Balance of Payments

Balance of payment refers to all economic transactions between domestic and foreign residents over a stipulated period. The balance of payment of a country provides an overall view of its international economic position. It is very much helpful for the policy macers and the business communities. It this unit, you will learn the concept of baIance of payment, the balance of payment accounting procedure, trends in India's balance of payment and recent policy measures.The balance of payments (BOP) is a statement of all transactions made between entities in one country and the rest of the world over a defined period of time, such as a quarter or a year

Balance of payments refer to all economic transactions between domestic and foreign residents over a stipulated period generally one year. The analysis of balance of payment is immensely useful for the policy makers and business communities. Moreover, it is an important instrument for maintaining external economic stability. A close understanding of dependence of international business upon balance of payments is necessary for successful strategy of international business.

Balance of Trade and Balance of Payments

Balance of trade refers to the difference between physical imports and exports, i.e. visible items only for a period say, a year. Visible items are those which are physically exported and imported, like merchandise, gold, silver and other commodities. During a given period of time, exports and imports may be exactly equal in whish 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 favourable 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 unfavourable. International trade includes not only import and export of goods but also services such as air and ocean shipping, financial and other services like banking, insurance, travel, investment income, etc. Export and import of gods are treated as visible trade as they are physically recorded at the customs barriers of the country. Receipts and payments for services are items of invisible trade.

The balance of payment is broader than the balance of trade for it includes not only visible items but also invisible items. Hence, the balance of payments presents a better picture of a country's economic and financial transactions with the rest of world than the balance of trade. Balance of payment is a comprehensive and systematic record of all economic transactions between the residents of a country and the rest of the world. It presents an account of all receipts and payments on account of goods exported, services rendered and capital received by residents Government of a country (inflows from abroad) and goods imported,  services received and capital transferred by the residents1 Government of a country (outflows abroad).
 Balance of Payment Accounting
In balance of payments accounting the balance of payments should be zero because every transaction is two- sided with debits balancing credits. But in practice, the balance of payments will not always be equal to zero. This can be due to, among other things, a country's central bank engaging in transactions that are not counted towards the country's balance of payments, or the lack of available statistical data to record all transactions. Balance of payments is classified as: (i) balance of payment on current account, and (ii) balance of payment on capital account.

Current Account: The balance of payment on current account record the current position of the country in the transfer of goods, services, and merchandise as well as invisible items, donations, unilateral transfers, ctc. Current account i6 like an income and expenditure account. Surplus or deficit in current account is transferred to capital account which is like a balance sheet and thus balances itself in historic sense,
Capital Account: Balance of payment3 on capital account shows the country's financial position in the international scenario, the extent of accumulated foreign exchange reserves, foreign assets and liabilities and the impact of current transactions on international financial positions. The changes in foreign exchange reserves arising out of current account transactions are included in the capital account in order to find out the exact foreign exchange reserve. The capital account provides relief to deteriorating balance of payment positions. Its favourable effect depends upon the availability of net capital transfers, i.e., gross inflow of capital minus payment by way of amortisation. In short, capital account reflects changes in foreign assets and liabilities of the country and affects its creditor debitor position. Net changes in current account are reflected by a corresponding opposite change in the capital account, changing the foreign assets and liabilities position of the country. 

Balance of Payments Deficits: In India, balance of payment deficits have been largely caused by excess of imports over exports in merchandise. At times and to a small extent the deficits have been in invisible trade also. The major source of deficits has been the rising obligations to meet amortisation payments. This has involved large sums on the return of loans which became due and the large interest payments thereon. Large withdrawals from lion-resident accounts also contributed to deficits. 

The crisis in the middle east had exacerbated the situation by contributing to higher oil import bill in 1990-91 and the temporary loss of exports markets and remittance earnings. Structural reforms encompassing the industrial sector, the foreign trade and foreign investment were taken. From 1991 the country embarked on a liberalised trade regime with a short'negative list of imports, removal of quantitative restrictions for all goods except consumer goods, a phased reduction in customs duties, an adjustment in the exchange rate through a two-step devaluation of the rupee in July 199 I and the movement to a market determined exchange rate. 'The policy towards foreign portfolio investment has also been substantially liberalised. Foreign investment policy was modified to eliminate barriers, alignment of taxes with international levels and transparency with full repatriation benefits and investor protection. The structural forms were aimed at integrating industrial, trade and exchange rate policies to enhance the efficiency in the economy. The beneficial effect of these measures are reflected in a robust export and invisible growth. The post 1991 period has seen a surge in capital tlows resulting in growth of foreign e. x. change reserves.

SALIENT FEATURES OF INDIA'S BALANCE OF PAYMENTS

1. India has always faced trade deficits except in 1972-73 and 1976-77 where there was a small surplus.
2. Trade deficit has been rising from plan to plan with the exception of the fourth plan when the trade deficit declined.
3. The rate of growth of exports has been fluctuating from plan to plan.
4. Net invisible receipts have been positive.
5. The crisis in the balance of payments during 1990-91 and in the first quarter of 1991-92 necessitated the mobilisation of additional external funds to fill the gap. The task of the government became particularly difficult in the context of the dwindling international faith in our economy. In the end, the Government could mobilise substantial additional financial resources from the IMF, the world Bank and the bilateral donors, spec,ially Japan.
6. Fiscal deficit not only affects the  for growth and stability but has a vital bearing on the balance of payment strategy. A strategy for ensuring a viable balance of payments requires correction in fiscal imbalance as well.
7. There has been a low level of utilisation of cstrrnal assistance, resulting in a substantial part of authorised loans being in the pipeline. The main factor for under utilisation of assistance is due to the time lag between conlmitments and conclusions of specific credit arrangements, time consuming procedures and domestic budgetary constraints in providing counterpart funds.
8. The emergence of a number of independent states out of the erstwhile USSR are bound to affect the country's exportsadversely. Thus, India's balance of payments  continued to be under strain.

9. The underlying weakness of the balance of payments remained. The falling support from net invisible receipts resulting from interest payments, the poor industrial and export performance and high rate of inflation stood in the way of achieving a sustainable balance of pa! nients. 

India's Balance of Payments

Key Features of India’s BoP in Q2 of 2019-20

• India’s Current Account Deficit (CAD) at US$ 6.3 billion (0.9 per cent of GDP) in Q2 of 2019-20 narrowed from US$ 19.0 billion (2.9 per cent of GDP) in Q2 of 2018-19 and US$ 14.2 billion (2.0 per cent of GDP) in the preceding quarter.

• The contraction in the CAD was primarily on account of a lower trade deficit at US$ 38.1 billion as compared with US$ 50.0 billion a year ago.

• Net services receipts increased by 0.9 per cent on a y-o-y basis, on the back of a rise in net earnings from computer, travel and financial services.

• Private transfer receipts, mainly representing remittances by Indians employed overseas, rose to US$ 21.9 billion, increasing by 5.2 per cent from their level a year ago.

• In the financial account, net foreign direct investment was US$ 7.4 billion, almost same level as in Q2 of 2018-19.

• Foreign portfolio investment recorded net inflow of US$ 2.5 billion – as against an outflow of US$ 1.6 billion in Q2 of 2018-19 – on account of net purchases in the debt market.

• Net inflow on account of external commercial borrowings to India was US$ 3.2 billion as compared with US$ 2.0 billion in Q2 of 2018-19.

• There was an accretion of US$ 5.1 billion to the foreign exchange reserves (on BoP basis) as against a depletion of US$ 1.9 billion in Q2 of 2018-19

BoP during April-September 2019-20 (H1 of 2019-20)

• The CAD narrowed to 1.5 per cent of GDP in H1 of 2019-20 from 2.6 per cent in H1 of 2018-19 on the back of a reduction in the trade deficit which shrank to US$ 84.3 billion in H1 of 2019-20 from US$ 95.8 billion in H1 of 2018-19.

• Net invisible receipts were higher in H1 of 2019-20 mainly due to increase in net services earnings and private transfer receipts.

• Net FDI inflows at US$ 21.2 billion in H1 of 2019-20 were higher than US$ 17.0 billion in H1 of 2018-19.

• Portfolio investment recorded a net inflow of US$ 7.3 billion in H1 of 2019-20 as against an outflow of US$ 9.8 billion a year ago.

• In H1 of 2019-20, there was an accretion of US$ 19.1 billion of the foreign exchange reserves (on a BoP basis).

INDIA'S CURRENT AND CAPITAL ACCOUNT

Most developing countries run current account deficits (CAD) in their balance of payments and attract external resources to supplement their domestic saving for achieving higher growth rates. Such financing through CAD mirrors the accretion to a country's external liabilities which have to be serviced. This raises the issue of the viability of the CAD. When the payments for servicing assume a rising trend, they pre-empt increasing proportions of current external earnings which could otherwise have been utilised for imports. As import purchasing power is crowded out by debt servicing, vital inputs for growth get choked of which ultimately retards the growth process itself. An unviable current account can, therefore, place an external constraint on growth. By the criterion of the world Bank, a debt-service ratio (DSR) of about 30 percent, in conjunction with other criteria, classifies a country as 'severely indebted'.

Current Account

The current account in the balance of payments covers all cross-border transactions relating to goods and services trade, receipt or payment of income from investments (primary income), and unilateral transfers (secondary income). Historically, India’s current account balance is largely driven by movements in the goods trade account (Chart 1). In 2018-19 also, higher deficit in goods trade mainly widened the current account deficit (Table 1). Trade Account - Goods The global economic environment remained adverse for exports of goods while higher prices of key import commodities expanded the import bill during 2018-19. Notwithstanding the uptrend in international crude oil prices that boosted export of petroleum products, the impact of tepid world goods trade volume growth partly a result of escalation of trade tensions and the associated increase in policy uncertainty impacted overall export growth. On BoP basis, non-oil export growth decelerated from 9.2 per cent in 2017-18 to 7.1 per cent in 2018-19, dragged down mainly by three major sectors, viz., gems and jewellery, readymade garments and marine products. By contrast, electronic goods, engineering goods, petroleum products and chemicals recorded higher shipments.

 

Import growth decelerated in 2018-19 despite a sharp rise in oil import bill. This was mainly caused by a decline in gold prices and lower growth in nonoil non-gold imports. Crude oil, being the largest item of import in the import basket, makes India’s trade account vulnerable to movements in international prices. During 2018-19, owing to tight supply conditions and relatively stronger global economic activity in H1:2018-19, global oil inventories fell rapidly and pushed up prices to over US$ 80 per barrel in early October. Subsequently, waivers granted by the US to major oil importers from Iran and higher production in Saudi Arabia and Russia eased oil prices, which helped in reducing India’s trade deficit in H2:2018-19. Nevertheless, India’s oil import bill rose by US$ 32.3 billion during the year.

Renewed strength of the US dollar scaled down the global demand for gold as a safe haven asset which eased global gold prices. This helped reduce the value of gold imports. Within non-oil non-gold imports, a sharp fall in pearls and precious stones, vegetable oil, pulses and metalliferrous ores contributed to lower import growth. As imports grew faster than exports, the trade deficit (goods) widened to 6.6 per cent of GDP in 2018-19 from 6.0 per cent a year ago (Chart 2).

Of the incremental increase of 0.6 percentage points in trade deficit, 0.5 percentage point was due to unfavourable movement in net terms of trade (ToT) and 0.1 percentage point was due to change in gross terms of trade (i.e., import volume growing faster than export volume). Services The globally interconnected production networks, especially in the pre-global financial crisis period, amplified cross-border trade not only in goods but also in services. Global trade in services increased from 9.2 per cent of global GDP in 2000 to 12.4 per cent in 2008 and then further to 13.1 per cent in 2018 (World Development Indicators, World Bank). In line with the expanding share of services in domestic Gross Value Added (GVA), India’s services exports too have increased, enabling an increase in its share in global services exports. India figures among the top ten global exporters and importers of services. A cross-country comparison of leading exporters of services shows that India’s services export growth during 2013-18 (average) was the third highest after Ireland and Japan (Chart 3). In 2018-19, surplus generated by services exports at US$ 81.9 billion could offset 45.5 per cent of goods trade deficit. India’s net services export growth moderated to 5.6 per cent in 2018-19 from 13.5 per cent in 2017-18. This was despite software exports, the largest contributor to net services exports, growing at a faster pace, surviving difficult global market conditions. Deceleration in growth in net export of services was contributed mainly by higher import of travel and business services. 

Software exports retained their share of 40 per cent in total exports of services in 2018-19 despite the global business environment turning more challenging during the year. The domestic IT companies faced increasing costs pressure due to higher local hiring in export destinations and lesser scope for labour cost arbitrage as well as higher visa fees and compliance burden associated with enhanced scrutiny of visa applications in the USA. This was discernible from the H-1B visa denial rate, which increased significantly for major indian IT companies during the year (Chart 4). Nevertheless, strong performance of banking, financial services and insurance (BFSI) verticals helped net export of software services to grow by 7.6 per cent during the year. 

Growth in exports of travel services – the second largest contributor to net services exports – remained muted at 0.3 per cent due to slower growth in in-bound tourist arrivals. By contrast, import of travel services rose sharply, in line with growing number of departures of Indian nationals from India. Accordingly, net exports of travel services declined by 23.8 per cent during the year. As India’s foreign trade volume increases, cross-border trade of transport services also tends to increase. Owing to higher payments towards imports than exports of transport services for the second consecutive year, there was a net import of transport services to the tune of US$ 1.1 billion in 2018-19. India turned a net importer of business services in 2018-19 from being a net exporter in the preceding two years. Business services include services provided for ‘professional and management consultancy’, ‘technical & trade related’ and ‘research and development (R&D)’ activities. While services delivered on account of these activities fetched receipts of US$ 39.1 billion, resident entities made payments of US$ 40.4 billion for import of these services, leading to a net import of US$ 1.3 billion during the year primarily on account of net payments for technical and trade related services. Within this segment, India was a net exporter of both ‘professional and management consultancy’ and ‘R&D services’ during the year. Other net exporter segment of services were insurance and financial services which together contributed US$ 2.2 billion to net export of services during the year. Going forward, the scope of expansion in services trade, especially software, business and financial services has further widened as economies are transitioning towards digitalisation. With greater emphasis on self-reliance in recent years, India’s professionals have acquired expertise and skill catering to a wide-ranging spectrum of IT services suitable for developed as well as developing countries. In such a milieu, India is rightly placed to reap the benefits of this transition on the back of its revealed comparative advantage (RCA) in software services.

Primary Income The primary income forms an important part of the current account and includes all amount payable and receivable to non-resident entities in return for providing temporary use of labour, financial resources or non-produced non-financial assets. Given India’s net international financial liabilities to the rest of the world (i.e., negative net international investment position), there has been a persistent outgo from the primary income account of the balance of payments. The net outgo increased marginally to US$ 28.9 billion in 2018-19 from US$ 28.7 billion a year ago (Chart 5). 

 

Secondary Income

In the case of India, secondary income mainly represents cross-border transfers (remittances) by expatriates sending a part of their income to support their families. With world’s largest diaspora (UN Migration Report 2019), India retained its position as the top recipient of cross-border remittances in 2018 (Chart 8).

In tandem with global recovery in remittances, India’s inward remittances (private) also increased by 10.5 per cent in 2018-19 on the back of increase in international crude oil prices and improved nominal income conditions in the US which is one of the major source country for inward remittances apart from the Gulf countries (Chart 9). Rupee depreciation of 7.8 per cent against the US dollar during 2018-19 also augured well for remittance flows to India. Another factor that seems to have boosted remittance inflows was higher amounts of transfers by migrants from Kerala to their families back home in the wake of the flooding disaster faced in the state.1 As India’s outbound remittance are comparatively miniscule relative to in-bound remittances, there has been a persistent net surplus position in this account which could offset about 39 per cent of the goods trade deficit in 2018-19.

The capital account

The capital account records all international transactions that involve a resident of the country concerned changing either his assets with or his liabilities to a resident of another country. Transactions in the capital account reflect a change in a stock – either assets or liabilities. ? It is difference between the receipts and payments on account of capital account. It refers to all financial transactions. ? The capital account involves inflows and outflows relating to investments, short term borrowings/lending, and medium term to long term borrowing/lending.

There can be surplus or deficit in capital account.

 It includes: - private foreign loan flow, movement in banking capital, official capital transactions, reserves, gold movement etc.

These are classifies into following categories:

•  Direct foreign investments
• Portfolio investments
• Other capital

Financial Flows

A deficit in the current account is sustainable when financed by foreign capital inflows involving transfers of both non-financial and financial assets between residents and non-residents. In 2018-19, foreign capital flows moderated as global headwinds weighed on investor sentiment leading to outflow of foreign portfolio investments. Consequently, the CAD could only be partly financed by net capital flows, resulting in a modest drawdown of foreign exchange reserves. The composition of capital flows, however, improved with an increase in the share of non-debt creating flows on account of robust inflows under foreign direct investment (FDI).

Foreign Direct Investment

Global FDI flows declined in 2018 as moderating rates of return and less favourable investment climate took a toll along with one-off factors like the US tax reform which led to large repatriation of accumulated investments by the US multinational enterprises (MNEs) (World Investment Report (WIR),UNCTAD 2019). However, with considerable domestic policy initiatives directed at improving the ease of doing business, India remained among the top 10 largest FDI recipient countries in 2018. Based on announced greenfield projects, India was the second largest recipient of capital investment behind China in the Asia Pacific region in 2018 (FDI Intelligence Report, Financial Times 2019). Higher FDI flows augur well not only for India’s exports but also for increased participation in the global value chains (GVCs). Net FDI flows to India increased to US$ 43.3 billion in 2018-19 from US$ 39.4 billion in 2017-18 led by higher equity investment, reinvested earnings by the existing companies and inter-corporate debt between parent and subsidiaries of multinational enterprises (MNEs). However, net inflows increased only marginally due to higher overseas direct investment by India in 2018-19.

India’s manufacturing sector and finance, banking, insurance, construction, computer and electricity generation attracted majority of FDI equity while investment in communication, retail and wholesale trade, business services and transport recorded a decline. Singapore and Mauritius continued to remain the top sources of FDI to India accounting for more than 50 per cent of total equity inflows (Chart 15).

The share of Mauritius, however, halved following the amendment of the double tax avoidance agreement (DTAA) in 2016 according to which capital gains arising out of shares acquired during April 2017 to March 2019 are subject to 50 per cent of prevailing tax rate and after April 2019 will be fully taxable under Indian tax laws. The investment from Singapore, the US, the UK and Japan increased. Despite the amendment of the DTAA with Singapore, investment through the Singapore route remained robust as transparent financial system, cheaper access to funds and better ease of doing business in Singapore make it a preferred country to re-route investment. India’s outward FDI expanded in line with the simplification of the procedures for outbound investments from India since 2004. In 2018-19, the rise in net outward FDI was due to a sharp increase in overseas equity investment by Indian entities.

Of the total net outward FDI equity flows of US$ 4.4 billion, Singapore remained the top destination country due to favourable business environment for Indian entities. There has, however, been a compositional shift towards developed countries viz., the US, the UK and Russia following the amendment of the DTAA with Singapore, Mauritius and Cayman Islands. Indian entities largely invested in financial, insurance, banking, manufacturing, wholesale trading and agriculture and mining– which together accounts for 90 per cent of the total outward FDI reported during the year.

Foreign Portfolio Investment Driven by geo-political tensions and countryspecific domestic policy uncertainties portfolio investment flows declined significantly worldwide in 2018 (WIR, UNCTAD 2019). Concerns on rising crude oil prices, geopolitical uncertainties, trade tensions, coupled with domestic political uncertainties, depreciating rupee led to the reversal of portfolio flows from India during April-December 2018-19. In Q4:2018-19, however, portfolio investors turned net buyers infusing US$ 11.5 billion, driven by dovish US monetary policy, enhanced liquidity in the global markets and positive growth outlook for India postbudget. This, coupled with easing of domestic norms including enhanced limits for investment in government securities and easing of minimum residual maturity augured well for the investors. In 2018-19, on a net basis, FPIs pulled out US$ 2.2 billion, as against a net purchase of US$ 22.2 billion a year ago, primarily on account of net sales in the debt segment (Chart 16). Sector-wise, the highest FPI outflow was from the sovereign sector (i.e., G-Secs) in the debt segment followed by automobile and auto-components, metals and mining, capital goods, telecom services and construction materials in the equity segment (Chart 17). As at end-March 2019, FPI utilised 68.6 percent of investment limits in central government securities, 6.5 percent in State Development Loans (SDLs) and 75.9 per cent in corporate debt. 

Other Investment Apart from foreign investments, external commercial borrowings, short term trade credit and net banking capital including non-resident deposits (NRD) are important sources of foreign capital. In 2018-19, ECBs (excluding inter-corporate loans by affiliated enterprises) recorded net inflows of US$ 9.8 billion after three successive years of outflows with increase in fresh borrowings and lower repayments (Chart 18). A slew of measures to liberalise ECBs including rationalisation of all-in-cost of ECBs, expansion of list of eligible borrowers, removal of sector-wise borrowing limits augured well for the borrowers.

 Removal of sectoral limits for all eligible borrowers up to US$ 750 million and approval of oil marketing companies to raise up to US$ 10 billion for working capital increased the attractiveness of ECBs. The top borrowing sectors included financial services, petroleum and petroleum products manufacturing, iron and steel, power generation, transmission and distribution in 2018-19. In terms of utilisation, ECBs were raised mainly for the purpose of refinancing of earlier loans, import of capital goods, raw materials, acquisition of goods and on-lending to sub-borrowers. Within ECBs, however, flows of rupee denominated bonds were almost negligible in 2018-19 relative to their level a year ago. Short-term trade credits, extended for imports directly by overseas suppliers, banks and financial institutions for maturities of up to five years, decelerated in 2018-19. The decline was evident both in total disbursement and repayments, indicating slowdown in trade credit activity in general, driven by both demand and supply side factors. Discontinuation of trade credit instruments, Letters of Undertaking (LOUs) / Letters of Comfort (LOCs) in March 2018 led to transition towards standardised instruments, viz., Letter of Credit or Standby Letter of Credit (SBLC) by banks and realignment of trade credit from buyers’ credit towards suppliers’ credit. Consequently, there was a decline in fresh disbursals and rise in relative cost for small and marginal importers which acted as a deterrent for trade credit demand. Accordingly, trade credit to import ratio fell to 8.4 per cent in 2018-19 from 21.4 per cent in 2017-18 (Chart 19).  

Reserve Assets

Three accounts: IMF, SDR, & Reserve and Monetary Gold are collectively called as The Reserve Account. The IMF account contains purchases (credits) and repurchase (debits) from International Monetary Fund. Special Drawing Rights (SDRs) are a reserve asset created by IMF and allocated from time to time to member countries. It can be used to settle international payments between monetary authorities of two different countries.

As net capital inflows recorded during 2018-19 fell short of the financing requirement of India’s CAD, there was a depletion of US$ 3.3 billion of the foreign exchange reserves as against an accretion of US$ 43.6 billion in 2017-18 on a BoP basis (i.e., excluding valuation effects). The foreign exchange reserves in nominal terms (including the valuation effects) decreased by US$ 11.7 billion in 2018-19 as against an increase of US$ 54.6 billion during the same period of the preceding year. Nominal change in reserve included a valuation loss of US$ 8.3 billion largely due to the appreciation of the US dollar against major currencies, excluding which depletion of reserve amounted to US$ 3.3 billion in 2018-19 (on BoP basis) (Chart 21). 

 

ROLE OF INVISIBLES IN BALANCE OF PAYMENTS
You have learnt that in the exchange of goods and services between countries there are 'visible' and 'invisible' exports and imports. 'Visible' items are those which are physically exported and imported, like merchandise, gold, silver and other commodities. The 'invisible' items comprise costs of services, income, and transfer payments (i.e. payments and remittances unrequisited or without quid pro quo or without any payment obligations). The IMF Manual classifies 'invisible' account data only under the following 8 heads:

(i) travel,

(ii) transportation

(iii) insurance,

(iv) investment income

(v) government, included elsewhere,
(vi) miscellaneous (receiptstpayments for patents and royalities),

(vii) transfer payments officials and

(viii) transfer payments private.

Around the 90s, there was a. great inflow into the invisibles account led by escalating private transfer, partly reflecting the conversion of Indian Development Bonds (IDBs), and a noteworthy improvement in software and other technology related exports.

It caused quite a surplus and even the gross invisible receipts did more than offset the increase in net investment income payments. Behind the growing surplus under the net invisible was the relative stable growth in outflows as well as profits and dividends. It was, in fact, quite contrary to expectations in the aftermath of current account convertibility.

Equilibrium or Disequilibrium of the Balance of Payments:

The account of international payments must necessarily be in balance; for every credit entry there has to be an off-setting debit entry. Charles P. Kindelberger has defined equilibrium as- “that state of balance of payments over the relevant time period which makes it possible to sustain an open economy without severe unemployment on a continuing basis.”

A state of disequilibrium of the balance of payments of a country assumes either the form of a surplus or a deficit. The disequilibrium is said to be favourable when the difference between the autonomous demand for and supply of foreign exchange is positive. On the contrary, a negative difference between the two denotes an unfavourable disequilibrium of payments.

A balance of payments disequilibrium, whether deficit or surplus, has some impact upon the international economic relations and sustained long term balanced growth of international trade. But of the two, the balance of payments deficit is generally considered as a more disturbing phenomenon, since the burden of adjustment tends often to fall more heavily upon the deficit rather than on the surplus countries.

A balance of payments disequilibrium must be attributed to a number of sources according as they have their impact upon the domestic economy.

These sources of balance of payments disequilibrium can be placed broadly in three main categories:

(i) Such sources of disequilibrium which simultaneously cause the worsening of the balance of payments and the lowering of incomes or improving the balance of payments and raising the income levels;

(ii) Such sources which while lowering the income level, tend to improve the balance of payments or while raising the income worsen payments situation; and

(iii) Such sources which have no impact upon the income levels.

In the first category, the disequilibrium is basically caused by the shift in demand from one country’s output to that of another. Such a shift, in addition to its effect upon balance of payments equilibrium, will cause a disturbance in the level of income. The second category covers such sources of payments disequilibria as the differences between the costs and prices in the different countries.

The third category is concerned with such disturbances in the balance of payments which while leaving a country’s current account unaffected bring about changes only in its liquidity position. Such disturbances are caused generally by the desire of domestic or foreign wealth-holders to change the composition of their asset portfolios.

The consideration of the above categories of sources of disturbances is essential for proper understanding of the dimension of the problem and to evolve its appropriate remedy. In this direction, it is worthwhile also to consider whether the balance of payments disequilibrium is temporary or chronic.

A temporary disequilibrium manifests a payments situation in which in-payments, for a short time, exceed the out-payments, followed by a period in which an opposite situation prevails. Such deficits or surpluses are caused by random variations in trade, seasonal fluctuations, and the effects of weather on agricultural output and so on. The deficits or surpluses resulting from such reasons are temporary and are expected to reverse themselves within a fairly short time.

The chronic or fundamental disequilibrium is due to the fundamental changes in the economic position of a country. The main factors that lead to such a situation are the shifts in consumer tastes at home or abroad which affect the country’s imports or exports, technological improvements in products or methods of production in the industries of home country or abroad, differences in the rates of growth of labour force or of capital accumulation between the country and its competitors.

The structural changes in an economic system may also be caused by a major war. The wartime destruction of a country’s productive capacity may hamper the capacity of a country to meet her domestic needs as well as to increase her exports for a considerably long time. The war may also lead to heavy liquidation of foreign investments as a means of obtaining foreign exchange to pay for the imports of war material and also to discharge heavily, mounting international debts.

The foreign policy consideration like heavy outlays for foreign grants and loan and military expenditure also have a very significant bearing upon payments situation. If these expenditures are undertaken and maintained for a considerable length of time, the chronic or fundamental disequilibrium in a country’s balance of payments is likely to result. The chronic deficits that have characterised the U.S. economy during the recent years have been principally on account of these reasons.

Causes of Disequilibrium In The Bop

• Cyclical fluctuations
•  Short fall in the exports
• Economic Development 
•  Rapid increase in population
•  Structural Changes
•  Natural Calamites 
•  International Capital Movements

RECENT POLICY MEASURES

Foreign Exchange Policy:

Since early seventies India. had adopted flexible exchange rates system. The guiding principle for monetary authorities was to allow the exchange rate to move in alignment with macro economic fundamentals. However, in general, countries prefer to limit exchange rate movement within the ceiling of movements that affect the fundamentals. India had large capital inflows soon after the adoption of the market based exchange rate system in 1993. The inflows surpassed the current account deficits and excess supply conditions prevailed in the foreign exchange market. This posed a new challenge for the government in devising monetary and exchange rate policies.

In such a state of affairs, a flexible exchange rate regime (i.e. allowing the nominal rate appreciate with large capital inflows) has the merits of insulating domestic economy from the inflows and containing inflation on account of an advantageous switchover from exchange rate to domestic prices.

However, these gains have to be evaluated against the cost of weakening of external competitiveness. It certainly amounts to sacrifice of the external balance objective. Instead, if the aim is to prevent real appreciation of exchange rate and protect external competitiveness, there are four options or a mixture thereof available. They are:

The central bank (RBI in case of India) intervenes in the foreign exchange market and then sterilizes the incremental liquidity generated. It thus keeps the monetary spreading out under check. This process has, however, quasi-fiscal costs associated with it and it also has the problem of inflating real interest rates which may tempt further capital inflows.

Trade restrictions are relaxed to permit capital flows supplement domestic saving. This has the potential of promoting economic growth. However, utmost care must be taken to ensure that it is the investment that increases and not the consumption. Otherwise, the debt servicing may go out of hand and become unsustainable. The authorities can relax restrictions on capital outflows. The advantage will be of better portfolio diversification for domestic residents as well as increased efficiency of the overall financial system. Often it develops further confidence thereby leading to bigger inflows.

The authorities can also reintroduce restrictions to control the swiftness of inflows. The restrictions could be in the form of increasing reserve requirements on non-resident deposits, tightening of norms for entities accessing global markets for private capital, higher withholding taxes on interest payments overseas, tapering. prudential standards on external loans, and insisting on end-use clauses.

Clearly, an open capital account not only limits the independence of authorities in the conduct of exchange rate policy but also exposes the economy to international fluctuations and shocks. Any plan of aiming at an exchange rate or the money stock may be counterbalanced by unexpected inflows, which affect the nominal exchange rate as well.

The free floating exchange rate is certain to increase volatility and cause constant misalignment’s which could knock off balance the financial system, thereby eroding the reducibility of an independent monetary policy. Obviously, there has to be consistency with the economic fundamentals, and therefore it may become necessary to allow short-term nominal appreciation when there is excess supply, but the authorities must be geared up for aggressive interference, backed by likewise aggressive sterilization to shield the money objective. Long-term measures to preserve external competitiveness may include increasing fiscal concessions, softer export credit etc.

These have to be constantly weighed against the possible losses due to higher debt servicing burden in the event of depreciation. This way, the exchange rate regime has to play an active role in the conduct of exchange rate policy.

Convertibility:

In August 1994, India opted for current account convertibility (CAC). CAC is also applicable to foreign investors (both direct and portfolio), non-resident depositors and resident corporate contraction of external commercial borrowings (ECB). Controls, however, exist on resident individuals and corporate bodies to send capital abroad as also on inflows and outflows of capital associated with banks and non-bank financial entities.

International experience with CAC has shown that, more often, liberalization of the capital account attracts large capital inflows. Such inflows can lead to real appreciation in the exchange rate and erode the effectiveness of domestic monetary policy. In addition, open capital account inflicts monstrous pressure on the financial system and brings out its weaknesses into sharper focus. Any move to Capital Account Convertibility asks for a very strong discipline from the financial system and warrants early removal of infirmities in the system.

As defined by the Committee on Capital Account, Capital Account Convertibility (CAC) refers to the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.

The Committee realized that there could be certain weaknesses in the system and that the entrenchment of preconditions can be had only after a period of time. The Committee therefore called for a phased implementation of CAC over a three year period i.e. phase I (1997-98), Phase II (1998-99) and Phase III (1999-2000).

The implementation of measures meant for each phase was based on a careful and constant monitoring of certain precondition signposts and also certain important attendant variables. These variables were. identified from the lessons of the .international experiences and the specifics of Indian situations. The Committee suggested that fiscal consolidation; a mandated inflation target and strengthening of financial system should be considered as the vital precondition signposts for CAC in India.

To organize the financial system for CAC, the committee made many suggestions. All suggestions aimed at creating a level playing field among various participants in the financial system. They sought to remove market segmentation and extend uniform treatment to resident and non-resident liabilities, to introduce more stringent capital adequacy standards and prudential standards for effective supervisory systems and give greater autonomy to banks and financial institutions.

The Committee recognized that even after finishing the third phase capital controls on. a number of items would be necessary. It therefore advised that at the end of three year phasing, there should be a stock taking of the progress on the preconditions/ signpost as well as the impact of the measures suggested by the Committee. CAC is a thus a continuous activity and more measures can be undertaken in the light of the experience acquired.