BALANCE OF PAYMENTS ADJUSTMENTS

When we discuss import licensing policy or exchange control we assume that the objective of the government is to restrict import so that the domestic import competing industries are given encouragement to expand and replace imported goods. Very often, however, the government’s objective is not so much to promote import substitution (because the country may not even produce the goods that are imported) but to reduce the import bill. This takes us to the concept of the balance of payment. Every country is like a company vis-a-vis the rest of the world and it has to settle accounts with the other countries. The statement of a country's financial transactions with the rest of the world is called the balance of payment statement. You may look at any issue of Economic Survey for India’s balance of payment statement. You have also learnt the balance of payment in Unit 3. To recapitulate, the statement is divided into three parts: the current account, the capital account and the official account, the entries in the current account show values of exports and imports during the financial year. The difference between the value of export and the value of imports (in rupees or dollars) is the balance on trade account. So we have a trade surplus or a trade deficit depending on whether the balance on trade account is positive or negative. There are other entries in the current account, like travel or tourism which are called invisibles. The invisibles are also like exports and imports of goods. When a foreign traveler comes to India and purchases hotel services, it is our invisible export. When our tourists go abroad and do the same thing, it is our invisible import. The balance on invisible trade (export minus import) plus the balance on trade account (trade deficit or surplus) is called the current account balance. Then we come to the capital account of the balance of payment statement. The transactions here are in the nature of capital import or export. If the government of India or an Indian company makes an investment abroad, say by purchasing a financial asset, it is capital export. If the foreigner invests in India it is capital import. The foreign investment may be either direct investment or portfolio investment. If a foreign company comes to India and sets up a factory or a shop to do business directly with the Indian people, it is direct investment. On the other hand, if the foreigner simply invests in shares and bonds floated by Indian companies, it is portfolio investment. There is an element of asymmetry between current account and capital account. In current account imports are items for which we make payments to the foreigners and exports are our receipts from the foreigners. In the capital account import of capital is a receipt item and the export of capital is a payment item. Therefore the balance on capital account is total capital import minus total capital export and a positive balance is a surplus and a negative balance is a deficit.

The total balance, i.e., the balance on current account plus the balance on capital account is called the balance of payment which may show an overall deficit or surplus. A country may have a deficit in the current account but a surplus in the capital account and an overall deficit in the balance of payment. This was precisely the position in India’s balance of payment in the last financial year. A balance of payment deficit simply means that certain payments are due to the foreigners and a surplus means that the foreigners are indebted to us in respect of certain payments. Since a deficit or a surplus needs adjustment, we have an official account showing how this adjustment is made. A BOP deficit may be adjusted by the Reserve Bank of India through sale of foreign currencies released from the foreign exchange reserves, or by borrowing from the International Monetary fund or by foreign aid. A surplus may be adjusted by increasing the foreign exchange reserves. When all these official transactions take place, the grand balance, i.e., balance on current account plus balance on capital account plus balance on official account, becomes zero and this has to happen by the law of accounting.

METHODS OF CORRECTING DISEQUILIBRIUM IN B.O.P.

When such a situation of disequilibrium arises, the following measures are usually adopted.

i) Use of past reserves 

ii) Borrowings from IMF 

iii) Monetary and fiscal policy measures 

iv) Exchange rate adjustments. 

Let us learn them in detail. 

Use of Past reserves: A country may make use of past reserves to finance the BOP deficit provided such reserves are available. Such reserves consist of gold, foreign currencies and fund related assets i.e., reserve position with the IMF and holdings of special drawing rights. In recent years, increase in quotas and additional allocations of SDRs and expanded private capital flows have contributed to an overall increase in national reserves of several countries. 

Borrowing from IMF: Countries with disequilibrium in B.O.P. Can make use of IMF facilities. These are: 

1. Stand by loans 

2. Extended Fund Facilities (EFF) 

3. Structure Adjustment Facilities (SAF) 

4. Enlarged Structural Adjustment Facilities (ESAF) 

5. Compensatory and Contingency Financing Facilities (CCFF) 

6. Systemic Transformation Facilities (STF).

Monetary and fiscal policy measures: Monetary and fiscal policies are also important tools for influencing B.O.P. Conditions. A change in money supply brought about either through fiscal or monetary policies can bring about the required change in the level of total demand, which includes demand for imported goods and services. 

Exchange rate adjustments; Adjustments in exchange rate is an effective tool. A down- ward adjustment in exchange rate will make exports cheaper and imports dearer. In other words, as a result of such a policy, exports will be encouraged and imports will be discouraged and equilibrium will be restored. 

All these methods, however, suffer from certain limitations. Hence, managing a state of disequilibrium in B.O.P. continues to be a major problem which every country faces. The major problem is that a policy initiative taken for the sake of achieving equilibrium in B.O.P. comes into conflict with other, rather more endearing objectives, such as, economic growth, employment and price stability. Reconciling such conflicts continues to worry policy makers.

FACTORS AFFECTING BALANCE OF' PAYMENTS

The Current Account

A country's current account balance can significantly affect its economy; therefore, it is important to identify the factors that influence it. The most important factors are: 

I) Inflation 

ii) National Income 

iii) Government Restructures 

iv) Exchange Rates. 

Let us discuss them one by one. 

Inflation: If a country's inflation rate increases relative to the countries with which it trades, its current account would be expected to decrease. Due to higher prices at home, consumers and corporations with in the country will most likely purchase more goods overseas (due to high local inflation), while tile country's exports to other countries will decline. 

National Income: If a country's national income rises by a higher percentage than those of other countries, its current account is expected to decrease, other things being equal. As the real income level (adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in consumption will most likely reflect an increased demand for foreign goods.

Government Restrictions: If a country's government imposes a tax on imported goods (often referred to as a tariff) the prices of foreign goods to consumers effectively increases. An increase in prices of imported goods relative to goods produced at home will discourage imports and is expected to increase the current account balance. In addition to tariffs, a government may reduce its imports by enforcing a quota, or a maximum limit on imports. 

Exchange Rates: Each country's currency is valued in terms of other currencies through the use of exchange rates, so that currencies can be exchanged to facilitate international transactions, The values of most currencies can fluctuate over time because of market and government forces, If a country’s current account balance decreases, other things being equal, goods exported by the country will become more expensive to the importing countries, if its currency strengthens, as a consequence, the demand for such goods will decline. For example, a refrigerator selling in the United State for $ 100 require a payment of Rs. 3500, if the dollar were worth Rs. 351- Ks. 1 = $0.028). Yet, if the dollar were worth Rs. 40/- (Rs. 1 = $ 0.025), it would take Rs, 4000 to buy the refrigerator. Which could discourage Indians to buy it, However, according to J-curve theory; a country's trade deficit worsens just after its currency depreciates because price effects will dominate the effect on volume of imports in the short run. That is the higher costs of imports will more than offset the reduced volume of imports. Thus, the J curve theory states that a decline in the value of home currency should be followed by a temporary worsening in the trade deficit before its longer term improvement.

The Capital Account

As with the current flows, government policies affect the capital account as well. A country's government could, for example, impose a special tax on income account by local investors who invested in foreign markets. A tax would discourage people from sending their funds for investment in the foreign markets and could therefore, increase the country's capital account. Capital flows are also influenced by capital controls of various types. Interest rates also affect the capital flows. A hike in interest rates relative to other countries may affect capital inflows from abroad. Similarly, a reduction in domestic rates may induce people to invest abroad. ' 

The anticipated exchange rate movements by investors in securities can affect the capital account. If a home currency is expected to strengthen, foreign investors may be willing to invest in the country’s securities to benefit from the currency movement. Conversely, a country's capital account balance is expected to decrease, if its home currency is expected to weaken, other things being equal. 

When attempting to assess why a country’s capital account changed and how it will change in future, all factors must be considered simultaneously. A particular country may experience a reduction in capital account even when its interest rates are attractive, if the home currency is expected to depreciate.

BALANCE OF PAYMENT DISEQUILIBRIUM

A nation's balance of payment is said to be in equilibrium when it is neither drawing upon its international reserves to make excess payments nor accumulating such reserves as a result of its receipts. In other words, when a country is not able to pay for its imports of goods and services from its export earnings, on accumulating reserves year after year, disequilibrium in balance of payments sets in. Policy initiatives are needed to restore equilibrium.

Disequilibrium in balance of payment may be short term or long term in nature. Short term disequilibrium, arises largely on account of cyclical factors. A crop failure leading to a sudden fall in export earnings may create a shortfall and consequently disequilibrium. 

Long term or structural disequilibrium arises on account of long term structural changes in the economy. Fall in demand of export products due to technological changes may bring about a decline in export proceeds. Decline in demand and prices for natural rubber on account of development of synthetics may be cited as an example. Such a situation call is remedied only by diversification of economy.

DEFICIT AND SURPLUS IN BALANCE OF PAYMENTS

You have learnt that BOP accounting is based on the principles of double entry book- keeping, meaning thereby that for every credit entry, there is a debit entry. Thus, a BOP account always balances. The difference between aggregate debit and credits is called balance. In case, debits exceed credit, balance is negative or deficit, when the credits exceed debits, the balance is positive or surplus. Obviously, the term, deficits or surplus cannot then refer to the entire BOP but sub set of accounts included in BOP. 

Where value of exports exceeds imports, the situation is referred as trade surplus or surplus on trade account. Excess of imports over exports results in trade deficit on trade account. 

The transactions appearing in a balance of payments can be classified in two categories, via autonomous transactions and accommodating or financing transactions, Autonomous transactions take place on their own, in response to their felt needs and are independent of situation in the balance of payments. Accommodating or financing transactions refer to the flows which take place in response to surplus or deficit in the balance of payments. For example, a country may incur or raise its liabilities or reduce its assets in order to pay for the deficit. A deficit in balance of payment exists when payments for autonomous or self motivated transactions exceed receipts. In case, there is a deficit or surplus, there have to be some compensatory transactions to balance the imbalance.

Autonomous and financing transactions are also referred to as above the line ad below the line respectively. 

There are several concepts of ‘balance’ in balance of payments. These are: 

Trade Balance: This is the balance on the merchandise trade account, i.e. Item 1 in the current account. 

Balance on goods and services: This is the balance between the export and import of goods and services. It is the net balance on item I and sub-items 1-6 of item III taken together. 

Current Account balance: This is the net balance on the entire current account items I+ll+IlI. When it is negative we have a current account deficit, when positive, a current account surplus. 

Balance on current account and long term capital: This is also called basic balance. This is supposed to indicate the long term trends in BOP. 

While changes in reserve assets are accurately measured, recording of other items is subject to errors arising out of data inadequacies, discrepancies of valuation and timing, erroneous reporting etc. These are reconciled through a fictitious head of account called 'Errors and Omissions'.

The capital Account & Other Accounts

The capital Account 

The account records the changes in the levels of international financial assets and liabilities. The various classifications within the capital account are private, banking and official. Distinction is also made between short term and long term capital flaws, loans with original maturity of more than one year are classified as long term flows. Long term foreign investment measures all capital investments made between countries, including both direct foreign investment and purchases of securities with maturities exceeding one year. Short term foreign investment measures flows of funds invested in securities with maturities of less than one year. Because of the short maturity, investors of such securities will often maintain their funds in a given country for only a short time, causing short term investment flows to be quite volatile over time.

 Private-capital Flows:

These flows consist of several types of transactions. Among them are: long term loans received by individuals and companies (other than banking institutions), investment by foreigners in the joint stock companies in India, repayment of long term loans by non- resident, obtained from residents, repatriation of Indian investments abroad, deposits in non-resident (external) rupee accounts and in foreign currency non-resident accounts. Capital outflows (debit entries) comprise investments by residents in shares and other financial assets abroad, repayment of foreign loans by residents, repatriation of foreign investments in India, long term loans made to non-residents and so forth. 

Short term capital flows on private account consists of short term borrowings and investments.

Banking Capital Flows:

Capital movements in banking sector covers changes in foreign assets and liabilities of commercial banks, whether privately owned or government owned and cooperative banks. Assets consist of balances held by banks with their foreign branches or correspondent banks abroad, and rupee assets representing loans granted by Indian banks to branches of foreign banks in India and correspondent banks. Liabilities consist of Indian banks' debit balances in their foreign accounts and credit balances held by nonresident banks and few other institutions with banks in India. Any increase in assets (or decrease in liabilities) will be a debit entry while a decrease in assets (or increase in liability) a credit. 

Official Capital flows: 

This category covers transactions affecting foreign financial assets and liabilities of the government of India and the Reserve Bank of India, excluding transactions relating to official reserve assets. Government of India's purchase and repurchase from the IMF are shown in a separate account. Loans received by the Government of India from foreign governments and international institutions are treated as credit entries and amortization or repayment of such loans as debit. 

Look at Table 3.2 which shows India’s balance of payments on Current Account and capital Account in recent years.

The Other Accounts
The remaining accounts in India’s BOP are set out in table 3.4.

The IMF account contains, as mentioned above, purchases (credits) and repurchases from the IMF. SDRs (Special Drawing Rights) are a reserve asset created by the JMF and allocated to member countries from time to time. Subject to IMF regulations, SDRs can be used to settle international payments between monetary authorities of member countries. .An allocation is a credit and the utilization is a debit. The reserves and Monetary Gold account increases (debits) and decreases (credits) in reserve assets. Reserve assets consist of RBI holdings of gold and foreign exchange (in the form of balances with foreign central banks and investments in foreign government’s securities) and Government’s holdings of SDRs.

The Current Account (BOP)

Look at Table below where the structure of the current account in India’s BOP statement has been shown. Let us briefly discuss each of the above heads and subheads. 

1. Merchandise: Merchandise exports valued on F.O.B... (Free on board) basis, on private and government account are the credit entries data for these items. They are calculated from the various documents exporters fill and submit to designated authorities. Imports valued at C.I.F. (Cost, Insurance and Freight) are the debit entries. The difference between the totals of credits and debits appears in the 'Net' column. This is the balance on Merchandise Trade Account, a deficit, if negative and a surplus if positive. 

2. Non-Monetary Gold Movements: Gold is both a commodity and a financial asset. It is treated as financial assets when it is held by the monetary authority. "Monetization" of gold refers to the transaction when the monetary authority acquires gold, from residents and non residents to add to reserves. This gets recorded as a debit entry in reserve account and the offsetting credit entry is made in the non monetary gold account. Conversely, when the monetary authority acquires gold demonetization, reserve account shows a credit and the non monetary gold movement account shows a debit. Gold imported (or exported) by other agencies form a part of the merchandise trade account. 

Table: Structure of Current Account in India's Balance of Payments Statement.

3. Invisibles: Credits under 'invisibles' consist of services rendered by residents to non residents, income earned by residents on their ownership of foreign financial assets (interest, dividends etc.), income earned from the use, by non residents, of non-financial assets such as patents and copy rights owned by residents and the offset entries to the cash and in kind gifts received by residents from non-resident. Debits consist of same items with the roles of residents and non-residents reversed. A few examples may be cited as follows: 

• Receipts in foreign exchange, reported by authorized dealers in foreign exchange, remitted to them by organizers of foreign tourist parties located, I abroad for meeting hotel and other local expenses of the tourists. This will be a credit under "travel". 
• Freight charges paid to nonresident airlines or shipping companies directly will appear as debits under transportation. 
• Premiums on all kinds of insurance and re-insurance provided by Indian insurance companies to non-resident clients is a credit entry under "insurance", 
• Profits remitted by the foreign branch of an Indian company to the parent company represent a receipt of 'direct investment income', to be recorded as a credit entry under 'investment income', Interest paid by an Indian company on its borrowings abroad will appear as a debit. 
• Funds received from a foreign government for the maintenance of their embassy, consulates etc, in India will constitute a credit entry under 'Government not included elsewhere’.
• Foreign exchange earnings of Indian consultancy firms for professional services rendered to non residents will be recorded as a credit entry under miscellaneous. Similarly, professional services provided to residents by nonresident companies will appear as debit entry. 
• Revenue contributions made by the Government of India to international institutions or nonresident entities abroad will be recorded as a debit entry under ‘official transfer’. Simply, cash remittances for family maintenance received from Indian nationals working abroad will be a credit entry under private transfers. 

Look at Table 3.2 which gives you an idea about India's balance of 'payments:

The net balance between the credit and debit entries under the heads merchandise, non- monetary gold movements taken together is the Current Account Balance. The net balance is taken as deficit, if negative (debits exceed credits), a surplus, if positive (credits exceed debits).

COMPONENTS OF BALANCE OF PAYMENTS

The balance of payments is a collection of accounts conventionally grouped into three main categories with subdivisions in each. Three main categories are: 

a) The Current Account: Under this are included imports and exports of goods and services and unilateral transfers, which reflect government and private gifts and grants. 

b) The Capital Account: Under this are grouped transactions leading to changes in foreign financial assets and liabilities of the country. 

c) The Reserve Account: In principle, this is not different from the capital account it as much as it relates to financial assets and liabilities. However, in this category, only reserve assets are included. These are the assets which the central bank of the country uses to settle the deficits and surpluses that arise in the other two categories.

Balance of Payments

DEFINITION 
Balance of payment is an accounting record of the transactions between the residents of one country and the residents of the rest of the world over a given period of time. Transactions in which domestic residents either purchase assets (goods and services) from abroad or reduce foreign liabilities are considered uses (out flow) of funds because payments abroad must be made. Similarly, transactions in which domestic residents either sell assets to foreign residents or increase their liabilities to foreigners are sources (inflows) of funds because payments from abroad are received. Thus, in a way, it resembles a company's sources and use of funds statement.

UNDERLYING PRINCIPLES AND CONCEPTUAL FRAMEWORK
The balance of payment is part of a larger system of social accounts recording the economic activity of an economy and its various sections. The social accounts relate to economic transactions not only within the domestic economy but also between the domestic economy and the rest of the world. Balance of payment is concerned with economic transactions; five basic types of economic transactions may be distinguished. They are: 

a) Purchases and sales of goods and services against financial items i.e. the interchange of goods and services against claims and monetary gold;

b) Barter, i.e. the interchange of goods and services against other goods and services;

c) The interchange of financial items against other financial items e.g. sale of securities for money, or the repayment of commercial debts in money;

d) The provisions or acquisition of goods and services without requital, e.g. grants in aid;

e) The provision or acquisition of financial items without requital, e.g. In payment of taxes or as a gift.

The social accounts have common rules of credit and debit for recording economic transactions. Credit entries are made for the provision of goods and services or of financial items, whether they are sold, bartered, or furnished without requital. Debit entries are made for acquisition of goods and services or of financial items, whether these items are purchased, obtained by barter, or acquired without requital, for the first three types of transactions, the rules immediately result in equal credit and debit entries. For the remaining types, a credit entry for goods and services or financial items is matched by a debit entry for an unrequited transfer, and vice versa.

As stated earlier, balance of payments is concerned with economic transactions between the residents of the reporting country and the residents of the rest of the world. To acquire an in depth understanding, it is necessary to clarify the concept of residents. This term is certainly not identical with the term “citizen” though there is normally a substantial overlap. As regards individuals, ‘residents’ means those individuals whose general centre of interest can be said to rest in the given economy. They consume goods and services, participate in the productive process or otherwise carry out economic activity within the territory of the country on other than a temporary basis. Members of diplomatic and consular staffs and official missions, members of armed forces stationed abroad, and citizens undergoing medical treatment or studying abroad are considered residents of their own rather than of the country where they are staying. The extent to which other citizens living abroad are treated as residents (travelers) or foreigners (emigrants) depends upon a number of factors such as permanence of their living and the extent to which they shift their general "centre of interest". As regards non-individuals a set of conventions have been evolved. For example, governments and nonprofit bodies servicing resident individuals are residents of the respective countries. For enterprises, rules are somewhat complex particularly those concerning unit of corporate branches of foreign multinationals, According to IMF rules, these are considered to be residents of countries where they operate, though they are not a separate legal entity from the parent located abroad, international organizations like the UN, the World Bank, the IMF are not considered to be residents of any national economy even though their offices may be located within the territories of any number of countries.

BALANCE OF PAYMENT ACCOUNTING
The balance of payment is a standard double entry accounting record and as such subject to all the rules of double entry book-keeping viz. For every transaction two entries must be made. One credit (+) and one debit (-) and leaving aside errors and omissions, the total of credits must exactly match the total of debits i.e. the balance of payments must always balance.

Simple accounting rules followed in BOP is the following:

1. All transactions which lead to an immediate or prospective payment from the rest of the world to the country should be recorded as credit. Hence, all payments received for export of goods and services as also loans received abroad or inward foreign investment-whether direct or portfolio would be credit items,

2. Conversely, all transactions which result in an actual or prospective payment from the country to the rest of the world should be recorded as debits.

3. A transaction which results in an increase in demand for foreign exchange is to be recorded as debit entry while a transaction which results in an increase in the supply of foreign exchange is a credit entry.