INTERNATIONAL FINANCE
MBA(FT)
TOPIC 03
International Flow of Funds-Balance of
Payments
Why Balance of Payments?
• THE EXCHANGE RATE OF A CURRENCY IS ITS VALUE IN TERMS OF
ANOTHER CURRENCY.
• THE DETERMINATION OF A COUNTRY’S EXCHANGE RATE DEPENDS ON
THE EXCHANGE RATE SYSTEM FOLLOWED BY THE COUNTRY.
• LIKE ALL OTHER COMMODITIES, THE PRICE OF A CURRENCY ALSO
DEPENDS ON ITS SUPPLY AND DEMAND FACTOR.
• WHEN THE EXCHANGE RATES ARE TRULY FLEXIBLE, THE DEMAND
AND SUPPLY ARISE ONLY FROM THE MARKET FORCES.
Why Balance of Payments?
• IN THE CASE OF FIXED EXCHANGE RATES, IN ADDITION TO SUPPLY
AND DEMAND ARISING FROM THE MARKET, THE CENTRAL
BANK/REGULATORY AUTHORITY ENSURES AN OFFICIAL DEMAND OR
SUPPLY, WHICH KEEPS THE OVERALL FORCES BALANCED IN ORDER TO
MAINTAIN THE EXCHANGE RATE AT AN EQUILIBRIUM LEVEL.
• TO FORECAST THE LEVEL OF EXCHANGE RATE, WE NEED TO KNOW
THE FACTORS THAT AFFECT THE DEMAND FOR AND SUPPLY OF A
CURRENCY. ALL SUCH FACTORS ARE REFLECTED IN THE BALANCE OF
PAYMENTS (BoP).
Balance of Payments
• THE BOP ACCOUNT IS A SUMMARY OF THE FLOW OF ECONOMIC
TRANSACTION BETWEEN THE HOME COUNTRY AND THE REST OF
WORLD DURING A GIVEN TIME PERIOD.
• IT IS A FUND FLOW STATEMENT.
• IT RECORDS ONLY THE CHANGES IN THE LEVELS OF INTERNATIONAL
ASSETS AND LIABILITIES.
• IT IS PRESENTED IN FORM OF DOUBLE ENTRY BOOK KEEPING SYSTEM.
Balance of Payments
BALANCE OF PAYMENTS IS DESCRIBED BY THE IMF IN ITS BALANCE OF
PAYMENTS MANUAL AS A STATISTICAL STATEMENT FOR A GIVEN
PERIOD SHOWING-
• Transaction in goods, services and income between an economy and
the rest of the world;
• Changes in ownership and other changes in the economy’s monetary
gold, Special Drawing Rights (SDRs), and claims and liabilities to the
rest of the world
Importance of Balance of Payments
• IT PROVIDES INFORMATION ABOUT THE DEMAND AND SUPPLY OF
COUNTRY’S CURRENCY
E.g. Imports and Exports, FDI, FII
• BOP DATA SHOWS A COUNTRY’S POTENTIAL AS A BUSINESS PARTNER.
E.g. A country with Trade deficit is not a potential importer.
• BOP DATA ARE IMPORTANT TO EVALUATE THE PERFORMANCE OF THE
COUNTRY IN INTERNATIONAL ECONOMIC COMPETITION.
COMPONENTS OF BALANCE OF PAYMENTS
1. Current Account
2. Capital Account
3. Official Reserve Account
COMPONENTS OF BALANCE OF PAYMENTS
Current Account
• IT RECORDS ALL THE INCOME-RELATED FLOWS
• THESE FLOWS COULD ARISE ON ACCOUNT OF TRADE IN GOODS AND
SERVICES AND TRANSFER PAYMENTS AMONG COUNTRIES.
• TRADE IN GOODS CONSISTS OF EXPORT AND IMPORT
• IT IS ALSO REFERRED TO AS MERCHANDISE TRADE.
• COUNTRY’S EXPORTS ARE SOURCE OF RESERVE, WHILE IMPORTS ARE USE
OF RESERVES.
• THE NET INFLOW ON THE ACCOUNT OF MERCHANDISE TRADE RESULTS IN
TRADE SURPLUS, AND A NET OUTFLOW RESULTS IN A TRADE DEFICIT.
• THE NET INFLOW(OUTFLOW) IN ALL ENTRIES OF CURRENT ACCOUNT
RESULTS IN CURRENT ACCOUNT SURPLUS(DEFICIT)
COMPONENTS OF BALANCE OF PAYMENTS
Structure of Current Account
I. MERCHANDISE
a) EXPORTS
b) IMPORTS
II. INVISIBLES (a+b+c)
a) SERVICES
• Travel
• Transportation
• Insurance
• Miscellaneous
b) TRANSFERS
• Official
• Private
c) INVESTMENT INCOME
• It is in form of dividend, interest etc.
COMPONENTS OF BALANCE OF PAYMENTS
Current Account
EXPORT OF GOODS AND SERVICES DEPENDS ON THE FOLLOWING
FACTORS
• The prevailing exchange rate of the domestic currency
• Inflation rate
• World prices of the commodity
• Incomes of foreigners
• Trade barriers
COMPONENTS OF BALANCE OF PAYMENTS
Current Account
IMPORT OF GOODS AND SERVICES DEPENDS ON THE FOLLOWING
FACTORS
• Value of the domestic currency
• Level of domestic income
• International prices
• Inflation rate
• Trade barriers
COMPONENTS OF BALANCE OF PAYMENTS
Current Account
TRANSFER PAYMENTS DEPENDS ON THE FOLLOWING FACTORS
• No of migrants to or from the country
• The desire of a country to generate goodwill by granting aids to other
countries
COMPONENTS OF BALANCE OF PAYMENTS
Current Account-THE J-CURVE EFFECT
IT EXPLAINS THE RELATIONSHIP BETWEEN NET CHANGE IN TRADE
BALANCE AND THE TIME AFTER CURRENCY DEVALUATION OR
DEPRECIATION.
COMPONENTS OF BALANCE OF PAYMENTS
Current Account-THE J-CURVE EFFECT
COMPONENTS OF BALANCE OF PAYMENTS
Capital Account
CAPITAL ACCOUNT BALANCE IS THE DIFFERENCE BETWEEN SALES OF
FOREIGN ASSET AND PURCHASE OF FOREIGN ASSET
SALES OF ASSET IS CREDIT
PURCHASE OF ASSET IS DEBIT
COMPONENTS OF BALANCE OF PAYMENTS
Capital Account
ASSETS INCLUDE ANY FORM IN WHICH WEALTH MAY BE HELD
• MONEY HELD AS CASH IN FORM OF BANK DEPOSIT
• SHARES
• DEBENTURES
• OTHER DEBT INSTRUMENTS
• REAL ESTATE, LAND
• FACTORIES
• ANTIQUES AND OTHER REAL AS WELL AS FINANCIAL ASSETS
THE EXCESS OF CREDIT OVER DEBITS IN THIS ACCOUNT IS REFERRED TO AS
THE CAPITAL ACCOUNT SURPLUS
COMPONENTS OF BALANCE OF PAYMENTS
Structure of Capital Account
DIRECT INVESTMENT
PORTFOLIO INVESTMENT
OTHER INVESTMENT
COMPONENTS OF BALANCE OF PAYMENTS
Structure of Capital Account
DIRECT INVESTMENT
• COUNTRY A INVESTS (PURCHASES ASSET) IN COUNTRY B. THIS IS A Cr.
ENTRY FOR COUNTRY A.
• FDI TAKES PLACE BECAUSE OF MARKET IMPERFECTIONS (E.g. return,
cost of capital differences across nations)
• FDI IS SENSITIVE TO EXCHANGE RATE CHANGES
COMPONENTS OF BALANCE OF PAYMENTS
Structure of Capital Account
PORTFOLIO INVESTMENT
• REPRESENTS THE SALES AND PURCHASE OF FOREIGN FINANCIAL
ASSETS (STOCKS, BONDS)
• PORTFOLIO INVESTMENT HAS BOOMED IN RECENT PAST BECAUSE OF
RELAXATION OF CAPITAL CONTROL AND REGULATIONS AND DESIRE
TO DIVERSIFY RISK GLOBALLY
COMPONENTS OF BALANCE OF PAYMENTS
Structure of Capital Account
OTHER INVESTMENT
• IT INCLUDES TRANSACTIONS IN FOREIGN EXCHANGE AND BANK
DEPOSITS.
• THESE TRANSACTIONS ARE VERY SENSITIVE TO CHANGES IN INTEREST
RATES AND THE ANTICIPATED CHANGES IN THE EXCHANGE RATE.
COMPONENTS OF BALANCE OF PAYMENTS
Official Reserve Account
• IT INCLUDES GOLD, RESERVE OF CONVERTIBLE FOREIGN CURRENCIES, SDRs
AND BALANCE WITH IMF.
• THESE ARE MEANS OF INTERNATIONAL PAYMENTS
• FOREIGN CURRENCIES MAY BE HELD IN THE FORM OF BALANCES WITH
FOREIGN CENTRAL BANKS, OR AS FOREIGN GOVERNMENT SECURITIES.
• IF THERE IS A NET SURPLUS IN THE OVERALL BOP, THERE WILL BE AN
INCREASE IN THE OFFICIAL RESERVES, AS THE INFLOWS WILL EXCEED THE
OUTFLOWS.
• THE OFFICIAL RESERVE ACCOUNT INCLUDES TRANSACTIONS UNDERTAKEN
BY THE AUTHORITIES (Government, RBI) TO FINANCE THE OVERALL
BALANCE AND INTERVENE IN FOREIGN EXCHANGE MARKETS.
• WHEN GOVERNMENT WANTS TO SUPPORT RUPEE, THEY BUY RUPEE, AND
SELL FOREIGN EXCHANGE, GOLD, OR SDRs
Accounting Principles of Balance of Payments
• ALL THE TRANSACTIONS WHICH LEAD TO PAYMENT FROM REST OF
THE WORLD TO THE COUNTRY SHOULD BE RECORDED AS CREDIT
ENTRY (+) AND THE PAYMENT AS A DEBIT ENTRY (-)
• INCREASE IN FOREIGN ASSETS OR DECREASE IN FOREIGN LIABILITY IS
A DEBIT ENTRY
• DECREASE IN FOREIGN ASSETS OR INCREASE IN FOREIGN LIABILITY IS
A CREDIT ENTRY.
Examples on BoP Mechanism
Ex-1: COUNTRY A EXPORTS GOODS WORTH 500 TO COUNTRY B. THE
GOODS HAVE BEEN INVOICED IN AND WILL BE PAID FOR IN COUNTRY
B’S CURRENCY. PAYMENT WILL BE EFFECTED BY CREDITING THE BANK
ACCOUNT, WHICH COUNTRY A EXPORTER HOLDS WITH A BANK IN
COUNTRY B
[Link] Account
Credit Debit
Merchandise Exports 500
2. Capital Account
Increase in foreign assets 500
Examples on BoP Mechanism
EX-2(i) An Indian resident exports goods to an American resident and his
payment is settled by a bill of exchange denominated in US dollars, having a
maturity of 90 days.
• Holding (↑) of Foreign Assets Dr.
• (Capital Account)
• Merchandise Export Cr.
• (Current Account)
Examples on BoP Mechanism
• EX-2(ii) The bill of exchange mentioned in Ex-2(i) is presented for
payment by the Indian exporter on maturity. He gets paid in US dollars
which he retains in an account in a US bank.
• Holding (↑) of Foreign Assets Dr.
• (Deposit)
• Holding (↓) of Foreign Assets Cr.
• (Bill of Exchange)
Examples on BoP Mechanism
• EX-2(iii) The exporter then converts the dollars into rupees by selling
the dollars to his local clearing bank.
• Holding (↑) of Foreign Assets Dr.
• (Indian bank)
• Holding (↓) of Foreign Assets Cr.
• (Exporter)
Examples on BoP Mechanism
• EX-2(iv) The clearing bank then sells the dollars to the central bank for
the domestic currency.
• Increase in official reserve Dr.
• (official reserve account)
• Decrease in Foreign Assets Cr.
• (Capital Account)
Examples on BoP Mechanism
• EX-3(i) An Indian resident imports goods from Germany and signs a
usance bill of exchange denominated in Herman Marks for the amount due
• Merchandise imports Dr.
• (Current account)
• Increase in foreign liability Cr.
• (Capital account)
Examples on BoP Mechanism
• EX-3(ii) On maturity of the bill, the Indian importer would buy german
marks from a bank and settle the payment
• Decrease in foreign liability Dr.
• (Capital account)
• Decrease in foreign assets Cr.
• (Capital account)
Examples on BoP Mechanism
• EX-3(iii) The bank purchases German marks from the central bank to
offset its earlier deal with the importer
• Increase in foreign assets Dr.
• Decrease in foreign reserves Cr.
Examples on BoP Mechanism
• Example:- Consider following transactions during a financial year
• Import of computers worth Rs. 50000 by an Indian.
• India imports oil from Iran in exchange of supply of wheat. The value is
placed at Rs. 60000.
• Tata steel borrows USD 1000 from a bank abroad. The exchange rate is INR
70/USD.
• India provides cloths of INR 35000 to another nation devastated by floods.
• An NRI software engineer sends USD 1000 to his parents in India. The
exchange rate is INR 70/USD.
Examples on BoP Mechanism
• Import of computers worth Rs. 50000 by an Indian.
Credit Debit
Merchandise Imports 50000
Short-Term Claims 50000
Examples on BoP Mechanism
• India imports oil from Iran in exchange of supply of wheat. The value is placed at
Rs. 60000.
Credit Debit
Merchandise Imports 60000
Merchandise Export 60000
Examples on BoP Mechanism
• Tata steel borrows USD 1000 from a bank abroad. The exchange rate is INR
70/USD.
Credit Debit
Foreign Exchange Reserve 70000
Commercial Borrowings 70000
Examples on BoP Mechanism
• India provides cloths of INR 35000 to another nation devastated by floods.
Credit Debit
Unilateral Transfers-Govt. 35000
Merchandise exports 35000
Examples on BoP Mechanism
• An NRI software engineer sends USD 1000 to his parents in India. The exchange
rate is INR 70/USD.
Credit Debit
Foreign Exchange Reserve 70000
Unilateral Transfers-Private 70000
Examples on BoP Mechanism
Description Credit Debit Net
I. Current Account
Merchandise 95000* 110000** -15000
*[Wheat and cloths] [60000+35000] [60000+50000]
**[Computer and Oil]
Transfers-Government 35000 -35000
Transfers-Private 70000 70000
Total-Current Account 165000 145000 20000
II. Capital Account
Commercial Borrowings 70000 70000
Short-term claims 50000 50000
Total Capital Account 120000 120000
Overall Balance 285000 145000 140000
Changes in foreign 140000 -140000
exchange reserve
[ECB + Private Transfer]
Examples on BoP Mechanism
1. What entries in the BOP of India would be passed for the following
transactions?
2. An American tourist arrives India and encashes US$2,000 at the exchange rate
of Rs. 72.00 at the airport.
3. An Indian remits a fee of £1,000 at Rs.103/£ for his son studying in Britain.
4. An Indian firm provides software in exchange of receiving hardware from
Germany for €1,000 when the exchange rate is Rs.98/€.
5. An American investor redeems ADRs worth $200 when the exchange rate is
Rs.71/$
6. A firm exports rice worth $3,000 and adjusts $2,000 towards the payment of
the representative of the importer and receives the remaining US$1,000 in the
bank account. The exchange rate is <73/$.
Examples on BoP Mechanism
1. What entries in the BOP of India would be passed for the following
transactions?
2. An American tourist arrives India and encashes US$2,000 at the exchange rate
of Rs. 72.00 at the airport.
3. An Indian remits a fee of £1,000 at Rs.103/£ for his son studying in Britain.
4. An Indian firm provides software in exchange of receiving hardware from
Germany for €1,000 when the exchange rate is Rs.98/€.
5. An American investor redeems ADRs worth $200 when the exchange rate is
Rs.71/$
6. A firm exports rice worth $3,000 and adjusts $2,000 towards the payment of
the representative of the importer and receives the remaining US$1,000 in the
bank account. The exchange rate is <73/$.
BoP and Domestic Economy
For an Open Economy
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀 …..(1)
National income consists of Disposable income and taxes, consumption equals
disposable income less savings. Hence eq-1
𝐷 + 𝑇 = 𝐷 − 𝑆 + 𝐼 + 𝐺 + 𝑋 − 𝑀 ….(2)
Rearranging Eq.-2;
𝑋 − 𝑀 = 𝑇 − 𝐺 + 𝑆 − 𝐼 …(3)
Where;
(X - M) = Current Account Balance
(T - G) = Budget Surplus
(S - I) = Saving Surplus
Cost of Undervaluation:China-USA
A rapid rise in current account surplus and associated build-up of reserves pose mounting
challenge for the Chinese central bank to keep its currency undervalued. The basic premise of
an undervalued currency is that the central bank has to intervene in the foreign exchange
market to postpone current consumption and delay inflation. The increased money supply on
account of foreign exchange receipts has to be sterilized by mopping up the surplus local
money. If it does not, then the excess liquidity causes inflation and appreciation of local
currency. In 2010 following the collapse of interest rates in the USA, the interest rates in China
exceeded those of the USA. Therefore, the cost of issuing sterilization bills increased. The
central bank had to rely more on upward adjustment of statutory reserve requirement of local
banks, thereby passing part of the cost to commercial banks. However, from long-term
perspective, interest rates in China had to be kept 10,"" to avert the capital inflows,
necessitating further sterilization. Exchange rates are not decided by pure economic forces.
Faced with extreme competition with Japan and heft/ current account deficit in 1985, the USA
deliberately devalued dollar under Plaza Accord. Many analysts also believed that expensive
Japanese yen had been largely responsible for halting its unprecedented economic progress
since the 19503. The case of Japan provides impetus to the policy of continuing to keep
currency devalued. Though devalued currency of China may be partly responsible for
unemployment in the USA it refrained from imposing penalties of any form because under Sino-
US mutual economic dependence, China remains the largest holder of US treasuries at USS800
billion. The dollar that goes from the USA to China on current account transaction returns back
to the USA in the form of capital account inflow.
Topics for Group Assignment
1. Analysis of BoP trends of selected 4 countries
2. Asian Currency Crisis
3. Brexit
4. Country Analysis of four Countries in America
5. Country Analysis of four Countries in Asia
6. Country Analysis of four Countries in Europe
7. Empirical evidences on International Parity relationship-Literature review
8. European Debt Crisis
9. Foreign Exchange Risk Hedging Practices of Selected 4 MNCs (2 groups)
[Link] of World Stock Markets-Literature review and analysis
[Link] Monetary System
[Link] Peso Crisis
[Link] between trade balance and forex rates: Literature review and analysis
[Link] Currency and Debt Crisis
