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DISEQUILIBRIUM

IN
BALANCE OF PAYMENTS

SUBMITTED BY
BHAVIK THAKER
ENROLLMENT NUMBER 200705473
CONTENTS

 Introduction

 Nature of Balance of Payments

 History of Balance of Payments

 Composition of Balance of Payments


 Disequilibrium in the balance of payments

 Types & Causes of Disequilibrium

 Methods of correcting BOP in disequilibrium

 BOP Crisis

 Balancing Mechanisms

 India’s balance of payments

 BOP Adjustment Policies


INTRODUCTION

 Balance of payments (BOP) is an accounting record of all monetary


transactions between a country and rest of the world.

 These transactions include payments for the country's exports and imports
of goods, services, and financial capital, as well as financial transfers.

 The BOP summarizes international transactions for a specific period,


usually a year, and is 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 sheet are included it 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 reserves or by receiving loans
from other countries.

NATURE OF BALANCE OF PAYMENTS

 Balance of payments (BOP) is a systematic record of transactions between


one country and rest of the world during a period of time.

 Balance of payments emerge as an important feature of modern


international trade , whereby the country can evaluate its position in terms
of international trade, currency movements, terms of trade and strength of
the currency.

 Balance of payments can also project the development status of the


economy in terms of industrial growth, economic stability and national
income.
HISTORY OF BALANCE OF PAYMENTS

 Historically, accurate balance of payments figures were not generally available.


However, this did not prevent a number of switches in opinion on questions relating
to whether or not a nations government should use policy to encourage a favourable
balance.

Pre-1820: Mercantilism
 Up until the early 19th century, measures to promote a trade surplus such as tariffs
were generally favoured. Power was associated with wealth, and with low levels of
growth, nations were best able to accumulate funds either by running trade
surpluses or by forcefully confiscating the wealth of others. From about the 16th
century, Mercantilism was a prevalent theory influencing European rulers, who
sometimes strove to have their countries out sell competitors and so build up a "war
chest" of gold.

 This era saw low levels of economic growth; average global per capita income is
not considered to have significantly risen in the whole 800 years leading up to
1820, and is estimated to have increased on average by less than 0.1% per year
between 1700 – 1820.With very low levels of financial integration between nations
and with international trade generally making up a low proportion of individual
nations GDP, BOP crises were very rare

1820–1914: Free trade

 Gold was the primary reserve asset during the gold standard era.

 From the late 18th century, mercantilism was challenged by the ideas of Adam
Smith and other economic thinkers favouring free trade. After victory in the
Napoleonic wars Great Britain began promoting free trade, unilaterally reducing
her trade tariffs. Hoarding of gold was no longer encouraged, and in fact Britain
exported more capital as a percentage of her national income than any other
creditor nation has since. Great Britain's capital exports further helped to correct
global imbalances as they tended to be counter cyclical, rising when Britain's
economy went into recession, thus compensating other states for income lost from
export of goods.

 According to historian Carroll Quigley, Great Britain could afford to act


benevolently] in the 19th century due to the advantages of her geographical
location, her naval power and her economic ascendancy as the first nation to enjoy
an industrial revolution. A view advanced by economists such as Barry
Eichengreen is that the first age of Globalization began with the laying of
transatlantic cables in the 1860s, which facilitated a rapid increase in the already
growing trade between Britain and America.

 Though Current Account controls were still widely used (in fact all industrial
nations apart from Great Britain and the Netherlands actually increased their tariffs
and quotas in the decades leading up to 1914, though this was motivated more by a
desire to protect "infant industries" than to encourage a trade surplus) , capital
controls were largely absent, and people were generally free to cross international
borders without requiring passports.

 A gold standard enjoyed wide international participation especially from 1870,


further contributing to close economic integration between nations. The period saw
substantial global growth, in particular for the volume of international trade which
grew tenfold in1820–1870 and then by about 4% annually from 1870 to 1914. BOP
crises began to occur, though less frequently than was to be the case for the
remainder of the 20th century. From 1880 - 1914, there were approximately 8 BOP
crises and 8 twin crises - a twin crises being a BOP crises that coincides with a
banking crises.

1914–1945: Deglobalisation

 The favourable economic conditions that had prevailed up until 1914 were
shattered by the First World War, and efforts to re-establish them in the 1920s were
not successful. Several countries rejoined the gold standard around 1925. But
surplus countries didn't "play by the rules" sterilising gold inflows to a much
greater degree than had been the case in the pre-war period. Deficit nations such as
Great Britain found it harder to adjust by deflation as workers were more
enfranchised and unions in particular were able to resist downwards pressure on
wages. During the great depression most countries abandoned the gold standard,
but imbalances remained an issue and international trade declined sharply. There
was a return to mercantilist type "beggar thy neighbour" policies, with countries
competitively devaluing their exchange rates, thus effectively competing to export
unemployment. There were approximately 16 BOP crises and 15 twin crises (and a
comparatively very high level of banking crises.)
1945–1971: Bretton Woods
 Following World War II, the Bretton Woods institutions (the International
Monetary Fund and World Bank) were set up to support an international monetary
system designed to encourage free trade while also offer states options to correct
imbalances without having to deflate their economies. Fixed but flexible exchange
rates were established, with the system anchored by the dollar which alone
remained convertible into gold, The Bretton Woods system ushered in a period of
high global growth, known as the Golden Age of Capitalism, however it came
under pressure due to the inability or unwillingness of governments to maintain
effective capital controls and due to instabilities related to the central role of the
dollar.

 Imbalances caused gold to flow out of the US and a loss of confidence in the
United States ability to supply gold for all future claims by dollar holders resulted
in escalating demands to convert dollars, ultimately causing the US to end the
convertibility of the dollar into gold, thus ending the Bretton Woods system. The
1945 - 71 era saw approximately 24 BOP crises and no twin crises for advanced
economies, with emerging economies seeing 16 BOP crises and just one twin
crises.

1971–2009: Transition, Washington Consensus, Bretton Woods II

 Manmohan Singh, currently PM of India, showed that the challenges caused by


imbalances can be an opportunity when he led his country's successful economic
reform programme after the 1991 crisis.
 The Bretton Woods system came to an end between 1971 and 1973. There were
attempts to repair the system of fixed exchanged rates over the next few years, but
these were soon abandoned, as were determined efforts for the US to avoid BOP
imbalances. Part of the reason was displacement of the previous dominant
economic paradigm – Keynesianism – by the Washington Consensus, with
economists and economics writers such as Murray Rothbard and Friedman arguing
that there was no great need to be concerned about BOP issues. According to
Rothbard

 Fortunately, the absurdity of worrying about the balance of payments is made


evident by focusing on inter-state trade. For nobody worries about the balance of
payments between New York and New Jersey, or, for that matter, between
Manhattan and Brooklyn, because there are no customs officials recording such
trade and such balances.

 In the immediate aftermath of the Bretton Woods collapse, countries generally tried
to retain some control over their exchange rate by independently managing it, or by
intervening in the Forex as part of a regional bloc, such as the Snake which formed
in 1971. The Snake was a group of European countries who tried to retain stable
rates at least with each other; the group eventually evolved into the ERM by 1979.
From the mid 1970s however, and especially in the 1980s and early 90s, many
other countries followed the US in liberalising controls on both their capital and
current accounts, in adopting a somewhat relaxed attitude to their balance of
payments and in allowing the value of their currency to float relatively freely with
exchange rates determined mostly by the market.

 Developing countries that chose to allow the market to determine their exchange
rates would often develop sizeable current account deficits, financed by capital
account inflows such as loans and investments, though this often ended in crises
when investors lost confidence. The frequency of crises was especially high for
developing economies in this era - from 1973–1997 emerging economies suffered
57 BOP crises and 21 twin crises. Typically but not always the panic among
foreign creditors and investors that preceded the crises in this period was usually
triggered by concerns over excess borrowing by the private sector, rather than by a
government deficit. For advanced economies, there were 30 BOP crises and 6
banking crises.
 A turning point was the 1997 Asian BOP Crisis, where unsympathetic responses by
western powers caused policy makers in emerging economies to re-assess the
wisdom of relying on the free market; by 1999 the developing world as a whole
stopped running current account deficits while the US current account deficit began
to rise sharply. This new form of imbalance began to develop in part due to the
increasing practice of emerging economies, principally China, in pegging their
currency against the dollar, rather than allowing the value to freely float. The
resulting state of affairs has been referred to as Bretton Woods II. According to
Alaistair Chan, "At the heart of the imbalance is China's desire to keep the value of
the yen stable against the dollar. Usually, a rising trade surplus leads to a rising
value of the currency. A rising currency would make exports more expensive,
imports less so, and push the trade surplus towards balance. China circumvents the
process by intervening in exchange markets and keeping the value of the yuan
depressed." According to economics writer Martin Wolf, in the eight years leading
up to 2007, "three quarters of the foreign currency reserves accumulated since the
beginning of time have been piled up". In contrast to the changed approach within
the emerging economies, US policy makers and economists remained relatively
unconcerned about BOP imbalances. In the early to mid 90s, many free market
economists and policy makers such as US Treasury secretary Paul O'Neill and Fed
Chairman Alan Greenspan went on record suggesting the growing US deficit was
not a major concern. While several emerging economies had intervening to boost
their reserves and assist their exporters from the late 1980s, they only began
running a net current account surplus after 1999. This was mirrored in the faster
growth for the US current account deficit from the same year, with surpluses,
deficits and the associated build up of reserves by the surplus countries reaching
record levels by the early 2000s and growing year by year. Some economists such
as Kenneth Rogoff and Maurice Obstfeld began warning that the record imbalances
would soon need to be addressed from as early as 2001, joined by Nouriel Roubini
in 2004, but it wasn't until about 2007 that their concerns began to be accepted by
the majority of economists.

2009 and later: Post Washington Consensus

 Speaking after the 2009 G-20 London summit, Gordon Brown announced "the
Washington Consensus is over." There is now broad agreement that large
imbalances between different countries do matter; for example mainstream US
economist C. Fred Bergsten has argued the US deficit and the associated large
inbound capital flows into the US was one of the causes of the financial crisis of
2007–2010 Since the crisis, government intervention in BOP areas such as the
imposition of capital controls or forex intervention has become more common and
in general attracts less disapproval from economists, international institutions like
the IMF and other governments.

 In 2007 when the crises began, the global total of yearly BOP imbalances was
$1680bn. On the credit side, the biggest current account surplus was China with
approx. $362Bn, followed by Japan at $213Bn and Germany at £185BN, with oil
producing countries such as Saudi Arabia also having large surpluses. On the debit
side, the US had the biggest current account deficit at over £700Bn, with the UK,
Spain and Australia together accounting for close to a further $300Bn.

 While there have been warnings of future cuts in public spending, deficit countries
on the whole did not make these in 2009, in fact the opposite happened with
increased public spending contributing to recovery as part of global efforts to
increase demand . The emphases has instead been on the surplus countries, with the
IMF, EU and nations such as the US, Brazil and Russia asking them to assist with
the adjustments to correct the imbalances.

 Economists such as Gregor Irwin and Philip R. Lane have suggested that increased
use of pooled reserves could help emerging economies not to require such large
reserves and thus have less need for current account surpluses. Writing for the FT
in Jan 2009, Gillian Tett says she expects to see policy makers becoming
increasingly concerned about exchange rates over the coming year. In June 2009,
Olivier Blanchard the chief economist of the IMF wrote that rebalancing the world
economy by reducing both sizeable surpluses and deficits will be a requirement for
sustained recovery.

 2008 and 2009 did see some reduction in imbalances, but early indications towards
the end of 2009 were that major imbalances such as the US current account deficit
are set to begin increasing again.

 Japan had allowed her currency to appreciate through 2009, but has only limited
scope to contribute to the rebalancing efforts thanks in part to her aging population.
The Euro used by Germany is allowed to float fairly freely in value, however
further appreciation would be problematic for other members of the currency union
such as Spain, Greece and Ireland who run large deficits. Therefore Germany has
instead been asked to contribute by further promoting internal demand, but this
hasn't been welcomed by German officials.
 China has been requested to allow the Renminbi to appreciate but until 2010 had
refused, the position expressed by her premier Wen Jiabao being that by keeping
the value of the Renmimbi stable against the dollar China has been helping the
global recovery, and that calls to let her currency rise in value have been motivated
by a desire to hold back China's development. After China reported favourable
results for her December 2009 exports however, the Financial Times reported that
analysts are optimistic that China will allow some appreciation of her currency
around mid 2010.

Competitive devaluation after 2009

 By September 2010, international tensions relating to imbalances had further


increased. Brazil's finance minister Guido Mantega declared that an "international
currency war" has broken out, with countries competitively trying to devalue their
currency so as to boost exports. Brazil has been one of the few major economies
lacking a reserve currency to abstain from significant currency intervention, with
the real rising by 25% against the dollar since Jan 2009. Some economists such as
Barry Eichengreen have argued that competitive devaluation may be a good thing
as the net result will effectively be equivalent to expansionary global monetary
policy. Others such as Martin Wolf saw risks of tensions further escalating and
advocated that coordinated action for addressing imbalances should be agreed on at
the November G20 summit.

 Commentators largely agreed that little substantive progress was made on


imbalances at the November 2010 G20. An IMF report released after the summit
warned that without additional progress there is a risk of imbalances approximately
doubling to reach pre-crises levels by 2014

COMPOSITION OF BALANCE OF PAYMENTS


The Balance of Payment is comprised of two main components:

 The Current Account (trade in goods, services + investment incomes

 The Financial Account (used to be called capital account)

Current account:
 It deals with the movements of merchandise (goods) by way of exports and
imports. The merchandise may be private or Governmental. Merchandise
is a major item on the current account. Other items appearing under current
account include, Transportation, insurance, tourism, and foreign remittances
are called as the invisibles because it involves foreign exchange flows but
has no physical movement of goods. The remittances can be in or out of the
country. Other items are non-monetary gold and miscellaneous head for
non-classified current transactions.

 Each one of these items has a credit or debit depending on the principles of
double entry book keeping.

 On current account there can be deficit or surplus, depending on the nature


of transactions.

 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 – payments for imports), factor income (earnings
on foreign investments – payments made to foreign investors) and cash
transfers. It's called the current account as it covers transactions in the "here
and now" - those that don't give rise to future claims.
 The position on the merchandise account is called the balance of trade. The
difference between exports and imports determine the position of balance of
trade. It is an important indicator because it will highlight the foreign
exchange commitments of the country with respect to each country and
currency.

In brief Current Account is a record of all payments for trade in goods and services
plus income flow it is divided into 4 parts

 Balance of trade in goods (visible)


 Balance of trade in services (invisibles) e.g. tourism, insurance
 Net income flows (wages and investment income)
 Net current transfers (e.g. govt aid)
Is Current Account Deficit a bad Thing?

Why a Current account is considered harmful to the economy

 A current account deficit is financed through borrowing or foreign investment

 Borrowing is unsustainable in the long term and countries will be burdened with
high interest payments. E.g Russia was unable to pay its foreign debt back in 1998.
Other developing countries have experience similar repayment problems Brazil,
African c (3rd World debt)

 Foreigners have an increasing claim on UK assets, which they could desire to be


returned at any time. E.g. a severe financial crisis in Japan may cause them to
repatriate their investments

 Export sector may be better at creating jobs

 A Balance of Payments deficit may cause a loss of confidence


However a current account deficit is not necessarily harmful

 Current Account deficit could be used to finance investment

 E.g. US ran a Current account deficit for a long time as it borrowed to invest in its
economy. This enabled higher growth and so it was able to pay its debts back and
countries had confidence in lending the US money

 Japanese investment has been good for UK economy not only did the economy
benefit from increased investment but the Japanese firms also helped bring new
working practices in which increased labour productivity.

 With a floating exchange rate a large current account deficit should cause a
devaluation which will help reduce the level of the deficit

 It depend on the size of the budget deficit as a % of GDP, for example the US trade
deficit has nearly reached 5% of GDP (02/03) at this level it is concerning
economists
Factors which cause a current account Deficit in the balance of Payments

 Fixed Exchange Rate


If the currency is overvalued, imports will be cheaper and therefore there will be a
higher Q of imports. Exports will become uncompetitive and therefore there will be
a fall in the Quantity of exports.

 Economic Growth
If there is an increase in AD and National Income increases, people will have more
disposable income to consume goods. If domestic producers can not meet the
domestic AD, consumers will have to imports goods from abroad. In the UK we
have a high Marginal propensity to imports mpm because we do not have a
comparative advantage in the production of manufactured goods. Therefore if there
is fast economic growth there tends to be a big increase in imports.

 Decline in Competitiveness.
IN the UK there has been a decline in the exporting manufacturing sector, because
it has struggled to compete with developing countries in the Far East. This has led
to a persistent deficit in the balance of trade.
 Higher inflation
This makes exports less competitive and imports more competitive. However this
factor may be offset by a decline in the value of sterling.

 Recession in other countries.


If the UK’s main trading partners experience negative economic growth then they
will buy less of our exports, worsening the current account.

 Borrowing money
If countries are borrowing money to invest e.g third world countries

 Deterioration in the current account

This means that the value of exports has increased at a slower rate than the value of
imports. Therefore there could have been an increase in the deficit or the surplus
could have changed into a deficit
Capital account:

 It deals with capital movements between one country and rest of the world.
Capital movements can be private, governmental or institutional (IMF,
World Bank and others).It can be again classified as short term and long
term capital movements.

 The capital account records the net change in ownership of foreign assets. It
includes the reserve account (the international 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).

 Other items include amortization, debt servicing, monetary gold and


miscellaneous. Amortisation is the loan liquidated, debt servicing is the
repayment of principle and interest and non-monetary gold is the payments
made in terms of gold.

 These capital transactions will also have a debit or credit depending on the
directions of flows. Capital account can show a deficit or a surplus
revealing the strength of the economy. The deficits of the current account
will be financed by the capital account. So there is a spill over of deficits of
current acceptant into capital account.

In brief Capital or Financial Account is a record of all transactions for financial


investment. It includes

 Net investment from abroad (e.g. A UK firm buying a factory in Japan


would be a debit item )

 Net financial flows - These are mainly short term monetary flows such as
“hot money flows” to take advantage of exchange rate changes.

 Reserves

Expressed with the standard meaning for the capital account, the BOP identity is:

 The balancing item is simply an amount that accounts for any statistical errors and
assures that the current and capital accounts sum to zero. At high level, 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 should balance. A
balance isn't always reflected in reported figures, which might, for example, report
a surplus for accounts, but when this happens it always means something has been
missed—most commonly, the operations of the country's central bank.

 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 the
merchandise balance). Invisible trade would record international buying and selling
of services, and sometimes would be grouped with transfer and factor income as
invisible earnings.

Balance of Payments Equilibrium

 In a floating exchange rate the supply of currency will always equal the demand for
currency, and the balance of payments is 0.

 Therefore if there is a deficit on the current account there will be a surplus on the
financial account.

 If there was an increase in interest rates this would cause hot money flows to enter
into the UK, therefore there would be a surplus on the financial account

 The appreciation in the exchange rate would make exports less competitive and
imports more competitive therefore with less X and more M there would be a
deficit on the current account
Balance of payments will have the deficit or surplus, reflecting the overall position
of all the international transactions.

 Balance of trade:

Balance of trade is an important indicator of the efficiency of export sector and


import substitution sector. It is the position of an economy interms of merchandise
on current account. It is an important indicator because it will highlight the foreign
exchange commitments of the country with respect to each country and currency.

 Basic balance:

This is the difference between exports + inflow of long term capital AND imports
+ out flow of private capital. It is measure of gross movements in currencies in and
out of the economy.

 Liquidity balance:

In international trade, liquidity is a major consideration in international payments.


Liquidity balance deals with the difference in the official exchange holdings over a
given period of time. High liquidity balance improves the credit worthiness of a
country.

 Official settlement balance:

It is a gross indicator of financial position arising out of the balance of payments. It


is the difference between exports + all private capital inflows AND imports + all
private out flows. It gives a clear picture of the balance of payments position
pertaining to a given time period.
Does balance of payments always balance?

In the classical school of thought it was popularly believed that balance of


payments should always balance. It was backed by the idea that under barter
system of exchange, every import shall have a corresponding export. So exports
will always be equal to imports.

Further, with no capital flows the payments can not be differed. With this there
will not be any difference between balance of trade and balance of payments.
Hence it was felt that balance of payments shall always balance.

With monetized transactions, barter is ruled out. There are capital movements
which can always upset export-import equality. Moreover, what the classical
economics considered balance of payments was indeed balance of trade.

There is no need for the balance of payments to balance, not even the balance of
trade. There can be deficit or surplus in any of the measures. On the other and
the balance of payments position reveals the strength of the country and
currency.
It is desirable to have a surplus in the balance of payments. A deficit in balance
of payments is called disequilibrium. Continuous deficits lead to problems of
mounting external debt burden and unstable currency.

Types and Causes of disequilibrium in the balance of payments

Types and Causes of disequilibrium in the balance of payments


 In general terms, a deficit in the balance of payments is called
disequilibrium. Such a deficit may be at the capital account, current
account; occasional, chronic; cyclical, enlarging deficits. Each type is
caused by different set of factors. But in general, disequilibrium is an
unfavourable position in BOP caused by continuous deficits which are
large.

Types of disequilibrium in the balance of payments

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:-

 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.
 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.
 A shift in demand due to the changes in tastes, fashions, income, etc, would
increase or decrease the demand for imported goods causing a disequilibrium in the
balance of payments.
 Changes in the rate of international capital movements may also cause structural
disequilibrium.
 A war also results in structural changes which may affect not only goods but also
factor of production causing disequilibrium in balance of payments.
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.

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.

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.

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 & vice-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.

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.

Causes of disequilibrium in the balance of payments

BOP disequilibrium is common with most developing economies. Study of the


factors and nature of disequilibrium will help in correction and design of methods
of protection.

Following are the important causes of disequilibrium:

 Large population, increasing growth rates of population.


 Stagnant exports due to out dated products.
 Increasing demand for imports.
 Low productivity and poor growth rates.
 Lack of bargaining power.
 Large external debt due to which the burden of debt servicing increases.
 Adverse terms of trade.
 Cyclical fluctuations in economic activity.
 Problems of international liquidity.
 Absence of ant trading association or regional block
 Weak currency
 Absence of trade ties with developed economies.
Methods of correcting disequilibrium in the balance of payments

There are several methods to correct balance of payment disequilibrium. The


methods depend on the nature and causes of disequilibrium.

The methods can be classified into two groups: viz. monetary and non monetary
methods.

 Monetary methods:
Monetary methods of correction affect the balance payments by changing the value
or flow of currencies; both domestic and foreign. Indirectly, it affects the volume
and value of exports and imports. With flexible exchange rate it is possible to affect
the value and volume of exports and imports.

Following are the various monetary methods of BOP correction

Devaluation

 Devaluation means decreasing the value of domestic currency with respect to a


foreign exchange. Devaluation is done by the Government of the country of origin.
Devaluation is done deliberately to get its advantages. The Government officially
declares the devaluation, indicating the extent of decrease in the value of its
currency. The Government can decide the time and the amount of decrease.

 Devaluation can determine a specific currency with which it is devalued. In such


case the trade with the target country improves. The devaluation is irreversible.
The country can not change the value of currency frequently.

 With a decrease in the value of its currency, the country has to pay more in
exchange to a foreign currency

 In case of exports the price shows a decline to the extent of decrease. The exports
become cheaper.
 At the same time the imports become expensive because more domestic currency is
payable.

 With this the exports increase and the imports decrease.

 This way the balance of payments position improves. The country gets better terms
of trade.

 Devaluation is opted during such times when:


• The imports are increasing rapidly,
• The exports are stagnant,
• The domestic currency has low demand
• The foreign currency is in high demand

The efficiency of devaluation, however depends on

MARSHALL-LERNER CONDITION.

 According to the Marshall-Lerner condition. Devaluation helps only incase the


elasticities of demand of exports and imports is equal to 1
• ex + em =1
 It is advisable to devalue currency only when the sum of the elasticities of exports
and imports in equal to one.
Incase the exports and imports are inelastic, the devaluation will help the
country. Generally, the developing countries have inelastic exports and
imports. Devaluation in such countries is not always useful.

 In case of inelastic exports, the decrease in price can not get proportionate increase
in the volume. So, there is a decrease in the revenue due to devaluation
 When the exports are elastic. The increase in the volume of exports will be grater
than the decrease in the price. The revenue from trade will increase after
devaluation.
 Similar case can be proved with imports where, outgoing are larger with inelastic
imports.
 The Marshall-Lerner condition stipulates the limitations of applicability of
devaluation. Further, devaluation can also bring in large scale retaliation from
other countries. Which again affect the BOP position the devaluating country.
 There are some other methods which are similar to devaluation but the nature is
different.
Depreciation

 Depreciation is similar to devaluation but it is done by the exchange


market. The exchange market is made up of demand and supply of
currency. Depending on the demand and supply, the value of currency can
be appreciated or depreciated. Depreciation is similar to devaluation. It
involves a decrease in value.

 Depreciation is done by the market; the Government has no control over the
value. Further, the value changes are small and reversible depending on the
demand and supply conditions.

Pegging Operations
 Pegging down the value of currency is done by the Government. The
Central bank depending on the need may artificially, increase or decrease
the value of currency, temporarily.

 Pegging operations can be done any number of times. Since it is done by


the Government, it may be beneficial. It is reversible; it offers the
Government the flexibility to manage the value of the currency for its
advantage.

Deflation

 With flexible exchange rate mechanism, the domestic value of currency


affects the international value of currency. The domestic value of currency
can be improves by any of the anti-inflationary methods. By reducing the
domestic money stock, the value of money can be improved. It improves the
foreign exchange rate as well.

Exchange Controls

 Deliberate management of exchange markets, value, and volumes of


currencies form the exchange controls. There are several methods of
exchange controls which can affect the value and flows of currencies for
improving the BOP position.
 Exchange controls include methods like, pegging operations, multiple
exchange rates, mutual clearing agreements etc.
 It can be seen that, monetary methods of correcting BOP disequilibrium aim
at solving the crisis on capital account and directly managing flow of
foreign exchange. Indirectly, the value of currency can bring equilibrium
on current account as well by changing volume of exports and imports.
Non - Monetary Methods

Non-monetary methods deal with real sector for correcting BoP disequilibrium. All
the non-monetary methods directly affect exports and imports. Following are the
important non-monetary methods:

 Export Promotion: The country with deficits can take up export promotion
measures like providing fiscal incentives, financial aid, Infrastructural
facilities, marketing support and support of imported inputs. The
Government offers a package of tax incentives which will reduce the costs
and make exports competitive in the world market.

 Import Substitution: The economy can progressively develop technology of


import substitution. A country produces those goods which were earlier
imported. It may require import of capital goods, technology or
collaborations.

 Import Substitution: The economy can progressively develop technology of


import substitution. A country produces those goods which were earlier
imported. It may require import of capital goods, technology or
collaborations.

 Import Licensing: The Government can have stringent controls over the
usage of imports. This can be done by licensing the users based on
centralised imports.

 Quota: Import quotas are important non-tariff barriers. They are positive
restrictions on incoming goods.

 Tariffs: Tariff is a tax duty levied on imports. The objective is to make


imports expensive, which will in turn produce domestic demand and make
home industry competitive.

Every Country has to use a combination of monetary and non-monetary methods


to effectively correct balance of payment disequilibrium and also prevent
retaliation from any developed country.

Balance of Payments Crisis:


 A BOP crisis, also called a currency crisis, occurs when a nation is unable
to pay for essential imports and/or service its debt repayments. Typically,
this is accompanied by a rapid decline in the value of the affected nation's
currency. Crises are generally preceded by large capital inflows, which are
associated at first with rapid economic growth. However a point is reached
where overseas investors become concerned about the level of debt their
inbound capital is generating, and decide to pull out their funds. The
resulting outbound capital flows are associated with a rapid drop in the
value of the affected nation's currency. This causes issues for firms of the
affected nation who have received the inbound investments and loans, as the
revenue of those firms is typically mostly derived domestically but their
debts are often denominated in a reserve currency. Once the nation's
government has exhausted its foreign reserves trying to support the value of
the domestic currency, its policy options are very limited. It can raise its
interest rates to try to prevent further declines in the value of its currency,
but while this can help those with debts in denominated in foreign
currencies, it generally further depresses the local economy.

Balancing Mechanisms:
 One of the three fundamental functions of an international monetary system
is to provide mechanisms to correct imbalances.
 Broadly speaking, there are three possible methods to correct BOP
imbalances, though in practice a mixture including some degree of at least
the first two methods tends to be used. These methods are adjustments of
exchange rates; adjustment of nation’s internal prices along with its levels
of demand; and rules based adjustment. Improving productivity and hence
competitiveness can also help, as can increasing the desirability of exports
through other means, though it is generally assumed a nation is always
trying to develop and sell its products to the best of its abilities.

Rebalancing by changing the exchange rate:

 An upwards shift in the value of a nation's currency relative to others will


make a nation's exports less competitive and make imports cheaper and so
will tend to correct a current account surplus. It also tends to make
investment flows into the capital account less attractive so will help with a
surplus there too. Conversely a downward shift in the value of a nation's
currency makes it more expensive for its citizens to buy imports and
increases the competitiveness of their exports, thus helping to correct a
deficit (though the solution often doesn't have a positive impact
immediately due to the Marshall–Lerner condition.
 Exchange rates can be adjusted by government in a rules based or managed
currency regime, and when left to float freely in the market they also tend to
change in the direction that will restore balance. When a country is selling
more than it imports, the demand for its currency will tend to increase as
other countries ultimately need the selling country's currency to make
payments for the exports. The extra demand tends to cause a rise of the
currency's price relative to others. When a country is importing more than it
exports, the supply of its own currency on the international market tends to
increase as it tries to exchange it for foreign currency to pay for its imports,
and this extra supply tends to cause the price to fall. BOP effects are not the
only market influence on exchange rates however, they are also influenced
by differences in national interest rates and by speculation.
Rebalancing by adjusting internal prices and demand:

 When exchange rates are fixed by a rigid gold standard, or when imbalances
exist between members of a currency union such as the Eurozone, the
standard approach to correct imbalances is by making changes to the
domestic economy. To a large degree, the change is optional for the surplus
country, but compulsory for the deficit country. In the case of a gold
standard, the mechanism is largely automatic. When a country has a
favourable trade balance, as a consequence of selling more than it buys it
will experience a net inflow of gold. The natural effect of this will be to
increase the money supply, which leads to inflation and an increase in
prices, which then tends to make its goods less competitive and so will
decrease its trade surplus. However the nation has the option of taking the
gold out of economy (sterilising the inflationary effect) thus building up a
hoard of gold and retaining its favourable balance of payments. On the other
hand, if a country has an adverse BOP its will experience a net loss of gold,
which will automatically have a deflationary effect, unless it chooses to
leave the gold standard. Prices will be reduced, making its exports more
competitive, and thus correcting the imbalance. While the gold standard is
generally considered to have been successful up until 1914, correction by
deflation to the degree required by the large imbalances that arose after
WWI proved painful, with deflationary policies contributing to prolonged
unemployment but not re-establishing balance. Apart from the US most
former members had left the gold standard by the mid 1930s.
 A possible method for surplus countries such as Germany to contribute to
re-balancing efforts when exchange rate adjustment is not suitable is to
increase its level of internal demand (i.e. its spending on goods). While a
current account surplus is commonly understood as the excess of earnings
over spending, an alternative expression is that it is the excess of savings
over investment. That is:

Where CA = current account, NS = national savings (private plus government


sector), NI = national investment.

 If a nation is earning more than it spends the net effect will be to build up
savings, except to the extent that those savings are being used for
investment. If consumers can be encouraged to spend more instead of
saving; or if the government runs a fiscal deficit to offset private savings; or
if the corporate sector divert more of their profits to investment, then any
current account surplus will tend to be reduced. However in 2009 Germany
amended its constitution to prohibit running a deficit greater than 0.35% of
its GDP and calls to reduce its surplus by increasing demand have not been
welcome by officials, adding to fears that the 2010s will not be an easy
decade for the eurozone. In their April 2010 world economic outlook report,
the IMF presented a study showing how with the right choice of policy
options governments can transition out of a sustained current account
surplus with no negative effect on growth and with a positive impact on
unemployment.

Rules based rebalancing mechanisms:

 Nations can agree to fix their exchange rates against each other, and then
correct any imbalances that arise by rules based and negotiated exchange
rate changes and other methods. The Bretton Woods system of fixed but
adjustable exchange rates was an example of a rules based system, though it
still relied primarily on the two traditional mechanisms. Keynes, one of the
architects of the Bretton Woods system had wanted additional rules to
encourage surplus countries to share the burden of rebalancing, as he argued
that they were in a stronger position to do so and as he regarded their
surpluses as negative externalities imposed on the global economy.[41]
Keynes suggested that traditional balancing mechanisms should be
supplemented by the threat of confiscation of a portion of excess revenue if
the surplus country did not choose to spend it on additional imports.
However his ideas were not accepted by the Americans at the time. In 2008
and 2009, American economist Paul Davidson had been promoting his
revamped form of Keynes's plan as a possible solution to global imbalances
which in his opinion would expand growth all round with out the downside
risk of other rebalancing methods

Discrepancies in the use of term ‘’balance of payments’’


 According to economics writer J. Orlin Grabbe the term Balance of
Payments is sometimes misused by people who aren't aware of the accepted
meaning, not only in general conversation but in financial publications and
the economic literature.
 A common source of confusion is to exclude the reserve account entry,
which records the activity of the nation's central bank. When the reserve
account is excluded, the BOP can be in surplus (which implies the central
bank is building up foreign exchange reserves) or in deficit (which implies
the central bank is running down its reserves or borrowing from abroad).
 The term "balance of payments" can also be misused to mean just relatively
narrow parts of the BOP such as the, which means excluding parts of the
current account and the entire capital account.
 Another cause of confusion is the different naming conventions in use.
Before 1973 there was no standard way to break down the BOP sheet, with
the separation into invisible and visible payments sometimes being the
principal divisions. The IMF have their own standards for the BOP sheet
which is equivalent to the standard definition but uses different
nomenclature, in particular with respect to the meaning given to the term
capital account.

IMF definition
The IMF use a particular set of definitions for the BOP, which is also used by the
OECD , and the United Nations' SNA.

The main difference with the IMF definition is that they use the term financial
account to capture transactions that in the standard definition are recorded in the
capital account. The IMF does use the term capital account, to designate a subset
of transactions that according to usage common in the rest of the world form a
small part of the overall capital account.[6] The IMF separates these transactions out
to form an additional top level division of the BOP sheet. Expressed with the IMF
definition, the BOP identity can be written:

The IMF uses the term current account with the same meaning as the standard
definition, although they have their own names for their three leading sub divisions,
which are:

• The goods and services account (the overall trade balance)


• The primary income account (factor income such as from
loans and investments)
• The secondary income account (transfer payments)
INDIA ‘’balance of payments’’

Key statistical concept

 The Reserve Bank of India (RBI) is responsible for compiling the


balance of payments for India. The RBI obtains data on the balance
of payments primarily as a by-product of the administration of the
exchange control. In accordance with the Foreign Exchange
Management Act (FEMA) of 1999, all foreign exchange
transactions must be channelled through the banking system, and the
banks that undertake foreign exchange transactions must submit
various periodical returns and supporting documents prescribed
under the FEMA. In respect of the transactions that are not routed
through banking channels, information is obtained directly from the
relevant government agencies, other concerned agencies, and other
departments within the RBI. The information is also supplemented
by data collected through various surveys conducted by the RBI.
Data are prepared on a quarterly basis and are published in the
Reserve Bank of India Bulletin.

The data are compiled in crores of rupees (one crore is equal to 10


million) and are broadly in conformity with the recommendations of
the BPM5. The data are also expressed in millions of U.S. The data
are compiled in crores of rupees (one crore is equal to 10 million)
and are broadly in conformity with the recommendations of the
BPM5. The data are also expressed in millions of U.S. dollars
Key statistical concept

Current Account

Goods

The RBI compiles data on merchandise transactions mainly as a by-product of the


administration of exchange control. Data on exports are based on export
transactions and the collection of export proceeds as reported by the banks. In the
case of imports, exchange control records cover only those imports for which
payments have been effected through banking channels in India. Information on
payments for imports not passing through the banking channels is obtained from
other sources, primarily government records and borrowing entities in respect of
their external commercial borrowing. Since 1992-93, the value of gold and silver
brought to India by returning travellers has been added to the imports data with a
contra-entry under current transfers, other sectors. Exports are recorded on an f.o.b.
basis, whereas imports are recorded c.i.f. The IMF adjusts imports, for publication,
to an f.o.b. basis by assuming freight and insurance to be 10 percent of the c.i.f.
value.

Services

Under the exchange control rules, authorized dealers (i.e., banks authorized to deal
in foreign exchange) are required to report details in respect of transactions, other
than exports, when the individual remittances exceed a stipulated amount. For
receipts below this amount, the banks report only aggregate amounts without
indicating the purpose of the incoming remittance. The balance of payments
classification of these receipts is made on the basis of the Survey of Unclassified
Receipts conducted by the RBI. This sample survey is conducted on a biweekly
basis.
Transportation

This category covers all modes of transport and port services; the data are based
mainly on the receipts and payments reported by the banks in respect of
transportation items. In addition to the exchange control records, the survey of
unclassified receipts is also used as a source. These sources are supplemented by
information collected from major airline and shipping companies in respect of
payments from foreign accounts. A benchmark Survey of Freight and Insurance on
Exports is also used to estimate freight receipts on account of exports.

Travel

Travel data are obtained from exchange control records, supplemented by


information from the surveys of unclassified receipts. The estimates of travel
receipts also use the information on foreign tourist arrivals and expenditure,
received from the Ministry of Tourism as a cross-check of the exchange control and
survey data.

Other services

The insurance category covers all types of insurance (i.e., life, nonlife, and
reinsurance transactions). Thus, the entries include all receipts and payments
reported by the banks in respect of insurance transactions. In addition to
information available from exchange control records, information in the survey of
unclassified receipts is also used. The benchmark survey of freight and insurance is
used to estimate insurance receipts on account of exports. Other services also cover
a variety of service transactions on account of software development, technical
know-how, communication services, management fees, professional services,
royalties, and financial services. Since 1997-98, the value of software exports for
onsite development, expenditure on employees, and office maintenance expenses
has been included in other services. Transactions in other services are captured
through exchange control records and the survey of unclassified receipts,
supplemented by data from other sources. For example, information on issue
expenses in connection with the issue of global depository receipts and foreign
currency convertible bonds abroad is obtained from the details filed by the
concerned companies with the Foreign Exchange Department, RBI.

Income

Investment income

Information on investment income transactions is obtained from exchange control


records and foreign investment surveys, supplemented by information available
from various departments of the RBI. Interest payments on foreign commercial
loans are also reported under the RBI Foreign Currency Loan reporting system. The
data on reinvested earnings of foreign direct investment companies are based on the
annual Survey of Foreign Liabilities and Assets, conducted by the RBI. Details of
investment income receipts on account of official reserves are obtained from the
RBI's internal records. Interest accrued during the year and credited to nonresident
Indian deposits is also included under this category.

Current transfers

General government

The data are obtained from the Controller of Aid Accounts and Audit, government
of India, whereas data on PL-480 grants are obtained from the U.S. Embassy in
India.

Other sectors
Transactions relating to workers' remittances are based on the information
furnished by authorized dealers regarding remittances received under this category,
supplemented by the data collected in the survey of unclassified receipts regularly
conducted by the RBI. Redemption, in India, of non-resident dollar account
schemes and withdrawals from non-resident rupee account schemes has been
included as current transfers, other sectors since 1996-97.
Key statistical concept

Financial Account

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. Because of this change in
methodology, data for years before 2000/2001 are not comparable with those for
data since then. However, as 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 non-
resident 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.
India’s Balance of Payments 2008 – 2009

BALANCE OF PAYMENT

Shrinking foreign trade

INDIA’s trade deficit during the first nine months of fiscal 2009-10 on a
balance of payments (BOP) basis was lower at US$ 89.51 bn compared with
US$ 98.44 bn during the same period in fiscal 2008-09. The trade deficit on a
BoP basis in Q3 (US$ 30.72 billion) was, however, less than that in Q3 of 2008-
09 (US$ 34.04 billion). This is revealed in e report (India's Balance of
Payments Developments during the first quarter (October-December) of 2009-
10) of the country’s central banking authority Reserve Bank of India (RBI).

The key features of India’s BOP that emerged in Q3 of fiscal 2009-10 were:(i)
Exports recorded a growth of 13.2 per cent during Q3 of 2009-10 over the
corresponding quarter of the previous year, after consecutive declines in the last
four quarters.(ii) Imports registered a growth of 2.6 per cent in Q3 of 2009-10
after recording consecutive declines in the last three quarters.(iii) Private
transfer receipts remained robust during Q3 of 2009-10.(iv) Despite low trade
deficit, the current account deficit was higher at US$ 12.0 billion during Q3 of
2009-10 mainly due to lower invisibles surplus.(v) The current account deficit
during April-December 2009 was higher at US$ 30.3 billion as compared to
US$ 27.5 billion during April-December 2008.(vi) Surplus in capital account
increased sharply to US$ 43.2 billion during April-December 2009 (US$ 5.8
billion during April-December 2008) mainly on account of large inflows under
FDI, Portfolio investment, NRI deposits and commercial loans.(vii) As the
surplus in capital account exceeded the current account deficit, there was a net
accretion to foreign exchange reserves of US$ 11.3 billion during April-
December 2009 (as against a drawdown of US$ 20.4 billion during April-
December 2008).
Major Items of India's Balance of Payments
(US$ million)

April-December April-December
(2007-08) (PR) (2008-09) (P)
(2008-09) (PR) (2009-10) (P)

Exports 166163 175184 150520 124473

Imports 257789 294587 248967 213988

Trade Balance -91626 -119403 -98446 -89515


Invisibles, net 74592 89587 70931 59185
Current Account
-17034 -29817 -27516 -30330
Balance
Capital Account* 109198 9737 7136 41630
Change in
Reserves#
(+ indicates
-92164 20080 20380 -11330
increase;-
indicates
decrease)
Including errors & omissions; # On BOP basis excluding valuation; P: Preliminary, PR:
Partially revised. R: revised

SOURCE: Reserve Bank of India Report


Invisibles

The decline in invisibles receipts, which started in the Q4 of 2008-09, continued


during Q3 of 2009-10. Invisibles receipts registered a decline of 3.1 per cent
during the quarter (as against an increase of 5.4 per cent in Q3 of 2008-09) mainly
on account of decline in business, communication and financial services, and
investment income receipts. Although, software exports recorded a robust growth
of 15.3 per cent, services exports as a whole witnessed a decline of 12.3 per cent
during the quarter as against an increase of 11.8 per cent during the corresponding
quarter of 2008-09.

Invisible receipts recorded a decline of 7.7 per cent during April-December 2009,
as compared with an increase of 22.2 per cent in the corresponding period of the
previous year, mainly due to the lower receipts under almost all components of
services coupled with lower investment income receipts.

Invisibles Payments

Invisibles payments recorded a growth of 12.9 per cent during Q3 of 2009-10, as


compared with a low growth of 2.4 per cent in Q3 of 2008-09, mainly led by
increase in payments under almost all components of services.

Invisibles payments witnessed a positive growth of 3.7 per cent in April-


December 2009 (10.4 per cent in April-December 2008) mainly supported by
higher business, communication and financial services, and increase in payments
under investment income account.

Invisibles Balance

Size of invisibles surplus in Q3 of 2009-10 was, however, lower than Q3 of


preceding year. Therefore, despite low trade deficit, the current account deficit
was higher at US$ 12.0 billion in Q3 of 2009-10 (US$ 11.7 billion in Q3 of 2008-
09).

Net invisibles (invisibles receipts minus invisibles payments) stood at US$ 59.2
billion during April-December 2009 as compared with US$ 70.9 billion during
April-December 2008. At this level, the invisibles surplus financed 66.1 per cent
of trade deficit during April-December 2009 as against 72.0 per cent during April-
December 2008.

Current Account Deficit


Net invisibles (invisibles receipts minus invisibles payments) stood at US$ 59.2
billion during April-December 2009 as compared with US$ 70.9 billion during
April-December 2008. At this level, the invisibles surplus financed 66.1 per cent
of trade deficit during April-December 2009 as against 72.0 per cent during April-
December 2008.

Net capital flows at US$ 43.2 billion in April-December 2009 was much higher as
compared with US$ 5.8 billion in April-December 2008 mainly due to larger
inflows under FDI, portfolio investments and NRI deposits

Due to lower outward FDI, the net FDI (inward FDI minus outward FDI) was
higher at US$ 16.5 billion in April-December 2009 as compared with US$ 14.3
billion in April-December 2008.

Portfolio investment witnessed large net inflows of US$ 23.6 billion during April-
December 2009 as against a net outflow of US$ 11.3 billion in April-December
2008 due to large net FII inflows of US$ 20.5 billion.

Net external commercial borrowings (ECBs) inflow slowed down to US$ 2.3
billion in April-December 2009 (US$ 6.9 billion in April-December 2008) mainly
due to increased repayments.

The increase in foreign exchange reserves on BoP basis (i.e., excluding valuation)
was US$ 11.3 billion in April-December 2009 (as against a sharp decline in
reserves of US$ 20.4 billion in April-December 2008). [A Press Release on the
Sources of Variation in Foreign Exchange Reserves is separately issued].

The gross disbursements of short-term trade credit was US$ 10.1 billion during
Q1 of 2009-10 almost same in Q1 of 2008-09. The repayments of short-term trade
credits, however, were very high at US$ 13.2 billion in Q1 of 2009-10 (US$ 7.8
billion in Q1 of 2008-09). As a result, there were net outflows of US$ 3.1 billion
under short-term trade credit during Q1 of 2009-10 (inflows of US$ 2.4 billion in
Q1 of 2008-09)

Banking capital mainly consists of foreign assets and liabilities of commercial


banks. NRI deposits constitute major part of the foreign liabilities. Banking
capital (net), including NRI deposits, were negative at US$ 3.4 billion during Q1
of 2009-10 as against a positive net inflow of US$ 2.7 billion during Q1 of 2008-
09. Among the components of banking capital, NRI deposits witnessed higher
inflows of US$ 1.8 billion in Q1 of 2009-10 (net inflows of US$ 0.8 billion in Q1
of 2008-09) reflecting the positive impact of the revisions in the ceiling interest
rate on NRI deposits.
Other capital includes leads and lags in exports, funds held abroad, advances
received pending for issue of shares under FDI and other capital not included
elsewhere (n.i.e.). Other capital recorded net outflows of US$ 1.6 billion in Q1 of
2009-10.

Balance of Payments (BOP)


Merchandise Trade
Exports

On a BOP basis, India’s merchandise exports posted a decline of 17.3 per cent
in April-December 2009 (as against a high growth of 27.5 per cent in the
corresponding period of the previous year).

INDIA's cumulative value of exports for the first 11 months of fiscal 2009-10 (April-
2009 to February-2010) stood at US $ 152983 million (Rs 727345 crore) as against
US $ 172379 million (Rs. 774585 crore) registering a negative growth of 11.3 per
cent in Dollar terms and 6.1 per cent in Rupee terms over the same period last year.
Country's cumulative value of imports for the period April, 2009- February, 2010 was
US $ 248401 million (Rs. 1180124 crore) as against US $ 287099 million (Rs.
1289412 crore) registering a negative growth of 13.5 per cent in Dollar terms and 8.5
per cent in Rupee terms over the same period last year.

Oil imports during this 11-month period were valued at US$ 73230 million which was
18.2 per cent lower than the oil imports of US $ 89492 million in the corresponding
period last year. Non-oil imports during April, 2009- February, 2010 were valued at
US$ 175171 million which was 11.4 per cent lower than the level of such imports
valued at US$ 197607 million in April 2008- February, 2009.

EXPORTS & IMPORTS (April-February, FY 2009-10)

In $ Million In Rs Crore

Exports including re-exports

2008-09 172379 774585

2009-10 152983 727345

Growth 2009-10/2008-2009
-11.3 -6.1
(percent)

Imports

2008-09 287099 1289412

2009-10 248401 1180124

Growth 2009-10/2008-2009
-13.5 -8.5
(percent)
Trade Balance

2008-09 -114721 -514827

2009-10 -95418 -452779

Figures for 2008-09 are the latest revised whereas figures for 2009-10 are provisional

The trade deficit for April 2009- February, 2010 was estimated at US $ 95418 million which was lower than the
deficit of US $ 114721 million during April 2008 -February, 2009.

Source: Federal Ministry of Commerce, Government of India

Imports

Import payments, on a BoP basis, also remained lower recording a decline of 14.0
per cent during April-December 2009 as compared with a high growth of 35.6 per
cent in the corresponding period of the previous year.

According to the DGCI&S data, exports declined by 17.3 per cent, and imports
growth was negative at 22.0 per cent led by the decline in both oil imports (a
decline of 29.7 per cent) and non-oil imports (a decline of 18.4 per cent) during
April-December 2009.

On a BOP basis, the merchandise trade deficit decreased to US$ 89.5 billion
during April-December 2009 from US$ 98.4 billion in April-December 2008
mainly on account of both lower oil and non-oil import payments

Inflows & Outflows from NRI Deposits and Local Withdrawals


(In $ million)

Inflows Outflows Local Withdrawals

2006-07 (R) 19914 15593 13208

2007-08 (PR) 29401 29222 18919

2008-09 (P) 37,089 32,799 20,617


2008-09 (Q1) (PR) 9063 8249 5157

2009-10 (Q1) (P) 11172 9354 5568

P: Preliminary, PR: Partially revised. R: revised

SOURCE: Reserve Bank of India report India's Balance of Payments


Developments during the First Quarter (April-June 2009) of 2009-10

Variation in Reserves

During April-December 2009, there was an accretion to foreign exchange


reserves mainly on account of valuation gains. Also, inflows under foreign
investments, Non-Resident Indian deposits and short-term trade credits have
contributed significantly to the increase in foreign exchange reserves during
April-December 2009.

On balance of payments basis (i.e., excluding valuation effects), the foreign


exchange reserves increased by US$ 11,300 million during April-December 2009
as against a decline of US$ 20,380 million during April-December 2008. The
valuation gains, reflecting the depreciation of the US dollar against the major
currencies, accounted for US$ 20,185 million during April-December 2009 as
compared with a valuation loss of US$ 33,375 million during April-December
2008. Accordingly, valuation gains during April-December 2009 accounted for
64.1 per cent of the total increase in foreign exchange reserves.
KEY INDICATORS OF INDIA'S BALANCE OF PAYMENTS

2008-09 (Q1) 2009-10 (Q1)


2008-09
2007-08 (PR) (P)

Merchandize Trade

Exports ($ on BoP basis) Growth Rate -21.0


28.9 5.4 43.0
(percent)

Imports ($ on BoP basis) Growth Rate -19.6


35.2 14.3 42.9
(percent)

Crude Oil Prices, Per Barrel (Indian 63.9


79.2 82.4 118.8
Basket)

-26.0
Trade Balance ($ billion) -91.6 -119.4 -31.4

Invisibles

20.2
Net Invisibles ($ Billion) 74.6 89.6 22.4

Net Invisibles Surplus/Trade Deficit 77.7


81.4 75.0 71.3
(Percent)

Invisible Receipts/Current Receipts 49.9


47.2 48.1 44.2
(Percent)

Services Receipts/Current Receipts 28.9


28.6 30.0 26.2
(Percent)

Private Transfers/Current Receipts 17.2


13.8 13.7 13.8
(Percent)

Current Account

77.5
Current Receipts ($ Billion) 314.8 337.7 88.1

83.3
Current Payments ($ Billion) 331.8 367.6 97.1

-5.8
Current Account Balance ($ Billion) -17.0 -29.8 -9.0

Capital Account

78.5
Gross Capital Inflows ($ Billion) 433.0 302.5 90.9

71.8
Gross Capital Outflows ($ Billion) 325.0 293.3 79.7

6.7
Net Capital Flows ($ Billion) 108.0 9.1 11.1

101.4
Net FDI/Net Capital Flows (Percent) 14.3 191.3 80.5

Net Portfolio Investment/Net capital 122.7


27.4 -153.4 -37.8
Flows (Percent)

-5.3
Net ECBs/Net capital Flows (Percent) 21.0 89.2 13.2

Reserves

11.4
Import Cover of Reserves (In months) 14.4 10.3 13.3

Outstanding Reserves as at end 265.1


309.7 252.0 312.1
period ($ Billion)
India's Merchandize Trade (2003-04 to 2008-09 )

Year Exports Growth (Percent) Imports Growth (Percent)

2003-04 63.8 - 78.1 -

2004-05 83.5 30.8 111.5 42.7

2005-06 103.1 23.4 149.2 33.8

2006-07 126.3 22.5 185.6 24.4

2007-08 162.9 29.0 251.4 35.5

2008-09 (April-
March) - 5.4 - 14.3
Gross Capital Inflows and Outflows (In $ Million)

Gross Inflows Gross Out flows

HEADS April-March April-March

2008- 2008-
2008- 09 2008- 09 2009-10
2009-10 (Q1) (P)
09 P (Q1) 09 P (Q1) (Q1) (P)
(PR) (PR)

Foreign Direct Investment 36258 12137 9612 18762 3170 2779

Portfolio Investment 128651 40764 38625 142685 44975 30357

External Assistance 5,042 909 821 2,404 558 737

External Commercial
15,382 2760 2092 7,224 1293 2448
Borrowings

NRI Deposits 37,089 9063 11172 32,799 8249 9354

Banking capital excluding


27,909 12889 4405 35596 11007 9588
NR Deposits

Short-term trade Credits 39,734 10176 10126 45529 7779 13211

Rupee Debt Service 0 0 0 101 30 23

Other Capital 12,391 2176 1636 8210 2678 3256

TOTAL 302,456 90784 78489 293310 79739 71753

R: Revised; P: Preliminary; PR: Partially Revised

SOURCE: Reserve Bank of India report India's Balance of Payments Developments during the First Quarter (April-
June 2009) of 2009-10
Business Services (In $ Million)

Receipts Payments
Item April-March April-March
2008- 2007- 2008- 2007-
2006-07 R 2006-07 R
09 P 08 PR 09 P 08 PR

Trade Related 2,008 2233 1325 1,642 2285 1801

Business &
Management 4,847 4433 4476 3,512 3653 3484
Consultancy

Architectural,
Engineering & 1,759 3144 3457 3,106 3173 3025
other Technical

Maintenance of
2,980 2861 2638 3,283 3,496 4,032
Offices

Others 4,657 4100 2648 3,726 4,108 3,522

16,25 15,26
TOTAL 16771 14544 16715 15866
1 9

R: Revised; P:
Preliminary; PR:
Partially Revised

SOURCE: Reserve Bank of India Report on Balance of Payment, December 2008


RBI releases India bop status in 2010-2011

Major Highlights of (BOP) during October-December 2010 (Q3) of 2010-11

 On a (BOP) basis, exports recorded a growth of 39.8 per cent while imports
registered a growth of 24.9 per cent, year-on-year, during Q3 of 2010-11.

 The trade deficit in absolute terms amounted to US$ 31.6 billion, broadly
the same as in the corresponding quarter of last year.

 Net services recorded a growth of 49.3 per cent (as against a decline of 46.0
per cent a year ago) mainly due to strong growth in receipts led by travel,
transportation, software, business and financial services.

 Private transfer receipts remained buoyant at US$ 14.1 billion during the
quarter.

 Consequently, net invisibles balance under reference showed an increase of


17.0 per cent (as against a decline of 19.0 per cent a year ago).

 The current account deficit (CAD) moderated to US$ 9.7 billion compared
to the corresponding quarter of last year mainly due to recovery in the
invisibles surplus.

 The capital account surplus increased marginally over the corresponding


quarter of last year mainly due to higher net inflows under FII investments,
external assistance, external commercial borrowings (ECBs) and banking
capital.

 With capital account surplus being higher than the current account deficit,
there was a net accretion to foreign exchange reserves of US$ 4.0 billion
during the quarter.

Major Highlights of BOP during April-December 2010

 Despite improvement in net invisibles surplus, the current account


deficit widened during April-December 2010 mainly due to higher
trade deficit as compared to the corresponding period of last year. At
this level, the CAD works out to 3.1 per cent of GDP during April-
December 2010.

 Net capital inflows increased significantly driven by higher net


inflows under FII investments, external assistance, short-term trade
credits, ECBs and banking capital.

 Although net capital inflows increased significantly, accretion to


reserves during April-December 2010 was marginally lower mainly
due to widening of the current account deficit over April-December
2009.
Balance of Payments for October-December 2010 (Q3) of 2010-11

The major items of the BOP for the third quarter (Q3) of 2010-11 are set out below
in Table 1.

Table 1: Major Items of India's Balance of Payments


(US $ billion)
October-
April-June July-September December
2009-10 2010-11 2009-10 2010-11 2009-10 2010-
Item (PR) (PR) (PR) (PR) (PR) 11 (P)
1 2 3 4 5 6 7
1. Exports 39.2 55.3 43.4 51.8 47.2 66.0
2. Imports 65.4 88.0 73.0 89.6 78.1 97.5
3. Trade Balance (1-2) -26.3 -32.8 -29.6 -37.8 -30.9 -31.6
4. Invisibles, net 22.1 20.3 20.4 21.0 18.7 21.9
5. Current Account Balance (3+4) -4.2 -12.5 -9.2 -16.8 -12.2 -9.7
6. Capital Account Balance* 4.3 16.2 18.6 20.1 14.0 13.7
7. Change in Reserves#
(-Indicates increase;+ indicates
decrease) -0.1 -3.7 -9.4 -3.3 -1.8 -4.0
*: Including errors and omissions. #: On BOP basis (i.e., excluding valuation).
P: Preliminary. PR: Partially Revised.
Note: Difference in totalling may be due to rounding off.
On a BOP basis, India’s merchandise exports recorded a growth of 39.8 per cent,
year-on-year, during Q3 of 2010-11 as compared with a growth of 19.6 per cent
during corresponding quarter of 2009-10.
Similarly, on a BOP basis, merchandise imports registered a growth of 24.9 per
cent, year-on-year, during the quarter as compared with a growth of 4.9 per cent
during same quarter last year.
Notwithstanding higher growth in exports relative to imports, the trade deficit in
absolute terms widened to US$ 31.6 billion as compared with US$ 30.9 billion
during the corresponding quarter of last year.
Invisibles receipts recorded a growth of 33.8 per cent (as against a decline of 4.6
per cent last year) mainly led by services exports.
Services receipts recorded a growth of 55.7 per cent (as against a decline of 14.4
per cent a year ago) mainly led by travel, transportation, software, business and
financial services.
Private transfer receipts increased by 5.9 per cent to US$ 14.1 billion during the
quarter (US$ 13.3 billion a year ago).
Investment income receipts declined by 24.1 per cent during the quarter (on top of
a decline of 20.5 per cent a year ago) mainly due to persistence of lower interest
rates abroad.
Invisibles payments recorded a growth of 48.2 per cent (as compared with a growth
of 12.7 per cent a year ago) mainly due to higher payments under services and
investment income.
Services payments increased by 59.0 per cent during the quarter (as compared with
a growth of 22.1 per cent a year ago) mainly due to travel,
transportation, business and financial services.
Notwithstanding higher growth in invisibles payments relative to receipts, net
invisibles (invisibles receipts minus invisibles payments) increased by 17.0 per cent
(as against a decline of 19.0 per cent a year ago) to US$ 21.9 billion.
Despite the higher trade deficit, the current account deficit moderated to US$ 9.7
billion (from US$ 12.2 billion a year ago) mainly due to strong recovery in
invisibles surplus.
As the higher net inflows under FII investments, external assistance, ECBs and
banking capital was offset by the moderation in inflows under foreign direct
investment (FDI) and short-term trade credits, the capital account surplus increased
only marginally to US$ 14.9 billion during the quarter (US$ 14.6 billion a year
ago).
While net FII inflows increased to US$ 7.2 billion during Q3 of 2010-11 as
compared to US$ 5.3 billion in the corresponding quarter of last year, gross inflows
and outflows under FII investments during the quarter almost trebled reflecting
large oversubscriptions to Coal India IPO in October 2010 and repatriations
thereafter.
Net ECBs were significantly higher at US$ 3.6 billion during the quarter (as
compared with US$ 1.7 billion last year) mainly due to higher disbursements of
commercial loans to India.
Banking capital recorded net inflows of US$ 4.9 billion during the quarter (as
compared with net inflows of US$ 1.9 billion a year ago) mainly due to drawdown
of foreign assets of commercial banks.
Net FDI flows (net inward FDI minus net outward FDI) moderated to US$ 2.1
billion during Q3 of 2010-11 (US$ 3.0 billion a year ago) mainly due to lower net
inward FDI during the quarter.
With capital account surplus being higher than the current account deficit, there
was a net accretion to foreign exchange reserves of US$ 4.0 billion during the
quarter (US$ 1.8 billion a year ago). In nominal terms (i.e., including valuation
changes), foreign exchange reserves increased by US$ 4.5 billion during the
quarter.
Balance of Payments for April-December 2010

On a BOP basis, the trade deficits widened to US$ 102.1 billion during April-
December 2010 (US$ 86.8 billion during April-December 2009) mainly due to
higher absolute increase in imports relative to exports on the back of robust
domestic economic performance
Net invisibles surplus increased to US$ 63.2 billion during April-December 2010
(US$ 61.2 billion last year) mainly due to higher increase in invisibles receipts
relative to payments in absolute terms. The increase in invisibles receipts was
mainly driven by services exports, which recorded a growth of 41.2 per cent during
April-December 2010 (as against a decline of 16.0 per cent a year ago).
Invisibles payments increased by 39.5 per cent during April-December 2010
mainly reflecting higher services payments, which recorded a growth of 51.7 per
cent (as against a moderate increase of 4.3 per cent a year ago).

Table 2: Major Items of India's Balance of Payments

(US $ billion)
April-March April-December
2009-10 2009-10
Item 2008-09 (R) (PR) (PR) 2010-11 (P)
1 2 3 4 5
1. Exports 189.0 182.2 129.7 173.0
2. Imports 308.5 300.6 216.5 275.1
3. Trade Balance (1-2) -119.5 -118.4 -86.8 -102.1
4. Invisibles, net 91.6 80.0 61.2 63.2
5. Current Account Balance (3+4) -27.9 -38.4 -25.5 -38.9
6. Capital Account Balance* 7.8 51.8 36.8 50.0
7. Change in Reserves#
(-Indicates increase;+ indicates
decrease) 20.1 -13.4 -11.3 -11.0

*: Including errors and omissions. #: On BOP basis (i.e., excluding valuation).


R: Revised. P: Preliminary. PR: Partially Revised.
Private transfer receipts recorded a marginal increase during April-December 2010
to US$ 41.3 billion (US$ 40.8 billion a year ago).
Investment income receipts, however, declined by 36.1 per cent to US$ 6.2 billion
during April-December 2010 (US$ 9.7 billion a year ago).
Despite improvement in net invisibles surplus, the current account deficit widened
during April-December 2010 to US$ 38.9 billion (US$ 25.5 billion a year ago)
mainly due to higher trade deficit.
Net capital inflows increased significantly to US$ 52.7 billion during April-
December 2010 (US$ 37.6 billion a year ago) driven by higher net inflows under
FII investments, external assistance, short-term trade credits, ECBs and banking
capital
Notwithstanding significant increase in net capital inflows, accretion to reserves
(on a BOP basis) during April-December 2010 was marginally lower mainly due to
widening of the current account deficit over April-December 2009.
Table 4: Net Capital Flows
(US$ billion)
April-March April-December
2008-09 2010-11
Item (R) 2009-10 (PR) 2009-10 (PR) (P)
1 2 3 4 5
1. Foreign Direct Investment 19.8 18.8 15.4 7.6
Inward FDI 37.7 33.1 27.0 18.0
Outward FDI -17.9 -14.4 -11.6 -10.4
2. Portfolio Investment
Of which: -14.0 32.4 23.6 30.1
FIIs -15.0 29.0 20.5 29.5
ADR/GDRs 1.2 3.3 3.2 1.8
3. External Assistance 2.4 2.9 1.9 4.2
4. External Commercial Borrowings 7.9 2.8 2.4 9.3
5. NRI Deposits 4.3 2.9 3.5 2.3
6. Banking Capital excluding NRI
Deposits -7.5 -0.8 -0.5 3.4
7. Short-term Trade Credits -2.0 7.6 3.1 8.5
8. Rupee Debt Service -0.1 -0.1 -0.02 -0.02
9. Other Capital -4.0 -13.0 -11.8 -12.7
1. Total (1 to 9) 6.8 53.4 37.6 52.7
R: Revised. P: Preliminary. PR: Partially Revised.
External Debt for the Quarter ending December 2010
(As per the existing practice, the external debt for the quarters ending March and June are
compiled and released by the Reserve Bank of India, while the external debt for quarters
ending September and December are compiled and released by the Ministry of Finance,
Government of India. Accordingly, the data on external debt for the quarter ending
December 2010 are being released by the Ministry of Finance, Government of India.
Information to this effect was made by Alpana Killawala , Chief General Manager through
Press Release: 2010-2011/1412.
BOP Adjustment Policies

Policies to correct a BOP imbalance

• Most discussions focus on countries running a current account deficit


• But persistent surpluses can also be a problem!
• Both deficit and surplus can be described as a disequilibrium
• Evaluation might consider:
– Automatic partial correction of a deficit
– Demand-side policies
– Supply-side policies
– The consequences of policies for other macroeconomic objectives such as
growth, inflation and jobs
Deficits and Surpluses as a share of GDP

Current Account Balances - Deficits and Surpluses


Current account deficit as a percentage of GDP
10.0 10.0

7.5 7.5

5.0 5.0

2.5 2.5
PERCENT

0.0 0.0

-2.5 -2.5

-5.0 -5.0

-7.5 -7.5

-10.0 -10.0

-12.5 -12.5
98 99 00 01 02 03 04 05 06 07 08

Germany Spain West Germany


Ireland United Kingdom
Japan United States
Source: OECD
Are Defecits self correcting?

• Some partial self-correction


• Economic slowdown and recession
– Squeeze on real incomes and output
– Fall in import demand
– Releases capacity for exporting
• Deficit might lead to depreciation in the exchange rate
– Change in relative prices of exports and imports
– Expenditure-switching towards exports and away from imports
– Depends on price elasticity of demand for X and M and also elasticity of
supply
The US trade deficit and their recession

United States Balance of Trade in Goods


$ billion per month
8 8

6 6

4 4
Percent

2 2

0 0

-2 -2

-4 -4

-25 -25
-30 -30
-35 -35
USD (billions)

-40 -40

billions
-45 -45
-50 -50
-55 -55
-60 -60
-65 -65
-70 -70
01 02 03 04 05 06 07 08

Annual growth of real GDP Trade balance in goods and services $bn
Source: Reuters EcoWin

Note the steep fall in the trade deficit as the economy hit recession.
Expenditure Switching

• Expenditure switching:
– Change in relative prices of X and M
– Changes incentives for consumers
– Changes profitability of exporting
– Can be caused by
• Movement in the exchange rate
• Introduction of import tariffs and other forms of protectionism
• Period of high or low relative inflation
– Key point is whether trade volumes respond to changing prices
I.e. price elasticity of demand for X and M
Does a depreciation cut the trade defecit

US Trade Deficit and the US Dollar


trade balance $ billion per month, dollar exchange rate index
130 130
125 125
120 120
115 Dollar depreciating 115
Index

110 110
105 105
100 100
95 95

-25 -25
-30 -30
-35 -35
USD (billions)

-40 -40

billions
-45 -45
-50 -50
-55 -55
-60 -60
-65 -65
-70 -70
00 01 02 03 04 05 06 07 08 09

Federal Reserve, Nominal Trade Weighted Exchange Index Broad


Trade Balance, Total, Goods and services, SA
Source: Reuters EcoWin
Any evidence for UK

UK Trade & the Sterling Exchange Rate


Quarterly trade balance, £ billion (bottom pane) and exchange rate index
105 105

100 100

95 95
Sterling index

90 90

85 85

80 80

75 75

70 70
Quarterly balance £ (billions)

0.0 0.0
-2.5 -2.5
-5.0 -5.0

billions
-7.5 -7.5
-10.0 -10.0
-12.5 -12.5
-15.0 -15.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Effective Exchange Rate Index Balance of Trade in Goods and Services


Source: Reuters EcoWin
The J Curve

• Effect of depreciation on the trade deficit depends on price elasticity of demand.


• In the short term, demand is often inelastic – limits extra revenue from exports
• Demand for M is inelastic – higher prices cause a rise in total spending on imports
• The J Curve effect says a trade deficit can worsen after a depreciation, but get
better in the long term provided that the elasticity of demand is high enough
• Marshall-Lerner condition: Trade balance will improve if Ped X + Ped M . 1
• Elasticity of supply of domestic producers is also important (often forgotten)

Expenditure Reduction

• Expenditure reduction
– Cutting aggregate demand
– Direct effect on consumption and therefore demand for imports:
– Possible routes:
• Higher direct taxes – lower disposable income
• Low taxes on saving
• Increased interest rates – to dampen consumption
• Cut in government spending
– Focus here is on income elasticity of demand for imports
Supply – side Policies

• To rebalance trade over the medium term


• Focus on
– Improving competitiveness in global markets:
• Innovation
• Research and development
• Product quality / design
• Infrastructure to support trade sectors
– Attracting inward investment – producing output domestically and then
exporting
– Raising productivity / lowering unit costs
– Developing areas of new competitive advantage
– Raising foreign income elasticity of demand for exports
– Reducing foreign price elasticity of demand for exports
Weakness on supply side and UK trade

• Persistent productivity gap


• Low business investment as a share of GDP
• Low levels of research and development
• Loss of capacity in manufacturing industry
Evidence that UK exports have lower income elasticity of demand than our income
elasticity of demand for import

The Productivity gap

GDP per hour worked


Comparison, 1996-2007
Index, UK = 100
140

135
130 France
125
Germany
120
UK
115
US
110

105
100

95
1992 1994 1996 1998 2000 2002 2004 2006

Source: ONS
The Investment gap

Business investment
Comparison, 1992-2007
Per cent of GDP in current prices

14

12
Germany

France

10
UK

US

8
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: OECD
The Research gap

Gross domestic expenditure on R&D


Comparison, 1992-2006
Per cent of GDP
3.0

France

Germany
2.5
UK

US

2.0

1.5
93

94

95

01

02
92

96

97

98

99

00

03

04

05

06

07
19

19

19

19

19

19

19

19

20

20

20

20

20

20

20

20
Source: OECD

UK Exports and Imports


UK Exports and Imports of Goods and Services
Annual value of trade - £billion at current prices
450 Balance of Payments: Exports: Total Trade in Goods & Services 368.337G 450
Balance of Payments: Imports: Total Trade in Goods & Services 415.817G

400 400

350 350

Imports
GBP (billions)

300 300

billions
250 Exports 250

200 200

150 150

100 100
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

SUMMARY POINTS
• Some trade deficits are partially self correcting
• But recession and a depreciation are not enough if the root causes lie on the supply-
side of the economy
• Ultimately BOP adjustment requires:
– Period of below trend growth
– Improvement in investment in traded goods industries
– Control of price and cost inflation relative to that of our competitors
– Open trade to drive better export performance
Protectionism is not the answer