Unit 1
Balance of Payment
Q1) What is Balance of Trade?
A1) Balance of trade (BOT) is the difference between the value of a country's imports and exports for a given period and is that the largest component of a country's balance of payments (BOP).
• A country that imports more goods and services than it exports in terms of value has a deficit while a country that exports more goods and services than it imports features a trade surplus.
• In 2019, Germany had the biggest trade surplus followed by Japan and China while the United States had the biggest deficit, even with the continued trade war with China, beating out the United Kingdom and India.
Q2) What are the features of BOT?
A2) Various features of balance of trade are explained below:
1. Exports and Imports:
The elements of the balance of trade are exports and imports. Export of products means movement of products from domestic country to foreign country. The vis-a-vis is understood as Imports.
2. Visible Goods:
Balance of trade constitutes imports and exports of products. The important features of the products are that it must be visible, have physical structure, size, shape and form. The products must be seen and touched, counted, measured and weighed.
3. Material Goods:
Goods constitute our imports and exports must be material. It means non- material goods and services won't constitute imports and exports.
Q3) What are the types of Balance of Trade?
A3)
1. Favourable Balance of Trade:
The situation, wherein country’s exports exceed imports may be a situation of favourable or surplus balance of trade.
2. Unfavourable/Deficit Balance of Trade:
Excess of total value of products, imported over the entire value of products exported is termed as unfavourable or adverse or deficit balance of trade.
It may even be expressed as under:
3. Equilibrium in Balance of Trade:
Equality between the entire value of products exported and total value of products imported is termed as equilibrium in balance of trade.
Q4) What is Balance of Payment?
A4) Balance of Payment (BOP) may be a statement which records all the monetary transactions made between residents of a country and therefore the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporate and therefore the government and helps in monitoring the flow of funds to develop the economy. When all the weather is correctly included within the BOP, it should sum up to zero during a perfect scenario. This means the inflows and outflows of funds should balance out. However, this doesn't ideally happen in most cases.
BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e., when a country’s export is more than its import, its BOP is said to be in surplus. On the opposite hand, BOP deficit indicates that a country’s imports are quite its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry.
Q5) Why Balance of payment is significant for a country?
A5) A country’s BOP is important for the following reasons:
• BOP of a country reveals its financial and economic status.
• BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
• BOP statement helps the government to make a decision on fiscal and trade policies.
• It provides important information to analyse and understand the economic dealings of a country with other countries.
• By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.
Q6) What is balance of payment on current account?
A6) The current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with reference to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they create up to a country’s Balance of Trade (BOT).
There are various categories of trade and transfers which happen across countries. It might be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries is stated as visible items and import/export of services (banking, information technology etc.) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This will even be personal transfers like – money sent by relatives to their family located in another country.
The current account includes: visible exports and import; invisible items concerning receipts and payments for various services like banking, insurance, shipping, travel etc. and other unilateral transfer of payments like donations, grants, taxes etc.
Q7) What is balance of payment on capital account?
A7) All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc. by migrants moving out/in to a different country. The deficit or surplus within the current account is managed through the finance from capital account and vice versa.
There are 3 major elements of capital account:
Loans & borrowings – It includes all kinds of loans from both the private and public sectors located in foreign countries.
Investments – These are funds invested within the corporate stocks by non-residents.
Foreign exchange reserves – foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account.
The balance of payments position of the country reflects on its economic health. The balance of payments of any country may be a comprehensive and systematic accounts of all the different transactions occurred between the residents of a country and therefore the rest of the world during a particular period of lime.
The balance of payments maintains detailed classified records of various kinds of receipts against exports of goods, services and all the capital received by its residents on the one hand and also of all the payments made by the residents against imports of goods and services received alongside the capital transferred to non-residents and foreigners, on the other hand. Thus, the balance of payments is far wider than the balance of trade which refers to only merchandise exports and imports.
The capital accounts of balance of payments include all the present economic transaction for the country’s international financial position resulting changes within the foreign financial assets and liabilities. The capital transaction includes both private, banking and official transactions.
The balance of payment account is maintained on the basis of double entry system of book keeping. If a country faces deficits within the current account of its balance of payment, then such deficit is generally met either by liquidating its assets or through borrowing from abroad. Thus, a persistent deficit within the balance of payments of a country result in a heavy debt burden on the economy.
Q8) What are the causes of disequilibrium in balance of payment?
A8) Disequilibrium in the balance of payments is the result of imbalance between receipts and payments for exports and imports.
Causes of Disequilibrium
Increase in Imports
Import of essential goods and services
Development Programmes
Population Growth
Demonstration Effect
Low or Decline in Exports
Low-income Elasticity of demand
Discovery of substitutes
Protectionist trade policy
Modernisation
Causes and Measures of Disequilibrium.
Overall account of BOP is usually in equilibrium. This balance or equilibrium is merely in accounting sense because deficit or surplus is restored with the help of capital account.
In fact, when we talk about disequilibrium, it refers to current account of the balance of payment. If autonomous receipts are but autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.
Causes of disequilibrium in BOP:
There are several factors which cause disequilibrium within the BOP indicating either surplus or deficit.
Such causes for disequilibrium in BOP are listed below:
(i) Economic Factors:
(a) Imbalance between exports and imports. (It is the main reason for disequilibrium in BOR),
(b) Large scale development expenditure which causes large imports,
(c) High domestic prices which cause imports,
(d) Cyclical fluctuations (like recession or depression) in general commercial activity
(e) New sources of supply and new substitutes.
(ii) Political Factors:
Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.
(iii) Social Factors:
(a) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports;
(b) High population growth in poor countries adversely affects their BOP because it increases the requirements of the countries for imports and reduces their capacity to export.
Q9) What are the monetary measures to correct disequilibrium in balance of payment?
A9) Monetary measures
1. Deflation
Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium a country faces deficit when its imports exceed exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting an increase in our exports. At the same time the demands for imports fall because of higher taxation and reduced income. This is able to build a favourable atmosphere in the balance of payment position. However, Deflation is often successful when the exchange rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline within the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the speed of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with reference to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange could also be said $1 = Rs. 50. This implies 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation: -
Exchange depreciation will be successful as long as there's no retaliatory exchange depreciation by other countries.
It is not suitable to a country desiring a fixed exchange rate system.
Exchange depreciation raises the prices of imports and reduces the prices of exports. So, the terms of trade will become unfavourable for the country adopting it.
It increases uncertainty & risks involved in foreign trade.
It may result in hyper-inflation causing further deficit in balance of payments.
3. Devaluation
Devaluation refers to deliberate attempt made by monetary authorities to bring down the worth of home currency against foreign currency. While depreciation is a spontaneous fall because of interactions of market forces, devaluation is official act enforced by the monetary authority. Generally, the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the worth of Indian currency has been reduced by 18 to 20 in terms of varied currencies. The 1991 devaluation brought the specified effect. The very next year the import declined while exports picked up.
When devaluation is affected, the value of home currency goes down against foreign currency, allow us to suppose the exchange rate remains $1 = Rs. 10 before devaluation. Allow us to suppose, devaluation takes place which reduces the worth of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is often because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At an equivalent time, imports become costlier as Indians need to pay more currencies to get one dollar. Thus, demand for imports is reduced.
Generally, devaluation is resorted to where there's serious adverse balance of payment problem.
Limitations of Devaluation: -
Devaluation is successful only if other country doesn't retaliate the same. If
Both the countries opt for the same, the effect is nil.
Devaluation is successful only if the demand for exports and imports is elastic.
In case it's inelastic, it may turn things worse.
Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.
Devaluation may bring inflation within the following conditions: -
Devaluation brings the imports down, when imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleashes inflationary trends.
A growing country like India is capital thirsty. Due to non-availability of capital goods in India, we've no option but to continue imports at higher costs. This may force the industries depending upon capital goods to push up their prices.
When demand for our export rises, more and more goods produced during a country would choose exports and thus creating shortage of such goods at the domestic level. This leads to inflation and inflation.
Devaluation might not be effective if the deficit arises thanks to cyclical or structural changes.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their exchange to the central authority. Thus, it results in concentration of exchange reserves in the hands of central authority. At the same time, the availability of foreign exchange is restricted just for essential goods. It can only help controlling situation from turning worse. Briefly it's only a temporary measure and not permanent remedy.
Q10) What are the non-monetary measure to correct disequilibrium in balance of payment?
A10) A deficit country alongside Monetary measures may adopt the following non-monetary measures too which can either restrict imports or promote exports.
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the costs of imports would increase to the extent of tariff. The increased prices will reduce the demand for imported goods and at a similar time induce domestic producers to produce more of import substitutes. Non-essential imports are often drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs: -
Tariffs bring equilibrium by reducing the quantity of trade.
Tariffs obstruct the expansion of world trade and prosperity.
Tariffs needn't necessarily reduce imports. Hence the consequences of tariff on the balance of payment position are uncertain.
Tariffs seek to determine equilibrium without removing the root causes of disequilibrium.
A new or a better tariff may aggravate the disequilibrium within the balance of payments of a country already having a surplus.
Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.
2. Quotas
Under the quota system, the govt may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the deficit is reduced and the balance of payments position is improved.
Q11) Explain Current Account Convertibility of the Rupee?
A11) Under Article VIII, Sections 2, 3 and 4 of the IMF the member countries of the IMF are obliged to revive current account convertibility of their currencies.
(a) don't have any restrictions on current payments (capital account restrictions are allowed); and
(b) Avoid discriminatory currency practices (including multiple exchange rates).
Current account convertibility is defined because the freedom to buy and sell foreign exchange for the subsequent international transactions:
(a) All payments due in reference to foreign trade, other current business, including services, and normal short-term banking and credit facilities;
(b) Payments due as interest on loans and as net income from other investments;
(c) Payments of moderate amount of amortization of loans or for depreciation of direct investments and
(d) Moderate remittances for family living expenses.
In his budget speech for 1992-1993, the minister of finance of India announced the partial convertibility of rupee on the current account. This measure was a section of the policy of economic reforms and it had been in line with the worldwide trend towards currency convertibility. By 1994, 97 countries including India had acquired Article VIII status on the current account convertibility. More countries have joined them subsequently.
Under the Liberalised rate of exchange Management System (LERMS) introduced in March 1992, 60 percent of all receipts under current transactions comprised of merchandise exports and invisible receipts might be converted at the free-market rate quoted by the authorised dealers. Just in case of the remaining 40 percent of receipts, the rate applicable was the official rate of exchange.
This provision of 40 percent of total foreign exchange under the current account was meant to cover exclusively the govt requirements and to enable the import of essential commodities. Moreover, the foreign exchange was also to be made available to fulfil 40 percent of the value of the advance licenses and special import licenses.
A major step within the direction of current account convertibility was adopted by India in March 1993, when the foreign exchange budget was abolished; the rate of exchange was unified and; the transactions on trade account were free of exchange control. The determination of rate of exchange of the rupee was left to the market forces.
On February 1994, the RBI announced the liberalisation of exchange control regulations up to a specified limit relating to- (a) foreign currency accounts of exchange earners, (b) basic travel quota, (c) studies abroad, (d) gift remittances, (e) donations, and (f) payments thanks to certain services rendered by foreign parties. Some more relaxations on current account payments were announced by RBI on August 19, 1994 in respect of various schemes associated with foreign currency non-resident accounts.
The rupee was made fully convertible on the current account of the balance of payments in August 1994. The Indian exporters to the Asian Clearing Union (ACU) countries and receiving export proceeds in rupee or in Asian Monetary Union (AMU) or within the currency of the participating country, were allowed to receive payments in any permitted currency through banking channels, provided it's offered by the overseas buyer within the ACU country.
The relaxations were made also in respect of the discharge of foreign exchange for foreign travel, interest income on Non-Resident Non-Reparable (NRNR) rupee deposits and remittances to relatives abroad. The reserve bank of India announced some major relaxations in exchange control in January 1997. The monetary ceilings prescribed for remittance of foreign exchange for a large range of purposes were removed and authorised dealers could now allow remittances for those purposes without prior clearance from the RBI.
Q12) Explain capital account convertibility of the rupee?
A12) Full convertibility of rupee wasn't introduced by the govt as it was risky in the conditions of huge deficit on current account faced by the country. Moreover, the intention was also to form the foreign exchange available at low prices for creating essential imports.
The cautious approach in respect of full convertibility of rupee was fully justified in sight of the Mexican crisis and subsequent East Asian crisis. The complete convertibility of rupee required the capital account convertibility of rupee together with the current account convertibility.
Capital account convertibility implies the right to transact in financial assets with foreign countries without restrictions. When there's completely free capital account convertibility, an Indian can dispose of his assets in India and take the money out of the country without hindrance.
Although the rupee isn't fully convertible on capital account, yet in respect of some elements, it had convertibility on capital account even earlier. As an example, capital account convertibility existed before for foreign investors and Non-Resident Indians for undertaking direct and portfolio investment in India.
In addition, Indian investments abroad up to U.S. $ 64 million were eligible for automatic approval by the RBI subject to certain conditions. No doubt, capital account convertibility may result in the large inflow of capital but, if the conditions are unfavourable within the home country, there's grave risk of capital flight from the home country, greater volatility in exchange rates and interest rates and wide fluctuations in exchange reserves. It's therefore prudent to undertake capital account convertibility only sometime after experimenting with the present account convertibility.
Q13) What preconditions are met by full convertibility of currency?
A13) The full convertibility of currency, including also capital account convertibility, should be introduced only after some preconditions are met:
(i) There should be domestic macro-economic stability.
(ii) The domestic enterprises should have reasonable degree of competitiveness.
(iii) The country should have trade-oriented development strategy and adequate incentives for export growth.
(iv) The country should have an appropriate industrial policy and a favourable investment climate.
(v) The country should have comfortable current account position.
(vi) The country should have adequate exchange reserves.
Q14) What are the merits of full convertibility of currency?
A14) The full convertibility of currency has the subsequent chief merits:
(i) The convertibility or floating of rupee would indicate truth value of it.
(ii) If the free-market rate were above the official rate of exchange, the profitability of exports would increase. As a result, the exporters would be induced to boost exports.
(iii) just in case the exportable products have high import-content, to that extent, a better market-determined rate of exchange can reduce profitability of exports. In such a situation, the import substitution would receive a boost not only in respect of exportable products but also in other imported products.
(iv) a higher rate of exchange of rupee can stimulate the remittances by the Non-Resident Indians (NRIs).
(v) As a result of full convertibility of rupee, the illegal remittance wouldn't remain attractive and, consequently, larger remittances from abroad would happen through proper channel.
(vi) If, alongside convertibility, there's liberalisation of import of gold, there would be an efficient deterrent to the smuggling of gold.
(vii) The fully convertible currency may result in automatic self-balancing of total foreign receipts and payments.
(viii) Full convertibility of rupee will enable the Indian investors to carry internationally diversified investment portfolio.
Q15) What are the demerits of full convertibility of rupee?
A15) Full convertibility of rupee has some demerits:
(i) If difficulty arises in keeping the current account balance under control, the free market rate of exchange is probably going to rise steeply.
(ii) If full convertibility causes appreciation of rupee, the possibility of reduction in exports can't be ruled out.
(iii) If there's appreciation of rupee, consequent upon its free convertibility, the imports are likely to increase and have adverse effect on BOP deficit.
(iv) If the complete convertibility causes depreciation of rupee, the import prices are likely to increase. As a result, the inflationary pressures can get intensified.
(v) Full convertibility of rupee can greatly strengthen the speculative tendencies and consequent instability within the whole system.
Q16) What is Devaluation? What are its limitations?
A16) Devaluation refers to deliberate attempt made by monetary authorities to bring down the worth of home currency against foreign currency. While depreciation is a spontaneous fall because of interactions of market forces, devaluation is official act enforced by the monetary authority. Generally, the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the worth of Indian currency has been reduced by 18 to 20 in terms of varied currencies. The 1991 devaluation brought the specified effect. The very next year the import declined while exports picked up.
When devaluation is affected, the value of home currency goes down against foreign currency, allow us to suppose the exchange rate remains $1 = Rs. 10 before devaluation. Allow us to suppose, devaluation takes place which reduces the worth of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is often because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At an equivalent time, imports become costlier as Indians need to pay more currencies to get one dollar. Thus, demand for imports is reduced.
Generally, devaluation is resorted to where there's serious adverse balance of payment problem.
Limitations of Devaluation: -
Devaluation is successful only if other country doesn't retaliate the same. If
Both the countries opt for the same, the effect is nil.
Devaluation is successful only if the demand for exports and imports is elastic.
In case it's inelastic, it may turn things worse.
Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.
Devaluation may bring inflation within the following conditions: -
Devaluation brings the imports down, when imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleashes inflationary trends.
A growing country like India is capital thirsty. Due to non-availability of capital goods in India, we've no option but to continue imports at higher costs. This may force the industries depending upon capital goods to push up their prices.
When demand for our export rises, more and more goods produced during a country would choose exports and thus creating shortage of such goods at the domestic level. This leads to inflation and inflation.
Devaluation might not be effective if the deficit arises thanks to cyclical or structural changes.
Q17) What are Tariffs? What are its drawbacks?
A17) Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the costs of imports would increase to the extent of tariff. The increased prices will reduce the demand for imported goods and at a similar time induce domestic producers to produce more of import substitutes. Non-essential imports are often drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs: -
Tariffs bring equilibrium by reducing the quantity of trade.
Tariffs obstruct the expansion of world trade and prosperity.
Tariffs needn't necessarily reduce imports. Hence the consequences of tariff on the balance of payment position are uncertain.
Tariffs seek to determine equilibrium without removing the root causes of disequilibrium.
A new or a better tariff may aggravate the disequilibrium within the balance of payments of a country already having a surplus.
Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.
Q18) What do you mean by Exchange depreciation? What are its limitations?
A18) Exchange depreciation means decline within the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the speed of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with reference to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange could also be said $1 = Rs. 50. This implies 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation: -
Exchange depreciation will be successful as long as there's no retaliatory exchange depreciation by other countries.
It is not suitable to a country desiring a fixed exchange rate system.
Exchange depreciation raises the prices of imports and reduces the prices of exports. So, the terms of trade will become unfavourable for the country adopting it.
It increases uncertainty & risks involved in foreign trade.
It may result in hyper-inflation causing further deficit in balance of payments.
Q19) What do you mean by Deflation?
A19) Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium a country faces deficit when its imports exceed exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting an increase in our exports. At the same time the demands for imports fall because of higher taxation and reduced income. This is able to build a favourable atmosphere in the balance of payment position. However, Deflation is often successful when the exchange rate remains fixed.
Q20) What is Exchange control?
A20) Exchange control is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their exchange to the central authority. Thus, it results in concentration of exchange reserves in the hands of central authority. At the same time, the availability of foreign exchange is restricted just for essential goods. It can only help controlling situation from turning worse. Briefly it's only a temporary measure and not permanent remedy.
A deficit country alongside Monetary measures may adopt the following non-monetary measures too which can either restrict imports or promote exports
Unit 1
Balance of Payment
Q1) What is Balance of Trade?
A1) Balance of trade (BOT) is the difference between the value of a country's imports and exports for a given period and is that the largest component of a country's balance of payments (BOP).
• A country that imports more goods and services than it exports in terms of value has a deficit while a country that exports more goods and services than it imports features a trade surplus.
• In 2019, Germany had the biggest trade surplus followed by Japan and China while the United States had the biggest deficit, even with the continued trade war with China, beating out the United Kingdom and India.
Q2) What are the features of BOT?
A2) Various features of balance of trade are explained below:
1. Exports and Imports:
The elements of the balance of trade are exports and imports. Export of products means movement of products from domestic country to foreign country. The vis-a-vis is understood as Imports.
2. Visible Goods:
Balance of trade constitutes imports and exports of products. The important features of the products are that it must be visible, have physical structure, size, shape and form. The products must be seen and touched, counted, measured and weighed.
3. Material Goods:
Goods constitute our imports and exports must be material. It means non- material goods and services won't constitute imports and exports.
Q3) What are the types of Balance of Trade?
A3)
1. Favourable Balance of Trade:
The situation, wherein country’s exports exceed imports may be a situation of favourable or surplus balance of trade.
2. Unfavourable/Deficit Balance of Trade:
Excess of total value of products, imported over the entire value of products exported is termed as unfavourable or adverse or deficit balance of trade.
It may even be expressed as under:
3. Equilibrium in Balance of Trade:
Equality between the entire value of products exported and total value of products imported is termed as equilibrium in balance of trade.
Q4) What is Balance of Payment?
A4) Balance of Payment (BOP) may be a statement which records all the monetary transactions made between residents of a country and therefore the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporate and therefore the government and helps in monitoring the flow of funds to develop the economy. When all the weather is correctly included within the BOP, it should sum up to zero during a perfect scenario. This means the inflows and outflows of funds should balance out. However, this doesn't ideally happen in most cases.
BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e., when a country’s export is more than its import, its BOP is said to be in surplus. On the opposite hand, BOP deficit indicates that a country’s imports are quite its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry.
Q5) Why Balance of payment is significant for a country?
A5) A country’s BOP is important for the following reasons:
• BOP of a country reveals its financial and economic status.
• BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
• BOP statement helps the government to make a decision on fiscal and trade policies.
• It provides important information to analyse and understand the economic dealings of a country with other countries.
• By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.
Q6) What is balance of payment on current account?
A6) The current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with reference to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they create up to a country’s Balance of Trade (BOT).
There are various categories of trade and transfers which happen across countries. It might be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries is stated as visible items and import/export of services (banking, information technology etc.) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This will even be personal transfers like – money sent by relatives to their family located in another country.
The current account includes: visible exports and import; invisible items concerning receipts and payments for various services like banking, insurance, shipping, travel etc. and other unilateral transfer of payments like donations, grants, taxes etc.
Q7) What is balance of payment on capital account?
A7) All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc. by migrants moving out/in to a different country. The deficit or surplus within the current account is managed through the finance from capital account and vice versa.
There are 3 major elements of capital account:
Loans & borrowings – It includes all kinds of loans from both the private and public sectors located in foreign countries.
Investments – These are funds invested within the corporate stocks by non-residents.
Foreign exchange reserves – foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account.
The balance of payments position of the country reflects on its economic health. The balance of payments of any country may be a comprehensive and systematic accounts of all the different transactions occurred between the residents of a country and therefore the rest of the world during a particular period of lime.
The balance of payments maintains detailed classified records of various kinds of receipts against exports of goods, services and all the capital received by its residents on the one hand and also of all the payments made by the residents against imports of goods and services received alongside the capital transferred to non-residents and foreigners, on the other hand. Thus, the balance of payments is far wider than the balance of trade which refers to only merchandise exports and imports.
The capital accounts of balance of payments include all the present economic transaction for the country’s international financial position resulting changes within the foreign financial assets and liabilities. The capital transaction includes both private, banking and official transactions.
The balance of payment account is maintained on the basis of double entry system of book keeping. If a country faces deficits within the current account of its balance of payment, then such deficit is generally met either by liquidating its assets or through borrowing from abroad. Thus, a persistent deficit within the balance of payments of a country result in a heavy debt burden on the economy.
Q8) What are the causes of disequilibrium in balance of payment?
A8) Disequilibrium in the balance of payments is the result of imbalance between receipts and payments for exports and imports.
Causes of Disequilibrium
Increase in Imports
Import of essential goods and services
Development Programmes
Population Growth
Demonstration Effect
Low or Decline in Exports
Low-income Elasticity of demand
Discovery of substitutes
Protectionist trade policy
Modernisation
Causes and Measures of Disequilibrium.
Overall account of BOP is usually in equilibrium. This balance or equilibrium is merely in accounting sense because deficit or surplus is restored with the help of capital account.
In fact, when we talk about disequilibrium, it refers to current account of the balance of payment. If autonomous receipts are but autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.
Causes of disequilibrium in BOP:
There are several factors which cause disequilibrium within the BOP indicating either surplus or deficit.
Such causes for disequilibrium in BOP are listed below:
(i) Economic Factors:
(a) Imbalance between exports and imports. (It is the main reason for disequilibrium in BOR),
(b) Large scale development expenditure which causes large imports,
(c) High domestic prices which cause imports,
(d) Cyclical fluctuations (like recession or depression) in general commercial activity
(e) New sources of supply and new substitutes.
(ii) Political Factors:
Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.
(iii) Social Factors:
(a) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports;
(b) High population growth in poor countries adversely affects their BOP because it increases the requirements of the countries for imports and reduces their capacity to export.
Q9) What are the monetary measures to correct disequilibrium in balance of payment?
A9) Monetary measures
1. Deflation
Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium a country faces deficit when its imports exceed exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting an increase in our exports. At the same time the demands for imports fall because of higher taxation and reduced income. This is able to build a favourable atmosphere in the balance of payment position. However, Deflation is often successful when the exchange rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline within the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the speed of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with reference to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange could also be said $1 = Rs. 50. This implies 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation: -
Exchange depreciation will be successful as long as there's no retaliatory exchange depreciation by other countries.
It is not suitable to a country desiring a fixed exchange rate system.
Exchange depreciation raises the prices of imports and reduces the prices of exports. So, the terms of trade will become unfavourable for the country adopting it.
It increases uncertainty & risks involved in foreign trade.
It may result in hyper-inflation causing further deficit in balance of payments.
3. Devaluation
Devaluation refers to deliberate attempt made by monetary authorities to bring down the worth of home currency against foreign currency. While depreciation is a spontaneous fall because of interactions of market forces, devaluation is official act enforced by the monetary authority. Generally, the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the worth of Indian currency has been reduced by 18 to 20 in terms of varied currencies. The 1991 devaluation brought the specified effect. The very next year the import declined while exports picked up.
When devaluation is affected, the value of home currency goes down against foreign currency, allow us to suppose the exchange rate remains $1 = Rs. 10 before devaluation. Allow us to suppose, devaluation takes place which reduces the worth of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is often because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At an equivalent time, imports become costlier as Indians need to pay more currencies to get one dollar. Thus, demand for imports is reduced.
Generally, devaluation is resorted to where there's serious adverse balance of payment problem.
Limitations of Devaluation: -
Devaluation is successful only if other country doesn't retaliate the same. If
Both the countries opt for the same, the effect is nil.
Devaluation is successful only if the demand for exports and imports is elastic.
In case it's inelastic, it may turn things worse.
Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.
Devaluation may bring inflation within the following conditions: -
Devaluation brings the imports down, when imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleashes inflationary trends.
A growing country like India is capital thirsty. Due to non-availability of capital goods in India, we've no option but to continue imports at higher costs. This may force the industries depending upon capital goods to push up their prices.
When demand for our export rises, more and more goods produced during a country would choose exports and thus creating shortage of such goods at the domestic level. This leads to inflation and inflation.
Devaluation might not be effective if the deficit arises thanks to cyclical or structural changes.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their exchange to the central authority. Thus, it results in concentration of exchange reserves in the hands of central authority. At the same time, the availability of foreign exchange is restricted just for essential goods. It can only help controlling situation from turning worse. Briefly it's only a temporary measure and not permanent remedy.
Q10) What are the non-monetary measure to correct disequilibrium in balance of payment?
A10) A deficit country alongside Monetary measures may adopt the following non-monetary measures too which can either restrict imports or promote exports.
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the costs of imports would increase to the extent of tariff. The increased prices will reduce the demand for imported goods and at a similar time induce domestic producers to produce more of import substitutes. Non-essential imports are often drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs: -
Tariffs bring equilibrium by reducing the quantity of trade.
Tariffs obstruct the expansion of world trade and prosperity.
Tariffs needn't necessarily reduce imports. Hence the consequences of tariff on the balance of payment position are uncertain.
Tariffs seek to determine equilibrium without removing the root causes of disequilibrium.
A new or a better tariff may aggravate the disequilibrium within the balance of payments of a country already having a surplus.
Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.
2. Quotas
Under the quota system, the govt may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the deficit is reduced and the balance of payments position is improved.
Q11) Explain Current Account Convertibility of the Rupee?
A11) Under Article VIII, Sections 2, 3 and 4 of the IMF the member countries of the IMF are obliged to revive current account convertibility of their currencies.
(a) don't have any restrictions on current payments (capital account restrictions are allowed); and
(b) Avoid discriminatory currency practices (including multiple exchange rates).
Current account convertibility is defined because the freedom to buy and sell foreign exchange for the subsequent international transactions:
(a) All payments due in reference to foreign trade, other current business, including services, and normal short-term banking and credit facilities;
(b) Payments due as interest on loans and as net income from other investments;
(c) Payments of moderate amount of amortization of loans or for depreciation of direct investments and
(d) Moderate remittances for family living expenses.
In his budget speech for 1992-1993, the minister of finance of India announced the partial convertibility of rupee on the current account. This measure was a section of the policy of economic reforms and it had been in line with the worldwide trend towards currency convertibility. By 1994, 97 countries including India had acquired Article VIII status on the current account convertibility. More countries have joined them subsequently.
Under the Liberalised rate of exchange Management System (LERMS) introduced in March 1992, 60 percent of all receipts under current transactions comprised of merchandise exports and invisible receipts might be converted at the free-market rate quoted by the authorised dealers. Just in case of the remaining 40 percent of receipts, the rate applicable was the official rate of exchange.
This provision of 40 percent of total foreign exchange under the current account was meant to cover exclusively the govt requirements and to enable the import of essential commodities. Moreover, the foreign exchange was also to be made available to fulfil 40 percent of the value of the advance licenses and special import licenses.
A major step within the direction of current account convertibility was adopted by India in March 1993, when the foreign exchange budget was abolished; the rate of exchange was unified and; the transactions on trade account were free of exchange control. The determination of rate of exchange of the rupee was left to the market forces.
On February 1994, the RBI announced the liberalisation of exchange control regulations up to a specified limit relating to- (a) foreign currency accounts of exchange earners, (b) basic travel quota, (c) studies abroad, (d) gift remittances, (e) donations, and (f) payments thanks to certain services rendered by foreign parties. Some more relaxations on current account payments were announced by RBI on August 19, 1994 in respect of various schemes associated with foreign currency non-resident accounts.
The rupee was made fully convertible on the current account of the balance of payments in August 1994. The Indian exporters to the Asian Clearing Union (ACU) countries and receiving export proceeds in rupee or in Asian Monetary Union (AMU) or within the currency of the participating country, were allowed to receive payments in any permitted currency through banking channels, provided it's offered by the overseas buyer within the ACU country.
The relaxations were made also in respect of the discharge of foreign exchange for foreign travel, interest income on Non-Resident Non-Reparable (NRNR) rupee deposits and remittances to relatives abroad. The reserve bank of India announced some major relaxations in exchange control in January 1997. The monetary ceilings prescribed for remittance of foreign exchange for a large range of purposes were removed and authorised dealers could now allow remittances for those purposes without prior clearance from the RBI.
Q12) Explain capital account convertibility of the rupee?
A12) Full convertibility of rupee wasn't introduced by the govt as it was risky in the conditions of huge deficit on current account faced by the country. Moreover, the intention was also to form the foreign exchange available at low prices for creating essential imports.
The cautious approach in respect of full convertibility of rupee was fully justified in sight of the Mexican crisis and subsequent East Asian crisis. The complete convertibility of rupee required the capital account convertibility of rupee together with the current account convertibility.
Capital account convertibility implies the right to transact in financial assets with foreign countries without restrictions. When there's completely free capital account convertibility, an Indian can dispose of his assets in India and take the money out of the country without hindrance.
Although the rupee isn't fully convertible on capital account, yet in respect of some elements, it had convertibility on capital account even earlier. As an example, capital account convertibility existed before for foreign investors and Non-Resident Indians for undertaking direct and portfolio investment in India.
In addition, Indian investments abroad up to U.S. $ 64 million were eligible for automatic approval by the RBI subject to certain conditions. No doubt, capital account convertibility may result in the large inflow of capital but, if the conditions are unfavourable within the home country, there's grave risk of capital flight from the home country, greater volatility in exchange rates and interest rates and wide fluctuations in exchange reserves. It's therefore prudent to undertake capital account convertibility only sometime after experimenting with the present account convertibility.
Q13) What preconditions are met by full convertibility of currency?
A13) The full convertibility of currency, including also capital account convertibility, should be introduced only after some preconditions are met:
(i) There should be domestic macro-economic stability.
(ii) The domestic enterprises should have reasonable degree of competitiveness.
(iii) The country should have trade-oriented development strategy and adequate incentives for export growth.
(iv) The country should have an appropriate industrial policy and a favourable investment climate.
(v) The country should have comfortable current account position.
(vi) The country should have adequate exchange reserves.
Q14) What are the merits of full convertibility of currency?
A14) The full convertibility of currency has the subsequent chief merits:
(i) The convertibility or floating of rupee would indicate truth value of it.
(ii) If the free-market rate were above the official rate of exchange, the profitability of exports would increase. As a result, the exporters would be induced to boost exports.
(iii) just in case the exportable products have high import-content, to that extent, a better market-determined rate of exchange can reduce profitability of exports. In such a situation, the import substitution would receive a boost not only in respect of exportable products but also in other imported products.
(iv) a higher rate of exchange of rupee can stimulate the remittances by the Non-Resident Indians (NRIs).
(v) As a result of full convertibility of rupee, the illegal remittance wouldn't remain attractive and, consequently, larger remittances from abroad would happen through proper channel.
(vi) If, alongside convertibility, there's liberalisation of import of gold, there would be an efficient deterrent to the smuggling of gold.
(vii) The fully convertible currency may result in automatic self-balancing of total foreign receipts and payments.
(viii) Full convertibility of rupee will enable the Indian investors to carry internationally diversified investment portfolio.
Q15) What are the demerits of full convertibility of rupee?
A15) Full convertibility of rupee has some demerits:
(i) If difficulty arises in keeping the current account balance under control, the free market rate of exchange is probably going to rise steeply.
(ii) If full convertibility causes appreciation of rupee, the possibility of reduction in exports can't be ruled out.
(iii) If there's appreciation of rupee, consequent upon its free convertibility, the imports are likely to increase and have adverse effect on BOP deficit.
(iv) If the complete convertibility causes depreciation of rupee, the import prices are likely to increase. As a result, the inflationary pressures can get intensified.
(v) Full convertibility of rupee can greatly strengthen the speculative tendencies and consequent instability within the whole system.
Q16) What is Devaluation? What are its limitations?
A16) Devaluation refers to deliberate attempt made by monetary authorities to bring down the worth of home currency against foreign currency. While depreciation is a spontaneous fall because of interactions of market forces, devaluation is official act enforced by the monetary authority. Generally, the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the worth of Indian currency has been reduced by 18 to 20 in terms of varied currencies. The 1991 devaluation brought the specified effect. The very next year the import declined while exports picked up.
When devaluation is affected, the value of home currency goes down against foreign currency, allow us to suppose the exchange rate remains $1 = Rs. 10 before devaluation. Allow us to suppose, devaluation takes place which reduces the worth of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is often because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At an equivalent time, imports become costlier as Indians need to pay more currencies to get one dollar. Thus, demand for imports is reduced.
Generally, devaluation is resorted to where there's serious adverse balance of payment problem.
Limitations of Devaluation: -
Devaluation is successful only if other country doesn't retaliate the same. If
Both the countries opt for the same, the effect is nil.
Devaluation is successful only if the demand for exports and imports is elastic.
In case it's inelastic, it may turn things worse.
Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.
Devaluation may bring inflation within the following conditions: -
Devaluation brings the imports down, when imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleashes inflationary trends.
A growing country like India is capital thirsty. Due to non-availability of capital goods in India, we've no option but to continue imports at higher costs. This may force the industries depending upon capital goods to push up their prices.
When demand for our export rises, more and more goods produced during a country would choose exports and thus creating shortage of such goods at the domestic level. This leads to inflation and inflation.
Devaluation might not be effective if the deficit arises thanks to cyclical or structural changes.
Q17) What are Tariffs? What are its drawbacks?
A17) Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the costs of imports would increase to the extent of tariff. The increased prices will reduce the demand for imported goods and at a similar time induce domestic producers to produce more of import substitutes. Non-essential imports are often drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs: -
Tariffs bring equilibrium by reducing the quantity of trade.
Tariffs obstruct the expansion of world trade and prosperity.
Tariffs needn't necessarily reduce imports. Hence the consequences of tariff on the balance of payment position are uncertain.
Tariffs seek to determine equilibrium without removing the root causes of disequilibrium.
A new or a better tariff may aggravate the disequilibrium within the balance of payments of a country already having a surplus.
Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.
Q18) What do you mean by Exchange depreciation? What are its limitations?
A18) Exchange depreciation means decline within the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the speed of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with reference to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange could also be said $1 = Rs. 50. This implies 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation: -
Exchange depreciation will be successful as long as there's no retaliatory exchange depreciation by other countries.
It is not suitable to a country desiring a fixed exchange rate system.
Exchange depreciation raises the prices of imports and reduces the prices of exports. So, the terms of trade will become unfavourable for the country adopting it.
It increases uncertainty & risks involved in foreign trade.
It may result in hyper-inflation causing further deficit in balance of payments.
Q19) What do you mean by Deflation?
A19) Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium a country faces deficit when its imports exceed exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting an increase in our exports. At the same time the demands for imports fall because of higher taxation and reduced income. This is able to build a favourable atmosphere in the balance of payment position. However, Deflation is often successful when the exchange rate remains fixed.
Q20) What is Exchange control?
A20) Exchange control is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their exchange to the central authority. Thus, it results in concentration of exchange reserves in the hands of central authority. At the same time, the availability of foreign exchange is restricted just for essential goods. It can only help controlling situation from turning worse. Briefly it's only a temporary measure and not permanent remedy.
A deficit country alongside Monetary measures may adopt the following non-monetary measures too which can either restrict imports or promote exports
Unit 1
Balance of Payment
Q1) What is Balance of Trade?
A1) Balance of trade (BOT) is the difference between the value of a country's imports and exports for a given period and is that the largest component of a country's balance of payments (BOP).
• A country that imports more goods and services than it exports in terms of value has a deficit while a country that exports more goods and services than it imports features a trade surplus.
• In 2019, Germany had the biggest trade surplus followed by Japan and China while the United States had the biggest deficit, even with the continued trade war with China, beating out the United Kingdom and India.
Q2) What are the features of BOT?
A2) Various features of balance of trade are explained below:
1. Exports and Imports:
The elements of the balance of trade are exports and imports. Export of products means movement of products from domestic country to foreign country. The vis-a-vis is understood as Imports.
2. Visible Goods:
Balance of trade constitutes imports and exports of products. The important features of the products are that it must be visible, have physical structure, size, shape and form. The products must be seen and touched, counted, measured and weighed.
3. Material Goods:
Goods constitute our imports and exports must be material. It means non- material goods and services won't constitute imports and exports.
Q3) What are the types of Balance of Trade?
A3)
1. Favourable Balance of Trade:
The situation, wherein country’s exports exceed imports may be a situation of favourable or surplus balance of trade.
2. Unfavourable/Deficit Balance of Trade:
Excess of total value of products, imported over the entire value of products exported is termed as unfavourable or adverse or deficit balance of trade.
It may even be expressed as under:
3. Equilibrium in Balance of Trade:
Equality between the entire value of products exported and total value of products imported is termed as equilibrium in balance of trade.
Q4) What is Balance of Payment?
A4) Balance of Payment (BOP) may be a statement which records all the monetary transactions made between residents of a country and therefore the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporate and therefore the government and helps in monitoring the flow of funds to develop the economy. When all the weather is correctly included within the BOP, it should sum up to zero during a perfect scenario. This means the inflows and outflows of funds should balance out. However, this doesn't ideally happen in most cases.
BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e., when a country’s export is more than its import, its BOP is said to be in surplus. On the opposite hand, BOP deficit indicates that a country’s imports are quite its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry.
Q5) Why Balance of payment is significant for a country?
A5) A country’s BOP is important for the following reasons:
• BOP of a country reveals its financial and economic status.
• BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
• BOP statement helps the government to make a decision on fiscal and trade policies.
• It provides important information to analyse and understand the economic dealings of a country with other countries.
• By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.
Q6) What is balance of payment on current account?
A6) The current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with reference to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they create up to a country’s Balance of Trade (BOT).
There are various categories of trade and transfers which happen across countries. It might be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries is stated as visible items and import/export of services (banking, information technology etc.) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This will even be personal transfers like – money sent by relatives to their family located in another country.
The current account includes: visible exports and import; invisible items concerning receipts and payments for various services like banking, insurance, shipping, travel etc. and other unilateral transfer of payments like donations, grants, taxes etc.
Q7) What is balance of payment on capital account?
A7) All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc. by migrants moving out/in to a different country. The deficit or surplus within the current account is managed through the finance from capital account and vice versa.
There are 3 major elements of capital account:
Loans & borrowings – It includes all kinds of loans from both the private and public sectors located in foreign countries.
Investments – These are funds invested within the corporate stocks by non-residents.
Foreign exchange reserves – foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account.
The balance of payments position of the country reflects on its economic health. The balance of payments of any country may be a comprehensive and systematic accounts of all the different transactions occurred between the residents of a country and therefore the rest of the world during a particular period of lime.
The balance of payments maintains detailed classified records of various kinds of receipts against exports of goods, services and all the capital received by its residents on the one hand and also of all the payments made by the residents against imports of goods and services received alongside the capital transferred to non-residents and foreigners, on the other hand. Thus, the balance of payments is far wider than the balance of trade which refers to only merchandise exports and imports.
The capital accounts of balance of payments include all the present economic transaction for the country’s international financial position resulting changes within the foreign financial assets and liabilities. The capital transaction includes both private, banking and official transactions.
The balance of payment account is maintained on the basis of double entry system of book keeping. If a country faces deficits within the current account of its balance of payment, then such deficit is generally met either by liquidating its assets or through borrowing from abroad. Thus, a persistent deficit within the balance of payments of a country result in a heavy debt burden on the economy.
Q8) What are the causes of disequilibrium in balance of payment?
A8) Disequilibrium in the balance of payments is the result of imbalance between receipts and payments for exports and imports.
Causes of Disequilibrium
Increase in Imports
Import of essential goods and services
Development Programmes
Population Growth
Demonstration Effect
Low or Decline in Exports
Low-income Elasticity of demand
Discovery of substitutes
Protectionist trade policy
Modernisation
Causes and Measures of Disequilibrium.
Overall account of BOP is usually in equilibrium. This balance or equilibrium is merely in accounting sense because deficit or surplus is restored with the help of capital account.
In fact, when we talk about disequilibrium, it refers to current account of the balance of payment. If autonomous receipts are but autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.
Causes of disequilibrium in BOP:
There are several factors which cause disequilibrium within the BOP indicating either surplus or deficit.
Such causes for disequilibrium in BOP are listed below:
(i) Economic Factors:
(a) Imbalance between exports and imports. (It is the main reason for disequilibrium in BOR),
(b) Large scale development expenditure which causes large imports,
(c) High domestic prices which cause imports,
(d) Cyclical fluctuations (like recession or depression) in general commercial activity
(e) New sources of supply and new substitutes.
(ii) Political Factors:
Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.
(iii) Social Factors:
(a) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports;
(b) High population growth in poor countries adversely affects their BOP because it increases the requirements of the countries for imports and reduces their capacity to export.
Q9) What are the monetary measures to correct disequilibrium in balance of payment?
A9) Monetary measures
1. Deflation
Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium a country faces deficit when its imports exceed exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting an increase in our exports. At the same time the demands for imports fall because of higher taxation and reduced income. This is able to build a favourable atmosphere in the balance of payment position. However, Deflation is often successful when the exchange rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline within the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the speed of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with reference to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange could also be said $1 = Rs. 50. This implies 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation: -
Exchange depreciation will be successful as long as there's no retaliatory exchange depreciation by other countries.
It is not suitable to a country desiring a fixed exchange rate system.
Exchange depreciation raises the prices of imports and reduces the prices of exports. So, the terms of trade will become unfavourable for the country adopting it.
It increases uncertainty & risks involved in foreign trade.
It may result in hyper-inflation causing further deficit in balance of payments.
3. Devaluation
Devaluation refers to deliberate attempt made by monetary authorities to bring down the worth of home currency against foreign currency. While depreciation is a spontaneous fall because of interactions of market forces, devaluation is official act enforced by the monetary authority. Generally, the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the worth of Indian currency has been reduced by 18 to 20 in terms of varied currencies. The 1991 devaluation brought the specified effect. The very next year the import declined while exports picked up.
When devaluation is affected, the value of home currency goes down against foreign currency, allow us to suppose the exchange rate remains $1 = Rs. 10 before devaluation. Allow us to suppose, devaluation takes place which reduces the worth of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is often because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At an equivalent time, imports become costlier as Indians need to pay more currencies to get one dollar. Thus, demand for imports is reduced.
Generally, devaluation is resorted to where there's serious adverse balance of payment problem.
Limitations of Devaluation: -
Devaluation is successful only if other country doesn't retaliate the same. If
Both the countries opt for the same, the effect is nil.
Devaluation is successful only if the demand for exports and imports is elastic.
In case it's inelastic, it may turn things worse.
Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.
Devaluation may bring inflation within the following conditions: -
Devaluation brings the imports down, when imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleashes inflationary trends.
A growing country like India is capital thirsty. Due to non-availability of capital goods in India, we've no option but to continue imports at higher costs. This may force the industries depending upon capital goods to push up their prices.
When demand for our export rises, more and more goods produced during a country would choose exports and thus creating shortage of such goods at the domestic level. This leads to inflation and inflation.
Devaluation might not be effective if the deficit arises thanks to cyclical or structural changes.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their exchange to the central authority. Thus, it results in concentration of exchange reserves in the hands of central authority. At the same time, the availability of foreign exchange is restricted just for essential goods. It can only help controlling situation from turning worse. Briefly it's only a temporary measure and not permanent remedy.
Q10) What are the non-monetary measure to correct disequilibrium in balance of payment?
A10) A deficit country alongside Monetary measures may adopt the following non-monetary measures too which can either restrict imports or promote exports.
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the costs of imports would increase to the extent of tariff. The increased prices will reduce the demand for imported goods and at a similar time induce domestic producers to produce more of import substitutes. Non-essential imports are often drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs: -
Tariffs bring equilibrium by reducing the quantity of trade.
Tariffs obstruct the expansion of world trade and prosperity.
Tariffs needn't necessarily reduce imports. Hence the consequences of tariff on the balance of payment position are uncertain.
Tariffs seek to determine equilibrium without removing the root causes of disequilibrium.
A new or a better tariff may aggravate the disequilibrium within the balance of payments of a country already having a surplus.
Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.
2. Quotas
Under the quota system, the govt may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the deficit is reduced and the balance of payments position is improved.
Q11) Explain Current Account Convertibility of the Rupee?
A11) Under Article VIII, Sections 2, 3 and 4 of the IMF the member countries of the IMF are obliged to revive current account convertibility of their currencies.
(a) don't have any restrictions on current payments (capital account restrictions are allowed); and
(b) Avoid discriminatory currency practices (including multiple exchange rates).
Current account convertibility is defined because the freedom to buy and sell foreign exchange for the subsequent international transactions:
(a) All payments due in reference to foreign trade, other current business, including services, and normal short-term banking and credit facilities;
(b) Payments due as interest on loans and as net income from other investments;
(c) Payments of moderate amount of amortization of loans or for depreciation of direct investments and
(d) Moderate remittances for family living expenses.
In his budget speech for 1992-1993, the minister of finance of India announced the partial convertibility of rupee on the current account. This measure was a section of the policy of economic reforms and it had been in line with the worldwide trend towards currency convertibility. By 1994, 97 countries including India had acquired Article VIII status on the current account convertibility. More countries have joined them subsequently.
Under the Liberalised rate of exchange Management System (LERMS) introduced in March 1992, 60 percent of all receipts under current transactions comprised of merchandise exports and invisible receipts might be converted at the free-market rate quoted by the authorised dealers. Just in case of the remaining 40 percent of receipts, the rate applicable was the official rate of exchange.
This provision of 40 percent of total foreign exchange under the current account was meant to cover exclusively the govt requirements and to enable the import of essential commodities. Moreover, the foreign exchange was also to be made available to fulfil 40 percent of the value of the advance licenses and special import licenses.
A major step within the direction of current account convertibility was adopted by India in March 1993, when the foreign exchange budget was abolished; the rate of exchange was unified and; the transactions on trade account were free of exchange control. The determination of rate of exchange of the rupee was left to the market forces.
On February 1994, the RBI announced the liberalisation of exchange control regulations up to a specified limit relating to- (a) foreign currency accounts of exchange earners, (b) basic travel quota, (c) studies abroad, (d) gift remittances, (e) donations, and (f) payments thanks to certain services rendered by foreign parties. Some more relaxations on current account payments were announced by RBI on August 19, 1994 in respect of various schemes associated with foreign currency non-resident accounts.
The rupee was made fully convertible on the current account of the balance of payments in August 1994. The Indian exporters to the Asian Clearing Union (ACU) countries and receiving export proceeds in rupee or in Asian Monetary Union (AMU) or within the currency of the participating country, were allowed to receive payments in any permitted currency through banking channels, provided it's offered by the overseas buyer within the ACU country.
The relaxations were made also in respect of the discharge of foreign exchange for foreign travel, interest income on Non-Resident Non-Reparable (NRNR) rupee deposits and remittances to relatives abroad. The reserve bank of India announced some major relaxations in exchange control in January 1997. The monetary ceilings prescribed for remittance of foreign exchange for a large range of purposes were removed and authorised dealers could now allow remittances for those purposes without prior clearance from the RBI.
Q12) Explain capital account convertibility of the rupee?
A12) Full convertibility of rupee wasn't introduced by the govt as it was risky in the conditions of huge deficit on current account faced by the country. Moreover, the intention was also to form the foreign exchange available at low prices for creating essential imports.
The cautious approach in respect of full convertibility of rupee was fully justified in sight of the Mexican crisis and subsequent East Asian crisis. The complete convertibility of rupee required the capital account convertibility of rupee together with the current account convertibility.
Capital account convertibility implies the right to transact in financial assets with foreign countries without restrictions. When there's completely free capital account convertibility, an Indian can dispose of his assets in India and take the money out of the country without hindrance.
Although the rupee isn't fully convertible on capital account, yet in respect of some elements, it had convertibility on capital account even earlier. As an example, capital account convertibility existed before for foreign investors and Non-Resident Indians for undertaking direct and portfolio investment in India.
In addition, Indian investments abroad up to U.S. $ 64 million were eligible for automatic approval by the RBI subject to certain conditions. No doubt, capital account convertibility may result in the large inflow of capital but, if the conditions are unfavourable within the home country, there's grave risk of capital flight from the home country, greater volatility in exchange rates and interest rates and wide fluctuations in exchange reserves. It's therefore prudent to undertake capital account convertibility only sometime after experimenting with the present account convertibility.
Q13) What preconditions are met by full convertibility of currency?
A13) The full convertibility of currency, including also capital account convertibility, should be introduced only after some preconditions are met:
(i) There should be domestic macro-economic stability.
(ii) The domestic enterprises should have reasonable degree of competitiveness.
(iii) The country should have trade-oriented development strategy and adequate incentives for export growth.
(iv) The country should have an appropriate industrial policy and a favourable investment climate.
(v) The country should have comfortable current account position.
(vi) The country should have adequate exchange reserves.
Q14) What are the merits of full convertibility of currency?
A14) The full convertibility of currency has the subsequent chief merits:
(i) The convertibility or floating of rupee would indicate truth value of it.
(ii) If the free-market rate were above the official rate of exchange, the profitability of exports would increase. As a result, the exporters would be induced to boost exports.
(iii) just in case the exportable products have high import-content, to that extent, a better market-determined rate of exchange can reduce profitability of exports. In such a situation, the import substitution would receive a boost not only in respect of exportable products but also in other imported products.
(iv) a higher rate of exchange of rupee can stimulate the remittances by the Non-Resident Indians (NRIs).
(v) As a result of full convertibility of rupee, the illegal remittance wouldn't remain attractive and, consequently, larger remittances from abroad would happen through proper channel.
(vi) If, alongside convertibility, there's liberalisation of import of gold, there would be an efficient deterrent to the smuggling of gold.
(vii) The fully convertible currency may result in automatic self-balancing of total foreign receipts and payments.
(viii) Full convertibility of rupee will enable the Indian investors to carry internationally diversified investment portfolio.
Q15) What are the demerits of full convertibility of rupee?
A15) Full convertibility of rupee has some demerits:
(i) If difficulty arises in keeping the current account balance under control, the free market rate of exchange is probably going to rise steeply.
(ii) If full convertibility causes appreciation of rupee, the possibility of reduction in exports can't be ruled out.
(iii) If there's appreciation of rupee, consequent upon its free convertibility, the imports are likely to increase and have adverse effect on BOP deficit.
(iv) If the complete convertibility causes depreciation of rupee, the import prices are likely to increase. As a result, the inflationary pressures can get intensified.
(v) Full convertibility of rupee can greatly strengthen the speculative tendencies and consequent instability within the whole system.
Q16) What is Devaluation? What are its limitations?
A16) Devaluation refers to deliberate attempt made by monetary authorities to bring down the worth of home currency against foreign currency. While depreciation is a spontaneous fall because of interactions of market forces, devaluation is official act enforced by the monetary authority. Generally, the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the worth of Indian currency has been reduced by 18 to 20 in terms of varied currencies. The 1991 devaluation brought the specified effect. The very next year the import declined while exports picked up.
When devaluation is affected, the value of home currency goes down against foreign currency, allow us to suppose the exchange rate remains $1 = Rs. 10 before devaluation. Allow us to suppose, devaluation takes place which reduces the worth of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is often because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At an equivalent time, imports become costlier as Indians need to pay more currencies to get one dollar. Thus, demand for imports is reduced.
Generally, devaluation is resorted to where there's serious adverse balance of payment problem.
Limitations of Devaluation: -
Devaluation is successful only if other country doesn't retaliate the same. If
Both the countries opt for the same, the effect is nil.
Devaluation is successful only if the demand for exports and imports is elastic.
In case it's inelastic, it may turn things worse.
Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.
Devaluation may bring inflation within the following conditions: -
Devaluation brings the imports down, when imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleashes inflationary trends.
A growing country like India is capital thirsty. Due to non-availability of capital goods in India, we've no option but to continue imports at higher costs. This may force the industries depending upon capital goods to push up their prices.
When demand for our export rises, more and more goods produced during a country would choose exports and thus creating shortage of such goods at the domestic level. This leads to inflation and inflation.
Devaluation might not be effective if the deficit arises thanks to cyclical or structural changes.
Q17) What are Tariffs? What are its drawbacks?
A17) Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the costs of imports would increase to the extent of tariff. The increased prices will reduce the demand for imported goods and at a similar time induce domestic producers to produce more of import substitutes. Non-essential imports are often drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs: -
Tariffs bring equilibrium by reducing the quantity of trade.
Tariffs obstruct the expansion of world trade and prosperity.
Tariffs needn't necessarily reduce imports. Hence the consequences of tariff on the balance of payment position are uncertain.
Tariffs seek to determine equilibrium without removing the root causes of disequilibrium.
A new or a better tariff may aggravate the disequilibrium within the balance of payments of a country already having a surplus.
Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.
Q18) What do you mean by Exchange depreciation? What are its limitations?
A18) Exchange depreciation means decline within the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the speed of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with reference to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange could also be said $1 = Rs. 50. This implies 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation: -
Exchange depreciation will be successful as long as there's no retaliatory exchange depreciation by other countries.
It is not suitable to a country desiring a fixed exchange rate system.
Exchange depreciation raises the prices of imports and reduces the prices of exports. So, the terms of trade will become unfavourable for the country adopting it.
It increases uncertainty & risks involved in foreign trade.
It may result in hyper-inflation causing further deficit in balance of payments.
Q19) What do you mean by Deflation?
A19) Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium a country faces deficit when its imports exceed exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting an increase in our exports. At the same time the demands for imports fall because of higher taxation and reduced income. This is able to build a favourable atmosphere in the balance of payment position. However, Deflation is often successful when the exchange rate remains fixed.
Q20) What is Exchange control?
A20) Exchange control is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their exchange to the central authority. Thus, it results in concentration of exchange reserves in the hands of central authority. At the same time, the availability of foreign exchange is restricted just for essential goods. It can only help controlling situation from turning worse. Briefly it's only a temporary measure and not permanent remedy.
A deficit country alongside Monetary measures may adopt the following non-monetary measures too which can either restrict imports or promote exports