Shah & Anchor Kutchhi Engineering College, DoMS

Balance of Payment

The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

Definition: 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

Shah & Anchor Kutchhi Engineering College, DoMS The Balance of Payments Divided The BOP is divided into three main categories: the current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction.

The Current Account The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account. Balance of Trade: difference between amount of export and import. Balance of Invisible Trade: eg: travel, insurance and interest and dividend on foreign investments. Unilateral Transfers gifts, personal remittances and such other one way transactions.

Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports.

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Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received.

X+M=O X = Value of tangible goods exported. M = Value of tangible goods imported. X is shown as positive. M is shown as negative. If X exceeds M, the value of O will be positive. If M exceeds X, the value of O will be negative.

The Capital Account The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets (assets such as equipment used in the production

Shah & Anchor Kutchhi Engineering College, DoMS process to generate income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to fixed assets. The current account balance is shown by the following equation. X - M + X + M = 0 X = Exports of invisibles M = Import of invisibles If the total of left hand side is zero, the current account in BOP is in balance. If the total of M + M, the current account balance will be in a surplus.

The Financial Account In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented. Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

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Shah & Anchor Kutchhi Engineering College, DoMS

Balance of payment balances

Since the balance of payment is based upon system of double-entry bookkeeping, the total debits must equal to total credits. This is because two aspects of each transaction recorded are equal in amount but appear on opposite sides of the balance of payments account. In this accounting sense, balances of payments for a country must always balance. The debit side shows the use of total foreign exchange acquired in a particular period. The credit side shows the sources from which the foreign exchange is acquired during a particular period. Against every credit entry, there is an offsetting debit entry & vise-versa, so the receipts and payments on these two sides must be equal. Hence the two sides must necessary balance. If X imports from Y, Y would also import from X. Hence there would be a debit and credit entries in the balance of payments of both the countries X & Y. The individual items in the balance of payments may not balance. But the total credits of the country must be equals to its total debits.

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Shah & Anchor Kutchhi Engineering College, DoMS

Disequilibrium in BOP : Surplus / Deficit

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. Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a situation arises when the effective demand for foreign exchange is less than its supply. Such a surplus disequilibrium is termed as 'favourable balance'. Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to foreigners. It arises when the effective demand for foreign exchange of the country exceeds its supply at a given rate of exchange. This is called an 'unfavourable balance'.

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Causes of Disequilibrium in Balance of Payment

1. Population Growth Most countries experience an increase in the population and in some like India 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.

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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 development in 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.

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.

Shah & Anchor Kutchhi Engineering College, DoMS 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.

Impact of Import & Export on Balance of Payment of India:

1. Indian exports depended largely on world trade situation. 2. India was mainly primary product exporter, the price of which fluctuated heavily with fluctuations in world market demand. 3. Primary product exporting countries have unfavorable term of trade. The earnings from primary product exporters were low & unstable. 4. The quality of Indian products was not up to the world standards due to which we could not sustain markets. 5. Only the residue products were mainly exported. The fact that export earnings also contribute to economic development was overlooked. 6. Cumbersome procedures for license etc. served as disincentives for exporters. Domestic inflation further reduced competitiveness of Indias exports. 7. However there is an improvement in Bop situation during of 2009-10 with regard to 200809. 8. Foreign Trade Policy of India 2009-14 had set a target of annual export growth of 15% with an export target US$ 200 Billion by March 2011. Changes in export composition: Share of Indias export in the world has increased from 0.4% in 1980, 0.7 % in 2000 & 1.1% in 2009. Indias share in world exports started rising after liberalization & globalization of the economy were initiated in 1990s. The more encouraging fact about Indian exports is the positive change in its composition. From a primary product exporting country & is also fast gaining the tag of service exporter. Composition of Merchandise Exports:

Shah & Anchor Kutchhi Engineering College, DoMS Agriculture products constituted of 45% of Indias export basket during the sixties. The manufacturing sector has now overtaken & it now constitutes 70% of the countrys export basket. Here is a list of percentage share of major export basket in last year: Agriculture & allied products 9% Ores & Minerals 4% Manufacturing Goods 69% Crude & petroleum products 14% Other( unclassified items) 4% 9. There are also changes in import composition of India.

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BoP Crisis in India

Crisis of 1956-57: From 1947 till 1956-57, the India had a current account surplus. By the end of the first plan, the Trade deficit was Rs. 542 Crore and Net Invisibles was Rs. 500 Crore, thus giving a BoP deficit in CurrentAccount worth Rs. 42 Crore. From this time onwards, the trade deficit increased from 3.8% of the GDP at market prices to 4.5% of GDP (at Market Prices). The result was an imposition of the exchange controls. This was the first BoP crisis, ever India faced, after independence.

Crisis of 1966 In 1965, when India was at War with Pakistan, the US responded by suspension of aid and refusal to renew its PL-480 agreement on a long term basis. The idea of US as well as World Bank was to induce India to adopt a new agricultural policy and devalue the rupee. Thus, the Rupee was devalued by 36.5% in June 1966. This was followed by a substantial rationalization of the tariffs and export subsidies in an expectation of inflow of the foreign aid. The BoP improved, but not because of inflow of foreign aid but because of the decline in imports. After the 1966-67, the BoP of India remained comfortable till 1970s. The first oil shock of 197374 was absorbed by the Indian Economy due to buoyant exports. After that there was an expansion of the international trade.

Crisis of 1990-91: BoP crisis had its origin from the fiscal year 1979-80 onwards. By the end of the 6th plan, India's BoP deficit (Current account) rose to Rs. 11384 crore. It was the mid of 1980s when the BoP issue occupied the centre position in India's macroeconomic management policy. The second Oil shock of 1979 was more severe and the value of the imports of India became almost double between 1978-78 and 1981-82. From 1980 to 1983, there was global recession and India's exports suffered during this time. The trade deficit was not been offset by the flow of the funds under net invisibles. Apart from the external assistance, India had to meet its colossal deficit in the current account through the withdrawal of SDR and borrowing from IMF under the extended facility arrangement. A large part of the accumulated foreign exchange fund was used to offset

Shah & Anchor Kutchhi Engineering College, DoMS the BoP. During the 7th plan, between 1985-86 and 1989-90, India's trade deficit amounted to Rs. 54, 204 Crore. The net invisible was Rs. 13157 Crore and India's BoP was Rs. 41047 Crore. India was under a sever BoP crisis. In 1991, India found itself in her worst payment crisis since 1947. The things became worse by the 1990-91 Gulf war, which was accompanied by double digit inflation. India's credit rating got downgraded. The country was on the verge of defaulting on its international commitments and was denied access to the external commercial credit markets. In October 1990, a Net Outflow of NRI deposits started and continued till 1991. The only option left to fulfil its international commitments was to borrow against the security of India's Gold Reserves. The prime Minister of the country was Chandra Shekhar and Finance Minister was Yashwant Sinha. The immediate response of this Caretaker government was to secure an emergency loan of $2.2 billion from the International Monetary Fund by pledging 67 tons of India's gold reserves as collateral. This triggered the wave of the national sentiments against the rulers of the country. India was called a "Caged Tiger". On 21 May 1991, Rajiv Gandhi was assassinated in an election rally and this triggered a nationwide sympathy wave securing victory of the Congress. The new Prime Minister was P V Narsimha Rao. P V Narsimha Rao was Minister of Planning in the Rajiv Gandhi Government and had been Deputy Chairman of the Planning Commission. He along with Finance Minister Manmohan Singh started several reforms which are collectively called "Liberalization". This process brought the country back on the track and after that India's Foreign Currency reserves have never touched such a "brutal" low. In 1991, the following measures were taken: In 1991, Rupee was once again devaluated. Due to the currency devaluation the Indian Rupee fell from 17.50 per dollar in 1991 to 45 per dollar in 1992. The Value of Rupee was devaluated 23%. Industries were delicensed. Import tariffs were lowered and import restrictions were dismantled. Indian Economy was opened for foreign investments. Market Determined exchange rate system was introduced.

Shah & Anchor Kutchhi Engineering College, DoMS LERMS In the Union Budget 1992-93, a new system named LERMS was started. LERMS stands for "Liberalized Exchange Rate Management". The LERMS was introduced from March 1, 1992 and under this, a system of double exchange rates was adopted. Under LERMS, the exporters could sell 60% of their foreign exchange earning to the authorized Foreign Exchange dealers in the open market at the open market exchange rate while the remaining 40% was to be sold compulsorily to RBI at the exchange rates decided by RBI. Another important feature of LERMS was that the Government was providing the foreign exchange only for most essential imports. For less important imports, the importers had to arrange themselves from the open market. Thus, we see that LERMS was introduced with twin objectives of building up the Foreign Exchange Reserves and discourage imports. The Government was successful in this.

Rangarajan Panel for Correcting BoP The Report of the High Level Committee on Balance of Payments, of which Dr. Rangarajan was the Chairman, was submitted in June 1993. The important recommendations of this panel were as follows: 1. A realistic exchange rate and a gradual relaxation of the restrictions on the current Account should go hand in hand. 2. Current account deficit of 1.6% of GDP should be treated as a ceiling. 3. Government should be cautious of extending concessions or facilities to the Foreign Investors. The concessions were more to the foreign investors than to the domestic players. 4. All external debts should be pursued on a prioritized on the basis of the Use on which the debt is to be put. 5. No approval should be accorded for a commercial loan which has a maturity of less than 5 years. 6. There should be efforts so that Debt flows can be replaced by the equity flows. The High Level Committee on Balance of Payments, 1993, chaired by Dr. C. Rangarajan, recommended that the RBI should target a level of reserves that took into account Liabilities that may arise for debt servicing, in addition to imports of three months.

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How to correct the 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.

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

Shah & Anchor Kutchhi Engineering College, DoMS 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:1. Exchange depreciation will be successful only if there is no retaliatory exchange depreciation by other countries. 2. It is not suitable to a country desiring a fixed exchange rate system. 3. 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. 4. It increases uncertainty & risks involved in foreign trade. 5. 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.

Shah & Anchor Kutchhi Engineering College, DoMS 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 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:1. Devaluation is successful only when other country does not retaliate the same. If both the countries go for the same, the effect is nil. 2. Devaluation is successful only when the demand for exports and imports is elastic. In case it is inelastic, it may turn the situation worse. 3. Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country. 4. Devaluation may bring inflation in the following conditions :1. 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. 2. 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. 3. 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. 4. Devaluation may not be effective if the deficit arises due to cyclical or structural changes.

Shah & Anchor Kutchhi Engineering College, DoMS 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.

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:1. Tariffs bring equilibrium by reducing the volume of trade. 2. Tariffs obstruct the expansion of world trade and prosperity. 3. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of payment position are uncertain. 4. Tariffs seek to establish equilibrium without removing the root causes of disequilibrium. 5. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a country already having a surplus.

Shah & Anchor Kutchhi Engineering College, DoMS 6. 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. Types of Quotas:1. the tariff or custom quota, 2. the unilateral quota, 3. the bilateral quota, 4. the mixing quota, and 5. Import licensing. Merits of Quotas:1. Quotas are more effective than tariffs as they are certain. 2. They are easy to implement. 3. They are more effective even when demand is inelastic, as no imports are possible above the quotas. 4. More flexible than tariffs as they are subject to administrative decision. Tariffs on the other hand are subject to legislative sanction. Demerits of Quotas:1. They are not long-run solution as they do not tackle the real cause for disequilibrium. 2. Under the WTO quotas are discouraged. 3. Implements of quotas are open invitation to corruption.

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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 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 :1. Such industries may lose the spirit of competitiveness. 2. Domestic industries enjoying various incentives will develop vested interests and ask for such concessions all the time. 3. Deliberate promotion of import substitute industries go against the principle of comparative advantage.