BALANCE OF PAYMENT (BOP) 

The relationship between the payments made by one country to all other countries and its receipts from all countries !

Syllabus of UGC Net Commerce (Unit I)

Before proceeding to the topic let's see the relevance of this topic in the new syllabus of UGC Net Commerce examination issued by NTA.

Unit I – Business Environment and International Business 

  • Concepts and elements of business environment: Economic environment- Economic systems, Economic policies(Monetary and fiscal policies); Political environment, Role of government in business; Legal environment- Consumer Protection Act, FEMA; Socio-cultural factors and their influence on business; Corporate Social Responsibility (CSR)
  • Scope and importance of international business; Globalization and its drivers; Modes of entry into international business
  • Theories of international trade; Government intervention in international trade; Tariff and non-tariff barriers; India’s foreign trade policy
  • Foreign direct investment (FDI) and Foreign portfolio investment (FPI); Types of FDI, Costs and benefits of FDI to home and host countries; Trends in FDI; India’s FDI policy
  • Balance of payments (BOP): Importance and components of BOP
  • Regional Economic Integration: Levels of Regional Economic Integration; Trade creation and diversion effects; Regional Trade Agreements: European Union (EU), ASEAN, SAARC, NAFTA
  • International Economic institutions: IMF, World Bank, UNCTAD
  • World Trade Organisation (WTO): Functions and objectives of WTO; Agriculture Agreement; GATS; TRIPS; TRIMS
Check out complete syllabus of UGC Net Commerce - Click Here

INTRODUCTION

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

CURRENT ACCOUNT

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.

Components of Current Account

  • Merchandise transactions or the visible trade (export and import of goods): the major part of foreign trade transaction include the export and import of a country. Payments made for the import of goods from other countries are shown as a negative side or debit items, and the receipts from the export of goods to other countries are shown as positive items. The balance of these exports and imports is called as the balance of trade or the merchandise trade balance. If the imports are more than exports, it will lead to trade deficit; while if the exports are more than imports, it will lead to a trade surplus. India has experienced consistent trade deficits except for the two years in the 1970s.
  • Invisible trade (the export and import of services): it includes the export and import of services such as Information Technology services, banking, insurance and consultancy services offered to foreign countries, BPO, tourism, outsourcing etc. The export of services is shown as a credit in the current account, while the import of services is shown as a debit to the current account. Since the export and import of services are invisible, they are known as invisible trade.
  • Unilateral or unrequited transfers (one sided transactions): the unilateral or unrequited transfers are one way transfer which include gifts and donations, personal remittances, foreign aid, charitable donations, withdrawal of NRI deposits locally etc. The inward transfers are shown as a credit to the current account and the outward remittances are shown as a debit to the current account. 
  • Income receipts and payments (investment income): it refers to the income from the investments made in the foreign countries, profits from the subsidiaries of companies located abroad, interest earned from loans and investments abroad, dividend income from the shares in the foreign companies etc. If the income is received from foreign sources, it is shown as a credit to the current account and if the payments are made to the residents of foreign countries, then it is shown as a debit to the current account.

Capital account

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.

Components of capital account:

  • Borrowing and lendings from foreign countries: it includes the financial transactions related to borrowing money from foreign countries by the private sector companies or individuals, government etc. The receipts from abroad which include the repayment of loans from the foreign citizens etc are shown as a credit in the capital account. The financial transactions dealing with lending to abroad by the private sector companies, individuals and the government, and the repayment of loans taken from foreign countries is shown as a debit in the capital account.
  • Investments to and from the foreign countries: the investments from the foreign countries in the Indian companies, government bonds, real estate etc in India are shown as a credit in the capital account as they lead to the inflow of foreign exchange. The investments made by the Indian residents in the stocks and shares of companies abroad, government bonds, real estate etc are shown as a debit in the capital account as they lead to the outflow of foreign exchange.
  • Foreign direct investment (FDI): when the foreign residents buy Indian capital assets such as companies, industrial complexes, machines etc, it is shown as a credit to the capital account. The FDI investment made by Indians in the foreign countries is shown as a debit in the capital account.
  • Foreign portfolio investment (FPI): when the foreign residents purchase stocks, government bonds, corporate securities etc, then these transactions are shown as a credit to the capital account. When the Indian residents purchase securities and bonds in foreign countries, it is shown as a debit in the capital account.

  • Changes in the Foreign Exchange Reserves: the foreign exchange reserves are the financial assets held by the central bank (RBI for India) of the country. These reserves serve as financing item in the Balance of payments. Any withdrawal from the foreign exchange reserves is shown as credit, while any addition in the reserves is shown as a debit in the capital account. The changes in foreign exchange reserves is shown in the BOP account and not the actual foreign exchange reserves

CURRENT ACCOUNT DEFICIT

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.

ERRORS & OMISSIONS

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.

BALANCE OF TRADE

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.

OFFICIAL RESERVE ACCOUNT

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.

AUTONOMOUS VS ACCOMODATING TRANSACTIONS

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.

DISEQUILIBRIUM IN BoP

The balance of payments is regarded as being in disequilibrium when it shows either a surplus or a deficit. 

Types of Disequilibrium in BoP: 

  • Cyclical Disequilibrium (Fluctuations in business cycle) 
  • Secular Disequilibrium (persistent, deep-rooted dynamic changes) 
  • Structural Disequilibrium (structural changes)
  • Temporary Disequilibrium (short period) · Fundamental Disequilibrium (persistent and long-run BOP disequilibrium of a country; chronic BOP deficit, according to IMF)
Solution to correct balance of payment disequilibrium lies in earning more foreign exchange through additional exports or reducing imports. They include:· 

  •  MONETARY MEASURES - Deflation, Exchange Depreciation, Devaluation & Exchange Control 
  • NON-MONETARY MEASURES - Tariffs, Quotas, Export Promotion & Import Substitution.

The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports and help in solving the balance of payments problem.


BoP CRISIS IN INDIA

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

Convertibility of currency means that the country’s currency becomes convertible in foreign exchange and vice versa in the market.

  • Current account convertibility relates to the removal of restrictions on payments relating to the international exchange of goals, services and factor incomes. 
  • Capital account convertibility refers to a similar liberalization of a country’s capital transactions such as loans and investment, both short term and long term. Convertibility on the capital account is usually introduced after a certain period of introducing the Current account convertibility. 
  • The rupee was made fully convertible on the current account of the balance of payments in August 1994. On February 28, 1997, the RBI instituted the Committee on Capital Account Convertibility (CAC) under the chairmanship of S.S. Tarapore related to capital account convertibility. For setting put a roadmap towards fuller capital account convertibility, the Reserve Bank of India constituted a Committee headed by S.S. Tarapore in March 2006. It submitted its Report on July 31, 2006. The committee suggested 3 phases of adopting the full convertibility of rupee in capital account - First Phase in 2006-07, Second phase in 2007-09 and Third Phase by 2011. Today we have Partial convertibility of Rupee on Capital Account.

Important MCQs on Balance of Payment

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