Balance Of PaymentsGeneral information & overview

Anjana KArun TKapil JRaju JSagar V

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Appendix

Introduction

Structure of Balance of Payments

Disequilibrium in the balance of payments

Causes of disequilibrium

Methods of correcting BOP disequilibrium

QA

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Introduction

IMF definition: Balance of payments is a statistical statement that summarizes transactions between residents non residents during a period.

Kindleberger definition: Balance of payments are “systematic records of all economic transactions between one country and rest of the world.

– Balance of payments is a statement of systematic record of all economic transactions between one country and rest of the world.

– It adopts a double entry book-keeping system with two sides. Debit and credit. Payments are recorded on the debit side and receipts on the credit side.**

– Broadly, it contains three sets of accounts: 1) Current account 2) Capital account 3) Financial account**

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Balance of Payments components Current A/c: It is a goods & services account.

– Current A/c = (Balance of trade + Net factor income from abroad + Net unilateral transfers from abroad)

Financial A/c: It involves transactions that involve financial assets and liabilities.

Financial A/c = (Increase in foreign ownership of domestic assets - Increase in foreign ownership of domestic assets)

= (FDI + Portfolio investment + Other investment).

Foreign exchange reserves: This is official international reserve held by government established central bank. These include official gold reserves, foreign currencies, IMF special drawing right (SDR) & other foreign assets.

Capital A/c: Capital accounts are investments over longer period of time. It involves exchange of migrant’s assets, foreign aid capital & intellectual property.

Net errors & omissions: Errors are common to occur due to complexity of the calculations and difficulty in obtaining results. Omissions are rarely used by governments to conceal transactions.

BOP Identity…

( X – M ) = Ko – Ki

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Current Account – General information

Current accounts mainly consists of two groups…

– Merchandise or trade account.

– Invisible account.

In trade or merchandise account, all PHYSICAL goods exported and imported are recorded.

Invisible account consists of services account and the gifts & charities account.

– Services account entries could be banking and insurance charges, interest on loans, tourist expenditure, transport charges etc.

– Gifts & Charities accounts consist of all those items which are received or given away free by residents of the nation. It may be physical goods or cash.

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Current account – Invisible account

IMF includes following items in the invisible account:

International transportation of goods including warehousing, in transit and other transit expenses.

Travel for reasons of business, education, health, international conventions or pleasure.

Insurance premiums and payments of claims.

Investment income, including interest, rents, dividends and profits.

Miscellaneous service items such as advertising, commissions, film rental, pensions, patent fees, royalties, subscriptions to periodicals and membership fees.

Donations, migrant remittances and legacies.

Repayment of commercial credits.

Contractual amortization and depreciation of direct investment.

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Capital Account

Capital account deals with payments of debts and claims.

It consists of those components of Imports & exports such as Private balances, Assistance by international institution agencies, Specie flow & Balances held on government account.

Summary of BOP is…

Current account and capital account should necessarily balance each other.

– If India’s imports of goods are more than its exports, then it will have a deficit in its current balance of payments.

– India will have to pay either in gold and other assets or by borrowing from other countries.

Microsoft Excel Worksheet

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Distinction between Balance of trade & Balance of Payments Balance of trade refers to the trade of Visible items only.

Balance of payments include all international economic transactions of visible and non visible items.

Import and export of GOODS is a visible item.

Whereas services, banking, insurance, capital flows, buying and selling of gold etc. are non visible items.

Balance of trade is partial study of Balance of payments. It simply refers to the difference of value of exports and visible import.

Thus, balance of trade is nothing but a major components of the balance of payments.

In short, balance of trade is a partial picture, while balance of payments is a complete picture of country’s international economic relations.

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Balance of Payments always balances

Balance of payments is based on a system of double entry of book keeping.

If all entries are made correctly, total debits must equal total credits.

Balance of Payments…Example

Microsoft Office Excel Worksheet

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Disequilibrium in the Balance of Payments

B = R – P

Where, B stands for balance of payments,

R denotes receipts from foreigners,

P stands for payments made to foreigners

A country whose balance of payments is positive is called as surplus country.

A country whose balance of payments is negative is called as deficit country.

Types of disequilibrium

– Cyclical disequilibrium.

– Structural disequilibrium.

– Short run disequilibrium.

– Long – run or secular disequilibrium

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Types of Disequilibrium

Cyclical disequilibrium: It occurs on account of trade cycles. Cyclical fluctuations in demand are caused by changes in Income, employment, output & price.

– Trade cycles follow different paths and patterns in different countries. There are no identical timings and periodicity of occurrence of cycles in different countries.

– No identical stabilization programmes and measures are adopted by different countries.

– Income driven demand for imports in different countries are not identical.

– Price driven demand for imports differ in different countries.

Structural disequilibrium: It is caused because of fluctuation in the demand based on changes in tastes, fashions, habits, income, economic progress etc.

– Structural changes are also produced by variations in the rate of international capital movements.

– Other causes are due to crop failure in prime commodities, shortage of raw materials, labor strikes etc. leads to reduction in Export.

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Type sof disequilibrium Short – run disequilibrium: When a country borrows or lends

internationally, it will have short run disequilibrium, as these are usually for short period.

– Short run disequilibrium may also emerge if a country’s exceeds its exports in a given year. It is a temporary one, because later on country will be in a position to correct it easily by importing more.

– Still this disequilibrium can not be justified as it may lead to Long – term disequilibrium. A persistent deficit will tend to reduce its foreign exchange reserves and country may not be able to raise any more loans from foreigners.

Long run disequilibrium: It occurs because of accumulation of deficits or surpluses over a long period.

– IMF uses the term ‘fundamental disequilibrium’ to describe a persistent, long run disequilibrium. It is mainly due to deficits which exist continuously for a long period of time in a country’s balance of payments.

– Unchecked series of short run disequilibria lead to the fundamental disequilibrium in long run.

– It is caused by persistent deep rooted dynamic changes which slowly takes place in the economy.

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Causes of disequilibrium

Trade cycle: Cyclical fluctuations, their phases and amplitudes, differences in different countries, generally produce cyclical disequilibrium.

Huge development & investment programmes:

– Due to huge development and investment programs , Import goes on increasing for want of capital for rapid industrialization, while exports may not be boosted up to that extent as these are the primary producing countries.

– Thus, there will be structural changes in the balance of payments and structural equilibrium will result.

Changing Export demand:

– A vast increase in the domestic production of foodstuffs, raw materials, substitute goods, etc. in advanced countries has decreased their need for import from the underdeveloped countries. Hence, export demand has considerably changed resulting in structural disequilibrium.

– Similarly, developed countries will loose their market share in underdeveloped countries, owing to the tendency of underdeveloped nations to self relaince.

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Causes of disequilibrium

Population growth: High population growth in poor countries ahs adverse impact on their balance of payments. Increase in the population increases the needs of these countries for imports and decreases the capacity of export.

Huge external borrowing: A country will have adverse balance of payments when it borrows heavily from another country, while the lending country will have a favorable balance and a deficit balance of payments.

Inflation: Rapid economic development, increase in the income & price will adversely affect BOP position of a developing country.

– With increase in income, import requirements will get increased. Also consumption of the domestic production will be fast. This leads to increase in Import and decrease in export.

– Also huge investment in heavy industries in the developing countries may have an inflationary impact, as the output of these industries will not be forthcoming immediately, whereas money income will have been already increased.

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Causes of disequilibrium

Demonstration effect: When people of underdeveloped nations come into contact with those of advance countries through economic, political or social relations there will be a demonstration effect on the consumption pattern. It will increase need for import whereas their export quantum remains same.

Reciprocal demands: Need of reciprocal demand for products of different countries differs leading terms of trade of a country may be set differently with differently with different countries under multi trade transactions. Which may lead to disequilibrium.

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Methods of correcting BOP disequilibrium

The various measures used for correcting an adverse balance of payments are of two kinds:

– Monetary measures

– Non monetary measures

Monetary measures.

– Deflation

– Exchange depreciation.

– Devaluation.

– Exchange control.

Non-Monetary measures

– Tariff – import duties.

– Import quotas

– Export promotion policies and programmes.

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Correcting BOP disequilibrium (Monetary) Deflation.

– Generally, deficit in the BOP occurs due to high imports and low exports.

– In this situation, country may adopt deflationary or dear money policy by raising interest rates and restricting credit.

– Thus, prices of domestic goods fall which makes exports attractive and imports relatively costlier.

– Deflation keeps exchange rates unaffected and tries to correct the deficit in the BOP through domestic changes.

– In short, deflation being inexpedient, its side effects are dangerous to a poor country. It creates more unemployment and poverty.

Exchange Depreciation.

– This is a correcting method in which “external value of the home currency” is depreciated.

– Exchange depreciation of a country will tend to cheapen its domestic goods for the foreigners so that its exports will be boosted, while its imports will be costlier.

– The success of this method hugely depends on the cooperation of the foreigners. If all countries start depreciating their exchange rates then the technique may not prove useful.

– This method is not feasible under the present system of IMF of fixed exchange rate system.

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Correcting BOP disequilibrium (Monetary) Devaluation.

– Devaluation is Official decrease in the external value of a currency or good.

– Exchange depreciation is based on the market mechanism whereas devaluation is arbitrary.

– Devaluation is undertaken when the currency is found to be unduly overvalued.

– If a country has persistent deficit in its BOP, it may devalue its currency with the permission of IMF.

– Once a country’s currency is devalued its exports become cheaper to foreigners and imports become relatively dearer.

Conditions for successful working of devaluation.

– A fairly elastic demand.

– Structure of exports and imports.

– Domestic price stability.

– International cooperation.

– Coordination of other measures.

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Correcting BOP disequilibrium (Monetary)

Exchange control.

– Restrictions on the use of foreign exchange by central banks are called “exchange controls”.

– During exchange control, all the exporters have to surrender their foreign exchange earnings to the central bank.

– Under exchange control, the central bank releases foreign exchanges only for essential imports and conserves the rest of the balance.

– An exchange control offers no permanent solution to the problem of persistent disequilibrium.