UNIT 4 INTERNATIONAL FINANCIAL

FLOWS

International Financial
Flows

After going through this unit, you should be able to:

understand different types of international financial flows

record the international financial flows in a prescribed-format statement known

as the balance of payments

understand the nature of equilibrium and disequilibrium in the balance of

payments

make adjustment in case of disequilibrium

enumerate recent trends in India's balance of payments

Structure
4.1

Introduction

4.2

Forms of International Financial Flows

4.3

Structure of Balance of Payments

4.4

Equilibrium, Disequilibrium and Adjustment

4.5

India's Balance of Payments during the Period of Economic Reform

4.6

Summary

4.7

Self Assessment Questions

4.8

Further Readings

UNIT 4.1

INTRODUCTION

Funds flowing into, or out of, a country on account of various types of international
transactions are recorded by the monetary authorities of that country in a prescribed
statement that is known as the balance of payments. You find an individual
maintaining an account of his/her cash receipts and payments. A company prepares a
cash-flow statement that shows incoming and outgoing of cash. Similarly, a country
records the inflows and outflows of funds in a statement known as the balance of
payments. In other words, balance of payments is a statement that records all
different forms of funds inflow and outflow and arrives at a conclusion whether there
Is a net inflow in the country / outflow out of the country influencing, in turn, the
foreign exchange reserves possessed by the country.
Thus any discussion of the balance of payments embraces the explanation of what the
different forms of international financial flows are and how they are recorded in the
balance of payments. It also involves the discussion of whether the balance of
payments experiences any disequilibrium, and if it is there, what would be the ways to
make necessary adjustments. These issues form the subject-matter of the present unit.
However, the learners shall be acquainted with the recent trends in India's balance of
payments in order to make the discussion even more meaningful.

4.2

FORMS OF INTERNATIONAL FINANCIAL FLOWS

The various types of transactions leading to international financial flows need some
discussion here. Trade flows, invisibles, foreign direct and portfolio investment,
external assistance and external commercial borrowings and some short-term flows

39

International Financial
Environment

Merchandise Trade Flows

Trade may be related to goods. Alternatively, it may be related to services. The
merchandise trade has two sides. While one is export, the other is import. If India
exports various goods, it will get convertible currencies and that will be an inflow of
funds. On the contrary, it has to make payments in convertible currencies for the
imports it makes. Thus export and import of goods lead to international financial
flows.
Invisibles
Invisibles include, broadly, trade in services, investment income and unilateral
transfers. If an Indian shipping company carries goods of a foreign exporter/importer
and gets the freight charges, it will be treated as inflow of funds on account of trade
in services. Similarly, if a foreign shipping company carries goods of an Indian
exporter, there will be outflow of funds in form of freight charges. There are many
examples of international flow of funds on account of trade in services.
Investment income relates to the receipt and payment of dividend, technical service,
fees, royalty, interest on loan, etc. A foreign company operating in India remits
dividend, etc. to its home country that will represent an outflow of funds. Similarly,
an Indian company operating abroad remits to India the dividend and other fees that
will represent inflow of funds. Likewise, payment of interest on foreign borrowings
represents outflow of funds. Any receipt of interest manifests in inflow of funds.
Unilateral transfers are unidirectional. They represent international financial flows
without any services rendered. If an Indian makes a gift to his/her friend in England,
it will be a case of outflow of funds on account of unilateral transfer. Similarly, a
large number of Indians living abroad remit a part of their income to their family
members living in India. This is a case of inflow of funds on account of unilateral
transfer.
Foreign Investment
Foreign investment may be of two kinds. While one is direct, the other is portfolio.
Foreign direct investment (FDI) occurs when a firm moves abroad for the production
of goods or provision of services and participates in the management of that company
located abroad. On the contrary, foreign portfolio investment (FPI) is not at all
concerned with the production of goods and rendering of services. The sole purpose
of a foreign portfolio investor is to earn a return through investment in foreign
securities without any intention of grabbing the voting power in the company
whose securities it purchases. In case of FDI too, an investor invests in the shares
of a foreign company, but the sole objective is to enjoy the voting power and thereby
a say in the management of the foreign company. Thus, it is primarily the voting
right that differentiates between FDI and FPI.
Whatever the forms may be, inflow of fiends occurs when a foreign investor makes
investment in the country. On the contrary, outflow of funds occurs when the
domestic investor invests in a foreign country.
External Assistance and External Commercial Borrowings

40

External assistance and external commercial borrowings are different in the sense
that while the former flows normally from an official institution -bilateral or
multilateral, the latter flows from international banks or other private lenders. The
rate of interest in the former is usually low along with a longer maturity period. The
latter carries market rate of interest and a shorter maturity. Last but not least,
external assistance is manifest often in outright grant that does not require
repayment of principal/interest payment.

Whatever may be the difference between the two, any borrowing from abroad is
treated as inflow of fiends Lending abroad, on the other hand, represents outflow of
funds, However, repayment of loads is treated just the other way,

International Financial
Flows

Short-term Flow of funds

Normally loans and foreign direct investment are meant for a period exceeding one
year 8tit there are financial flows that occur for less than a year. Movement of funds
relating to banking channels, euro notes, speculative and arbitrage activities, etc. are
the examples of short=term funds that move across countries.
Activity I
1.

Try to find out the Quantum of Various financial flows in the context of Indian
Economy.

4.3

STRUCTURE OF BALANCE OF PAYMENTS

Basic Principles
While recording the international financial flows in the balance of payments, a couple
of norms need to be followed. One is that the structure of the balance of payments is
based just on the principles of the double-entry book-keeping. It means that all the
inflows of funds are put on the credit side and all the outflows of funds are debited;
and ultimately, the two sides are balanced.
The second norm is that since the different forms of the financial flows vary in
nature, they are to be entered accordingly in the two compartments of the balance of
payments. It may be mentioned that the balance of payments statement is divided into
two compartments. One is known as the current account followed by the other known
as the capital account. Those transactions that represent earning or spending are
recorded in the current account. For example, when a country earns foreign exchange
through export, the amount is entered in the current account. On the other hand, if'
the financial flow does not represent earning, it is entered in the capital account. For
example, foreign direct investment or foreign portfolio investment is entered in the
capital account. Thus, it is on this basis that the different types of financial flows are
recorded in the current and the capital accounts.
Prescribed Format for Recording transactions
Current Account
As per the prescribed format adopted by the Reserve Bank of India (shown in Table
4.1), in the current account, first, merchandise trade is entered. Export receipts are
entered on the credit side and the imports are entered on the debit side. And then, the
balance is found out. The difference between the export and the import is known as
the balance of trade. Excess of export over import is known as the surplus balance of
trade and, on the contrary, the excess of import over export is known as the deficit
balance of trade. Table 4.1 shows a deficit balance of trade amounting to $ 38.130
billion.

41

International Financial
Environment

The second item to be entered in the current account is nothing but invisibles.
Invisibles, as mentioned earlier, include primarily:
1.

Trade in services

2.

Investment income

3.

Unilateral transfers

There are both inflows and outflows on account of invisibles. The inflows are entered
on the credit side and the outflows are entered on the debit side. However, a common
practice is that only the net amount is written in the current account.
After entering the invisibles, balancing is done for the whole of the current account.
This balance is known as the balance of current account. The debit side being bigger
than the credit side shows a deficit balance of current account. On the contrary, the
excess of credit side over the debit side for the whole of the current account shows a
surplus balance of current account. Table 4.1 shows a deficit balance of current
account amounting to $ 6.431 billion.
Table 4.1: India's Balance of Payments during 2004-05
(Amount in US $ billion)
A. Current Account

Amount

Exports

80.831

Imports

118.961

Balance of Trade

-38.130

Invisibles (net)

31.699

Services

14.690

Income

-3.979

Transfers

21.048

Current Account Balance

-6.431

B. Capital Account
Foreign direct investment (net)

3.037

Foreign Portfolio Investment (net)

8.907

External Assistance (net)

1.922

External Commercial Borrowings (net)

5.947

Banking capital

4.002

Short-term credits

3.792

Others

4.568

Balance of Capital Account

C. Statistical Discrepancy
D.

Overall Balance

Monetary Movements

IMF (net)

G. Foreign Exchange Reserves (increase)

42

32.175
0.415
26.159
-26.159
26.159

Source: RBI, Annual Report. 2004-05, Bombay, 2005.

Capital Account
In the capital account, foreign investment -both direct and portfolio - is entered,
Sometimes, a part of the investment is taken back by the investors which is known as
disinvestment; The usual practice is that the disinvestment are not shown, rather the
foreign investment, net of disinterments, is shown in the capital account.

Similarly, external assistance and external commercial borrowing are also shown net
repayment. Here the readers must be aware of the fact the repayment is subject matter
of capital account whereas the interest payment showing a sort of earning is a part of
invisibles. Again, the banking capital is inclusive of both short-term and long-term
funds. Short-term credits are purely short-term funds. Finally, the two sides of longterm and short-term funds are balanced that is known as balance of capital account,
Table 4:1 shows the balance of capital account amounting to US $ 32.175 billion.

International Financial
Flows

Statistical Discrepancy
After recording different forms of international financial flows in the balance of
payments, the statistical discrepancy, often known as errors and omissions, is also
recorded. The statistical discrepancy arises on different accounts. Firstly, it arises
because of difficulties involved in collecting balance of payments data. There are
different sources of data that sometimes differ in their approach. In India, the trade
figures differ between those compiled by the Reserve Bank of India and those
compiled by the Director-General of Commercial Intelligence and Statistics. Secondly,
the movement of funds may lead or lag the transactions that they (funds) are
supposed to finance. For example, goods are shipped in March, but the payments are
received in April. If figures are compiled on the 31st March, the figures may differ if
the shipment is the basis of collecting data from those which are based on the actual
payment. Such differences lead to the emergence of statistical discrepancy. Thirdly,
certain figures are derived on the basis of estimates. For example, figures for earning
on travel and tourism account are estimated on the basis of sample cases. If the
sample is defective, there is every possibility for the emergence of errors and
omissions. Fourthly, errors and omissions are explained by unrecorded illegal
transactions that may be either on debit side or on credit side or on both sides. Only
the net amount is written on the balance of payments. Table 10.1 shows the amount at
US $ 415 million on this account.
The Overall Balance
After the statistical discrepancy is located, the overall balance is arrived at. The
overall balance represents the balancing between the credit items and the debit items
appearing on the current account, capital account and the statistical discrepancy.
Table 1 shows an overall balance that is surplus by US $ 26.159 billion during
2004-05.
Official Reserves Account
If the overall balance is surplus, the surplus amount is transferred to the official
reserves account that increases the foreign exchange reserves held by the monetary
authorities. They comprise of monetary gold, SDR allocations by the IMF and the
foreign currency assets. The foreign currency assets are normally held in the form of
deposits with foreign central banks and investment in foreign government securities.
It there is deficit, an amount equivalent to the deficit is drawn from the official
reserves account bringing the balance of payments into equilibrium. Again, if the
amount of foreign exchange reserves is not sufficient to meet the deficit, the
government approaches the International Monetary Fund for the balance of payments
support. In Table 4.1, where the overall balance shows surplus, there is no need to
approach the IMF.

43

International Financial
Environment

4.4

EQUILIBRIUM, DISEQUILIBRIUM AND

ADJUSTMENT

Accounting and Economic Equilibrium

Since the balance of payments is constructed on the basis of double-entry book
keeping, credit is always equal to debit. If debit on current account is greater than the
credit side, funds flow into the country that are recorded on the credit side of the
capital account. The excess of debit is wiped out. It means that the balance of
payments is always in accounting equilibrium.
The accounting balance is an ex post concept. It describes what has actually
happened over a specific past period. There may be accounting disequilibrium for a
short period when the two sides of the autonomous flows differ in size. But in such
cases, accommodating flows bring the balance of payments back to equilibrium. To
make the distinction between the autonomous flow and accommodating flow more
clear, it can be said that foreign investment, external assistance and commercial
borrowings are autonomous capital flow because they flows in normal course of
business. But when the country borrows from the International Monetary Fund to
meet the overall deficit, such borrowings represent accommodating capital flow.
However, in real life, economic equilibrium is not found because the two sides of the
current account are seldom equal. Rather it is the economic disequilibrium in the
balance of payments that is a normal phenomenon.
Process of Adjustment
The focus of adjustment lies primary on the trade account, although the size of
adjusting deficit is sometimes reduced by the net inflow on the invisibles account.
There are different views on adjustment that need a brief discussion here.
The Classical Approach
The classical economists were of the view that the balance of payments was self
adjusting due to the price-specie-flow mechanism. The mechanism stated that an
increase in money supply raises domestic prices. Exports become uncompetitive.
Export earnings drop. Foreign goods become cheaper. Imports rise. Current account
balance goes deficit in the sequel. Precious metal flows outside the country in order
to finance imports. As a result, quantity of money lessens that lowers the price
level. Lower prices in the economy lead to greater export. Trade balance reaches
back to equilibrium.
Elasticity Approach
The adjustment in the balance of payments disequilibrium is thought of in terms of
changes in the fixed exchange rate, that is through devaluation or upward revaluation.
But its success is dependent upon the elasticity of demand for export and import.
Marshall (1924) and Lerner (1944) explained this phenomenon through the
"elasticity" approach.

44

The elasticity approach is based on partial equilibrium analysis where everything is

held constant except for the effects of exchange rate changes on export or import. It
is also assumed that elasticity of supply of output is infinite so that the price of export
in home currency does not rise as demand increases, nor the price of import falls with
a squeeze in demand for imports. Again, the approach ignores the monetary effects
of variation in exchange rates.

If the elasticity of demand is greater than unity, the import bill will contract and export
earnings will increase as a sequel to devaluation. Trade deficit will be removed.
However, the problem is that the trade partner may also devalue its own currency as a
retaliatory measure. Moreover, there may be a long lapse of time before the
quantities adjust sufficiently to changes in price. Till then, trade balance will be even
worse than that before devaluation.

International Financial
Flows

Stem (1973) incorporated the concept of supply elasticity in the elasticity approach.
Based on the figures of British exports and imports, Stem has come to a conclusion that
the balance of trade should improve if:
1.

Elasticity of demand for exports and imports is high and is equal to one coupled
with elasticity of supply both for imports and exports which is either high or low.

2.

Elasticity of demand for imports and exports is low but the elasticity of supply
for imports and exports is lower.

On the contrary, if the elasticity of demand is low matched with high elasticity of
supply, the balance of trade should worsen.
The Keynesian Approach
The Keynesian view takes into consideration primarily the income effect that was
ignored under the elasticity approach. There are various versions of the Keynesian
approach. One is the absorption approach that explains the relationship between
domestic output and trade balance and conceives of adjustment. Sidney A. Alexander
(1959) treats balance of trade as a residual given by the difference between what the
economy produces and what it takes for domestic use or what it absorbs. He begins
with the contention that the total output, Y is equal to the sum of consumption, C,
investment, I , government spending, G, and net export (X-M). In form of an
equation,
Y=C+I+G+(X-M)
Substituting C +l+ G by absorption, A, it can be rewritten as:
Y=A +X-M
or

Y-A=X-M

This means that the amount, by which total output exceeds total spending or
absorption is represented by export over import or the net export which means a
surplus balance of
trade. This also means that if A > Y , deficit balance of trade will occur. This is
because excess absorption in absence of desired output will cause imports. Thus in
order to bring equilibrium in the balance of trade, the government has to increase
output or income. Increase in income without corresponding and equal increase in
absorption will lead to improvement in balance of trade.
In case of full employment, where resources are fully employed, output cannot be
expanded. Balance of trade deficit can be remedied through decreasing absorption
without equal fall in output. It may be noted that validity of absorption approach
depends upon the operation of the multiplier effect that is essential for accelerating
output generation, It also depends on the marginal propensity to absorb that
determines the rate of absorption.
J. Black (1959) explains the absorption in a slightly different way. He ignores the
governmental expenditure, G and equates X - M with S - I (where S is saving and I is
investment). He is of the opinion that when balance of trade is negative, the country
has to increase saving on the one hand and to reduce investment, on the other. In case
of full employment, he suggests for redistribution of national income in favour of
profit earners who possess greater propensity to save.

45

International Financial
Environment

Again, Mundell (1968) incorporates also interest rate and capital account in the
ambit of discussion. In his view, it is not only the government spending but also the
interest rate that does have an influence on income as well on the balance of
payments. While larger government spending increases income, an increase in
income leads to rise in import. With a positive marginal propensity to import, any
rise in income as a sequel to increase in government spending will lead to greater
imports and worsen the current account. However, changes in interest rate
influence both the capital account and the current account. A higher interest rate
will lead to improvement in current account through lowering of income. At the
same time, a higher interest rate will improve the capital account through attracting
the flow of foreign investment.
Yet again, the New Cambridge School approach takes into account savings (S) and
investment (I), taxes (T) and government spending (G) and their impact on the trade
account. In form of equation, it can be written as:
S+T+M=G+X+I
Or

(S - I ) + ( T - G ) + ( M - X ) = 0

Or

( X - M ) =(S - I)+ ( T - G )

The theory assumes that (S - I) and (T - G) are determined independently of each

other and of the trade gap. (S - I) is normally fixed as the private sector has a fixed
net level of saving. And so the balance of payments deficit or surplus is dependent
upon (T - G) and the constant (S - I). In other words, with constant (S - I), it is only
the manipulation of (T - G) which is a necessary and sufficient tool for balance of
payments adjustment.
Monetary Approach
The monetarists believe that the balance of payments disequilibrium is a monetary
phenomenon and not structural (Connolly, 1978). The adjustment is automatic
unless the government is intentionally following an inflationary policy for quite a
long period. Adjustment is brought about through making changes in monetary
variables.
The process of adjustment varies among the types of exchange rate regime the
country has opted for. In a fixed exchange rate regime or in gold standard, if the
demand
for money, that is the amount of money people wish to hold is greater than the
supply of money, the excess demand would be met through the inflow of money
from abroad. On the contrary, with the supply of money being in excess of the
demand for it, the excess supply is eliminated through the outflow of money to
other countries. The inflow and the outflow influence the balance of payments. To
explain it further, with constant prices and income and thus constant demand for
money, any increase in domestic credit will lead to outflow of foreign exchange as
the people will import more to lower the excessive cash balances. In the sequel, the
balance of payments will turn deficit. Conversely a decrease in domestic credit
would lead to an excess demand for money. International reserves will flow in to
meet the excess demand. Balance of payments will improve.

46

However, in a floating-rate regime, the demand for money is adjusted to the supply
of money via changes in exchange rate. Especially in a situation when the central
bank makes no market intervention, the international reserves component of the
monetary

base remains unchanged. The balance of payments remains in equilibrium with

neither surplus nor deficit. The spot exchange rate is determined by the quantity of
money supplied and the quantity of money demanded.

International Financial
Flows

When the central bank increases domestic credit through open market operations,
supply of money is greater than the demand for it. The households increase their
imports. With increased demand for imports, the domestic currency will depreciate
and it will continue depreciating until supply of money equals the demand for money.
Conversely, with decrease in domestic credit, the households reduce their import.
Domestic currency will appreciate and it will continue appreciating until supply of
money equals demand for money.
In case of managed floating, the central bank often intervenes to peg the rates at some
desired level. And so this case is a mix of fixed and floating rate regimes. It means
that changes in the monetary supply and demand do influence the exchange rate but
also the quantum of international reserves.

4.5

INDIA'S BALANCE OF PAYMENTS DURING THE

PERIOD OF ECONOMIC REFORM

An analysis of the trends in India's balance of payments is very much relevant in

view of the fact that during 1990-91, the financial year preceding the period of
economic reform, size of current account deficit was unprecedented amounting to
over $ 9.6 billion. The Indian Government initiated reforms in many sectors and
especially the external sector. It reformed the trade and foreign investment policies.
Imports were liberalised. Export promotion schemes were implemented. Exchange
rate policies were restructured. Foreign investment policy was liberalised in order to
attract foreign direct investment and foreign portfolio investment. India's overseas
investment was encouraged. All this made an impact on the country's balance of
payments.
Current Account
During 1991-94, the trade deficit shrank to US $ 2.8 - 5.4 billion annually from a
figure of US $ 9.4 billion during 1990-91. The net invisible earnings too improved. The
deficit on current account was slightly over one billion US dollar in 1991-92 and
1993-94, although it was around US $ 3.5 billion in 1992-93. However, since 199495, with slow pace of export, trade deficit began to grow and touched US $ 14.3
billion during 1996-97 and US $ 16.3 billion during 1997-98. The fast rising earnings
on invisible account mainly due to spurt in remittances saved the position from going
worse and the deficit on current account moved in the range of US $ 3.4 to 6.5 billion
annually. During 1998-99, imports fell reducing in turn the trade deficit to $ 13.2
billion; and considering invisibles, the current account deficit was also lower. But in
the following year, trade deficit increased, but since the invisibles were large, the
current account deficit rose barely to $ 4.2 billion. In 2000-01, the trade deficit was
lower reducing in turn the current account deficit to $ 2.3 billion. During the
following three-year period, the trade deficit moved between $ 12 billion and $ 17
billion, but since the invisibles showed larger earnings, the current account turned
surplus that was as large as $ 8.7 billion during 2003-04. In 2004-05, large growth in
imports led to deficit on current account amounting to over $ 6.4 billion.

47

International Financial
Environment

Table 4.2: India's Balance of Payments (Current Account)

(Millions of US Dollar)
Year

Import

Export Trade

Invisibles (net)

Balance Of

Balance

Current
Total

Investment Remittances

I991-92

21064

18266

-2798

1620

-3830

3798

-1178

1992-93

24316

18869

-5447

1921

-3423

3865

-3526

1993-94

26739

22683

-4056

2898

-3270

5287

- 1158

1994-95

35904

26855

-9049

5680

-3431

8112

-3369

1995-96

43670

32311

-11359

5460

-3205

8539

-5899

1996-97

48063

33764

-14294 10638

-3250

11139

-3631

1997-98

51126

34849

-16277

9804

-3457

11830

-6473

1998-99

47544

34298

-13246

9208

-3544

10587

-4038

1999-00

55383

38285

-17098 12935

-3559

12638

-4163

2000-01

59264

44894

-14370 12106

-3918

12798

-2264

2001-02

57618

44915

-12703 14054

-2654

12125

1351

2002-03

65474

53000

-12474 16182

-4882

14448

3708

2003-04

79658

62952

-16706 25425

-4703

19444

8719

80831

-38130 31699

-3979

21048

-6431

2004-05

Sources: 1. Govt: of India, Economic Survey, New Delhi: Ministry of Finance,

various Issues.
2. Reserve Bank of India, Annual Report, Mumbai, various issues.
Capital Account
The picture of capital account transactions was satisfactory to a great extent. The net
inflow of foreign investment was sizeable - r i s i n g from US $ 133 million in 1991-92
to over US $ 5.8 billion in 1996-97. The amount dropped to US $ 5.0 billion in 199798 and to US $ 2.3 billion in 1998-99, but again crossed the US $ 5-billion mark in
1999-2000. During 2000-01, net foreign investment inflow was lower and stood at US
$ 2.9 billion. But thereafter, it took a great jump touching $ 14.5 billion in 2003.04,
although in 2004-05, it shrank to $ 11.9 billion.
Net external assistance showed on the whole a declining trend, except for some
marginal rise in a few years. Almost similar was the case with the commercial
borrowings that remained confined within a low range, except for 1997-99 and for
2000-01 when they were large. Owing to strong capital account position, the IMF
funds that were borrowed in the initial phases of economic reform, were repaid in
installments. Moreover, the deficit on current account was met by the capital account
transactions. The rest of the flow added to the official reserves. The size of the
foreign currency assets that was just over one billion US dollar during May-June
1991, inflated to US $ 42.3 billion at the end of March 2001 and as large as $ 141
billion by March 2005.

48

Table 4.3: Capital Account Transactions during the Period of Reform

International Financial
Flows

Millions of US Dollar

1991-92

3031

948

786

133

3777

Foreign
Currency
Assets at
the
Year- end
5631

1992,-93

1856

-1445

1288

567

2936

6434

1993-94

1896

-84

187

4235

9695.

15068

1994-95

1518

1517

-1143

4807

9156

20809

1995-96

867

1334

-1715

4604

4678

17044

1996-97

1101

1855

-975

5834

10454

22367

1997-98

877

4010

-618

4993

11924

25975

1998-99

799

4367

393

2312

8565

29522

1999-00

891

333

-260

5117

10242

35058

2000-01

410

4016

-26

2911

7487

42281

2001-02

1204

-1147

5925

9545

51049

2002-03

-2460

-1698

4555

12638

71890

2003-04

-2661

-1853

14492

22122

112959

2004-05

1922

5947

11944

32175

141514

Year

External
Assistance
(net)

Commercial
Borrowings
(net)

IMF
Funds
(net)

Foreign
Investment
(net)

Total
Capital
Account
(net)

Sources: 1. Govt. of India, Economic Survey, New Delhi: Ministry of Finance,

various issues.
2. Reserve Bank of India, Annual Report, Mumbai, various issues.

4.6

SUMMARY

All the international financial flows arising out of various international financial
transactions are recorded by the monetary authorities of a country in a statement
known as balance of payments.

The international financial flows relate broadly to merchandise trade flows,

invisibles such as trade in services, investment income and unilateral transfers,
foreign direct and portfolio investment, external assistance and external
commercial borrowings and also short-Term movement of funds.

Recording of funds flow in the balance of payments is based on the double-entry

book-keeping having debit and credit entries.

Balance of payments entries are bifurcated into current and capital accounts based
on whether, or not, those entries show the flow of real income.

While the current account includes merchandise trade and invisibles, capital
account embraces foreign investment, external assistance, external commercial
borrowing and the movement of short-term funds.

Statistical discrepancy, if any, is added and then the current account, capital
account and the statistical discrepancy are summed up in order to arrive at the
overall balance. If the overall balance is positive, it adds to the foreign exchange
reserves. If it is negative, foreign exchange reserves are eroded to that extent; or in
case of insufficient reserves, IMF is approached to bridge the deficit.

49

International Financial
Environment

From accounting viewpoint, balance of payments is always in equilibrium. But

from economic viewpoint, disequilibrium is a common phenomenon. Adjustment
is made; however, the views on the modalities for adjustment differ widely among
the economists of different schools.

As regards trends in India's balance of payments during the period of economic

reform, import liberalisation led to bigger import's, but the growth in exports and
especially the growth in remittances led to a surplus balance of current account at
least in some of the years. Again, liberal foreign investment policy led to large
inflow of foreign capital. It strengthened the capital account and increased in turn
the foreign exchange reserves of the country.

4.7

SELF ASSESSMENT QUESTIONS

1.

Describe the different kinds of international financial flows.

2.

Comment on the structure of balance of payments. What are the basic principles
governing recording of the flows?

3.

How can the trade deficit be reduced or eliminated? Give your arguments based
on the elasticity approach,

4.

Comment on the Keynesian approach explaining adjustment in the balance of

payments. How far does the monetarists' approach differ in this context?

5.

Analyse the recent trends in India's balance of payments.

6.

Write note on:

a) Invisibles
b) Autonomous and accommodating capital flows
c) Statistical discrepancy in BOP.

4.8

FURTHER READINGS

Alexander, Sidney A. (1959), "Effects of a Devaluation: A Simplified Synthesis of

Elasticity and Absorption Approaches", American Economic Review, I L (1),
2242.
Black, J. (1959), "Saving and Investment Approach to Devaluation", Economic
Journal, LXIX (273), 267-74.
Connolly, M. (1978), "The Monetary Approach to an Open Economy: The
Fundamental Theory" in Putnam, R. et al. (eds.), The Monetary Approach to
International Adjustment, New York, Praeger, pp. 46-59.
Lerner, A. P. (1944), The Economics of Control, New York: Macmillan, Chaps. 2829.
Marshall, A. (1924), Money, Credit and Commerce, London, Macmillan, Book, III.
Mundell, R. A. (1968), International Economics, New York: Macmillan.
Stem, R. M. (1973), The Balance of Payments, London: Macmillan.
Daniels, J. and D. Vanhoose (1999), International Monetary and Financial
Economics, New York: International Thomson Publishing Company.
Sharan, V. (2006), International Financial Management, New Delhi: Prentice-Hall of
India.

50

P.K. Jain, Josette Peyrard and Surendra S. Yadav (1998), International Financial
Management, Macmillan India Ltd., New Delhi. 50