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Balance of payment

BOP Accounting
The Balance of Payments is the statistical record of a countrys international transactions over a certain period of time presented in the form of double-entry bookkeeping. N.B. when we say a countrys balance of payments we are referring to the transactions of its citizens and government.

Purposes of BOP Accounts


Provides useful data for the economic analysis of the countrys weakness and strengths as a partner in international trade. Reveals changes in the composition and magnitude of foreign trade. Provides indications of future repercussions of countrys past trade performances. Reveals the weak and strong points in countrys foreign trade relations and invites govt. attention for corrective measures.

Terminologies
Favorable BOP = Value of total receipts more than total payments. Adverse BOP = Value of total receipts less than total payments. Balance BOP = Receipts equal to payments. Unrequited receipts = Receipts for which nothing has to be paid in return. Unrequited payments =Payments for which nothing is received in return.

Balance of Trade
Difference between value of exports and imports of visible items only.
BOT BOP Records only merchandise transactions Records transactions related to goods and services. Does not record transactions of capital nature A part of current account of BOP Records transactions of capital nature Includes BOT, balance of services, balance of unrequited transfers, balance of capital transactions

Balance of payment Accounts


Current Account: In the current account, goods, services, income and current transfers are recorded. Goods - Movable goods include general merchandise, goods used for processing other goods. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out). Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit).

Income :Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production. The overall balance on the current account- surplus or deficit, is carried over to the capital account.

Capital accounts
All transactions indicating changes in stock magnitudes concerning capital receipts and payments constitute capital accounts. Relates to : - Borrowing - Capital repayment - Sale of assets - Change in stock of gold - Change in reserve of foreign currency

Short term capital movement includes: - Purchase of short term securities. - Speculative purchase of foreign currency. - Cash balances held by foreigners. - Net balance of current account. Long term capital movement includes: - Investment in shares , bonds, physical assets etc. - Amortization of capital i.e. repurchase and resale of securities earlier sold to or purchased from foreigners.

BOP accounts are always in balance


The BOP accounting is based on double entry book keeping system in which both sides of a transaction receipts and payments- are recorded. Also , in accounting procedure, a deficit in the Current Account is offset by a surplus on Capital account.

Disequilibrium in BOP accounts


Disequilibrium in the BOP arises because total receipts during the reference period need not always be equal to the total payment obligations of that period. Assessment of overall BOP position of the country is done by regrouping total receipts and payments under following two categories: a) Autonomous transactions b) Induced transactions or accommodating capital flows.

All exports and imports of goods and services, long term and short term capital movements motivated by the desire to earn higher returns abroad or to give gifts and donations etc. are the autonomous transactions. The short term capital movements like gold movements and accomodating capital movements on account of the autonomous transactions are induced transactions.

Example
Exports and imports of goods are undertaken with a view to make profits. Hence these are autonomous transactions. If exports equal imports in value, there will be no other transactions. If exports are not equal to imports, it leads to short run capital movements e.g. international borrowing or lending. Hence these are called induced transactions.

In the assessment of balance of payment position, only autonomous transactions are taken into account. They determine the deficit or surplus in the balance of payments. Total payments> total receipts is deficit total receipts > Total payments is surplus total receipts = Total payments is equilibrium The disequilibrium of surplus nature is not a serious matter of worry as against the disequilibrium of deficit nature.

Types of disequilibrium in BOP


Structural disequilibrium: It takes place due to structural changes in the economy affecting demand and supply relations in commodity and factor market. Structural disequilibrium in balance of payments persists for relatively longer periods; as it is not easy to remove structural imbalance in the economy. Some of the important causes of structural disequilibrium are as follows : If the foreign demand for a country's products decline due to the discovery of cheaper substitutes abroad, then the country's export will decline causing a deficit.

If the supply position of a country is affected due to factors like crop failure, shortage of raw-materials, strikes, political instability, etc, then there would be the deficit in the balance of payments. A shift in demand due to the changes in tastes, fashions, income, etc, would increase or decrease the demand for imported goods . Changes in the rate of international capital movements. A war may also affect not only goods but also factor of production causing a disequilibrium.

Cyclical Disequilibrium
Disequilibrium is caused due to the changes in trade cycles. Different phases of trade cycles like depression, prosperity, boom, recession, etc, may disturb terms of trade and cause disequilibrium in BOP. e.g. during boom period, imports may increase considerably due to increase in demand for imported goods. During recession and depression, imports may be reduced due to fall in demand on account of reduced income. During recession exports may increase due to fall in price. During boom period, a country may face deficit in its BoP position on account increase in imports. However, during recession its export may increase, and as such BoP position may show surplus.

Also, the importing countries may face cyclical changes. For instance, there may be recession in the importing countries, which in turn would reduce demand for imports. Therefore, the demand for exports will decline and the exporting country may face a trade deficit, which in turn may affect BoP positions.

Technological Disequilibrium :
It is caused by various technological changes involving inventions or innovations of new goods or new technique of production. These technological changes affect the demand for factors and goods. A technological change will give comparative advantage to the innovating country leading to the increase in exports or a decline in imports. This will create disequilibrium in the balance of payments.

Short run Disequilibrium


Disequilibrium caused on a temporary basis for a short period. Such disequilibrium does not pose a serious threat as it can be overcome within a short run. Such a disequilibrium may be caused due to international borrowing and lending. Short run disequilibrium may also be caused when a country's imports exceeds exports in a particular year. Such disequilibrium is not justified as it has the potentiality to develop in to a crisis in time..

Long run or Secular Disequilibrium It prevails for a long period of time and is persistent.The IMF terms such disequilibrium as "Fundamental Disequilibrium". When there is a continuous increase in the stock of gold and foreign exchange reserves. there is a persistent surplus & vise-versa. A permanent deficit or surplus may make a country debtor or creditor causing a fundamental disequilibrium.

A developing country in its initial stages may import large amount of capital & hence its imports would exceed exports. When this becomes chronic, there emerges a secular deficit in its balance of payments. Deep rooted dynamic changes like capital formation, innovations, technological advancements, growth of population etc. also contribute to fundamental disequilibrium. When there is a series of short-run disequilibrium in a country's balance of payments, ultimately it would lead to fundamental disequilibrium.

Monetary Disequilibrium Monetary disequilibrium, takes place on account of inflation or deflation. Due to inflation, the prices of the products in the domestic market rise, and therefore, export items will become expensive. Such a situation may affect the BoP equilibrium. Inflation also results in increase in money income with the people, which in turn may increase demand for imported goods. As a result imports may turn Bop position in disequilibrium.

Causes of disequilibrium
Trade Cycles- Cyclical fluctuations lead to cyclical disequilibrium. Huge developmental and Investment programmes may increase imports without a commensurate increase in exports leading to structural disbalance. Changing export demand affects underdeveloped and developing counrtries more than the developed nations.

Population growth leading to large scale imports of food grains and wage goods (consumer goods). Huge external borrowings. Inflation- increases the marginal propensity to import and marginal propensity to consume affecting exports. Demonstration effect of advanced countries on the consumption pattern of the people in less developed countries. Reciprocal demands.
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Measures for correcting disequilibrium


Solution to correct BOP disequilibrium lies in earning more foreign exchange through additional exports or reducing imports. Quantitative changes in exports and imports require policy changes. Such policy measures are in the form of : a) Monetary measures b) Non monetary measures.

Monetary measures : i) Deflation ii) Exchange depreciation iii) Devaluation iv) Exchange control Non monetary measures i) Tariffs- imports duties ii) Import quotas iii) Export promotion policies and programmes

Deflation:Deflation means falling prices. Deflation is used to correct deficit disequilibrium. A country faces deficit when its imports exceeds exports. Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting a rise in our exports. At the same time the demands for imports fall due to higher taxation and reduced income. This would build a favourable atmosphere in the balance of payment position. Deflation can be successful when the exchange rate remains fixed.

Exchange Depreciation: Exchange depreciation means decline in the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy. e.g.Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse BOP with regard to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange may be say $1 = Rs. 50. This means 25% exchange depreciation of the Indian currency. This will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge.

Limitations of Exchange Depreciation : Exchange depreciation will be successful only if there is no retaliatory exchange depreciation by other countries. It is not suitable to a country desiring a fixed exchange rate system. It raises the prices of imports and reduces the prices of exports. So the terms of trade will become unfavourable for the country adopting it. It increases uncertainty & risks involved in foreign trade. It may result in hyper-inflation causing further deficit in balance of payments.

Devaluation Devaluation refers to deliberate attempt made by monetary authorities to bring down the value of home currency against foreign currency. While depreciation is a spontaneous fall due to interactions of market forces, devaluation is official act enforced by the monetary authority. When devaluation is effected, the value of home currency goes down against foreign currency. After such a change our goods becomes cheap in foreign market because dollar is exchanged for more Indian currencies which pushes up the demand for exports. At the same time, imports become costlier and demand for imports is reduced. Generally devaluation is resorted to where there is serious adverse balance of payment problem.

Limitations of Devaluation :-Devaluation is successful only when: other country does not retaliate the same. If both the countries go for the same, the effect is nil. the demand for exports and imports is elastic.In case it is inelastic, it may turn the situation worse. Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.

Contd.
Devaluation may bring inflation in the following conditions : Devaluation brings the imports down, scarcity of such goods unleash inflationary trends. A growing country like India is capital thirsty. Due to non availability of capital goods in India, we have no option but to continue imports at higher costs. This will force the industries depending upon capital goods to push up their prices. When demand for our export rises, more and more goods produced in a country would go for exports and thus creating shortage of such goods at the domestic level. This results in rising prices and inflation. Devaluation may not be effective if the deficit arises due to cyclical or structural changes

Exchange Control It is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their foreign exchange to the central authority. Thus it leads to concentration of exchange reserves in the hands of central authority. At the same time, the supply of foreign exchange is restricted only for essential goods. It can only help controlling situation from turning worse. In short it is only a temporary measure and not permanent remedy.

Non-Monetary Measures
Tariffs Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports would increase to the extent of tariff. The increased prices will reduced the demand for imported goods and at the same time induce domestic producers to produce more of import substitutes. Nonessential imports can be drastically reduced by imposing a very high rate of tariff.

Drawbacks of Tariffs : Tariffs bring equilibrium by reducing the volume of trade. Obstruct the expansion of world trade and prosperity. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of payment position are uncertain. Tariffs seek to establish equilibrium without removing the root causes of disequilibrium. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a country already having a surplus.

Quotas Under the quota system, the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the deficit is reduced and the balance of payments position is improved. Merits of Quotas : Quotas are more effective than tariffs as they are certain. They are easy to implement. They are more effective even when demand is inelastic, as no imports are possible above the quotas. More flexible than tariffs as they are subject to administrative decision. Tariffs on the other hand are subject to legislative sanction.

Export Promotion
The government can adopt export promotion measures to correct disequilibrium in the balance of payments. This includes substitutes, tax concessions to exporters, marketing facilities, credit and incentives to exporters, etc. The government may also help to promote export through exhibition, trade fairs; conducting marketing research & by providing the required administrative and diplomatic help to tap the potential markets.

Import Substitution A country may resort to import substitution to reduce the volume of imports and make it self-reliant. Fiscal and monetary measures may be adopted to encourage industries producing import substitutes. Industries which produce import substitutes require special attention in the form of various concessions, which include tax concession, technical assistance, subsidies, providing scarce inputs, etc. Non-monetary methods are more effective than monetary methods and are normally applicable in correcting an adverse balance of payments. ________________________

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