BALANCE OF PAYMENTS

The balance of payments is a record of one country's trade dealings with the rest of the world. It aims to provide an account of all receipts and payments on account of goods residents of the country export, render services and receive capital and residents of the country import goods, receive services d and transfer capital.

The balance of payments is usually divided into two sections:

1.  The current account that deal with international trade in goods and services;

2.  Transactions in assets and liabilities which deals with overseas flows of money from international investments and loans; 

THE CONCEPT OF BALANCE OF PAYMENTS

"The balance of payments of a country is a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period of time" (Kindle Berger), The term ‘systematic record’ refers to the system generally adopted in double entry book-keeping system. ‘Economic transaction’ includes all such transactions that involve the transfer of title or ownership.

The balance of payments records the flow of economic transactions between the residents of a given country and the residents of other countries during a certain period of time. 

·        This record shows transactions in goods, services and income between an economy and the rest of the world, changes in ownership and other changes in that economy’s monetary god.

·         Special Drawing Rights (SDRs) and claims on the liabilities to the rest of the world. Capital transfers and unrequited transfers and counterpart entries that are needed to balance any entries for the foregoing transactions and changes that are not mutually offsetting.

PURPOSES OF BALANCE OF PAYMENTS

The balance of payments fulfills a very useful purpose in so far as it provides necessary information for the formulation of domestic monetary, fiscal and foreign trade policies. The important uses of BOP accounts may be enumerated as below:

• Provides an extremely useful data for the economic analysis of the country’s weakness and strength as a partner in international trade.
• A comparison of the statements of BOP for several successive years can indicate the improvements or deterioration in international economic position of the country. In case of any deterioration, necessary corrective measures can be taken.
• Reveals the changes in the composition and magnitude of foreign trade. The changes that are deterrent to the economic well being of the country require necessary action by the government. For example, a regular outflow of capital or export of essential goods causing scarcity on the domestic market needs to be curbed through policy measures or direction action.
• Indicates future repercussions of a country’s past trade performance. If balance of payments shows continuous and large deficit overtime, it shows the growing international indebtedness of the country that may ultimately lead to financial bankruptcy.
• Reveals the strengths and weaknesses in the country’s foreign trade relations and thereby inviting government attention to the need for corrective measures against the weak spots and unhealthy developments.

STRUCTURE OF BALANCE OF PAYMENTS

The economic transactions taking place between a country and the rest of the world may be divided under two broad categories:

(i)                 Current transactions and

(ii)               Capital transactions

CURRENT ACCOUNT

The current account records the net flow of goods, services and unilateral transfers. In India, the current account of the balance of payments records India’s total transactions in merchandise, services and transfers with the rest of the world. A surplus on current accounts means an acquisition of assets or repayment of debts previously contracted. Similarly, a deficit involves a withdrawal of previously accumulated assets or borrowing from abroad.

The items entered in the current account of the balance of payments are shown in Table 1, in the order of their importance. The credit side has values receivable and in debit side are the values payable. The net balance shows the excess of credit over the debit for each item; it may be negative or positive

The items of the Current Account can further be categorized as:

·         Visible items and

·         Invisible items.

• 1        Merchandise trade, i.e. export and import of goods, falls under the visible items.
  2.   All other items in the current account i.e. payment and receipt for the services such as insurance, banking and shipping etc. are known as invisible.
  3.      Items like gifts, donations, technical assistance etc. are dealt with as ‘un-required transfer as they involve unilateral transfers.
  4.      The net balance on the visible items is called balance of trade. 
  5.      If export of merchandise is greater than import of merchandise, the balance of trade is said to be favorable, in the reverse situation the balance of trade is said to be unfavorable. The overall balance on the Current Account- surplus or a deficit is carried over to the Capital Account.
  
  CAPITAL ACCOUNT
  The items recorded in the Capital Account of the balance of payments are those that affect the existing stock of capital of the country. The capital account items are broadly of three categories.
  
  
  (a)    Short term capital movement;
  (b)   Long term capital movements; and
  (c)    Changes taking place in the gold and exchange reserves.
  
  
  (a)   Short-term capital movements
  Short term capital movements comprise purchase of short-term securities; speculative purchase of foreign currency; and  cash balances held by foreigners for such reasons as fear of war, political instability etc. Another item of short-term capital is the net balances (positive or negative) in the Current Account. 
  (b) Capital movements for the long term include:  
  1. Direct investments in shares, bonds and in real estate and physical assets such as plant, building, equipments etc., in which investors hold a controlling power
  2. Portfolio investments in stocks and bonds.
  3. Amortization of capital which means repurchase and resale of securities earlier sold to or purchase from the foreigners. The category of direct investment covers direct export or import of capital goods. and are treated as such import of capital and that of merchandise is their contrasting effect on the economy. Export of goods results in inflow of foreign currency which is an addition to the circular flow of money, whereas export of capital takes place in outflow of foreign exchange amounting to withdrawal from the foreign exchange reserves.
  
  
  © Gold and foreign exchange reserves constitute the third component of items in the capital account. In order to stabilize the exchange rate of the home currency and to make payments to the creditors in case there are payment deficits on all other accounts gold and foreign exchange reserves are maintained. Export of capital is a debit item and import of capital is a credit item whereas export of merchandise is a credit item and import of merchandise is a debit term. The reason for this contrasting treatment of export and
  
  
  Balance of Payments Accounts are Always in Balance
  The Double-entry book keeping system is the basis of the balance of payments accounting in which both sides of a transaction receipts and payments are recording. For example, imports involve inflow of goods and outflow of foreign currency, export involve outflow of goods and inflow of foreign currency. Balance of Payments records both inflow and outflow. International borrowing and lending give rise to credit to the lender and debit to the borrower. Balance of payments records both. However, donations, gifts, aids, assistance, etc., are unilateral transfers and do not involve transfer of an equivalent value. In regards to these items there is only give, no take. Yet the receiving country is debited to keep the record of non-refundable amounts or values and donor is credited for the record purposes. These entries possess information value for other than economic purposes. Further, these transactions reduce the deficit, if any, in the Current Account of the receiving country. Since in this system of BOP accounting international transactions are entered on both debit and credit sides. Thus BOP accounts are always in balance.
  DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS
      There are a number of factors that cause disequilibrium in the balance of payments. A deficit kind of disequilibrium in the balance of payments arises when a country’s autonomous payments are greater than its autonomous receipts. The autonomous payments arise due to import of goods and services and export of capital. In the same manner, autonomous receipts arise from the merchandise export and import of capital. Therefore, disequilibrium of deficit nature arises when total imports exceed total exports. But a host of other factors determine the volume of imports and exports. Here, we will discuss three causes of BOP disequilibrium:
  
  
  1.      Changes in Prices
  A change in the price level is a major cause balance of payments in disequilibrium. The variation in the price level may cause either inflation or deflation. Deflationary changes in the price level normally cause a surplus in the balance of payments which is not a matter of serious concern from the surplus country’s viewpoint. However, it may be lead to wasteful expenditure and misallocation of resources. The inflation changes in the prices cause deficits in the BOP which results in increased indebtedness, reduction of gold reserves, loss of employment, disturbances in the domestic economy and cause other economic problems in the deficit countries.
  
  
       Inflationary changes in the price level make a change in the relative prices of imports and exports. Imports become cheaper and exports become costlier. Therefore, exchange rate remaining the same, inflation increases imports because domestic prices become comparatively higher than the import prices. On the other side, inflation causes a decrease in export because of fall in foreign demand due to increase in domestic prices.
  
  
  2.      Business Cycles and Cyclical Disequilibrium
  Economic ups and downs characterize the business cycles that are often associated with inflationary rise or deflationary decline in the general price level. These ups and downs do lay an effect on the balance of payments. The price changes may be local, regional or global in nature. If price fluctuations take the form of a business cycle, most countries face inflation or deflation almost simultaneously.  But since the economic size of the nations differs, their imports are affected in varying degrees. Deficits and surpluses in the balance of payments vary from moderate to large. The higher marginal propensity to import is associated with larger deficits during inflationary phase of a business cycle and moderate deficit, or even a surplus during the period of depression. Such disequilibria are known as cyclical disequilibria.
  
  
  3.      Structural Disequilibrium
  Factors such as depletion of the cheap natural resources, technological changes with which a country is not in a position to keep pace, i.e. technology lag, and change in consumer’s taste and preference make structural changes in an economy which cause inefficiency and high cost in the exporting countries. They may find it difficult to face the competition in the international market, due to either high cost of production or lack of foreign demand. For example, the gradual exhaustion of better coal seams in Great Britain resulted in increased cost of coal production despite technology improvement. This factor along with labor problems made Great Britain from a net coal-exporting nation to a net-importing one. All such changes bring about a change in demand and supply conditions. If the size of foreign trade is fairly large, then the BOP is adversely affected. The ultimate result is structural disequilibrium.
  
  
  4.      Other Factors
  There are certain other factors that may cause temporal disequilibrium. Some of them are:
  
  • Crop failure particularly in countries producing primary goods may cause temporal disequilibrium.  India faced deficits in her BOP during the 1950s and 1960s due to this factor.
  • Rapid growth in population resulting in large scale imports of food grains and wage goods.
  • Ambitious development projects requiring heavy imports of technology, equipment, machinery and technical know-how.
  • Advanced countries exercise demonstration-effect on the consumption pattern of less developed countries may also result in disequilibrium.
  
  
  CORRECTION OF DISEQUILIBRIUM:
  When serious disequilibrium arises in a country’s balance of payments, steps must be taken to correct if, if the country’s economy is to be kept in a sound condition.  The following mechanisms are commonly applied for correction of disequilibrium in the balance of payments:
  
  
  (a)   Income and Expenditure Policies
  Demand for goods and services may be reduced through affecting a change in its main determinants, viz. income and price. A reduction in income can lead to reduction in demand and reduce the deficit in the balance of payments. Monetary and Fiscal Policies are the two policy tools that can affect changes in disposable income. Monetary policy operates on the demand for and supply of money while fiscal policy operates on the disposable income of the people. Bank rate policy, open market operations, statutory reserve ratio, and selective credit controls are the main instruments of monetary policy. Bank rate policy and open market operations are generally adopted in the context of balance of payments. Fiscal policy as a tool of changing household incomes includes variation in taxation and public expenditure.
  
  
  
  (b)    Stimulating exports and/or discouraging imports
  If the imports exceed exports, efforts should be made to encourage exports. To encourage exports the levels of costs in the country may have to be brought down. This may involve cutting down of wages and interest rates and other incomes and also contraction of currency to bring the prices down. Exports are also encouraged by granting bounties to manufacturers and exporters. Imports may be discouraged either by total prohibition or by imposition of import duties or by adopting the quota system.
  
  
  
  (c)    Depreciation of External Value
  Another method is to depreciate the external value of the home currency. This makes domestic goods cheaper for the foreigner. However, this course has serious limitation, because other countries may also follow the same course and competitive depreciation of exchange rates may begin, as it happened during the depression years in the thirties.
  
  
  
  (d)   Deflate the currency
  The third method is to deflate the currency. As currency contracts, prices begin to fall. This will stimulate exports and restrict imports.  But the course of deflation is also not free from risks. If prices are brought down while costs do not come down, the country may face a serious depression and unemployment.  Once disequilibrium has taken place correcting the balance of payments is not an easy matter.
  
  
  (e)    Devaluation
  Devaluation has the same effects as that of depreciation. When a currency is devalued its value in terms of foreign currency increases. The consequence is that foreigners are able to buy more goods than before with the same amount of their currency. This would encourage exports and discourage imports as foreign goods have become dearer. Thus in the course of time, the balance of trade turns in our favor and corrects the balance of payments.
  
  
  
  (f)    Exchange Control
  Exchange control may be partial, or total depending on the requirement of the country. In exchange control all the exporters are ordered to surrender their foreign exchange to the central bank, and it is then rationed out among the licensed importers.  No one else is allowed to import goods without a license. The balance of payments is thus rectified by keeping the imports within limits.