Foreign exchange reserves and the balance of payments

A couple of days ago someone asked about the balance of payments - and I thought of penning down some notes because simple though it is, the concepts do sometimes cause confusion as our Economics 101 gets rusty. A brief write up on how the current and capital account balances add up to the changes in forex reserves.

Foreign exchange reserves and the balance of payments

The balance of payments is an account of all of a country’s transactions with the rest of the world. On one side of the account are money flows out of the country (debits), and on the other are the receipts (credits). The interesting thing is that the balance of payments is, by definition, balanced. However, this balance is struck in a mere accounting sense as debits must equal credits.

Taking a very simple view of world trade, a country would export and earn foreign exchange with which it can buy goods from abroad. Let us assume a simple scenario where a country’s demand for imports is more than its exports. In such a case, the country’s ability to import would be limited by the foreign exchange it has earned from its exports, or from what is called the ‘current account’ – unless it chooses, as countries often do, to finance their deficit by borrowings, i.e. from the ‘capital account’. To the extent that the deficit is not financed by the capital account, it will experience a reduction in its foreign currency ‘cash balance’, i.e. a fall in its forex reserves. In the same way, forex reserves will increase if the exports are more than the imports. Forex reserves however cannot increase (or decrease) forever. Over a period of time, a sustained excess of imports over exports (or the other way round) will move the exchange rates in a way as to bring the two in balance by affecting demand and supply. But we digress – back to the balance of payments.

Ultimately:

Deficit/Surplus of the current account + Deficit/Surplus of the capital account = Net change in foreign exchange reserves

Transactions inside the balance of payments can be classified in two broad categories: transactions on the capital account, and those on the current account.

The current account: The current account is a record of all transactions relating to trade in goods and services, net interest and dividend payments and any transfers in the form of foreign aid. Therefore, the three component of the current account are:

1. The trade balance: This is the difference between the exports and imports of goods and services. The excess of exports over imports is called the trade surplus, and likewise if the imports exceed exports, there is a trade deficit. Often, a distinction is made between goods and services by calling them visible and invisible trade. The trade balance is the most significant element of the current account. Often, a ‘worsening balance of payments’ refers to an increase in the trade deficit.

2. Net foreign income: Income is earned by residents on assets held abroad and likewise foreigners earn income on the domestic assets. Net foreign income is the difference of the two and includes interest and dividends.

3. Unilateral transfers: include transfers such as foreign aid which are made without consideration.

The capital account: The capital account is a record of all financing transactions. These represent flow of money for investment and international loans. It is different from the current account in that it does not include settlements for current transactions. To illustrate with an example, while the purchase of a machinery would feature in the current account, its financing with an international loan would be an entry in the capital account. Investments by foreigners in a domestic stock market, raising of capital by domestic companies in markets abroad, foreign direct investments in domestic industry are all inflows on the capital account. Likewise, extinguishment of debt by settlement, investments in foreign financial assets (eg, in the US treasuries) represent an outflow on the capital account.

Long and short term capital flows
One characteristic of the capital account is the nature of the capital flow, i.e. whether it is short term or long term in nature. ‘Hot money’, or investments in local debt or equity markets to exploit differences in interest rate or stock market expectations, are short term capital flows that can reverse quickly. On the other hand, long term loans or investment in equity that cannot be easily monetized and taken out of a country are examples of long term or ‘stable’ capital flows. The difference is crucial because short term capital flows can cause significant market disruptions & economic hardship as they did in the late nineties in the South Asian crisis.

Debt and non-debt creating inflows
It is also possible to consider the capital account transactions as being debt creating or not. Investment in equity, whether in the secondary market or direct investment in the equity of an Indian venture, are not debt creating. On the other hand, external commercial borrowings and external debt assistance both create a debt liability.

The current account and the capital account are complementary to each other. The net total of the two decides the net increase or decrease in the country’s forex reserves. A deficit in the current account is not necessarily a negative indicator, so long as the deficit is used to augment productive capacity. This can take the form of investments in infrastructure that make economic expansion possible and increase the capacity of the country to export in the future. At the same time, a surplus in the current account does not necessarily imply prosperity, for instance Russia had a large current account surplus in the nineties from its export of commodities and arms, which was offset by large scale capital flight and therefore a deficit on the capital account. China currently has a surplus on both the capital and current accounts and so we see their foreign exchange reserves go up each month.


The composition of the ‘balance’ of payments can therefore be summarised as follows:

About exchange controls:
Countries impose different levels of controls on exchange flows, for example, a number of developing countries have opened their current accounts but not their capital accounts. What that means is that people are free to trade with foreigners and settle bills that arise from such trades, but need central bank or other regulatory approval before investing or borrowing from abroad. Both India and China, for example, have controls on the capital account while the current account is largely open. The United States and most developed countries have no restrictions on either.