Macroeconomic

Theory and Policy

Biswa Swarup Misra

Session-12

slide 0
Material covered
1. Equivalences of a Current Account Surplus
2. Characteristics of a Safe Haven Economy
3. Benefits of a Safe Haven Economy
4. Official reserve Account
5. Accretion and Depletion of Forex reserves
6. National income identity in an Open economy
7. Link between trade and capital flows
8. Saving, Investment, and their Relationship to the International Flows

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Table 1 Why the Current Account Balance and the Capital and
Financial Account Balance Sum to Zero: An Example
(Balance of Payments Data Refer to the United States)

2
Why the BoP Balances
• The Briton may use the $75 to buy a U.S. product say, a computer
game. This purchase is a $75 export for the United States. This U.S.
export together with the original import of the sweater into the
United States results in no net change in the U.S. current account
balance CA.

• A second possibility is that the Briton will use the $75 to buy a U.S.
asset say, a bond issued by a U.S. corporation. The purchase of this
bond is a financial inflow to the United States. This $75 increase in
the U.S. capital and financial account offsets the $75 reduction in the
U.S. current account caused by the original import of the sweater.

3
Why the BoP Balances
• Finally, the Briton may decide to go to his bank and trade
his dollars for British pounds. Alternatively, the bank
may sell the dollars to the Federal Reserve in exchange
for pounds. But in giving up $75 worth of British pounds,
the Federal Reserve reduces its holdings of official
reserve assets by $75, which counts as a financial inflow.
• As in the previous case, the capital and financial account
balance rises by $75, offsetting the decline in the
current account balance caused by the import of the
sweater

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 How the Pieces Fit Together
• Walmart decides to buy more toys from China
• Gives rise to a current account deficit in US
• Toy makers in China receive the money and must do something
with it.
• Option-1: They use the money to buy tractors from US and the
current account back in balance
• Option-2: They utilise the money to purchase stocks in US. This
puts the capital account in surplus by an equivalent amount for
US
• Option-3: They exchange dollars for Remnibis. This again
increases the capital account surplus of US.

5
 Net Foreign Assets and BOP Accounts
• Net Foreign Assets =foreign assets held by the country’s
residents including foreign stocks, bonds and real estate –
country’s foreign liabilities(domestic physical and financial
assets owned by foreigners.

• If a country has a CA surplus of US$10bn, the country must use

this this US$10bn to acquire foreign assets or reduce foreign
liabilities. In this sense we can say, the country has undertaken
net foreign lendings of US$10bn.

6
Summary

7
 The Official Reserve Account
• Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF

• The balance on current account and capital account together will result in the country’s
reserves of foreign exchange going up or down correspondingly

• A current account deficit may be combined with a higher capital account surplus and
therefore reflect as an addition to the country’s reserves of foreign exchange.

• Thus, we may write the BOP identity

CA + KFA +RA = 0 or CA + KFA = - RA

where CA = Balance on Current Account

KFA = Balance on Capital and Financial Account
RA = Balance on the Reserves Account

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 India’s Balance of Payments Data
2005-06
Credits Debits
Current Account
1 Exports $104,780

2 Imports ($156,334)

3 Invisibles $91,481 ($50,539)

Balance on Current Account ($10,612)
Financial Account
4 Direct Investment $8,520 ($2,787)
5 Portfolio Investment $68,115 ($55,626)
6 Other Investments $62,665 ($56,194)
Balance on KFA $24,693
7 Statistical Discrepancies $971

Official Reserve Account ($15,052)

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 India’s Balance of Payments Data

Credits Debits
Current Account
1 Exports $104,780

2 Imports ($156,334)

3 Invisibles $91,481 ($50,539)

Balance on Current Account ($10,612) In 2005-06,
Capital Account India imported
4 Direct Investment $8,520 ($2,787) more than it
5 Portfolio Investment $68,115 ($55,626) exported, thus
6 Other Investments $62,665 ($56,194) running a
Balance on KFA $24,693 current account
7 Statistical Discrepancies $971
deficit of
Official Reserve Account
$10,612 million.
($15,052)

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 India’s Balance of Payments Data

Credits Debits During the same

Current Account year, India
1 Exports $104,780 attracted net
2 Imports ($156,334) investment of
$24,693 million -
3 Invisibles $91,481 ($50,539)
Balance on Current Account ($10,612)
clearly the rest
Capital and Financial Account of the world
4 Direct Investment $8,520 ($2,787) found India to
5 Portfolio Investment $68,115 ($55,626) be a good place
6 Other Investments $62,665 ($56,194) to invest.
Balance on KFA $24,693
7 Statistical Discrepancies $971

Official Reserve Account ($15,052)

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 India’s Balance of Payments Data

Credits Debits
Current Account
1 Exports $104,780 Under a pure
2 Imports ($156,334)
flexible
exchange rate
3 Invisibles $91,481 ($50,539)
Balance on Current Account
regime, these
($10,612)
Capital and Financial Account numbers would
4 Direct Investment $8,520 ($2,787) balance each
5 Portfolio Investment $68,115 ($55,626) other out.
6 Other Investments $62,665 ($56,194)
Balance on KFA $24,693
7 Statistical Discrepancies $971

Official Reserve Account ($15,052)

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 India’s Balance of Payments Data
Credits Debits
Current Account
1 Exports $104,780
In the real
2 Imports ($156,334)
world, there
3 Invisibles $91,481 ($50,539)
Balance on Current Account ($10,612) is a
Capital and Financial Account statistical
4 Direct Investment $8,520 ($2,787)
discrepancy
5 Portfolio Investment $68,115 ($55,626)
6 Other Investments $62,665 ($56,194)
Balance on KFA $24,693
7 Statistical Discrepancies $971

Official Reserve Account ($15,052)

The Official reserve account represents the movement in the forex reserve of the country.
An accretion in the forex is presented as a debit item in the Capital and Financial account of BoP.
The negative entry signifies that the central bank is purchasing forex from the
market by selling rupees.
Check that the balance on the current account with statistical discrepancies match the balance on the
capital and financial account and the official reserve account.

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 Statement I: Standard Presentation of India's Balance of Payments as per BPM6
(US$ Million)
April-March 2020-21 P April-March 2022-23 P
Credit Debit Net Credit Debit Net
1 Current Account 603545 579535 24011 921,865 988,848 -66,984
(1.A+1.B+1.C)
1.A Goods and Services 502390 515977 -13587 781,402 903,410 -122,008
(1.A.a+1.A.b)
1.A.a Goods 296300 398452 -102152 456,073 721,364 -265,291
1.A.b Services 206090 117524 88565 325,329 182,046 143,283
1.B Primary Income 20835 56796 -35960 27,845 73,769 -45,923
1.C Secondary Income 80321 6762 73558 112,618 11,669 100,948
1.C.1.1.1 Workers’ remittances 54428 4177 50252 70,963 7,736 63,227
2 Capital Account 490 1565 -1075 677 795 -118
3 Financial Account 598542 621131 -22589 702,268 634,143 68,126
3.1 Direct Investment 86286 42330 43955 75,232 47,246 27,986
3.2 Portfolio Investment 313715 277579 36137 309,857 315,009 -5,152
3.4 Other investment 186854 197448 -10594 264,909 223,391 41,519
3.4.2.2 NRI Deposits 46465 39101 7364 64,274 55,285 8,989
3.4.3 Loans (External 75483 92735 -17253 97,286 82,979 14,308
Assistance, ECBs and
Banking Capital)
3.4.3.4 External Commercial 28525 28285 240 19,410 23,549 -4,139
Borrowings
3.5 Reserve assets 0 87286 -87286 30,379 21,244 9,135
4 Net errors and omissions 951 1298 -347 900 1,924 -1,024 14
 Statement I: Standard Presentation of India's Balance of Payments as per BPM6
(US$ million)
April-March 2022-23 April-March 2023-24 P
Credit Debit Net Credit Debit Net
1 Current Account (1.A+1.B+1.C) 9,21,865 9,88,848 -66,984 9,42,891 9,66,100 -23,209
1.A Goods and Services (1.A.a+1.A.b) 7,81,402 9,03,410 -1,22,008 7,82,548 8,61,847 -79,299
1.A.a Goods (1.A.a.1 to 1.A.a.3) 4,56,073 7,21,364 -2,65,291 4,41,484 6,83,549 -2,42,065
1.A.b Services (1.A.b.1 to 1.A.b.13) 3,25,329 1,82,046 1,43,283 3,41,064 1,78,298 1,62,766
1.B Primary Income (1.B.1to1.B.3) 27,845 73,769 -45,923 41,455 91,227 -49,772
1.B.1 Compensation of employees 6,732 3,421 3,311 7,529 3,700 3,829
1.C Secondary Income (1.C.1+1.C.2) 1,12,618 11,669 1,00,948 1,18,888 13,026 1,05,863
1.C.1.1.1 Workers’ remittances 70,963 7,736 63,227 72,523 8,474 64,049

2 Capital Account (2.1+2.2) 677 795 -118 673 764 -91

3 Financial Account (3.1 to 3.5) 7,02,268 6,34,143 68,126 8,49,617 8,27,030 22,587
3.1 Direct Investment (3.1A+3.1B) 75,232 47,246 27,986 74,565 64,774 9,790
3.2 Portfolio Investment 3,09,857 3,15,009 -5,152 4,66,115 4,22,034 44,081
3.4 Other investment 2,64,909 2,23,391 41,519 2,86,547 2,46,238 40,309
3.4.2.2 NRI Deposits 64,274 55,285 8,989 88,576 73,875 14,702
3.4.3 Loans (External Assistance, 97,286 82,979 14,308 1,17,414 85,232 32,181
ECBs and Banking Capital)
3.4.3.4 External Commercial Borrowings 19,410 23,549 -4,139 33,439 29,678 3,761
3.5 Reserve assets 30,379 21,244 9,135 0 63,702 -63,702
4 Net errors and omissions 900 1,924 -1,024 1,503 791 712
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 ECB
• ECB or External Commercial Borrowings refer to commercial
loans in the form of bank loans, buyers’ credit, suppliers’ Credit
availed of from non-resident lenders with a minimum average
maturity of 3 years (i.e., 3 years and above).
• ECB can be raised only for specific purposes, such as
investment [such as the import of capital goods, new projects,
modernisation/expansion of existing production units] in the
real sector - the industrial sector including small and medium
enterprises (SME), the infrastructure sector and specific service
sectors, namely hotels, hospitals and software in India.

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Short‐Term Loans
• Trade credits refer to credits extended for imports directly by
the overseas supplier, banks and financial institutions for a maturity
of less than three years.
• Depending on the source of finance, such trade credits are
classified as Suppliers' Credit or Buyers' Credit.
• Suppliers' credit relates to credit for imports into India extended
by the overseas supplier
• Buyers' credit refers to loans for repayment of imports into
India arranged by the importer from a bank or financial institution
outside India for a maturity of less than three years.

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 BoP Indicators
Capital
Trade Invisibles Current Account
Account Import Cover
Year of Reserves
Current Current
Current Foreign Foreign (In months)
Exports/ Imports/ Receipts/ Payments/ Receipts/ Account
Net/ GDP Receipts/ Investment/ Investme
GDP GDP GDP GDP Current Balance
GDP Exports nt/ GDP
Payments /GDP

2021-22 13.5 19.5 11.6 6.9 4.7 25.1 95.4 -1.2 5.1 0.7 11.8
2020-21 11.1 14.9 11.5 6.8 4.7 22.6 104.1 0.9 27.0 3.0 17.4
2019-20 11.3 16.9 11.4 6.7 4.7 22.7 96.3 -0.9 13.9 1.6 12.0
2018-19 12.5 19.1 11.3 6.8 4.6 23.8 91.8 -2.1 8.9 1.1 9.6
2017-18 11.7 17.7 10.7 6.5 4.2 22.3 92.4 -1.8 17.0 2.0 10.9
2016-17 12.2 17.1 10.5 6.3 4.3 22.8 97.3 -0.6 15.4 1.9 11.3
2015-16 12.7 18.8 11.2 6.0 5.1 23.8 95.8 -1.1 12.0 1.5 10.9
2014-15 15.5 22.6 11.9 6.1 5.8 27.4 95.4 -1.3 23.2 3.6 8.9
2013-14 17.2 25.1 12.6 6.4 6.2 29.7 94.5 -1.7 8.3 1.4 7.8
2012-13 16.8 27.5 12.3 6.4 5.9 29.0 85.8 -4.8 15.2 2.6 7.0
2011-12 17.0 27.4 12.0 5.9 6.1 29.0 87.1 -4.3 12.7 2.2 7.1
2010-11 15.3 22.9 11.4 6.6 4.7 26.7 90.3 -2.9 16.4 2.5 9.5
2009-10 13.6 22.4 12.2 6.2 6.0 25.8 90.1 -2.8 27.6 3.8 11.1
2008-09 15.8 25.7 14.0 6.4 7.6 29.8 92.7 -2.3 4.4 0.7 9.8
2007-08 13.7 21.2 12.2 6.0 6.2 25.9 95.2 -1.3 26.1 3.6 14.4
2006-07 13.7 20.3 12.2 6.6 5.6 25.9 96.2 -1.0 11.4 1.6 12.5
2005-06 12.8 19.1 10.9 5.8 5.1 23.7 95.2 -1.2 14.8 1.9 11.6

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 Understanding the Arithmetic of Open
Economies
Test your understanding of the relationship between the current account
and the financial account by evaluating the following assertion by a
political commentator:
“The industrial countries are committing economic suicide. Every year,
they invest more and more in developing countries. Every year, more
U.S., Japanese, and European manufacturing firms move their factories
to developing countries. With extensive new factories and low wages,
developing countries now export far more to the industrial countries
than they import.”
The national income identity
in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
spending
net exports
output

slide 20
 Trade surpluses and deficits

NX = EX – IM = Y – (C + I + G )

▪ trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX
▪ trade deficit:
spending > output and imports > exports
Size of the trade deficit = –NX

slide 21
 International capital flows
▪ Net capital outflow
= S –I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets

▪ When S > I, country is a net lender

▪ When S < I, country is a net borrower

slide 22
 The link between trade & cap. flows

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
trade balance = net capital outflow
Thus,
a country with a trade deficit (NX < 0)
is a net borrower (S < I ).

slide 23
The Equality of Net Exports and Net Capital Outflow

▪ For an economy as a whole, NX and NCO must balance

each other so that:
NCO = NX
▪ This holds true because every transaction that affects
one side must also affect the other side by the same
amount.

slide 24
 Saving, Investment, and Their Relationship to the
International Flows

▪ Net exports is a component of GDP:

Y = C + I + G + NX
▪ National saving is the income of the nation that is left
after paying for current consumption and government
purchases:
Y – C – G = I + NX

slide 25
 Saving, Investment, and Their Relationship to the
International Flows

▪ National saving (S) equals Y – C – G so:

S = I + NX
▪ or
Saving =
Domestic + Net Capital
Investment Outflow
S = I + NCO

slide 26
Saving, Investment, and their Relationship to the
International Flows
▪ Thus, we find that for developed countries
S=I+ NCO
▪ In other words, I = S-NCO
=S+NCI
▪ NCI stands for Net Capital Inflow which is negative of
NCO.
▪ I=S+NCI is Typical of Developing countries
▪ Suppose India has savings rate as a proportion of GDP is
around 26% and Investment of around 30%. The 4% is
the net capital flow to India
slide 27
NX and NCO for India
(Per centage of GDP)
Year Gross Gross Capital NX=Current Account
NCO=S-I
savings (S) Formation (I) Balance /GDP
2020-21 28.2 27.3 0.9 0.9
2019-20 29.8 30.7 -0.9 -0.9
2018-19 31.7 33.8 -2.1 -2.1
2017-18 32 33.8 -1.8 -1.8
2016-17 31.3 32 -0.7 -0.6
2015-16 31.1 32.1 -1 -1.1
2014-15 32.2 33.5 -1.3 -1.3
2013-14 32.1 33.8 -1.7 -1.7
2012-13 33.9 38.7 -4.8 -4.8
2011-12 34.6 39 -4.4 -4.3
2010-11 36.9 39.8 -2.9 -2.9
2009-10 36 38.9 -2.9 -2.8
2008-09 36 38.4 -2.4 -2.3
2007-08 37.8 39.1 -1.3 -1.3
2006-07 34.9 36 -1.1 -1
2005-06 35.2 36.4 -1.2 -1.2
In the above table, you can see the equality of NX and NCO for India in the last 15
years.
Rounding off errors leads to slight difference in matching NX and NCO for some
years slide 28
The International Sector and National
Saving and Investment
Net Exports Equal Net Foreign Investment

Current Account Balance + Financial Account Balance = 0

or:

Current Account Balance = -Financial Account Balance

or:

Net Exports = Net Foreign Investment

slide 29
Which of the following equalities is correct?
a. The current account balance equals the
financial account balance.
b. Net exports = Net foreign investment
c. The financial account balance equals net
exports.
d. Net foreign investment equals the current
account balance.

Answer-b

slide 30
International Flows of Goods and Capital:
Summary

slide 31
What Next?

1. NX and NCO equality

2. National Savings Identity (NSI) and the Twin Deficits
3. How the Fiscal Deficit and Current Account Deficits are linked
4. Sustainable Bond Financing
5. Caselet on link between fiscal deficit and Current Acount
Deficit
6. Exchange Rate determination

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