Balance a payments is an overall statement of a country's economic transactions with the rest of the world over some period- usually one year. It includes all outflow and inflows (payments and receipts). Countries have either balance of payment surplus or a balance of payment deficit. Balance of payments is a way of listing receipts and payments in international transactions of a country. Balance of payments can be broken down into balance of trade (export and import goods), balance of current account (includes the balance of trade, the balance of services and remittances; and capital account (investment and borrowing). Trade account is part of the current account. Capital account deals with investment and borrowings and the rest of the) BOP is the current account of which foreign trade is a part.

The left side of the Table shows all the ways is which a country can acquire foreign currency - how it can acquire purchasing power which can be used in foreign markets. The right side of table shows how the foreign currency is spent and how the purchasing power over foreign goods is used.

Account of a country’s BoP

Current account (Balance of trade)

Trade of goods (Visible trade)

The most straightforward way in which a country can acquire foreign currency is by exporting goods (Row 1) and analogously the country spends foreign currency on imports of goods (Row 5). These two describes the country’s visible/tangible trade and the difference shows the balance of trade. Exports are normally calculated f.o.b. (free on board[1]), whereas imports are normally calculated c.i.f. (cost, insurance, freight[2]). 

Trade of services (Invisible trade)

Row (2) enumerates the receipts of the country from the sale of services to the foreigners during the period in question. The most important items under this heading are usually Shipping Services.

Interest And Dividends, which citizens of the country earn on investment abroad. Such payments are regarded as payments made by foreigners for current services which they derive from the capital in question. Citizens of the country whose BOP we are dealing with, own land, shares, bonds etc., and the foreigners who enjoy the services of this capital will have to pay for them; these payments would be registered as exports of services or invisible exports.

Income through Tourism is another example under the same heading. Other payments registered under this heading are those for banking and insurance services made by domestic firms to foreigners.

In a completely analogous way, payments which residents of the country in question make to foreigners for similar services, i.e. shipping, banking and insurance services, payments the residents make as tourists abroad, and payment for capital services on foreign-owned capital (Row 6) are regarded as imports of services.

Unrequited[3] receipts

The items in row (3) have been called ‘unrequited receipts’, i.e. receipts which the residents of a country receive ‘for free’, without having to make any present or future payments in return. Example of this kind of receipt are gifts which residents receive from foreigners.

Balance of current account

((1)+(2)+(3))-((5)+(6)+(7) = Balance of current account

Capital Account

A government, a corporation, or an individual might have borrowed money abroad, and such borrowing can be of different kinds.

Capital inflows

The government of the country in question may get a loan from another government; a firm may issue stocks abroad; or a bank might float a loan in the foreign currency. In all these instances, the country in question will acquire foreign currency, and these transactions, which express changes in capital stock magnitudes, are listed in item (4).

Foreigners might acquire assets in the country with whose BOP we are concerned. These assets can be of different kinds. They may be land, houses, productive plants, shares, etc. Changes in the country’s stock of gold or reserves of foreign currency are also included in row (4).

A government, a corporation, or an individual resident may receive sums from abroad in repayment for a loan that it had previously extend to a borrowing agency in a foreign country.

Capital Outflows

Analogously, if residents of the country in their turn were to acquire foreign assets, for instance in the form of land abroad, of or foreign shares, or if the government were to lend money to a foreign government, this would give rise to an outflow of foreign currency and come as a capital transfer under row (8).

Balance of capital account

(4)-(8) = Balance of capital account.

Balance of Payments

((1)+(2)+(3)+(4))-((5)+(6)+(7)+(8)) = Balance of Payments.

Exchange Rate system

For the above transactions to take place foreign exchange is required. Foreign exchange rate is the price of a country’s money in relation to another country’s money.

Fixed exchange rate

An exchange rate is “fixed” when countries use gold or another agreed-upon standard, and each currency is worth a specific measure of the metal or other standard.

Floating exchange rate

An exchange rate is “floating” when supply and demand or speculation sets exchange rates (conversion units). If a country imports large quantities of goods, the demand will push up the exchange rate for that country, making the imported goods more expensive to buyers in that country. As the goods become more expensive, demand drops, and that country’s money becomes cheaper in relation to other countries’ money. Then the country’s goods become cheaper to buyers abroad, demand rises, and exports from the country increase.

World trade now depends on a managed floating exchange system. Governments act to stabilize their countries’ exchange rates by limiting imports, stimulating exports, or devaluing currencies.

Exchange Rate System in India

The devaluation of the rupee in 1991 brought about a sharp drop in its value against the dollar. The decline was hardly surprising, given the great strain on the economy during the 1990s, what with the external account perilously close to breaking point. A host of factors, including domestic political crises and increase in oil prices contributed to the decline in the rupee value. India's credit rating was downgraded twice and with instalment payments against some foreign loans coming due, the economy nearly collapsed.

Dual exchange rate system

In the Union budget for 1992-93, the rupee was made "partly convertible,'' or more correctly, partly floating, thus ushering in LERM. Under the new scheme, 40 per cent of the export receipts (denominated in dollars) was to be surrendered to the RBI at a predefined (official) rate;). The balance 60 per cent could be sold in the "free market'' to importers.

LERMS (Liberalised exchange rate management system)

Finally, in the Union budget for 1993-94, "full float'' of the rupee was allowed. Rupee was made fully convertible on

(i)   Almost the entire merchandise trade transanction

(ii) All receipts whether on current or capital account of BoP but not all payments.

Side by side the official RBI rate also stayed on for the conversion of items not permitted under unified market rate, (more than a half dozen in visible items of current account as well as capital payments).

In 94-95 full convertibility of rupee on current account was allowed.

The `managed float' system

Although the exchange rate system in India is supposed to be a full float, the RBI intervenes in the market at regular intervals to direct the movement in rupee values (thus the term "managed float''). The intervention by the RBI in the market could be passive (whereby the apex bank engages in off-market deals) or active (whereby it purchases or sells dollars). Therefore, it may well be stated that the exchange rate system in India is not exactly full float.

The J Curve Effect

J curve effect is a theory stating that a country’s trade deficit will initially worsen after the depreciation of its currency. This is because higher prices on foreign imports will be greater than the reduced volume of imports. When exports become price-competitive and imports are reduced due to high cost, the BOP turns positive.

Purchasing Power Parity

Purchasing Power Parity (PPP) is an indicator for cross-country comparison in living standards. In this method Gross National Product (GNP) is valued roughly in American prices (Dollar terms) for a proper comparison. It reflects upon the capacity of the currencies to buy basic goods and services.

Convertibility

• Presently Indian currency is partially convertible.
• In 1993-94 100% conversion for a number of current account transactions was allowed , thus making rupee convertible on current account.
• The Tarapore Committee-I was set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of Capital Account Convertibility. It was headed by SS Tarapore, former RBI Deputy Governor. It laid down a three-year road-map ending 1999-2000 for CAC. It also cautioned that this time-frame could be speeded up or delayed depending on the success achieved in establishing certain pre-conditions — primarily fiscal consolidation, strengthening of the financial system and a low rate of inflation.
• However, following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realised that the dangers of going in for CAC without adequate preparation could be catastrophic. Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accorded to fiscal consolidation and financial sector reform above all else.
• The Tarapore Committee-II, also called committee on fuller capital account convertibility revisited the same issue in 2006 and submitted its report in September the same year
• It suggested a three phase road map to achieve fuller CAC. The first phase of the three-part road map begins in 2006-07 followed by the second spread over 2007-09 with the third ending in 2011. It also suggested few strong measures like banning FII investment through Participatory Notes (PNs) and gave disapproval to discriminatory tax treaties as they lead to distortions thereby raising the cost of capital to the host country.
• However the 2008 global financial crisis did dampen the spirits of the advocates of fuller CAC. There was a view that India escaped unscathed as it had prudent capital controls. Although are some voices emerging in favour of CAC, it remains a matter of intense debate.

Latest trends in External Sector

India’s macroeconomic situation on the external side continues to be stable. Though the current account deficit is projected at 2.4 per cent of GDP in 2018-19, up from 1.8 per cent in 2017-18, this is within reasonable levels. The widening of the current account deficit has been driven by a deterioration of trade deficit from 6.0 per cent of GDP to 6.7 per cent across the two years. Rise in crude prices in Q4 of 2018-19 and a decline in the growth of merchandize exports have led to the deterioration of trade deficit. The acceleration in the growth of remittances has offset the deterioration of the current account deficit. In funding the current account deficit, the total liabilities-to-GDP ratio, inclusive of both debt and non-debt components, has declined from 43 per cent in 2015 to about 38 per cent at end of 2018. The share of foreign direct investment has risen and that of net portfolio investment has fallen in total liabilities, thereby reflecting a transition to more stable sources of funding the current account deficit. In sum, although the current account deficit to GDP ratio has started to increase lately, the external indebtedness continues to be on a declining path. India’s foreign exchange reserves continue to be comfortably placed in excess of US$400 billion. The Indian Rupee traded in the range of 65-68 per US$ in 2017-18 but depreciated to a range of 70-74 in 2018-19. The Real Effective Exchange Rate also depreciated in 2018-19, making India’s exports potentially more competitive. The income terms of trade, a metric that measures the purchasing power to import, has been on a rising trend, possibly because the growth of crude prices has still not exceeded the growth of India’s export prices. The exchange rate in 2018-19 has been more volatile than in the previous year, mainly due to volatility in crude prices, but not much due to net portfolio flows. The composition of India’s exports and import basket has almost remained unchanged in 2018-19 over 2017-18. Petroleum products, precious stones, drug formulations, gold and other precious metals continue to be top export items. Crude petroleum, pearl, precious, semi-precious stones and gold remain as top import items. India’s main trading partners continue to be the US, China, Hong Kong, the UAE and Saudi Arabia.

Foreign Exchange Management Act (FEMA)

Considered “draconian” by industry, the nearly three-decade-old Foreign Exchange Regulation Act (FERA) finally ceased to exist from MAY 31, 2000 and was replaced by the much milder Foreign Exchange Management Act (FEMA). Actually, FEMA came into existence on June 1, 2000 but FERA was provided a sunset clause of two years to enable the Enforcement Directorate (ED) to complete investigations into cases already detected by it for FERA violations before May 31, 2000.  The need for replacing FERA with FEMA was felt with the introduction of economic reforms in the country since FERA was considered to be quite rigorous and more in line with the period of extreme foreign exchange crisis of early 1970s but out of tune with the liberalised economic scenario of the 1990s.

Provisions of FEMA

• Violation of foreign exchange rules has ceased to be a criminal offence and would now be treated as a civil offence
• ED would no longer have the power to arrest persons for such offences.
• Extreme cases of money laundering, drug trafficking and gun running would now be dealt with under the proposed new legislation aimed at curbing money laundering.
• After June 1 this year the ED would have powers to search and seize foreign currencies, summon people and adjudicate and impose penalties. But the Directorate would not have powers to arrest or prosecute.

Policies of Export Promotion vs Import Substitution

Foreign trade involves trading of goods among countries of the world foreign trade leads to better use of available resources in the country with the help of imported machinery, equipment and technical skill from the developed country. Import and export often reduce violent fluctuation of prices of those commodities, which are scarce, or in surplus. It enables an underdeveloped country to earn the much-needed foreign exchange.

A developing country in order to develop needs capital goods. However, there is a limit since most developing countries face constraint of foreign exchange. Moreover as most developing countries are exporters of primary products, the revenue earned is not adequate. This is precisely because primary products have inelastic demand.

Thus developing countries have been following a policy of giving different kinds of incentives and promotion measures towards their export industries. The idea is that the measures will help the industries in increasing their exports and thus earn higher foreign exchange. This can be used to acquire capital goods. This policy is known as Export Promotion.

There is also a different strategy where the items which have to be imported are produced at home. Subsidies, tax concessions and other benefits are made available so that the import competing industries produce the imported commodities domestically. This mechanism has been described as import substitution.

However in recent years, experience has shown that the above two policies are not mutually exclusive. In fact, a judicious mixture of the two is most beneficial.