current account
deficit. Suppose foreigners find the India a great place to invest and send their
capital to the India, resulting in India capital account surplus. This capital inflow
will strengthen the dollar, hurting the India export and encouraging imports
from foreign countries, causing current account deficits.
7) Explain how a country can run into an overall balance-of-payments deficit or
surplus and what it needs to do to manage the deficits or surpluses.
 A country can run an overall BOP deficit or surplus by engaging in the official
reserve transactions. For example, an overall BOP deficit can be supported by
drawing down the central bank’s reserve holdings. Likewise, an overall BOP
surplus can be absorbed by adding to the central bank’s reserve holdings.
8) Since the early liberalization India’s economy in the early 1990s foreign portfolio
investors have purchased a significant portion of Indian Government’s G-Secs.
Discuss the short-term and long-term effects of foreigners’ portfolio investment on
India’s balance of payments.

9) Discuss the relationship between BOP and National Income Accounting.
 A country with a current account surplus is earning more from its exports than it
spends on imports. A country’s current account balance equals the change in its
net foreign wealth. A country with a current account deficit (surplus) is
importing (exporting) present consumption and exporting (importing) future
consumption.

Y = C + I + G + CA

 We can also express this as:

Y – C – G – I = CA, or S – I = CA,
so the current account is the difference between national saving and investment.
 An open economy can save either by building up its capital stock or by acquiring
foreign wealth, but a closed economy can only save by building up its capital
stock. A country’s current account surplus is often referred to as its net foreign
investment.
10) An open economy can save either by building up its capital stock or by acquiring
foreign wealth, but a closed economy can only save by building up its capital stock.
A country’s current account surplus is often referred to as its net foreign
investment. In 1999, Germany had a current account deficit and at the same time
a capital account deficit. Explain how this can happen
 In 1999, Germany experienced an overall BOP deficit, which must have been
accommodated by the central bank, e.g., drawing down its reserve holdings.

11) Explain how each of the following transactions will be classified and recorded in
the debit and credit of the India’s balance of payments:
(i) A Japanese portfolio investor purchases G-Secs U.S. T and pays out of its
bank account kept in New York City.
(ii) An Indian citizen consumes a meal at a restaurant in Paris and pays with her
Citibank card.
(iii) An Indian immigrant living in Los Angeles sends a check drawn on his L.A.
bank account as a gift to his parents living in Mumbai.
(iv) An Indian computer programmer is hired by a U.S. company for consulting
and gets paid from the U.S. bank account maintained by the U.S.company.

Transactions

Japanese purchase of U.S. T bonds Credit

Japanese payment using NYC account Debit

U.S. citizen having a meal in Paris Debit

Paying the meal with American Express Credit

Gift to parents in Bombay Debit

Receipts of the check by parents
Credit
(goodwill)

Export of programming service Credit

British payment out its account in U.S. Debit

12) (i) As the value of the Indian rupee rises, what is likely to happen to India’s
balance on the current account? Explain.
  A devaluation means that more local currency is needed to purchase imports
and exporters get more local currency when they convert the export proceeds
(the foreign exchange that they get for their exports). This is supposed to
discourage imports – and to encourage exports and, in turn, to reduce trade
deficits. Which in turn affects the current account.
(ii) What is likely to happen to the value of the Indian rupee as India’s current
account deficit increases?
 If the current account deficit increases that means imports are larger than
exports, in this case the value of rupee will appreciate.
(iii) A current account deficit is no always a sign of weakness and current account
surplus is not always a sign of health. Explain.
 A current account deficit means that the value of goods and services imported is
greater than the value of exports. ... In a recession, you would expect a fall in
consumer spending and therefore lower spending on imports. Usually, this fall in
import spending causes a reduction in a current account deficit.
 A current account surplus is partly due to high exports, but the other side of the
equation is imports and domestic demand. A country may have a large current
account surplus because of relatively weak domestic demand. This weak
demand leads to lower consumer spending and lower spending on imports.
13) China’s overall savings rate is now nearly 50% of its GDP, the highest in the world.
China’s domestic investment rate at 43%, is also high, but not as high as the
savings rate. What do these facts imply about China’s current account balance?
 China has a remarkably high savings rate in a typical year--and sometimes its
higher than that. In fact, the main reason for China's high trade surpluses is that
with such a high savings rate, China doesn't consume either a lot of imports or
domestically produced goods. A reason that China can invest so much, year after
year, is that the investment is financed by high savings rates.
 The balance 7 % of the savings may be the household(personal) expenses of
people.
14) According to several opinions by economists, India’s trade deficits indicate any or
all of the following:
(i) A lack of India’s competitiveness owing to low productivity or low- quality
of products and/ or lower wages
(ii) Superior technology and unfair trade practices by foreign countries.
Which of the above factors os likely to underlie the persistent trade deficit of India.

15) In the early 1990s, Japan underwent a recession that brought about a prolonged
slump in consumer spending and capital investment. Some estimate that in 1994
only 65% of its manufacturing capacity was being used. At the same time, the U.S.
economy emerged from its recession and began expanding rapidly. Under these
circumstances, what would you predict would happen to the U.S. trade deficit with
Japan?
16) Discuss the effect of fall in crude oil price on India’s BOP.
 Higher crude prices will adversely affect the twin deficits—fiscal and current
account deficit—of the economy, which will have spillover impact on the
monetary policy, and consumption and investment behavior in the economy.
 The higher crude oil imports bill could be offset by higher oil and non-oil exports.
Similarly, better domestic economic activity could help meet fiscal deficit targets.
 Higher oil prices will push the import bill higher; however, it will be partly offset
by higher oil exports and better remittances.
17) Discuss the effect of Fed hike rise on India’s BOP.
 Already rising interest rates have started to hit corporate as well as multiple
sectors. For example, rising interest rates, as well as crude prices, have started to
dent volumes in the auto sector. Rising interest rates will further strengthen the
dollar and thereby may put further pressure on Indian rupee. Rising crude oil
prices, as well as interest rates, will led to an outflow of foreign money. As a
result, Indian markets may see some short-term pressure amid upcoming
elections. One should prepare for 10-15 per cent cut in broader index.

18) Suppose Govt. of India donates $100 million to Govt. of Nepal for the recent
earthquake. The Nepal Govt. awards a contract to an Indian company for an equal
amount for construction of roads, buildings etc. What will be the effect of these
transactions on India’s BOP?

Mini Case Studies

Yin and Yang of Capital Flow Management

1. What was the major issue facing emerging market countries when facing an
influx of foreign capital?
  The increasing demand on domestic currencies that can lead to increasing the
exchange rate and make export become incompetitive and will end up to current
account deficit
 The increasing of demand of domestic assets such as stocks and bonds and it will
end up to the nation spending financed by borrowing from abroad

2. What would be the likely effect of a surge in capital inflows and in capital
outflows?
Effect of surge in capital inflows:

 Increasing demand in domestic currencies

 Increasing demand of domestic assets
 Current account deficit due to high foreign investment

Efect of surge in capital outflows:

 Dropped in domestic currencies due to high demand of dollars (Hard Currencies)

 Nett sell on domestic portfolio assets that can lead to panic situation in stock
market.
3. What prompts domestic residents to dampen the effect of sudden surges by
repatriating assets?
 Higher return from higher saving rate policy from repatriate their assets and put
on domestic economy
 Tax deduction from cutting tax rate policy for domestic repatriate assets
 Improving in easiness of access to consumer credit for working capital through
financial transparency
4. How can policymakers encourage domestic residents to offset the flow of
foreign capital?
1. Tax rate cutting policy on repatriating domestic residents assets placing in a
country
2. Tax holiday policy for domestic repatriating assets put on domestic capital market
and banking institutions
3. Creating policy for financial institutions strenghtening through financial
transparency regulations and creating the prudent policy for financial institutions
such as strict regulations on bank CAR and NPL
4. Boosting the saving rate to encourage residents increasing the private saving on
domestic economy