MEANING AND STRUCTURE OF BALANCE OF PAYMENTS

International trade involves international means of payments. A country engaged in foreign trade receives payments from countries to which it exports goods and services and requires to make payments to those nations from where it imports. Accordingly a country with foreign trade maintains an account of all its receipts and payments from and to the rest of the world. Such an account is called balance of payments. It is defined as a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period of time". The balance of payments account records all the transactions between the residents of reporting (domestic) country and the residents of foreign countries (rest of the world). The transactions include sales and purchases of all types of goods and services, financial assets and any other transactions which result in the flow of money in and out of the country. The figures recorded are usually in domestic currency of the reporting country. However, as and when necessary, they are also expressed in internationally accepted currency like U.S. dollars. There is no unique method of presenting balance of payments record. Table 10.1 presents a model balance of payments accounts by incorporating all the transactions under major heads.

TABLE 10.1 : BALANCE OF PAYMENTS ACCOUNT Receipts (Credits) Payments (Debits) 1) Exports of goods I) Imports of goods Trade Account Balance Exports of services 2) Imports of services Interest, profits and 3) Interest, profits and dividends received dividends paid 4) Unilateral receipts 4) Unilateral payments Current Account Balance ( 1 to 4 )
2) 3)

Foreign investments 5) Investments abroad Short term borrowing 6) Short term lending Medium and long term 7) Medium and long term borrowing lending Capital Account Balance ( 5 to 7 ) Statistical discrepancy (Errors and Omissions) 9) Change in reserves (+) 9) Change in reserves (-) Total Receipts = Total Payments
5) 6) 7)

The balance of payments account in Table 10.1 shows all the receipts and payments grouped under major accounting heads. Current Account : The current account includes all items which give rise to or use up nations income. It consists of two major items, i.e. Merchandise exports and import' and Invisible exports and imports. Merchandise Exports and Imports : Item no. 1 on both sides refer to the merchandise exports and imports. They are also referred as tangible exports and imports as they include the exports and imports of tangible or visible items. The balance of exports and imports of goods (Item No. 1) is referred as balance of trade or balance of visible trade or balance of merchandise trade. Invisible Exports and Imports : They consist of items 2, 3 and 4. Item no. 2 on both sides constitute exports and imports of services. The major items included in this are Shipping, International Airways, Insurance, Banking and other Financial Services. Tourism and any other services including knowledge related Services. The 3rd item relates to interest, profits and dividends received from and paid to. Investments, direct and portfolio, give rise to interest and dividends. The share of this item has been slowly

increasing in recent years under the era of globalisation where movement of capital has become easier. Multinationals from rich countries invest in developing countries. The advanced countries, to which these multinationals belong to, receive substantial amount of profits. T he poor countries, however, hardly have any such income. Their outflow is much more than what they receive, if any, on this account. Unilateral or unrequited payments and receipts shown in item no. 4 refers to those receipts and payments for which there is no corresponding quid pro quo. They include remittances from migrant workers to their families back home, the payment of pensions to foreign residents, foreign donations, gifts etc. For all these receipts and payments there is no counter obligations. The receipts on this account lead to an increase in income due to receipts from foreigners and are shown as credit. Similarly the payments to foreign countries or residents results in decrease in income and thus recorded as debit. All the receipts and payments on items nos 1 to 4 are treated under current account and the balance between them is called balance on current account. The current account in the balance of payments may have a surplus or deficit. A surplus provides resource enabling the country to pay off past debts, if any, or to import capital or consumer goods as per their requirement. A surplus increases a country's stock of claims on the rest of the world. A deficit on this account is treated as a problem and calls for remedial measures. Deficit reduces a country's capacity to import, increases foreign debt burden and may lead to foreign debt trap and other international financial problems. Both surplus as well as deficit will no doubt pose a problem but the former is hardly considered to be one, where as the latter draws immediate attention and also the application of corrective measures.

The Capital Account

The capital account transaction is concerned with asset related flow as against current account which is income related flow. All inflows which add to foreign claims by the reporting country is shown as credit and all outflow which add to the domestic claims on foreign countries is recorded as debit. Foreign Investment comes in the form of direct or portfolio investment. In terms of ownership it can be private which includes both multinationals and banking or official that is from other governments or international institutions. Direct investment is undertaken mostly by multinationals. Most of the investments are in consumer goods industries. In recent years investment in capital goods industries and infrastructure sector is also steadily increasing. There is also investment by individuals who acquire assets in the form of houses in other countries. Portfolio investment refers to the acquisition of financial assets in foreign countries. Purchase of shares of a foreign company, bonds issued by a foreign government are some examples. Short term Borrowing / Lending refers to borrowing for a period of one year or less. Credits are in the form of loans secured from foreigners, advance payment on deferred credit exports and other miscellaneous capital receipts. Borrowing includes commercial borrowing from the foreign commercial banks. Such borrowing may go beyond short term that is it may be for more than one year, making it a medium term borrowing. In a similar way all the lending, private and official to the residents of other countries, are shown as debit. This item may hardly figure in the balance of payment of very poor countries. The figures may increase and may appear prominently in case of advanced countries. Medium and long term borrowing / lending : The distinction of capital flow in and out of the economy as short, medium and long term capital is more on the nature of investment

rather than time dimension. A bank deposit in a foreign country is considered a short term investment though the deposit may remain for many years. A purchase of government bond usually comes under long term. However, borrowing from the international institutions such as IMF, IBRD etc. can clearly be marked as medium or long term based on the time period involved.

Acquiring of assets through direct or portfolio investment appear as a negative item in the capital account of the balance of payments record of the reporting country and as a positive item in the capital account of the other country. All capital outflows (investments or lendings) appear as negative (payments or debits) items as the money goes out of the economy. Similarly all capital inflows (foreign investments or borrowings from other countries) are positive items though some of them may increase the liabilities of the receiving country. To avoid any confusion it should be kept in mind that all capital inflows are recorded as credit. Errors and Omissions (Statistical Discrepancy) From the accounting sense the balance of payments always balances, that is, in the double entry recording system the sum of credit should match the sum of the debit entries for a given period. A surplus in current account must be matched by the equal amount of deficit in capital account and vice-versa. However in reality the entries in both sides may not in fact, do not equal. The balancing amount which is required to balance both the sides is called Errors and Omissions'. Errors may arise as values of credit and debit may not be identical or due to different procedures followed by different sources of information. Omissions may occur as some entries might have escaped recording. Statistical discrepancies are unavoidable components of any balance of payments statements, however, they do not invalidate the reliability of a balance of payments statements. Errors

and Omissions reflect the difficulties involved in recording accurately numerous transactions that take place during a given period. Errors and Omissions amount equals to the number necessary to make both sides equal. It is equal to the discrepancy in foreign exchange reserve. The significance of this particular item is only from accounting sense, that is. to make the difference between credits and debits equal to zero. Reserves Item no. 9 in table 10.1 shows the foreign exchange reserves (Forex). They are held by the Central bank of a country. They are used to finance deficits in other accounts and payments are made into these reserves when there is a surplus in other items. Foreign exchange reserves are held in a number of forms such as (i) financial claims on foreign governments or central banks; (ii) claims on the International Monetary Fund, (iii) Gold, (iv) internationally accepted currencies like U.S. dollar; German mark, Japanese Yen. etc. Change in foreign exchange reserves can be explained by an example of individual's holdings of cash. The cash holdings increase when an individual has a surplus of income over expenditure. They decrease when expenditure exceeds income. Similarly when there is surplus in the balance of payments (current and capital account) it results in the increase in foreign exchange reserves and a deficit brings down its volume. The changes in foreign exchange reserves are shown as plus (+) or minus (-) depending on where and in what form the reserves are held. If India holds the reserves in U.S.A. or any other country, with IMF or in the form of any financial or other assets abroad then money flows out of the country and is thus recorded as minus. Foreign exchange held at home by the RBI in any acceptable form involves inflow of foreign exchange, accordingly it is recorded as plus.

In an economy with floating exchange rate the disequilibrium in balance of payments gets adjusted automatically and there is no need for any reserves. Therefore with a clean float, the reserves by definition are zero. In reality however, most of the economies practice a managed float therefore they do require reserves for market intervention or other official settlement. Usually it is expected that a country must possess reserves equal to three months import bill. The Basic Balance The basic balance is the sum of the current account and capital account, when the two sides of the current and capital accounts are equal i.e. when the difference between the two is equal to zero, the basic balance is achieved. An increase in deficit or reduction in surplus or a move from surplus to deficit is considered worsening of the basic balance. Basic balance as Bo Sodersten points out. need not necessarily be a happy state of affairs. A basic balance achieved through long term borrowing from abroad may lead to future problems at the time of repayment. Similarly an outflow of capital may indicate a deficit but may earn profits and dividends in the future which will help improve the current account balance. Deficits and Surpluses The balance of payments always balances in a technical or accounting sense. The balance in the balance of payments implies that a net credit in any one of the items must have a counter part net debit in another. When the total credits and debits of all accounts balance, we say the balance of payments balances. A clear picture of deficit or surplus is revealed when we examine the balance of payments statement splitting it vertically into current account and capital account. It is in the current account that the surplus or deficit becomes more evident. A current account surplus is achieved when the exports of goods and services are greater than their imports. A reverse situation results in deficit. If the current account deficit has to be corrected by accommodating inflow of capital, the balance of payments is in deficit. In other words if the autonomous receipts are less than the autonomous payments, the balance of

payments is said to be in deficit. It is in surplus when such receipts are more than the payments. POLICIES FOR CORRECTING BALANCE OF PAYMENTS DISEQUILIBRIUM In order to correct balance of payments disequilibrium, the countries have the following policy instruments at their disposal, i.e.
5) 6) 7)

Expenditure Changing or Expenditure Adjusting Policies Expenditure Switching Policies Direct Controls

EXPENDITURE-CHANGING POLICIES Expenditure changing policies refer to expenditure reducing or expenditure increasing policies. Expenditure changing policies bring changes in the income of a country. Hence, they are, sometimes, called income adjustment policies. Expenditure reducing policies can be used to curb a deficit in the balance of payments, while an expenditure increasing policies are used to correct a surplus in the balance of payments. On the other hand, expenditureswitching policies primarily work by changing relative prices. Generally, the burden of adjustment falls on the country experiencing a balance of payments deficit rather than on a country experiencing a surplus in the balance of payments. We, therefore, analyze the effect of above policies with respect to a country having a deficit in its balance of payments. Expenditure changing policies include both monetary and fiscal policies.1 Monetary policy involves a change in the country's money supply that affects /. See BO Sodersten: International Economocs, Macnillan, 1970, p.273 abd Meade J.E: The balance of payments, Oxford University Press. 1972 Ch.8

domestic interest rates. Monetary policy is easy if the money supply is increased and the interest rates fall. This will induce an increase in investment and income which in turn will increase imports. At the same time, the reduction in interest rates will lead to a short-term capital outflow or reduce capital inflow. On the other hand, a tight monetary policy will involve a reduction in money supply and an increase in the interest rate. This will discourage investment, income and imports and also will lead to a short-term capital inflow or reduced capital outflow. Fiscal policy refers to changes in government expenditures, taxes or both. Expansionary fiscal policy involves increase in government expenditures and / or reduction in taxes. These measures will increase domestic production, income and imports. Contractionary fiscal policy refers to a reduction in government expenditures and/or an increase in taxes. These measures will reduce domestic production and income and hence lead to a fall in imports. Both monetary and fiscal policies are the important means of implementing expenditure adjusting policies. A country can correct a deficit in the balance of payments by pursuing a tight monetary policy and/or a restrictive fiscal policy. This will have a deflationary effect on the national income. This will lead to a fall in imports and an increase in exports. On the other hand, a country having a surplus in the balance of payment can pursue an expansionist monetary and fiscal policies. T his will have an inflationary effect on the national income and, may, therefore, increase imports and decrease exports. Thus, an expenditure reducing policy will have a positive effect on the balance of payments, while an expenditure increasing policy will have a negative effect on the balance of payments. EXPENDITURE-SWITCHING POLICIES Expenditure switching policies primarily work by changing relative prices. According to Meade, price adjustments can be brought out through changes in exchange rate or wage flexibility. The main instrument to bring out changes in relative prices is a change in

exchange rates i.e., a devaluation or revaluation of the domestic currency. Devaluation is often used interchangeably with depreciation, and revaluation with appreciation. However, the main distinction between the two sets of terms is that devaluation means a lowering of the value of currency with respect to the price of gold or SDRs (Special Drawing Rights), and is brought about by the government, while, depreciation means a lowering of value of currency with respect to other currencies, and it is brought about automatically by market forces. The former occur under fixed exchange rate system while the latter occur under flexible exchange rate system. In essence both devaluation or depreciation means a fall in the price of domestic currency in terms of foreign currency, that is, a rise in the number of units of domestic currency (e.g. rupees) which have to be given to obtain a unit of foreign currency (e.g. U.S. dollars). Similarly revaluation or appreciation means a rise in the price of domestic currency in terms of foreign currency i.e.; a fall in the number of units of domestic currency to be given to obtain a unit of foreign currency. The immediate effect of exchange rate changes is a change in relative prices. For instance, if India devalues its currency in terms of U.S. dollar, it will make the price of Indian goods to fall relative to the price of U.S. Goods. If the sum of the price elasticity of demand for imports in India and in U.S. is greater than one, then a fall in the price of India's products relative to the price of U.S.s products will cause a favorable movement in India's balance of trade. This will cause the purchasers in both the countries to shift from the purchase of U.S. goods to the purchase of Indian goods which are relatively cheap. The change in the quantities bought will more than outweigh the fall in the price of Indian goods in terms of U.S.s products. Therefore, the value of India's total exports will rise relatively to the value of India's imports. This will improve India's balance of trade.

If the sum of the price elasticities of demand for imports in India and US is less than unity, then a fall in the price of India's products relatively to that of U.S.s products will cause an unfavorable movement in Indias balance of trade. In this case, the volume of Indias imports may not decrease and the volume of U.S.'s imports may not rise substantially. Then, a fall in the price of India's products relatively to the price of U.S.'s products will cause the total value of India's exports to fall relatively to the total value of India's imports. This will worsen Indias balance of trade.1 If the sum of the price elasticity of demand for imports in India and U.S. is equal to unity, then a fall in the price of India's products relatively to that of U.S.'s products will not cause any change in India's balance of trade. In this case, changes in the quantities demanded are just enough to balance the fall in the relative price of India's products to that of U.S.'s products, so that there is no change in the balance of trade. If we assume the sum of the elasticity of demand for imports in the two countries (India and United States) is greater than one and if the price of Indias products is reduced relative to that of USs product (i.e.; if there is devaluation), it will have the following effects:
8)

Effect on Commodity Flows: In general, the volume of imports of devaluing country

(i.e. India) will decrease, while the volume of exports will increase.
9)

Inflationary Effect: Devaluation will increase the demand for its products. Thus, it

causes a net inflationary effect in the devaluing country.

10)

Deflationary Effect: Devaluation will reduce the demand for the other country's

product (i.e. U.S's products). This will cause a net deflationary effect in the other country (U.S.)
11)

Effect on Balance of Trade: It causes a favorable effect on the balance of trade of

the devaluing country. This is the most important effect of devaluation or depreciation.

The relative fall in the price of India's products to that of U.S.'s products can be undertaken by either of the following policies:
5) 6) 7)

A fall in money wage rate in the domestic country (e.g. India). A rise in money wage rate in the foreign country (United States). A depreciation or devaluation of domestic currency (Indian currency) in terms of

foreign currency (U.S. dollars).

8)

Any other switching policy which will reduce price of domestic products relative to

foreign products, (e.g. direct controls) The main form of the expenditure switching policy used to reduce relative prices is devaluation. DIRECT CONTROLS The use of monetary or fiscal policy or of devaluation as a policy means to cure a deficit in the balance of payments pre-supposes that there are possibilities for income and price adjustments in the economy. A country can also use direct controls to restore equilibrium in the balance of payments. They are usually used to restrict imports. Then consumers will try to buy domestic goods instead of imported goods. Hence, direct controls can be viewed as a switching policy Direct controls can be broadly divided into two groups i.e.. (a) Commercial controls and (b) financial controls.
12)

Commercial Controls: To improve the balance of payments, commercial controls

can be used to increase exports and discourage imports. Exports can be encouraged by reducing or abolishing export duties, providing export subsidy, encouraging production of export items, and export marketing. AH these may be undertaken by giving monetary', fiscal and institutional and physical incentives and facilities.

The volume of imports may be controlled by imposing or increasing import duties, restricting imports through quotas, licensing and even by prohibiting altogether the import of certain items.
13)

Financial Controls: They take the form of exchange control and use of multiple

exchange rates. Under the exchange control, a government tries to have complete control over all dealings in foreign exchange. The recipients of foreign exchange like exporters are required to surrender their foreign exchange to a central board/bank in exchange for domestic currency and those who need foreign exchange, like importers, have to buy their foreign exchange from the same board/ bank. Under the system of multiple exchange rates a country fixes different rates of exchange for the trade of different commodities and for transactions with different countries. The main objective is to maximize the foreign exchange earnings of a country by increasing exports and reducing imports. The essence of direct controls is to restrict imports. It may be a feasible policy in the shortrun, but in the long-run its effect may be harmful to the country. It brings about price distortions which will have harmful effects on production and consumption. ROLE OF MONETARY AND FISCAL POLICIES IN BALANCE OF

PAYMENTS ADJUSTMENT Monetary and Fiscal policies play an important role in correcting the disequilibrium in the balance of payments under fixed exchange rates. Under floating rates, balance of payments disequilibrium is corrected through changes in exchange rates. Fiscal and monetary policies are mainly used to influence internal balance. Thus, in this section we analyze the role of monetary and fiscal policies in the balance of payments adjustment under fixed exchange rates. Meaning of Monetary and Fiscal Policies

Monetary policy involves changes in money supply in the country that affect domestic interest rates. An easy monetary policy brings about increase in money supply and fall in the interest rate. On the other hand, a tight monetary policy will involve a reduction in money supply and an increase in the interest rate. Fiscal policy refers to changes in government expenditures, taxes or both. Expansionary fiscal policy involves increase in government expenditures and / or reduction in taxes. On the other hand, contractionary fiscal policy involves reduction in government expenditure, and / or an increase in taxes. Role of Monetary Policy In order to correct a deficit the monetary authorities have to adopt a tight monetary policy. The important instruments of monetary policy are changes in interest rates and open market operations, in order to correct a deficit they may increase the interest rates and/or may engage in open market operation and sell bonds. The primary effect of an increase in interest rate is on investment. It makes it difficult and expensive to borrow money to carry out investments. As the availability of credit becomes scarce, the producers are likely to borrow and invest less. The standard means of reducing the money supply and the availability of credit is through the open market operations. The central bank sells bonds and securities. This will reduce the prices of bonds and increase the effective interest yield on them. The purchase of bonds and securities by commercial banks and others will lead to a fall in the liquidity of the banking system. This will reduce the availability of credit. It is also likely to create an upward pressure on the interest. Higher interest rate will lead to a short-term capital inflow or reduced capital outflow or both.

Thus, a tight monetary policy leads to fall in money supply and rise in interest rates. This is likely to lead to fall in expenditure, income and prices which is likely to reduce imports and encourage exports. This is likely to improve the trade balance, current account balance of the country and overall balance of payments. Further, the rise in the interest rate will lead to capital inflow or reduced capital outflow or both in the short-run. This too will lead to improvement in the balance of payments of the country. This is shown in the Fig. 10.1.

On the other hand, an expansionist or easy monetary policy will help to reduce a surplus in balance of payments. It will lead to fall in interest rates and an increase in expenditure which, in turn, will lead to an increase in income. This is likely to increase imports. At the same time, it may increase prices which may discourage exports. This will cause an unfavorable movement in the balance of trade and current account balance which in turn may cause unfavorable movement in the balance of payments or reduce the surplus in the balance of payments of the country. Further the fall in interest rates will lead to capital outflow which too worsen the balance of payments. In this case the direction of all changes reverses. This is shown in Fig. 10.2.

diagram

Role of Fiscal Policy Fiscal Policy can be used to correct a disequilibrium in the balance of payments. A deficit in the balance of payments can be cured by reducing expenditure. Contractionary fiscal policy

can be used to reduce expenditure. Two important instruments of fiscal policy are changes in tax rates and government expenditure. An increase in tax rates, both direct and indirect taxes, will reduce the income of the households which, in turn, will reduce the demand for goods and services. Another instrument to reduce expenditure is to cut government expenditure. This involves lower deficit or higher budget surplus. It will decrease transfer payments such as old-age pensions, family allowances, etc. This will immediately reduce the consumption expenditure since the groups receiving such benefits are generally the low-income groups with a high marginal propensity to consume. A cut in government expenditure is also likely to reduce public consumption and investment, which, in turn, will lead to a fall in national income and imports. Since prices are likely to fall due to reduction in demand it may encourage exports. This will improve the balance of trade, current account balance and the balance of payments of the country. Further, a contractionary fiscal policy will lead to fall in demand for money which in turn will reduce the interest rates. This will lead to capital outflow in the short-run. T his may worsen the balance of balance of payments. Thus, the combined effect of fiscal policy on the balance of payment is not predictable. It may worsen first but eventually may improve. This is shown in the Fig. 10.3.

On the other hand, a surplus in the balance of payments can be corrected by a reduction in taxes and an increase in government expenditure i.e. by expansionary fiscal policy. A reduction in direct and indirect tax rates will stimulate the demand for goods and services. A reduction in direct tax rates will increase the disposable income of the tax payers which will lead to an increase in demand for goods and services. A reduction in indirect taxes will enable the people to buy greater amounts of goods and services from the given income. Similarly, an increase in government expenditure will cause a direct increase in the total demand for goods and services. This will cause an increase in income and, therefore, increase imports. Since the prices are likely to rise with the increase in demand, it may discourage exports. In this way, expansionary fiscal policy can reduce the surplus or worsen the balance of payments. Expansionary fiscal policy is likely to increase the demand for money and the rate of interest. This may encourage capital inflows in the short run which may improve the overall balance of payments.

Thus, the expansionary fiscal policy may improve the balance of payments at first, but eventually may worsen the balance of payments or reduce the surplus in the balance of payments. This is shown in Fig. 10.4.
Fig. 10.4 : Effect of Expansionary Fiscal Policy on the Balance of Payments