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Friday, 9 March 2012

Balance of Payment
Introduction
Balance of payments (BoP) accounts are an
accounting record of all monetary transactions between a country and
the rest of the world. These transactions include payments for the
country's exports and imports of goods, services, financial capital, and
financial transfers. The BoP accounts summarize international
transactions for a specific period, usually a year, and are prepared in a
single currency, typically the domestic currency for the country

concerned. Sources of funds for a nation, such as exports or the

receipts of loans and investments, are recorded as positive or surplus
items. Uses of funds, such as for imports or to invest in foreign
countries, are recorded as negative or deficit items.
When all components of the BOP accounts are
included they must sum to zero with no overall surplus or deficit. For
example, if a country is importing more than it exports, its trade
balance will be in deficit, but the shortfall will have to be counterbalanced in other ways such as by funds earned from its foreign
investments, by running down central bank reserves or by receiving
loans from other countries.
While the overall BOP accounts will always balance
when all types of payments are included, imbalances are possible on
individual elements of the BOP, such as the current account, the capital
account excluding the central bank's reserve account, or the sum of
the two. Imbalances in the latter sum can result in surplus countries
accumulating wealth, while deficit nations become increasingly
indebted. The term "balance of payments" often refers to this sum: a
country's balance of payments is said to be in surplus (equivalently,
the balance of payments is positive) by a certain amount if sources of
funds (such as export goods sold and bonds sold) exceed uses of funds
(such as paying for imported goods and paying for foreign bonds
purchased) by that amount. There is said to be a balance of payments
deficit (the balance of payments is said to be negative) if the former
are less than the latter.
Under a fixed exchange rate system, the central bank
accommodates those flows by buying up any net inflow of funds into
the country or by providing foreign currency funds to the foreign
exchange market to match any international outflow of funds, thus
preventing the funds flows from affecting the exchange rate between
the country's currency and other currencies. Then the net change per
year in the central bank's foreign exchange reserves is sometimes
called the balance of payments surplus or deficit. Alternatives to a
fixed exchange rate system include a managed float where some
changes of exchange rates are allowed, or at the other extreme a
purely floating exchange rate (also known as a purely flexible exchange
rate). With a pure float the central bank does not intervene at all to
protect or devalue its currency, allowing the rate to be set by the
market, and the central bank's foreign exchange reserves do not
change.
Historically there have been different approaches to the question of
how or even whether to eliminate current account or trade imbalances.
With record trade imbalances held up as one of the contributing factors
to the financial crisis of 20072010, plans to address global imbalances
have been high on the agenda of policy makers since 2009.
Balance of Payment
The two principal parts of the BOP accounts are the current account
and the capital account.
The current account shows the net amount a country is earning if it
is in surplus, or spending if it is in deficit. It is the sum of the balance
of trade (net earnings on exports minus payments for imports),

factor income (earnings on foreign investments minus payments

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

o
o

o
o

The balancing item, which may be positive or negative, is simply an

amount. That accounts for any statistical errors and assures that the
current and capital accounts sum to zero. By the principles of double
entry accounting, an entry in the current account gives rise to an
entry in the capital account, and in aggregate the two accounts
automatically balance. A balance isn't always reflected in reported
figures for the current and capital accounts, which might, for
example, report a surplus for both accounts, but when this happens
it always means something has been missedmost commonly, the
operations of the country's central bankand what has been missed
is recorded in the statistical discrepancy term (the balancing item).
An actual balance sheet will typically have numerous sub headings
under the principal divisions. For example, entries under Current
account might include:
Trade buying and selling of goods and services
Exports a credit entry
Imports a debit entry
Trade balance the sum of Exports and Imports
Factor income repayments and dividends from loans and
investments
Factor earnings a credit entry
Factor payments a debit entry
Factor income balance the sum of earnings and
payments.
Especially in older balance sheets, a common division was between
visible and invisible entries. Visible trade recorded imports and
exports of physical goods (entries for trade in physical goods
excluding services is now often called themerchandise balance).

Invisible trade would record international buying and selling of

services, and sometimes would be grouped with transfer and factor
income as invisible earnings.
The term "balance of payments surplus" (or deficit a deficit is
simply a negative surplus) refers to the sum of the surpluses in the
current account and the narrowly defined capital account (excluding
changes in central bank reserves). Denoting the balance of
payments surplus as BOP surplus, the relevant identity is

Disequilibrium in Balance of Payment

Though the credit and debit are written balanced in the balance of
payment account, it may not remain balanced always. Very often,
debit exceeds credit or the credit exceeds debit causing an
imbalance in the balance of payment account. Such an imbalance is
called the disequilibrium. Disequilibrium may take place either in
the form of deficit or in the form of surplus.
Disequilibrium of Deficit arises when our receipts from the
foreigners fall below our payment to foreigners. It arises when the
effective demand for foreign exchange of the country exceeds its
supply at a given rate of exchange. This is called an 'unfavourable
balance'.
Disequilibrium of Surplus arises when the receipts of the country
exceed its payments. Such a situation arises when the effective
demand for foreign exchange is less than its supply. Such a surplus
disequilibrium is termed as 'favourable balance'.

Causes of Disequilibrium in Balance of Payment

1. Population Growth

Most countries experience an increase in the population and in

some like India and China the population is not only large but
increases at a faster rate. To meet their needs, imports become
essential and the quantity of imports may increase as population
increases.

2. Development Programmes
Developing countries which have embarked upon planned
development programmes require to import capital goods, some
raw materials which are not available at home and highly skilled and
specialized manpower. Since development is a continuous process,
imports of these items continue for the long time landing these
countries in a balance of payment deficit.

3. Demonstration Effect

When the people in the less developed countries imitate the

consumption pattern of the people in the developed countries, their
import will increase. Their export may remain constant or decline
causing disequilibrium in the balance of payments.

4. Natural Factors

Natural calamities such as the failure of rains or the coming floods

may easily cause disequilibrium in the balance of payments by
adversely affecting agriculture and industrial production in the
country. The exports may decline while the imports may go up
causing a discrepancy in the country's balance of payments.

5. Cyclical Fluctuations

Business fluctuations introduced by the operations of the trade

cycles may also cause disequilibrium in the country's balance of
payments. For example, if there occurs a business recession in
foreign countries, it may easily cause a fall in the exports and
exchange earning of the country concerned, resulting in a
disequilibrium in the balance of payments.

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

7. Poor Marketing Strategies

The superior marketing of the developed countries have increased

their surplus. The poor marketing facilities of the developing
countries have pushed them into huge deficits.

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

9. Globalisation

Due to globalisation there has been more liberal and open

atmosphere for international movement of goods, services and
capital. Competition has beer increased due to the globalisation of
international economic relations. The emerging new global
economic order has brought in certain problems for some countries
which have resulted in the balance of payments disequilibrium.
Types of Disequilibrium in Balance of Payment
Balance of Payment of the country is determined by a multiplicity of
forces and the equilibrium in it is the resultant of numerous interr2elated elements. The main types of disequilibrium in the balance
of payment are as follows :-

1. Structural Disequilibrium
It takes place due to structural changes in the economy affecting
demand and supply relations in commodity and factor market.
Structural disequilibrium in balance of payments persists for
relatively longer periods; as it is not easy to remove structural
imbalance in the economy.
Some of the important causes of structural disequilibrium are as
follows:1. If the foreign demand for a country's products decline due to
the discovery of cheaper substitutes abroad, then the
country's export will decline causing a deficit.

2. If the supply position of a country is affected due factors like

crop failure, shortage of raw-materials, strikes, political
instability, etc, then there would be the deficit in the balance
of payments.
3. A shift in demand due to the changes in tastes, fashions,
income, etc, would increase or decrease the demand for
imported goods causing disequilibrium in the balance of
payments.
4. Changes in the rate of international capital movements may
also cause structural disequilibrium.
5. A war also results in structural changes which may affect not
only goods but also factor of production causing disequilibrium
in balance of payments.

2. Cyclical Disequilibrium

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

is termed as cyclical disequilibrium. It is possible that different
phases of trade cycles like depression, prosperity, boom, recession,
etc, may disturb terms of trade and cause disequilibrium in balance
of payments.
For instance, during boom period, imports may increase
considerably due to increase in demand for imported goods. During
recession and depression, imports may be reduced due to fall in
demand on account of reduced income. During recession exports
may increase due to fall in price. During boom period, a country
may face deficit in its BoP position on account increase in imports.
However, during recession its export may increase, and as such BoP
position may show surplus.
Also, the importing countries may face cyclical changes. For
instance, there may be recession in the importing countries, which
in turn would reduce demand for imports. Therefore, the demand for
exports will decline and the exporting country may face a trade
deficit, which in turn may affect BoP positions.

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

4. Short run Disequilibrium

Disequilibrium caused on a temporary basis for a short period, say

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

Short run disequilibrium may also be caused when a country's

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

5. Long run or Secular Disequilibrium

It prevails for a long period of time i.e. when the disequilibrium is

persistent & long run oriented, it is called long run disequilibrium
The IMF terms such disequilibrium as "Fundamental Disequilibrium".
Long-run or fundamental disequilibrium refers to a persistent deficit
or a surplus in the balance of payments of a country. It is also known
as secular disequilibrium.
When there is a continuous increase in the stock of gold and foreign
exchange reserves. there is a persistent surplus & vies-versa.
Permanent changes in the conditions of demand and supply of
exports and imports cause fundamental disequilibrium. A permanent
deficit or surplus may make a country debtor or creditor causing a
fundamental disequilibrium.
A developing country in its initial stages may import large amount of
capital & hence its imports would exceeds exports. When this
becomes chronic, there emerges a secular deficit in its balance of
payments. Deep rooted dynamic changes like capital formation,
innovations, technological advancements, growth of population etc.
also contribute to fundamental disequilibrium.
When there is a series of short-run disequilibrium in a country's
balance of payments, ultimately it would lead to fundamental
disequilibrium.

6.Monetary Disequilibrium
Monetary disequilibrium, takes place on account of inflation or
deflation. Due to inflation, the prices of the products in the domestic
market rises, and therefore, export items will become expensive.
Such a situation may affect the BoP equilibrium. Inflation also results
in to increase in money income with the people, which in turn may
increase demand for imported goods. As a result imports may turn
Bop position in disequilibrium.
Measures To Correct Deficit in the Balance of Payment BoP
Solution to correct balance of payment disequilibrium lies in earning
more foreign exchange through additional exports or reducing
imports. Quantitative changes in exports and imports require
policy changes. Such policy measures are in the form of
monetary, fiscal and non-monetary measures.

Monetary Measures for Correcting the BoP

The monetary methods for correcting disequilibrium in the balance

of payment are as follows

1. Deflation

Deflation means falling prices. Deflation has been used as a

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

2. Exchange Depreciation

Exchange depreciation means decline in the rate of exchange of

domestic currency in terms of foreign currency. This device implies
that a country has adopted a flexible exchange rate policy.
Suppose the rate of exchange between Indian rupee and US dollar is
$1 = Rs. 40. If India experiences an adverse balance of payments
with regard to U.S.A, the Indian demand for US dollar will rise. The
price of dollar in terms of rupee will rise. Hence, dollar will
appreciate in external value and rupee will depreciate in external
value. The new rate of exchange may be say $1 = Rs. 50. This
means 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports
because exports will become cheaper and imports costlier. Hence, a
favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation:1. Exchange depreciation will be successful only if there is no
retaliatory exchange depreciation by other countries.
2. It is not suitable to a country desiring a fixed exchange rate
system.
3. Exchange depreciation raises the prices of imports and
reduces the prices of exports. So the terms of trade will
become unfavourable for the country adopting it.
4. It increases uncertainty & risks involved in foreign trade.
5. It may result in hyper-inflation causing further deficit in
balance of payments.

3. Devaluation
Devaluation refers to deliberate attempt made by monetary
authorities to bring down the value of home currency against foreign
currency. While depreciation is a spontaneous fall due to interactions
of market forces, devaluation is official act enforced by the
monetary authority. Generally the international monetary fund
advocates the policy of devaluation as a corrective measure of
disequilibrium for the countries facing adverse balance of payment
position. When India's balance of payment worsened in 1991, IMF
suggested devaluation. Accordingly, the value of Indian currency
has been reduced by 18 to 20% in terms of various currencies. The

1991 devaluation brought the desired effect. The very next year the
import declined while exports picked up.
When devaluation is effected, the value of home currency goes
down against foreign currency, Let us suppose the exchange rate
remains $1 = Rs. 10 before devaluation. Let us suppose,
devaluation takes place which reduces the value of home currency
and now the exchange rate becomes $1 = Rs. 20. After such a
change our goods becomes cheap in foreign market. This is
because, after devaluation, dollar is exchanged for more Indian
currencies which push up the demand for exports. At the same time,
imports become costlier as Indians have to pay more currencies to
obtain one dollar. Thus demand for imports is reduced.
Generally devaluation is resorted to where there is serious adverse
balance of payment problem.
Limitations of Devaluation:1. Devaluation is successful only when other country does not
retaliate the same. If
both the countries go for the same, the effect is nil.
2. Devaluation is successful only when the demand for exports
and imports is elastic.
In case it is inelastic, it may turn the situation worse.
3. Devaluation, though helps correcting disequilibrium, is
considered to be a weakness for the country.
4. Devaluation may bring inflation in the following conditions :i.
Devaluation brings the imports down, when imports are
reduced; the domestic supply of such goods must be
increased to the same extent. If not, scarcity of such
goods unleashes inflationary trends.
ii.
A growing country like India is capital thirsty. Due to non
availability of capital goods in India, we have no option
but to continue imports at higher costs. This will force
the industries depending upon capital goods to push up
their prices.
iii.
When demand for our export rises, more and more
goods produced in a country would go for exports and
thus creating shortage of such goods at the domestic
level. This results in rising prices and inflation.
iv.
Devaluation may not be effective if the deficit arises due
to cyclical or structural changes.

4. Exchange Control

It is an extreme step taken by the monetary authority to enjoy

complete control over the exchange dealings. Under such a
measure, the central bank directs all exporters to surrender their
foreign exchange to the central authority. Thus it leads to
concentration of exchange reserves in the hands of central
authority. At the same time, the supply of foreign exchange is
restricted only for essential goods. It can only help controlling

situation from turning worse. In short it is only a temporary measure

and not permanent remedy.

Non-Monetary Measures for Correcting the BoP

A deficit country along with Monetary measures may adopt the

following non-monetary measures too which will either restrict
imports or promote exports.

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

2. Quotas

Under the quota system, the government may fix and permit the
maximum quantity or value of a commodity to be imported during a
given period. By restricting imports through the quota system, the
deficit is reduced and the balance of payments position is improved.
Types of Quotas:1. the tariff or custom quota,
2. the unilateral quota,
3. the bilateral quota,
4. the mixing quota, and
5. Import licensing.
Merits of Quotas:1. Quotas are more effective than tariffs as they are certain.
2. They are easy to implement.
3. They are more effective even when demand is inelastic, as no
imports are possible above the quotas.
4. More flexible than tariffs as they are subject to administrative
decision. Tariffs on the other hand are subject to legislative
sanction.

Demerits of Quotas:1. They are not long-run solution as they do not tackle the real
cause for disequilibrium.
2. Under the WTO quotas are discouraged.
3. Implements of quotas are open invitation to corruption.

3. Export Promotion

The government can adopt export promotion measures to correct

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

4. Import Substitution
A country may resort to import substitution to reduce the volume of
imports and make it self-reliant. Fiscal and monetary measures may
be adopted to encourage industries producing import substitutes.
Industries which produce import substitutes require special attention
in the form of various concessions, which include tax concession,
technical assistance, subsidies, providing scarce inputs, etc.
Non-monetary methods are more effective than monetary methods
and are normally applicable in correcting an adverse balance of
payments.
Drawbacks of Import Substitution:1. Such industries may lose the spirit of competitiveness.
2. Domestic industries enjoying various incentives will develop
vested interests and ask for such concessions all the time.
3. Deliberate promotion of import substitute industries go
against the principle of comparative advantage.

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

paying for imported goods and paying for foreign bonds purchased)
by that amount. There is said to be a balance of payments deficit
(the balance of payments is said to be negative) if the former are
less than the latter.
Disequilibrium of Deficit arises when our receipts from
the foreigners fall below our payment to foreigners. It arises when
the effective demand for foreign exchange of the country exceeds
its supply at a given rate of exchange. This is called an
'unfavourable balance'. Solution to correct balance of payment
disequilibrium lies in earning more foreign exchange through
additional exports or reducing imports. Quantitative changes in
exports and imports require policy changes. Such policy measures
are in the form of monetary, fiscal and non-monetary measures
Note by Notes For You at 6:53:00 a.m.
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