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Balance of payments

Study Material > Economics
  • Balance of payments (BOP) of a country is a systematic record of all economic transactions during a given period of time, usually a year.
  • A country trade with another country in three items namely:
    1. Visible items, which includes all types of physical goods exported and imported.
    2. Invisible items, which include all those services, whose export and import are not visible.
    3. Capital transfer, which are concerned with capital receipts and capital payments. 

Importance of Balance of Payments

  • A study of BOP is important because – 
    1. It serves as an indicator of the changing international economic or financial position of a country.
    2. It helps in formulation of a country’s monetary, fiscal and trade policies.
    3. It helps in determining the influence of foreign trade & transactions on the level of national income of a country.
    4. It is useful to banks, firms, financial institutions and individuals which are directly or indirectly involved in international trade and finance.
    5. It is an economic barometer of nation’s progress vis-à-vis rest of the world.

Balance of Trade

  • Balance of Trade is the difference in the monetary value of imports and exports of only physical goods or visible items.
  • There are three condition of Balance of Trade:
    1. Positive or surplus: In this situation, exports are greater than imports.
    2. Negative or Deficit: In this situation, exports are less than imports.
    3. Balanced or Equilibrium: In this situation, exports are equal to imports.
  • The balance of tradeis the largest component of the country's balance of payments (BOP).

Balance of Payments

  • When the difference in the monetary value of imports and exports of all the three items i.e., visible, invisible and capital transfers, is taken into account, it is called Balance of Payments (BoP).
  • Thus in simple terms we can define Balance of Payment (BoP) as the overall record of a country’s economic transactions with the rest of the world.

Structure of Balance of Payments

  • There are two types of accounts in BoP, namely: 
    1. Current account
    2. Capital account

Current account

  • Current account refers to an account which records all the transactions relating to export and import of goods and services and unilateral transfers during a given period of time. Earning on investments, both public and private, are also put into the current account.
  • Current account records the following transactions: 
    1. Export and Import of Goods(Visible Trade)
    2. Export and Import of Services (Invisible Trade)
    3. Unilateral transfers to and from abroad
  • In the current account, receipts from export of goods, services and unilateral receipts are entered as credit or positive items and payments for import of goods, services and unilateral payments are entered as debit or negative items. The net value of credit and debit balances is the balance on current account.
  • Hence, Current Account Balance: Balance of Visible Trade + Balance of Invisible Trade + Balance of Unilateral Transfers.

Capital Account

  • Capital account of BOP records all those transactions, between the residents of a country and the rest of the world, which cause a change in the assets or liabilities of the residents of the country or its government. 
  • Components of Capital Account
    1. Foreign Investment. which includes: 
      1. Foreign Direct Investment (FDI): It refers to the purchase of assets in the rest of the world, which allows control over that assets. Ex: Purchase of a firm by an Indian company.
      2. Portfolio Investment: It refers to purchase of an asset in the rest of the world, without any control over that asset. Ex: Purchase of some shares of a company by an Indian Company. Portfolio investment into India also consists of Foreign Institutional Investment (FII).
    2. Loans: It consists of :
      1. Commercial Borrowings: It refers to borrowing by a country (Including government and private sector), from the international money market. This involves market rate of interest without considerations of any concession.
      2. Borrowings as External Assistance: It refers to borrowing by a country with considerations of assistance. It involves lower rate of interest compared to that prevailing in the open market.
    3. Banking Capital Transactions: It refers to transactions of external financial assets and liabilities of Commercial Banks and Co-operative Banks operating as authorised dealers in foreign exchange. These transactions include NRI deposits.
    4. Reserve Account: The official reserve account records the change in stock of reserve assets (also known as foreign exchange reserves) at the country’s monetary authority.
  • All capital transactions causing flow of foreign exchange into the country are recorded as positive items in the capital account of BoP. Ex: Loans from rest of the world, foreign direct investment or portfolio investment by the non-residents in our country.
  • All capital transactions causing flow of foreign exchange out of the country are recorded as negative items in the capital account of BoP.
  • While FDI and portfolio investments are non-debt creating capital transactions, borrowings are debt-creating capital transactions.

Classification foreign investment

  • The Indian government differentiates cross-border capital inflows into various categories like foreign direct investment (FDI), foreign institutional investment (FII), non-resident Indian (NRI) and person of Indian origin (PIO) investment. Inflow of investment from other countries is encouraged since it complements domestic investments in capital-scarce economies of developing countries, India opened up to investments from abroad gradually over the past two decades, especially since the landmark economic liberalisation of 1991.
  • Apart from helping in creating additional economic activity and generating employment, foreign investment also facilitates flow of technology into the country and helps the industry to become more competitive. 

Foreign direct investment (FDI)

  • Foreign direct investment (FDI) is an investment made by a company or individual in one country in business interests in another country, in the form of either establishing business operations or acquiring business assets in the other country, such as ownership or controlling interest in a foreign company. Foreign direct investmentsare distinguished from portfolio investments in which an investor merely purchases equities of foreign-based companies. The key feature of foreign direct investment is that it is an investment made that establishes either effective control of, or at least substantial influence over, the decision making of a foreign business.
  • Types of FDI: There are two types of FDI:
    1. Greenfield Investment
    2. Brownfield Investment
  • Green-field investments occur when a parent companybegins a new venture by constructing new facilities in a foreign country. Whereas, Brown-field investments occur when a company or government purchases or leases an existing facility to begin new production.
  • In simple terms Greenfield investment is investment in new plants. It is establishing new production capacity by an investor or company. On the other, Brownfield investment is an investor investing in an existing plant. Brownfield investment is mainly made through merger and acquisitions.
  • The Department of Industrial Policy & Promotion is the nodal Department for formulation of the policy of the Government on Foreign Direct Investment (FDI). It is also responsible for maintenance and management of data on inward FDI into India, based upon the remittances reported by the Reserve Bank of India.
  • Foreign Institutional Investment (FII): These are investments by entities from outside the country into the financial assets like debts and shares of companies from a different country, in which they are incorporated. FIIs are required to register with SEBI and any foreign individual wanting to invest into India has to come through one of these FIIs.
  • In India, a particular FII is allowed to invest upto 10% of the paid up capital of a company, which implies that any investment above 10% will be construed as FDI. In order to remove the ambiguity that prevails on what is Foreign Direct Investment (FDI) and what is Foreign Institutional Investment (FII), it is proposed to follow the international practice and lay down a broad principle that, where an investor has a stake of 10 percent or less in a company, it will be treated as FII and, where an investor has a stake of more than 10 percent, it will be treated as FDI. 
  • FIIs, Sub-Accounts and QFIs are merged together to form the new investor class, namely Foreign Portfolio Investors, with an aggregate investment limit of 24% which can be raised by the Company up to the applicable sectoral cap.
  • FDI is preferred over FII investments since it is considered to be the most beneficial form of foreign investment for the economy as a whole. Direct investment targets a specific enterprise, with the aim of increasing its capacity/productivity or changing its management control. Direct investment to create or augment capacity ensures that the capital inflow translates into additional production. In the case of FII investment that flows into the secondary market, the effect is to increase capital availability in general, rather than availability of capital to a particular enterprise.
  • FDI tends to be much more stable than FII inflows. Moreover, FDI brings not just capital but also better management and governance practices and, often, technology transfer. The know-how thus transferred along with FDI is often more crucial than the capital per se. No such benefit accrues in the case of FII inflows, although the search by FIIs for credible investment options has tended to improve accounting and governance practices among listed Indian companies. 
  • According to the government’s definition, FIIs include asset management companies, pension funds, mutual funds, investment trusts as nominee companies, incorporated/institutional portfolio managers or their power of attorney holders, university funds, endowment foundations, charitable trusts and charitable societies.
  • FIIs are required to allocate their investment between equity and debt instruments in the ratio of 70:30. However, it is also possible for an FII to declare itself a 100% debt FII in which case it can make its entire investment in debt instruments.
  • The government allows greater freedom to FDI in various sectors as compared to FII investments. However, there are peculiar cases like airlines where foreign investment, including FII investment, is allowed to the extent of 49%, but FDI from foreign airlines is not allowed. 

Prohibited Sectors

  • FDI is prohibited in: 
    1. Lottery Business including Government/private lottery, online lotteries, etc.
    2. Gambling and Betting including casinos etc.
    3. Chit funds
    4. Nidhi company
    5. Trading in Transferable Development Rights (TDRs)
    6. Real Estate Business or Construction of Farm Houses ‘Real estate business’ shall not include development of townships, construction of residential /commercial premises, roads or bridges and Real Estate Investment Trusts (REITs) registered and regulated under the SEBI (REITs) Regulations 2014.
    7. Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes
    8. Activities/sectors not open to private sector investment e.g.
      1. Atomic Energy and
      2. Railway operations

Sector wise FDI Limits

  • Many changes have been made to the Foreign Direct Investment (FDI) policyin the last few years. Further, FDI is also allowed through two different routes namely, Automatic and the Government route.
  • The erstwhile Foreign Investment Promotion Board (FIPB) has been phased out In the automatic route, foreign entities do not need the prior approval of the government to invest. However, they have to inform the RBI about the amount of investment within a stipulated time period.
  • In the government route, any investment can be made only after the prior approval of the government. Various other conditions as defined in the consolidated FDI policyare applicable to various sectors. In specific sectors, the FDI is prohibited.

Sector

FDI Limit

Entry Route & Remarks

Agriculture & Animal Husbandry
• Floriculture, Horticulture, Apiculture and Cultivation of Vegetables &    Mushrooms under controlled conditions
• Development and Production of seeds and planting material
• Animal Husbandry(including breeding of dogs), Pisciculture,  Aquaculture
• Services related to agro and allied sectors

100%

Automatic

Plantation Sector
• Tea sector including tea plantations
• Coffee plantations
• Rubber plantations
• Cardamom plantations
• Palm oil tree plantations
• Olive oil tree plantations

100%

Automatic

Mining
Mining and Exploration of metal and non-metal ores including diamond, gold, silver and precious ores but excluding titanium bearing minerals and its ores

100%

Automatic

Mining (Coal & Lignite)

100%

Automatic

Mining
Mining and mineral separation of titanium bearing minerals and ores, its value addition and integrated activities

100%

Government

Petroleum & Natural Gas
Exploration activities of oil and natural gas fields, infrastructure related to marketing of petroleum products and natural gas, marketing of natural gas and petroleum products etc

100%

Automatic

Petroleum & Natural Gas
Petroleum refining by the Public Sector Undertakings (PSU), without any disinvestment or dilution of domestic equity in the existing PSUs.

49%

Automatic

Defence Manufacturing

100%

Automatic up to 49%
Above 49% under Government route in cases resulting in access to modern technology in the country

Broadcasting
• Teleports(setting up of up-linking HUBs/Teleports)
• Direct to Home (DTH)
• Cable Networks (Multi System operators (MSOs) operating at National or State or District level and undertaking up gradation of networks towards digitalization and addressability
• Mobile TV
• Head end-in-the Sky Broadcasting Service(HITS)

100%

Automatic

Broadcasting
Cable Networks (Other MSOs not undertaking up gradation of networks towards digitalization and addressability and Local Cable Operators (LCOs))

100%

Automatic

Broadcasting Content Services
• Terrestrial Broadcasting FM(FM Radio)
• Up-linking of ‘News & Current Affairs’ TV Channels

49%

Government

Up-linking of Non-‘News & Current Affairs’ TV Channels/ Down-linking of TV Channels

100%

Automatic

Print Media
• Publishing of newspaper and periodicals dealing with news and current affairs
• Publication of Indian editions of foreign magazines dealing with news and current affairs

26%

Government

Publishing/printing of scientific and technical magazines/specialty journals/ periodicals, subject to compliance with the legal framework as applicable and guidelines issued in this regard from time to time by Ministry of Information and Broadcasting.

100%

Government

Publication of facsimile edition of foreign newspapers

100%

Government

Civil Aviation – Airports
Green Field Projects & Existing Projects

100%

Automatic

Civil Aviation – Air Transport Services
• Scheduled Air Transport Service/ Domestic Scheduled Passenger Airline
• Regional Air Transport Service

(Foreign Airlines are barred from Investing in Air India)

100%

Automatic up to 49%
Above 49% under Government route
100% Automatic for NRIs

Civil Aviation
• Non-Scheduled Air Transport Service
• Helicopter services/seaplane services requiring DGCA approval
• Ground Handling Services subject to sectoral regulations and security clearance
• Maintenance and Repair organizations; flying training institutes; and technical training institutions

100%

Automatic

Construction Development: Townships, Housing, Built-up Infrastructure

100%

Automatic

Industrial Parks (new & existing)

100%

Automatic

Satellites- establishment and operation, subject to the sectoral guidelines of Department of Space/ISRO

100%

Government

Private Security Agencies

74%

Automatic up to 49%
Above 49% & up to 74% under Government route

Telecom Services

100%

Automatic up to 49%
Above 49% under Government route

Cash & Carry Wholesale Trading

100%

Automatic

E-commerce activities (e-commerce entities would engage only in Business to Business (B2B) e-commerce and not in Business to Consumer (B2C) e-commerce.)

100%

Automatic

Single Brand retail trading
Local sourcing norms will be relaxed up to three years and a relaxed sourcing regime for another five years for entities undertaking Single Brand Retail Trading of products having ‘state-of-art’ and ‘cutting edge’ technology.

100%

Automatic up to 49%
Above 49% under Government route

Multi Brand Retail Trading

51%

Government

Duty Free Shops

100%

Automatic

Railway Infrastructure
Construction, operation and maintenance of the following
• Suburban corridor projects through PPP
• High speed train projects
• Dedicated freight lines
• Rolling stock including train sets, and locomotives/coaches manufacturing and maintenance facilities
• Railway Electrification
• Signaling systems
• Freight terminals
• Passenger terminals
• Infrastructure in industrial park pertaining to railway line/sidings including electrified railway lines and connectivities to main railway line
• Mass Rapid Transport Systems.

100%

Automatic

Asset Reconstruction Companies

100%

Automatic

Banking- Private Sector

74%

Automatic up to 49%
Above 49% & up to 74% under Government route

Banking- Public Sector

20%

Government

Credit Information Companies (CIC)

100%

Automatic

Infrastructure Company in the Securities Market

49%

Automatic

Insurance
• Insurance Company
• Insurance Brokers
• Third Party Administrators
• Surveyors and Loss Assessors
• Other Insurance Intermediaries

49%

Automatic

Pension Sector

49%

Automatic

Power Exchanges

49%

Automatic

White Label ATM Operations

100%

Automatic

Financial services activities regulated by RBI, SEBI, IRDA or any other regulator

100%

Automatic

Pharmaceuticals(Green Field)

100%

Automatic

Pharmaceuticals(Brown Field)

100%

Automatic up to 74%
Above 74% under
Government route

Food products manufactured or produced in India
Trading, including through e-commerce, in respect of food products manufactured or produced in India.

100%

Government

 

  • Participatory Notes(P-Notes): These are financial instruments used by investors or hedge funds that are not registered with the Securities and Exchange Board of India to invest in Indian securities. Indian based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.
  • Global Depository Receipts (GDRs): These are equity instruments issued in international markets like London, Luxembourg etc. Indian companies use GDRs to raise capital from abroad. GDRs are designated in dollars, euros etc.
  • American Depository Receipts (ADRs): These are the equity instruments issued to American retail and institutional investors. They are listed in New York, either on Nasdaq or New York Stock Exchange.
  • Indian Depository Receipts (IDRs): These are similar to ADR/GDR. They are used by non-Indian companies in the Indian stock markets for issuing equity to Indian investors.

Reason for India’s Balance of Payment deficit

  1. Expanding trade gap: Due to rise in imports against exports a big trade gap is created over the years. Some of the reason for increasing trade gap are:
    1. Import liberalisation: Due to import liberalisation during the eighties there has been a quantum jump in imports of capital goods and modern technology. The new economic and trade policies of 1991 have favoured a further liberalisation of imports.
    2. Irreversible trade deficit: Our imperative imports of oil and coal and India’s passion for gold.
    3. Building industrial base: Building of industrial base has increased the imports of industrial raw materials and also increases in imports which are used for exports after processing (gems, jewellery).
    4. Import of Essential Items:Due to scarcity created by drought conditions, time to time, the country had to import essential items such as cereals and edible oils on a large scale.
  2. Devaluation and Depreciation of the rupee: A devaluation means there is a fall in the value of a currency and hence imports become more expensive. As imports of essential items cannot be avoided trade gaps increases with more imports than exports.
  3. Appreciation of rupee: Appreciation of rupee makes exports costlier and imports cheaper. Which always increases imports of various products and add to the Balance of Payment (BoP) problem.

Foreign Exchange

  • Foreign exchange reserves are an important component of the BoP and an essential element in the analysis of an economy’s external position. Foreign-exchange reserves are called reserve assetsin the balance of payments and are located in the capital account. Hence, they are usually an important part of the international investment position of a country. India’s foreign exchange reserves comprise Foreign Currency Assets (FCAs), gold, Special Drawing Rights (SDRs) and Reserve Tranche Position (RTP) in the International Monetary Fund (IMF).

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