The relationship between the payments made by one country to all other countries and its receipts from all countries !
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Unit I – Business Environment and International Business
The relationship between the payments made by one country to all other countries and its receipts from all countries. The balance of payments accounts records all flows of money in and out of a country. These flows might result from exports (an inflow or credit) or from imports (an outflow or debit). Reserve Bank of India (RBI) has been compiling and publishing Balance of Payments (BoP) data for India since 1948.
All flows of money are added together and grouped according to their type. The overall account is then called the balance of payments – principally because the total of outflows must equal the total of inflows. These transactions consist of imports and exports of goods, services and capital, as well as transfer payments such as foreign aid and remittances.
Note: IMF accounting standards of the BOP statement divides international transactions into three accounts: the current account, the capital account, and the financial account, where the current account should be balanced by capital account and financial account transactions. But, in countries like India, the financial account is included in the capital account itself
The current account records exports and imports of goods and services as well as unilateral transfers. A unilateral transfer is a one-way transfer of money, goods, or services from one country to another.
The capital account records purchase and sale transactions of foreign assets and liabilities during a Particular year. The capital account is a record of the inflows and outflows of capital that directly affect a nation’s foreign assets and liabilities.
Current account deficit refers to a situation when the value of goods and services imported by a country exceeds the value of goods and services exported by it. In other words, it simply means that a country imports more than what it exports. This current account deficit is paid through surplus in the capital account i.e through surplus foreign investments or foreign loans or through the forex reserves. When foreign exchange reserves fall below the critical level, the country faces the balance of payment crisis.
This constitute the third element in the BoP (apart from the current and capital accounts) which is the ‘balancing item’ reflecting our inability to record all international transactions accurately.
The difference in value between a country’s imports and exports is termed as balance of trade. Balance of payments is the overall record of all economic transactions of a country with the rest of the world. Balance of trade includes imports and exports of goods alone i.e., visible items.
The official reserve account is a part of the capital account, are the foreign currency and securities held by the central bank of a country and used to balance the payments from year-to-year. The reserves increase in case of a trade surplus and decrease when there is a trade deficit. The central banks use it to change the exchange rate to what the government perceives as more favourable. The difference between the current account and the capital account of a country is reflected in the change in the foreign exchange reserves of that country.
International economic transactions are called autonomous when transactions are made independently of the state of the BoP (for instance due to profit motive). Accommodating transactions (termed ‘below the line’ items), on the other hand, are determined by the net consequences of the autonomous items, that is, whether the BoP is in surplus or deficit.
The balance of payments is regarded as being in disequilibrium when it shows either a surplus or a deficit.
Types of Disequilibrium in BoP:
The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports and help in solving the balance of payments problem.
The balance of payment crisis occurs when there are insufficient capital account surplus and foreign exchange reserves for financing the current account deficit. India faced the BOP crisis in 1991 due to factors such as the Gulf War which increased the oil prices. The disintegration of USSR also negatively impacted India's exports contributing to the BOP crisis. The value of Indian rupee fell and the Reserve Bank of India sold its forex reserves for making the balance of payment zero. Since the RBI did not had enough forex reserves, India had to pledge 65 tons of gold for getting foreign loans to make the balance of payment zero. India liberalized its economy after 1991, and now the Reserve Bank of India holds large volume of forex reserves.
Convertibility of currency means that the country’s currency becomes convertible in foreign exchange and vice versa in the market.