What is Balance of Payments (BoP)?

by Manshu on May 27, 2012

in Economy

Balance of Payments (BoP) is an account of the international transactions of a country, and shows how the country is faring in trade, attracting capital from abroad, and the effect of that on its foreign exchange reserves.

The budget website has a BoP document and that contains the components of the BoP and understanding the components is a very good way to understand what BoP is.

When talking about the BoP – you will usually hear reference to the current account and the capital account and along with the change in forex reserves these form the most important parts of the reserves. They have mentioned errors and omissions as the fourth part, and I’ve included it for accuracy but if you think about it, that’s not really a head on its own.

Before we go any further, let’s look at this chart that has the hierarchy of these components and then look at each component one by one.

 

What is Balance of Payments

What is Balance of Payments

Current Account

The current account shows you the trade position of the country. It shows you the merchandise imports and exports, and then the invisibles part of it is also trade but it’s that part of trade where there is no physical good exported or imported.

In India’s case, the transfers and grants part of the invisibles is quite big relative to other countries because of the large Indian diaspora.

As far as I know India has always run a current account deficit which means that it has always imported more than it has exported. This is something I’ve touched upon several times earlier and if you want to read more about this you can read the posts on what India imports and exports.

The rest of this is fairly self explanatory so I’ll move to the capital account now.

Capital Account

Where current account shows you trade, capital account can be thought of as the investments part of the international transactions.

This is further broken out into equity and debt investment and the FII money and FDI money is part of the equity investments while the external commercial borrowings, money deposited in banks by NRIs and trade credits are debt investments.

Till recent years, India’s current account deficit was being financed by a capital account surplus which meant that foreigners were buying more assets in India or lending more capital to India than India was doing to the rest of the world, and as a result the foreign exchanges reserves were steadily growing. However, the trend has reversed lately, and even the capital flows have been negative.

Change in forex reserves

The difference between the current account and the capital account is reflected in the change in the forex reserves.

For example, in 2010 – 11 – India’s current account deficit was $45.9 billion but the capital account surplus was $62.0 billion and this resulted in increase in foreign exchange reserves of $13.1 billion. This doesn’t exactly total up due to the effect of errors and omissions.

Conclusion

India’s forex reserves had dwindled to lows of $5.1 billion in 1991 and as a result India had to borrow from the IMF by pledging its entire stock of gold. The IMF simply didn’t lend money against the gold, but India had to physically move all its gold to IMF locations and people talk about Air India planes full of India’s gold.

Though that happened more than two decades ago, it is always fresh in memory for most people and that’s why as soon as the foreign reserves start going down you start reading articles that talk about a BoP crisis or a repeat of 1991.

At over $290 billion, India’s position is far better than it was in 1991 but if you look at the example of any of our neighboring Asian tigers, or even the western countries when they were growing, all of them have grown by relying on exports and running trade surpluses, and that’s what India’s goal should also be.

This post is from the Suggest a Topic page.

 

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{ 21 comments… read them below or add one }

Ams May 28, 2012 at 1:37 pm

Very nice article Manju.

Reply

Manshu May 30, 2012 at 5:14 am

Thanks!

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preet saini December 12, 2012 at 12:45 pm

nice article

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kartik May 28, 2012 at 7:07 pm

Very good article Manshu. Explained in really simple terms :)

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Manshu May 30, 2012 at 5:14 am

Thanks Kartik!

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manish May 29, 2012 at 7:53 pm

one of the best article i have ever read in my life very simple and very impressive especially the chart was mindblowing manshu hatsoff to u keep up the good work.

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Manshu May 30, 2012 at 5:08 am

What a great compliment! Thanks very much!

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manish May 29, 2012 at 7:57 pm

In India’s case,” the transfers and grants part of the invisibles is quite big relative to other countries because of the large Indian diaspora “.what means diaspora?

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Manshu May 30, 2012 at 5:07 am

Diaspora means Indians living abroad in foreign countries.

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venkat Kumbha June 1, 2012 at 11:07 am

Dear Manshu,
Recently, I come across your Onemint. The articles are amazing, giving good insight, who is poor in financial terms. Thank you very much. I will continue to build my knowledge through Onemint.

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Manshu June 2, 2012 at 6:49 pm

Dear Venkat – thanks a lot for your comment, please leave comments and ask any questions you may have. The comment section is probably the best part of this site.

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Abhishek Sinha June 4, 2012 at 5:44 pm

Dear Manshu ,
Your explanation is very lucid and the chart is so simple and yet self explanatory . Great Blog .

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Manshu June 6, 2012 at 4:36 am

Thanks for your comment Abhishek! I appreciate it!

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Stanley October 3, 2012 at 12:29 pm

Good work …

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kani December 31, 2012 at 12:23 pm

excellent article…very useful…thank u :)

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Manshu December 31, 2012 at 11:35 pm

Great – thanks!

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Richard April 13, 2013 at 4:53 pm

The PDF on balance of payment as a topic , the page did not open. Please help me with the full details with relevant to Nigeria status.

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ramamurthy April 21, 2013 at 9:50 am

Do you have the breakup of invisible imports? I presume it includes remittances made by Indians working abroad who send money to India?I think you did a post showing this? I cant access this?

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Manshu April 21, 2013 at 10:43 pm

I don’t think I ever did a post with the break up of invisibles, but I can do one – it is a good idea. I’ll try to get it done this week.

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Sunita June 12, 2013 at 4:38 pm

Hi Manshu!!! It was grt to read the article, too simple to understand…
I need to ask a question…..
Pls let me know….

Is Current Account Deficit and Trade Deficit two different things? If yes, what is the difference between two?

Reply

Manshu June 14, 2013 at 2:53 am

Thank you Sunita.

Trade Deficit is the difference between exports and imports.

In addition to that, the Current Account Deficit also takes into account net income (such as interest and dividends) and transfers from abroad (such as foreign aid).

Here is a good link about this if you want to read more.

http://www.imf.org/external/pubs/ft/fandd/basics/current.htm

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