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Wednesday, July 25, 2012

What is Balance of payments (BOP) ?

BOP or Balance Of Payments reflects the monetary transactions between a particular country and the rest of the world for a specific period usually a year recorded in a single currency (either the local currency or the reserve currency-US dollar).
Simply put, BOP tracks whether ‘net money’ is flowing in a country or out of the country.
·         Positive BOP: net money is flowing in a country
Inflows & Outflows
·         negative BOP : net money flowing of the country

 BOP record following monetary transactions –

     1.       Imports and exports of goods and services: if we talk about India then India primarily imports crude and gold and this payment takes the money out of the country(Outflows)
On the other hand India is a major exporter of IT solutions and services, apparels, automobiles, precious stones etc and the payment received brings money in the country (Inflows).The difference between imports and exports is termed as the Trade balance-
When exports are in excess of imports, it is trade surplus and when imports exceed exports it is called trade deficit.

      2.       Inflows and outflows of the financial capital: Due to cheaper wages and being a potential consumer market many foreign companies have set up their  manufacturing  facilities, many foreign investors invest in lucrative businesses and ventures in India.
This is inflow of the capital. Foreign capital is the investment by non-resident foreign institutes and foreign governments.
Similarly when Indian businessmen invest in businesses abroad, this falls under outflow of the capital.

       3.       Other financial transfers: Foreign inflows that come as loans and grants from foreign governments or World Bank etc, fall under this category.
These transfers don’t create any physical assets for creditors or grantors and this is how these transfers differ from the foreign capital.
 Nonresident citizens remitting money to their homeland and FII (Foreign Institutional Investment) brings money in the country.
Repayment of foreign loans or  giving grants abroad, redemption of money by non-resident citizens and FIIs takes the money out of the country.
When investment income and foreign aids are added to the trade balance, what we get is the current account balance.
When ‘current account balance’ is positive i.e. inflows higher than the outflows-it is termed as current account surplus.
When outflows to current balance exceed inflows we call it current account deficit or CAD.
It is important to note that current account balance is inclusive of the trade balance.

 (4) Change in foreign exchange reserve: when a currency exports goods or services it gets the payment in the foreign currency-mostly in dollars as the dollar is the reserve currency of the world.  
For imports payment this dollar reserve is utilized while exports add up to it.


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