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MEANING AND STRUCTURE OF BALANCE OF PAYMENTS

International trade involves international means of payments. A country engaged in foreign

trade receives payments from countries to which it exports goods and services and requires to

make payments to those nations from where it imports. Accordingly a country with foreign

trade maintains an account of all its receipts and payments from and to the rest of the world.

Such an account is called balance of payments. It is defined as a systematic record of all

economic transactions between the residents of the reporting country and residents of

foreign countries during a given period of time".

The balance of payments account records all the transactions between the residents of

reporting (domestic) country and the residents of foreign countries (rest of the world). The

transactions include sales and purchases of all types of goods and services, financial assets

and any other transactions which result in the flow of money in and out of the country. The

figures recorded are usually in domestic currency of the reporting country. However, as and

when necessary, they are also expressed in internationally accepted currency like U.S.

dollars.

There is no unique method of presenting balance of payments record. Table 10.1 presents a

model balance of payments accounts by incorporating all the transactions under major heads.


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TABLE 10.1 : BALANCE OF PAYMENTS ACCOUNTece pts re ts ayments e ts

1) Exports of goods I) Imports of goods

ra e ccount a ance

2)

Exports of services3) Interest, profits anddividends received

4) Unilateral receipts

2)

Imports of services3) Interest, profits anddividends paid

4) Unilateral paymentsurrent ccount a ance ( 1 to )

5) Foreign investments6) Short term borrowing7) Medium and long termborrowing

5) Investments abroad6) Short term lending7) Medium and long termlending

Capital Account Balance ( 5 to 7 )

tat st ca screpancy rrors an m ss ons

9 C ange n reserves + 9) Change in reserves (-)

ota ece pts = ota ayments

The balance of payments account in Table 10.1 shows all the receipts and payments grouped

under major accounting heads.

Current Account :

The current account includes all items which give rise to or use up nations income. It consists

of two major items, i.e. Merchandise exports and import' and Invisible exports and imports.

Merchandise Exports and Imports : Item no. 1 on both sides refer to the merchandise

exports and imports. They are also referred as tangible exports and imports as they include

the exports and imports of tangible or visible items. The balance of exports and imports of

goods (Item No. 1) is referred as balance of trade or balance of visible trade or balance of

merchandise trade.

Invisible Exports and Imports : They consist of items 2, 3 and 4. Item no. 2 on both sides

constitute exports and imports of services. The major items included in this are Shipping,

International Airways, Insurance, Banking and other Financial Services. Tourism and any

other services including knowledge related Services.

The 3rd item relates to interest, profits and dividends received from and paid to. Investments,

direct and portfolio, give rise to interest and dividends. The share of this item has been slowly


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increasing in recent years under the era of globalisation where movement of capital has

become easier. Multinationals from rich countries invest in developing countries. The

advanced countries, to which these multinationals belong to, receive substantial amount of

profits. T he poor countries, however, hardly have any such income. Their outflow is much

more than what they receive, if any, on this account.

Unilateral or unrequited payments and receipts shown in item no. 4 refers to those receipts

and payments for which there is no corresponding quid pro quo. They include remittances

from migrant workers to their families back home, the payment of pensions to foreign

residents, foreign donations, gifts etc. For all these receipts and payments there is no counter

obligations. The receipts on this account lead to an increase in income due to receipts from

foreigners and are shown as credit. Similarly the payments to foreign countries or residents

results in decrease in income and thus recorded as debit.

All the receipts and payments on items nos 1 to 4 are treated under current account and the

balance between them is called balance on current account. The current account in the

balance of payments may have a surplus or deficit. A surplus provides resource enabling the

country to pay off past debts, if any, or to import capital or consumer goods as per their

requirement. A surplus increases a country's stock of claims on the rest of the world.

A deficit on this account is treated as a problem and calls for remedial measures. Deficit

reduces a country's capacity to import, increases foreign debt burden and may lead to foreign

debt trap and other international financial problems.

Both surplus as well as deficit will no doubt pose a problem but the former is hardly

considered to be one, where as the latter draws immediate attention and also the application

of corrective measures.


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The Capital Account

The capital account transaction is concerned with asset related flow as against current

account which is income related flow. All inflows which add to foreign claims by the

reporting country is shown as credit and all outflow which add to the domestic claims on

foreign countries is recorded as debit.

Foreign Investment comes in the form of direct or portfolio investment. In terms of

ownership it can be private which includes both multinationals and banking or official that is

from other governments or international institutions. Direct investment is undertaken mostly

by multinationals. Most of the investments are in consumer goods industries. In recent years

investment in capital goods industries and infrastructure sector is also steadily increasing.

There is also investment by individuals who acquire assets in the form of houses in other

countries.

Portfolio investment refers to the acquisition of financial assets in foreign countries.

Purchase of shares of a foreign company, bonds issued by a foreign government are some

examples.

Short term Borrowing / Lending refers to borrowing for a period of one year or less.

Credits are in the form of loans secured from foreigners, advance payment on deferred credit

exports and other miscellaneous capital receipts. Borrowing includes commercial borrowing

from the foreign commercial banks. Such borrowing may go beyond short term that is it may

be for more than one year, making it a medium term borrowing.

In a similar way all the lending, private and official to the residents of other countries, are

shown as debit. This item may hardly figure in the balance of payment of very poor countries.

The figures may increase and may appear prominently in case of advanced countries.

Medium and long term borrowing / lending : The distinction of capital flow in and out of

the economy as short, medium and long term capital is more on the nature of investment


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rather than time dimension. A bank deposit in a foreign country is considered a short term

investment though the deposit may remain for many years. A purchase of government bond

usually comes under long term. However, borrowing from the international institutions such

as IMF, IBRD etc. can clearly be marked as medium or long term based on the time period

involved.

Acquiring of assets through direct or portfolio investment appear as a negative item in the

capital account of the balance of payments record of the reporting country and as a positive

item in the capital account of the other country. All capital outflows (investments or lendings)

appear as negative (payments or debits) items as the money goes out of the economy.

Similarly all capital inflows (foreign investments or borrowings from other countries) are

positive items though some of them may increase the liabilities of the receiving country. To

avoid any confusion it should be kept in mind that all capital inflows are recorded as credit.

Errors and Omissions (Statistical Discrepancy)

From the accounting sense the balance of payments always balances, that is, in the double

entry recording system the sum of credit should match the sum of the debit entries for a given

period. A surplus in current account must be matched by the equal amount of deficit in

capital account and vice-versa. However in reality the entries in both sides may not in fact, do

not equal. The balancing amount which is required to balance both the sides is called Errors

and Omissions'. Errors may arise as values of credit and debit may not be identical or due to

different procedures followed by different sources of information. Omissions may occur as

some entries might have escaped recording.

Statistical discrepancies are unavoidable components of any balance of payments statements,

however, they do not invalidate the reliability of a balance of payments statements. Errors


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and Omissions reflect the difficulties involved in recording accurately numerous transactions

that take place during a given period.

Errors and Omissions amount equals to the number necessary to make both sides equal. It is

equal to the discrepancy in foreign exchange reserve. The significance of this particular item

is only from accounting sense, that is. to make the difference between credits and debits equal

to zero.

Reserves

Item no. 9 in table 10.1 shows the foreign exchange reserves (Forex). They are held by the

Central bank of a country. They are used to finance deficits in other accounts and payments

are made into these reserves when there is a surplus in other items. Foreign exchange reserves

are held in a number of forms such as (i) financial claims on foreign governments or central

banks; (ii) claims on the International Monetary Fund, (iii) Gold, (iv) internationally accepted

currencies like U.S. dollar; German mark, Japanese Yen. etc.

Change in foreign exchange reserves can be explained by an example of individual's holdings

of cash. The cash holdings increase when an individual has a surplus of income over

expenditure. They decrease when expenditure exceeds income. Similarly when there is

surplus in the balance of payments (current and capital account) it results in the increase in

foreign exchange reserves and a deficit brings down its volume.

The changes in foreign exchange reserves are shown as plus (+) or minus (-) depending on

where and in what form the reserves are held. If India holds the reserves in U.S.A. or any

other country, with IMF or in the form of any financial or other assets abroad then money

flows out of the country and is thus recorded as minus. Foreign exchange held at home by the

RBI in any acceptable form involves inflow of foreign exchange, accordingly it is recorded as

plus.


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In an economy with floating exchange rate the disequilibrium in balance of payments gets

adjusted automatically and there is no need for any reserves. Therefore with a clean float, the

reserves by definition are zero. In reality however, most of the economies practice a managed

float therefore they do require reserves for market intervention or other official settlement.

Usually it is expected that a country must possess reserves equal to three months import bill.

The Basic Balance

The basic balance is the sum of the current account and capital account, when the two sides

of the current and capital accounts are equal i.e. when the difference between the two is equal

to zero, the basic balance is achieved. An increase in deficit or reduction in surplus or a move

from surplus to deficit is considered worsening of the basic balance. Basic balance as Bo

Sodersten points out. need not necessarily be a happy state of affairs. A basic balance

achieved through long term borrowing from abroad may lead to future problems at the time

of repayment. Similarly an outflow of capital may indicate a deficit but may earn profits and

dividends in the future which will help improve the current account balance.

Deficits and Surpluses

The balance of payments always balances in a technical or accounting sense. The balance

in the balance of payments implies that a net credit in any one of the items must have a

counter part net debit in another. When the total credits and debits of all accounts balance, we

say the balance of payments balances. A clear picture of deficit or surplus is revealed when

we examine the balance of payments statement splitting it vertically into current account and

capital account. It is in the current account that the surplus or deficit becomes more evident.

A current account surplus is achieved when the exports of goods and services are greater than

their imports. A reverse situation results in deficit. If the current account deficit has to be

corrected by accommodating inflow of capital, the balance of payments is in deficit. In other

words if the autonomous receipts are less than the autonomous payments, the balance of


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payments is said to be in deficit. It is in surplus when such receipts are more than the

payments.

POLICIES FOR CORRECTING BALANCE OF PAYMENTS

DISEQUILIBRIUM

In order to correct balance of payments disequilibrium, the countries have the following

policy instruments at their disposal, i.e.

5) Expenditure Changing or Expenditure Adjusting Policies6) Expenditure Switching Policies7) Direct ControlsEXPENDITURE-CHANGING POLICIES

Expenditure changing policies refer to expenditure reducing or expenditure increasing

policies. Expenditure changing policies bring changes in the income of a country. Hence,

they are, sometimes, called income adjustment policies. Expenditure reducing policies can be

used to curb a deficit in the balance of payments, while an expenditure increasing policies are

used to correct a surplus in the balance of payments. On the other hand, expenditure-

switching policies primarily work by changing relative prices.

Generally, the burden of adjustment falls on the country experiencing a balance of payments

deficit rather than on a country experiencing a surplus in the balance of payments. We,

therefore, analyze the effect of above policies with respect to a country having a deficit in its

balance of payments.

Expenditure changing policies include both monetary and fiscal policies.1

Monetary policy

involves a change in the country's money supply that affects

/. See BO Sodersten: International Economocs, Macnillan, 1970, p.273 abd Meade J.E: The

balance of payments, Oxford University Press. 1972 Ch.8


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domestic interest rates. Monetary policy is easy if the money supply is increased and the

interest rates fall. This will induce an increase in investment and income which in turn will

increase imports. At the same time, the reduction in interest rates will lead to a short-term

capital outflow or reduce capital inflow. On the other hand, a tight monetary policy will

involve a reduction in money supply and an increase in the interest rate. This will discourage

investment, income and imports and also will lead to a short-term capital inflow or reduced

capital outflow.

Fiscal policy refers to changes in government expenditures, taxes or both. Expansionary

fiscal policy involves increase in government expenditures and / or reduction in taxes. These

measures will increase domestic production, income and imports. Contractionary fiscal policy

refers to a reduction in government expenditures and/or an increase in taxes. These measures

will reduce domestic production and income and hence lead to a fall in imports.

Both monetary and fiscal policies are the important means of implementing expenditure

adjusting policies. A country can correct a deficit in the balance of payments by pursuing a

tight monetary policy and/or a restrictive fiscal policy. This will have a deflationary effect on

the national income. This will lead to a fall in imports and an increase in exports. On the

other hand, a country having a surplus in the balance of payment can pursue an expansionist

monetary and fiscal policies. T his will have an inflationary effect on the national income

and, may, therefore, increase imports and decrease exports. Thus, an expenditure reducing

policy will have a positive effect on the balance of payments, while an expenditure increasing

policy will have a negative effect on the balance of payments.

EXPENDITURE-SWITCHING POLICIES

Expenditure switching policies primarily work by changing relative prices. According to

Meade, price adjustments can be brought out through changes in exchange rate or wage

flexibility. The main instrument to bring out changes in relative prices is a change in


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exchange rates i.e., a devaluation or revaluation of the domestic currency. Devaluation is

often used interchangeably with depreciation, and revaluation with appreciation. However,

the main distinction between the two sets of terms is that devaluation means a lowering of the

value of currency with respect to the price of gold or SDRs (Special Drawing Rights), and is

brought about by the government, while, depreciation means a lowering of value of currency

with respect to other currencies, and it is brought about automatically by market forces. The

former occur under fixed exchange rate system while the latter occur under flexible exchange

rate system. In essence both devaluation or depreciation means a fall in the price of domestic

currency in terms of foreign currency, that is, a rise in the number of units of domestic

currency (e.g. rupees) which have to be given to obtain a unit of foreign currency (e.g. U.S.

dollars). Similarly revaluation or appreciation means a rise in the price of domestic currency

in terms of foreign currency i.e.; a fall in the number of units of domestic currency to be

given to obtain a unit of foreign currency.

The immediate effect of exchange rate changes is a change in relative prices. For instance, if

India devalues its currency in terms of U.S. dollar, it will make the price of Indian goods to

fall relative to the price of U.S. Goods.

If the sum of the price elasticity of demand for imports in India and in U.S. is greater than

one, then a fall in the price of India's products relative to the price of U.S.s products will

cause a favorable movement in India's balance of trade. This will cause the purchasers in both

the countries to shift from the purchase of U.S. goods to the purchase of Indian goods which

are relatively cheap. The change in the quantities bought will more than outweigh the fall in

the price of Indian goods in terms of U.S.s products. Therefore, the value of India's total

exports will rise relatively to the value of India's imports. This will improve India's balance of

trade.


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If the sum of the price elasticities of demand for imports in India and US is less than unity,

then a fall in the price of India's products relatively to that of U.S.s products will cause an

unfavorable movement in Indias balance of trade. In this case, the volume of Indias imports

may not decrease and the volume of U.S.'s imports may not rise substantially. Then, a fall in

the price of India's products relatively to the price of U.S.'s products will cause the total value

of India's exports to fall relatively to the total value of India's imports. This will worsen

Indias balance of trade.1

If the sum of the price elasticity of demand for imports in India and U.S. is equal to unity,

then a fall in the price of India's products relatively to that of U.S.'s products will not cause

any change in India's balance of trade. In this case, changes in the quantities demanded are

just enough to balance the fall in the relative price of India's products to that of U.S.'s

products, so that there is no change in the balance of trade.

If we assume the sum of the elasticity of demand for imports in the two countries (India and

United States) is greater than one and if the price of Indias products is reduced relative to

that of USs product (i.e.; if there is devaluation), it will have the following effects:

8) Effect on Commodity Flows: In general, the volume of imports of devaluing country(i.e. India) will decrease, while the volume of exports will increase.

9) Inflationary Effect: Devaluation will increase the demand for its products. Thus, itcauses a net inflationary effect in the devaluing country.

10) Deflationary Effect: Devaluation will reduce the demand for the other country'sproduct (i.e. U.S's products). This will cause a net deflationary effect in the other country

(U.S.)

11) Effect on Balance of Trade: It causes a favorable effect on the balance of trade ofthe devaluing country. This is the most important effect of devaluation or depreciation.


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The relative fall in the price of India's products to that of U.S.'s products can be undertaken

by either of the following policies:

5) A fall in money wage rate in the domestic country (e.g. India).6) A rise in money wage rate in the foreign country (United States).7) A depreciation or devaluation of domestic currency (Indian currency) in terms offoreign currency (U.S. dollars).

8) Any other switching policy which will reduce price of domestic products relative toforeign products, (e.g. direct controls)

The main form of the expenditure switching policy used to reduce relative prices is

devaluation.

DIRECT CONTROLS

The use of monetary or fiscal policy or of devaluation as a policy means to cure a deficit in

the balance of payments pre-supposes that there are possibilities for income and price

adjustments in the economy. A country can also use direct controls to restore equilibrium in

the balance of payments. They are usually used to restrict imports. Then consumers will try to

buy domestic goods instead of imported goods. Hence, direct controls can be viewed as a

switching policy

Direct controls can be broadly divided into two groups i.e.. (a) Commercial controls and (b)

financial controls.

12) Commercial Controls: To improve the balance of payments, commercial controlscan be used to increase exports and discourage imports. Exports can be encouraged by

reducing or abolishing export duties, providing export subsidy, encouraging production of

export items, and export marketing. AH these may be undertaken by giving monetary', fiscal

and institutional and physical incentives and facilities.


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The volume of imports may be controlled by imposing or increasing import duties, restricting

imports through quotas, licensing and even by prohibiting altogether the import of certain

items.

13) Financial Controls: They take the form of exchange control and use of multipleexchange rates. Under the exchange control, a government tries to have complete control

over all dealings in foreign exchange. The recipients of foreign exchange like exporters are

required to surrender their foreign exchange to a central board/bank in exchange for domestic

currency and those who need foreign exchange, like importers, have to buy their foreign

exchange from the same board/ bank.

Under the system of multiple exchange rates a country fixes different rates of exchange for

the trade of different commodities and for transactions with different countries. The main

objective is to maximize the foreign exchange earnings of a country by increasing exports

and reducing imports.

The essence of direct controls is to restrict imports. It may be a feasible policy in the short-

run, but in the long-run its effect may be harmful to the country. It brings about price

distortions which will have harmful effects on production and consumption.

ROLE OF MONETARY AND FISCAL POLICIES IN BALANCE OF

PAYMENTS ADJUSTMENT

Monetary and Fiscal policies play an important role in correcting the disequilibrium in the

balance of payments under fixed exchange rates. Under floating rates, balance of payments

disequilibrium is corrected through changes in exchange rates. Fiscal and monetary policies

are mainly used to influence internal balance. Thus, in this section we analyze the role of

monetary and fiscal policies in the balance of payments adjustment under fixed exchange

rates.Meaning of Monetary and Fiscal Policies


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Monetary policy involves changes in money supply in the country that affect domestic

interest rates. An easy monetary policy brings about increase in money supply and fall in the

interest rate. On the other hand, a tight monetary policy will involve a reduction in money

supply and an increase in the interest rate.Fiscal policy refers to changes in government expenditures, taxes or both. Expansionary

fiscal policy involves increase in government expenditures and / or reduction in taxes. On the

other hand, contractionary fiscal policy involves reduction in government expenditure, and /

or an increase in taxes.Role of Monetary PolicyIn order to correct a deficit the monetary authorities have to adopt a tight monetary policy.

The important instruments of monetary policy are changes in interest rates and open market

operations, in order to correct a deficit they may increase the interest rates and/or may

engage in open market operation and sell bonds. The primary effect of an increase in interest

rate is on investment. It makes it difficult and expensive to borrow money to carry out

investments. As the availability of credit becomes scarce, the producers are likely to borrow

and invest less.The standard means of reducing the money supply and the availability of credit is through

the open market operations. The central bank sells bonds and securities. This will reduce the

prices of bonds and increase the effective interest yield on them. The purchase of bonds and

securities by commercial banks and others will lead to a fall in the liquidity of the banking

system. This will reduce the availability of credit. It is also likely to create an upward

pressure on the interest. Higher interest rate will lead to a short-term capital inflow or

reduced capital outflow or both.


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Thus, a tight monetary policy leads to fall in money supply and rise in interest rates. This is

likely to lead to fall in expenditure, income and prices which is likely to reduce imports and

encourage exports. This is likely to improve the trade balance, current account balance of the

country and overall balance of payments. Further, the rise in the interest rate will lead to

capital inflow or reduced capital outflow or both in the short-run. This too will lead to

improvement in the balance of payments of the country. This is shown in the Fig. 10.1.

On the other hand, an expansionist or easy monetary policy will help to reduce a surplus in

balance of payments. It will lead to fall in interest rates and an increase in expenditure

which, in turn, will lead to an increase in income. This is likely to increase imports. At the

same time, it may increase prices which may discourage exports. This will cause an

unfavorable movement in the balance of trade and current account balance which in turn

may cause unfavorable movement in the balance of payments or reduce the surplus in the

balance of payments of the country. Further the fall in interest rates will lead to capital

outflow which too worsen the balance of payments. In this case the direction of all changes

reverses. This is shown in Fig. 10.2.


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diagram

Role of Fiscal PolicyFiscal Policy can be used to correct a disequilibrium in the balance of payments. A deficit in

the balance of payments can be cured by reducing expenditure. Contractionary fiscal policy


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can be used to reduce expenditure. Two important instruments of fiscal policy are changes in

tax rates and government expenditure. An increase in tax rates, both direct and indirect taxes,

will reduce the income of the households which, in turn, will reduce the demand for goods

and services.Another instrument to reduce expenditure is to cut government expenditure. This involves

lower deficit or higher budget surplus. It will decrease transfer payments such as old-age

pensions, family allowances, etc. This will immediately reduce the consumption expenditure

since the groups receiving such benefits are generally the low-income groups with a high

marginal propensity to consume. A cut in government expenditure is also likely to reduce

public consumption and investment, which, in turn, will lead to a fall in national income and

imports. Since prices are likely to fall due to reduction in demand it may encourage exports.

This will improve the balance of trade, current account balance and the balance of payments

of the country. Further, a contractionary fiscal policy will lead to fall in demand for money

which in turn will reduce the interest rates. This will lead to capital outflow in the short-run.

T his may worsen the balance of balance of payments.Thus, the combined effect of fiscal policy on the balance of payment is not predictable. It

may worsen first but eventually may improve. This is shown in the Fig. 10.3.


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On the other hand, a surplus in the balance of payments can be corrected by a reduction in

taxes and an increase in government expenditure i.e. by expansionary fiscal policy. A

reduction in direct and indirect tax rates will stimulate the demand for goods and services. A

reduction in direct tax rates will increase the disposable income of the tax payers which will

lead to an increase in demand for goods and services. A reduction in indirect taxeswill enable the people to buy greater amounts of goods and services from the given income.

Similarly, an increase in government expenditure will cause a direct increase in the total

demand for goods and services. This will cause an increase in income and, therefore,

increase imports. Since the prices are likely to rise with the increase in demand, it may

discourage exports. In this way, expansionary fiscal policy can reduce the surplus or worsen

the balance of payments.Expansionary fiscal policy is likely to increase the demand for money and the rate of interest.

This may encourage capital inflows in the short run which may improve the overall balance

of payments.


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Thus, the expansionary fiscal policy may improve the balance of payments at first, but

eventually may worsen the balance of payments or reduce the surplus in the balance of

payments. This is shown in Fig. 10.4.Fig. 10.4 : Effect of Expansionary Fiscal Policy on the Balance of Payments

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