Balance of Payment

Introduction

Balance of payments (BoP) accounts are an accounting record of all monetary

transactions between a country and the rest of the world. These transactions
include payments for the country's exports and imports of goods, services, financial
capital, and financial transfers. The BoP accounts summarize international
transactions for a specific period, usually a year, and are prepared in a single
currency, typically the domestic currency for the country concerned. Sources of
funds for a nation, such as exports or the receipts of loans and investments, are
recorded as positive or surplus items. Uses of funds, such as for imports or to
invest in foreign countries, are recorded as negative or deficit items.

When all components of the BOP accounts are included they must sum to zero
with no overall surplus or deficit. For example, if a country is importing more than
it exports, its trade balance will be in deficit, but the shortfall will have to be
counter-balanced in other ways such as by funds earned from its foreign
investments, by running down central bank reserves or by receiving loans from
other countries.

While the overall BOP accounts will always balance when all types of payments
are included, imbalances are possible on individual elements of the BOP, such as
the current account, the capital account excluding the central bank's reserve
account, or the sum of the two. Imbalances in the latter sum can result in surplus
countries accumulating wealth, while deficit nations become increasingly indebted.
The term "balance of payments" often refers to this sum: a country's balance of
payments is said to be in surplus (equivalently, the balance of payments is positive)
by a certain amount if sources of funds (such as export goods sold and bonds sold)
exceed uses of funds (such as paying for imported goods and paying for foreign
bonds purchased) by that amount. There is said to be a balance of payments deficit
(the balance of payments is said to be negative) if the former are less than the
latter.

Under a fixed exchange rate system, the central bank accommodates those flows
by buying up any net inflow of funds into the country or by providing foreign
currency funds to the foreign exchange market to match any international outflow
of funds, thus preventing the funds flows from affecting the exchange rate between
the country's currency and other currencies. Then the net change per year in the
central bank's foreign exchange reserves is sometimes called the balance of
payments surplus or deficit. Alternatives to a fixed exchange rate system include a
managed float where some changes of exchange rates are allowed, or at the other
extreme a purely floating exchange rate (also known as a purely flexible exchange
rate). With a pure float the central bank does not intervene at all to protect or
devalue its currency, allowing the rate to be set by the market, and the central
bank's foreign exchange reserves do not change.

Historically there have been different approaches to the question of how or even
whether to eliminate current account or trade imbalances. With record trade
imbalances held up as one of the contributing factors to the financial crisis of
20072010, plans to address global imbalances have been high on the agenda of
policy makers since 2009.

Balance of Payment

The two principal parts of the BOP accounts are the current account and the capital
account.

The current account shows the net amount a country is earning if it is in surplus, or
spending if it is in deficit. It is the sum of the balance of trade (net earnings on
exports minus payments for imports), factor income (earnings on foreign
investments minus payments made to foreign investors) and cash transfers. It is
called the current account as it covers transactions in the "here and now" - those
that don't give rise to future claims.

The capital account records the net change in ownership of foreign assets. It
includes the reserve account (the foreign exchange market operations of a nation's
central bank), along with loans and investments between the country and the rest of
world (but not the future regular repayments/dividends that the loans and
investments yield; those are earnings and will be recorded in the current account).
The term "capital account" is also used in the narrower sense that excludes central
bank foreign exchange market operations: Sometimes the reserve account is
classified as "below the line" and so not reported as part of the capital account.
Expressed with the broader meaning for the capital account, the BOP identity
assumes that any current account surplus will be balanced by a capital account
deficit of equal size - or alternatively a current account deficit will be balanced by
a corresponding capital account surplus:

The balancing item, which may be positive or negative, is simply an amount. That
accounts for any statistical errors and assures that the current and capital accounts
sum to zero. By the principles of double entry accounting, an entry in the current
account gives rise to an entry in the capital account, and in aggregate the two
accounts automatically balance. A balance isn't always reflected in reported figures
for the current and capital accounts, which might, for example, report a surplus for
both accounts, but when this happens it always means something has been missed
most commonly, the operations of the country's central bankand what has
been missed is recorded in the statistical discrepancy term (the balancing item).

An actual balance sheet will typically have numerous sub headings under the
principal divisions. For example, entries under Current account might include:

Trade buying and selling of goods and services

o Exports a credit entry

o Imports a debit entry

Trade balance the sum of Exports and Imports

Factor income repayments and dividends from loans and investments

o Factor earnings a credit entry

o Factor payments a debit entry

Factor income balance the sum of earnings and payments.

Especially in older balance sheets, a common division was between visible and
invisible entries. Visible trade recorded imports and exports of physical goods
(entries for trade in physical goods excluding services is now often called
themerchandise balance). Invisible trade would record international buying and
selling of services, and sometimes would be grouped with transfer and factor
income as invisible earnings.

The term "balance of payments surplus" (or deficit a deficit is simply a negative
surplus) refers to the sum of the surpluses in the current account and the narrowly
defined capital account (excluding changes in central bank reserves). Denoting the
balance of payments surplus as BOP surplus, the relevant identity is

Disequilibrium in Balance of Payment

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 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'.

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'.

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.

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.

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.

Types of Disequilibrium in Balance of Payment

Balance of Payment of the country is determined by a multiplicity of forces and the

equilibrium in it is the resultant of numerous inter-related elements. The main
types of disequilibrium in the balance of payment are as follows :-

1. Structural Disequilibrium

It takes place due to structural changes in the economy affecting demand and
supply relations in commodity and factor market. Structural disequilibrium in
balance of payments persists for relatively longer periods; as it is not easy to
remove structural imbalance in the economy.

Some of the important causes of structural disequilibrium are as follows:-

1. If the foreign demand for a country's products decline due to the discovery
of cheaper substitutes abroad, then the country's export will decline causing
a deficit.

2. If the supply position of a country is affected due factors like crop failure,
shortage of raw-materials, strikes, political instability, etc, then there would
be the deficit in the balance of payments.
 3. A shift in demand due to the changes in tastes, fashions, income, etc, would
increase or decrease the demand for imported goods causing disequilibrium
in the balance of payments.

4. Changes in the rate of international capital movements may also cause

structural disequilibrium.

5. A war also results in structural changes which may affect not only goods but
also factor of production causing disequilibrium in balance of payments.

2. Cyclical Disequilibrium

When disequilibrium is caused due to the changes in trade cycles, it is termed as

cyclical disequilibrium. It is possible that different phases of trade cycles like
depression, prosperity, boom, recession, etc, may disturb terms of trade and cause
disequilibrium in balance of payments.

For instance, during boom period, imports may increase considerably due to
increase in demand for imported goods. During recession and depression, imports
may be reduced due to fall in demand on account of reduced income. During
recession exports may increase due to fall in price. During boom period, a country
may face deficit in its BoP position on account increase in imports. However,
during recession its export may increase, and as such BoP position may show
surplus.

Also, the importing countries may face cyclical changes. For instance, there may
be recession in the importing countries, which in turn would reduce demand for
imports. Therefore, the demand for exports will decline and the exporting country
may face a trade deficit, which in turn may affect BoP positions.

3. Technological Disequilibrium

Technological disequilibrium in balance of payments is caused by various

technological changes involve inventions or innovations of new goods or new
technique of production. These technological changes affect the demand for factors
and goods.
A technological change will give comparative advantage to the innovating country
leading to the increase in exports or a decline in imports. This will create
disequilibrium in the balance of payments.

4. Short run Disequilibrium

Disequilibrium caused on a temporary basis for a short period, say one year is
called short run disequilibrium. Such disequilibrium does not pose a serious threat
as it can be overcome within a short run. Such an disequilibrium may be caused
due to international borrowing and lending. When a country goes for borrowing or
lending it leads to short run disequilibrium. Such disequilibrium is justified as they
do not pose a serious threat.

Short run disequilibrium may also be caused when a country's imports exceeds
exports in a particular year. Such disequilibrium is not justified as it has the
potentiality to develop in to a crisis in time. The crisis in India in 1990-91 is
nothing but the development of short run disequilibrium. If the short run
disequilibrium is persistent & occurs repeatedly; it may pave the way for long run
disequilibrium.

5. Long run or Secular Disequilibrium

It prevails for a long period of time i.e. when the disequilibrium is persistent &
long run oriented, it is called long run disequilibrium The IMF terms such
disequilibrium as "Fundamental Disequilibrium".

Long-run or fundamental disequilibrium refers to a persistent deficit or a surplus in

the balance of payments of a country. It is also known as secular disequilibrium.

When there is a continuous increase in the stock of gold and foreign exchange
reserves. there is a persistent surplus & vies-versa.

Permanent changes in the conditions of demand and supply of exports and imports
cause fundamental disequilibrium. A permanent deficit or surplus may make a
country debtor or creditor causing a fundamental disequilibrium.

A developing country in its initial stages may import large amount of capital &
hence its imports would exceeds exports. When this becomes chronic, there
emerges a secular deficit in its balance of payments. Deep rooted dynamic changes
like capital formation, innovations, technological advancements, growth of
population etc. also contribute to fundamental disequilibrium.

When there is a series of short-run disequilibrium in a country's balance of

payments, ultimately it would lead to fundamental disequilibrium.

6.Monetary Disequilibrium

Monetary disequilibrium, takes place on account of inflation or deflation. Due to

inflation, the prices of the products in the domestic market rises, and therefore,
export items will become expensive. Such a situation may affect the BoP
equilibrium. Inflation also results in to increase in money income with the people,
which in turn may increase demand for imported goods. As a result imports may
turn Bop position in disequilibrium.

Measures To Correct Deficit in the Balance of Payment BoP

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 non-monetary 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 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.

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 :-

i. 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 unleashes inflationary trends.

ii. 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.

iii. 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.

iv. 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.

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.

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.

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 self-reliant. 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.

Conclusion

BOP accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BOP, such as the current
account, the capital account excluding the central bank's reserve account, or the
sum of the two. Imbalances in the latter sum can result in surplus countries
accumulating wealth, while deficit nations become increasingly indebted. The term
"balance of payments" often refers to this sum: a country's balance of payments is
said to be in surplus (equivalently, the balance of payments is positive) by a certain
amount if sources of funds (such as export goods sold and bonds sold) exceed uses
of funds (such as paying for imported goods and paying for foreign bonds
purchased) by that amount. There is said to be a balance of payments deficit (the
balance of payments is said to be negative) if the former are less than the latter.

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'. 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 non-
monetary measures