23

Balance of Payments

INTRODUCTION

In Chapter 7, we had developed the model for a closed economy and in Chapter 8 to the model of an open economy. However, the discussion was limited to only the economy’s exports and imports of goods and services and the affect of a change in the net exports on the aggregate demand and the equilibrium level of income and output. However, there is much more to the international economic relationships than just simple exports and imports of goods and services. Transfer payments between the individuals of the different countries and also the governments are of extreme importance. Capital flows between countries is again important.

The balance of payment is a statement which summarizes the exports and imports and the other international transactions between the countries. This chapter analyses the different aspects of the balance of payments.

MEANING AND STRUCTURE OF BALANCE OF PAYMENTS

The balance of payments is a summary statement of all the economic transactions between the residents of one country with the rest of the world during a particular period of time, which is usually a year.

 

In the balance of payments accounting, any transaction that involves a payment by the residents of a country will be shown as a debit item while any transaction that involves a receipt by the residents of a country will be shown as a credit item in the balance of payments of that country.

The transactions entering into the balance of payments can be grouped under three broad accounts:

1. Current account
2. Capital account
3. Official international reserve account

Current Account

The current account of the balance of payments measures the flow of goods, services and income which occur across the national borders. The current account of the balance of payments includes the following items:

 

1. Balance of trade which includes the export and import of goods (or merchandise). It is also called the balance of visible trade. The balance of trade is the difference between the exports and imports of goods. While exports of goods are entered as a positive entry or credit claims in the balance of payments, imports of goods are entered as a negative entry or debits in the balance of payments.

   The balance of trade is one of the most important components of the balance of payments. It is not necessary for the balance of trade to be always in balance. If in a country:

    

   The balance of trade is the difference between the exports and imports of goods.

   1. Exports are greater than the imports, there is a trade surplus. Hence, the country has a favourable balance of trade.
   2. Exports are smaller than the imports, there is a trade deficit. Hence, the country has an unfavourable balance of trade.
2. Balance of invisible trade which includes the export and import of services. The balance of invisible trade is the difference between the exports and imports of services. The services include the following:

    

   The balance of invisible trade is the difference between the exports and imports of services.

   1. Travel, for example, expenditure by foreign tourists in India on hotels will be a credit entry in India’s balance of payments.
   2. Insurance, banking, shipping and freight services, and others, provided, for example, by Indian firms to foreigners will again be a credit entry in India’s balance of payments.
   3. Expenditure abroad by the government agencies (in India) will be a debit entry in India’s balance of payments.
   4. Interest and dividend on foreign investment earned by domestic entities will be a credit entry in India’s balance of payments.

   While the exports of services are entered as a positive entry or credit claims in the balance of payments, imports of services are entered as a negative entry or debits in the balance of payments.

3. Unilateral transfers These are also called unrequited transfers since they are one way transactions as there is no claim involved as far as repayment is concerned, either at present or in the future. Unilateral transfers include gifts, personal remittances, indemnities and others. Unilateral transfers appearing on the:

    

   Unilateral transfers (also called unrequited transfers) are one way transactions since there is no claim involved as far as repayment is concerned, either at present or in future.

   1. Credit side of the balance of payments include personal remittances of the emigrants to relatives in the country and gifts and grants which are received by the country from the individuals, institutions and governments of the foreign countries.
   2. Debit side of the balance of payments includes payments made by the country to the other countries in the form of personal remittances, gifts and grants.

The balance of current account or the current account balance includes the balance of trade, the balance of invisible trade and the balance of unrequited transfers or unilateral transfers. It represents the country’s current receipts from abroad and unilateral receipts on the credit side and country’s current international expenditures abroad and unilateral payments on the debit side. It has a flow dimension.

It is important to understand that

1. If the sum of receipts (or credits) is greater than the sum of payments (or debits), then there will be a current account surplus. It implies that there is a net inflow of income into the country.
2. If the sum of receipts (or credits) is smaller than the sum of payments (or debits), then there will be a current account deficit. It implies that there is a net outflow of income from the country. It not only leads to a loss of income from the country but also involves a problem in making payments.

The transactions in the current account have an effect on the national income and, thus, the income and output levels in the economy.

Capital Account

The capital account of the balance of payments measures the outflow and inflow of capital into the economy. The outflow of capital occurs due to the purchase of foreign assets by the households and firms in the domestic country. The inflow of capacity occurs due to the purchase of assets in the domestic country by the households and firms of the foreign countries. The capital account has a stock dimension.

 

The capital account of the balance of payments includes the following capital transactions:

1. Long-term movements of capital: This includes:
   1. Portfolio investment which refers to the purchase of long term securities by foreigners from the residents of the domestic country. The holding/maturity period is normally greater than a year. This involves the acquiring of an asset which does not give any control to the investor, for example purchase of the shares of a company in the country by a foreigner.
   2. Direct investment which refers to the private direct foreign investment in shares, bonds, plant and machinery in the country. In direct investment, the investor has a controlling power.
2. Short-term movements of capital: This includes:
   1. Purchase of short-term government and corporate securities (with a maturity period of one year or less than one year); for example, commercial bills and treasury bills.
   2. Holdings of cash balances by foreigners due to, for example, political uncertainty.
   3. Purchase of foreign currency for speculation.
3. Loan repayments: This includes:
   1. Loans by the international financial institutions to the government of a country.
   2. Loans received by the government of the country from the government of another country.
   3. Receipts of funds in the repayments of loans, for example, to loans extended to business firms and governments in the foreign countries.

All these involve an inflow of capital and are, thus, entered as a positive entry or credit claims in the balance of payments. Similarly, an outflow of capital is entered as a negative entry or debits in the balance of payments.

 

Table 23.1 Balance of Payments

Current Account	Capital Account	The Official International Reserve Accounts
1. Balance of Trade	1. Long-term movements of capital	(a) Foreign currencies
(a) Export and import of goods	(a) Portfolio investment	(b) Gold: Monetary and Non-monetary gold
(b) Non-monetary gold (according to which gold is a commodity and all exports and imports of gold are treated like any other commodity.)	(b) Direct investment	(c) Special Depository Receipts (SDRs)
2. Balance of Invisible Trade (includes exports and imports of services)	2. Short-term movements of capital
(a) Travel	(a) Purchase of short-term government and corporate securities.
(b) Insurance, banking, shipping and freight services, and others.	(b) Holdings of cash balances by foreigners.
(c) Expenditure abroad by government agencies.	(c) Purchase of foreign currency for speculation.
(d) Interest and dividend income.
(e) Miscellaneous
3. Unilateral Transfers	3. Repayment of Loans
(a) Personal remittances	(a) Loans by the international financial institutions.
(b) Transfers from the government	(b) Loans received by the government.
	(c) Receipts of funds in the repayments of loans.

 

The transactions in the capital account influence the position of the economy as an international creditor or debtor.

The Official International Reserve Account

The official reserves of a country include:

1. Foreign currencies: Most countries prefer to hold their foreign exchange reserves in dollars which is the most widely accepted and important currency in the world today.
2. Gold: As far as gold is concerned, it can be divided into two categories:
   1. Monetary gold, where the movements occur when gold is used as a means of payment. Hence, all monetary gold movements are included under the official reserves.
   2. Non-monetary gold according to which gold is a commodity. Hence, all exports and imports of gold are treated like any other commodity in the balance of payments.
3. Special depository receipts: (SDRs): When a country becomes a member of the IMF, it has to deposit a subscription of which 25 per cent is in the form of gold or even SDRs while the rest is in the form of the country’s own currency. Depending on its subscription a country can draw other convertible currencies from the IMF, and this enters as a positive entry or credit claims in the balance of payments.

The foreign exchange reserves are maintained not only to make payments in case of deficits in the balance of payments but also to stabilize the foreign exchange rate.

The transactions in the international reserve account determine the foreign exchange reserves which are available for settling a deficit in the current or capital account of the country.

The different components of the balance of payments can be shown as in Table 23.1.

• The current account of the balance of payments includes the following items: balance of trade, balance of invisible trade and unilateral transfers.
• The balance of trade is one of the most important components of the balance of payments.
• The transactions in the current account have an effect on the national income and, thus, the income and output levels in the economy.
• The transactions in the capital account influence the position of the economy as an international creditor or debtor.
• The transactions in the international reserve account determine the foreign exchange reserves which are available for settling a deficit in the current or capital account of the country.

DOUBLE ENTRY BOOKKEEPING

It is important to note that the balance of payments of a country will always balance and, thus, will always be in equilibrium. This is based on the double entry system of bookkeeping where each transaction is recorded twice, as a debit entry and as a credit entry.

Table 23.2 depicts a hypothetical example of the balance of payments of a country. The left side of the table shows the ways in which a country can acquire foreign currency while the right side of the table shows the ways in which the country spends the foreign currency.

Balance of trade: In Table 23.2, Row 1 indicates that the country earns Rs. 500 crores as foreign exchange by exporting goods. Similarly, Row 6 indicates that the country spends Rs. 600 crores of the foreign exchange by importing goods. These two rows depict the balance of trade equal to –100 crores as Row (a) in Table 23.3. This implies that there is an adverse balance of trade.

Balance of services: In Table 23.2, Row 2 indicates that the country earns Rs. 250 crores as foreign exchange by exporting services. Similarly, Row 7 indicates that the country spends Rs. 50 crores of the foreign exchange by importing services. These two rows depict the balance of invisible trade equal to 200 crores as Row (b) in Table 23.3. This implies that there is a favourable balance of services or invisible trade.

 

Table 23.2 Balance of Payments of a Country

Balance of unilateral transfers: In Table 23.2, Row 3 indicates that the country earns Rs. 50 crores as foreign exchange from unilateral receipts. Similarly, Row8 indicates that the country spends Rs. 80 crores of the foreign exchange on unilateral payments. These two rows depict the balance of unilateral transfers or unrequited receipts equal to –30 crores as Row (c) in Table 23.3. This implies that there is an unfavorable balance of unilateral transfers.

Balance of current account: In Table 23.2, the balance of current account includes Rows 1, 2, 3 and 6, 7 and 8. In Table 23.3, the balance of current account includes Rows (a), (b) and (c) to depict a surplus on the current account equal to Rs. 70 crores as in Row (d).

Balance of capital account: In Table 23.2, Row4 indicates that the country earns Rs. 100 crores as foreign exchange from capital receipts. Similarly, Row 9 indicates that the country spends Rs. 120 crores of the foreign exchange on capital payments. These two rows depict a deficit in capital account. Table 23.3 shows a balance of capital account equal to Rs.–20 crores as Row (e).

Balance of official reserve account: In Table 23.2, Row5 indicates that the country earns Rs. 100 crores as foreign exchange from the sale of gold. Similarly, Row 10 indicates that the country spends Rs. 150 crores of the foreign exchange on purchase of gold. These two rows depict the balance of official reserve account equal to Rs.–50 crores as Row (f) in Table 23.3.

Balance of payments: In Table 23.3, the balance of payments includes Rows (d), (e) and (f) to depict a balance in the balance of payments in an accounting sense. The balance of current account equals Rs. 70 crores while the balance of capital account depicts a deficit equal to Rs. –20 crores. The official reserve account provides the balancing factor through a net purchase of gold equal to Rs. 50 crores.

• The official reserve account provides the balancing factor in the balance of payments.

A DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS

As we have already observed, the balance of payment always balances as it is prepared on the basis of the double entry system of bookkeeping. This leads us to the very important issue of how a surplus or a deficit occurs in the balance of payments, or in other words how disequilibrium occurs in the balance of payments. To understand this very crucial aspect of the balance of payments, we first examine autonomous and accommodating transactions.

Autonomous and Accommodating Transactions

One can distinguish between two types of transactions, autonomous and accommodating transactions.

 

Table 23.3 The External Balances in the Balance of Payments

1.	Balance of trade (Rows 1 and 6 of Table 23.2)	500 – 600 = – 100
2.	Balance of services (Rows 2 and 7 of Table 23.2)	250 – 50 = 200
3.	Balance of unilateral transfers (Rows 3 and 8 of Table 23.2)	50 – 80 = – 30
4.	Balance of current account (Rows (a), (b) and (c) of Table 23.3)	–100 + 200 – 30 = 70
5.	Balance of capital account (Rows 4 and 9 of Table 23.2)	100 – 120 = –20
6.	Balance of official reserve account (Rows 5 and 10 of Table 23.2)	100 – 150 = – 50
7.	Balance of payments (Rows (d), (e) and (f) of Table 23.3)	1000 – 1000 – 0

 

Autonomous transactions are those transactions that take place independently of other items in the balance of payments. Thus, these transactions take place for the satisfaction that they give or for the profit that they yield. They take place in both the current and the capital accounts.

 

1. Current account: Here, autonomous transactions include the exports and imports of goods and services. Unilateral transfers are also included under autonomous transactions though they are not commercial transactions (since they do not, in any way, bring about a balance in the balance of payments).
2. Capital account: Here, autonomous transactions include the long-term movements of capital because they are commercial transactions for the explicit purpose of making profits.

Accommodating transactions are those transactions that take place for the specific purpose of equalizing the balance of payments from an accountant’s point of view. They take place for balancing a deficit or surplus in the foreign account. They are not motivated by profit. They include short-term movements of capital, monetary gold movements and variations in the foreign exchange reserves.

 

To determine whether the balance of payments is in equilibrium or disequilibrium, only the autonomous transactions are considered.

1. If the total receipts from autonomous transactions are equal to the total payments from autonomous transactions, then there is equilibrium in the balance of payments.
2. If the total receipts from autonomous transactions are not equal to the total payments from autonomous transactions, then there is disequilibrium in the balance of payments. The disequilibrium is in the form of a
   1. Surplus if the total receipts from autonomous transactions are larger than the total payments from autonomous transactions.
   2. Deficit if the total receipts from autonomous transactions are smaller than the total payments from autonomous transactions.

Any disequilibrium in the balance of payments is offset by the accommodating transactions which make up for any deficit or surplus. Hence, the sum of accommodating transactions and autonomous transactions will always be zero. Thus, theoretically speaking, from an accountant’s point of view the balance of payment always balances, yet there will exist disequilibrium in the balance of payments from an economist’s point of view.

• To determine whether the balance of payments is in equilibrium or disequilibrium, only the autonomous transactions are considered.

KINDS OF DISEQUILIBRIA IN THE BALANCE OF PAYMENTS

One can differentiate between different kinds of disequilibrium on the basis of the source of the disequilibrium.

1. Structural Disequilibrium: This occurs due to structural imbalances caused by the shifts in the international demand and/or the supply of the factors of production, goods or services. They persist for a long time and are difficult to eliminate. Some causes of structural disequilibrium are:
   1. Change in production pattern: Some countries may experience a change in its factor endowments over long periods of time. This happened in the case of Britain which had to face competition in its exports, especially of manufactured goods, from countries of West Europe and US. Hence, there occurred a structural imbalance in its balance of payments which Britain could not tackle even by changing its production pattern and shifting to new industries.
   2. Loss of capital: A country may experience a loss of capital. For example, during times of war there is widespread destruction including that of industries. Hence, on the one hand, a country has to rely on imports not only for goods but also for capital at least over a short period of time. On the other hand, its exports will experience a slow down. All this will lead to a structural disequilibrium in the country’s balance of payments.
   3. Resource deficiencies: Many countries have to go through a shortage of resources which prevents them from achieving the level of growth which they desire to achieve. Hence, they have to face an increased dependence on imports which creates a problem in their balance of payments. For example, India has to rely heavily on imports of petroleum for its development, thus, putting a strain on India’s balance of payments.
   4. A change in the supply of long-term flows of capital: Often a country which depends heavily on foreign capital may find a change in that it may stop coming perhaps because the investor may find other avenues of investment more attractive. This may have a serious affect on the production structure and, thus, on the balance of payments of the country.
   5. Change in the demand pattern: Countries which experience growth and change in the income distribution experience a shift in the demand from agricultural goods to manufactured goods. Hence, countries whose exports are primarily based on agricultural goods suffer a setback as the demand for their exports fails to keep up with the growing world demand for exports. They face difficulties in their balance of payments. They can tackle this problem through a change in their production pattern and also through a diversification of their exports.
   6. Changes in the political, economic and social environment: This again plays a crucial role in influencing the relations between countries and, hence, their exports and imports.
2. Cyclical Disequilibrium: Business cycles are another major cause of disequilibrium in the balance of payments. Business cycles, which are global, affect almost all the countries though to differing degrees. A recession and inflation is accompanied by a trade surplus in some countries and a deficit in the others depending on the nature of their exports and imports and also on the elasticity of demand for their exports and imports. Countries with a high marginal propensity to import experience huge trade deficits during inflation and smaller deficits during recession times.
3. Exchange Rate Disequilibrium: There often occurs an overvaluation or an undervaluation of a currency on the foreign scenario.

   Overvaluation of a currency is said to occur when the official value of a currency is fixed at a higher rate than what would have been determined by the free market forces of demand and supply. The effects of overvaluation are similar to that of inflation. It has an adverse affect on exports and a favourable effect on imports, thus, producing a deficit in the balance of payments.

    

   Overvaluation of a currency is said to occur when the official value of a currency is fixed at a higher rate than what would have been determined by the free market forces of demand and supply.

   Undervaluation of a currency is said to occur when the official value of a currency is fixed at a lower rate than what would have been determined by the free market forces of demand and supply. The effects of undervaluation are opposite to that of overvaluation. It has an adverse affect on imports and a favourable effect on exports, thus, producing a surplus in the balance of payments.

    

   Undervaluation of a currency is said to occur when the official value of a currency is fixed at a lower rate than what would have been determined by the free market forces of demand and supply.

   Capital flows are also influenced by disequilibrium in the exchange rate. An undervaluation of the currency attracts foreign capital, thus, adding to the surplus in the balance of payments.

4. Monetary Disequilibrium: Inflation and deflation are the accompaniments of a monetary disequilibrium. Inflation has a two-fold effect on trade. On the one hand, inflation makes imports relatively cheaper leading to an increase in the demand for imports.

   On the other hand, inflation makes exports relatively costlier leading to a decrease in the demand for exports. Thus inflation leads to a deficit in the balance of payments, which will persist if the inflation continues to persist.

THE PROCESS OF ADJUSTMENT IN THE BALANCE OF PAYMENTS

Disequilibrium in the balance of payments is a cause for concern for every economy, more so if the disequilibrium is in the form of a deficit. We here analyse the macroeconomic policies that are utilized for adjustment in the balance of payments. Since deficit is more of a basis for concern, our analysis will focus on a deficit. They can be grouped under two heads:

1. Expenditure reducing or Expenditure changing policies:
   1. Monetary policy
   2. Fiscal policy
2. Expenditure switching policies:
   1. Devaluation: The elasticity approach
   2. Devaluation: The absorption approach

Expenditure Reducing or Expenditure Changing Policies

Expenditure reducing policies are aimed at bringing about a change in the aggregate expenditure in the country. To simplify our analysis, we exclude autonomous capital movements. Thus, the balance of payments can be written as

 

 

	B = Y – E
where,	B = balance of payments (net)
	Y = domestic output
	E = domestic expenditure

 

If in a country:

1. Y > E: The domestic output is greater than the domestic expenditure and there will be a surplus in the country’s balance of payments.
2. Y = E: The domestic output is equal to the domestic expenditure and there will be balance of payments equilibrium.
3. Y < E: The domestic output is smaller than the domestic expenditure and there will be a deficit in the country’s balance of payments.

It is a deficit in the balance of payments that is of concern for the policy makers. The deficit can be eliminated in two ways: either by increasing the domestic output, Y or by reducing the domestic expenditure, E. However in the short run, it may be difficult to increase the output if there are structural constraints. Hence, most economies prefer to resort to expenditure reducing policies to reduce a balance of payments deficit.

Expenditure reducing policies can be divided under two broad groups: monetary and fiscal policy.

Monetary Policy

During the gold standard monetary policies were quite popular in correcting disequilibrium in the balance of payments. However, in the 1930s they were not successful in bringing about stabilization during the Depression and they lost popularity. It was only in the 1950s that interest and belief in the effectiveness of monetary policy was once again revived.

The instruments of monetary policy are discussed in depth in Chapter 25. Here, we will throw light only on some of these instruments.

To tackle a deficit in the balance of payments, a contractionary or tight monetary policy is followed. The instruments of monetary policy which are most effective and used often include:

1. Changes in interest rates: The effect of an increase in the interest rates on the level of investment will depend on the general economic situation. Suppose there is a boom in the economy and,
   1. If the producers expect prices and thus the interest rate to fall in the future, they will postpone all investments. Through the multiplier effect, this will lead to a decrease in the national income and thus a reduction in the imports which will, to some extent, reduce the deficit in the balance of payments.
   2. If the producers expect prices and thus the interest rate to rise in the future, they will go ahead with all investments. Through the multiplier effect, this will lead to an increase in the national income and thus an increase in the imports which will increase, rather than decrease, the deficit in the balance of payments.
2. Open market operations: Suppose the central bank sells bonds and securities in the open market. Commercial banks, insurance companies and others purchase it with liquid money. This will not only reduce the liquidity in the banking system but will also decrease the availability of credit. The interest rates will also increase. This will have an adverse effect on investment and the national income, leading to a fall in the imports.

Other instruments of monetary policy like changes in reserve requirements are also often applied to correct a deficit in the balance of payments.

Fiscal Policy

Fiscal policies can also be used to reduce expenditure. They can be divided into two groups:

1. Those that work on the income side of the government budget: Here, the most important instrument is taxation. As far as taxes are concerned
   1. an increase in direct taxes—for example, income tax—reduces the incomes of households leading to a decrease in consumption (and also in savings) and thus a decrease in imports.
   2. an increase in indirect taxes—for example, sales tax—leads to a decrease in consumption and thus a decrease in imports.
2. Those that work on the expenditure side of the government budget: As far as government expenditure is concerned,
   1. a reduction in transfer payments will immediately decrease consumption since it is the low income group, with a high marginal propensity to consume, which is the main beneficiary of transfer payments.
   2. a decrease in public consumption expenditure will lead to a fall in income and thus in imports.
   3. a decrease in public investment expenditure will—similar to private investment—lead to a decrease in national income and imports.

   Monetary and fiscal policies are the two most important ways of implementing an expenditure reducing policy. To eliminate a deficit in the balance of payments, a country can pursue a contractionary monetary policy or a restrictive fiscal policy. Both policies lead to the following:

   1. On the one hand, a deflationary impact on the national income leading to a decrease in imports.
   2. On the other hand, a positive effect on exports and the import competing industries.

   Thus, an expenditure reducing policy affects exports favourably and imports adversely leading to a positive effect on the balance of payments.

Expenditure Switching Policies: Devaluation–the Elasticity Approach

The expenditure switching policies work mainly through changing the relative price of exports and imports. This is achieved through a change in the exchange rates that is a revaluation or devaluation of the domestic currency. One can include direct controls, which includes commercial controls (like limiting the volume of imports), financial controls and exchange restrictions, also as a switching device.

 

In a flexible exchange rate system a country with a deficit in the balance of payments experiences depreciation, or in other words a lowering in the value of its currency with respect to other currencies. Similarly, a country with a surplus in the balance of payments experiences appreciation, or in other words a rise in the value of its currency with respect to other currencies.

Under a stable exchange rate system in case of a deficit or a surplus in the balance of payments, the authorities have to take a conscious decision to bring about changes in the value of the currency with respect to the price of gold or to some primary asset. Devaluation refers to a conscious action by the monetary authorities to lower the value of a currency with respect to the price of gold.

 

Devaluation leads to a change in the relative prices. A devaluation of 10 per cent leads to

1. an increase in the price of imports by 10 per cent in the home currency which will, on the one hand, discourage imports and, on the other hand, encourage the import competing industries which will be in a better position to compete.
2. a decrease in the price of exports by 10 per cent in the foreign currency which will encourage exports.

Devaluation of a currency improves the balance of payments by encouraging exports and discouraging imports. The extent to which devaluation encourages exports and discourages imports depends on the elasticity of demand for its exports and imports.

The traditional approach to the effects of devaluation has been analysed in the Marshall Lerner condition in terms of elasticity. According to the Marshall Lerner condition, for a devaluation to have a positive effect on a country’s balance of payments the sum of the absolute values of the elasticity of demand for its exports and imports should be greater than one. If the sum of the absolute values of the elasticity of demand for its exports and imports is less than one, then a country can improve its balance of payments through a revaluation.

The Marshall Lerner condition can be expressed as follows:

where,	∆B =	change in the trade balance
	k =	devaluation in percentage terms
	Xf =	value of exports in terms of foreign currency
	e1m =	the elasticity of demand for imports of the devaluing country
	e2m =	the elasticity of demand for exports (imports of the foreign country) of the devaluing country

A devaluation leads to a

1. an increase in the price of imports: The larger is the elasticity of demand for imports, the greater will be the decrease in the volume of imports. The value of the elasticity of demand for imports will depend on the type of good that the country imports. In case a country imports goods like necessities and raw materials, the elasticity of demand for imports will be low and devaluation may not be effective in correcting a balance of payment deficit.
2. a decrease in the price of exports: The larger is the elasticity of demand for exports of a country, the greater will be the increase in the volume of exports. The value of the elasticity of demand for exports will depend on the type of good that the country exports and also the conditions in the market. In case a country exports goods like necessities and raw materials, the elasticity of demand for exports will be low and devaluation may not be effective in correcting a balance of payment deficit. On the other hand, if a country exports industrial goods the elasticity of demand for exports will be high and devaluation will be very effective in correcting a balance of payment deficit.

The Marshall Lerner condition is based on some conditions which should be satisfied:

1. The supply elasticities should be large: This may be true in times of a recession when there are unemployed resources. However, when there exists full employment an increase in the price of exports will fail to increase the supply of exports.
2. When devaluation takes place the trade balance is in equilibrium, which again is not always possible.

Devaluation has some adverse effects on the economy. It has an inflationary impact which is, to some extent, limited if devaluation is pursued with a contractionary monetary and fiscal policy. It is also felt that devaluation leads to a redistribution of income from the labour class to the others.

In spite of all the restrictions and adverse effects, the Marshall Lerner condition holds in that the larger are the elasticities of demand for a country’s exports and imports, the greater is the favourable effect of devaluation on the balance of payments.

Expenditure Switching Policies: Devaluation–the Absorption Approach

Sidney Alexander in 1952 presented an alternative approach, the absorption approach, to the effects of devaluation. The approach is in macro terms.

where,	B = balance of trade
	Y = national income
	A = total absorption or total expenditure or total demand.

Since total demand includes consumption and investment, for a two sector economy A = C + I.

Devaluation affects the balance of trade, B either by influencing the national income, Y or by influencing the total absorption, A. We have

The effect of devaluation on absorption can be split into two parts:

1. Direct effect on absorption which depends mainly on the real income at which the devaluation occurs, ∆D.
2. Indirect effect on absorption which depends on the propensity to absorb, c out of real income, c∆Y.

where,	∆A = change in absorption
	∆D = direct effect on absorption
	c∆Y = indirect effect on absorption

 

Combining Eqs. (3) and (4), we get

It is obvious from the above equation that the effects of devaluation on the balance of trade depend on three factors. These three factors depend on how devaluation effects the

1. national income, Y
2. propensity to absorb, c
3. direct absorption, D

The effects of devaluation will be different according to whether there is full employment in the economy or whether there exist unemployed resources.

When there is full employment in the economy, devaluation will not have any influence on the national income. However, it will affect the economy to some extent through its affect on absorption.

When there are unemployed resources in the economy, devaluation leads to an expansionary effect on exports and hence on income and absorption. If the increase in income is greater than the increase in absorption, then there will be an improvement in the trade balance.

Policy Mix and a Simultaneous External and Internal Balance

Trevor Swan had developed a diagrammatic analysis to explain the impact of expenditure changing and expenditure policies on the external and internal balance of a country, in what is called the Swan diagram.

Figure 23.1 depicts the impact of expenditure changing and expenditure policies on the external and internal balance of a country.

 

where    x-axis = domestic absorption

y-axis = real exchange rate (amount of the domestic currency that is required to purchase one unit of the foreign currency)

Curve IB = combinations of the real exchange rate and domestic absorption at which there exists an internal balance.

Curve EB = combinations of the real exchange rate and domestic absorption at which there exists an external balance.

An increase in R, the real exchange rate (amount of the domestic currency that is required to purchase one unit of the foreign currency) implies a devaluation of the domestic currency. A decrease in R, the real exchange rate implies a revaluation of the domestic currency.

Curve IB is downward sloping with negative slope because a lower rate of exchange worsens the balance of trade and, thus, a higher domestic absorption is required for the economy to maintain an internal balance. Curve EB is upward sloping with a positive slope because a higher rate of exchange improves the balance of trade and, thus, a higher domestic absorption is required for the economy to maintain an external balance.

Figure 23.1 Policy Mix and a Simultaneous External and Internal Balance

In Figure 23.1,

1. At all points to the right (and above) of the IB curve, there exists an inflationary situation while at all points to the left (and below) of the IB curve, there exists unemployment.
2. At all points to the left (and above) of the EB curve, there exists a surplus in the balance of payments while at all points to the right (and below) of the EB curve there exists a deficit in the balance of payments.

In Figure 23.1, there are four quadrants:

Quadrant A: Unemployment and balance of payments surplus

Quadrant B: Inflation and balance of payments surplus

Quadrant C: Inflation and balance of payments deficit

Quadrant D: Unemployment and balance of payments deficit

At a point like G in Quadrant D where there exists unemployment and a deficit in the balance of payments, a movement to point E (where there exists a simultaneous external and internal balance) would require a devaluation of the currency on the one hand and an increase in domestic absorption (expansionary fiscal policy) on the other hand. Thus, a combination of two policies is usually required to achieve two goals.

At a point like H in Quadrant D where there again exists unemployment and a deficit in the balance of payments, a movement to point E would require a devaluation of the currency on the one hand and a decrease in domestic absorption (contractionary fiscal policy) on the other hand.

Thus, we have observed that in most cases a combination of both expenditure reducing and expenditure switching policies is required to achieve both external and internal balance in a country.

• Often economies prefer to resort to expenditure reducing policies to reduce a balance of payments deficit.
• The expenditure switching policies work through a change in the exchange rates, that is, a revaluation or devaluation of the domestic currency.
• The extent to which devaluation encourages exports and discourages imports depends on the elasticity of demand for its exports and imports.
• A combination of both expenditure reducing and expenditure switching policies is required to achieve both external and internal balance in a country.

 

Table 23.4 Balance of Payments

ANALYSIS OF PERFORMANCE OF INDIAN ECONOMY IN THE EXTERNAL SECTOR

The Indian economy suffered adverse developments in the external sector in the year 2008–09. This economic slowdown was a reflection of the global financial crisis. Most emerging economies of the world were affected by the unfavourable conditions in the global market. The impact of the global financial crisis, perhaps the worst since the Great Depression, spread from the developed to the emerging economies through the financial and trade channels.

In the beginning, the impact was not very significant in India. In fact, it was more or less positive in the beginning. However once the global crisis deepened, it spread to most of the countries including India through the capital and current account of the balance of payments. Despite these adverse developments in the balance of payments of India, including a sharp deceleration in the net capital flows and a slowdown in the demand for exports, the foreign sector of the Indian economy showed resilience. India continued to remain an attractive destination for foreign direct investment while its foreign exchange reserves continued to be in comfortable position.

Table 23.4 gives India’s balance of payments as in the Indian Economic Survey, 2008–09.

• Despite the adverse developments in the global scenario, the foreign sector of the Indian economy showed resilience and India continued to remain an attractive destination for foreign direct investment.

INTRODUCTION

The balance of payment is a statement which summarizes the exports and imports and the other international transactions between the countries. The present chapter analysed the different aspects of the balance of payments.

MEANING AND STRUCTURE OF BALANCE OF PAYMENTS

1. The balance of payment is a statement which summarizes the exports and imports and the other international transactions between the countries.
2. The transactions entering into the balance of payments can be grouped under three broad accounts: current account, capital account and official international reserve account.
3. The current account of the balance of payments measures the flow of goods, services and income which occur across the national borders.
4. The capital account of the balance of payments measures the outflow and inflow of capital into the economy.

CURRENT ACCOUNT

1. The current account of the balance of payments includes the following items: balance of trade which includes the export and import of goods (or merchandise); balance of invisible trade which includes the export and import of services; unilateral transfers which are one way transactions as there is no claim involved as far as repayment is concerned, either at present or in the future.
2. The transactions in the current account have an effect on the national income and, thus, the income and output levels in the economy.

CAPITAL ACCOUNT

1. The capital account of the balance of payments measures the outflow and inflow of capital into the economy.
2. The capital account of the balance of payments includes the following capital transactions: long-term movements of capital which further includes portfolio investment and direct investment; short-term movements of capital which includes items like purchase of short-term government and corporate securities and loan repayments which include loans by the international financial institutions.
3. The transactions in the capital account influence the position of the economy as an international creditor or debtor.

THE OFFICIAL INTERNATIONAL RESERVE ACCOUNT

1. The official reserves of a country include foreign currencies, monetary gold and SDRs.
2. The transactions in the international reserve account determine the foreign exchange reserves which are available for settling a deficit in the current or capital account of the country.

DOUBLE ENTRY BOOKKEEPING

1. The balance of payments of a country will always balance because of the double entry system of bookkeeping and thus will always be in equilibrium.
2. The official reserve account provides the balancing factor in the balance of payments.

A DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS

1. Autonomous transactions are those transactions that take place independently of other items in the balance of payments. Thus, these are transactions that take place for the satisfaction that they give or for the profit that they yield.
2. Autonomous transactions include exports and imports of goods and services, unilateral transfers and long-term movements of capital.
3. Accommodating transactions are those transactions that take place for the specific purpose of equalizing the balance of payments from an accountant’s point of view. They take place for balancing a deficit or surplus in the foreign account.
4. Accommodating transactions include short-term movements of capital, monetary gold movements and variations in the foreign exchange reserves.
5. To determine whether the balance of payments is in equilibrium or disequilibrium, only the autonomous transactions are considered.
6. Any disequilibrium in the balance of payments is offset by the accommodating transactions which make up for any deficit or surplus. Hence, the sum of accommodating transactions and autonomous transactions will always be zero.

KINDS OF DISEQUILIBRIA IN THE BALANCE OF PAYMENTS

1. Structural disequilibrium occurs due to structural imbalances caused by the shifts in the international demand and/or the supply of the factors of production, goods or services.
2. Cyclical disequilibrium is caused by business cycles.
3. Exchange rate disequilibrium: Overvaluation of a currency has an adverse affect on exports and a favourable effect on imports, thus, producing a deficit in the balance of payments. Undervaluation of a currency has an adverse affect on imports and a favourable effect on exports, thus, producing a surplus in the balance of payments.
4. Monetary disequilibrium: Inflation makes exports relatively costlier leading to a decrease in the demand for exports. Thus, inflation leads to a deficit in the balance of payments.

THE PROCESS OF ADJUSTMENT IN THE BALANCE OF PAYMENTS

The macroeconomic policies that are utilized for correcting disequilibrium in the balance of payments include expenditure reducing policies and expenditure switching policies.

EXPENDITURE REDUCING OR EXPENDITURE CHANGING POLICIES

1. Expenditure reducing policies are aimed at bringing about a change in the aggregate expenditure in the country.
2. Expenditure reducing policies can be divided under two broad groups: monetary and fiscal policy.
3. To tackle a deficit in the balance of payments, a contractionary or tight monetary policy is followed.
4. Fiscal policies can be divided into two groups: those that work on the income side of the government budget and those that work on the expenditure side of the government budget.

EXPENDITURE SWITCHING POLICIES: DEVALUATION - THE ELASTICITY APPROACH

1. The expenditure switching policies work mainly through changing the relative price of exports and imports.
2. Under a stable exchange rate system in case of a deficit or a surplus in the balance of payments, the authorities have to take a conscious decision to bring about changes in the value of the currency with respect to the price of gold or to some primary asset.
3. Devaluation refers to a conscious action by the monetary authorities to lower the value of a currency with respect to the price of gold.
4. Devaluation of a currency improves the balance of payments by encouraging exports and discouraging imports.
5. The extent to which devaluation encourages exports and discourages imports depends on the elasticity of demand for its exports and imports.
6. According to the Marshall Lerner condition, for a devaluation to have a positive effect on a country’s balance of payments the sum of the absolute values of the elasticity of demand for its exports and imports should be greater than one.

EXPENDITURE SWITCHING POLICIES: DEVALUATION–THE ABSORPTION APPROACH

1. Sidney Alexander in 1952 presented an alternative approach, the absorption approach, to the effects of devaluation.
2. Devaluation affects the balance of trade, B either by influencing the national income, Y or by influencing the total absorption, A.
3. The effects of devaluation will be different according to whether there is full employment in the economy or whether there exist unemployed resources.

POLICY MIX AND A SIMULTANEOUS EXTERNAL AND INTERNAL BALANCE

1. Trevor Swan had developed a diagrammatic analysis to explain the impact of expenditure changing and expenditure policies on the external and internal balance of a country, in what is called the Swan diagram.
2. In most cases, a combination of both expenditure reducing and expenditure switching policies are required to achieve both external and internal balance in a country.

ANALYSIS OF PERFORMANCE OF INDIAN ECONOMY IN THE EXTERNAL SECTOR

1. Once the global crisis deepened, it spread to most of the countries including India through the capital and current account of the balance of payments.
2. Despite these adverse developments in the balance of payments of India, including a sharp deceleration in the net capital flows and a slowdown in the demand for exports, the foreign sector of the Indian economy showed resilience.
3. India continued to remain an attractive destination for foreign direct investment while its foreign exchange reserves continued to be in comfortable position.

TRUE OR FALSE QUESTIONS

1. The capital account of the balance of payments measures the flow of goods, services and income which occurs across the national borders.
2. Autonomous transactions are those transactions that take place independently of other items in the balance of payments.
3. To determine whether the balance of payments is in equilibrium or disequilibrium, only the accommodating transactions are considered.
4. Structural disequilibrium occurs due to business cycles.
5. According to the Marshall Lerner condition, for a devaluation to have a positive effect on a country’s balance of payments the sum of the absolute values of the elasticity of demand for its exports and imports should be greater than one.

VERY SHORT-ANSWER QUESTIONS

1. Define the balance of payments.
2. What are unilateral transfers?
3. What do you understand by autonomous transactions?
4. What are accommodating transactions?
5. Which two macroeconomic policies are utilized for correcting disequilibrium in the balance of payments?

SHORT-ANSWER QUESTIONS

1. Write short notes on the
   1. Balance of Trade
   2. Balance of Invisible Trade
2. Write a short note on the official international reserve account.
3. Differentiate between autonomous and accommodating transactions.
4. Briefly discuss the different kinds of disequilibria in the balance of payments.
5. Discuss the effectiveness of monetary and fiscal policies as expenditure reducing policies in tackling a balance of payments deficit.

LONG-ANSWER QUESTIONS

1. What does the current account of the balance of payments measure? Discuss the constituents of the current account of the balance of payments.
2. What does the capital account of the balance of payments measure? Discuss the constituents of the capital account of the balance of payments.
3. The balance of payments of a country will always balance because of the double entry system of bookkeeping’. Explain.
4. ‘To determine whether the balance of payments is in equilibrium or disequilibrium, only the autonomous transactions are considered.’ Explain.
5. What is devaluation? Discuss the conditions under which it is expected to improve a deficit in the balance of payments of a country?

TRUE OR FALSE QUESTIONS

1. False. The current account of the balance of payments measures the flow of goods, services and income which occurs across the national borders. The capital account of the balance of payments measures the outflow and inflow of capital into the economy.
2. True. Autonomous transactions are those transactions that take place independently of other items in the balance of payments. Thus, these are transactions that take place for the satisfaction that they give or for the profit that they yield.
3. False. To determine whether the balance of payments is in equilibrium or disequilibrium, only the autonomous transactions are considered.
4. False. Structural disequilibrium occurs due to structural imbalances caused by the shifts in the international demand and/or the supply of the factors of production, goods or services.
5. True. If the sum of the absolute values of the elasticity of demand for its exports and imports is less than one, then a country can improve its balance of payments through a revaluation.