BALANCE OF PAYMENTS

Balance of Payment and Balance of Trade

 The Balance of Payments of a country is a systematic record of all economic
transactions between the residents of a country and the rest of the world. It is composed
of all receipts on account of goods exported, services rendered and capital received by
residents and payments made by them on account of goods imported, services received
and capital transferred to non-residents or foreigners.
 
Balance of Payment (Figure1 below) consists of (i) current account, (ii) capital
account and (iii) cash account/official reserve assets account. The current account
component records all current transactions that involve the flow of goods and services in
the form of exports and imports for a country during a given year. The current account
has two sub parts viz. trade account (that records export and import of goods) and
invisible account (that records movements of services and other invisibles). The
difference between credit (goods exported) and debit (goods imported) side of the trade
account is termed as Balance of Trade (BOT). During a given period of time, exports
and imports may be exactly equal in which case, the balance of trade is said to be
balanced. If the value of exports of a country exceeds the value of imports, the country is
said to have an export surplus or a favorable balance of trade, when the value of imports
coming to a country is greater than the value of exports, the balance of trade is said to
be deficit or unfavorable. The balance on invisibles or services(BOS) account depicts
exports and imports of services such as financial services like banking, insurance and
other services like shipping, travel, investment income, etc. The BOS account is
included in BOT to get balance of current account.

Components of Balance of Payments: (1) Current Account; (2) Capital Account!

(1) Current Account:
Current account refers to an account which records all the transactions relating to export
and import of goods and services and unilateral transfers during a given period of time.

Current account contains the receipts and payments relating to all the transactions of
visible items, invisible items and unilateral transfers.
Components of Current Account:
The main components of Current Account are:
1. Export and Import of Goods (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). Payment for import of goods is written on the negative side (debit items)
and receipt from exports is shown on the positive side (credit items). Balance of these
visible exports and imports is known as balance of trade (or trade balance).

2. Export and Import of Services (Invisible Trade):

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.

Services are generally of three kinds:

(a) Shipping,

(b) Banking, and

(c) Insurance.

Payments for these services are recorded on the negative side and receipts on the
positive side.

3. Unilateral or Unrequited Transfers to and from abroad (One sided

Transactions):

Unilateral transfers 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. Receipt of unilateral transfers from rest of the world is shown on the
credit side and unilateral transfers to rest of the world on the debit side.
4. Income receipts and payments to and from abroad:
It includes investment income in the form of interest, rent and profits.

5. Income and expenses of embassies in different countries

Current Account shows the Net Income:

Current Account records all the actual transactions of goods and services which affect
the income, output and employment of a country. So, it shows the net income generated
in the foreign sector.

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.

1. Surplus in current account arises when credit items are more than debit items. It
indicates net inflow of foreign exchange.

2. Deficit in current account arises when debit items are more than credit items. It
indicates net outflow of foreign exchange.

2) Capital Account:
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 used to:

(i) Finance deficit in current account; or
(ii) Absorb surplus of current account.

Capital account is concerned with financial transfers. So, it does not have direct effect on
income, output and employment of the country.

Components of Capital Account:

The main components of capital account are:
1. Borrowings and lendings to and from abroad: It includes:
A. All transactions relating to borrowings from abroad by private sector, government,
etc. Receipts of such loans and repayment of loans by foreigners are recorded on the
positive (credit) side.

B. All transactions of lending to abroad by private sector and government. Lending

abroad and repayment of loans to abroad is recorded as negative or debit item.

2. Investments to and from abroad: It includes:

A. Investments by rest of the world in shares of Indian companies, real estate in India,
etc. Such investments from abroad are recorded on the positive (credit) side as they
bring in foreign exchange.

B. Investments by Indian residents in shares of foreign companies, real estate abroad,

etc. Such investments to abroad be recorded on the negative (debit) side as they lead to
outflow of foreign exchange.

3. Change in Foreign Exchange Reserves:

The foreign exchange reserves are the financial assets of the government held in the
central bank. A change in reserves serves as the financing item in India’s BOP. So, any
withdrawal from the reserves is recorded on the positive (credit) side and any addition to
these reserves is recorded on the negative (debit) side. It must be noted that ‘change in
reserves’ is recorded in the BOP account and not ‘reserves’.

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.

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

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

In addition to current account and capital account, there is one more element in BOP,
known as ‘Errors and Omissions’. It is the balancing item, which reflects the inability to
record all international transactions accurately.

Trends of Balance of Trade and Balance of Payment in India

           The trends of India’s balance of payment position can be studied as follows:
 
BOP Position in the 50s
In the early 1950s when India launched its economic planning, the balance of payments
position was more or less comfortable. However, in 1951-52, there was a large trade
deficit and as a result, despite net surplus invisible transfers and capital account surplus
(which was due to long term loans) there was overall deficit on the current and capital
accounts which was met by the official reserves account. India witnessed surplus in the
current account and surplus in BOP position in the year 1952-53 and 1953-54. During
1954-55 and 1955-56 there was surplus on both current and capital accounts.
BOP Position during 1960
          During the decade of 60’s the balance on current account was unfavorable mainly
because of steep rise in imports of food grains, machinery and equipments and sluggish
exports. The balance on invisibles account which had been positive so far turned
negative during this decade. India sought external assistance in a big way under capital
account and loans from World Bank and withdrawals from IMF. Heavy trade deficits,
debt obligations and a sharp fall in foreign exchange reserves led to the devaluation of
the rupee in 1966.
 BOP Position during 1970’s
          In the early 70s, though exports grew more significantly, the larger increase in
imports led to continued trade deficits and India had deficits even in terms of invisible
transfers. In the year 1973-74, however, the country had a substantial current account
surplus despite a trade deficit. This was due to large surplus in terms of invisible
transfers.  Further, there was a huge inflow of foreign aid. This results into comfortable
BOP position during this decade. 
BOP Position during 1980’s
           In the year 1979-80 India faced second oil shock that had a far more severe
impact on the economy’s balance of payment than that of the first shock. Increase in oil
prices substantially increased the import bill while exports failed to cope up with the
rising imports. Export performance was depressed by the severe international recession
of 1980-83. Exports grew by about 3 percent, in terms of volume. As a result trade
deficit widened during the entire decade of 1980 barring three years 1982-85.
BOP crisis — 1990-92
           In the year 1991, India experienced the worst ever BOP crisis since
independence. The year 1990-91 witnessed three major developments which contributed
to this crisis- i) substantial increase in oil price following Gulf war that led to substantial
increase in the import’s bill of the country. Further the remittances from Indian workers
employed in Kuwait also stopped; ii) decline in exports due to disintegration of USSR
and iii) problems on the domestic front. Though emergency borrowings from the I.M.F.
provided some temporary relief, the decline in reserves continued. By June 1991, the
level of foreign exchange reserves dropped to the extent that they were barely sufficient
to finance imports for a fortnight
 Balance of Payment Position (1960-2008)
Year Trade Net InvisiblesCurrent AccountIncrease(-)/ Decrease
Balance Balance (+) in Foreign
Exchange Reserves
1960-61 –475.2 82.8 –392.4 59.2
1970-71 –421.6 –23.8 –445.4 88.6
1980-81 –5967.2 4310.6 –1656.6 516.0
1990-91 –16934 –435 –17369 2293
2000-01 -27302 45139 -11598 -27528
2001-02 -36182 71381 16426 -56593
2002-03 -42069 82357 30660 -82037
2003-04 -65741 127369 63983 -143993
2005-06 -203991 185927 -43737 -65896
2006-07 -268727 240933 -45343 -163634
2007-08 -324678 291739 -70357 -369689
   Source: RBI annual reports and Economic Survey, Government of India
 
BOP Position: 1992-95
          During 1991 the economic reforms and macro-economic stabilization measures
were introduced to tide over the BOP crisis of 1991.The drastic changes occur in the
trade policy that includes devaluation of rupee, convertibility of rupee, tariffs cuts, and
import liberalization. In the initial year of reforms the import growth picked up and since
the growth in exports was not that significant, trade deficit, increased. The invisibles
account also recorded deterioration. On the other hand, there was a rise in the outgo on
interest payments, royalties, technical fees and miscellaneous payments. As a result,
current account deficit increased.
 
India’s BoP in 2018:
 Capital Account data was reported at -42.869 USD mn in Mar 2018. This
records a decrease from the previous number of 33.385 USD mn for
Dec 2017.
 India’s BoP: Capital Account data is updated quarterly, averaging 7.486
USD mn from Jun 2009 to Mar 2018,

Reasons for Adverse Balance of Payments:

(a) The single most important item of imports throughout was food-grain, particularly in
the years of drought. The value of imports of food-grains was of the order of Rs. 1,140
crores over the period 1983-86.

(b) Apart from food-grains, raw materials constitute another major item of imports. Prior
to Independence, India exported raw materials. The scenario changed after the partition
of the country and the launching of the five year plans. As industrialisation proceeded,
the import bill on account of raw materials mounted up.

c) The deficit in the balance of payments in current account due to rising imports was
partially justified. This is because capital imports have been, and are, serving the aims
and purpose of industrialisation. The slow growth of exports is caused by:
(i) Recessionary tendencies in the world market,

(ii) Low quality of exportables,

(iii) Shortage of exportable goods,

(iv) Lack of competitive strength,

(v) Inadequate institutional arrangements,

(vi) Import-oriented exportables, and

(vii) Domestic inflation.

Causes of Unfavourable Balance of Payments/Unfavourable Balance of Trade

Main Causes of unfavourable balance of payment of India are as follows:

1.Import of Machinery:

Since independence,import of machines has increased on two scores:

i. During World War II,machines in Indian industries overworked.Consequently, these

were large-scale depreciation and wear and tear of machines.In order to replace he
same,large quantity of new machines was imported.

ii.Industrialisation of the country in the wake of Five year Plans also necessitated import
of machines worth crores of rupees. This turned India’s Balance of payments
unfavourable.

2. Import of War equipments:

In order to defend itself against China and Pakistan, large amount of war equipment
were imported by India.These imports also caused disequilibrium in the balance of
payments.

3. More demand of Consumption Goods

In the post war period,demand not only of foreign goods but also of Indian goods went
up. Previously,large amount of oilseeds,tea, iron ores etc. used to be exported out of
India.Now because of increase in population their demand within the country has gone
up.So export of these goods has gone down very much.

4. Price disequilibrium

There has been wide difference in the domestic prices of the goods and the prices of
goods in foreign countries.Due to inflation,domestic prices have increased more than the
increase in prices of foreign goods.This has led to increase in imports and decrease in
exports.
5. Expenditure on Embassies

Independent India had to establish its political relations with other countries.To that
end,it had to set up its embassies in foreign countries.It was an expensive affair.It also
turned balance of payments unfavourable.This item does not affect balance of trade,as it
is an invisible item,but it does affect balance of payments.

6. Foreign Competition

India mainly exports jute,tea and textiles,but now foreign competition inthese goods is
growing.Bangladesh is India’s rival in jute export and Sri Lanka and Indonesia in the
export of tea and Korea and china in the export of cloth.This has also adversely affected
our exports.

7. Increase in price of Crude Oil

Value of imports has gone up on account of constant hike in the price of crude oil.Of the
exports 30% is spent on petroleum products.

8. Payments of interest on foreign Debts

The huge interest burden also caused disequilibrium in th balance of payments.This item
does not affect balance of trade, as it is an invisible item.

9. Less growth in Exports

Despite various export promotion schemes,our exports are still less than our
imports.Moreover growth rate of exports is less than the growth rate of imports.

10. Gulf War

In 1991,Gulf War(War between Iraq and several western countries)had also its adverse
effect on India’s balance of payments.On the one hand,price of petrol shoot up and on
the other,foreign remittances by Indians working in gulf area,viz., Kuwait,Iraq,etc. to
India altogether stopped.It rendered the imports expenses and reduced the foreign
remittances.

11. Disintegration of USSR

India had large amount of foreign trade with USSR.The disintegration of USSR had an
adverse effect on India’s foreign trade.

Beside,there are some other minor factors also accounting for adverse balance of
payments,viz., poor quality,malpractices of Indian traders causing impediments in
exports,bad effects of high cost of production on exports, etc.

Measures/Suggestions to correct disequilibrium in the Balance of Payments

The main factor accounting for disequilibrium of payments is the excess of imports over
exports.

 Exports should be promoted and imports discouraged.

 Import substitution should be resorted to.

Following specific measures are suggested to correct disequilibrium in the balance of

payments:

1.Promotion of Exports

Promotion of exports is the best measure to correct an adverse balance of payments. To

achieve this all, taxes on export goods be withdrawn, Export industries should be
provided raw materials and transport facilities at reduced prices, so that prices of these
goods remain low. These industries should be provided credit facilities at liberal rates.
To promote exports, intensive publicity of Indian goods be undertaken in foreign
markets and goods be designed to the tastes of the foreign consumers.

2. Increase in Production

To cut down imports and encourage exports, it is essential that agricultural, industrial
and mineral production be increased. Jute manufactured products tea and coffee are of
great importance among exports from India. Efforts have been made to increase the
production of these products in Five Year Plans. Their production needs to be further
increased. Recently several new items have entered the export list viz. machines, electric
fans,cycles, ready made garments, gems and jewellery. Raw materials should be made
available to export industries at international prices. Production capacity of
cement,fertilizers,iron and steel etc. should be utilized fully.
3.Trade Agreements

Government of India enters into trade agreements with the governments of other
countries in order to expand trade. Many foreign trade delegates visit India to strengthen
trade ties. India has negotiated trade agreements with many countries viz.
Bangladesh,Bulgaria,Germany,Egypt,France,Korea,Iran,Iraq etc.On 15April,1994,India
enters into trade agreements with all other countries signing GATT, automatically. India
has entered into trade agreement with WTO nations, SAARC nations. As a member of
World Trade Organization, India is having trade relations with other 149 member
nations of WTO. More trade agreements should be done with foreign countries to
promote our foreign trade and exports.

4. Encouragement to Foreign Investment

Foreign industries and multinational corporations (MNCs) are encouraged to invest their
capital in India. Special facilities are provided to attract foreign capital.It leads to inflow
of foreign exchange in the country. It also increases production of export goods and thus
exports are encouraged. However, care should be taken that foreign capitalists do not
dominate our economy.

5. Attraction to Foreign Tourists

Attractive picnic spots be developed in different parts of the country to attract foreign
tourists.Government spends lot of money to develop such spots.Besides,foreign tourists
be provided with transport and other facilities.Large amount of foreign exchange can be
earned from foreign tourists.

6.Devaluation of Indian Currency

Lowering of the value of domestic currency in terms of foreign currencies is called

devaluation.A country resorts to devaluation when its exports fall short of imports.As a
result of devaluation imports become dearer and exports cheaper.India devalued its
rupee in the year 1949,1966, and twice in the year 1991.But now this measure is not
used,as now exchange rate of rupee with other currencies of the world is determined by
market forces of demand and supply and not by government.
7.Deflation

It means that prices of the goods produced in the country should be brought down.As a
result of it, foreigners will get export goods at cheaper price. Thus exports will be
encouraged. Moreover,because of availability of Indian goods at lower rates the demand
of imports will also come down.

8.Restriction on Imports

Another important method of correcting balance of payments is restriction on imports.

Following measures can be adopted to cut down imports.

i. Restrictions on the import of luxury goods.

ii. Issue of licenses for the import of essential goods only.

iii. Fixation of quotas for the import of different goods.

iv. Levying of new import duties and enhancing of the rates old duties.

v.Motivating the Indians to use indigenous goods.

vi. Less credit facilities for imported goods etc.

9. Import Substitution

Import substitution plays an important role to correct an adverse balance of

payments.Import substitution means total or partial replacement of an imported product
of the same functional requirement mainly from indigenous material and know how.Its
main objective is to reduce imports.For instance,prior to independence,cycles, sewing
machines,electric fans etc. used to be imported from abroad.Now,the same are being
produced in the country.Similarly,in place of copper wire imported for power
industry,aluminium wire produced in the country is being increasingly used.

In short,disequilibrium in the balance of payments can be corrected by increasing

exports and reducing imports. Government of India has taken several measures to
promote exports and popularize import substitutions.
Remedies Adopted Against Imbalance:
(a) Raising Agricultural Production:
To reduce imports of food-grains, agricultural production had to be increased. The GOI
had laid due emphasis on agriculture in almost all plans, except in the Second Plan. As a
result the agricultural sector experienced Green Revolution in the early 1970s. A record
output of food-grains was also achieved since then. Yet, the increase in food production
was not adequate. The country had failed to build up a huge buffer stock of food-grains
to tide over the drought years. Hence, there was the need to import food-grains.
However, in recent years, imports of food have gone down considerably.

(b) Import Substitution:

The policy of import substitution has also been in operation for a long time. It refers to
growing substitution of imported goods by encouraging domestic production of such
goods. The adoption of this policy has enabled the country to save a considerable
amount of foreign exchange.

Due to the success of this policy, the import of capital goods is, at present, much less
(e.g., around 16% total imports). A large number of industrial products are now being
produced domestically. Imports of non-essential items have been reduced considerably.

(c) Export Promotion:

Another important measure is export promotion.

The GOI’s measures relating to export promotion are of three categories:

(i) choosing of commodities with export potential such as engineering goods, readymade
garments, chemicals and allied products, gems and jewellery, etc.,

(ii) incentives to exporters such as various types of encouragements, concessions and

facilities in the form of cash subsidies, duty-free import of capital goods, raw materials,
exemption from union excise duty, exemption of export income from income tax, special
import licences for raw materials required for export, bank loans at low rates of interest
to exporters and so on; and

Measures to correct disequilibrium in BOP:

Sustained or prolonged deficit has to be settled by short term loans or depletion of
capital reserve of foreign exchange and gold.
Following remedial measures are recommended:
(i) Export promotion:
Exports should be encouraged by granting various bounties to manufacturers and
exporters. At the same time, imports should be discouraged by undertaking import
substitution and imposing reasonable tariffs.

(ii) Import:
Restrictions and Import Substitution are other measures of correcting disequilibrium.

(iii) Reducing inflation:

Inflation (continuous rise in prices) discourages exports and encourages imports.
Therefore, government should check inflation and lower the prices in the country.

(iv) Exchange control:

Government should control foreign exchange by ordering all exporters to surrender their
foreign exchange to the central bank and then ration out among licensed importers.