UNIT-IV: Balance of Payment: Concept, Components of BOP, and Disequilibrium in BOP Causes for disequilibrium and Methods to correct

t the disequilibrium in Balance of Payment.

The Balance of Payments

Learning Objectives To understand the fundamental principles of how countries measure international business activity, the balance of payments To understand the critical differences between trade in merchandise and services To understand how countries with different government policies toward international trade and investments, or different levels of economic development, differ in their balance of payments

Purpose of BOP
Pro ides data for economic analysis !e eals chan"es in the composition # ma"nitude of forei"n trade Pro ides indications of future repercussions of countrys past trade performances !e eals the $ea% and stron" points of a country&s forei"n trade relations
Introduction The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP)

Expressed with the IMF definition, the BO identity can be written!

" balance of payments #BO $ sheet is an accounting record of all monetary transactions between a country and the rest of the world%&'( These transactions include payments for the country)s exports and imports of goods, services, and financial capital, as well as financial transfers% The BO summari*es international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned% +ources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items% ,ses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit item% -hen all components of the BO sheet are included it must balance . that is, it must sum to *ero . there can be no overall surplus or deficit% For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will

have to be counter balanced in other ways . such as by funds earned from its foreign investments, by running down reserves or by receiving loans from other countries% The two major sub accounts of the balance of payments are/ components of BOP: Current account: The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit% It is the sum of the balance of trade #net earnings on exports . payments for imports$ , factor income #earnings on foreign investments . payments made to foreign investors$ and cash transfers% Its called the current account as it covers transactions in the /here and now/ 0 those that don)t give rise to future claims

-here 1" 2 current account, 3+ 2 national savings #private plus government sector$, 3I 2 national investment% Current Account I A goods! ser"ices! and income: # $erchandise % &hipment and other transportation ' Tra"el ( In"estment income ) Other official * Other pri"ate B +nre,uited transfers: # Pri"ate % Officials

Capital account: The capital account records the net change in ownership of foreign assets% It includes the reserve account #the international operations of a nation)s central ban4$, along with loans and investments between the country and the rest of world #but not the future regular repayments 5 dividends that the loans and investments yield, those are earnings and will be recorded in the current account$% Capital e-cluding reser"es # .irect in"estment % Portfolio in"estment ' Other long/term! official ( Other long/ term! Pri"ate

) Other short/ term! official * Other short 0 term! pri"ate The balancing item is simply an amount that accounts for any statistical errors and ma4e sure the current and capital accounts sum to *ero% "t high level, by the principles of double entry accounting, an entry in the current account gives rise to an entry in the capital account, and in aggregate the two accounts should balance 1eser"es! 6eserve assets consist of those external assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitude of such imbalances through intervention in exchange mar4ets to affect the currency exchange rate and5or for other purposes% The category of reserve assets in the IMF)s Balance of ayments Manual comprises! 0 Monetary gold7 0 +pecial drawing rights #+86s$7 0 reserve position in the Fund7 0 Foreign exchange assets #consisting of currency and deposits and securities$7 and 0 Other claims% Balance of payment e,uilibrium Occurs when surplus or deficit is eliminated from the BOP Causes for dise,uilibrium # 2ational output and 2ational spending % $oney supply ' 3-change 1ate ( Interest rate

Balance of Payment 3,uilibrium: E9uilibrium is that state of balance of payment over the relevant time period which ma4es it possible to sustain an open economy without severe unemployment on a continuing basis% In BO e9uilibrium, we have to ma4e certain assumptions for the simplicity of our analysis% These assumptions are! #a$ " given supply curve, #b$ 3o change in price expectations,

#c$ Internal capital flows depend on the level of the interest rate at home and abroad, #d$ 3o accumulation of real capital% It is evident that the balance of payments depends on both the level of domestic economic activity and the level of domestic interest rate% Types of BOP 3,uilibrium: There are two types of BO e9uilibrium, i%e%, static e9uilibrium and dynamic e9uilibrium! #a$ &tatic 3,uilibrium! The distinction between static and dynamic e9uilibrium depends upon the time period% In static e9uilibrium, exports e9ual imports including exports and imports of services as well as goods and the other items on the BO s . short term capital, long term capital and monetary gold are on balance *ero% 3ot only should the BO s be in e9uilibrium, but also national money incomes should be in e9uilibrium vis0:0vis money incomes abroad% The foreign exchange rate must also be in e9uilibrium% #b4 .ynamic 3,uilibrium! The condition of dynamic e9uilibrium for short periods of time is that exports and imports differ by the amount of short0term capital movements and gold #net$ and there are no large establishing short0term capital movements% Additional The condition for dynamic e9uilibrium in the long run is that exports and imports differ by the amount of long term autonomous capital movements made in a normal direction, i%e% from the low0interest rate country to those with high rates% -hen the BO of a country is in e9uilibrium, the demand for domestic currency is e9ual to its supply% The demand and supply situation is thus neither favorable nor unfavorable% If the BO moves against a country, ad;ustments must be made by encouraging exports of goods, services or other forms of exports or by discouraging imports of all 4inds% 3o country can have a permanently unfavorable BO , though it is possible . and is 9uite common for some countries . to have a permanently unfavorable balance of trade% Total liabilities and total assets of nations, as of individuals, must balance in the long0run% Types and Causes of BOP .ise,uilibrium: There are three main types of BO 8ise9uilibrium which are discussed below! #a$ 1yclical dise9uilibrium,

#b$ +ecular dise9uilibrium, and #c$ +tructural 8ise9uilibrium%

#a$ Cyclical .ise,uilibrium! 1yclical dise9uilibrium occurs because of two reasons. First, two countries may be passing through different paths of business cycle. Second, the countries may be following the same path but the income elasticities of demand or price elasticities of demand are different. If prices rise in prosperity and decline in depression, a country with a price elasticity for imports greater than unity will experience

a tendency for decline in the value of imports in prosperity7 while those for which import price elasticity is less than one will experience a tendency for increase% 5These tendencies may be overshadowed by the effects of income changes, of course% 1onversely, as prices decline in depression, the elastic demand will bring about an increase in imports, the inelastic demand a decrease% 4 #b$ &ecular .ise,uilibrium: The secular or long-run disequilibrium in BOP occur because of long-run and deep seated changes in an economy as it ad ances from one stage of growt to another. 5The current account follows a varying pattern from one state to another% In the initial stages of development, domestic investment exceeds domestic savings and imports exceed exports .ise,uilibrium arises owing to lac6 of sufficient funds a"ailable to finance the import surplus! or the import surplus is not co"ered by a"ailable capital from abroad % Then comes a stage when domestic savings tend to exceed domestic investment and exports outrun imports% 8ise9uilibrium may result, because the long0term capital outflow falls short of the surplus savings or because surplus savings exceed the amount of investment opportunities abroad% "t a still later stage, domestic savings tend to e9ual domestic investment and long term capital movements are on balance, *ero% $ #c$ +tructural 8ise9uilibrium! +tructural dise9uilibrium can be further bifurcated into! #i$ &tructural .ise,uilibrium at 7oods 8e"el! !tructural disequilibrium at goods le el occurs when a change in demand or supply of e"ports or imports alters a pre iously e"isting 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. 5+uppose the demand for a4istani handicrafts falls off% The resources engaged in the production of these handicrafts must shift to some other line or the country must restrict imports, otherwise the country will experience a structural dise9uilibrium% " deficit arising from a structural change can be filled by increased production or decreased expenditure, which in turn affect international transactions in increased exports or decreased imports% "ctually it is not so easy, because the resources are relatively immobile and expenditure not readily compressible% 8isinflation or depreciation may be called for to correct a serious dise9uilibrium% 4 #ii$ &tructural .ise,uilibrium at 9actors 8e"el! !tructural disequilibrium at the factor le el results from factor prices which fall to reflect accurately factor endowments, i.e., when factor prices are out of line with factor endowments, distort the structure of production from the allocation of resources which appropriate factor prices would ha e indicated. If, for instance, the price of labour is too high, it will be used more sparingly and the country will import goods with a higher labour content% This will lead to unemployment, upsetting the balance in the economy%

7eneral $easures to Correct BOP .ise,uilibrium:

To correct the different types of dise9uilibrium in BO the following general measures are used! #a$ Exchange depreciation #price effect$ or devaluation #by government$, #b$ 8eflate the currency, #c$ Tariffs,

#d$ Import 9uotas, and #e$ Export duties%

#a$ 3-change .epreciation 5Price 3ffect4 or .e"aluation 5by 7o"ernment4: #"change depreciation means a reduction in the alue of a currency in terms of gold or other currencies under $free mar%et& conditions and coming about through a decline in the demand for that currency in relation to the supply. This is usually applied to <floating e-change rates:% The purpose of this method is to depreciate the external exchange value of the home currency, thus cheapening the domestic goods for the foreigner. 'hereas, under $fi!ed"parity system# or $fi"ed e"change rate&, the reduction of currency alue in against the gold or other currencies is official and not mar%et based. This official reduction of e"change rate is called $de aluation&. The purpose of both <depreciation= and <devaluation= is to cheapen the domestic goods and boost up the exports% 5But the governments regarded devaluation as a means of correcting a balance of payments deficit only as a measure of last resort% They predominantly relied on deflation of the home mar4et and international borrowing% 8evaluation or depreciation of the exchange rate can correct a balance of payment deficit because it lowers the price of exports in terms of foreign currencies and raises the price of imports on the home mar4et% This does not necessarily succeed in its purpose% The immediate effect is similar to an unfavorable change in the TOT% For the resources devoted to the production of exports, less foreign exchange is earned with which to pay for imports% If the level of imports remained the same, more output would have to be diverted to exports and away from home consumption and investment simply to maintain the status 9uo% 8evaluation or depreciation could lead to a loss of real income without any benefit to the balance of payments% 4 a4istan has always faced negative BOT except for three years, i%e% '>?@0?A, '>BC0B' and '>@D0@E% The newly born a4istan had a 9uite high exports and a handsome balance of trade #,+ F ?D million$% -ith the Gorean -ar boom in '>BC0B', once again a4istan gained a surplus in BOT #,+ F BE million$% However, the reason for '>@D0@E=s positive BOT #F DC million$ was the massive currency devaluation in '>@D when the rupee was devalued from 6s% ?%@I to D%E times higher level of 6s% '' per ,+ dollar% The exports increased significantly and the share of exports in J8 rose to '?%>K% #b$ .eflate the Currency: (ccording to this method, the currency is deflated. (s the currency contracts, prices will fall, which will stimulate e"ports and chec% imports. But the method of deflation is also full of dangers. )f prices are forced down while costs, which are pro erbially rigid *especially as regards wages in countries where trade unions are well organised+, do not follow suit, the country may face a serious depression and unemployment. 1orrecting the balance of payments, therefore, once a dise9uilibrium has arisen is not an easy matter%

#c$ Tariffs! Tariff is a tax levied on imports% It is synonymous with import duties or custom duties% Tariffs are used for two different purposes7 For revenue and For protection% <6evenue Tariffs= are a source of government revenue and < rotective Tariffs= are meant to maintain and encourage those branches of home industry protected by the duties% Tariff duties are of four types! #i$ Ad ;alorem Tariff! It is levied as a percentage of the total value of the imported commodity% #ii$ &pecific .uties! These are levied per unit of the imported commodity% #iii$ Compound .uties! These are a mixture of above two% #iv$ &liding &cale .uties! These vary with the prices of commodities imported% #d$ Import <uotas! "s a protective device, import 9uotas are alternative to tariffs% ,nder an import 9uota, fixed amount of a commodity in volume or value is allowed to be imported into the country during a specified period of time% The ma;or objecti"es of import 9uotas are! #i$ To avoid foreign competition, #ii$ To provide greater administrative flexibility, #iii$ To solve the problem of BO and BOT% Import 9uotas are of the following five types! #i$ Tariff 9uota, #ii$ ,nilateral 9uota, #iii$ Mixing 9uota, #iv$ Bilateral 9uota, and #v$ Import licensing% #e$ 3-port .uties! -hen world prices are higher than domestic prices, there is an incentive to export% In such a situation, a government may levy export duties% Export duties are used to prevent exports% The reason may be that exported commodities are re9uired domestically%