Balance of Payments Class 12 Notes

The balance of payments is the systematic record of all economic transactions between the residents of a country and the rest of the world in a given period, usually a year. It is an accounting statement, and it is always balanced as a record, because every inflow is matched by an outflow, even while particular sections of it are in surplus or deficit.The statement is organised into the current account and the capital account, and the two must be kept apart in every answer.

The current account records the flows of goods, services, income and transfers. Exports and imports of goods are the visible trade; services, income and transfers are the invisible items. The current account balance is the sum of the trade balance and the invisible balance.

• Merchandise trade: the exports and imports of visible goods — the balance of trade is this difference alone.
• Invisibles: services such as travel, transport, banking, insurance and software; income such as the earnings on investments abroad; and transfers such as remittances and grants.
• Trade balance = exports of goods − imports of goods.
• Current account balance = trade balance + invisibles balance.
• A deficit on the current account means the payments to the rest of the world on the current account exceed the receipts.
• A surplus on invisibles, driven largely by software exports and private remittances, softens India's trade deficit.

The capital account records the changes in the assets and liabilities of the country with foreigners — the flows of capital into and out of the country. Borrowing from abroad, foreign investment and the sale of assets are inflows that appear on the capital account; lending abroad and the purchase of foreign assets are outflows.A capital inflow is a credit (the country receives the money) and a capital outflow a debit (the country parts with it). An overall surplus on the current and capital accounts is offset in the official reserve account.

• FDI, foreign direct investment: investment in the control of a foreign enterprise, the equity of a plant.
• FII, foreign institutional investment: investment in the portfolio of shares and securities.
• Loans and borrowings: external assistance, commercial borrowings and the repayments of them.
• Banking capital: the changes in the foreign deposits and assets of the commercial banks.
• Official reserves: the foreign exchange reserves the central bank holds, drawn down when the overall balance is in deficit and built up when in surplus.

The balance of payments as a record always balances, but a deficit or surplus is read in the 'autonomous' transactions, those undertaken for their own sake. When the autonomous inflows fall short of the autonomous outflows, the deficit must be financed by the official reserve transactions, a drawdown of the foreign exchange reserves.The BOP deficit is therefore the amount by which the autonomous payments exceed the autonomous receipts, and it is met by the sale of reserves.

The foreign exchange rate is the price of one currency in terms of another, the number of rupees for a dollar. Under a flexible or floating rate, the price is struck by the market, the demand for and the supply of foreign exchange; under a fixed rate, the central bank pegs the rate through its intervention, buying and selling reserves.The flexible rate clears the market, while the fixed rate commits the authority to defend the peg.

• Determination in a free market: the demand for dollars and the supply of dollars meet at the equilibrium exchange rate.
• Demand for foreign exchange: the demand for imports, services, foreign assets and the outward transfers.
• Supply of foreign exchange: the export receipts, the invisible earnings and the inward capital flows.
• A fall in demand raises the value of the rupee; a rise in the supply of dollars raises it further — the equilibrium moves accordingly.
• Fixed exchange rate: the rate is pegged by the government or the central bank and defended by intervention.
• Flexible exchange rate: the rate floats with the market, and no authority defends a level.
• Managed floating: the market, in principle, flexibly determines the rate, but the central bank leans on it to avoid sharp swings.

Each exchange rate system carries its own balance of merits and demerits, and the examiner asks for either side in the comparative form. The flexible rate settles automatically and needs no reserves, but brings uncertainty and speculation; the fixed rate brings stability and certainty, but costs reserves and invites speculative attack.

• Flexible, merits: automatic adjustment, no need to hold large reserves, monetary independence and a market-clearing price.
• Flexible, demerits: volatility and uncertainty for trade, the risk of speculation and the absence of a stable anchor for planning.
• Fixed, merits: certainty for trade and contracts, stability of the price level via the anchor, and discipline on monetary policy.
• Fixed, demerits: the need to hold and spend reserves to defend the peg, vulnerability to speculative pressure, and the loss of monetary autonomy.
• Managed floating: the practical middle — market-determined in the long run, nudged by the authorities in the short run.

The unit is examined through the definitions of the accounts, the distinction between the trade balance and the current account, the meaning of a BOP deficit, and the exchange rate systems with their merits and demerits. The questions are mostly analytical and comparative, and the answers are best built on a small set of fixed sentences.

• Define the balance of payments, the balance of trade, the current account and the capital account.
• Classify a given transaction as visible, invisible, current or capital.
• Distinguish the trade balance from the current account balance, and the autonomous from the accommodating transactions.
• State the meaning of a BOP deficit and how it is financed.
• Explain the determination of the exchange rate in a free market with a diagram.
• Give the merits and the demerits of the fixed and the flexible exchange rate systems.
• Explain the meaning and the working of a managed floating rate.