Introduction

The international Balance of Payments (BOP) of any country is a measure of its

economic performance as compared to the rest of the world. In this regard, it becomes
imperative to study the nations Balance of Payments trends, so that necessary corrective
policies and actions may be taken to improve the nations economic standing in the
world.
With respect to India, its BOP situation is quite delicate now. The problem of BOP
disequilibrium has been persisting in India right since independence, which led to the
BOP crisis of 1990-91. Even though the BOP situation has improved since then, BOP
management still remains one of the main concerns for Indian policy makers.
This report describes ,firstly, the structure of BOP (the manner in which BOP is
calculated) so that it is easier for the reader to appreciate the significance and
implications of the BOP trends and it then moves on to describe in detail the trends of
BOP in India right from Independence till today. Secondly, a list of all internal and
external factors for BOP disequilibria problem have also been listed as well as the
impacts of the various policies on Indias BOP, that the Government of India has
implemented. Both pros and cons of such policies have been evaluated. Lastly, further
policy recommendations have been made to further improve the current BOP scenario
and reduce the BOP deficits.

a) Objectives of study
The objective of this study is to investigate the causes of BOP disequilibria
prevailing in India and its various consequences on the Indian economy.
To Study likely trends in India BOP SINCE 2005-2013.
To study of BOP trends and its implications is very vital to gauge the growth and
development of various trade and financial transactions of the nation with the rest
of the world.
This paper, therefore, attempts to evaluate the trends and emerging challenges of
Indias Balance of Payments.
b) Methods of Research
This data has been collected by secondary sources such as Books, News Papers, Google
Search, Magazines and e-data.
c) Significance of study
Since the BOP of a nation is a measure of its economic strengths and weaknesses, the
study of BOP trends and its implications is very vital to gauge the growth and
development of various trade and financial transactions of the nation with the rest of the
world. Naturally, for any nation, its economy will thrive if it has a healthy BOP.
Generally, for nations, a healthy BOP indicates surplus in the overall trade balance, as
this maintains confidence in the economy and among investors.
India right now, is suffering from a Current Account (one of the components of BOP)
deficit. The following questions arise: Should Indian policy makers focus on narrowing
the Current Account deficit or should they maintain the same amount of deficit so as to
ensure long term local productivity and increased exports in the future? What strategies
are to be implemented by the policy makers to reduce the Current Account deficit? What
should be the optimum amount of Current Account deficit that a developing country like
India can handle? These questions clearly indicate that the BOP position plays a
significant role in governing the decisions of policy makers, which are crucial for any
economy.

Also, since credit ratings are based on BOP positions, flows of credit to businesses may
be affected because of them. Furthermore, predictions regarding foreign exchange rates
can also be made by studying BOP positions.
d) Review of Literature
The problem regarding the current BOP scenario of India is of significant importance.
According to Anita Chanda (Indias Balance of Payments-2010), Indias poor BOP
situation during the post independence period right till the 1990s was because of the
protectionist policies that India implemented. She also maintains that it was only because
of the New Economic Policy (NEP) regime that Indias BOP situation improved. She also
says that even though India has maintained a decent BOP position, BOP management still
remains an issue of concern for policy makers, as now India is exposed to every change
in the global scenario.
Manu Gupta (What is Balance of Payments and what does it mean for your business2009) is of the opinion that healthy BOP position term is relative to every country. While
developed countries have surplus in Current Account, developing countries like India
place more importance on Capital Account surplus. He also says that BOP position of a
country is of prime importance for a countrys trade as it influences the decisions of
policy makers.
Richard Pettiger (Is a Current Account deficit harmful? 2005) says that a current
account deficit can prove to be harmful only if the deficit is financed by borrowing or by
running down reserves as this leads to depreciation of the currency. He further says that if
however, the deficit is financed by long term investment; it can lead to increased
productive capacity and more exports and help in the growth of the economy.

Chapter Scheme
This study consists of the following chapters:
Chapter 1: Introduction
Chapter 2: India BOP
Chapter 3: Trends In India BOP since 2005-2013
Chapter 4: Conclusion

Chapter 2- Balance of Payments

Conceptual Framework
The balance of payments (BOP) of a country is the record of all economic transactions
between the residents of a country and the rest of the world in a particular period (over a
quarter of a year or more commonly over a year). These transactions are made by
individuals, firms and government bodies. Thus the balance of payments includes all
external visible and non-visible transactions of a country during a given period, usually a
year. It represents a summation of country's current demand and supply of the claims on
foreign currencies and of foreign claims on its currency.[1]
Balance of payments accounts are an accounting record of all monetary transactions
between a country and the rest of the world. [2] These transactions include payments for
the

country's exports and imports of goods, services, financial

capital,

and financial

transfers. The BOP accounts summarize international transactions for a specific period,
usually a year, and are prepared in a single currency, typically the domestic currency for
the country concerned. Sources of funds for a nation, such as exports or the receipts
of loans and investments, are recorded as positive or surplus items. Uses of funds, such as
for imports or to invest in foreign countries, are recorded as negative or deficit items.
When all components of the BOP accounts are included they must sum to zero with 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 counterbalanced in other
ways such as by funds earned from its foreign investments, by running down central
bank reserves or by receiving loans from other countries.
While the overall BOP accounts will always balance when all types of payments are
included, imbalances are possible on individual elements of the BOP, such as the current
account, the capital account excluding the central bank's reserve account, or the sum of
the two. Imbalances in the latter sum can result in surplus countries accumulating wealth,
while deficit nations become increasingly indebted. The term balance of payments often
refers to this sum: a country's balance of payments is said to be in surplus (equivalently,
5

the balance of payments is positive) by a specific amount if sources of funds (such as

export goods sold and bonds sold) exceed uses of funds (such as paying for imported
goods and paying for foreign bonds purchased) by that amount. There is said to be a
balance of payments deficit (the balance of payments is said to be negative) if the former
are less than the latter. A BOP surplus (or deficit) is accompanied by an accumulation (or
decumulation) of foreign exchange reserves by the central bank.
Under a fixed exchange rate system, the central bank accommodates those flows by
buying up any net inflow of funds into the country or by providing foreign currency
funds to the foreign exchange market to match any international outflow of funds, thus
preventing the funds flows from affecting the exchange rate between the country's
currency and other currencies. Then the net change per year in the central bank's foreign
exchange reserves is sometimes called the balance of payments surplus or deficit.
Alternatives to a fixed exchange rate system include a managed float where some
changes of exchange rates are allowed, or at the other extreme a purely floating exchange
rate (also known as a purely flexible exchange rate). With a pure float the central bank
does not intervene at all to protect or devalue its currency, allowing the rate to be set by
the market, and the central bank's foreign exchange reserves do not change, and the
balance of payments is always zero.
The balance of payments account of a country is constructed on the principle of doubleentry bookkeeping. Each transaction is entered on the credit and debit side of the balance
sheet. But balance of payments accounting differs from business accounting in one
respect. In business accounting, debits (-) are shown on the left side and credits (+) on the
right side of the balance sheet. But in balance of payments accounting, the practice is to
show credits on the left side and debits on the right side of the balance sheet.
When a payment is received from a foreign country, it is a credit transaction while
payment to a foreign country is a debit transaction. The principal items shown on the
credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the
form of gifts, grants, etc. from foreigners, borrowings from abroad, investments by

foreigners in the country, and official sale of reserve assets including gold to foreign
countries and international agencies.
The principal items on the Debit side (-) include imports of goods and services, transfer
(or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries,
investments by residents to foreign countries, and official purchase of reserve assets or
gold from foreign countries and international agencies.
These credit and debit items are shown vertically in the balance of payments account of a
country according to the principle of double-entry book-keeping.
Horizontally, they are divided into three categories:
The current account, the capital account, and the offcial settlements account or the
Official reserve assets account.
The balance of payments account of a country is constructed in Table 1.

BALANCE OF PAYMENTS
The balance of payments of a country is a systematic record of all economic transactions
between the residents of a country and the rest of the world. It presents a classified record
of all receipts on account of goods exported, services rendered and capital received by
residents and payments made by theme on account of goods imported and services
received from the capital transferred to non-residents or foreigners.
Reserve Bank of India
The above definition can be summed up as following: - Balance of Payments is the
summary of all the transactions between the residents of one country and rest of the
world for a given period of time, usually one year.
The definition given by RBI needs to be clarified further for the following points:
A.

Economic Transactions

An economic transaction is an exchange of value, typically an act in which there is

transfer of title to an economic good the rendering of an economic service, or the transfer
of title to assets from one economic agent (individual, business, government, etc) to
another. An international economic transaction evidently involves such transfer of title or
rendering of service from residents of one country to another. Such a transfer may be a
requited transfer (the transferee gives something of an economic value to the transferor in
return) or an unrequited transfer (a unilateral gift). The following are the basic types of
economic transactions that can be easily identified:
1.

Purchase or sale of goods or services with a financial quid pro quo cash or a
promise to pay. [One real and one financial transfer].
8

2.

Purchase or sale of goods or services in return for goods or services or a barter

transaction. [Two real transfers].

3.

An exchange of financial items e.g. purchase of foreign securities with payment

in cash or by a cheque drawn on a foreign deposit. [Two financial transfers].

4.

A unilateral gift in kind [One real transfer].

5.

A unilateral financial gift. [One financial transfer].

B.

Resident

The term resident is not identical with citizen though normally there is a substantial
overlap. As regards individuals, residents are those individuals whose general centre of
interest can be said to rest in the given economy. They consume goods and services;
participate in economic activity within the territory of the country on other than
temporary basis. This definition may turnout to be ambiguous in some cases. The
Balance of Payments Manual published by the International Monetary Fund provides
a set of rules to resolve such ambiguities.
As regards non-individuals, a set of conventions have been evolved. E.g. government
and non profit bodies serving resident individuals are residents of respective countries,
for enterprises, the rules are somewhat complex, particularly to those concerning
unincorporated branches of foreign multinationals. According to IMF rules these are
considered to be residents of countries in which they operate, although they are not a
separate legal entity from the parent located abroad.
International organisations like the UN, the World Bank, and the IMF are not considered
to be residents of any national economy although their offices are located within the
territories of any number of countries.
To certain economists, the term BOP seems to be somewhat obscure. Yeager, for
example, draws attention to the word payments in the term BOP; this gives a false
impression that the set of BOP accounts records items that involve only payments. The
truth is that the BOP statements records both payments and receipts by a country. It is, as
Yeager says, more appropriate to regard the BOP as a balance of international
transactions by a country. Similarly the word balance in the term BOP does not imply

that a situation of comfortable equilibrium; it means that it is a balance sheet of receipts

and payments having an accounting balance.
Like other accounts, the BOP records each transaction as either a plus or a minus. The
general rule in BOP accounting is the following:a)

If a transaction earns foreign currency for the nation, it is a credit and is

recorded as a plus item.

b)

If a transaction involves spending of foreign currency it is a debit and is

recorded as a negative item.

The BOP is a double entry accounting statement based on rules of debit and credit similar
to those of business accounting & book-keeping, since it records both transactions and
the money flows associated with those transactions. Also in case of statistical discrepancy
the difference amount is adjusted with errors and omissions account and thus in
accounting sense the BOP statement always balances.
Components of Balance of payments
The various components of a BOP statement are:

Current Account
Capital Account
IMF
SDR Allocation
Errors & Omissions
Reserves and Monetary Gold

BALANCE OF TRADE
Balance of trade may be defined as the difference between the value of goods and
services sold to foreigners by the residents and firms of the home country and the value
of goods and services purchased by them from foreigners. In other words, the difference
between the value of goods and services exported and imported by a country is the
measure of balance of trade.

10

If two sums (1) value of exports of goods and services and (2) value of imports of goods
and services are exactly equal to each other, we say that there is balance of trade
equilibrium or balance; if the former exceeds the latter, we say that there is a balance of
trade surplus; and if the later exceeds the former, then we describe the situation as one of
balance of trade deficit. Surplus is regarded as favourable while deficit is regarded as
unfavourable.
The above mentioned definition has been given by James. E. Meade a Nobel Prize
British Economist. However, some economists define balance of trade as a difference
between the value of merchandise (goods) exports and the value of merchandise imports,
making it the same as the Goods Balance or the Balance of Merchandise Trade. There
is n doubt that the balance of merchandise trade is of great significance to exporting
countries, but still the BOT as defined by J. E. Meade has greater significance.
Regardless of which idea is adopted, one thing is certain i.e. that balance of trade is a
national injection and hence it is appropriate to regard an active balance (an excess of
credits over debits) as a desirable state of affairs. Should this then be taken to imply that a
passive trade balance (an excess of debits over credits) is necessarily a sign of
undesirable state of affairs in a country? The answer is no. Because, take for example,
the case of a developing country, which might be importing vast quantities of capital
goods and technology to build a strong agricultural or industrial base. Such a country in
the course of doing that might be forced to experience passive or adverse balance of trade
and such a situation of passive balance of trade cannot be described as one of undesirable
state of affairs. This would therefore again suggest that before drawing meaningful
inferences as to whether passive trade balances of a country are desirable or undesirable,
we must also know the composition of imports which are causing the conditions of
adverse trade balance.
BALANCE OF CURRENT ACCOUNT
BOP on current account refers to the inclusion of three balances of namely
Merchandise balance, Services balance and Unilateral Transfer balance. In other words it
reflects the net flow of goods, services and unilateral transfers (gifts). The net value of the
11

balances of visible trade and of invisible trade and of unilateral transfers defines the
balance on current account.
BOP on current account is also referred to as Net Foreign Investment because the sum
represents the contribution of Foreign Trade to GNP.
Thus the BOP on current account includes imports and exports of merchandise (trade
balances), military transactions and service transactions (invisibles). The service account
includes investment income (interests and dividends), tourism, financial charges (banking
and insurances) and transportation expenses (shipping and air travel). Unilateral transfers
include pensions, remittances and other transfers for which no specific services are
rendered.
It is also worth remembering that BOP on current account covers all the receipts on
account of earnings (or opposed to borrowings) and all the payments arising out of
spending (as opposed to lending). There is no reverse flow entailed in the BOP on current
account transactions.
BASIC BALANCE
The basic balance was regarded as the best indicator of the economys position vis--vis
other countries in the 1950s and the 1960s. It is defined as the sum of the BOP on
current account and the net balance on long term capital, which were considered as the
most stable elements in the balance of payments. A worsening of the basic balance [an
increase in a deficit or a reduction in a surplus or even a move from the surplus to deficit]
was seen as an indication of deterioration in the [relative] state of the economy.
The short term capital account balance is not included in the basic balance. This is
perhaps for two main reasons:
a)

Short term capital movements unlike long term capital movements are relatively
volatile and unpredictable. They move in and out of the country in a period of less
than a year or even sooner than that. It would therefore be improper to treat short term
capital movements on the same footing as current account BOP transactions which
are extremely durable in nature. Long term capital flows are relatively more durable
12

and therefore they qualify to be treated along side the current account transactions to
constitute basic balance.
b)

In many cases, countries dont have a separate short term capital account as they
constitute a part of the Errors and Omissions Account.

A deficit on the basic balance could come about in various ways, which are not mutually
equivalent. E.g. suppose that the basic balance is in deficit because a current account
deficit is accompanied by a deficit on the long term capital account. The long term capital
outflow will, in the future, generate profits, dividends and interest payments which will
improve the current account and so, ceteris paribus, will reduce or perhaps reduce the
deficit. On the other hand, a basic balance surplus consisting of a deficit on current
account that is more than covered by long term borrowings from abroad may lead to
problems in future, when profits, dividends etc are paid to foreign investors.
THE OFFICIAL SETTLEMENT CONCEPT
An alternative approach for indicating, a deficit or surplus in the BOP is to consider the
net monetary transfer that has been made by the monetary authorities is positive or
negative, which is the so called settlement concept.
If the net transfer is negative (i.e. there is an outflow) then the BOP is said to be in
deficit, but if there is an inflow then it is surplus. The basic premise is that the monetary
authorities are the ultimate financers of any deficit in the balance of payments (or the
recipients of any surplus). These official settlements are thus seemed as the
accommodating item, all other being autonomous.
The monetary authorities may finance a deficit by depleting their reserves of foreign
currencies, by borrowing from the IMF or by borrowing from other foreign monetary
authorities. The later source is of particular importance when other monetary authorities
hold the domestic currency as a part of their own reserves. A country whose currency is
used as a reserve currency (such as the dollars of US) may be able to run a deficit in its
balance of payments without either depleting its own reserves or borrowing from the IMF
since the foreign authorities might be ready to purchase that currency and add it to its
13

own reserves. The settlements approach is more relevant under a system of pegged
exchange rates than when the exchange rates are floating.
THE CAPITAL ACCOUNT
The capital account records all international transactions that involve a resident of the
country concerned changing either his assets with or his liabilities to a resident of another
country. Transactions in the capital account reflect a change in a stock either assets or
liabilities.
It is often useful to make distinctions between various forms of capital account
transactions. The basic distinctions are between private and official transactions, between
portfolio and direct investment and by the term of the investment (i.e. short or long term).
The distinction between private and official transaction is fairly transparent, and need not
concern us too much, except for noting that the bulk of foreign investment is private.
Direct investment is the act of purchasing an asset and the same time acquiring control of
it (other than the ability to re-sell it). The acquisition of a firm resident in one country by
a firm resident in another is an example of such a transaction, as is the transfer of funds
from the parent company in order that the subsidiary company may itself acquire assets
in its own country. Such business transactions form the major part of private direct
investment in other countries, multinational corporations being especially important.
There are of course some examples of such transactions by individuals, the most obvious
being the purchase of the second home in another country.
Portfolio investment by contrast is the acquisition of an asset that does not give the
purchaser control. An obvious example is the purchase of shares in a foreign company or
of bonds issued by a foreign government. Loans made to foreign firms or governments
come into the same broad category. Such portfolio investment is often distinguished by
the period of the loan (short, medium or long are conventional distinctions, although in
many cases only the short and long categories are used). The distinction between short
term and long term investment is often confusing, but usually relates to the specification
of the asset rather than to the length of time of which it is held. For example, a firm or
individual that holds a bank account with another country and increases its balance in that
14

account will be engaging in short term investment, even if its intention is to keep that
money in that account for many years. On the other hand, an individual buying a long
term government bond in another country will be making a long term investment, even if
that bond has only one month to go before the maturity. Portfolio investments may also
be identified as either private or official, according to the sector from which they
originate.
The purchase of an asset in another country, whether it is direct or portfolio investment,
would appear as a negative item in the capital account for the purchasing firms country,
and as a positive item in the capital account for the other country. That capital outflows
appear as a negative item in a countrys balance of payments, and capital inflows as
positive items, often causes confusions. One way of avoiding this is to consider that
direction in which the payment would go (if made directly). The purchase of a foreign
asset would then involve the transfer of money to the foreign country, as would the
purchase of an (imported) good, and so must appear as a negative item in the balance of
payments of the purchasers country (and as a positive item in the accounts of the sellers
country).
The net value of the balances of direct and portfolio investment defines the balance on
capital account.
ACCOMMODATING & AUTONOMOUS CAPITAL FLOWS
Economists have often found it useful to distinguish between autonomous and
accommodating capital flows in the BOP. Transactions are said to Autonomous if their
value is determined independently of the BOP. Accommodating capital flows on the other
hand are determined by the net consequences of the autonomous items. An autonomous
transaction is one undertaken for its own sake in response to the given configuration of
prices, exchange rates, interest rates etc, usually in order to realise a profit or reduced
costs. It does not take into account the situation elsewhere in the BOP. An
accommodating transaction on the other hand is undertaken with the motive of settling
the imbalance arising out of other transactions. An alternative nomenclature is that capital
flows are above the line (autonomous) or below the line (accommodating). Obviously
15

the sum of the accommodating and autonomous items must be zero, since all entries in
the BOP account must come under one of the two headings. Whether the BOP is in
surplus or deficit depends on the balance of the autonomous items. The BOP is said to be
in surplus if autonomous receipts are greater than the autonomous payments and in deficit
if vice a versa.
Essentially the distinction between both the capital flow lies in the motives underlying a
transaction, which are almost impossible to determine. We cannot attach the labels to
particular groups of items in the BOP accounts without giving the matter some thought.
For example a short term capital movement could be a reaction to difference in interest
rates between two countries. If those interest rates are largely determined by influences
other than the BOP, then such a transaction should be labelled as autonomous. Other short
term capital movements may occur as a part of the financing of a transaction that is itself
autonomous (say, the export of some good), and as such should be classified as
accommodating.
There is nevertheless a great temptation to assign the labels autonomous and
accommodating to groups of item in the BOP. i.e. to assume, that the great majority of
trade in goods and of long term capital movements are autonomous, and that most short
term capital movements are accommodating, so that we shall not go far wrong by
assigning those labels to the various components of the BOP accounts. Whether that is a
reasonable approximation to the truth may depend in part on the policy regime that is in
operation. For example what is an autonomous item under a system of fixed exchange
rates and limited capital mobility may not be autonomous when the exchange rates are
floating and capital may move freely between countries.
BALANCE OF INVISIBLE TRADE
Just as a country exports goods and imports goods a country also exports and imports
what are called as services (invisibles). The service account records all the service
exported and imported by a country in a year. Unlike goods which are tangible or visible
services are intangible. Accordingly services transactions are regarded as invisible items
in the BOP. They are invisible in the sense that service receipts and payments are not
16

recorded at the port of entry or exit as in the case with the merchandise imports and
exports receipts. Except for this there is no meaningful difference between goods and
services receipts and payments. Both constitute earning and spending of foreign
exchange. Goods and services accounts together constitute the largest and economically
the most significant components in the BOP of any country.
The service transactions take various forms. They basically include 1) transportation,
banking, and insurance receipts and payments from and to the foreign countries, 2)
tourism, travel services and tourist purchases of goods and services received from foreign
visitors to home country and paid out in foreign countries by home country citizens, 3)
expenses of students studying abroad and receipts from foreign students studying in the
home country, 4) expenses of diplomatic and military personnel stationed overseas as
well as the receipts from similar personnel who are stationed in the home country and 5)
interest, profits, dividends and royalties received from foreign countries and paid out to
foreign countries. These items are generally termed as investment income or receipts and
payments arising out of what are called as capital services. Balance of Invisible Trade
is a sum of all invisible service receipts and payments in which the sum could be positive
or negative or zero. A positive sum is regarded as favourable to a country and a negative
sum is considered as unfavourable. The terms are descriptive as well as prescriptive.
BALANCE OF VISIBLE TRADE
Balance of visible trade is also known as balance of merchandise trade, and it covers all
transactions related to movable goods where the ownership of goods changes from
residents to non-residents (exports) and from non-residents to residents (imports). The
valuation should be on F.O.B basis so that international freight and insurance are treated
as distinct services and not merged with the value of goods themselves. Exports valued
on F.O.B basis are the credit entries. Data for these items are obtained from the various
forms that the exporters have fill and submit to the designated authorities. Imports valued
at C.I.F are the debit entries. Valuation at C.I.F. though inappropriate, is a forced choice
due to data inadequacies. The difference between the total of debits and credits appears in
the Net column. This is the Balance of Visible Trade.

17

In visible trade if the receipts from exports of goods happen to be equal to the payments
for the imports of goods, we describe the situation as one of zero goods balance.
Otherwise there would be either a positive or negative goods balance, depending on
whether we have receipts exceeding payments (positive) or payments exceeding receipts
(negative).
ERRORS AND OMISSIONS
Errors and omissions is a statistical residue. It is used to balance the statement because
in practice it is not possible to have complete and accurate data for reported items and
because these cannot, therefore, ordinarily have equal entries for debits and credits. The
entry for net errors and omissions often reflects unreported flows of private capital,
although the conclusions that can be drawn from them vary a great deal from country to
country, and even in the same country from time to time, depending on the reliability of
the reported information. Developing countries, in particular, usually experience great
difficulty in providing reliable information.
Errors and omissions (or the balancing item) reflect the difficulties involved in recording
accurately, if at all, a wide variety of transactions that occur within a given period of
(usually 12 months). In some cases there is such large number of transactions that a
sample is taken rather than recording each transaction, with the inevitable errors that
occur when samples are used. In others problems may arise when one or other of the
parts of a transaction takes more than one year: for example wit a large export contract
covering several years some payment may be received by the exporter before any
deliveries are made, but the last payment will not made until the contract has been
completed. Dishonesty may also play a part, as when goods are smuggled, in which case
the merchandise side of the transaction is unreported although payment will be made
somehow and will be reflected somewhere in the accounts. Similarly the desire to avoid
taxes may lead to under-reporting of some items in order to reduce tax liabilities.
Finally, there are changes in the reserves of the country whose balance of payments we
are considering, and changes in that part of the reserves of other countries that is held in
the country concerned. Reserves are held in three forms: in foreign currency, usually but
18

always the US dollar, as gold, and as Special Deposit Receipts (SDRs) borrowed from
the IMF. Note that reserves do not have to be held within the country. Indeed most
countries hold a proportion of their reserves in accounts with foreign central banks.
The changes in the countrys reserves must of course reflect the net value of all the other
recorded items in the balance of payments. These changes will of course be recorded
accurately, and it is the discrepancy between the changes in reserves and the net value of
the other record items that allows us to identify the errors and omissions.
UNILATERAL TRANSFERS
Unilateral transfers or unrequited receipts, are receipts which the residents of a country
receive for free, without having to make any present or future payments in return.
Receipts from abroad are entered as positive items, payments abroad as negative items.
Thus the unilateral transfer account includes all gifts, grants and reparation receipts and
payments to foreign countries. Unilateral transfer consist of two types of transfers: (a)
government transfers (b) private transfers.
Foreign economic aid or assistance and foreign military aid or assistance received by the
home countrys government (or given by the home government to foreign governments)
constitutes government to government transfers. The United States foreign aid to India,
for BOP 9but a debit item in the US BOP). These are government to government
donations or gifts. There no well worked out theory to explain the behaviour of this
account because these flows depend upon political and institutional factors. The
government donations (or aid or assistance) given to government of other countries is
mixed bag given for either economic or political or humanitarian reasons. Private
transfers, on the other hand, are funds received from or remitted to foreign countries on
person to person basis. A Malaysian settled in the United States remitting $100 a
month to his aged parents in Malaysia is a unilateral transfer inflow item in the Malaysian
BOP. An American pensioner who is settled after retirement in say Italy and who is
receiving monthly pension from America is also a private unilateral transfer causing a
debit flow in the American BOP but a credit flow in the Italian BOP. Countries that attract
retired people from other nations may therefore expect to receive an influx of foreign
19

receipts in the form of pension payments. And countries which render foreign economic
assistance on a massive scale can expect huge deficits in their unilateral transfer account.
Unilateral transfer receipts and payments are also called unrequited transfers because as
the name itself suggests the flow is only in one direction with no automatic reverse flow
in the other direction. There is no repayment obligation attached to these transfers
because they are not borrowings and lendings but gifts and grants exchanged between
government and people in one country with the governments and peoples in the rest of
the world.
Is Balance of Payments Always in Equilibrium?
Balance of payments always balances means that the algebraic sum of the net credit and
debit balances of current account, capital account and official settlements account must
equal zero. Balance of payments is written as.
B = Rf -Pf
B =where, represents balance of payments,
Rf receipts from foreigners,
Pf payments made to foreigners.
When = Rf-- Pf = 0, the balance of payments is in equilibrium.
When Rf Rf > 0, it implies receipts from foreigners exceed payments made to foreigners
and there is surplus in the balance of payments. On the other hand, when R f - Pf < 0 or
Rf < Pf - there is deficit in the balance of payments as the payments made to foreigners
exceed receipts from foreigners.
If net foreign lending and investment abroad are taken, a flexible exchange rate creates an
excess of exports over imports. The domestic currency depreciates in terms of other
currencies.

20

The export becomes cheaper relatively to imports. It can be shown in equation

form:
X + = M + If
Where X represents exports, M imports, 1, foreign investment, foreign borrowing
or X-M= If -B
or (X-M)-(If -B) = 0
The equation shows the balance of payments in equilibrium. Any positive balance in its
current account is exactly offset by negative balance on its capital account and vice versa.
In the accounting sense, the balance of payments always balances. This can be shown
with the help of the following equation:
C + S + T= C + I + G + (X-M)
or Y=C + I + G + (X M) [. Y = + S + T]
where represents consumption expenditure, S domestic saving, T tax receipts, I
investment expenditures, G government expenditures, X exports of goods and services,
and M imports of goods and services.
In the above equation
+ S + T is GNI or national income (Y), and
+ I + G =A,
where A is called absorption.
In the accounting sense, total domestic expenditures ( + I + G) must equal current
income (C + S + T) that is A = Y. Moreover, domestic saving (S d) must equal domestic
investment (7d). Similarly, an export surplus on current account (X > M) must be offset
21

by an excess of domestic savings over investment (S d > Id). Thus the balance of payments
always balances in the accounting sense, according to the basic principle of accounting.
In the accounting system, the inflow and outflow of a transaction are recorded on the
credit and debit sides respectively. Therefore, credit and debit sides always balance. If
there is a deficit in the current account, it is offset by a matching surplus in the capital
account by borrowings from abroad or/and withdrawing out of its gold and foreign
exchange reserves, and vice versa. Thus, the balance of payments always balances in this
sense also.

Measuring Deficit or Surplus in Balance of Payments

If the balance of payments always balances, then why does a deficit or surplus arise in the
balance of payment of a country? It is only when all items in the balance of payments are
included that there is no possibility of a deficit or surplus. But if some items are excluded
from a countrys balance of payments and then a balance is struck, it may show a deficit
or surplus.
There are three ways of measuring deficit or surplus in the balance of payments:
First, there is the basic balance which includes the current account balance and the longterm capital account balance.
Second, there is the net liquidity balance which includes the basic balance and the shortterm private non-liquid capital balance, allocation of SDRs, and errors and omissions.
Third, there is the official settlements balance which includes the total net liquid balance
and short-term private liquid capital balance.
If the total debits are more than total credits in the current and capital accounts, including
errors and omissions, the net debit balance measures the deficit in the balance of

22

payments of a country. This deficit can be settled with an equal amount of net credit
balance in the official settlements account.
On the contrary, if total credits are more than total debits in the current and capital
accounts, including errors and omissions, the net debit balance measures the surplus in
the balance of payments of a country. This surplus can be settled with an equal amount of
net debit balance in the official settlements account.
Persistent 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 (b) affects the progress of the economy adversely.
It must be cured by taking appropriate measures. There are many methods to 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 money income of the people.
The central bank, by raising the bank rate, by selling the securities in the open market and
by other methods can reduce the volume of credit in the economy which will lead to a fall
in prices and money income of the people.
Fall in prices will stimulate exports and reduction in income checks imports. Thus,
deflationary policy restores equilibrium to the balance (a) by encouraging exports
through reduction in their prices and (b) by discouraging imports through the reduction in
incomes at home.
Moreover, a higher interest rate in the domestic market will attract foreign funds which
can be used for correcting disequilibrium.

23

However, deflation is not considered a suitable method to correct adverse balance of

payments because of the following reasons: (a) Deflation means reduction in income or
wages which is strongly opposed by the trade unions, (b) 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 the
developmental needs.
2. Depreciation:
Another method of correcting disequilibrium in the balance of payments is depreciation.
Deprecation means a fall in the rate of exchange of one currency (home currency) in
terms of another (foreign currency).
A currency will depreciate when its supply in the foreign exchange market is large in
relation to its demand. In other words, a currency is said to depreciate if its value falls in
terms of foreign currencies, i.e., if more domestic currency is required to buy a unit of
foreign currency.
The effect of depreciation of a currency is to make imports dearer and exports cheaper.
Thus, depreciation helps a country to achieve a favourable balance of payments by
checking imports and stimulating exports.
Exchange depreciation is automatic:
It works in a flexible exchange rate system and can correct a mild adverse balance of
payments if the country's demand for imports and the foreign demand for its exports are
fairly elastic. But the method of exchange depreciation has the following defects:
(i) It is not suitable for a country which follows a fixed exchange rate system.
(ii) It makes international trade risky and thus reduces the volume of trade.

24

(iii) The terms 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.
(iv) Experience of certain countries has indicated that exchange depreciation may
generate inflationary pressure by increasing the domestic price level and money income.
(v) The success of the method of exchange depreciation depends upon the cooperation of
other countries. If other countries also start depreciating their exchange rates, then these
methods will not benefit any country.
3. Devaluation:
Devaluation refers to the official reduction of the external values of a currency. The
difference between devaluation and depreciation is that while devaluation means the
lowering of external value of a currency by the government, depreciation means an
automatic fall in the external value of the currency by the market forces; the former is
arbitrary and the latter is the result of market mechanism.
Thus, devaluation serves only as an alternative method to depreciation. Both the methods
imply the same thing, i.e., decrease in the value of a currency 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 :
(i) 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.
(iii) The exports of the country should be non-traditional and the increasingly demanded
from other countries.
25

(iv) The domestic price should not rise and should remain stable after devaluation.
(v) 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:
(i) Devaluation is a clear revelation on the country's economic weakness.
(ii) It reduces the confidence of the people in country's currency and this may lead to
speculative outflow of capital.
(ii) It encourages inflationary tendencies in the home country.
(iv) It increases the burden of foreign debt.
(v) It involves large time lag to produce effects.
(vi) It is a temporary device and does not provide a permanent remedy to correct adverse
balance of payments.
4. Exchange Control:
Exchange control is the most widely used method for correcting disequilibrium in the
balance of payments. Exchange control refers to the control over the use of foreign
exchange by the central bank.
Under this method, all the exporters are directed by the central bank to surrender their
foreign exchange earnings. Foreign exchange is rationed among the licensed importers.
Only essential imports are permitted.
Exchange control is the most direct method of restricting a country's imports. The major
drawback of this method is that it deals with the deficit only, and not its causes. Rather it
may aggravate these causes and thus may create a more basic disequilibrium. In short,
exchange control does not provide a permanent solution for a chronic disequilibrium.
26

Chapter3: Trends in India BOP SINCE 2000

HISTORY OF INDIAS BOP SINCE INDEPENDENCE
Period from 1949-1991:

Throughout this period, the BOP situation of India remained weak, because of the
protectionist policies that were implemented by the Indian government. The
Current Account was in excess of 3% of GDP during this period. Under Capital
27

Account, foreign aid and commercial borrowings were used to balance the CA

deficit.
Indias main aim after attaining independence was to achieve self-reliance. This
was the main objective of the Second Five-year Plan.

It implemented

protectionist policies like import substitution, with gross neglect on exports. The
capital goods industry remained, to a large extent, import intensive. The Indian
economy was put under further strain because of the increasing petroleum
products demand, domestic inflation, the two oil shocks and harvest failure.
Because of this and also because of the recession in the 1980s, Indias BOP

situation deteriorated.
This BOP deterioration saw the External Debt situation of India change from bad
to worse because the government resorted to large borrowings to rectify the BOP
situation in the short run. The constant depreciation of the Rupee to promote
exports also raised the amount of External Debt. The country was on the verge of

defaulting.
Although the process of liberalization began from the mid 1980s, the situation
was already very bad, and all this mismanagement ultimately culminated in the
1990-91 BOP crisis.

Period from 1990-99:

The BOP crisis of 1990-91
The triggering factors for this crisis were primarily the growing fiscal deficits,
rapid accumulation of external debt, the Gulf War and the Oil Price Shock, very

low foreign currency reserves and threat of default on external debt repayments.
The New Economic Policy (NEP) was implemented to combat this BOP crisis,
which focused on liberalization and globalization of the economy. This opened up
the Indian economy and lifted the restrictions on free trade, allowed foreign
investments and introduced a new Liberalized Exchange Management System to
avail the benefits and advantages of a competitive market. Apart from this, other
economic restructuring was done to counter the weak BOP position of India.
Some of them were float of the Rupee, Industrial delicensing, fiscal adjustment,
tight caps on external borrowing and lowering of direct and indirect taxes.

28

The BOP position of India steadily became more stable, after overseeing the
initial doubts during the period 1991-99.

Period from 2000-present:

Since 2000, the BOP position of India went through ups and downs until 2008.
The Current Account (CA) balance was positive till 2004, after which it started
decreasing and the CA balance became negative. The Capital Account (KA)
increased gradually till 2008. This was possible because of the liberalized policy

that India implemented.

The CA balance widened in 2008-09 (-2.4% of GDP) as compared to 2007-08 (1.3% of GDP). The overall balance went into negative figures, and the KA
balance decreased substantially as well. This happened because of the global

recession that took place during that period.

After the recession, as the economy improved and picked up momentum again,
the BOP position improved. Both the overall and KA balance continued to
improve. However, the CA balance still continued to deteriorate.

Currently, Indias foreign exchange reserves are quite comfortable, exchange rate is
pretty competitive and exports and capital inflow through FDIs are also encouraging.
The BOP situation of India is fairly well managed, although it rests on a very
precarious position. The main concern for India now, is the increasing Current
Account deficit.

Trends in India Bop

Indias Balance of Payments picture since 1991

Independent Indias external trade and performance had faced severe threats many a
times.The most challenging one was that of 1991.The economic crisis of 1991 was
primarily due to the large and growing fiscal imbalances over the 1980s. Indias balance
of payments in 1990-91 also suffered from capital account problems due to a loss of
investor confidence. The wideningcurrent account imbalances and reserve losses
29

contributed to low investor confidence putting theexternal sector in deep dilemma.

During 1990-91, the current account deficit steeply hiked to $-9680 million while the
capital account surplus was far below at $ 7188 million. This led to anever time high
deficit in BoP position of India. bIndia initiated economic reforms to find the way out of
the growing crisis. Structural measures emphasized accelerating the process of industrial
and import delicensing and then shifted to further trade liberalization, financial sector
reform and tax reform. Prior to 1991, capital flows to India predominately consisted of
aid flows, commercial borrowings, and nonresident Indian deposits. Direct investment
was restricted, foreign portfolio investment was channeled almost exclusively into a
small number of public sector bond issues, and foreign equity holdings in Indian
companies were not permitted (Chopra and others, 1995). However, this development
strategy of both inward-looking and highly interventionist, consisting of import
protection, complex industrial licensing requirements etc underwent radical changes with
the liberalization policies of 1991. The post reform period really eased Indias struggles
with regard to external sector. This is evident from the RBI data summarizing the BOP in
current account and capital account. The current account which measures all transactions
including exports and imports of goods and services, income receivable and payable
abroad, and current transfers from and to abroad remained almost negative throughout the
post reform period except for the three financial years. Until 2000-01, the current account
deficit that comprises both trade balance and the invisible balance, remained stagnant and
stood around $ 5000 million. However, for the first time since 1991, the current account
recorded surplus in its account during three consecutive financial years from 2001-02.
The deficit in current account continued to occur from 2004-05 onwards and the from
2001-02. The deficit in current account continued to occur from 2004-05 onwards and the
growth rate was comparatively faster. Surprisingly, the current account deficit grew like
anything since 2007-08, the period witnessed financial crisis. The current account balance
of India during 2011-12 is recorded to be $ - 78155 million, signifying a deficit eight
times that of the figures of 2007-08. Huge negative debits and comparatively low positive
credits caused for this negative value in current account. Another notable feature of
current account balance is that the deficit was mounting during the previous years. Two
major items of current account are merchandise and the invisibles. These two items
30

generate the value of current account balance of the country. The net merchandise has
been always found to be huge negative figure. During 2011-12 it was recorded to be $ 189759 million. During the same period, our total merchandise credit was $ 309774
million while our merchandise debit was $ 499533 million. This is a common feature of
Indias merchandise figures during all the years. The recent crisis of 2008 affected the
trade performance of India in a large way. Indian economy had been growing robustly at
an annual average rate of 8.8 per cent for the period 2003-04 to 2007-08. Concerned by
the inflationary pressures, Reserve Bank of India (RBI) increased the interest rates, which
resulted in a slowdown of Indias trade flows prior to the Lehman crisis (Kumar and
Alex, 2009). The trade flows, which are one of the important channels through which
India was affected during the recent global crisis of 2008, started to collapse from late
2008. Merchandise trade, software exports and remittances declined in absolute terms in
response to the exogenous external shock. The growing trade deficit since 2008 can be
attributed to destination wise collapse of Indias exports. Trade with US, EU and Asia
(Indias most important trading partners) fell considerably during the year 2009, with the
least being in case of Asia. As a result, the value of export reduced from $ 189001 million
during 2008-09 to $ 189442 million during 2009-10. During the same period of economic
crisis, our import bill too declined from $ 308520 million to $ 300644 million. This fact
certifies the phenomenon that Indian trade flows was hit by the global crisis, but with a
lag. However, Indian economy could find way out of the crisis driven path to the
recovery as a result of various measures implemented by the Reserve Bank of India.

Emerging role of invisibles and software services in Balance of Payments

Indias balance of payments, which is built up of a large trade deficit sustained by large
positive invisible inflows, is truly a miracle of the new service-oriented global economy.
The liberalized environment has made India's services attractive to the new IT dependent
sector of the developed countries. The trade deficit is financed largely by net invisible
earnings consisting of remittances from expatriates and software. The importance of
invisibles in the BoP is increasing in the post reform period. A notable development
found in the performance of Indias current account is the growing contribution of the
invisibles. Among the three components such as services, transfers and income, the
31

largest surplus is generated by the services followed by transfers while income flow is
greater from India adding net deficit in the BoP account. The net invisible to the current
account was deficit during 1990-91 worth $ 242 million. However, the post reform period
witnessed rapid growth in this category contributing a large surplus to Indias BoP
account. This surplus though not enough to eliminate the merchandise deficit, could
contribute significantly to neutralize the magnitude of the impact of the huge deficit.
From 2001-02 onwards, the growth of invisibles was at very high rate. Interestingly, it
grew from $ 14974 million during 2001-02 to $ 91605 million during 2008-09. The very
next two consecutive years, global crisis affected the net flow of invisibles as the surplus
from it declined to $ 80022 million and $ 84648 million respectively. However, 2011-12
figures show that net invisibles in the current account is positive and very high in value
i.e. $ 111604 million. It can be found that value has almost doubled within a gap of just 6
years. The mounting share from software services shows another optimistic external
sector picture. Software services include the software related services offered by Indian
IT professional to foreigners including those done by the IT parks. Notable feature is that
the credit from this item is very huge say for instance, during 2011-12, it stood at $ 62212
million while the debit i.e., the amount we pay out for foreign software services was only
a meager figure - $ 1256 million only. The growth of Indias IT sector especially during
the period of globalization turned favorably. The growth of software services earnings is
a recent development in the reform period. India possesses huge manpower
professionally equipped with software services potentials who find the way in earning
foreign exchange by exporting the services. The NASSCOM data exhibits the growing
share of software services in Indias current account balance. The Total software services
exports was only $754 million during 1995-96. The total software export contribution
increased unbelievably in the years of economic liberalization. The earnings from
software services multiplied several times within a decade of time i.e., it increased from $
7556 million during 2001-02 to $ 60956 million during 2011-12. The growth rate was
steady and above 10 percent during every year despite the global challenges put forward
by the so called financial crisis. Interestingly the debit in this item is very narrow say $
1256 million during 2011-12 that declined from $2267 million during 2006-07. United
States remained the major destination for software services exports from India.
32

Unhealthy trends in Foreign Direct Investment

Foreign direct investment (FDI) has played an important role in the process of
globalization during the past two decades. The rapid expansion in FDI by multinational
enterprises since the mid-eighties may be attributed to significant changes in
technologies, greater liberalization of trade and investment regimes, and deregulation and
privatization of markets in many countries including developing countries like India. The
widening gap of deficit in Indias current account is always compensated by the surplus
accumulated in capital account. Major components in the capital account are foreign
investment and borrowings. There are several studies revealing the relevance of FDI in
the economy. Some of the literature reviews are worth mentioning at this moment. FDI
plays a multidimensional role in the overall development of host economies. It is widely
discussed in theliterature that, besides capital flows, FDI generates considerable benefits.
These include employment generation, the acquisition of new technology and knowledge,
human capital development, contribution to international trade integration, creation of a
more competitive business environment and enhanced local/domestic enterprise
development, flows of ideas and global best practice standards and increased tax
revenues from corporate profits generated by FDI (Klein et al., 2001;Tambunan, 2005)
FDI in manufacturing is generally believed to have a positive and significant effect on a
countrys economic growth(Alfaro, 2003).
Total FDI inflows into India during 1991-92 were only $ 129 million. There was gradual
increase in inflows during that decade and it reached $ 6130 million during 2001-02.
Though the inflow fluctuated during first part of 2000s the year 2006-07 witnessed 154
percent hike in inflow which is treated as the highest in the last two decades. However,
during the global recession the inflow was negatively affected showing negative growth
during 2009-10 and 2010-11. The Indian economy regained confidence of the foreign
investors during 2011-12 attracting $49007 million. The huge sum of FDI inflow is
contributing significantly in reducing the deficit in Indias current account and
maintaining surplus in overall balance of payment account. Along with mounting credits
in foreign investment account, there is growing debits in it in the form of capital outflow.
It can be noted that the total outflow of FDI from India was only $ 829 million during
33

2000-01. Until 2004-05, the growth rate of outflow was moderate but thereafter, the FDI
outflow increased significantly. During last five years, the outflow stood above $ 20000
million which seems unhealthy for India capital account is concerned. The logic behind
this trend is that Indian companies are reaching overseas destinations to tap new markets
and acquire technologies. Acquisitions bring with them major benefits such as existing
customers, a foothold in the destination market and the niche technologies they require.
Due to the rapid growth in Indian companies M&A activity, Indian companies are
acquiring international firms in an effort to acquire new markets and maintain their
growth momentum, buy cutting-edge technology, develop new product mixes, improve
operating margins and efficiencies, and take worldwide competition head-on. It is noted
that inflow of FDI has got very favorable impact on Indias BoP balance. However, the
danger alarmingly growing on the other side of the coin is in the form of outflow of FDI
from India and massive withdrawal of foreign funds from the domestic economy.
d) Vulnerability and challenges ahead
Post 1991 crisis, Indian economists have managed to reduce the external debt through
various strategies. They have succeeded as India withstood the global 2008 downturn
well. But now, troubles are looming large over our emerging economy. After the 2008
downturn of global economy, the vulnerability of Indias external sector has increased.
The latest report from Reserve Bank of India about the rising external debt is a case of
worry for the government. According to the data given by the Reserve Bank of India,
Indias external debt stood at $390 billion as of March 2013, which was up by 12.9 %
from its previous year figure. External debt is a cumulative sum of External Commercial
Borrowings (ECBs), Foreign Currency Convertible Bonds (FCCBs) and trade bill of the
country. Any countrys inability to repay the external debt may lead to a crisis situation
and worsen our balance of payment sustainability in near future. Yet another challenge to
BoP emerges today in the form of rupee depreciation. The Indian Rupee has been losing
its value against the US Dollar marking a new risk for Indian economy. Grim global
economic outlook along with high inflation, widening current account deficit and FII
outflows have contributed to this fall. Though RBI has responded with timely
interventions by selling dollars intermittently, in times of global uncertainty, investors
34

prefer USD as a safe haven. To attract investments, RBI can ease capital controls by
increasing the FII limit on investment in government and corporate debt instruments and
introduce higher ceilings in ECBs, which may ultimately attract BoP burden on the
economy. Government can create a stable political and economic environment. The
depreciation of the rupee was brought about by the adverse external trade position and the
depreciation of regional currencies. It was an inevitable response to the balance of
payments difficulties caused by a huge trade deficit. The deterioration in Indias current
account and thereby overall BoP has led to a series of debates in the policy arena r lating
to sustainability, the importance ofexchange rates in influencing the trade balance, and
the role of high and rising inflation. Appropriate exchange rate policies, monetary
policies and fiscal policies are vital to ensure economic stability and growth. The
depreciation of the currency is one of the means of correcting the trade deficit to
manageable proportion. Higher interest rates, containment of the fiscal deficit and control
public expenditure that restrains imports are crucial to containing the trade deficit. This is
especially so with respect to oil imports that is the single most import expenditure. A
depreciating rupee is not the only concern that Indian economy is striving to retrieve for
the moment. The bigger challenge is to reduce external sector vulnerability. Boosting
investor confidence remains the key to attracting capital flows. Fiscal consolidation,
reducing inflation and further careful liberalization of capital inflow could all contribute
towards creating an environment conducive to domestic and foreign investors.
Sustainability and strength of Balance of Payments, being the symptoms of economys
strength and competitiveness in the global scene, need to be maintained using every
tough measure possible.
Analysis of the current BOP POSISTION AND ITS IMPACT ON ECONOMY
As mentioned earlier, BOP of any nation has two components:

Current Account (CA)

Capital Account (KA)

Currently, India has a CA deficit and a KA surplus. Its BOP situation is precarious and
unless India treads with caution, it might worsen again.
35

A Current Account deficit can have both favourable and unfavourable impacts on the
Indian economy. Both the merits and the demerits of a CA deficit have been presented
below, through a detailed analysis.
Merits of CA Deficit
A Current Account deficit is not necessarily harmful to certain economies. For
developing countries like India, a CA deficit may prove itself useful to the economy in
the long run. Following are the advantages of a CA deficit:
Sound Capital Market
India is emerging as one of the most favoured venues for overseas investments, especially
after the global recession of 2008. It has one of the most open and sound capital markets
in the world, and since so far, after 2008, financing a trade deficit in goods and services
has not led to a sharp decline in the value of the Rupee, there is little need to be
concerned about the CA deficit. In such a case, a CA deficit will only serve to strengthen
a developing economy like India.
Current Account financed by foreign investment

A Current Account deficit can be considered to be a by-product of Indias rapid economic

growth and its appeal as a hot destination for foreign investment.
CA = S I, where
S = Savings &
I = investments
According to this relation, a CA deficit exists when I>S, as a result of which foreign
investment occurs. Whenever I>S, the overspending or the investments abroad must be
financed by foreign investment. This implies that there will exist a KA surplus, because
more and more foreign firms will invest capital in India, thus making up for the CA
deficit. India currently has a CA deficit; this simply indicates that India is importing

36

capital from abroad. This can in turn allow India to increase its exports and eventually,
reverse its deficit.
Benefits of Long term Investment
CA deficit is financed partly by long term investment. In such a scenario, India stands to
gain a lot from the benefits of long term investment, which include:

Increased productive capacity

Favourable working practices of foreign firms
More jobs
Increased exports in the distant future

CA deficit as an engine of growth

A Current Account deficit for India indicates a growing demand for imports, and only if
Indias economy is growing and expanding as well as creating jobs and Disposable
Income can there be an increase in the demand for imports. This clearly shows that there
is a direct coherence to Indias CA deficit and its economic growth.
Demerits of CA Deficit
There are a number of reasons why a CA deficit can prove detrimental to Indias
economy. Some of them are:
Financing of CA deficit by Borrowing
Financing of CA deficit through borrowing or running down reserves will prove
unsustainable in the long run. This in turn would lead to depreciation of the Rupee as the
supply of the Rupee would exceed it demand. Such a rapid depreciation will in turn lead
to problems like inflation and falling confidence in India. Imported good will become
more expensive and depreciation of the Rupee will reduce the living standards.

37

Low Competitiveness
Indias CA deficit has been persisting since 2004 and has been increasing since then.
Such a persisting deficit suggests a fundamental weakness in the Indian economy. It may
lead to:

Decreasing competitiveness
Decreasing productive capacity
Declining comparative advantage in various manufactured goods

These factors could have a profound and adverse impact on job creation in India, leading
to unemployment, thereby worsening the situation and leading to lower growth and
development of the economy.
Increasing claim on Indian assets by foreigners
India has primarily relied upon attracting foreign investment in the form of FDIs and
FIIs to finance the CA deficit. This means that foreigners now have an increasing claim
on Indian assets. If the foreigners were to withdraw their investment from India due to
some economic crisis, it would leave India highly vulnerable.
Drying up of Capital Flows
Since the rates of borrowing from other countries is pretty high, Capital
flows may dry up and India will no longer be able to finance its CA
deficit by attracting capital flows from different countries. This will in
turn pile up the external debt burden of India.
Lower Economic Growth
If the Indian CA deficit is due to excessive consumer demand, a recession or slowdown
will help to resolve the problem. As consumers cannot go on spending far in excess of
their income forever, they have to start saving and controlling their expenditure to
improve their own finances. To accomplish this, both high interest rates and significant

38

reductions in consumer spending will be required, and this could ultimately push India
into recession or slowdown of the economy, leading to overall lower economic growth.
Replacement of Domestic Products with Imported Goods
Since India faces a CA deficit, most often domestic products are replaced by imported
goods, and thus, when the imported goods are growing, it signals a weakening Indian
economy.

39

POLICY SUGGESTIONS AND RECOMMENDATIONS

Based on the merits and demerits of the current BOP situation in which the Current
Account deficit has deteriorated since 2004, as a result of the overheating of the Indian
economy, and keeping in mind the various factors responsible for the current BOP
situation in India, the following policy suggestions have been made:

Devalue the Rupee by lowering the interest rates. This will make exports cheaper
to foreign buyers; while at the same time make foreign goods more expensive.
Such a policy would increase the exports and at the same time lead to a reduction
in imports, thus ensuring that CA deficit is reduced. However, such a policy
measure can also lead to inflation. So care must be taken as to not lower the

interest rates too much that it puts an inflationary pressure on the Indian economy.
Lower aggregate demand by raising taxes or cutting down on spending. This will

decrease the demand for imports, thus ensuring that CA deficit is reduced.
Raise import tariffs, import quotas and other non-tariff barriers so as to decrease
the demand for imports and keep the foreign goods out. This would also lead to a

reduction in Indias CA deficit.

Set up tax-free export processing zones and subsidize capital to exporting sectors.
Such policies will channel resources to the exporting sectors and therefore the

exports will rise, thus correcting the CA deficit problem in India.

Build an infrastructure that makes it conducive and far easier to export.
Implement policies that attract direct foreign investment into the Indian economy
as well as those policies that attract short term flows of money in the Indian

banking sector.
Contract the money supply as this will reduce consumption and reduce the

demand for imports, thereby improving Indias current BOP situation.

Implement policies that provide subsidies or incentives to export producers. This

will ensure large volume of exports and will help in combating the CA deficit.
Adopt import substitution and introduce QRs thereby prohibiting imports and
solving Indias current CA def

CONCLUSION

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The volume of a countrys current account (one of the two main components of BOP) is a
good sign of economic activity. By analyzing the current account, one can get a clear
picture of the extent of economic activity of a country- including its industries and its
capital markets. However, depending on whether the nation is a developed or a
developing nation and its goals, the state of the current account decides whether the
economy is prospering or not.
Since India is a developing country, a Current Account deficit works well for Indias
economic progress as long as it is kept in check. However, since 2004, the Current
Account deficit of India has been increasing continuously and if it continues to increase,
Indias economic growth might become unsustainable. When analyzing the Current
Account of India, it is important to know what is fueling the extra deficit and what is
being done to counter the effects and whether the actions being taken are providing
results or not. The primary aim for India is to control this deficit before it gets out of
hand.
This report has dealt exclusively with the causal factors of BOP disequilibria in India and
various policy measures that reduce the demand for imports and increase exports have
been suggested that can combat the Current Account deficit of India.

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Bibliography
A. Reference books
Margaret Garritsen De Vries, March 15 1987, Balance of Payments Adjustment,
1945 to 1986: The IMF Experience, International monetary fund
International Monetary fund,1977,The monetary approach to balance
of payments ,imprint of epub direct
Cathelline.A.Petillo, Andre Berg, Jan 24 2000,Anticipating the Balance
of Payments crises,International Monetary Fund.

B. E-data
http://en.wikipedia.org/wiki/Balance_of_payments#Causes_of_BOP_imbalances
https://www.scribd.com/search?query=BALANCE+OF+PAYMENTS
http://study-material4u.blogspot.in/2012/07/chapter-15-emerging-trends-inindias.html
http://www.yourarticlelibrary.com/economics/balance-of-payments-of-a-countrymeaning-components-and-other-information/29236/

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