Balance of Payments The Balance Of Payments of a country is a systematic record of all economic transactions between the residents of a country

y and the rest of the world. It presents a classified record of all receipts on account of goods exported, services rendered and capital received by residents and payments made by them on account of goods imported and services received from the capital transferred to non-residents or foreigners. Reserve Bank of India (RBI)

Features of BOP Systematic records-It is the systematic records of receipts and payment of a country with other countries. Fixed period of time-It is a statement of account pertaining to a given period of time usually say one year. Comprehensiveness- It includes all the three items i.e. visible invisible and capital system. Double entry systems- Receipts and payments are recorded on the basis of double entry system. Adjustment of differences- whenever there is difference in actual total receipt and payment need for necessary adjustment is felt. All items- government and non government BOP includes receipts and payment of all items- government and non government.

Importance of BOP The BOP is an important indicator of pressure on a countrys foreign exchange rate . The BOP helps to forecast a countrys market potential, especially in the short run. Changes in a countrys BOP may signal the imposition or removal of controls over payment of dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors

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Components of BOP Current account Capital account & Financial account Reserves and related items: official reserve account Net errors and omissions account

Current Account Current account covers the transactions other than those in financial items that involve economic values and occur between resident and nonresident entities. Net export/import of goods (trade balance) Net export/import of services Net income (investment income from direct and portfolio investment plus employee compensation) Net transfers (sums sent home by migrants and permanent workers aboard, gifts, grants and pensions) BOP on current account= (visible+invisible exports)-(visble+invisible imports) components of the current account: goods, services, income and current transfers.

Goods - These are movable and physical in nature, and in order for a transaction to be recorded under "goods", a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out). Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit).

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Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production. The following variables go into the calculation of the current account balance (CAB): X = Exports of goods and services M = Imports of goods and services NY = Net income abroad NCT = Net current transfers The formula is: CAB = X - M + NY + NCT The Capital and Financial Accounts Along with transactions pertaining to non-financial and non-produced assets, the capital account relates to dealings including debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties and uninsured damage to fixed assets.

Direct investment Basic data are obtained from the exchange control records, but information on noncash inflows and reinvested earnings is taken from the Survey of Foreign Liabilities and Assets, supplemented by other information on direct investment flows. Up to 1999/2000, direct investment in India and direct investment abroad comprised mainly equity flows. From 2000/2001 onward, the coverage has been expanded to include, in addition to equity, reinvested earnings, and debt transactions between related entities. The data on equity capital include equity in both unincorporated business (mainly branches of foreign banks in India and branches of Indian banks abroad) and incorporated entities. Because there is a lag of one year for reinvested earnings, data for the most recent year (2003/2004) are estimated as the average of the previous two years. However, as
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intercompany debt transactions were previously measured as part of other investment, the change in methodology does not make any impact on India's net errors and omissions. Portfolio investment Basic data are obtained from the exchange control records. These are supplemented with information from the Survey of Foreign Liabilities and Assets. In addition, the details of the issue of global depository receipts and stock market operations by foreign institutional investors are received from the Foreign Exchange Department, RBI.

Other investment Most of the information on transactions in other investment assets and liabilities is obtained from the exchange control records, supplemented by information received from the departments of the RBI and various government agencies. Entries for transactions in external assets and liabilities of commercial banks are obtained from their periodic returns on foreign currency assets and rupee liabilities. Data on nonresident deposits with resident banks are obtained from exchange control records, the survey of unclassified receipts, and information submitted by the relevant banks to the RBI. Reserve assets Transactions under reserve assets are obtained from the records of the RBI. They comprise changes in its foreign currency assets and gold, net of estimated valuation changes arising from exchange rate movement and revaluations owing to changes in international prices of bonds/securities/gold. They also comprise changes in SDR balances held by the government and a reserve tranche position at the IMF, also net of revaluations owing to exchange rate movement.

Officials Reserve Account - The official reserve account records the change in stock of reserve assets (also known as foreign exchange reserves) at the country's monetary authority . Frequently, this is the responsibility of a government established central bank. Reserves include official gold reserves, foreign exchange reserves, IMF Special Drawing Rights (SDRs), or nearly any foreign property held by the monetary authority all denominated in domestic currency. Changes in the official reserve account equal the differences between the capital account and current account (and errors & omissions) by accounting identity and are mostly composed of foreign exchange interventions and deposits into international organizations such as the IMF; the magnitude of these changes will depend upon monetary policy and government mandate.

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Net errors and omissions- This is the last component of the balance of payments and principally exists to correct any possible errors made in accounting for the three other accounts. These errors are common to occur due to the complexity of the calculations and difficulty in obtaining measurements. Omissions are rarely used usually by governments to conceal transactions. They are often referred to as "balancing items".

Though the credit and debit are written balanced in the balance of payment account, it may not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of surplus.

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Reasons for Adverse Balance of Payment 1. Population Growth Most countries experience an increase in the population and in some likeIndia and China the population is not only large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may increase as population increases.

2. Development Programmes Developing countries which have embarked upon planned development programmes require to import capital goods, some raw materials which are not available at home and highly skilled and specialized manpower. Since development is a continuous process, imports of these items continue for the long time landing these countries in a balance of payment deficit. 3. Demonstration Effect When the people in the less developed countries imitate the consumption pattern of the people in the developed countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the balance of payments.

4. Natural Factors Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial production in the country. The exports may decline while the imports may go up causing a discrepancy in the country's balance of payments.

5. Cyclical Fluctuations Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments.

6. Inflation An increase in income and price level owing to rapid economic developmentin developing countries, will increase imports and reduce exports causing a deficit in balance of payments.

7. Poor Marketing Strategies The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the developing countries have pushed them into huge deficits.

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8. Flight Of Capital Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing countries may also shift their capital to developed countries to safeguard against political uncertainties. These capital movements adversely affect the balance of payments position.

9. Globalisation Due to globalisation there has been more liberal and open atmosphere for international movement of goods, services and capital. Competition has beer increased due to the globalisation of international economic relations. The emerging new global economic order has brought in certain problems for some countries which have resulted in the balance of payments disequilibrium.

A number of factors may cause disequilibrium in the balance of payments. These causes may be broadly categorised into 1Economic factors

i. Development Disequilibrium Large scale development expenditures usually increase the purchasing power, aggregate demand and prices, resulting in substantially large imports. The development disequilibrium is common in developing countries, because the above factores, and large scale capital goods imports needed for carrying out the various development programmes, give rise to a deficit in the balance of payments.

ii. Capital Disequilibrium Cyclical fluctuations in general business activity are one of the prominent reasons for the balance of payments disequilibrium. As Lawrance W. Towle points out, depression always brings about a drastic shrinkage in world trade, while prosperity stimulates it. A country enjoying a boom all by itself ordinarily experiences more rapid growth in its imports than its exports, while the opposite is true of other countries. But production in the other countries will be activated as a result of the increase exports to the boom country.

iii. Secular disequilibrium Sometimes, the balance of payments disequilibrium persists for a long time because of certain secular trends in the economy. For instance in a developed country, the disposal income is generally very high and, therefore, the aggregate demand, too, is very high. At the same time, production costs are very high because of the higher wages. This naturally results in higher prices. These two factors-high domestic prices may result in the imports being much higher than the exports. This could be one of the reasons for the persistent balance of payments deficits of the USA.

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iv. Structural disequilibrium Structural changes in the economy may also cause balance of payments disequilibrium. Such structural changes include the development of alternative sources of supply, the development of better substitutes, the exhaustion of productive resources, the changes in transport routes and costs, etc. 2. Political Factors Certain political factors may also produce a balance of payment disequilibrium. For, instance a country plagued with political instability may experience large capital outflows, inadequacy of domestic investment and production, etc. These factors may sometimes, cause disequilibrium in the balance of payments. Further factors like wars, changes in world trade routes, etc. may also produce balance of payments difficulties. 3. Social Factors Certain social factors may also produce a balance of payments. For instance, changes in tastes, preferences, fashion, etc. may affect imports and exports and thereby affect the balance of payments

Remedies for Adverse Balance of Payment Solution to correct balance of payment disequilibrium lies in earning more foreign exchange through additional exports or reducing imports. Quantitative changes in exports and imports require policy changes. Such policy measures are in the form of monetary, fiscal and nonmonetary measures.

Monetary Measures for Correcting the BoP The monetary methods for correcting disequilibrium in the balance of payment are as follows :-

1. Deflation Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium. A country faces deficit when its imports exceeds exports. Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting a rise in our exports. At the same time the demands for imports fall due to higher taxation and reduced income. This would built a favourable atmosphere in the balance of payment position. However Deflation can be successful when the exchange rate remains fixed.

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2. Exchange Depreciation Exchange depreciation means decline in the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy. Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with regard to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange may be say $1 = Rs. 50. This means 25% exchange depreciation of the Indian currency. Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.

Limitations of Exchange Depreciation : Exchange depreciation will be successful only if there is no retaliatory exchange depreciation by other countries. It is not suitable to a country desiring a fixed exchange rate system. Exchange depreciation raises the prices of imports and reduces the prices of exports. So the terms of trade will become unfavourable for the country adopting it. It increases uncertainty & risks involved in foreign trade. It may result in hyper-inflation causing further deficit in balance of payments.

3. Devaluation

Devaluation refers to deliberate attempt made by monetary authorities to bring down the value of home currency against foreign currency. While depreciation is a spontaneous fall due to interactions of market forces, devaluation is official act enforced by the monetary authority. Generally the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the value of Indian currency has been reduced by 18 to 20% in terms of various currencies. The 1991 devaluation brought the desired effect. The very next year the import declined while exports picked up. When devaluation is effected, the value of home currency goes down against foreign currency, Let us suppose the exchange rate remains $1 = Rs. 10 before devaluation. Let us suppose, devaluation takes place which reduces the value of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At the same time, imports UNIT 1 International Financial Management

become costlier as Indians have to pay more currencies to obtain one dollar. Thus demand for imports is reduced. Generally devaluation is resorted to where there is serious adverse balance of payment problem.

Limitations of Devaluation : Devaluation is successful only when other country does not retaliate the same. If both the countries go for the same, the effect is nil. Devaluation is successful only when the demand for exports and imports is elastic. In case it is inelastic, it may turn the situation worse. Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country. Devaluation may bring inflation in the following conditions : Devaluation brings the imports down, When imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleash inflationary trends. A growing country like India is capital thirsty. Due to non availability of capital goods in India, we have no option but to continue imports at higher costs. This will force the industries depending upon capital goods to push up their prices. When demand for our export rises, more and more goods produced in a country would go for exports and thus creating shortage of such goods at the domestic level. This results in rising prices and inflation. Devaluation may not be effective if the deficit arises due to cyclical or structural changes.

4. Exchange Control It is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their foreign exchange to the central authority. Thus it leads to concentration of exchange reserves in the hands of central authority. At the same time, the supply of foreign exchange is restricted only for essential goods. It can only help controlling situation from turning worse. In short it is only a temporary measure and not permanent remedy

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Non-Monetary Measures for Correcting the BoP A deficit country along with Monetary measures may adopt the following non-monetary measures too which will either restrict imports or promote exports.

1. Tariffs Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports would increase to the extent of tariff. The increased prices will reduced the demand for imported goods and at the same time induce domestic producers to produce more of import substitutes. Non-essential imports can be drastically reduced by imposing a very high rate of tariff. Drawbacks of Tariffs : Tariffs bring equilibrium by reducing the volume of trade. Tariffs obstruct the expansion of world trade and prosperity. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of payment position are uncertain. Tariffs seek to establish equilibrium without removing the root causes of disequilibrium. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a country already having a surplus. Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.

2.Quotas Under the quota system, the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the deficit is reduced and the balance of payments position is improved.

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Types of Quotas : the tariff or custom quota, the unilateral quota, the bilateral quota, the mixing quota, and import licensing.

Merits of Quotas : Quotas are more effective than tariffs as they are certain. They are easy to implement. They are more effective even when demand is inelastic, as no imports are possible above the quotas. More flexible than tariffs as they are subject to administrative decision. Tariffs on the other hand are subject to legislative sanction. Demerits of Quotas : They are not long-run solution as they do not tackle the real cause for disequilibrium. Under the WTO quotas are discouraged. Implements of quotas is open invitation to corruption.

3.Export Promotion The government can adopt export promotion measures to correct disequilibrium in the balance of payments. This includes substitutes, tax concessions to exporters, marketing facilities, credit and incentives to exporters, etc. The government may also help to promote export through exhibition, trade fairs; conducting marketing research & by providing the required administrative and diplomatic help to tap the potential markets.

4. Import Substitution

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A country may resort to import substitution to reduce the volume of imports and make it selfreliant. Fiscal and monetary measures may be adopted to encourage industries producing import substitutes. Industries which produce import substitutes require special attention in the form of various concessions, which include tax concession, technical assistance, subsidies, providing scarce inputs, etc. Non-monetary methods are more effective than monetary methods and are normally applicable in correcting an adverse balance of payments. Drawbacks of Import Substitution : Such industries may lose the spirit of competitiveness. Domestic industries enjoying various incentives will develop vested interests and ask for such concessions all the time. Deliberate promotion of import substitute industries go against the principle of comparative advantage.

Capital account convertibility Capital Account Convertibility refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. It is associated with changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. Convertibility is an IMF clause that all the member countries must adhere to in order to work towards the common goals of the organization. However CONVERTIBILITY per se can be looked into from various perspectives and incorporated accordingly by the member nations. An economy can choose to be (a) partially convertible on CURRENT ACCOUNT (b) partially convertible on CAPITAL ACCOUNT (c) fully convertible on current account and (d) fully convertible on capital account. It is important to state here that The IMFs mandate is conspicuous on current account convertibility as current account liberalization is among the IMFs official purposes outlined in its Articles of Agreement, but it has no explicit mandate to promote capital account liberalization. Indeed, the Articles give the IMF only limited jurisdiction over the capital account however the IMF has given greater attention to capital account issues in recent decades, given the increasing importance of international capital flows for macroeconomic stability and exchange rate management in many countries. Thus there is no official binding over any member state to opt for FULL CAPITAL ACCOUNT CONVERTIBILTY but it has been a constant component of the IMFs advisory reports on member countries.

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