Balance Of Payments

General information & overview

Anjana K
Arun T
Kapil J
Raju J
Sagar V
Appendix
 Introduction

 Structure of Balance of Payments

 Disequilibrium in the balance of payments

 Causes of disequilibrium

 Methods of correcting BOP disequilibrium

 QA

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Introduction
 IMF definition: Balance of payments is a statistical statement
that summarizes transactions between residents non residents
during a period.
 Kindleberger definition: Balance of payments are “systematic
records of all economic transactions between one country and
rest of the world.
– Balance of payments is a statement of systematic record of all
economic transactions between one country and rest of the world.
– It adopts a double entry book-keeping system with two sides. Debit
and credit. Payments are recorded on the debit side and receipts on
the credit side.**
– Broadly, it contains three sets of accounts: 1) Current account 2)
Capital account 3) Financial account**

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Balance of Payments components
 Current A/c: It is a goods & services account.
– Current A/c = (Balance of trade + Net factor income from abroad + Net
unilateral transfers from abroad)
 Financial A/c: It involves transactions that involve financial assets and liabilities.
 Financial A/c = (Increase in foreign ownership of domestic assets -
Increase in foreign ownership of domestic assets)
= (FDI + Portfolio investment + Other investment).
 Foreign exchange reserves: This is official international reserve held by government
established central bank. These include official gold reserves, foreign currencies, IMF
special drawing right (SDR) & other foreign assets.

 Capital A/c: Capital accounts are investments over longer period of time. It involves
exchange of migrant’s assets, foreign aid capital & intellectual property.
 Net errors & omissions: Errors are common to occur due to complexity of the
calculations and difficulty in obtaining results. Omissions are rarely used by
governments to conceal transactions.
 BOP Identity…
 ( X – M ) = Ko – Ki

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Current Account – General information
 Current accounts mainly consists of two groups…
– Merchandise or trade account.
– Invisible account.
 In trade or merchandise account, all PHYSICAL goods exported and imported are
recorded.
 Invisible account consists of services account and the gifts & charities account.
– Services account entries could be banking and insurance charges, interest on loans, tourist
expenditure, transport charges etc.
– Gifts & Charities accounts consist of all those items which are received or given away free
by residents of the nation. It may be physical goods or cash.

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Current account – Invisible account
IMF includes following items in the invisible account:
 International transportation of goods including warehousing, in transit
and other transit expenses.
 Travel for reasons of business, education, health, international
conventions or pleasure.
 Insurance premiums and payments of claims.
 Investment income, including interest, rents, dividends and profits.
 Miscellaneous service items such as advertising, commissions, film
rental, pensions, patent fees, royalties, subscriptions to periodicals
and membership fees.
 Donations, migrant remittances and legacies.
 Repayment of commercial credits.
 Contractual amortization and depreciation of direct investment.

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Capital Account
 Capital account deals with payments of debts and claims.
 It consists of those components of Imports & exports such as Private
balances, Assistance by international institution agencies, Specie flow
& Balances held on government account.
 Summary of BOP is…

Microso ft Ex cel
W orksheet

 Current account and capital account should necessarily balance each

other.
– If India’s imports of goods are more than its exports, then it will have a
deficit in its current balance of payments.
– India will have to pay either in gold and other assets or by borrowing from
other countries.

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Distinction between Balance of trade & Balance of
Payments
 Balance of trade refers to the trade of Visible items only.
 Balance of payments include all international economic transactions
of visible and non visible items.
 Import and export of GOODS is a visible item.
 Whereas services, banking, insurance, capital flows, buying and
selling of gold etc. are non visible items.
 Balance of trade is partial study of Balance of payments. It simply
refers to the difference of value of exports and visible import.
 Thus, balance of trade is nothing but a major components of the
balance of payments.
 In short, balance of trade is a partial picture, while balance of
payments is a complete picture of country’s international economic
relations.

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Balance of Payments always balances
 Balance of payments is based on a system of double entry of book
keeping.
 If all entries are made correctly, total debits must equal total credits.
 Balance of Payments…Example

Microsoft Office
Excel Worksheet

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Disequilibrium in the Balance of Payments

B=R–P
Where, B stands for balance of payments,
R denotes receipts from foreigners,
P stands for payments made to foreigners
 A country whose balance of payments is positive is called as surplus
country.
 A country whose balance of payments is negative is called as deficit
country.

 Types of disequilibrium
– Cyclical disequilibrium.
– Structural disequilibrium.
– Short run disequilibrium.
– Long – run or secular disequilibrium

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Types of Disequilibrium
 Cyclical disequilibrium: It occurs on account of trade cycles.
Cyclical fluctuations in demand are caused by changes in Income,
employment, output & price.
– Trade cycles follow different paths and patterns in different countries.
There are no identical timings and periodicity of occurrence of cycles in
different countries.
– No identical stabilization programmes and measures are adopted by
different countries.
– Income driven demand for imports in different countries are not identical.
– Price driven demand for imports differ in different countries.
 Structural disequilibrium: It is caused because of fluctuation in the
demand based on changes in tastes, fashions, habits, income,
economic progress etc.
– Structural changes are also produced by variations in the rate of
international capital movements.
– Other causes are due to crop failure in prime commodities, shortage of
raw materials, labor strikes etc. leads to reduction in Export.

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Type sof disequilibrium
 Short – run disequilibrium: When a country borrows or lends
internationally, it will have short run disequilibrium, as these are
usually for short period.
– Short run disequilibrium may also emerge if a country’s exceeds its
exports in a given year. It is a temporary one, because later on country
will be in a position to correct it easily by importing more.
– Still this disequilibrium can not be justified as it may lead to Long – term
disequilibrium. A persistent deficit will tend to reduce its foreign exchange
reserves and country may not be able to raise any more loans from
foreigners.
 Long run disequilibrium: It occurs because of accumulation of
deficits or surpluses over a long period.
– IMF uses the term ‘fundamental disequilibrium’ to describe a persistent,
long run disequilibrium. It is mainly due to deficits which exist
continuously for a long period of time in a country’s balance of payments.
– Unchecked series of short run disequilibria lead to the fundamental
disequilibrium in long run.
– It is caused by persistent deep rooted dynamic changes which slowly
takes place in the economy.

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Causes of disequilibrium
 Trade cycle: Cyclical fluctuations, their phases and amplitudes,
differences in different countries, generally produce cyclical
disequilibrium.
 Huge development & investment programmes:
– Due to huge development and investment programs , Import goes on
increasing for want of capital for rapid industrialization, while exports may not
be boosted up to that extent as these are the primary producing countries.
– Thus, there will be structural changes in the balance of payments and
structural equilibrium will result.
 Changing Export demand:
– A vast increase in the domestic production of foodstuffs, raw materials,
substitute goods, etc. in advanced countries has decreased their need for
import from the underdeveloped countries. Hence, export demand has
considerably changed resulting in structural disequilibrium.
– Similarly, developed countries will loose their market share in
underdeveloped countries, owing to the tendency of underdeveloped nations
to self relaince.

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Causes of disequilibrium
 Population growth: High population growth in poor countries ahs
adverse impact on their balance of payments. Increase in the
population increases the needs of these countries for imports and
decreases the capacity of export.
 Huge external borrowing: A country will have adverse balance of
payments when it borrows heavily from another country, while the
lending country will have a favorable balance and a deficit balance of
payments.
 Inflation: Rapid economic development, increase in the income &
price will adversely affect BOP position of a developing country.
– With increase in income, import requirements will get increased. Also
consumption of the domestic production will be fast. This leads to
increase in Import and decrease in export.
– Also huge investment in heavy industries in the developing countries may
have an inflationary impact, as the output of these industries will not be
forthcoming immediately, whereas money income will have been already
increased.

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Causes of disequilibrium
 Demonstration effect: When people of underdeveloped nations
come into contact with those of advance countries through economic,
political or social relations there will be a demonstration effect on the
consumption pattern. It will increase need for import whereas their
export quantum remains same.
 Reciprocal demands: Need of reciprocal demand for products of
different countries differs leading terms of trade of a country may be
set differently with differently with different countries under multi trade
transactions. Which may lead to disequilibrium.

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Methods of correcting BOP disequilibrium
 The various measures used for correcting an adverse balance of
payments are of two kinds:
– Monetary measures
– Non monetary measures
 Monetary measures.
– Deflation
– Exchange depreciation.
– Devaluation.
– Exchange control.
 Non-Monetary measures
– Tariff – import duties.
– Import quotas
– Export promotion policies and programmes.

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Correcting BOP disequilibrium (Monetary)
 Deflation.
– Generally, deficit in the BOP occurs due to high imports and low exports.
– In this situation, country may adopt deflationary or dear money policy by raising interest rates
and restricting credit.
– Thus, prices of domestic goods fall which makes exports attractive and imports relatively
costlier.
– Deflation keeps exchange rates unaffected and tries to correct the deficit in the BOP through
domestic changes.
– In short, deflation being inexpedient, its side effects are dangerous to a poor country. It
creates more unemployment and poverty.
 Exchange Depreciation.
– This is a correcting method in which “external value of the home currency” is depreciated.
– Exchange depreciation of a country will tend to cheapen its domestic goods for the foreigners
so that its exports will be boosted, while its imports will be costlier.
– The success of this method hugely depends on the cooperation of the foreigners. If all
countries start depreciating their exchange rates then the technique may not prove useful.
– This method is not feasible under the present system of IMF of fixed exchange rate system.

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Correcting BOP disequilibrium (Monetary)
 Devaluation.
– Devaluation is Official decrease in the external value of a currency or good.
– Exchange depreciation is based on the market mechanism whereas
devaluation is arbitrary.
– Devaluation is undertaken when the currency is found to be unduly overvalued.
– If a country has persistent deficit in its BOP, it may devalue its currency with the
permission of IMF.
– Once a country’s currency is devalued its exports become cheaper to
foreigners and imports become relatively dearer.
 Conditions for successful working of devaluation.
– A fairly elastic demand.
– Structure of exports and imports.
– Domestic price stability.
– International cooperation.
– Coordination of other measures.

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Correcting BOP disequilibrium (Monetary)
 Exchange control.
– Restrictions on the use of foreign exchange by central banks are called
“exchange controls”.
– During exchange control, all the exporters have to surrender their foreign
exchange earnings to the central bank.
– Under exchange control, the central bank releases foreign exchanges
only for essential imports and conserves the rest of the balance.
– An exchange control offers no permanent solution to the problem of
persistent disequilibrium.

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