balance of payment concepts

7/27/2019 Balance of payment concepts

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Balance of payment


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BOP Accounting

The Balance of Payments is the statisticalrecord of a countrys internationaltransactions over a certain period of time

presented in the form of double-entrybookkeeping.

N.B. when we say a countrys balance ofpayments we are referring to thetransactions of its citizens and government.


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Purposes of BOP Accounts

Provides useful data for the economic analysis ofthe countrys weakness and strengths as apartner in international trade.

Reveals changes in the composition and

magnitude of foreign trade. Provides indications of future repercussions of

countrys past trade performances.

Reveals the weak and strong points in countrys

foreign trade relations and invites govt. attentionfor corrective measures.


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Terminologies

Favorable BOP = Value of total receipts morethan total payments.

Adverse BOP = Value of total receipts less than

total payments. Balance BOP = Receipts equal to payments.

Unrequited receipts = Receipts for which

nothing has to be paid in return. Unrequited payments =Payments for which

nothing is received in return.


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Balance of Trade

Difference between value of exports and

imports of visible items only.

BOT BOP

Records only merchandise transactions Records transactions related to goods

and services.

Does not record transactions of capital

nature

Records transactions of capital nature

A part of current account of BOP Includes BOT, balance of services,

balance of unrequited transfers,

balance of capital transactions


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Balance of payment AccountsCurrent Account: In the current account, goods,

services, income and current transfers are recorded.

Goods - Movable goods include general

merchandise, goods used for processing other goods.

An export is marked as a credit (money coming in)and an import is noted as a debit (money going out).

Services - These transactions result from an intangible

action such as transportation, business services,

tourism, royalties or licensing. If money is being paidfor a service it is recorded like an import (a debit),

and if money is received it is recorded like an export

(credit).


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Income :Income is money going in (credit) or out

(debit) of a country from salaries, portfolio

investments (in the form of dividends, for example),direct investments or any other type of investment.

Current Transfers - Current transfers are unilateral

transfers with nothing received in return. These

include workers' remittances, donations, aids and

grants, official assistance and pensions. Due to their

nature, current transfers are not considered real

resources that affect economic production.

The overall balance on the current account- surplus or

deficit, is carried over to the capital account.


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Capital accounts

All transactions indicating changes in stock magnitudesconcerning capital receipts and payments constitute

capital accounts.

Relates to :

- Borrowing

- Capital repayment

- Sale of assets

- Change in stock of gold

- Change in reserve of foreign currency


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Short term capital movement includes:

- Purchase of short term securities.

- Speculative purchase of foreign currency.

- Cash balances held by foreigners.

- Net balance of current account.

Long term capital movement includes:

- Investment in shares , bonds, physical assets etc.

- Amortization of capital i.e. repurchase and resale of

securities earlier sold to or purchased fromforeigners.


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BOP accounts are always in

balance

The BOP accounting is based on double entry

book keeping system in which both sides of a

transactionreceipts and payments- are

recorded.

Also , in accounting procedure, a deficit in the

Current Account is offset by a surplus on

Capital account.


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Disequilibrium in BOP accounts

Disequilibrium in the BOP arises because total receipts

during the reference period need not always be

equal to the total payment obligations of that period.

Assessment of overall BOP position of the country isdone by regrouping total receipts and payments

under following two categories:

a) Autonomous transactions

b) Induced transactions or accommodating capital

flows.


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All exports and imports of goods and services,

long term and short term capital movementsmotivated by the desire to earn higher returns

abroad or to give gifts and donations etc. are

the autonomous transactions.

The short term capital movements like gold

movements and accomodating capital

movements on account of the autonomous

transactions are induced transactions.


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Example

Exports and imports of goods are undertaken

with a view to make profits. Hence these are

autonomous transactions. If exports equal

imports in value, there will be no othertransactions. If exports are not equal to

imports, it leads to short run capital

movements e.g. international borrowing orlending. Hence these are called induced

transactions.


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In the assessment of balance of payment

position, only autonomous transactions are

taken into account. They determine the

deficit or surplus in the balance of payments.

Total payments> total receipts is deficit

total receipts > Total payments is surplus

total receipts = Total payments is equilibrium

The disequilibrium of surplus nature is not aserious matter of worry as against the

disequilibrium of deficit nature.


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Types of disequilibrium in BOP

Structural disequilibrium: It takes place due to structural

changes in the economy affecting demand and supply

relations in commodity and factor market. Structural

disequilibrium in balance of payments persists for relatively

longer periods; as it is not easy to remove structuralimbalance in the economy.

Some of the important causes of structural disequilibrium are as

follows :-

If the foreign demand for a country's products decline due tothe discovery of cheaper substitutes abroad, then the

country's export will decline causing a deficit.


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If the supply position of a country is affected due to

factors like crop failure, shortage of raw-materials,

strikes, political instability, etc, then there would bethe deficit in the balance of payments.

A shift in demand due to the changes in tastes,

fashions, income, etc, would increase or decrease

the demand for imported goods .

Changes in the rate of international capital

movements.

A war may also affect not only goods but also factorof production causing a disequilibrium.


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Cyclical Disequilibrium

Disequilibrium is caused due to the changes in trade

cycles. Different phases of trade cycles like depression,prosperity, boom, recession, etc, may disturb terms of

trade and cause disequilibrium in BOP.

e.g. during boom period, imports may increase considerably

due to increase in demand for imported goods. Duringrecession and depression, imports may be reduced due

to fall in demand on account of reduced income. During

recession exports may increase due to fall in price.

During boom period, a country may face deficit in its BoPposition on account increase in imports. However, during

recession its export may increase, and as such BoP

position may show surplus.


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Also, the importing countries may face cyclical

changes. For instance, there may be recession

in the importing countries, which in turn

would reduce demand for imports. Therefore,the demand for exports will decline and the

exporting country may face a trade deficit,

which in turn may affect BoP positions.


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Technological Disequilibrium :

It is caused by various technological changes involvinginventions or innovations of new goods or new

technique of production. These technological

changes affect the demand for factors and goods.

A technological change will give comparative

advantage to the innovating country leading to the

increase in exports or a decline in imports. This will

create disequilibrium in the balance of payments.


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Short run Disequilibrium

Disequilibrium caused on a temporary basis for a shortperiod. Such disequilibrium does not pose a serious

threat as it can be overcome within a short run. Such

a disequilibrium may be caused due to international

borrowing and lending. Short run disequilibrium may also be caused when a

country's imports exceeds exports in a particular

year. Such disequilibrium is not justified as it has the

potentiality to develop in to a crisis in time..


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Long run or Secular Disequilibrium

It prevails for a long period of time and is

persistent.The IMF terms such disequilibrium

as "Fundamental Disequilibrium".

When there is a continuous increase in the

stock of gold and foreign exchange reserves.there is a persistent surplus & vise-versa.

A permanent deficit or surplus may make a

country debtor or creditor causing afundamental disequilibrium.


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A developing country in its initial stages may import

large amount of capital & hence its imports would

exceed exports. When this becomes chronic, there

emerges a secular deficit in its balance of payments.

Deep rooted dynamic changes like capital formation,

innovations, technological advancements, growth ofpopulation etc. also contribute to fundamental

disequilibrium.

When there is a series of short-run disequilibrium in

a country's balance of payments, ultimately it wouldlead to fundamental disequilibrium.


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Monetary Disequilibrium

Monetary disequilibrium, takes place on accountof inflation or deflation. Due to inflation, the

prices of the products in the domestic market

rise, and therefore, export items will become

expensive. Such a situation may affect the BoP

equilibrium. Inflation also results in increase in

money income with the people, which in turn

may increase demand for imported goods. Asa result imports may turn Bop position in

disequilibrium.


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Causes of disequilibrium

Trade Cycles- Cyclical fluctuations lead to

cyclical disequilibrium.

Huge developmental and Investment

programmes may increase imports without a

commensurate increase in exports leading to

structural disbalance.

Changing export demand affects

underdeveloped and developing counrtries

more than the developed nations.


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. Population growth leading to large scale

imports of food grains and wage goods

(consumer goods).

Huge external borrowings.

Inflation- increases the marginal propensity to

import and marginal propensity to consumeaffecting exports.

Demonstration effect of advanced countries

on the consumption pattern of the people inless developed countries.

Reciprocal demands.


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Measures for correcting

disequilibrium

Solution to correct BOP disequilibrium lies in

earning more foreign exchange through

additional exports or reducing imports.

Quantitative changes in exports and importsrequire policy changes. Such policy measures

are in the form of :

a) Monetary measuresb) Non monetary measures.


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Monetary measures :

i) Deflation

ii) Exchange depreciation

iii) Devaluation

iv) Exchange control

Non monetary measures

i) Tariffs- imports duties

ii) Import quotasiii) Export promotion policies and programmes


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Deflation:Deflation means falling prices. Deflation is used to

correct deficit disequilibrium. A country faces deficit when its

imports exceeds exports.

Deflation is brought through monetary measures like bank

rate policy, open market operations, etc or through fiscal

measures like higher taxation, reduction in public

expenditure, etc.

Deflation would make our items cheaper in foreign market

resulting a rise in our exports. At the same time the demands

for imports fall due to higher taxation and reduced income.

This would build a favourable atmosphere in the balance of

payment position. Deflation can be successful when the exchange rate remains

fixed.

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Exchange Depreciation: Exchange depreciation means decline

in the rate of exchange of domestic currency in terms of

foreign currency. This device implies that a country has

adopted a flexible exchange rate policy.

e.g.Suppose the rate of exchange between Indian rupee and US

dollar is $1 = Rs. 40. If India experiences an adverse BOP with

regard to U.S.A, the Indian demand for US dollar will rise. The

price of dollar in terms of rupee will rise. Hence, dollar will

appreciate in external value and rupee will depreciate in

external value. The new rate of exchange may be say $1 = Rs.

50. This means 25% exchange depreciation of the Indian

currency. This will stimulate exports and reduce imports because

exports will become cheaper and imports costlier. Hence, a

favourable balance of payments would emerge.


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Limitations of Exchange Depreciation :-

Exchange depreciation will be successful only if there is no

retaliatory exchange depreciation by other countries.

It is not suitable to a country desiring a fixed exchange rate

system.

It raises the prices of imports and reduces the prices of

exports. So the terms of trade will become unfavourable for

the country adopting it.

It increases uncertainty & risks involved in foreign trade.

It may result in hyper-inflation causing further deficit in

balance of payments.


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Devaluation

Devaluation refers to deliberate attempt made by monetary

authorities to bring down the value of home currency against

foreign currency. While depreciation is a spontaneous fall due

to interactions of market forces, devaluation is official act

enforced by the monetary authority.

When devaluation is effected, the value of home currency

goes down against foreign currency. After such a change our

goods becomes cheap in foreign market because dollar is

exchanged for more Indian currencies which pushes up the

demand for exports. At the same time, imports become

costlier and demand for imports is reduced. Generally devaluation is resorted to where there is serious

adverse balance of payment problem.


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Limitations of Devaluation :-Devaluation is successful only

when:

other country does not retaliate the same. Ifboth the countries go for the same, the effect is nil.

the demand for exports and imports is elastic.In case it is

inelastic, it may turn the situation worse.

Devaluation, though helps correcting disequilibrium, isconsidered to be a weakness for the country.

d


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Contd. Devaluation may bring inflation in the following conditions :-

Devaluation brings the imports down, scarcity of such

goods unleash inflationary trends.

A growing country like India is capital thirsty. Due to non

availability of capital goods in India, we have no option but

to continue imports at higher costs. This will force the

industries depending upon capital goods to push up their

prices.

When demand for our export rises, more and more goods

produced in a country would go for exports and thus

creating shortage of such goods at the domestic level. Thisresults in rising prices and inflation.

Devaluation may not be effective if the deficit arises due to

cyclical or structural changes


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Exchange Control

It is an extreme step taken by the monetary authority to enjoy

complete control over the exchange dealings. Under such ameasure, the central bank directs all exporters to surrender

their foreign exchange to the central authority. Thus it leads

to concentration of exchange reserves in the hands of central

authority. At the same time, the supply of foreign exchange isrestricted only for essential goods. It can only help controlling

situation from turning worse. In short it is only a temporary

measure and not permanent remedy.


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Non-Monetary Measures

Tariffs

Tariffs are duties (taxes) imposed on imports. When tariffs areimposed, the prices of imports would increase to the extent

of tariff. The increased prices will reduced the demand for

imported goods and at the same time induce domestic

producers to produce more of import substitutes. Non-essential imports can be drastically reduced by imposing a

very high rate of tariff.


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Drawbacks of Tariffs :-

Tariffs bring equilibrium by reducing the volume of trade.

Obstruct the expansion of world trade and prosperity.

Tariffs need not necessarily reduce imports. Hence the effects

of tariff on the balance of payment position are uncertain.

Tariffs seek to establish equilibrium without removing the

root causes of disequilibrium.

A new or a higher tariff may aggravate the disequilibrium in

the balance of payments of a country already having a

surplus.

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Quotas

Under the quota system, the government may fix and permit the

maximum quantity or value of a commodity to be importedduring a given period. By restricting imports through the

quota system, the deficit is reduced and the balance of

payments position is improved.

Merits of Quotas :- Quotas are more effective than tariffs as they are certain.

They are easy to implement.

They are more effective even when demand is inelastic, as no

imports are possible above the quotas.

More flexible than tariffs as they are subject to administrative

decision. Tariffs on the other hand are subject to legislative

sanction.


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Export Promotion

The government can adopt export promotion

measures to correct disequilibrium in the balance of

payments. This includes substitutes, tax concessions

to exporters, marketing facilities, credit and

incentives to exporters, etc. The government may also help to promote export

through exhibition, trade fairs; conducting marketing

research & by providing the required administrative

and diplomatic help to tap the potential markets.


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Import Substitution

A country may resort to import substitution to reduce the

volume of imports and make it self-reliant. Fiscal andmonetary measures may be adopted to encourage industries

producing import substitutes. Industries which produce

import substitutes require special attention in the form of

various concessions, which include tax concession, technicalassistance, subsidies, providing scarce inputs, etc.

Non-monetary methods are more effective than monetary

methods and are normally applicable in correcting an adverse

balance of payments.

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balance of payment concepts

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