ECONOMIC AND SOCIAL ISSUES (ESI)

CHAPTER
BALANCE OF PAYMENTS

SUMMARY SHEET

FOR RBI GRADE B AND NABARD GRADE

A/B 2019

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Contents
1 Balance of Payments (BoP) - What is it? .............................................................................................................. 3
2 Why do we need to have this record?.................................................................................................................. 3
3 Components of India’s BOP Account: ................................................................................................................... 3
3.1 Current Account of BoP: ............................................................................................................................... 3
3.1.1 Merchandise Transactions or Visible Trade: ........................................................................................ 4
3.1.2 Invisible Trade:...................................................................................................................................... 4
3.1.3 Balance on current account: ................................................................................................................. 5
3.1.4 Difference between Balance of Trade and Current Account: .............................................................. 5
3.2 Capital Account of BoP: ................................................................................................................................ 5
3.2.1 Debt-creating and non-debt creating capital inflows:.......................................................................... 6
3.2.2 Foreign Investments: ............................................................................................................................ 6
3.2.3 Key points from Mayaram Committee Report: .................................................................................... 6
3.2.4 Balance on Capital Account: ................................................................................................................. 6
3.3 Foreign Exchange Reserves: ......................................................................................................................... 7
3.4 Errors and Omissions: ................................................................................................................................... 8
BoP Deficit or Surplus: ............................................................................................................................................. 8
4 Rupee Convertibility: ............................................................................................................................................ 8
4.1 Current Account Convertibility: .................................................................................................................... 8
4.2 Liberalized remittance scheme (2004): ........................................................................................................ 8
4.3 Capital Account Convertibility: ..................................................................................................................... 9
4.4 Restrictions under FEMA for Capital Account Convertibility:....................................................................... 9
4.5 The Committee on Capital Account Convertibility (CAC) or Tarapore Committee: ..................................... 9
4.6 The Second Tarapore Committee recommendations (2006): ...................................................................... 9
4.7 Following were some important recommendations of this committee: ..................................................... 9
4.8 Tarapore Committee mentioned the following benefits of capital account convertibility to India: .........10
5 BoP Crisis: ...........................................................................................................................................................10
5.1 Origin of the Crisis: .....................................................................................................................................10
5.2 What factors led to the culmination of this crisis? .....................................................................................10
6 Economic Reforms 1991 .....................................................................................................................................10

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1 Balance of Payments (BoP) - What is it?
The balance of payments is a systematic record of all economic transactions of residents of a
country with the rest of the world during a given period of time.

2 Why do we need to have this record?

The main purpose of keeping these records is to know the international economic position of a
country which helps the Government in making decisions on monetary and fiscal policies on the one
hand, and trade and payments policies on the other.

3 Components of India’s BOP Account:

Balance of payment (BoP) comprises of current account, capital account, errors and omissions and
changes in foreign exchange reserves.

3.1 Current Account of BoP:

Under current account of the BoP, transactions are classified into merchandise (exports and
imports) and invisibles.

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3.1.1 Merchandise Transactions or Visible Trade:
A major part of transactions in foreign trade is in the form of export and import of goods (visible
items). The money earned from Indian exports of goods (e.g., cars sold to Nepal) is credited (added)
to this account, whilst payments for imported goods (e.g., American aircraft sold in India) are
debited.
• Balance of Trade: The difference between exports of goods and imports of goods is known as
the Balance of Trade.
• If, export of goods (in terms of value) > import of goods (In terms of value), then we have a
Trade Surplus.
• If, export of goods (in terms of value) < import of goods (In terms of value), then we have a
Trade Deficit.

3.1.2 Invisible Trade:

Invisible transactions are further classified into three categories, namely Services, Income and
Transfers.

Let us see them one by one in detail:

Services: It includes a large variety of non-factor services (known as invisible items) sold and
purchased by the residents of a country, to and from the rest of the world. Payments are either
received or made to the other countries for use of these services.

For example: The income earned from the sale of Indian services abroad is known as an invisible
export, e.g., an insurance premium paid by a British ship-owner to an Indian broker. When Indian
residents spend money on foreign services, e.g., a week’s accommodation in London, they are
creating invisible imports, because payment is going out of India.

Income: It includes Profits and Dividends earned by residents of India on their investments abroad
and vice versa. It also includes interest payments i.e. servicing of debt liabilities.

Transfers: These are unilateral transfers which include gifts, donations, personal remittances and
other ‘one-way’ transactions. These refer to those receipts and payments, which take place without
any service in return.

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3.1.3 Balance on current account:
In the current account, receipts from export of goods, services and unilateral receipts are entered as
credit or positive items and payments for import of goods, services and unilateral payments are
entered as debit or negative items. The net value of credit and debit balances is the balance on
current account.

• A current account deficit means the value of imports of goods/services / investment incomes
/ transfers is greater than the value of exports. It indicates net outflow of foreign exchange.

• A current account surplus means the value of imports of goods/services / investment

incomes / transfers is less than the value of exports. It indicates net inflow of foreign
exchange.

Note: A deficit on the current account is a warning that the nation is spending more than it is
earning, in the short run.

3.1.4 Difference between Balance of Trade and Current Account:

Basis Balance of Trade (BOT) Current Account
Components Balance of trade includes only visible Current Account records both visible and
items. invisible items.
Scope It is a narrow concept as it is only a It is a wider concept and it includes BOT.
part of current account

3.2 Capital Account of BoP:

Capital account of BOP records all those transactions, between the residents of a country and the
rest of the world, which cause a change in the assets or liabilities of the residents of the country or
its government. It is related to claims and liabilities of financial nature. Capital account is concerned
with financial transfers. So, it does not have direct effect on income, output and employment of the
country.

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The main components of the capital account include foreign investment, loans and banking
capital.

3.2.1 Debt-creating and non-debt creating capital inflows:

Capital inflows in the capital account can be classified into debt creating and non-debt creating.
Foreign investment (both direct and portfolio) represents non-debt creating capital inflows,
whereas external assistance (i.e. concessional loans taken from abroad), external commercial
borrowing (ECB) and non-resident deposits are debt-creating capital inflows.

3.2.2 Foreign Investments:

• Foreign investment, comprising Foreign Direct Investment (FDI) and Portfolio Investment
consisting of Foreign Institutional Investors (FIIs) investment, American Depository
Receipts/Global Depository Receipts (ADRs/GDRs) represents non-debt liabilities.
• FDI and FII: Both are the forms of investment made in a foreign country. FDI is made to
acquire controlling ownership in an enterprise but FII tends to invest in the foreign financial
market. In most cases, the former is given preference over the latter because it benefits the
whole economy.
• In June 2014, Government of India had accepted the recommendations Mayaram Committee
thereby accepting the definitions of FII and FDI. The panel headed by Finance Secretary was
set up to rationalize the definitions of FDI and FII.

3.2.3 Key points from Mayaram Committee Report:

Foreign investment of 10 percent or more through eligible instruments made in an Indian listed
company would be treated as FDI. All existing foreign investments below the threshold limit made
under the FDI Route shall however, continue to be treated as FDI. Foreign Investment in an unlisted
company irrespective of threshold limit may be treated as FDI. The Committee has recommended
the merger of the FII and Qualified Foreign Investors (QFI) regimes under the new “Foreign Portfolio
Investors” (FPI) regime.

Loans: Loans include external assistance, external commercial borrowings and trade credit.

Banking Capital: Banking capital, including non-resident Indian (NRI) deposits are debt liabilities.

3.2.4 Balance on Capital Account:

The transactions, which lead to inflow of foreign exchange (like receipt of loan from abroad, sale of
assets or shares in foreign countries, etc.), are recorded on the credit or positive side of capital
account. Similarly, transactions, which lead to outflow of foreign exchange (like repayment of loans,
purchase of assets or shares in foreign countries, etc.), are recorded on the debit or negative side.
The net value of credit and debit balances is the balance on capital account.

• Surplus in capital account arises when credit items are more than debit items. It indicates
net inflow of capital.
• Deficit in capital account arises when debit items are more than credit items. It indicates net
outflow of capital.

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Balance on Current Account Vs. Balance on Capital Account:
Balance on current account and balance on capital account are interrelated.
• A deficit in the current account must be settled by a surplus on the capital account.
• A surplus in the current account must be matched by a deficit on the capital account.

3.3 Foreign Exchange Reserves:

➢ The foreign currency held in a country is also taken into account while maintaining the
balance of payments accounts. The components of India’s Foreign Exchange Reserves
include: Foreign exchange (Foreign Currency Assets), Gold, Special Drawing Rights (SDR) and
Reserve Tranche Position in the IMF.

Exchange Rate:
• Exchange rate is the price of one currency in terms of another currency.
• The exchange rate is used when simply converting one currency to another (such as for the
purposes of travel to another country), or for engaging in speculation or trading in the foreign
exchange market.
• Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central
banks of a country whereas floating exchange rates are decided by the mechanism of market
demand and supply.
• In a floating rate regime, an increase in the value of the domestic currency against other
currencies is called an appreciation, while a decrease in value is called depreciation.
• In contrast, an increase in the exchange rate in a fixed rate regime is called a revaluation (for
an increase) and a decrease in the exchange value of the domestic currency is referred to as
devaluation.
• In India, RBI follows a managed floating exchange rate system. Here, the RBI interferes to
manage volatility in floating exchange regime. To stop depreciation of rupee, RBI should sell
dollars from its forex reserve and to stop appreciation of rupee, RBI should purchase dollars
from the market.
• Nominal exchange rate is the price of one currency in terms of number of units of some other
currency.
• It is ‘nominal’ because it measures only the numerical exchange value, and does not say
anything about other aspects such as the purchasing power of that currency.
• To incorporate the purchasing power and competitiveness aspect and, therefore, make the
measure more meaningful, real exchange rates are used.
• The real exchange rates are nothing but the nominal exchange rates multiplied by the price
indices of the two countries.
• NEER and REER: NEER is the Nominal Effective Exchange Rate, and REER is the Real Effective
Exchange Rate.
• Unlike nominal and real exchange rates, NEER and REER are not determined for each foreign
currency separately. Rather, each is a single number (usually expressed as an index) that
expresses what is happening to the value of the domestic currency against a whole basket of
currencies.

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3.4 Errors and Omissions:
Since BOP always balances in theory, all debits must be offset by all credits and vice versa. In
practice, rarely it happens particularly because statistics are incomplete as well as imperfect. That is
why errors and omissions are considered so that BOP accounts are kept in balance.

The Balance of Payments can be summarized as:

Current account balance + Capital account balance + Reserve balance = Balance of Payments

BoP Deficit or Surplus:

• The decrease (increase) in official reserves is called the overall balance of payments deficit
(surplus).
• The balance of payments deficit or surplus is obtained after adding the current and capital
account balances.
• The balance of payments surplus will be considered as an addition to official reserves (reserve
use).

4 Rupee Convertibility:
Indian rupee is fully convertible only in the current account and not in the capital account. This
means one can import and export goods or receive or make payments for services
rendered. However, investments and borrowings are restricted.

4.1 Current Account Convertibility:

Current account convertibility allows free inflows and outflows for all purposes other than for
capital purposes such as investments and loans. In other words, it allows residents to make and
receive trade-related payments -- receive dollars (or any other foreign currency) for export of goods
and services and pay dollars for import of goods and services, make sundry remittances, access
foreign currency for travel, studies abroad, medical treatment and gifts, etc. Though Current
account in India is fully convertible but still some restrictions from FEMA (Foreign Exchange
Management Act) viz.

4.2 Liberalized remittance scheme (2004):

Indian residents may spend $2.5 lakh dollars per year per person abroad apart from FEMA limit.

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4.3 Capital Account Convertibility:
It means the freedom to convert local financial assets into foreign financial assets and vice versa at
market determined rates of exchange. This implies that Capital Account Convertibility allows anyone
to freely move from local currency into foreign currency and back. It refers to the removal of
restraints on international flows on a country’s capital account, enabling full currency convertibility
and the opening of the financial system.

4.4 Restrictions under FEMA for Capital Account Convertibility:

4.5 The Committee on Capital Account Convertibility (CAC) or Tarapore Committee:

It was constituted by the Reserve Bank of India for suggesting a roadmap on full convertibility of
Rupee on Capital Account. The committee submitted its report in May 1997.
The Tarapore committee observed that the Capital controls can be useful in insulating the economy
of the country from the volatile capital flows during the transitional periods and also in providing
time to the authorities, so that they can pursue discretionary domestic policies to strengthen the
initial conditions. The CAC Committee recommended the implementation of Capital Account
Convertibility for a 3 year period viz. 1997-98, 1998-99 and 1999-2000.
The above committee’s report was not translated into any actions. India is still a country with
partial convertibility.

4.6 The Second Tarapore Committee recommendations (2006):

Reserve Bank of India appointed the second Tarapore committee to set out the framework for fuller
Capital Account Convertibility. The report of this committee was made public by RBI on 1st
September 2006. In this report, the committee suggested 3 phases of adopting the full convertibility
of rupee in capital account. First Phase in 2006-07; Second phase in 2007-09; Third Phase by 2011.

4.7 Following were some important recommendations of this committee:

• The ceiling for External Commercial Borrowings (ECB) should be raised for automatic
approval.
• NRI should be allowed to invest in capital markets NRI deposits should be given tax benefits.
• FII (Foreign Institutional Investors) should be prohibited from investing fresh money raised to
participatory notes.
• Existing PN (Participatory notes) holders should be given an exit route to phase out
completely the PN notes. At present the rupee is fully convertible on the current account,
but only partially convertible on the capital account.

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4.8 Tarapore Committee mentioned the following benefits of capital account
convertibility to India:

1. Availability of large funds to supplement domestic resources and thereby promote economic
growth.
2. Improved access to international financial markets and reduction in cost of capital.
3. Incentive for Indians to acquire and hold international securities and assets, and
4. Improvement of the financial system in the context of global competition.

5 BoP Crisis:
Countries with current account deficits can run into difficulties. If the deficit is large and the
economy is not able to attract enough inflows of foreign investment, then their currency reserves
will dwindle. There may come a point when the country needs to seek emergency borrowing from
institutions such as the International Monetary Fund that may lead to external debt. Countries with
deficits in their current accounts will build up increasing debt and/or see increased foreign
ownership of their assets. BoP crisis is also known as the currency crisis. India also faced BoP crisis
in 1990-91.

5.1 Origin of the Crisis:

• It all began in the year 1985 and India had started having a balance of payment problems and
towards the end of the year 1990, it was in a serious economic crisis.
• The government was nearing to the line of the default and the country’s central bank was
refusing to give any credit or loan and foreign exchange reserves had been reduced to such a
point that India could barely finance itself for even 20 days and the worth of imports which
led the Indian government to basically take away the national gold reserves as a pledge to
the International monetary fund (IMF) to get a loan or credit in order to overcome this
balance of payment crisis they had been suffering trough from the year 1985.
• And now the Indian economy would have failed a big time if they did not do this.

5.2 What factors led to the culmination of this crisis?

• The BOP crisis hit the country in the year 1990-1 but the journey of the crisis had been
building for at least a half a decade, preceeding the year of 1991.
• The rising of the fiscal deficit and gradually increasing overvaluation has all resulted and
contributed to the rising imbalance in the balance of payment of the country.
• Improper exchange rate adjustment with respect to the external and domestic shocks during
1990-91 was an add-on to the crisis.

6 Economic Reforms 1991

• India approached the International Bank for Reconstruction and Development (IBRD),
popularly known as World Bank and the International Monetary Fund (IMF) and received $7
billion as loan to manage the crisis.

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 • For availing the loan, these international agencies expected India to liberalize and open up
the economy by removing restrictions on the private sector, reduce the role of the
government in many areas and remove trade restrictions between India and other countries.
• India agreed to the conditionalities of World Bank and IMF and announced the New
Economic Policy (NEP).
• The NEP consisted of wide ranging economic reforms. The thrust of the policies was towards
creating a more competitive environment in the economy and removing the barriers to entry
and growth of firms.
• This set of policies can broadly be classified into two groups: the Stabilization measures and
the structural reform measures.
• Stabilization measures are short-term measures, intended to correct some of the
weaknesses that have developed in the balance of payments and to bring inflation under
control.
• In simple words, this means that there was a need to maintain sufficient foreign exchange
reserves and keep the rising prices under control.
• On the other hand, structural reform policies are long-term measures, aimed at improving
the efficiency of the economy and increasing its international competitiveness by removing
the rigidities in various segments of the Indian economy.
• The government initiated a variety of policies which fall under three heads viz., liberalization,
privatization and globalization.

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