Importance of Balance of Payment:

A balance of payment is an essential document in the finance department or transaction as it gives the status of a country and it’s economy. The importance of the balance of payment can be calculated from the below points:

1. It examines the transaction of all the export and import of goods and services for a given period
2. It helps the government to analyse the potential of a particular industry export growth and formulate policy to support that growth
3. It gives the government a broad perspective on a different range of import and export tariff. The government then takes measure to increase and decrease the tax to discourage import and encourage export respectively and be self-sufficient
4. If the economy urges support in the mode of import, the government plan according to the BOP and divert the cash flow and technology to the unfavourable sector of the economy, and seek future growth

The Balance of Payment also indicates the government to detect the state of the economy, and plan expansion, monetary, and fiscal policy.

Relationship between Balance of Trade and Balance of Payment:

The relationship between the balance of trade and the balance of payment is quite simple, i.e., when exports of goods and services rise more than or fall less than, imports of goods and services, it is said to ‘improve’ and in the opposite care, it is said to ‘deteriorates’.

Similarly, when the balance of payments deficit gets smaller or the balance of payments surplus gets trigger the balance of payments is said to ‘improve’ and in the opposite case, there is ‘deteriorates’.

It is to be noted in this connection that a balance of trade improvement must be accompanied by the balance of payments improvement unless and until there is a corresponding change in the long-term lending. For example, if our exports rise to Rs. 540 crores in this year in comparison with the last year without changing our imports, our balance of trade, naturally, will improve by Rs. 60 crores.

However, if long-term lending remain constant, the balance of payment will also improve by the like amount which reduces our deficit and comes to Rs. 20 crores. On the contrary, if our long-term lending reduces from Rs. 120 crores to Rs. 40 crores, the balance of payments deficit deteriorates correspondingly.

It is interesting to note that there may be a balance of trade deficit, but still then there is a balance of payments surplus or vice-versa. Thus, if we find any trade deficit, it does not mean that the country is losing its reserves (foreign exchange etc.), the difference so happened due to long-term capital movements.

In short, the balance of payments account has two parts viz. the current account and the capital account.

Balance of Payments must always Balance:

It has already been stated about that the balance of payments must always balance. It will be balanced only when the total of credit items will exactly be equal to the total of debit items which really happens. As such, there must be either a deficit or a surplus in the current account. The deficit or surplus so created is met by transferring to capital account.

 Equilibrium of Balance of Payments:

Equilibrium is that state of the balance of payment over the relevant time period which makes it possible to sustain an open economy without severe unemployment on a continuing basis.

Whether the Balance of Payments is in equilibrium or not, it can be justified with this help of the three following test:

(i) Decrease in Foreign Exchange:

If gold continuously flows from the country, it may be assumed that the balance of payments is in disequilibrium. At present the decrease in foreign exchange reserves of our country indicate such a situation.

(ii) Increase in Foreign Debts and Loans:

If the amount of foreign debts and loans increase, that indicates the balance of payment of the country is in disequilibrium i.e., exports are less than imports,

(iii) Decrease in Foreign Exchange Rates:

If the foreign exchange rates of a country decrease, it may be said that the country is suffering from the disequilibrium in the balance of payments position.

 Causes of Dis-Equilibrium of Balance of Payments:

Disequilibrium in the balance of payments in the product of so many factors, e.g. the prices of goods and services, national incomes at home or abroad, the rate of interest, the supply of money, the state of technology, tastes, the distribution of incomes etc.

Now, if any of the above factors change without a corresponding change in other factors there must be a case of disequilibrium in the balance of payment position.

We know that the exports and imports of a country are influenced by a number of factors. It is hardly possible that equilibrium in balance of trade of a country is possible at fixed exchange rate over a long period of time. The balance of payments is quite disturbed by the factors which affect and change imports and exports continuously.

The reasons for the cause of disequilibrium in the balance of payments are noted below:

(a) Domestic Inflation

The greater bulk of balance of payments difficulties are the result of domestic inflation and the same can be corrected by disinflation i.e., eliminating the inflationary gap and reducing demand to the level of full employment. It is possible by increasing exports and reducing imports. Similarly halting of inflation and correction of exchange rate may also help in this regard.

(b) Technological Changes:

No doubt, these are other significant reasons for disequilibrium in balance of payments positions. It is quite known that every change in technology brings some comparative advantages which the other country tries to adjust, but the adjustment process itself brings a deficit in balance of payments.

Thus, the innovation, whatever form it is, invites disequilibrium. So, a new equilibrium requires either to reduce exports or to increase imports.

(c) Short Supply:

Disequilibrium of balance of payment arises due to a fall in supply. For example, due to industrial strike the sugar production of India fall which affect the supply and as a result there is a corresponding shortfall in exports and consequently increases the amount of imports which is the result of disequilibrium.

(d) Fall in Demand or Structural Disequilibrium:

Disequilibrium also arises out of a fall in demand of the export product. For example, if the demand of the Indian jute product decreases in the world due to a change in taste or what so ever, the resources which are engaged in jute production must be shifted to other lines of activity.

In such a situation, we are to restrict our imports and our resources must be diverted into another export line product. If the same is not possible, there must be a structural disequilibrium in balance of payment position.

Of the other causes, the deficit in current account due to the loss of service incomes creates disequilibrium position which may arise through the bankruptcy of direct investment abroad or nationalization etc.

Methods of Correcting Disequilibrium in Balance of Payments:

In order to maintain a country’s sound economic condition, its disequilibrium in balance of payment position (if any) must be corrected. Naturally, the reasons for creating such a situation must be removed. Otherwise if the situation continues for a long, the country will exhaust its foreign exchange reserves.

If such a situation arises the country concerned will have to depreciate its currency below par. We describe hereunder, certain measures to correct or improve the adverse balance of payments position.

These are explained below one by one:

(a) Stimulating exports or to check imports:

If there is a declining trend in exports, various steps must be taken to improve it. In other words, the total cost of the product must be brought down to encourage export which may require cutting down of wages and rate of interest etc. Exports may be also encouraged by granting bounties to exporters and to manufactur­ers also.

Similarly, imports must be discouraged by:

(i) Imposing import duty,

(ii) Prohibiting the product totally or

(iii) Adopting quota system,

(iv) Manufacturing the equivalent product within the country etc.

(b) Depreciate the External Exchange value:

Another measure to correct the disequilibrium is to depreciate the external (exchange) value of the home currency, which brings domestic goods cheaper to the foreigner. It must be remembered in this respect that the rate of exchange serves as an equilibrating factor between the balance of payments positions.

(c) To deflate the Currency:

It is quite known to us that if our currency contracts, no doubt, prices will fall which will check imports and stimulate exports, although the method of deflation is not even free from snags. Because, if the prices of the product are forced to come down while the cost of the same is rigid, these two do not follow suit. As a result, the country concerned may have to face a serious depression as well as unemployment.

(d) Exchange Control:

Under exchange control, all the exporters are directed to surrender their foreign exchange to the central bank or to sell it at the official rate to the government. Then it is rationed out among the licensed importers i.e., the government will allocate the scarce foreign exchange among the importers on the basis of some non-price criteria.

No importer is allowed to import goods without a license. In this way, the balance of payment is to some extent rectified by reducing the imports.

(e) Devaluation:

The effect of devaluation is almost same like depreciation. In other words, when a currency is devalued its values are decreased in terms of foreign currency. It means, the foreigners can buy more goods than before with the same amount of currency which no doubt, stimulates exports and check imports.

Since the imports are discouraged and exports are encouraged, a time will come when the adverse balance of payment will be corrected and will turn in our favour. From the decision made so far, we can draw a conclusion about the correction of adverse balance of payment position on the basis of the judicious combination of the following:

(i) Adjustment of exchange rate (i.e. appreciation/depreciation of the home currency).

(ii) Movement of Capital (i.e., lending/borrowing abroad).

(iii) Fiscal and Monetary changes that affect prices and incomes.

(iv) Trade restrictions (quotas/tariffs).

Thus, in order to correct the adverse balance of payments no single method is found suitable. We should try to implement all the methods stated above although the application of the factor depends on the nature and type of disequilibrium in balance of payments, (e.g., exchange rate will play a significant role in structural dis-equilibriums).

 

Is Balance of Payments Always in Equilibrium?

Balance of payments always balances means that the algebraic sum of the net credit and debit balances of current account, capital account and official settlements account must equal zero.

Balance of payments is written as:

B = R_f P_f

Where, B represents balance of payments,

R_f receipts from foreigners,

P_f payments made of foreigners

When B = R_f – P_f = 0, the balance of payments is in equilibrium.

When R – P_f > 0, it implies receipts from foreigners exceed payments made to foreigners and there is surplus in the balance of payments. On the other hand, when R_f — P_f < 0 or R_f < P_f there is deficit in the balance of payments as the payments made to foreigners exceed receipts from foreigners.

If net foreign lending and investment abroad are taken, a flexible exchange rate creates an excess of exports over imports. The domestic currency depreciates in terms of other currencies.

The exports becomes cheaper relatively to imports, It can be shown in equation form:

X+ B = M+ l_f

Where X represents exports, M imports I. foreign investment, B foreign borrowing

or X-M= I_f — B

or (X-M)-(I_f-B)=0

The equation shows the balance of payments in equilibrium. Any positive balance in its current account is exactly offset by negative balance on its capital account and vice versa. In the accounting sense the balance of payments always balances.

This can be shown with the help of the following equation:

C + S +T= C +I+G + (X-M)

or Y=C + I+G + (X-M) ( Y=C + S+T)

Where C represents consumption expenditure,

S domestic saving,

T tax receipts,

I investment expenditures,

G government expenditures,

X exports of goods and services and

M imports of goods and services.

In the above equation C + S + T is GNI or national income (Y), and

C + I+G = A,

Where A is called ‘absorption’

In the accounting sense, total domestic expenditures (C + I + G) must equal current income (C + S + T) that is A = Y. Moreover, domestic saving (S_d) must equal domestic investment (I_d). Similarly, an export surplus on current account (X > M) must be offset by an excess of domestic saving over investment (S > I_d).

Thus the balance of payments always balances in the accounting sense, according to the basic principle of accounting. In the accounting system, the inflow and outflow of a transaction are recorded on the credit and debit sides respectively.Therefore, credit and debit sides always balance. If there is a deficit in the current account, it is offset by a matching surplus in the capital account by borrowings from abroad or/and withdrawing out of its gold and foreign exchange reserves, and vice versa. Thus, the balance of payments always balances in this sense also.

 

Measuring Deficit or Surplus in Balance of Payments:

If the balance of payments always balances, then why does a deficit or surplus arise in the balance of payment of a country? It is only when all items in the balance of payments are included that there is no possibility of a deficit or surplus. But if some items are excluded from a country’s balance of payments and then a balance is struck, it may show a deficit or surplus.There are three ways of measuring deficit or surplus in the balance of payments. First, there is the basic balance which includes the current account balance and the long-term capital account balance. Second, there is the net liquidity balance which includes the basic balance and the short-term private non-liquid capital balance, allocation of SDRs, and errors and omissions. Third, there is the official settlements balance which includes the total net liquid balance and short-term private liquid capital balance.

If the total debits are more than total credits in the current and capital accounts, including errors and omissions, the net debit balance measures the deficit in the balance of payments of a country. This deficit can be settled with an equal amount of net credit balance in the official settlements account. On the contrary, if total credits are more than total debits in the current and capital accounts, including errors and omissions, the net debit balance measures the surplus in the balance of payments of a country. This surplus can be settled with an equal amount of net debit balance in the official settlements account. The relationship between these balances is summarised in Table 11.

Each balance would give different figure of the deficit. The items that are included in a particular balance are placed ‘above the line’ and those excluded are put ‘ below the line’. Items that are put above the line are called autonomous items. Items that are placed below the line are called settlement or accommodating or compensatory or induced items. All transactions in the current and capital accounts are autonomous items because they are undertaken for business or profit motives and are independent of balance of payments considerations.

According to Sodersten and Reed, “Transactions are said to be autonomous if their value is determined independently of the balance of payments”. Whether there is BOP deficit or surplus depends on the balance of autonomous items. If autonomous receipts are less than autonomous payments, BOP is in deficit and vice versa. “Accommodating items on the other hand are determined by the net consequences of the autonomous items”, according to Sodersten and Reed. They are in the official reserve account. They are compensating (induced or accommodating) short-term capital transactions which are meant to correct disequilibrium in the autonomous items of balance of payments.

But it is difficult to determine which item is compensatory and which is autonomous. For instance, in the table given above, the main difference in the three balances is their treatment of short-term capital movements which are responsible for deficit in the balance of payments. The basic balance places short-term private non- liquid capital movements below the line while the net liquid balance puts them above the line. Similarly, the net liquid balance places short-term private liquid capital movements below the line and the official settlements balance puts them above the line. Thus, as pointed out by Sodersten and Reed, “Essentially the distinction between autonomous and accommodating items lies in the motives underlying a transaction, which are almost impossible to determine”.