Question

Twinings (a UK firm) buys £1 billion of tea leaves from India using money from its Indian bank account. It brings the tea to the UK. In the UK, it uses the tea leaves to make boxes of tea, and sells 500 million boxes back to India, each for a price of £2. It then credits the resulting revenue of £1 billion back into its Indian bank account. What happens to the UK’s balance of payments as a result of this transaction?

Please provide a full answer.

Answer 1

STEP 1 UK must have imported some INR by exchanging £ on the foreign exchange market at a spot exchange rate of 90 ₹/£.

The transaction can be recorded by noting the following:

1) The transaction involves an exchange of currency for currency. Since currency is an asset, both sides of the transaction are recorded on the financial account.

2) The currency exported is £1 billion in UK currency, hence we have made a credit entry in the financial account in the Table below. What matters is not whether the item leaves the country, but that the ownership changes from a UK resident to a foreign resident.

3) The currency imported into the country is the ₹90 billion. We record this as a debit entry on the financial account and value it at the current exchange value which is £1 billion as noted in the Table.

Step 1	UK Balance of Payments (£)
	Credits (+)	Debits (-)
Current Account	0	0
Financial Account	+ £1 billion	- £1 billion
(£ currency)	(₹ currency)

STEP 2 Next let's assume that the UK firm uses his ₹90 billion to purchase tea leaves from India and then brings it back to the UK. Since the transaction is between the UK firm and the Indian firm, it is an international transaction and must be recorded on the balance of payments. The item exported in this case is the Indian currency. We'll assume that there has been no change in the exchange rate and thus the currency is still valued at £1 billion. This is recorded as a credit entry on the financial account and labeled '₹ currency' in the Table below. The item being imported into the UK, are tea leaves. Since the tea leaves are merchandise goods and are valued at ₹90 billion = £1 billion, the import is recorded as a debit entry on the current account in the Table below.

Step 2	UK Balance of Payments (£)
	Credits (+)	Debits (-)
Current Account	0	- £1 billion
(tea leaves)
Financial Account	+ £1 billion	0
(₹ currency)

STEP 3 Next let's assume that some Indian firm uses these £1 billion to purchase tea boxes from the UK firm and then brings it back to India. The tea boxes, valued at £1 billion, are being exported out of the UK and are merchandise goods. Therefore, a credit entry of £1 billion is made in the following Table on the current account and labeled 'Tea boxes.' The other side of the transaction is the £1 billion of UK currency being given to the UK firm by the Indian firm. Since the currency, worth £1 billion, is being imported and is an asset, a £1 billion debit entry is made in the Table on the financial account and labeled '£1 billion'.

Step 3	UK Balance of Payments (£)
	Credits (+)	Debits (-)
Current Account	+ £1 billion	0
(tea boxes)
Financial Account	0	- £1 billion
(£ currency)

SUMMARY

Summary 1,2,3	UK Balance of Payments (£)
	Credits (+)	Debits (-)
Current Account	0	- £1 billion
(tea leaves)
Financial Account	+ £1 billion	- £1 billion
(£ currency)	(£ currency)
+ £1 billion	- £1 billion
(₹ currency)	(₹ currency)
+ £1 billion
(tea boxes)

After cancellations, the summary balance of payments statistics would look as in the following table:

Summary 1,2,3	UK Balance of Payments (£)
	Credits (+)	Debits (-)
Current Account	0	- £1 billion
(tea leaves)
Financial Account	+ £1 billion	0
(tea boxes)