Balance of Payments {earning Outcomes ‘ter studying this chapter, you should be able to understand: ‘Meaning of Balance of Payments (BOP) Balance of Trade Balance of Trade and Balance of Payments Components of Balance of Payments Difference Between Current Account and Capital Account ‘Autonomous and Accomodating Items of Balance of Payments (BOP) Equilibrium and Disequilibrium in the Balance of Payment Measures to Control Disequilibrium in Balance of Payment vvv = vv 9.1 Meaning of Balance of Payments (BOP) Inthe words of Kindleberger, “The balance of payments of a country is a systematic record of all economic tnansactions between the residents of the reporting country and the residents of foreign countries during a sven period of time” In other words, itis a statement of account recording all international receipts and peyments of a country with the rest of the world. ‘Thus, the balance of payments of a country serves as an important index that reflects the true economic position of a country. ‘The economic transactions of a country with the rest of the world can be broadly classified as: 1. Visible items which include the export and import of all types of physical goods (made of matter/material) which are recorded at the ports (ie. can be seen crossing the borders). |. Charles P. Kindleberger, International Economics, 1978, p-17-9.2 || International Business i .d import of all types of services, like those 2, Invisible items which include the export ans e : rai shipping, banking and insurance companies, payment ports of interest etc., wh ier recorded at the (ie. cannot be seen crossing the borders) : Capital transfers that i ich transfers are concerned that involve the transfer of assets. Such wii i receipts and payments of a country with the other countries. capitg ‘Thus, “the balance of payments shows the country’ trading position, changes in its net posit, 3 {foreign lender or borrower, and changes in ts oficial reserve holding’? 9.2 Balance of Trade The balance of trade (positive i.e. visible items only. Thus, ee Balance of Trade = Export of visible items - Import of visible items During a given period of time, the balance of trade is said to be balanced if the difference the value of exports and the value of imports of visible items is zero. In other words, the country is si to have a balance of trade if the value of exports is exactly equal to the value of imports. But, itis ng, necessary that the country will always have a balanced balance of trade. If the value of exports .d, the country is said to have an export center, the value of imports during a given time perio favorable balance of trade. On the other hand, if the value of imports exceeds the value of exports, the country is said to have an import surplus (export deficit) or unfavorable (adverse) balance of trade3 or negative) is the difference between the value of exports and import. of goo, 9.3 Balance of Trade and Balance of Payments “The terms balance of trade and balance of payments, though related to each other, do not have the same meaning. Table 1, summarizes the difference between the balance of trade (BOT) and the balance of payments (BOP). ‘Table 1: Difference between the Balance of Trade and Balance of Payments Poe Balance of Trade is defined as the difference | Balance of payment is defined as‘a record between the exports and imports of goods (visible | of all pope anionl bene shee items.) of the reporting country and the residents of foreign, countries during a given period of time? 2. BOT = Net Earnings on Exports ~ Net payments | BOP = Current Account Balance + Capital Account made for imports. Balance + Errors & Omissions (- Balancing item) 2. BJ. Coher, Balance of Payments Policy, 1969. 3. the ercantilist writers of the 18" century coined the terms “favorable” and “unfavorable” Since in those days settlement of international transactions was made in terms of gold and gold being regarded as wealth, the bela Thong ne azor rps es favorable belance: wherees an, imeoct:serplatsphed cate — a = reign transactions are not settled in terms of god, yet the terms “aworablBalance of Payments || 9-3 Balance of Trade (BOT) le Poor is favorable if exports exceed the imports | BOP will be favorable if the country is able to pay 3 Bros and ‘unfavorable if imports exceed the | off all past loans in her capital account from the os of goods surplus in the current account. However, BOP is said to be unfavorable if the country borrows from the foreigners to offset its current deficit. ean factors that affect BOT are: ‘The main factors that affect BOP are: roduction (i) All factors affecting BOT () Costof pt Ga) Availabilty of raw materials i) Economic policy of the government i) Exchange rate (iii) Conditions of foreign lenders. ji) Domestic price of goods BOT may be favorable, | In the accounting sense, BOP always balances i.e. Fin the accounting sense, savorable or in equilibrium. receipts are always equal to payments. seat indicator of the economicperformance | It gives a trae picture of the economy's economic ofacountry. ce \ pot isa narrow concept ‘BOP is a more comprehensive term. i fg BOT is part of the current ‘account of thé BOP | BOP comprises of three accounts of which BOT is ‘only one part of the current account. 44 Components of Balance of Payments i sadly the balance of payment (BOP) account includes: (i) current account (ii) capital account and i (i)ofcial settlements account as shown in Table 2. 11 ‘Table 2: Components of Balance of payments (BOP) Account |. Export of goods 5, Import of goods 2. Export of services 6. Import of services 3 Income received (Interest, profit and 7. Income paid (Interest, profit and dividends paid) dividends received) 8, Unilateral payments sae 4 Unilateral receipts (Transfer payments made) (Transfer payments received) ih 12. Investment abroad 1 Ser term borrowings 13, Short-term lending - Medium and long term borrowing 14, Medium and long-term lendingae Balance of Payments || 9.5 external Assistance: External assistan ae foreign counties under concesion Porrowings by the country from the assistance involve a lower rate of interest as compared tothe vee ee oe emeraal jopen market ipared to the interest rate prevailing in the @ ce includes ‘al rate of int ‘Foreign Investment (i) Foreign Direct Investment (FDD;: Foreign Dit Fe te oak east cig Direct Investment refers to the purchase of assets upa plant by RELIANCE INDUSTRIES ioe Sechaba Saauinatn 3 (a) Portfolio Investment: when the residents (indust Wee the foreign companies or bonds issued by for control is referred to as portfolio investment. in foreign companies. stry/firm) of a country purchase shares in eign government over which they have no For eg., the Reliance Industries buys shares 3, Banking Capital: Banking capital refers to the capital transactions in the f Set cau urn pct eco age of Indian commercial banks. It also includes deposits made by non-resi gold and foreign exchange reserves with the RBI es ts af iat) in 3 4, Other Capital: All movement of capital not included above are recorded under this head. ‘Thus, capital account in the balance of payments shows international lending and borrowing of hagterm as well as short term capital. 443 Offical Settlement Account rieoficial settlement account is in fact @ part of the capital account. The official settlement account ae gresthe change in nation’s liquid and non-liquid liabilities to foreign official holders and the change stanation’ official reserve assets during the year. ‘The offcial reserve assets of a country include its gold stock, holdings of its convertible foreign caencies and SDR’s and its net position in the IME. 444 Errors and Omissions lnperfect compilation procedures and different data sources may lead to imbalances in the balance of payment account. This imbalance is termed as ‘net error and omissions’ and is explicitly identified in the 40? statement. In simple terms, net errors and omissions is the difference between the current balance andthe capital balance. 45 Difference between Current Account and Capital Account Thefollowing differences between the current account and the capital account of the balance of payments count have been enumerated below: Payment for currently produced goods and services is | Payment of debts and claims is recorded in | a in the current account. Interest earned or paid | capital account. ims, gifts and donations are also included.9.6 || International Business 2. The level of national income is directly affected by the current account of the balance of payment. In other words, receipts and payments in the current account cause a respective increase and decrease in the flow of income in the economy. 9.6 Autonomous and Accomodating Items of Balance of Payments (BOP) In the words of Sodersten and Reeds, “transactions are said to be autonomous if their value is independently of the balance of payments” Thus, all those items of BOP accounts are termed asaut items or ‘above the line’ items that are : omous (a) related to such transactions that are undertaken for profit motive (b) independent of BOP considerations-positive/negative or favorable/unfavorable, and (c)_ not meant to establish BOP identity. . Since all transactions in the current account and capital account are autonomous items, their balance determines the deficit or surplus of balance of payments. If the autonomous payments aes the autonomous receipts, the balance of payment is said to be in deficit and vice-versa. Accomodating items, also known as compensatory items are short-ter drawings from SDR, borrowings from IMF or central banks of other cot be made to correct the disequilibrium in the autonomous items of balanc Sodersten and Reed, “Accomodating items are determined by the net cons ‘The capital account influences the yo] assets held by the country. It, ho = not affect the level of national income ay direc 'm capital flows, such as untries etc., which have to e of payment. According to. Soders equences of the autonomous ems.’ ‘Thus accommodating items often referred to as ‘below the line of items, are meant to bring about equality between the payment and receipts of foreign exchange by compensating the surplus or deficit in the autonomous items. In the accounting sense, therefore, the balance of Payments always balances ie, it is always in equilibrium theoretically. Table 3 summarizes the relationship between the autonomous and accommodating items. Table 3: Relationship between Autonomous and Accomodating Items ® ‘Trade balance .. Transfer payment balance b Autonomous items Current account balance . = (a+b) Long-term capital balance , Basic balance Short term private non-liquid capital balance .. Allocation of SDR’s . Errors and omissions . Net liquid Balance .. Short term private liquid capital balance . Official Settlements Balance kBalance of Payments || 9-7 a. and Reed thus point out that “essentially the distinction between autonomous and je ‘ - m8 items lies in the motives underlying a transaction, which are almost impossible to ine’. W fqulbrium and Disequilibrium in the Balance of Payment when we speak about the equilibrium and disequilibrium in the balance of payment, we refer to the basic palance’ i.e. we only consider the autonomous items and exclude the accomodating items. jgneither a deficit nor a surplus in the overall balance of payment, when accomodating items are the balance of payment of a country is said to be in equilibrium. On the contrary, the balance payment is said fo be in disequilibrium if there is either a deficit or surplus. Lah ilibrium in the balance of payments is undesirable and harmful for the country concerned. refit balance of payment creates more dificulties for the economy than the surplus balance ras the burden of bringing about adjustments init falls more heavily on the countries having ly of pay deficit 48 Measures to Control Disequilibrium in Balance of Payment ‘pedsequbrium in the balance of payments can be corrected (controlled) by adopting the measures asdisussed below. 98.1 Automatic Measure ‘he equlibrium in the balance of payments of an economy can be restored automatically after some tine period. For eg, under the gold standard, the disequilibrium in the balance of payments of the tacened country was automatically corrected through the outflow and inflow of gold. Similarly, under thepaper standard, the disequilibrium in the balance of payment is automatically corrected through the facuations in the exchange rate, For eg. ina situation of an adverse balance of payment, the demand for foreign exchange becomes more than its supply. As a result, the exchange value of the currency goes own, Consequently, the exports are encouraged and the imports are discouraged. The opposite happens ina favorable balance of payments situation. However, the automatic measures were not very effective in the short run as well as in dealing with ‘serious disequilibrium in the balance of payments. Thus, deliberate measures had to be undertaken by ‘heconcerned country in order to bring about an improvement in its balance of payments. 482 Deliberate Measures sre to improve the disequilibrium inthe balance of payment situation, the concerned country has sort to certain deliberate measures that can be classified as follows |. Trade Measures z [tad plicy measures refer tothe measures adopted bythe ci vt ierdero improve the balance of payments s balance isthe sum of the current account balance and the capital ac :9.8 || International Business _ Exports can be pushed up by the government by: He pe cae abolishing the ree duties. The goods become cheaper foreign countries thereby encouraging exports: eee : (a) Giving subsidies and cash assistance to the exporters, This helps in cutting down produstion costsononehandand improving thelr competitive position inthe interna mn the other. (iii) ae incentives to the exporters in the form of tax exemption on exportable goods (b) Import Control ~ The deficit in the balance of payment can be kept in check by redug, imports. The imports can be cut down by: (i) Imposing new import duties or tariffs and increasing the existing import duties. The pr; of the imported goods rises. They become more expensive in the domestic economy ang asa consequence the demand for imported goods will decline. This helps in reversing deficit in the balance of payment. (ii) Adopting the import quota system. The volume of imports are restricted by ota by applying quantitative restrictions i.e, the imports of the country carmot exceed the qu, fixed by the government. If, however, the importers import more than the fixed quog they have to pay a penal rate of import duty. (ii) Prohibiting the imports of certain commodities, which are considered non-essential fom the national perspective. 2. Monetary Measures ‘The disequilibrium in the balance of payments s dealt with by the government by adopting the following monetary measures that are used individually or jointly: () Money Contraction - Currency contraction leads to an automatic fall in the prices of goot and services. As a result, imports are discouraged and exports are encouraged. Consequeni the disequilibrium in the balance of payments is reduced. However, certain economists dot favour currency contraction as a method to improve balance of payments. This is because fil in prices of goods and services may cause the producers to incur heavy financial losses dueio which they may be compelled to close down their business. Thus, utmost care must be taken while using this method to remove the disequilibrium in the balance of payment. Devaluation ~ When the value of domestic currency in terms of foreign currency is deliberady reduced by the government in order to improve its balance of payments, it is referred to devaluation. It means that the exports are encouraged because foreigners pay less for te devalued currency and imports are discouraged because the residents of the country whos currency has been devalued pay more for foreign currencies. Let’s explain this with an example Suppose, a commodity is worth $5 in the U.S.A. If the exchange rate is $1 = %60, the prit of the commodity in terms of Indian currency (2) is €300 (5 x 60 = 300). Now, if the Indise Gi) BSY