The Balance of Payments: What It Is

Notice what the second entry always is. It records how the transaction was settled: an asset acquired, a liability incurred, or reserves changed. Exports are not simply "credits"; an export is a credit and a matching entry showing what the exporter got for it.

The consequence: the balance of payments always balances. Total credits equal total debits by construction. It follows that:

"India has a balance of payments deficit" is, read literally, a false statement. What is always meant is a deficit on some part of the account, almost always the current account. A student who writes that the balance of payments does not balance has said something the accounting makes impossible.

Then why is there an errors and omissions line? Because the two entries are collected from different sources: exports from customs records, payments from banks, investment from company returns. The mismatch is not a failure of the identity but of the data, so a residual is inserted to make the recorded figures add up. In India's accounts for 2024-25 net errors and omissions were 1,402 million dollars on a current account of over a million million, which is small, and a large or persistently one sided errors and omissions line is a warning sign of unrecorded capital movement.

The balance of trade distinguished

The difference between those two figures, 283.5 and 22.9, is the entire content of the distinction, and it is made up of the services surplus and remittances described in [Structural Changes Since 1991: Volume, Direction and Services]. An examiner asking a student to distinguish the balance of trade from the balance of payments is asking for exactly this.

A note on the old vocabulary. Older books call merchandise items visible and services invisible, so that "invisibles" means services plus income plus transfers. The vocabulary is still used in India and an examiner may use it, but the current manuals do not, and an answer is safer using the modern heads.

The manual India follows

The balance of payments is compiled to the International Monetary Fund's Balance of Payments and International Investment Position Manual, and India's published accounts are given on the sixth edition, which the Statistical Appendix labels "Balance of Payments Manual 6", with the older presentation on the fifth edition printed alongside for continuity.

Why a manual matters. A country's account with the world is only meaningful if every country classifies the same transaction the same way, since one country's credit is another's debit. The manual is what makes the world's balance of payments statements comparable, and the changes between the fifth and the sixth editions, chiefly in the treatment of the financial account and its sign conventions, are why figures from books of different vintages do not always agree.

The law that mirrors the accounting

This is where a law student has an advantage over an economics student, and the answer should use it.

The balance of payments divides transactions into those on current account and those on capital and financial account. The Foreign Exchange Management Act 1999 makes the same division and attaches different legal consequences to each.

Section 2(j): current account transaction means a transaction other than a capital account transaction, and without prejudice to that generality includes payments due in connection with foreign trade, other current business, services and short term banking and credit facilities in the ordinary course of business; payments due as interest on loans and as net income from investments; remittances for living expenses of parents, spouse and children residing abroad; and expenses in connection with foreign travel, education and medical care of parents, spouse and children.

Section 2(e): capital account transaction means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India, or assets or liabilities in India of persons resident outside India, and includes the transactions referred to in section 6(3).

Compare that definition with the accounting. A current account transaction is one that is complete when it is done; a capital account transaction changes the stock of what is owed and owned across the border. That is exactly the distinction the balance of payments draws, written as a definition in an Act of Parliament.

Section 5: current account transactions. "Any person may sell or draw foreign exchange to or from an authorised person if such sale or drawal is a current account transaction", subject to a proviso permitting the Central Government, in public interest and in consultation with the Reserve Bank, to impose such reasonable restrictions as may be prescribed.

Section 6: capital account transactions. Any person may sell or draw foreign exchange for a capital account transaction, but subject to what the Reserve Bank, in consultation with the Central Government, specifies for transactions involving debt instruments, and what the Central Government, in consultation with the Reserve Bank, prescribes for those not involving debt instruments: the classes that are permissible, the limits, and the conditions. A proviso forbids any restriction on the drawal of foreign exchange for amortisation of loans or depreciation of direct investments in the ordinary course of business.

Those two sections are the legal statement of a fact of Indian economic policy: the rupee is convertible on the current account and only partly convertible on the capital account. Section 5 says you may, subject to reasonable restrictions; section 6 says you may, subject to what is specified. A student who can state the difference in that form has answered a question about convertibility, about the balance of payments and about FEMA at once.

Section 3, for completeness, sets the background rule: save as provided by the Act or with the Reserve Bank's permission, no person shall deal in or transfer foreign exchange to a person who is not an authorised person, make any payment to or for the credit of a person resident outside India, or receive any payment otherwise than through an authorised person.

A worked example: reading India's account for 2024-25

In millions of US dollars, from the Reserve Bank's statement:

Check the identity. minus 22,947 minus 193 plus 1,402 = minus 21,738, and the financial account is plus 21,738. The two are equal and opposite, so the account balances exactly, which is what "the balance of payments always balances" means in practice.

Read it in words. India spent about 23 billion dollars more than it earned on current transactions with the world, and financed that by a net inflow on the financial account of the same size, made up of foreign investment and borrowing. A current account deficit is always financed by somebody, and identifying who is the whole of the analysis.

What beginners get wrong

"India has a balance of payments deficit." The balance of payments cannot be in deficit. Say current account deficit, and give the figure.

"The balance of payments and the balance of trade are the same." The balance of trade is merchandise only. In 2024-25 India's trade balance was minus 283.5 billion dollars and its current account balance minus 22.9 billion.

"Only trade in goods is in the balance of payments." Services, investment income, transfers, investment and borrowing are all in it.

"An Indian citizen abroad is a resident of India for the balance of payments." The test is residence, not nationality, which is why remittances are a transfer between a non resident and a resident.

"Errors and omissions means the account did not balance." It means the two sides were measured from different sources. The identity holds; the data is imperfect.

"FEMA has nothing to do with the balance of payments." Sections 2(e), 2(j), 5 and 6 are the current and capital account distinction of the balance of payments turned into law.

Limits

Compilation is imperfect. Services, informal transfers and unrecorded capital flows are hard to measure, and the errors and omissions line records what the compilers could not reconcile.

The manual has changed. Figures on the fifth edition and the sixth edition are not identical, so a comparison across sources must check which is used.

A balance is not a verdict. A current account deficit may reflect strong investment financed from abroad or reckless consumption; the number alone does not say which, as [Disequilibrium in the Balance of Payments] shows.

Provisional figures are revised. The 2024-25 figures used here are marked partially revised.

Quick revision

1. Balance of payments: a systematic record on double entry principles of all economic transactions between residents and non residents over a period, usually a year. Compiled in India by the Reserve Bank.
2. Residence, not nationality, is the test.
3. Credits are receipts from non residents; debits are payments to them. Every transaction produces two entries, the second recording how it was settled.
4. The whole account always balances; only a part of it can be in deficit. Say "current account deficit".
5. Errors and omissions exist because the two sides come from different sources. India, 2024-25: plus 1,402 million dollars, which is small.
6. Balance of trade is merchandise only, the visible balance: India minus 283.5 billion dollars in 2024-25. Current account balance: minus 22.9 billion. The difference is services and remittances.
7. Manual: the International Monetary Fund's Balance of Payments Manual, sixth edition, with the fifth edition presentation printed alongside.
8. FEMA 1999 mirrors the accounting: s.2(j) current account transaction, defined residually and illustratively; s.2(e) capital account transaction, one that alters assets or liabilities across the border; s.5, current account transactions permitted subject to reasonable restrictions prescribed in public interest; s.6, capital account transactions permitted subject to what the Reserve Bank specifies for debt instruments and the Central Government prescribes for others, with a proviso protecting amortisation of loans and depreciation of direct investments. s.3 is the background prohibition.
9. 2024-25 identity: current minus 22,947, capital minus 193, errors plus 1,402, financial plus 21,738. They sum to zero.

Test yourself

1. Define the balance of payments and explain why it always balances. The balance of payments is a systematic record, prepared on double entry principles, of all economic transactions between the residents of a country and the residents of the rest of the world during a stated period, ordinarily a financial year. Receipts from non residents are entered as credits and payments to non residents as debits, and the test of who is a resident is residence and not nationality, so that a foreign company operating in India is a resident and an Indian citizen settled abroad is not.

It always balances because every transaction gives rise to two entries of equal value. When a firm exports software for a hundred, the export is a credit and the increase in the foreign assets it holds is a debit of the same amount; when an importer buys a machine on credit, the import is a debit and the trade credit received from abroad is a credit. The second entry always records how the transaction was settled, whether by acquiring an asset, incurring a liability or drawing on reserves. Total credits therefore equal total debits by construction, and it follows that a statement that a country has a balance of payments deficit is, read literally, impossible; what is meant is a deficit on a part of the account, almost always the current account. The errors and omissions line does not contradict the identity: it exists because the two sides of a transaction are collected from different sources, customs records for goods and banking returns for payments, so a residual is inserted to reconcile imperfect data.

2. Distinguish the balance of trade from the balance of payments, with figures. The balance of trade is the difference between the value of a country's merchandise exports and its merchandise imports, and is for that reason also called the visible balance. The balance of payments covers every economic transaction with non residents, adding to merchandise trade the trade in services, income earned on and paid for investment, transfers such as remittances and grants, and the acquisition and disposal of assets and liabilities. The difference is not merely one of scope but of magnitude.

In 2024-25 India's merchandise trade balance was a deficit of 283.5 billion US dollars, but its current account deficit was only 22.9 billion, because the services surplus of 188.8 billion and remittances of about 135 billion dollars offset the greater part of the goods deficit. A second difference follows from the double entry rule: the balance of trade can be, and for India almost always is, in deficit, whereas the balance of payments as a whole cannot be in deficit at all, since every debit has a matching credit. The practical consequence is that any assessment of India's external position that uses the trade figure alone overstates the problem by roughly three times.

3. How does the Foreign Exchange Management Act 1999 reflect the structure of the balance of payments? It adopts the same division and gives each side a different legal regime. Section 2(e) defines a capital account transaction as one which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India, or assets or liabilities in India of persons resident outside India, together with the transactions listed in section 6(3). Section 2(j) defines a current account transaction residually, as a transaction other than a capital account transaction, and then illustrates it: payments due in connection with foreign trade, other current business, services and short term banking and credit facilities in the ordinary course of business; interest on loans and net income from investments; remittances for the living expenses of parents, spouse and children residing abroad; and expenses of foreign travel, education and medical care for the same persons. That is exactly the accounting distinction, since a current transaction is complete when it is done while a capital transaction changes the stock of what is owned and owed across the border.

The legal consequences then differ. Section 5 provides that any person may sell or draw foreign exchange for a current account transaction, subject only to a proviso permitting the Central Government, in public interest and in consultation with the Reserve Bank, to impose such reasonable restrictions as may be prescribed. Section 6 provides that a person may sell or draw foreign exchange for a capital account transaction, but subject to the classes, limits and conditions specified by the Reserve Bank in consultation with the Central Government for transactions involving debt instruments, and prescribed by the Central Government in consultation with the Reserve Bank for those not involving debt instruments, with a proviso forbidding any restriction on drawal for the amortisation of loans or the depreciation of direct investments in the ordinary course of business. In substance the two sections are the statutory form of India's position that the rupee is convertible on the current account and only partly convertible on the capital account.

4. Explain the double entry principle with examples. Every transaction with a non resident produces two entries of equal amount, one credit and one debit, because whenever something is given something is received. If an Indian company exports software worth a hundred and is paid into a foreign currency account, the services export is a credit of a hundred and the increase in the foreign assets held by a resident is a debit of a hundred. If an Indian imports a machine worth sixty on three months' credit, the goods import is a debit of sixty and the trade credit extended by the foreign supplier, which is a liability incurred to a non resident, is a credit of sixty.

If a worker in Dubai remits twenty rupees' worth of foreign exchange to a family in Kerala, secondary income received is a credit of twenty and the increase in India's holding of foreign exchange is a debit of twenty. If a foreign investor buys fifty of shares in an Indian company, the portfolio investment liability incurred is a credit of fifty and the foreign exchange received is a debit of fifty. In each case the second entry records how the first was settled, by an asset acquired, a liability incurred or reserves changed. Since this is true of every transaction, total credits must equal total debits, which is why the account balances and why any deficit or surplus is necessarily a statement about one part of it.

5. Take India's balance of payments for 2024-25 and show that it balances. On the Reserve Bank's statement for 2024-25, in millions of US dollars, the current account recorded credits of 1,018,622 and debits of 1,041,569, a net deficit of 22,947. The capital account, which in the sixth edition of the manual holds only capital transfers and the acquisition and disposal of non produced non financial assets, recorded credits of 755 and debits of 948, a net deficit of 193. Net errors and omissions were a credit of 1,402. Those three sum to a net requirement of 21,738.

The financial account recorded credits of 1,155,466 against debits of 1,133,728, a net of 21,738, made up of direct investment of 959, portfolio investment of 3,564, financial derivatives of minus 22,143, other investment including loans, currency and deposits and trade credit of 34,325, and reserve assets of 5,032. The financial account inflow of 21,738 exactly equals the deficit of 21,738 on the other three, so the account balances to the last million. In words, India spent about twenty three billion dollars more than it earned on current transactions with the world and financed that entirely by a net inflow of investment and borrowing of the same amount, and the identity is not a coincidence but a consequence of the double entry rule.