Question No. 5 - MMPC 03 - Business Environment - MBA and MBA (Banking & Finance)

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                            MBA and MBA (Banking & Finance)

MMPC 03 - Business Environment

MMPC-003/TMA/JULY/2022

Question No. 5. What are the main components of Balance of Payments (BoP)? Discuss the factors affecting the BoP.

The Balance of Payments (BoP) for a country can be defined as a systematic record of all the transactions between the economic units of one country (such as households, firms and the government) and the rest of the world in any given period of time. This includes all the transaction records made among the individuals, corporates and the government and helps in keeping the flow of funds in track, to develop the economy as a whole.

There are two main components of Balance of Payments (BoP): 

- Current Account 

- Capital Account 

1. Current Account 

The current account in the BoP, comprises of the transactions in goods and services, alongside transfers during the current time period. 

The net exports are also termed as the trade balance, which is the net sum of a country’s exports and imports in goods as well as in services. Trade in services is often said to be invisible as they cannot be seen to cross national borders. For instance, when a foreign country pays for the maintenance of its factory in the domestic home (or domestic) country or for the services by a home resident who is working in that foreign country, then the home country is said to be exporting a service. Tourism, is one major service export. The trade balance reflects a surplus (positive) if the value of exports of a country exceeds its imports while it is said to reflect a deficit (negative) if the value of imports of a country is higher than its exports. Transfers to and from abroad may be in the form of gifts or remittances that residents of one country might send (receive) to (from) another country. If the net transfers from abroad is positive, it means that transfers from residents in abroad are greater than that sent by domestic residents to abroad. Similarly, the net transfers from abroad is negative, if transfers from foreign countries are lesser than the transfers to abroad. Net foreign aid received by a country during a particular period is also a part of transfers. If the right-hand side of the equation (i) is positive (negative), then the current account is in surplus (deficit). It must be noted that large transfers from abroad may put the current account in surplus, even if the net exports is negative. However, to keep things simple, the term “net transfers” will be ignored in the subsequent analysis and hence, the current account will comprise of net exports or trade balance only. 

2. Capital Account 

The capital account records all transactions in assets. An asset may include any one of the type in which wealth can be held, for instance, stocks, bonds, government debt, etc. Purchase of an asset records a deduction in the capital account. If an Indian is purchasing a US Car company, then it is recorded as debit in the capital account of India (as the Indian has to pay in dollars which means that the foreign exchange is going out of India). The sale of assets, for instance, the sale of share of an Indian company to a US customer is recorded as a surplus in India’s capital account (as sale of assets to foreign country will bring foreign exchange into the country). Taking the two accounts together, the BoP can be summed up as:

Balance of Payments = current account + capital account…… (ii)

BoP is in surplus (deficit) if both the current and the capital account (combined) has a surplus (deficit). Thus, a deficit in current (capital) account doesn’t alone lead to a BoP deficit. It has to be outweighed by a large surplus in the capital (current) account. Thus, it is very important to keep the basic rule of BoP accounting in mind. 

FACTORS AFFECTING THE BALANCE OF PAYMENTS (BoP)

The factors which affect the Balance of Payments (BoP) are divided into two groups: 

A. The factors affecting the current account 

B. The factors affecting the capital account 

A. The factors affecting the Current Account 

The current account may be affected by the following factors:

1. Rate of Inflation in the Resident (domestic) Country: 

A higher rate of inflation in the domestic economy, compared to its trading partners, lead to: 

• cheaper imports which lead to increase in purchase of foreign goods. Imports therefore, tend to rise with rise in the inflation rate; and 

• rise in cost of the exports in the foreign market, as a result of which the foreign nationals will less likely be purchasing the domestic country’s goods. Exports, therefore tend to decline. 

Thus, rise in imports and fall in exports will lead to a current account deficit. 

2. National Income: According to most of the empirical studies, an increase in national income of a country, in comparison with its trading partners, may lead to: 

• higher tendency among domestic residents to purchase more of foreign products which will generate a significant rise in imports and thus, more outflow of foreign reserves from the country leading to current account deficit; and 

• in some exceptional cases, a rise in national income may also lead to improvement in the current account as it may be associated with increase in production capacity in the economy and surplus generation of exports. 

3. Import Restrictions by Government: Imposition of taxes (such as tariffs) by the government on the goods imported, leads to a rise in its prices in the domestic economy. As a result, domestic residents will reduce their purchase of foreign products, thereby improving the current account. Sometimes, the government also imposes quota restrictions on its imports which again, lead to decline in the imports and generates a current account surplus.

 4. Exchange Rate: The Exchange rates measure the prices of the domestic currencies in terms of the foreign currencies. The Current account is a function of Real Exchange Rate (RER). A higher RER is associated with lowering of exports and increase in imports whereas a lower RER is associated with higher number of exports and decline in imports. Thus, it can be interpreted that lowering of RER (which might happen through devaluation of currency) might lead to improvement of current account.

B. The factors affecting the Capital Account 

Capital movement across borders are affected by the following factors: 

1. Imposition of tax by the government on the income accumulated by the domestic investors, who have invested in the foreign markets. This will lead to lower outflow of capital. 

2. Economic liberalization might have an impact on the capital account. 

3. An expected change in the exchange rates may affect the flow of capital as it tends to have an impact on the expected rate of return in the foreign investment. 

4. Changes in the interest rates, in comparison to other countries, may tend to affect capital flows across borders. A higher domestic interest rate may lead to lower capital flows into the country whereas a reduction in domestic interest rates may tend to have greater capital flows into the country.