The Current Account component in Balance of Payments (BoP)

The Current Account records a nation’s total exports of goods, services and transfers, and its total imports of them.

The current account is subdivided into two components (1) balance of trade (BoT), and (2) balance of invisibles (BOIs).

Structure of Current Account in India’s BOP Statement

A. CURRENT ACCOUNT

I. Merchandise (BOT): Trade Balance (A-B)

A. Exports, f.o.b.
B. Imports, c.i.f.

II. Invisibles (BOI): (a + b + c)

a. Services
i. Travel
ii. Transportation
iii. Insurance
iv. Govt. not elsewhere classified
v. Miscellaneous

b. Transfers
i. Official
ii. Private

c. Income
i. Investment Income
ii. Compensation to employees
Total Current Account = I + II

1. Balance of Trade (BoT)

Balance of payments refers the difference between merchandise exports and merchandise imports of a country. BOT is also known as “general merchandise”, which covers transactions of movable goods with changes of ownership between residents and nonresidents. So, balance of trade deals with the export and import of merchandise, except ships, airline stores, and so on. Purchased by non-resident transport operators in the given country and similar goods purchased overseas by that country’s operators, purchases of foreign travelers, purchases by domestic missions. The data of exports and imports are obtained from trade statistics and reports on payments/receipts submitted by individuals and enterprises.

The valuation for exports should be in the form of f.o.b (free on board) basis and imports are valued on the basis of c.i.f (cost, insurance and fright). Exports, are credit entries. The data for these items are obtained from the various forms of exporters, which would be filled by exporter and submitted to designate authorities. While imports are debit entries. The excess of exports over imports denotes favorable (surplus) balance of trade, while the excess of imports over exports denotes adverse (deficit) balance of trade.

The balance of the current account tells us if a country has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not necessarily. But to understand the significance of this part of the BOP, we should start by looking at the components of the current account: goods, services, income and current transfers.

  1. Goods – These are movable and physical in nature, and in order for a transaction to be recorded under “goods”, a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out).
  2. Services – Service trade is export / import of services; common services are financial services provided by banks to foreign investors, construction services and tourism services. These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is
    recorded like an import (a debit), and if money is received it is recorded like an export (credit).
  3. Current Transfers – Financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries, which is one-way, workers’ remittances, donations, a gift or a grant, official assistance and pensions are termed a current transfer. Current transfers are unilateral transfers with nothing received in return. Due to their nature, current transfers are not considered real resources that affect economic production.
  4. Income – Predominately current income associated with investments, which were made in previous periods. Additionally the wages & salaries paid to non-resident workers. In other words, income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.

2. Balance of Invisibles (BoI)

These transactions result from an intangible action such as transportation, business services, tourism, royalties on patents or trade marks held abroad, insurance, banking, and unilateral services. All the cash receipts received by the resident from non-resident are credited under invisibles. The receipts include income received for the services provided by residents to non-residents, income (interest, dividend) earned by residents on their foreign financial investments, income earned by the residents by way of giving permission to use patents, and copyrights that are owned by them and offset entries to the cash and gifts received in-kind by residents from non-residents. On the other hand debits of invisible items consists of same items when the resident pays to the non-resident. Put in simple debit items consists of the same with the roles of residents and nonresidents reversed.

The sum of the net balance between the credit and debit entries under the both heads Merchandise, and invisibles is Current Account Balance (CAB). Symbolically: CAB = BOT +BOI It is surplus when the credits are higher than the debits, and it is deficit when the credits are less than debits.

Use of Current Account

Theoretically, the balance should be zero, but in the real world this is improbable. The current account may have a deficit or a surplus balance, that indicates about the state of the economy, both on its own and in comparison to other world markets.

A country’s current accounts credit balance (surplus) indicates that the country (economy) is a net creditor to the rest of the countries with which it has dealt. It also shows that how much a country is saving as opposed to investing. It indicates that the country is providing an abundance of resources to other economies, and is owed money in return. By providing these resources abroad, a country with a current account balance surplus gives receiving economies the chance to increase their productivity while running a deficit. This is referred to as financing a deficit.

On the other hand a country’s current account debit (deficit) balance reflects an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements. For example, let us say an economy decides that it needs to invest for the future (to receive investment income in the long run), so instead of saving, it sends the money abroad into an investment project. This would be marked as a debit in the financial account of the balance of payments at that period of time, but when future returns are made, they would be entered as investment income (a credit) in the current account under the income section.

A current account deficit is usually accompanied by depletion in foreign exchange assets because those reserves would be used for investment abroad. The deficit could also signify increased foreign investment in the local market, in which case the local economy is liable to pay the foreign economy investment income in the future. It is important to understand from where a deficit or a surplus is stemming because sometimes looking at the current account, as a whole could be misleading.

Source: Scribd.com

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