Balance of Payments in India: Meaning, Concept, Features and Disequilibrium

In this article we will discuss about Balance of Payments in India:- 1. Meaning of Balance of Payment Accounts 2. The Concept of Balance of Payments 3. Features 4. Balance of Payments Always Balance 5. Disequilibrium in Balance of Payments.

Meaning of Balance of Payment Accounts:

The circular flow of economic activities under a four sector model shows that all the domestic sectors, households, firm or government, carry out numerous transactions with the entities from the rest of the world. From the viewpoint of a country, all such transactions are required to be recorded in a scientific and systemic manner for keeping an eye on the aggregate liability or earnings of a country, as also to evaluate their impacts on the economy from time to time.

For this purpose, a system of accounting has been developed which is commonly known as Balance of Payment (BoP) accounts.

A BoP account is a summary of systematic recording of economic transactions taking place between residents of a country and the entities from the rest of the world during a given time period. It presents monetary aspects of global transactions of a country.

It primarily includes three kinds of transactions:

i. Transactions relating to the goods’ trade, which are also called as merchandise trade or visible trade.

ii. Transactions relating to services, which are called as invisible trade.

iii. Capital related transactions including investments, deposits and loans.

Under every head, we include both way transactions, i.e., inflows in a country and outflows from the country. Former is considered as a debit entry as they result in outflow of foreign exchange and the latter as a credit entry as they generate inflow of foreign exchange.

A few definitions of the BoP accounts by different experts are presented as follows:

Definitions of Balance of Payments:

Kindleberger has defined it as: the balance of payment of a country is systematic record of all economic transactions between its residents and residents of foreign countries.

In the words of Ellsworth, Balance of payments is an annual summary statement of all the transactions between the residents of a country and the rest of the world.

Dominick Salvatore, in this regard, wrote, the Balance of payments is a summary statement in which, in principle, all the transactions of the residents of a nation with the residents of all other nations are recorded during a particular period of time, usually a calendar year.

Benham has provided a simple definition of it, Balance of payments of a country is a record of all economic transactions over a period with the rest of the world.

From the above definitions of a BoP account, following important obser­vations can be made:

1. It is usually related to a country and to a specific period which is usually one year. In some cases, quarterly or monthly statements of BoP accounts are also prepared by the concerned authority.

2. It is nothing but just a statement of records which includes both payments made and payments received by all the resident entities of a country to the various entities from rest of the world. The foreign entities may include individuals, firms, NGOs, international institu­tions or governments.

3. It includes all kinds of transactions, whether on visible or invisible flows. It includes transactions of any nature, current or capital.

4. It follows a double entry accounting system, the net balance of which is always zero. This is because of the fact that every transaction will have a credit and a debit entry of equal magnitude.

5. The term resident of a country will cover all individual entities: individuals, households, firms, institutions, NGOs, as well as govern­ment agencies/departments.

6. For a meaningful understanding of a BoP accounts, it is divided into categories and sub-categories.

The Concept of Balance of Payments:

The balance of payments records the flow of economic transactions between the residents of a given country and the residents of other countries during a certain period of time. This record shows transactions in goods, services and income between an economy and the rest of the world, changes in ownership and other changes in that economy’s monetary god. Special Drawing Rights (SDRs) and claims on the liabilities to the rest of the world. Capital transfers and unrequited transfers and counterpart entries that are needed to balance any entries for the foregoing transactions and changes that are not mutually offsetting.

The balance of payment is defined as “a systematic record of all economic transactions between the residents of a country and residents of foreign countries” during a certain period of time. The term ‘systematic record’ does not refer to any particular system. However, the system generally adopted is double entry book­keeping system. The term ‘economic transaction’ includes all such transactions that involve the transfer of title or ownership. While some transactions involve physical transfer of goods, services, assets and money along with the transfer of title, some transactions do not.

Features of Balance of Payments:

Balance of Payments has the following features:

(i) It is a systematic record of all economic transactions between one country and the rest of the world.

(ii) It includes all transactions, visible as well as invisible.

(iii) It relates to a period of time. Generally, it is an annual statement.

(iv) It adopts a double-entry book-keeping system. It has two sides: credit side and debit side. Receipts are recorded on the credit side and payments on the debit side,

(v) When receipts are equal to payments, the balance of payments is in equilibrium; when receipts are greater than payments, there is surplus in the balance of payments; when payments are greater than receipts, there is deficit in the balance of payments,

(vi) In the accounting sense, total credits and debits in the balance of payments statement always balance each other.

Purposes of Balance of Payments:

The balance of payments fulfills a very useful purpose in so far as it provides necessary information for the formulation of domestic monetary, fiscal and foreign trade policies.

The important uses of BOP accounts may be enumerated as below:

1. The balance of payments accounts give an extremely useful data for the economic analysis of the country’s weakness and strength as a partner in international trade. A comparison of the statements of BOP for several successive years can indicate the improving or deteriorating international economic position of the country. In case of any deterioration, necessary corrective measures can be taken.

2. BOP also reveals the changes in the composition and magnitude of foreign trade. The changes that are deterrent to the economic well-being of the country require necessary action by the government. For example, a regular outflow of capital or export of essential goods causing scarcity on the domestic market needs to be curbed through policy measures or direction action.

3. BOP also indicates future repercussions of a country’s past trade performance. If balance of payments shows continuous and large deficit overtime, it shows the growing international indebtedness of the country that may ultimately lead to financial bankruptcy.

4. Detailed Balance of Payments account reveals also the weak and strong points in the country’s foreign trade relations and thereby invites government attention to the need for corrective measures against the weak spots and unhealthy developments.

Balance of Payments Always Balance:

In the accounting sense, the balance of payments of a country is always in equilibrium. The statement of balance of payments is prepared in terms of credits and debits based on the system of double-entry book-keeping. In the double-entry system, each transaction gives rise to two equal entries: a credit entry (i.e., a receipt) and a debit entry (i.e., payment). Thus the sum of all credits equals the sum of all debits.

Similarly, an international transaction generates two equal entries: a credit (+) for an export of a good or service, or for a foreign borrowing, or for the receipt of a unilateral transfer (gifts, donations, grants, etc.); and a debit (-) for an import of a good or service, or for a foreign lending, or for the making of a unilateral transfer.

In other words, a country must pay for its imports of goods and services, or foreign borrowings, or receipts of unilateral transfers by the equal-valued export of goods and services or foreign lending, or making unilateral transfers. Thus, the sum of all international receipts (credit items) always equals the sum all international payments (debit items).

While receipts and payments in the international transactions always must be equal or must balance in the accounting sense, they may not be equal or in equilibrium in operational sense. The accounting balance of a balance of payments account, which is merely a truism, should not be confused with the ‘economic balance’ which recognised the possibility of a deficit or a surplus in the balance of payments.

When the current account of the balance of payments shows a deficit or a surplus, the balance is restored through changes in the capital account. In fact, the capital account is specially prepared to neutralise the imbalance in the current account.

The deficit in the current account is neutralised by the equal amount of surplus in the capital account; and the surplus in the current account is neturalised by the equal amount of deficit in the capital account. Thus, the current and capital accounts together balance each other and restore equilibrium in the balance of payments.

Suppose, a country experiences a deficit in the current account of its balance of payments statement due to excess of imports over exports.

Such a deficit can be met by resorting to the following changes in the capital account:

(i) By raising loans and getting grants from other countries;

(ii) By drawing on past accumulated balances of the country which it may be keeping in the foreign countries;

(iii) By exporting gold;

(iv) By drawings from International Monetary Fund.

Table-1, which represents a hypothetical balance of payments statement, shows that the current and capital accounts together must necessarily balance. The deficit in the current account (excess of payments over receipts, i.e., Rs. 1500 -1300 = 200 crores) is equal to the surplus in the capital account (excess of receipts over payments, i.e., Rs. 800 – 600 = 200 crores). Thus, the sum of all receipts is equal to the sum of all payments and the balance of payments account is balanced.

Balancing of international transactions is symbolically summarised below:

Importance of Balance of Payment:

1. It provides an overview of a country’s financial transactions with the rest of world.

2. At the same time, it also presents a disaggregated view of different kinds of transactions a country may carry out with the rest of the world. For example, it may throw light on the volume of visible and invisible exports.

3. It also shows the extent to which a country depends on global economy.

4. A balance of payment account also reflects upon the health of the economy.

5. It also indicates a change in foreign indebtedness of an economy. How much it has borrowed during the year. Moreover, it also facilitates a review of interest burden on its foreign loans.

6. From the BoP accounts, we can also evaluate the impact of change in value of currency.

Disequilibrium in Balance of Payments:

Normally, the balance of payments of a country should be in equilibrium, i.e., the imports and exports of goods and services should be equal. But, in reality it is not so. Disequilibrium generally arises in the balance of payments account.

Balance of payments maybe unfavourable when there is excess of imports over exports (deficit balance); it may be favourable when there, is excess of exports over imports (surplus balance).

The phenomenon of disequilibrium is particularly related to the current account of balance of the payments statement; the capital account is used to settle the imbalance in the current account through changes in the financial flows of funds.

Viewed in this sense, a disequilibrium in the balance of payments (deficit or surplus) affects the fundamental economic relationships among the nations and reflects a country’s economic weakness or strength relative to others.

Types of Disequilibrium:

The main types of disequilibrium in the balance of payments are as given below:

I. Cyclical Disequilibrium:

Cyclical disequilibrium in the balance of payments arises due to business cycles. It is caused- (a) by cyclical patterns of income, or (b) by different income elasticity’s, or (c) by different price elasticity’s. These factors bring changes in the terms of trade as well as growth of trade which, in turn, lead to a deficit or surplus in the balance of payments.

When prices rise in prosperity, a country with more elastic demand for imports will experience a decline in the value of imports, thus leading to a surplus in the balance of payments. Conversely, as prices decline in depression, more elastic demand will increase imports and cause a deficit in the balance of payments.

These tendencies may, however, be offset by the effects of income changes. High incomes during prosperity increase imports and low incomes during depression reduce imports.

II. Secular Disequilibrium:

Secular or long-term disequilibrium in balance of payments occurs because of long-seated and deep-rooted changes in the economy as it moves from one stage of growth to another- (a) In the initial stages of economic development, domestic investment exceeds savings and imports exceed exports. Disequilibrium occurs due to lack of funds to finance the import surplus. (b) Then comes a stage when domestic savings tend to exceed domestic investment and exports exceed imports. Disequilibrium arises because the surplus savings exceed investment opportunities abroad, (c) At a still later stage, domestic savings tend to equal domestic investment and long-term capital movements on balance become zero.

III. Structural Disequilibrium:

Structural disequilibrium in the balance of payments occurs when structural changes in some sectors of the economy alter the demand and supply forces influencing exports and imports.

According to Kindleberger, structural disequilibrium may be of two types:

(i) “Structural disequilibrium at the goods level occurs when a change in demand or supply of exports or imports alters a previously existing equilibrium or when a change occurs in the basic circumstances under which income is earned or spent abroad, in both cases without the requisite parallel changes elsewhere in the economy.”

(ii) “Structural disequilibrium at the factor level results from factors which fail to reflect accurately factor endowments … i.e., when factor prices, out of line with factor endowments, distort the structure of production from the allocation of resources which appropriate factor prices would have indicated.”

Structural disequilibrium is caused by changes in technology, tastes and attitude towards foreign investment, Political disturbances, strikes, lockouts, etc., which affect the supply of exports, also cause structural disequilibrium.

IV. Fundamental Disequilibrium:

The term fundamental disequilibrium has been originally used by the I.M.F., to indicate a persistent and long-term disequilibrium in a country’s balance of payments. Fundamental disequilibrium is generally caused by dynamic factors and particularly lead to chronic deficit in the balance. The main causes of fundamental disequilibrium are- (a) excessive or inadequate internal demand for foreign goods; (b) excessive or inadequate competitive strength in the world market; (c) excessive capital movements.

Causes of Disequilibrium:

Various causes of disequilibrium in the balance of payments or adverse balance of payments are as follows:

a. Development Schemes:

The main reason for adverse balance of payments in the developing countries is the huge investment in development schemes in these countries. The propensity to import of the developing countries increases for want of capital for industrialisation.

The exports, on the other hand, may not increase because these countries are traditionally primary producing countries. Moreover the volume of exports may fall because newly created domestic industries may need them. All this leads to Structural changes in the balance of payment resulting in structural disequilibrium.

b. Price-Cost Structure:

Changes in price-cost structure of export industries affect the volume of exports and create disequilibrium in the balance of payments. Increase in prices due to higher wages, higher cost of raw materials, etc. reduces exports and makes the balance of payments unfavourable.

c. Changes in Foreign Exchange Rates:

Changes in the rate of exchange are another cause of disequilibrium in the balance of payments. An increase in the external value of money makes imports cheaper and exports dearer; thus, imports increase and exports fall and balance of payments become unfavourable. Similarly, a reduction in the external value of money leads to a reduction in imports and an increase in exports.

d. Fall in Export Demand:

There has been a considerable decline in the export demand for the primary goods of the underdeveloped countries as a result of the large increase in the domestic production of foodstuffs raw materials and substitutes in the rich countries.

Similarly, the advanced countries also find a fall in their export demand because of loss of colonial markets. However, the deficit in the balance of payment due to the fall in export demand is more persistent in the underdeveloped countries than in the advanced countries.

e. Demonstration Effect:

According to Nurkse, the people in the less developed countries tend to follow the consumption patterns of the developed countries. As a result of this demonstration effect, the imports of the less developed countries will increase and create disequilibrium in the balance of payments.

f. International Borrowing and Lending:

International borrowing and lending is another reason for the disequilibrium in the balance of payments. The borrowing country tends to have unfavourable balance of payments, while ‘he lending country tends to have favourable balance of payments.

g. Cyclical Fluctuations:

Cyclical fluctuations cause cyclical disequilibrium in the balance of payments. During depression, the incomes of the people in foreign countries fall. As a result, the exports of these countries tend to decline which, in turn, produces disequilibrium in the home country’s balance of payment.

h. Newly Independent Countries:

The newly independent countries, in order to develop international relations, incur huge amounts of expenditure on the establishment of embassies, missions, etc. in other countries. This adversely affects their balance of payments position.

i. Population Explosion:

Another important reason for adverse balance of payments in the poor countries is population explosion. Rapid growth of population in countries like India increases imports and decreases the capacity to export.

j. Natural Factors:

Natural calamities, such as droughts, floods, etc., adversely affect the production in the country. As a result, the exports fall, the imports increase and the country experiences deficit in its balance of payments.

Methods of Correcting Disequilibrium:

Persistent disequilibrium in the balance of payments, particularly the deficit balance, is undesirable because it- (a) weakens the country’s economic position at the international level, and (b) affects the progress of the economy adversely. It must be cured by taking appropriate measures.

There are many methods to correct disequilibrium in the balance of payments.

Important among them are discussed below:

1. Deflation:

Deflation is the classical medicine for correcting the deficit in the balance of payments. Deflation refers to the policy of reducing the quantity of money in order to reduce the prices and the money income of the people.

The central bank, by raising the bank rate, by selling the securities in the open market and by other methods can reduce the volume of credit in the economy which will lead to a fall in prices and money income of the people. Fall in prices will stimulate exports and reduction in income checks imports.

Thus, deflationary policy restores equilibrium to the balance- (a) by encouraging exports through reduction in their prices and (b) by discouraging imports through the reduction in incomes at home. Moreover, a higher interest rate in the domestic market will attract foreign funds which can be used for correcting disequilibrium.

However, deflation is not considered a suitable method to correct adverse balance of payments because of the following reasons:

(a) Deflation means reduction in income or wages which is strongly opposed by the trade unions. (b) Deflation causes unemployment and suffering to the working class, (c) In a developing economy, expansionary monetary policy rather than contractionary (deflationary) monetary policy is required to meet the developmental needs.

2. Depreciation:

Another method of correcting disequilibrium in the balance of payments is depreciation. Deprecation means a fall in the rate of exchange of one currency (home currency) in terms of another (foreign currency). A currency will depreciate when its supply in the foreign exchange market is large in relation to its demand.

In other words, a currency is said to depreciate if its value falls in terms of foreign currencies, i.e., if more domestic currency is required to buy a unit of foreign currency. The effect of depreciation of a currency is to make imports dearer and exports cheaper. Thus, depreciation helps a country to achieve a favourable balance of payments by checking imports and stimulating exports.

Exchange depreciation is automatic. It works in a flexible exchange rate system and can correct a mild adverse balance of payments if the country’s demand for imports and the foreign demand for its exports are fairly elastic.

But the method of exchange depreciation has the following defects:

(i) It is not suitable for a country which follows a fixed exchange rate system.

(ii) It makes international trade risky and thus reduces the volume of trade.

(iii) The terms of trade go against the country whose currency depreciates because the foreign goods have become costlier than the local goods and the country has to export more to pay for the same volume of imports.

(iv) Experience of certain countries has indicated that exchange depreciation may generate inflationary pressure by increasing the domestic price level and money income.

(v) The success of the method of exchange depreciation depends upon the cooperation of other countries. If other countries also start depreciating their exchange rates, then this methods will not benefit any country.

3. Devaluation:

Devaluation refers to the official reduction of the external values of a currency. The difference between devaluation and depreciation is that while devaluation means the lowering of external value of a currency by the government, depreciation means an automatic fall in the external value of the currency by the market forces; the former is arbitrary and the latter is the result of market mechanism.

Thus, devaluation serves only as an alternative method to depreciation. Both the methods imply the same thing, i.e., decrease in the value of a currency in terms of foreign currencies. Both the methods can be used to produce the same effects; they discourage imports, encourage exports and thus lead to a reduction in the balance of payments deficit.

The success of the method of devaluation depends upon the following conditions:

(i) The elasticity of demand for the country’s exports should be greater than unity.

(ii) The elasticity of demand for the country’s imports should be greater than unity.

(iii) The exports of the country should be non-traditional and the increasingly demanded from other countries.

(iv) The domestic price should not rise and should remain stable after devaluation.

(v) Other countries should not retaliate by resorting to corresponding devaluation. Such a retaliatory measure will offset each other’s gain.

Devaluation also suffers from certain defects:

(i) Devaluation is a clear reflation on the country’s economic weakness.

(ii) It reduces the confidence of the people in country’s currency and this may lead to speculative outflow of capital.

(ii) It encourages inflationary tendencies in the home country.

(iv) It increases the burden of foreign debt.

(v) It involves large time lag to produce effects.

(vi) It is a temporary device and does not provide a permanent remedy to correct adverse balance of payments.

4. Exchange Control:

Exchange control is the most widely used method for correcting disequilibrium in the balance of payments. Exchange control refers to the control over the use of foreign exchange by the central bank. Under this method, all the exporters are directed by the central bank to surrender their foreign exchange earnings. Foreign exchange is rationed among the licensed importers. Only essential imports are permitted.

Exchange control is the most direct method of restricting a country’s imports. The major drawback of this method is that it deals with the deficit only, and not its causes. Rather it may aggravate these causes and thus may create a more basic disequilibrium. In short, exchange control does not provide a permanent solution for a chronic disequilibrium.

5. Capital Movement:

Inflow of capital or capital imports can be used to correct a deficit in the balance of payment. If the capital is perfectly mobile between the countries, an increase in the domestic rate of interest above the world rate will result in the inflow of capital. This will reduce the deficit in the balance of payments.

6. Encouraging Exports:

In order to correct an adverse balance of payments, all efforts should be made to encourage exports. The government should adopt various export promotion programmes, such as, the reduction of export duties, provision of export subsidies, quality controls, incentives for exports etc.

7. Discouraging Imports:

Attempt should also be made to reduce imports by adopting various measures.

Important measures to discourage imports are:

(i) Import Duties:

Import duty or tariff is a tax on imports. The government imposes tax on some or all imports. This raises the price of imports which, in turn discourages imports and thus helps correcting adverse balance of payments.

(ii) Import Quotas:

Fixing Import quotas is another method for correcting adverse balance of payments by reducing imports. Under the system of import quota, the government fixes the maximum quantity or value of a commodity to be imported. Thus, by restricting imports through import quotas, the balance of payments deficit is reduced.

Import quotas is a direct method of correcting disequilibrium in a balance of payments and is considered better than import duty. Instead of taxing imports, the import quota directly limits that quantity that can be brought into the country.

(iii) Import Substitution:

Yet another method of correcting disequilibrium in the balance of payments through reducing imports is to encourage industries producing import substitutes. Import substitution helps the national economy to become more self-sufficient and reduce its dependence on imports.