Equilibrium, Disequilibrium and Adjustment in the Balance of Payments

Balance of Payment Account : Meaning, Features and Components

Meaning of Balance of Payment Account:

A Balance of Payment Account is a systematic record of all economic transactions between residents of a country and the rest of the world carried out in a specific period of time.

Briefly put, ‘Balance of Payment Account is a summary of international transactions of a country for a given period’ (i.e., financial year). It records a country’s transactions with the rest of the world involving inflow and outflow of foreign exchange. In short BOP Account is a summary statement of transactions in foreign exchange in a year.

Simply put, BOP account is a statement of a country’s sources and uses of foreign exchange in which main sources are: exports, transfers and remittances from abroad, borrowings from abroad, foreign investments whereas uses of foreign exchange are: imports, transfers to abroad, lending abroad and purchase of assets, etc.

BOP account, like a typical business account, is based on double entry system which contains two sides—Credit side and Debit side. Any transaction which brings in foreign exchange (currency) is recorded on credit side whereas any transaction that causes a country to lose foreign exchange is recorded on debit side. For example, export is credit item as it brings in foreign exchange whereas import is a debit item since it causes outflow of foreign exchange. Similarly, borrowing from rest of the world (ROW) is a credit item while lending to ROW is a debit item. main purpose of BOP Account is to know international economic position of a country and to help the government make appropriate trade and payment policies.

Features of Balance of Payment Account:

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

(ii) It includes all transactions in goods (visible items), services (invisible) and assets (flow of capital) during a period of time.

(iii) It is constructed on double entry system of accounting. Thus, every international transaction will result in credit entry and debit entry of equal size.

(iv) All economic transactions that are carried out with the rest of world are either credited or debited.

(v) In accounting sense total debit will always be equal to total credits, i.e., balance of payments will always be in equilibrium. But in economic sense, if receipts are larger than payments, there is surplus in BOR Similarly, if payments are larger than receipts, there is deficit in BOP.

A hypothetical simplified example of a country’s Balance of Payment Account is given in the following table. It has two sides—credits (receipts) on the left side and debits (payments made) on the right side. 

BOP account records a country’s all economic transactions with ROW which Involve inflow or outflow of foreign exchange.

Visible and Invisible items:

Visible items refer to items relating to trading in goods with other countries. For example export and import of goods (like machinery, tea, etc.) are called visible items because goods are visible items and can be verified by Custom officials. Invisible items refer to items relating to trading of services with other countries and unilateral transfers. Export and import of services are called Invisible items because services are not seen crossing the border. All types of services like services of shipping, banking, tourism, investment services and unilateral transfers are invisible items.

Components of Balance of Payment Account:

The various items which make up country’s Balance of Payment Account are listed in a simplified consolidated form in the above table. They are explained as under:

1. Export and import of goods (Merchandise):

The most straightforward way in which a country can acquire foreign currency is by exporting goods. These are called visible items because goods can be seen, touched and measured. This is shown by Row (1) which indicates that the country has exported goods to a value of Rs 550 crore. In an analogous (similar) way Row (5) shows that the country has imported goods to a value of Rs 800 crore. These two rows describe the country’s visible trade. Movement of goods between countries is known as visible trade because the movement is open and can be verified by Customs officials.

2. Services rendered and received:

(Shipping, banking, insurance, tourism, interest, dividend etc) Under this head, following types of earnings are included.

(a) Non-factor income:

Income from shipping, banking, insurance, tourism, software services is called non-factor income. All such payments are listed under Row (2) as export of services or invisible exports.

(b) Investment income (Factor income):

Interest and dividends which citizens of a country earn on investment abroad are investment income and treated as factor income. Remember, citizens of the country own land, bonds, shares, etc. in foreign countries for which the foreigners who enjoy the services of this capital will have to pay for them. These payments will be registered under Row (2) as export of services or invisible exports.

In a completely analogous way, Row(6) covers payments which residents of the country m question make to foreigners for similar services, i.e., shipping, banking, insurance payments made by residents as tourists abroad, payments in the form of interest, dividends, profits/or capital services on foreign owned capital.

3. Unilateral transfers:

(Gifts, remittances, indemnities, etc. from foreigners) The items in Row (3) are called unrequited receipts because residents of a country receive ‘for free. Nothing has to be paid in return at present or in future for these receipts. These are like transfer payments. Examples of this head are gifts received by residents from foreigners, remittances sent by emigrants to relatives, war indemnities paid by a defeated country, etc. Note: In India unrequited or unilateral transfers are treated as a part of invisible trade.

4. Capital receipts and Payments: [Borrowings, capital repayments, sale of assets, changes in foreign exchange reserve):

It records international transactions which affect assets and liabilities of domestic country with rest of the world. Items (4) and (8) of the table indicate changes in stock magnitudes and refer to capital receipts and payments .Government of a country may borrow (get loan) from another government; a firm may issue stocks abroad or a bank may float a loan in a foreign country.

In all these instances, the country in question will acquire foreign currency and these transactions will be entered as credit items in Row (4). Similarly foreigners may acquire assets in the country with whose balance of payments they are concerned.

Assets maybe in the form of land, houses, plants, and shares, etc. Changes m stock of gold or reserves of foreign currency are also included in Row (4). Analogously, if residents of the country in their turn were to acquire similar foreign assets, this would give rise to outflow of foreign currency and come as a capital transfer recorded as a debit item in Row(8).

First three items of credits and debits shown in the above imaginary table are flow items because they refer to certain value of exports/imports per time period. Since all these payments/receipts are made with reference to current period of time, therefore, they comprise Current Account of Balance of Payment. As against it, the last item of debits and credits, viz. capital receipts/capital payments comprise Capital Account of Balance of Payment as they express changes in stock magnitudes.

Balance of Payment (BOP) is statistical statement of transactions of the residents of the country with the rest-of-the-world over a given period of time. Capital account surplus is called net capital inflow.

Capital account surplus is when the receipts from the sale of stock, bonds and other assets is greater than the payment for our own purchase of foreign asset.

If there is a deficit in current account it is met by:

(i) Selling assets or

(ii) By borrowing from abroad or

(iii) By selling the foreign currency in the FOREX market.

(i) If there is a deficit in both the current and capital account, then the overall BOP is in deficit.

(ii) If there is a surplus in one account and deficit in the other account to same extent then BOP equals Zero, that is, there is neither a surplus nor a deficit.

The Central Bank solves the problem of BOP surplus and deficit through exchange rate.

Fixed Exchange Rate or Pegged Exchange Rate:

BOP measures the amount of foreign exchange intervention needed by the Central Bank to keep the exchange rate stable. The Central Bank brings stability in the exchange rate through buying and selling of dollars at a predetermined price. To intervene in the Forex market to bring the exchange rate stability, it will have to keep necessary reserves.

 

 

Balance of Payments Equilibrium:

Before we analyse the conditions of disequilibrium, we would like to explain what is meant by equilibrium balance of payments. “Equilibrium is that state of the balance of payments over the relevant time period which makes it possible to sustain an open economy without severe unemployment on a continuing basis”. 

The essentials in this definition are:

(a) Relevant time period,

(b) Open-ness of economy (i.e., no undue restrictions on imports),

(c) Absence of unemp­loyment, and

(d) Continuing basis of the equilibrium (i.e.; it is capable of being sustained).

The period is generally one year. Thus, seasonal inequality between exports and imports is not a sign of disequilibrium. When the balance of payments of a country is in equilibrium, the demand for domestic currency is equal to its supply.

The demand and supply situation is thus neither favourable nor unfavorable. If the balance of payments moves against a country, adjustments must be made by encouraging exports of goods, services or other forms of exports, or by discouraging imports of all kinds. No country can have a permanently unfavorable balance of payments, though it is possible—and is quite common for some countries—to have a permanently un-favourable balance of trade. Total liabilities and total assets of nations, as of individuals, must balance in the long run.

This does not mean that the balance of payment of a country should be in equilibrium individually with every other country with which she has trade relations. This is not necessary nor is it the case in the real world. Trade rela­tions are multilateral. India, for instance, may have an active (i.e. surplus) balance of payments with the United States and passive balance with the United Kingdom and/or other countries. But each country, in the long run, cannot receive more value than she has exported to other countries taken together.

Equilibrium in the balance of payments, therefore, is a sign of the soundness of a country’s economy. But disequilibrium may arise either for short or long periods. A continued disequilibrium indicates that the country is heading towards economic and financial bankruptcy. Every country, therefore, must try to maintain balance of payments in equilibrium.

Correcting Disequilibrium in the Balance of Payments:

The balance of payments 01 India for 1982-83 gives above shows a heavily adverse balance of payments on current account. When the visible and invisible exports of a country are less than all her imports (or the imports exceed the exports) over a long period and the difference is big, steps have to be taken to bridge the gap. A number of methods are used.

They are:

Improving the balance of trade through import restrictions and measures of export promotion. Since balance of payments becomes adverse chiefly on account of excess of imports over exports, the most urgent steps are to be taken in this direction. A country having an adverse balance of payments must to check imports, or to stimulate exports, or do both. Imports can be checked either by total prohibition, or by levying import duties, or by a quota system.

Another method is adopting of measures of import substitutions, i.e., trying to produce in the country what it currently imports from abroad. Exports can be stimulated by measures of export promotion i.e. granting bounties or other concessions to industrialists and exporters.

Deflation:

Another method is deflation. Under this method, total money income in the economy is sought to be reduced, so that the aggregate demand in the country falls. As a result, the people tend to import less and their demand for home-produced goods too becomes less, releasing more of them for exports.Owing to a fall in aggregate demand, prices also fall, so that the country becomes a good market to buy from and a bad market to sell in. In this way, imports get discouraged and exports are stimulated, thus correcting the adverse balance of payments. But deflation is not a healthy method, because the reduction of money incomes hits business, trade and industry hard and brings about depression and unemployment.

Exchange control:

Sometimes the adoption of any of the above methods is not “considered desirable. It is feared that the depreciation may lead to retaliatory depreciation by other countries. Devaluation is supposed to damage the prestige of a country. Deflation brings in its wake disastrous consequences in the form of depression and widespread unemployment.It may, therefore, be considered necessary to avoid these methods and instead exchange control adopted. Under a system of exchange Control all exporters are asked to surrender their claims on foreign currencies to the central bank which pays in return home currency, which the exporters really want.

This available foreign exchange is rationed out by the central bank among me needed importers of the essential commodities. Thus, imports are restricted to the foreign exchange available. There is no danger of more goods being imported than exported.

Devaluation:

A very common method of correcting an adverse balance of payments is the devaluation of the home currency. The devalued currency falls in value against foreign currencies so that the foreigners have to pay less in terms of their own currencies for our goods.The importers in the country, on the other hand, have now to pay more in terms of the devalued currency for foreign goods. Hence, they (i.e., foreigners) are induced to import more from such a country. Thus her imports decrease and exports increase, and the balance of payments is corrected. For example, India, following the U.K., devalued her currency in terms of the dollar in September 1949. Her trade balance had been very unfavorable.

There used to be a big gap between her exports and imports. After the devaluation, however, her balance of payments was set right. In June 1966, again, India had to devalue the rupee. This resulted in some improvement in the balance of payments position.The success of devaluation in improving the balance of trade, and through it the balance of payments depends upon the demand elasticity’s of imports and exports of the devaluing country. In other words, an improvement in the balance of trade will depend upon whether the demand for imports and exports is elastic or inelastic. Devaluation makes the imports of the devaluing country costlier than before and in case her demand for imports is inelastic, a higher amount will be spent for the same imports, thereby worsening her balance of trade.

Similarly, if her export demand is inelastic, then, after devaluation, lesser amount will be spent by the foreigners thereby affecting adversely the balance of payments of the devaluing country. However, if her demand for exports is elastic then with a fall in the prices of the exports as a result of devaluation, more will be purchased by the foreigners, which, in turn, will help in restoring the equilibrium in her balance of payments. Likewise, if her demand for imports is elastic, then the imports of the country will be significantly reduced by devaluation, which in turn would improve the balance of payments of the devaluing country.

The success of devaluation in improving the balance of trade also depends on the reactions of her trading partners. If the trading partners retaliate, then devaluation will not make any impact on the imports or exports of the devaluing country, even though her demand of imports and exports may be elastic.

Causes and Measures of Disequilibrium

Overall account of BOP is always in equilibrium. This balance or equilibrium is only in accounting sense because deficit or surplus is restored with the help of capital account. In fact, when we talk of disequilibrium, it refers to current account of balance of payment. If autonomous receipts are less than autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.

1. Causes of disequilibrium in BOP:

There are several factors which cause disequilibrium in the BOP indicating either surplus or deficit.

Such causes for disequilibrium in BOP are listed below:

(i) Economic Factors:

(a) Imbalance between exports and imports. (It is the main cause of disequilibrium in BOR), (b) Large scale development expenditure which causes large imports, (c) High domestic prices which lead to imports, (d) Cyclical fluctuations (like recession or depression) in general business activity, (e) New sources of supply and new substitutes.

(ii) Political Factors:

Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.

(iii) Social Factors:

(a) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports; (b) High population growth in poor countries adversely affects their BOP because it increases the needs of the countries for imports and decreases their capacity to export.

2. 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.

(v) Devaluation of domestic currency:

It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level.

(vi) Depreciation: 

Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)