1. INTRODUCTION Meaning. Balance of payments is a systematic record of all economic transactions. Visible as well as invisible, in a period, between one country and the rest of the world. It shows the rel: ry and t lationship between one country’s total Payments o all other countries and its total receipts from them. Balance of payments thus s statement of payments and receipts on international transactions. Payments and receipts on int F fernational account are of three kinds : (a) the visible balance of t-ade; (6) the invisible items ; and (c) capital transfers, Kindleberger defines balance of payments as “a systematic record of all economic transactions between the resisdents of the reporting country and the residents of foreign countries during a given period of time.” In the words of Benham, “Balance of payments of a country isa record of the monetary transactions over a peried with the rest of the world.” Features of Balance of Payments Balance of Payments has the following features : () Itis a systematic record of all economic transactions between one country and the rest of the world. (i) Itincludes all transactions, visible as well as invisible. (iii) Ttrelates to a period of time. Generally, it is an annual statement. (iv) Ttadopts a double-entry book-keeping system. It has two sides : credit side and debit side. Receipts are recorded on the credit side and payments cn the debit side. (®) When receipts are equal {6 payments, the balance of payments is in equilibrium ; when receipts are greater than payments, there is surplus in the balance of payments ; when payments are greater than Teceipts, there is deficit in the balance of payments. (vi) In the accounting sense, total credits and debits in the balance of payments statement always balance cach other. Balance of Payments and Balance of Trade senmp Palance of payments should be distinguished from balance of trade, Balance of trade refers to the export and {Port of visible items, ie., material goods. It is thé difference between the value of visible exports and imports. ‘Visible items are those items which are recorded in the customs returns ; for example, material goods Se es ‘ported. Ithe value of visible exports is greater than that of visible imports, the balance of trade is favourable; if the Value of visible imports is greater than that of visible exports the balance of trade is unfavourable ae JE of visible export is equal to that of visible imports, the balance of trade is in equilibrium. Balance o 'salso known as merchandise account of exports and imports. ; ‘able ems e, Pilan©® of payments, on the other hand, is a more comprehensive concept because it covers Oe (ie. balance of trade or merchandise account) and (5) invisible items. Invisible items are those items which ae Foe, dedi the customs returns; for example, services (such as trasporation, banking, insane, eee cee Purchase and ste of gold, ete, Thus, balance of payments i a broader term than balance of tad aieet or ayients includes both visible as well as invisible items, whereas balance of trade includes onlyEE 72D NTS 2. STRUCTURE OF BALANCE OF PAYME tsisa summary statement of. country’s total econ transactions with other coin : Balance) ‘of payment ide and debit side. ‘The credit side ‘shows all paym« PERCE eae abroad ag, = oe te ach ‘tobe made to the foreigners. ‘Abalance of payments istsof two pan it side sl 0 (a) current account and (5): capital account. Current Account ; current account tatement relates to real and short-term transactions, a tof the balance of payments si re and invisible items. Exports and imports L* ins receipts and payments on account of exports, a si s ‘impo faaterial ee viable items ; and exports and imports of services are invisible items. Transactions in the materia! Soon ae called rel transactions because they are concerned with actual transfer of goods and service, coreraffect income, output and expenditure of the country. These are income generating transfers and are not ‘merely financial transactions. Items of Current Account According to the International Monetary includes the following items = | Ee 1. Merchandise. Exports and imports of goods form the visible account and have a dominant position in the current account of balance of payments, Exports constitutes the credit side and imports the debit side. 2. Travel. Travel is an invisible item in the balance of payments. Travel may be for reasons of business, education, health, international conventions or pleasures. Expenditure by the foreign tourists in our country forms the credit item and the expenditure by our tourists abroad consistutes the debit item in our balance of payments. 3, Transporation. International transporation of goods is another invisible transaction. It includes warehousing (while in transit) and other transit expenses. Use of domestic transpoart services by the foreigners is the credit item and the use of foreign transport services by domestic traders is the debit item. 4, Insurance. Insurance premium and payments of claims is also an invisible transaction in a country’s balance of payments account. Insurance policies sold to foreigners are a credit item and the insurance policies purchased by domestic users from the foreigners are a debit item. 5. Investment Income. Another invisible item in the current account of the balance of payment is the investment income which includes interest, rents, dividends and profits. Income received on capital invested abroad is the credit item and income paid on capital borrowed from abroad is the debit item. 6. Government Transactions. Government transactions refer to the expandit : ane -xpanditure incurred by a government ee ue upkeep Seton: arena -Pmet of salaries to the ambassadors, high. eaantabuer, etc.). such amounts rece’ ‘a government from abroad constitute the credit iter ts, form the debit item. mand made to the foreign government 7. Miscellaneous. Misccllancous invisible items include i i : ; expendi like advertisement, commissions, film rental, patent fees, royaltics, subscriptions ‘0 the genatinte haberahin fees, ete. Such pay It o A etc. Such payments received by a country from abroad area creititem and made by a country to foreign counts 8. Donations and gifts. Donations, gifts, etc, recei i sent the foreign countries ae the debit item in dictaknccateajoanne en seal inn Yor 5 any nati ifts are ‘unilal transfers’ or ‘unrequited payments’ because nothing is given in return for them. ta eemesane 4 Capital Account Monetary Econom, Fund (IMM), the current account of the balance of payments= alance of Payments 230 Items of Capital Account ‘The main items of eapital account in India are : 4, Private Loans. Fo:eign loans received by the private sector (credit item) and forcign loans repaid by the private sector (debit items), 2, Movements in Banking Capital. Inflow of banking capital excluding the central bank (credit item) and outflow of banking, capital excluding the central Bank (debit items). ‘ 3, Official Capital Transactions (Loans. Forcign loans and credits received by the official sector including the drawings from the IMF (Credit item) ; and loans extended to the other countries as well as repurchase ofthe drawings from the IMF (dcbit item). (i) Amortisation, Repayment of official loans by other countries (credit items); and repayment of official Joans by home country (debit item). (ii) Miscellaneous. All other official receipts including those of central bank (credit item) ; and all other official capital payments including those of central bank (debit item). (iv) Reserve and Monetary Gold. Changes in the official foreign exchange holdings, gold resefves of the central bank and SDR holdings of te government, purchases from the IMF and similar other capital transactions; all such receipts represent credit item and payments represent debit item. ‘Alypothetical balance of payments statement has been prepared in Table 1 which represents both current as well as capital accounts. Table 1 : Balance of Payments Statement (Rs. Crores) ‘tel Debit x ae (Payments) TCurrent Account | —— Visibles 1. Merchandise Trade 400 600 200 Invisibles . 2. Services 200 400 —200 F 3. Investment Earnings 300 200 100 4. Unilateral Receipts 400 300 wo | (@ Sub-Total 1300 1500 ~ = 200 al TL. Capital Account 5. Long-term Loans 400 350 50 Short-term Loans 200 150 50 L 7. Gold Movernent 200 100 100 (©) Sub-Total 800 600 200 Grand Total (a+ 5) 2100 2100 0 |_ ____—" Balance of Payments always Balance ln the accounting sense, the balance of ay payments of a country is always in Palane of paymentsis prepared in terms of ereils and debits based on the sysem of dovble-enty bok Kern Seon catbleenty sistem, each transaction gives rise to two equal erie 9 crit ein (i ace) ant eaten e., payment), hus the sum of all credits equals the sum of all debits. Similar! \, an TS ation generates two equal entries: a credit (+) for an export of a good oF serie, or fora foreign beroving, x, the recip ofa uniateral transfer (gis, donations, grants, ec); and hit (© foran import ofa good oF OF for a foreign lending, or for the making of a unilateral transfer. In other words, a country must pay equilibrium. The statement of74D Monetary Economics it goods and services, or foreign borrowings, or receipts of unilateral transfers by the equal Spor or good ad services or foreign lending, of making unilateral transfers, Thus, the sum of all inna receipts (credit items) always equals the sum all international payments (debit items). While receipts and payments in the international transactions always must be equal or must balance in the accounting sense, they may not be equal or in equilibrium in operational sense. The accounting balance of s balance of payments account, which is merely a truism, should not be confused with the ‘economic balance" which recognised the possibility of a deficit or a surplus in the balance of payments. When the current account of the balance of payments shows a deficit or a surplus, the balance is restored through changes in the capital account, In fact, the capital account is specially prepared to neutralise the imbalance in the current account. The deficit in, the current account is neutralised by the equal amount of surplus in the capital account ; and the surplus in the current account is neturalised by the equal amount of deficit in the capital account. Thus, the current and capital accounts together balance each other and restore equilibrium in the balance of payments. Suppose, a country experiences a deficit in the current account of its balance of payments statement due to exess of imports over exports. Such a deficit can be met by resorting to the following changes in the capital account: (® by raising loans and getting grants from other countries : (ii) by drawing on past accumulated balances of the country which it may be keeping in the foreign ‘countries; (iif) by exporting gold; (iv) by drawings from International Monetary Fund. Table-1, which represents a hypothetical balance of payments statement, shows that the current and capital accounts together must necessarily balance. The deficit in the current account (excess of payments over receipts, i.e. Rs. 1500 — 1300 = 200 crores) is cqual to the surplus in the capital account (excess of receipts over payments, i.e., Rs. 800 - 60( 100 crores). Thus, the sum ofall receipts are equal to the sum of all payments and the balance of payments account is balanced. Balancing of international transactions is symbolically summarised below Trade balance ‘ational Peles, (X-M)+S+E+U+C+G=0 Cd Current balance Capital balance Using the values from Table 1, Trade batance (400 — 600) + (- 200) + 100 + 100 + (50 + 50) + 100 =0 ——_— Es Current balance Capital balance Symbols used : x Exports of goods (400) ; M_ = _ Import of goods (600) ; S = _ Net services exported (i-¢., services exported minus services imported (200 — 400 = ~ 200); E u = Net earning from forcign investment (/.e., income from foreign investment minus foreign income from investment at home (300 — 200 = 100) ; = Netunilateral receipts, ie., unilateral transfers received minus unilateral transfers made (400~ 300 = 100); C = Net capital inflow, i.e., long-term and short-term borrowings minus long~ term and short-term endings [(400 - 350) + (200 — 150) = (50 + 50)) ; G = Net sale of gold, i.e., sale of gold minus purchase of gold (200 — 100 = 100). 3. DISEQUILIBRIUM IN BALANCE OF PAYMENTS Normally, the balance of payments of a country should be in equilibrium, i.., the.imports and exports of goods and services should be equal. But, in reality it is not so, Disequilibrium generally arises in the balance © P_ salonee of Payments 75D account, Balance of payments may be unfavourable when theres excess ofimports over exports (deficit payments aceon favourable when ther, is excess of exports over imports (surplus balance). The phenomenon apis particularly related to the current account of balance of the payments statement ; the capital gull to sete the imbalance inthe current account through changes in the financial flows of funds cz sense, adisequilibrium in the balance of payments (deficit or sruplus) affects the fundamental economic vinshpe Stmong the nations and reflects a country's economic weakness or strength relative to others. types of Disequilibrium “The main types of disequilibrium in the balance of payments are as given below : 4. Gyelical Disequilibrium. Cyclical disequilibrium in the balance of payments arises due to business Jes is caused (a) by cyclical patterns of income, ar (b) by different income elasticities, o (c) by different or lasticiies. These factors bring changes in the terms of trade as well as growth of trade which, in turn, lead price (fit or surplus in the balance of payments. When prices rise in prosperity, a country with more elastic {08 snd for imports will experience a decline in the value of imports, thus leading to a surplus in the balance of ments, Conversely, as prices decline in depression, more elastic demand will increase imports and cause a Bayi in the balance of payments. These tendencies may, however, be offset by the effects of income changes. High incomes during prosperity increase imports and low incomes during depression reduce imports. 2, Secular Disequilibrium. Secular or long-term disequilibrium in balance of payments occurs because oflong-seated and deep-rooted changes in the economy as it moves from one stage of growth to another. (a) Inthe fnitial stages of economic development, domstic investment exceeds savings and imports exceed exports. Disequilibrium occurs due to lack of funds to finance the import surplus. (b) Then comes a stage when domestic savings tend to exoeed domestic investment and exports exceed imports. Disequilibrium arises because the surplus savings exceed investment opportunities abroad. (c) At a still later stage, domestic savings tend to equal domestic. investment and long-term capital movements on balance become zero. 4, Structural Disequilibrium. Structural disequilibrium in the balance of payments occurs when structural changes in some sectors of the economy alter the demand and supply forces influencing exports and imports. ‘According to Kindleberger, structural disequilibrium may be of two types : (“Structural disequilibrium at the goods level occurs when a change in demand or supply of exports or imports alters a previously existing equilibrium or when a change occurs in the basic circumstances under which income is earned or spent abroad, in both cases without the requisite parallel changes elsewhere in the economy.” (ii) “Structural disequilibrium at the factor level results from factors which fail to reflect accurately factor endowments... e., when factor prices, out of line with factor endowments, distort the structure of production from the allocation of resources which appropriate factor prices would have indicated.” out disequilibrium is caused by changes in technology, tastes and attitude towards foreign investment. litical disturbances, strikes, lockouts, etc., which affect the supply of exports, also cause structural disequilibrium. ice Fundamental Disequilibrium. The term fundamental disequilibrium has been originally used by the deck indicate a persistent and long-term disequilibrium in a country’s balance of payments. Fundamental mrangentrum s generally caused by dynamic factors and particularly lead to chronic deficit in the balance. The Gy eates of fandamental disequilibrium are : (a) excessive or inadequate internal demand for foreign goods; ‘or inadequate competitive strength in the world market ; (c) excessive capital movements. Causes of Disequilibrium Vs follows: ious Rieti i Causes of disequilibrium in the balance of payments or adverse balance of payments are as __._1.Develoy is the huge investi Schemes. ‘The main reason for adverse balance of payments in the developing countries Countries increases for meee oPment schemes in these countries. The propensity to import of the developing Because hese comin ant Of capital for industrialistion, The exports, oh the other hand, may not increase be — newly created encase primary producing countries, Moreover the volume of exports may fn a lustries esulting in stn lalate ane need them. All this leads to structural changes in the balance ee76D Monetary Economics 2. Price-Cost Structure. Changes in price-cost structure of export industries affect the volume of exports and create disequilibrium in the balance of payments. Increase in prices due to higher wages, higher cost of raw materials, etc. reduces exporis and makes the balance of payments unfavourable. 3. Changes in Foreign Exchange Rates. Changes in the rate of exchange is another cause of disequilibrium in the balance of payments. An increase in the external value of money makes imports cheaper and” exports dearer ; thus, imports increase and exports fall and balance of payments become unfavourable. Similarly, a reduction in the external value of money leads to a reduction in imports and an increase in export. f 4. Fall in Export Demand. There has been a considerable decline in the export demand for the primary goods of the underdeveloped countries as a result of the large increase in the domestic production of foodstufis Taw materials and substitutes in the rich.countries. Similarly, the advanced countries also find a fall in their export demand because of loss of colonial markets, However, the deficit in the balance of payment due to the fall in export demand is more presistent in the underdeveloped countries than in the advanced countries. 5, Demonstration Effect. According to Nurkse, the people in the less developed countries tend to follow the consumption patterns of the developed countries. As a result of this demonstration effect, the imports of the less developed countries will increase and create disequilibrium in the balance of payments. 6. International Borrowing and Lending. International borrowing and lending is another reason for the disequilibrium in the balance of payments, The borrowing country tends to have unfavourable balance of payments, while the lending country tends to have favourable balance of payments. 7. Cyclical Fluctuations. Cyclical fluctuations cause cyclical disequilibrium in the balance of payments. During depression, the incomes of the people in foreign countries fall. As a result, the exports of these countries tend to decline which, in turn, produces discquilibrium in the home country’s balance of payment. 8. Newly Independent Countries. The newly independent countries, in order to develop international relations, incur huge amounts of expenditure on the establishment of ambassies, missions, etc. in other countries, This adversely affects thier balance of payments position. 9. Population Explosion. Another important reason for adverse balance of payments in the poor countries is population explosion. Rapid growth of population in countries like India increases imports and decreases the capacity to export. 10. Natural factors. Natural calamities, such as droughts, floods, ctc., adversely affect the production in the country. As a result, the exports fall, the imports increase and the country experiences deficit in its balance of payments, 4. METHODS OF CORRECTING DISEQUILIBRIUM Persistant disequilibrium in the balance of payments, particularly the deficit balance, is undesirable because it (a) weakens the country’s economic position at the international level, and () affects the progress of the economy adversely. It must be cured by taking appropriate measures. There are many methods (o correct disequilibrium in the balance of payments. Important among them are discussed below : 1. Deflation. Deflation is the classical medicine for correcting the deficit in the balance of payments Deflation refers to the policy of reducing the quantity of money in order to reduce the prices and the nion®y income of the people. The céntral bank, by raising the bank rate, by selling the securities in the open market: and by other methods ean reduce the volume of eredit in the economy which will Icad to a fall in prices and money income of the people. Fall in prices will stimulate exports and reduction in income checks imports. Thus, deflation policy restores equilibrium to the balance (a) by encouraging exports through reduction in their prices and (b) f discouraging imports through the reduction in incomes at home. Moreover, a higher interest rate in the domesti¢ market will attract foreign funds which can be used for correcting disequilibrium. s However, deflation ig not considered a suitable method to correct adverse balance of payrients becaUst 1 the following reasons : (a) Deflation means reduction in income or wages which is strongly opposed by the unions. (5) Deflation causes unemployment and suffering to the working class. (c) In a developing economy: expansionary monetary policy rather than contractionary (deflationary) monetary policy is required to meet developmental needs.- anc? ‘of Payments TID 2, pepreciation. Another method of correcting disequilibrium inthe balance of payments is depreciation. Der eans a fallin the rate of exchange of one currency (home currency) in terms of another (foreign reek cuency will depreciate when its supply inthe foreign exchange market is large in relation to its caret) her words, currency is said to depreciate iis value fallin terms of foreign currencics, ie., if more el ig currency is required to buy a unit of foreign currency. The effect, of depreciation of a currency is to make domestic rsrand exports cheaper. Thus, depreciation helps a country to achievea favourable balance of payments ipenocking {imports and stimulating exports. change depreciation is automatic. Itworks na flexbleexchange rate system and can correcta mild adverse pons af paymenis the county's demand for imports and the foreign demand fr its exports are fairly elastic. Bat the method of exchange depreciation has the following defects {9 It isnot suitable fora country which follows a fixed exchange rate system {iy Teimakes international trade risky and thus reduces th: volume of trade. Gi) Theterms of trade go against the country whose currency depreciates because the foreign goods have ‘become costlier than the local goods and the country has to export more to pay for the same volume of imports. (w) Expericnce of certain countries has indicated that exchange depreciation may generate inflationary pressure by increascing the doinestic price level and money income, (0) The success of the method of exchange depreciation depends upon the cooperation of other countries. Ifother countries also start depreciating their exchange rates, then this methods will not benefit any country. 43, Devaluation. Devaluation refers to the official reduction of the external values of a currency. ‘The differenee between devaluation and depreciation is that while devaluation means the lowering of external value of t curency by the government, depreciation means an automatic fall in the external value of the currency by the trarket forces ; the former is arbitrary and the latter is the result of market mechanism. Thus, devaluation serves tnlyasan alternative method (o depreciation. Both the methods imply the same thing, ie., decrease in the value of aacurreacy in terms of foreign currencies. Both the methods can be used to produce the same effects ; they discourage imports, encourage exports and thus lead to a reduction in the balance of payments deficit ‘The success of the method of devaluation depends upon the following conditions : (The elasticity of demand for the country’s exports should be greater than unity. (ii) The elasticity of demand for the country’s imports should be greater than unity. (iil) Theexports of the country should be non-traditional and the increasingly demanded from other countries. (iv) The domestic price should not rise and should remain stable after devaluation. (%) Other countries should not retaliate by resorting to corresponding devaluation. Such a retaliatory measure will offset each other's gain. Devaluation also suffers from certain defects ¢ o Devaluation is a clear reflation on the country’s economic weakness. (ii) tomar the confidence of the people in country’s currency and this may lead to speculative outflow io it encourages inflationary tendencies in the home country. ttease the burden of foreign debt wolves, large timelag to produce effects. ou a payne shipormry device and does not provide a permanent remedy to correct adverse balance of 4. Exe! & balance range Control Exchange control is the most widely used method for correcting, disequilibrium in bank. Under tis mean =x hange control refers to the control over the use of foreign exchange by the central mings. Forcign ae all the exporters are directed by the central bank to surrender their foreign exchange Exchange eo, _ Inge is rationed among the licenced importers. Only essential imports are permitted. isthatit deate tte Most direct method of restricting a country’s imports. The major drawback of this ‘With the deficit only, and not its causes. Rather it may aggravate these causes and thus may iteMonetary Economics disequilibrium. In short, exchange control does not provide a permanent solution for a chronj create a more basic disequilibrium. 5, Capital cent. If the capital is pe! Pete inflow of capital. This Wil | Movement. Inflow of capital or: capital imports can’ beused to correct a deficit in the balance: rt tly mobile between the countTiet ' Senorease in the domestic rate of interest ab ot Il result 1 reduce the deficit in the balance of payments. we ports. In! order to correct an adverse balance of| ‘payments, all efforts should be made ag ine government should “adopt various export promotion programmes, suchas, the reductio ‘duties, provision ‘of export subsidies, quality control: centives for exports etc. m "7, Discouraging Imports. ‘Attempt should also be made (0 reduce imports by adopting various measures, Important measures {0 discourage imports are : (i) Import Duties. Import duty oF tariff is a tax on imports. ‘The government imposes tax on some or all imports. This raises the price ‘ofimports which, in turn discourages imports and thus helps correcting adverse balance of payments. tas is another method for correcting adverse balance of payments by ‘maximum quantity or the world rate wil Go Import quotas. Fixing Import quot seducing imports. Under the systems ofimport quota, the government fixes the vethe of a commodity to be imported, Thue by restricting imports through "mport quotas, the balance Bf payments deficit is reduced " direet method of correcting disequilibrium in a eaRhee of payments and is onside imports, the import quota directly limits that quantity that can th . (i Import Substitution. Yetanowner ethod of correcting disequilibrium ‘of payments through Jedacing imports is to encourage industries prod. eates, Import substitution helps the ‘on imports. Tetional economy to become more 5