BALANCE OF PAYMENTS

Balance of Payment of a country is one of the important indicators for International trade, which significantly affect the economic policies of a government. As every country strives to a have a favorable balance of payments, the trends in, and the position of, the balance of payments will significantly influence the nature and types of regulation of export and import business in particular. Balance of Payments is a systematic and summary record of a country¶s economic and financial transactions with the rest of the world over a period of time. (a) Transactions in good and services and income between an economy and the rest of the world, (b) Changes of ownership and other changes in that country¶s monetary gold, SDRs, and claims on and liabilities to the rest of the world, and (c) Unrequited transfers and counterpart entries that are needed to balance, in the accounting sense, any entries for the foregoing transactions and changes which are not mutually offsetting. Balance of Trade and Balance of Payments The Balance of Trade takes into account only the transactions arising out of the exports and imports of the visible terms; it does not consider the exchange of invisible terms such as the services rendered by shipping, insurance and banking; payment of interest, and dividend; expenditure by tourists, etc. The balance of payments takes into account the exchange of both the visible and invisible terms. Hence, the balance of payments presents a better picture of a country¶s economic and financial transactions with the rest of the world than the balance of trade. Nature of Balance of Payments Accounting The transactions that fall under Balance of Payments are recorded in the standard double-entry book-keeping form, under which each international transaction undertaken by the country results in a credit entry and a debit entry of equal size, As the international transactions are recored in the double-entry book-keeping form, the balance of payments must always balance, i.e., the total amount of debits must equal the total amount of credits. Somethimes, the balancing item, error and omissions, must be added to balance the balance of payments. Components of Balance of Payments Balance of Payments is generally grouped under the following heads i) Current Account ii) Capital Account iii) Unilateral Payments Account iv) Official Settlement Account. Current Account ³The Current Account includes all transactions which give rise to or use up national income.´ The Current Account consists of two major items, namely: i) Merchandise exports and imports, and ii) Invisible exports and imports. Merchandise exports, i.e., the sale of goods abroad, are credit entries because all transactions giving rise to monetary claims on foreigners represent credits. On the other hand, merchandise

imports, i.e., purchase of goods from abroad, are debit entries because all transactions giving rise to foreign money claims on the home country represent debits. Merchandise imports and exports form the most important international transaction of most of the countries. Invisible exports, i.e., sales of services, are credit entries and invisible imports, i.e. purchases of services, are debit entries. Important invisible exports include the sale abroad of such services as transport, insurance, etc., foreign tourist expenditure abroad and income paid on loans and investments (by foreigners) in the home country form the important invisible entries on the debit side. Capital Account The Capital Account consists of short- terms and long-termcapital transactions A capital outflow represents a debit and a capital inflow represents a credit. For instance, if an American firm invests Rs.100 million in India, this transaction will be represented as a debit in the US balance of payments and a credit in the balance of payments of India. The payment of interest on loans and dividend payments are recorded in the Current Account, since they are really payments for the services of capital. As has already been mentioned above, the interest paid on loans given by foreigners of dividend on foreign investments in the home country are debits for the home country, while, on the other hand, the interest received on loans given abroad and dividends on investments abroad are credits. Unilateral Transfers Account Unilateral transfers is another terms for gifts. These unilateral transfers include private remittances, government grants, disaster relief, etc. Unilateral payments received from abroad are credits and those made abroad are debits. Official Settlements Accounts Official reserves represent the holdings by the government or official agencies of the means of payment that are generally accepted for the settlement of international claims. Balance of Payments Disequilibirum The balance of payments of a country is said to be in equilibrium when the demand for foreign exchange is exactly equivalent to the supply of it. The balance of payments is in disequilibrium when there is either a surplus or a deficit in the balance of payments. When there is a deficit in the balance of payments, the demand for foreign exchange exceeds the demand for it. A number of factors may cause disequilibrium in the balance of payments. These various causes may be broadly categorized into: (i) Economic factors; (ii) Political factors; and (iii) Sociological factors. Economic Factors A number of economic factors may cause disequilibrium in the balance of payments. These are: Development Disequilibrium Large-scale development expenditures usually increase the purchasing power, aggregate demand and prices, resulting in

substantially large imports. The development disequilibrium is common in developing countries, because the above factors, and large-scale capital goods imports needed for carrying out the various development programmes, give rise to a deficit in the balance of payments. Capital Disequilibrium Cyclical fluctuations in general business activity are one of the prominent reasons for the balance of payments disequilibrium. As Lawrance W. Towle points out, depression always brings about a drastic shrinkage in world trade, while prosperity stimulates it. A country enjoying a boom all by itselt ordinarily experiences more rapid growth in its imports than its exports, while the opposite is true of other countries. But production in the other countries will be activated as a result of the increased exports to the boom country. Secular Disequilibrium Sometimes, the balance of payments disequilibrium persists for a long time because of certain secular trends in the economy. For instance, in a developed country, the disposable income is generally very high and, therefore, the aggregate demand, too, is very high. At the same time, production costs are very high because of the higher wages. This naturally results in higher prices. These two factors ± high aggregate demand and higher domestic prices may result in the imports being much higher than the exports. This could be one of the reasons for the persistent balance of payments deficits of the USA. Structural Disequilibrium Structual changes in the economy may also cause balance of payments disequilibrium. Such structural changes include the development of alternative sources of supply, the development of better substitutes, the exhaustion of productive resources, the changes in transport routes and costs, etc. Political Factors Certain political factors may also produce a balance of payments disequilibrium. For instance, a country plagued with political instability may experience large capital outflows, inadequacy of domestic investment and production, etc. These factors may, sometimes, cause disequilibrium in the balance of payments. Further, factors like war, changes in world trade routes, etc., may also produce balance of payments difficulties. Social Factors Certain social factors influence the balance of payments. For instance, changes in tastes, preferences, fashions, etc. may affect imports and exports and thereby affect the balance of payments. Correction Of Disequilibrium A country may not be bothered about a surplus in the balance of payments; but every country strives to remove, or at least to reduce, a balance of payments deficit. A number of measures are available for correcting the balance of payments disequilibrium. These various measures fall into measures. We outline below the important measures for Correcting the disequilibrium caused by a deficit in the balance of payments. Automatic Corrections The balance of payment disequilibrium may be automatically corrected under the Paper Currency Standard. The theory of automatic correction is that if the market forces of demand and supply are allowed to have free play, the equilibrium will automatically be restored in the course of time. For example, assume that there is a deficit in the balance of payments. When there is a

deficit, the demand for foreign exchange exceeds its supply, and this results in an increase in the exchange rate and a fall in the external value of the domestic currency. This makes the exports of the country cheaper and its imports dearer than before. Consequently, the increase in exports and the fall in imports will restore the balance of payments equilibrium. Deliberate Measures This measure is widely employed today. The various deliberate measures may be broadly grouped into; (a) Monetary measures (b) Trade measures;and (c) Miscellaneous. (a) Monetary Measures The important monetary measures are outlined below; Monetary contraction; the level of aggregate domestic demand, the domestic price level and the demand for imports and exports may be influenced by a contraction or expansion in money supply and correct the balance of payments disequilibrium.the measure required is a contraction in money supply. A contraction in money supply is likely to reduce the purchasing power and thereby the aggregate demand. It is also likely to bring about a fall domestic prices. The fall in the domestic aggregate demand and domestic prices reduces for imports. The fall in the domestic aggregate demand and domestic prices reduces the demand for imports. The fall in domestic prices is likely to increase exports. Thus, the fall in imports and the rise in exports would help correct the disequilibrium. Devaluation : Devaluation means a reduction in the official rate at which one currency is exchanged for another currency. A country with a fundamental disequilibrium in the balance of payments may devalue its currency in order to stimulate its exports and discourage imports to correct the disequilibrium. To illustrate, let us take the example of the devaluation of the Indian Rupee in 1966, Just before the devaluation of the Rupees with effect from 6th June 1966, the exchange rate was $ I= Rs. 4.76. The devaluation of the Rupee by 36.5 per cent changed the exchange rate to $ I = Rs. 7.50. Before the devaluation, the price of an imported commodity, which cost $ I abroad, was Rs. 4.76 (assuming a costless free trade). But after devaluation, the same commodity, which cost $ I abroad, cost Rs. 7.50 when imported. Thus, devaluation makes foreign goods costlier in terms of the domestic currency, and this would discourage imports. On the hand, devaluation makes exports (from the country that has devalued the currency) cheaper in the foreign markets. For example, before the devaluation, a commodity which cost Rs. 4.76 in India could be sold abroad at $ I (assuming a costless free trade); but after devaluation, the landed cost abroad of the same commodity was only $ 0.64. This comparative cheapness of the Indian goods in the foreign markets was expected to stimulate demand for Indian exports. The success of devaluation, however, depends on a number of factors, such as the price elasticity of demand for exports and imports. Exchange Control: Exchange control is a popular method employed to influence the balance of payments position of a country. Under exchange control, the government or central bank assumes complete control of the foreign exchange

reserves and earnings of the country. The recipients of foreign exchange such as exporters are required to surrender foreign exchange to the government/central bank in exchange for domestic currency. By the virtue of its control over the use of foreign exchange, the government can control the imports. (a) Trade Measures Trade measures include export promotion measures and measures to reduce imports. Export Promotion Exports may be encouraged by reducing or abolishing export duties, providing an export subsidy, and encouraging export production and export marketing by offering monetary, fiscal, physical and institutional incentives and facilities. Import Control: Imports may be controlled by imposing or enhancing import duties, restricting imports through import quotas and licensing, and even by prohibiting altogether the import of certain inessential items. Miscellaneous Measures Apart from the measures mentioned above, there are a number of other measures that can help make the Balance of Payments position more favourable, such as obtaining foreign loans, encouraging foreign investment in the home country, development of tourism to attract foreign tourists, providing incentives to enhance inward remittances, developing import substituting industries, etc