Balance of Payment Notes

Balance of Payment

Introduction

• Balance of Payments (BOP) accounts record all monetary transactions between a country and the rest of the world.
• These include payments for exports and imports of goods and services, financial capital, and financial transfers.
• A country deals with other countries in respect of:
  • Visible items: Physical goods exported and imported.
  • Invisible items: Services whose export and import are not visible (e.g., transport, medical services).
  • Capital transfers: Capital receipts and payments.

Features of BOP

• Systematic record of all economic transactions between one country and the rest of the world.
• Includes all transactions, visible and invisible.
• Relates to a period of time, generally an annual statement.
• Adopts a double-entry book-keeping system with credit and debit sides.
  • Receipts are recorded on the credit side.
  • Payments are recorded on the debit side.

Components of BOP

• A. Current Account
  1. Merchandise Trade
     • (a) Visible exports
     • (b) Visible imports
  2. Invisible Trade
     • (a) Invisible exports
     • (b) Invisible imports
  3. Other Flows
     • (a) Investment income
     • (b) Unrequited transfers
• B. Capital Account
  • (a) Long term capital transactions
  • (b) Short term capital transactions
• C. Balancing Item
  • Net Errors and Omissions
• D. Official Reserve Account

Current Account Balance

• BOP on the current account is a statement of actual receipts and payments in the short period.
• Records imports and exports of physical goods.
• The balance of visible exports and visible imports is called the balance of visible trade or balance of merchandise trade.
• The invisibles account records all exports and imports of services (balance of invisible trade).
• These transactions are not recorded in the customs office, unlike merchandise trade, hence they are called invisible items.

Capital Account Balance

• The difference between receipts and payments on the capital account.
• Refers to all financial transactions.
• Involves inflows and outflows in foreign assets like shares, property, direct acquisitions of companies, bank loans, government securities, etc.
• Can have a surplus or deficit.
• Includes:
  • Private foreign loan flow
  • Movement in banking capital
  • Official capital transactions
  • Reserves
  • Gold movement etc.

Overall BOP

• The total of a country’s current and capital account.
• Includes errors and omissions and official reserve transactions.
• Errors may be due to statistical discrepancies.
• Omissions may be due to certain transactions not being recorded.
• For example:
  • A remittance by an Indian working abroad may not be recorded.
  • A payment of dividend abroad by an MNC operating in India may not be recorded.
• The errors and omissions amount equals the amount necessary to balance both sides.

How to correct the Balance of Payment?

1. Monetary measures
   • Deflation
   • Exchange Depreciation
   • Devaluation
2. Non-Monetary Measures
   • Export Promotion
   • Quotas
   • Tariffs

BOP vs. BOT

2. Economic policy of Govt.
3. all the factors of BOT | 1. cost of production
4. availability of raw materials
5. Exchange rate
6. Prices of goods manufactured at home |

Types of Disequilibrium in BOP

• Cyclical Disequilibrium
  • Caused by fluctuations in economic activity or trade cycles.
  • During depression, prices fall and incomes decrease, affecting exports and imports.
  • If prices rise in prosperity and decline in depression, a country with a price elasticity for imports greater than unity will experience a tendency for a decline in the value of imports in prosperity, while those for which imports price elasticity is less than one will experience a tendency for increase.
• Secular or Long-Run Disequilibrium
  • Occurs due to long-run changes in an economy as it develops.
  • In initial stages, domestic investment exceeds domestic savings, and imports exceed exports.
  • Disequilibrium arises due to a lack of funds to finance the import surplus.
  • Later, domestic savings exceed domestic investment and exports outrun imports.
  • Disequilibrium results if long-term capital outflow falls short of surplus savings.
• Technological Disequilibrium
  • Results from inventions or innovations.
  • Affects demand for goods and productive factors, influencing BOP items.
  • Innovation leads to increased exports if it is a new good (export-biased).
  • May lead to a decline in imports if it is import-biased.
  • Requires either increased imports or reduced exports to create a new equilibrium.
• Structural Disequilibrium
  • Occurs when a change in demand or supply of exports alters an existing equilibrium.
  • Or when a change occurs in the basic circumstances under which income is earned or spent abroad.
  • For example, if demand for Indian handicrafts falls, resources must shift to another line or the country must restrict imports.

Disequilibrium in the Balance of Payments

• A condition of surplus or deficit.
• Surplus: Total Receipts > Total Payments (BOP CREDIT > DEBIT)
• Deficit: Total Payments > Total Receipts (BOP CREDIT < DEBIT)

Causes of Disequilibrium

1. Natural causes: floods, earthquake, etc.
2. Economic causes: Cyclical Fluctuations, Inflation, Demonstration Effect, etc.
3. Political causes: international relations, political instability, etc.
4. Social factors: change in taste and preferences, etc.

Measures to Correct Disequilibrium in the BOP

1. Monetary Measures
   • a) Monetary Policy
     • Concerns money supply and credit.
     • The Central Bank expands or contracts the money supply through measures affecting prices.
   • b) Fiscal Policy
     • Government's policy on income and expenditure.
     • Government incurs development and non-development expenditure.
     • Income comes from taxation and non-tax sources.
     • Expenditure may be increased or decreased depending on the situation.
   • c) Exchange Rate Depreciation
     • Reduces the value of the domestic currency.
     • Imports become costlier, and exports become cheaper.
     • Leads to inflationary trends.
   • d) Devaluation
     • Lowering the exchange value of the official currency.
     • Exports become cheaper, and imports become more expensive.
     • Causes a reduction in the BOP deficit.
2. Non-Monetary Measures
   • Export Promotion
     • Government adopts measures like subsidies, tax concessions, marketing facilities, credit, and incentives.
     • Promotes export through exhibitions, trade fairs, marketing research, and administrative and diplomatic help.
   • Quotas
     • Government fixes and permits the maximum quantity or value of a commodity to be imported during a given period.
     • Restricting imports reduces the deficit.
   • Tariffs
     • Duties (taxes) imposed on imports.
     • Increase the prices of imports, reducing demand.

Adjustment Mechanism

• (i) Protectionist measures: Customs duties and other restrictions, quotas on imports, etc., aim at restricting the flow of imports.
• (ii) Demand management policies: Restrictionary monetary and fiscal policies to control aggregate demand $(C + I + G + (X - M))$.
• (iii) Supply-side policies: Aim at increasing the nation's output through greater productivity and other efficiency measures.
• (iv) Exchange rate management policies: May involve a fixed exchange rate, a flexible exchange rate, or a managed exchange rate system.