January 7, 2013

IB0010 [International Financial Management] Set1 Q1

1. What are the major components of BOP (balance of Payments) ?

Ans.


Components of balance of Payments

The balance of payment statement records all types of international transactions that a country consummates over a certain period of time.

It is divided into three sections:
1. The Current Account
2. The Capital Account
3. The Official Reserve Account.

1. The current account
The current account is typically divided into three sub-categories; the merchandise trade balance, the services balance and the balance on unilateral transfers.  Entries in this account are “current” in value asd they do not give rise to future claims.  A surplus in t he current account represents an in flow of funds while a deficit represents an outflow of funds.

a. The balance of merchandise trade refers to the balance between exports and imports of tangible goods such as automobiles, computers, machinery and so on.

b. Services represent the second category of the current account. Services include interest payments, shipping and insurance fees, tourism, dividends and military expenditures.  These trades in services are sometimes called invisible trade.

c. Unilateral transfers are gifts and grants by both private parties and governments.  Private gifts and grants include personal  gifts of all kinds and also relief organization shipments.  For example, money sent by immigration workers to their families in their native country represents private transfer. Government transfers include money, goods and services sent as aid to other countries.  For example, if the United States government provides relief to a developing country as part of its drought-relief programme, this would represent a unilateral government transfer.

2. The Capital Account
The capital account is an accounting measure of the total domestic currency value of financial transactions between domestic rersidents and the rest of the world over a period of time.  This account consists of loans, investments, other transfers of financial assets and the creation of liabilities.  It includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits.

The capital account can be divided into three categories: direct investment, portfolio investment and other capital flows.

a. Direct investment occurs when the investor acquires equity such as purchases of stocks, the acquisition of entire firms, or the establishment of new subsidiaries.

For example, many US firms are engaged in direct investment in foreign countries. 
Coca-Cola has built bottling facilities all over the world.

b. Portfolio investments represent sales and purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of management control.  A desire for return, safety and liquidity in investments is the same for international and domestic portfolio investors.    International portfolio investments have specifically boomed in recent years due to investors desire to diversify risk globally.

c. Capital flows represent the third category of capital account and represent claims with a maturity of less than one year.  Such claims include bank deposits, short-term securities, money market investments and so forth.

3. The official reserve account
Official reserves are government assets.  The official reserve account represents only purchases and sales by the central bank of the country (e.g, the Reserve Bank of India).  The change sin official reserves are necessary to account for the deficit or surplus in the balance of payments.  For example, if a country has a BOP deficit, the central bank will have to either run down its official reserve assets such as gold, foreign exchange and SDRs or borrow fresh from foreign central banks.   However, if a country has a BOP surplus, its central bank will either acquire additional reserve assets from foreigners or retire some of its foreign debts.


Balance of payments (BOP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. The BOP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.

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.

Historically there have been different approaches to the question of how or even whether to eliminate current account or trade imbalances. With record trade imbalances held up as one of the contributing factors to the financial crisis of 2007–2010, plans to address global imbalances have been high on the agenda of policy makers since 2009.

Composition of the balance of payments sheet
Basic analysis
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. It is called the current account as it covers transactions in the "here and now" - those that don't give rise to future claims.

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 term "capital account" is also used in the narrower sense that excludes central bank foreign exchange market operations: Sometimes the reserve account is classified as "below the line" and so not reported as part of the capital account.

Expressed with the broader meaning for the capital account, the BOP identity assumes that any current account surplus will be balanced by a capital account deficit of equal size - or alternatively a current account deficit will be balanced by a corresponding capital account surplus:

The balancing item, which may be positive or negative, is simply an amount that accounts for any statistical errors and assures that the current and capital accounts sum to zero. By the principles of double entry accounting, an entry in the current account gives rise to an entry in the capital account, and in aggregate the two accounts automatically balance. A balance isn't always reflected in reported figures for the current and capital accounts, which might, for example, report a surplus for both accounts, but when this happens it always means something has been missed—most commonly, the operations of the country's central bank—and what has been missed is recorded in the statistical discrepancy term (the balancing item).

An actual balance sheet will typically have numerous sub headings under the principal divisions. For example, entries under Current account might include:
Trade – buying and selling of goods and services 
Exports – a credit entry
Imports – a debit entry 
Trade balance – the sum of Exports and Imports
Factor income – repayments and dividends from loans and investments 
Factor earnings – a credit entry
Factor payments – a debit entry 
Factor income balance – the sum of earnings and payments.

Especially in older balance sheets, a common division was between visible and invisible entries. Visible trade recorded imports and exports of physical goods (entries for trade in physical goods excluding services is now often called the merchandise balance). Invisible trade would record international buying and selling of services, and sometimes would be grouped with transfer and factor income as invisible earnings.

The term "balance of payments surplus" (or deficit — a deficit is simply a negative surplus) refers to the sum of the surpluses in the current account and the narrowly defined capital account (excluding changes in central bank reserves). Denoting the balance of payments surplus as BOP surplus, the relevant identity is

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