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Balance of Payment

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Balance of Payment:Balance of Payment of a country is one of the important indicators for

International trade, which significantly affect the economic policies of a government. Asevery country strives to a have a favourable balance of payments, the trends in, and theposition of, the balance of payments will significantly influence the nature and types of

regulation of export and import business in particular.

Balance of Payments is a systematic and summary record of a countrys economic and

financial transactions with the rest of the world over a period of time.

a) Transactions in good and services and income between an economy and the restof the world,

b) Changes of ownership and other changes in that countrys monetary gold, SDRs,and claims on and liabilities to the rest of the world, and

c) Unrequited transfers and counterpart entries that are needed to balance, in theaccounting sense, any entries for the foregoing transactions and changes which

are not mutually offsetting.

Balance of Trade and Balance of Payments

The Balance of Trade takes into account only the transactions arising out of the exportsand imports of the visible terms; it does not consider the exchange of invisible terms suchas the services rendered by shipping, insurance and banking; payment of interest, anddividend; expenditure by tourists, etc.

The balance of payments takes into account the exchange of both the visible and invisibleterms. Hence, the balance of payments presents a better picture of a countrys economic

and financial transactions with the rest of the world than the balance of trade.

Nature of Balance of Payments Accounting

The transactions that fall under Balance of Payments are recorded in the standard double-entry book-keeping form, under which each international transaction undertaken by thecountry results in a credit entry and a debit entry of equal size, As the internationaltransactions are recorded in the double-entry book-keeping form, the balance of paymentsmust always balance, i.e., the total amount of debits must equal the total amount ofcredits. Sometimes, the balancing item, error and omissions, must be added to balancethe balance of payments.

Components of Balance of PaymentsBalance of Payments is generally grouped under the following headsi) Current Accountii) Capital Accountiii) Unilateral Payments Accountiv) Official Settlement Account.

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Current Account

The Current Account includes all transactions which give rise to or use up nationalincome.The Current Account consists of two major items, namely:

i) Merchandise exports and imports, andii) Invisible exports and imports.

Merchandise exports, i.e., the sale of goods abroad, are credit entries because alltransactions giving rise to monetary claims on foreigners represent credits. On the otherhand, merchandise imports, i.e., purchase of goods from abroad, are debit entries becauseall transactions giving rise to foreign money claims on the home country represent debits.

Merchandise imports and exports form the most important international transaction ofmost of the countries.Invisible exports, i.e., sales of services, are credit entries and invisible imports, i.e.

purchases of services, are debit entries.

Important invisible exports include the sale abroad of such services as transport,insurance, etc., foreign tourist expenditure abroad and income paid on loans andinvestments (by foreigners) in the home country form the important invisible entries onthe debit side.

Capital AccountThe Capital Account consists of short- terms and long-term capital transactions A capitaloutflow represents a debit and a capital inflow represents a credit. For instance, if anAmerican firm invests Rs.100 million in India, this transaction will be represented as a

debit in the US balance of payments and a credit in the balance of payments of India.

The payment of interest on loans and dividend payments are recorded in the CurrentAccount, since they are really payments for the services of capital. As has already beenmentioned above, the interest paid on loans given by foreigners of dividend on foreigninvestments in the home country are debits for the home country, while, on the otherhand, the interest received on loans given abroad and dividends on investments abroadare credits.

Unilateral Transfers Account

Unilateral transfers is another terms for gifts. These unilateral transfers include private

remittances, government grants, disaster relief, etc. Unilateral payments received fromabroad are credits and those made abroad are debits.

Official Settlements AccountsOfficial reserves represent the holdings by the government or official agencies of themeans of payment that are generally accepted for the settlement of international claims.

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Balance of Payments Disequilibrium

The balance of payments of a country is said to be in equilibrium when the demand forforeign exchange is exactly equivalent to the supply of it. The balance of payments is inDisequilibrium when there is either a surplus or a deficit in the balance of payments.

When there is a deficit in the balance of payments, the demand for foreign exchangeexceeds the demand for it.A number of factors may cause disequilibrium in the balance of payments. These variouscauses may be broadly categorized into:(i) Economic factors(ii) Political factors and(iii) Sociological factors.

Economic Factors

A number of economic factors may cause disequilibrium in the balance of payments.These are:

Development DisequilibriumLarge-scale development expenditures usually increase the purchasing power, aggregatedemand and prices, resulting in substantially large imports. The developmentdisequilibrium is common in developing countries, because the above factors and large-scale capital goods imports needed for carrying out the various developmentprogrammes, give rise to a deficit in the balance of payments.

Capital Disequilibrium

Cyclical fluctuations in general business activity are one of the prominent reasons for thebalance of payments disequilibrium. As Lawrance W. Towle points out, depression

always brings about a drastic shrinkage in world trade, while prosperity stimulates it. Acountry enjoying a boom all by itselt ordinarily experiences more rapid growth in itsimports than its exports, while the opposite is true of other countries. But production inthe other countries will be activated as a result of the increased exports to the boomcountry.

Secular DisequilibriumSometimes, the balance of payments disequilibrium persists for a long time because ofcertain secular trends in the economy. For instance, in a developed country, thedisposable income is generally very high and, therefore, the aggregate demand, too, isvery high. At the same time, production costs are very high because of the higher wages.

This naturally results in higher prices. These two factors high aggregate demand andhigher domestic prices may result in the imports being much higher than the exports.This could be one of the reasons for the persistent balance of payments deficits of theUSA.

Structural Disequilibrium

Structural changes in the economy may also cause balance of payments disequilibrium.Such structural changes include the development of alternative sources of supply, the

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development of better substitutes, the exhaustion of productive resources, the changes intransport routes and costs, etc.

Political Factors

Certain political factors may also produce a balance of payments disequilibrium. For

instance, a country plagued with political instability may experience large capitaloutflows, inadequacy of domestic investment and production, etc. These factors may,sometimes, cause disequilibrium in the balance of payments.

Further, factors like war, changes in world trade routes, etc., may also produce balance ofpayments difficulties.

Social FactorsCertain social factors influence the balance of payments. For instance, changes in tastes,preferences, fashions, etc. may affect imports and exports and thereby affect the balanceof payments.

Correction Of DisequilibriumA country may not be bothered about a surplus in the balance of payments; but everycountry strives to remove, or at least to reduce, a balance of payments deficit. A numberof measures are available for correcting the balance of payments disequilibrium. Thesevarious measures fall into measures. We outline below the important measures forcorrecting the disequilibrium caused by a deficit in the balance of payments.

Automatic Corrections

The balance of payment disequilibrium may be automatically corrected under the PaperCurrency Standard. The theory of automatic correction is that if the market forces of

demand and supply are allowed to have free play, the equilibrium will automatically berestored in the course of time. For example, assume that there is a deficit in the balanceof payments. When there is a deficit, the demand for foreign exchange exceeds itssupply, and this result in an increase in the exchange rate and a fall in the external valueof the domestic currency. This makes the exports of the country cheaper and its importsdearer than before. Consequently, the increase in exports and the fall in imports willrestore the balance of payments equilibrium.

Deliberate MeasuresThis measure is widely employed today.The various deliberate measures may be broadly grouped into;

(a) Monetary measures(b) Trade measures and(c) Miscellaneous.

(a) Monetary Measures

The important monetary measures are outlined below;Monetary contraction; the level of aggregate domestic demand, the domestic price leveland the demand for imports and exports may be influenced by a contraction or expansion

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in money supply and correct the balance of payments disequilibrium.the measurerequired is a contraction in money supply. A contraction in money supply is likely toreduce the purchasing power and thereby the aggregate demand. It is also likely to bringabout a fall domestic prices. The fall in the domestic aggregate demand and domesticprices reduces for imports. The fall in the domestic aggregate demand and domestic

prices reduces the demand for imports. The fall in domestic prices is likely to increaseexports. Thus, the fall in imports and the rise in exports would help correct thedisequilibrium.

Devaluation : Devaluation means a reduction in the official rate at which one currency isexchanged for another currency. A country with a fundamental disequilibrium in thebalance of payments may devalue its currency in order to stimulate its exports anddiscourage imports to correct the disequilibrium.

To illustrate, let us take the example of the devaluation of the Indian Rupee in 1966, Justbefore the devaluation of the Rupees with effect from 6 th June 1966, the exchange rate

was $1= Rs. 4.76. The devaluation of the Rupee by 36.5 per cent changed the exchangerate to $1 = Rs. 7.50. Before the devaluation, the price of an imported commodity, whichcost $1 abroad, was Rs. 4.76 (assuming a costless free trade). But after devaluation, thesame commodity, which cost $ 1 abroad, cost Rs. 7.50 when imported. Thus, devaluationmakes foreign goods costlier in terms of the domestic currency, and this woulddiscourage imports. On the hand, devaluation makes exports (from the country that hasdevalued the currency) cheaper in the foreign markets. For example, before thedevaluation, a commodity which cost Rs. 4.76 in India could be sold abroad at $ I(assuming a costless free trade); but after devaluation, the landed cost abroad of the samecommodity was only $ 0.64. This comparative cheapness of the Indian goods in theforeign markets was expected to stimulate demand for Indian exports. The success of

devaluation, however, depends on a number of factors, such as the price elasticity ofdemand for exports and imports.

Exchange Control: Exchange control is a popular method employed to influence thebalance of payments position of a country. Under exchange control, the government orcentral bank assumes complete control of the foreign exchange reserves and earnings ofthe country. The recipients of foreign exchange such as exporters are required tosurrender foreign exchange to the government/central bank in exchange for domesticcurrency. By the virtue of its control over the use of foreign exchange, the governmentcan control the imports.

(b) Trade MeasuresTrade measures include export promotion measures and measures to reduce imports.

Export PromotionExports may be encouraged by reducing or abolishing export duties, providing an exportsubsidy, and encouraging export production and export marketing by offering monetary,fiscal, physical and institutional incentives and facilities.

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Import Control: Imports may be controlled by imposing or enhancing import duties,restricting imports through import quotas and licensing, and even by prohibitingaltogether the import of certain inessential items.

(c)Miscellaneous Measures

Apart from the measures mentioned above, there are a number of other measures that canhelp make the Balance of Payments position more favourable, such as obtaining foreignloans, encouraging foreign investment in the home country, development of tourism toattract foreign tourists, providing incentives to enhance inward remittances, developingimport substituting industries, etc.