UNIT-2

Balance of payments
The balance of payments is the record of all international trade and financial transactions made
by a country's residents. 

The balance of payments has three components—the current account, the financial account, and

the capital account. Current accounts measure international trade, net income on investments,
and direct payments. The financial account describes the change in international ownership of
assets. The capital account includes any other financial transactions that don't affect the nation's
economic output

Significance/Why is Balance of Payment (BOP) vital for a country

A country’s BOP is vital for the following reasons:

 The BOP of a country reveals its financial and economic status.

 A BOP statement can be used as an indicator to determine whether the country’s currency
value is appreciating or depreciating.

 The BOP statement helps the Government to decide on fiscal and trade policies.

 It provides important information to analyze 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.

Elements of a Balance of Payment

There are three components of balance of payment viz current account, capital account, and
financial account. The total of the current account must balance with the total of capital and
financial accounts in ideal situations.

Current Account

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 respect 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 make up to a country’s Balance Of Trade (BOT).

There are various categories of trade and transfers which happen across countries. It could be
visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods
between countries are referred to 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 can also be personal transfers like – money sent by relatives to their family located in
another country.

Capital Account

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/into a different country. The deficit or surplus in the current account is
managed through the finance from the capital account and vice versa. There are 3 major elements
of a capital account:

Loans and borrowings – It includes all types of loans from both the private and public sectors
located in foreign countries.

Investments – These are funds invested in 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.

Financial Account

The flow of funds from and to foreign countries through various investments in real estates,
business ventures, foreign direct investments etc is monitored through the financial account. This
account measures the changes in the foreign ownership of domestic assets and domestic
ownership of foreign assets. On analyzing these changes, it can be understood if the country is
selling or acquiring more assets (like gold, stocks, equity etc).

DISEQUILIBRIUM

A disequilibrium in the balance of payment means its condition of Surplus Or deficit. A

Surplus in the BOP occurs when Total Receipts exceeds Total Payments. Thus, BOP=
CREDIT>DEBIT. A Deficit in the BOP occurs when Total Payments exceeds Total Receipts.
Causes and Measures of Disequilibrium!

(i) Economic Factors:

(a) Imbalance between exports and imports. (It is the main cause of disequilibrium in BOR), (b)
Large scale development expenditure which causes large imports, (c) High domestic prices
which lead to imports, (d) Cyclical fluctuations (like recession or depression) in general business
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 needs of the countries for imports and decreases their capacity
to export.

Measures to correct disequilibrium in BOP:/ Methods of Correction

Sustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve
of foreign exchange and gold.

Following remedial measures are recommended:

(i) Export promotion:
Exports should be encouraged by granting various bounties to manufacturers and exporters. At
the same time, imports should be discouraged by undertaking import substitution and imposing
reasonable tariffs.

(ii) Import:
Restrictions and Import Substitution are other measures of correcting disequilibrium.

(iii) Reducing inflation:

Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore,
government should check inflation and lower the prices in the country.

(iv) Exchange control:

Government should control foreign exchange by ordering all exporters to surrender their foreign
exchange to the central bank and then ration out among licensed importers.

(v) Devaluation of domestic currency:

It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign
exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a
government order when a country has adopted a fixed exchange rate system. Care should be
taken that devaluation should not cause rise in internal price level.

(vi) Depreciation:
Like devaluation, depreciation leads to fall in external purchasing power of home currency.
Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds
the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is
done in fixed exchange rate system.)

TYPES OF DISEQUILIBRIUM

i. Cyclical Disequilibrium:
It occurs on account of trade cycles. Depending upon the different phases of trade cycles like
prosperity and depression, demand and other forces vary, causing changes in the terms of trade
as well as growth of trade and accordingly a surplus or deficit will result in the balance of
payments.

Cyclical disequilibrium in the balance of payments may occur because:

i. Trade cycles follow different paths and patterns in different countries. There are no identical
timings and periodicity of occurrence of cycles in different countries.

ii. No identical stabilisation programmes and measures are adopted by different countries.

iii. Income elasticities of demand for imports in different countries are not identical.

iv. Price elasticities of demand for imports differ in different countries.

In short, cyclical fluctuations cause disequilibrium in the balance of payments because of

cyclical changes in income, employment, output and price variables. When prices rise during
prosperity and fall during a depression, a country which has a highly elastic demand for imports
 experiences a decline in the value of imports and if it continues its exports further, it will show a
surplus in the balance of payments.

Since deficit and surplus alternatively take place during the depression and prosperity phase of a
cycle, the balance of payments equilibrium is automatically set forth over the complete cycle.

Cyclical Disequilibrium in the BOP in the occur, because:

1. The business cycle/Trade cycle follow different paths and patterns in different countries.

2. There are no identical timing and periodicity of occurrence of cycles in different nations.
3. No identical stabilization programs and measures are adopted by different states.
4. Income Elasticities of demand for imports in different nations are not identical.
5. Price Elasticities of demand for imports differ in different nations. Deficit and surplus
alternatively take place during the depression and prosperity phase of a cycle. The balance of
payments equilibrium is automatically set forth over the complete cycle.

ii. Structural Disequilibrium:

Structural disequilibrium in the balance of payments occurs when structural changes in some
sectors of the economy alter the demand and supply forces influencing exports and imports.
According to Kindleberger, structural disequilibrium may be of two types:

(i) “Structural disequilibrium at the goods level occurs when a change in demand or supply of
exports or imports alters a previously existing equilibrium or when a change occurs in the basic
circumstances under which income is earned or spent abroad, in both cases without the requisite
parallel changes elsewhere in the economy.”

(ii) “Structural disequilibrium at the factor level results from factors which fail to reflect
accurately factor endowments i.e., when factor prices, out of line with factor endowments, distort
the structure of production from the allocation of resources which appropriate factor prices
would have indicated.”

Structural disequilibrium is caused by changes in technology, tastes and attitude towards foreign
investment. Political disturbances, strikes, lockouts, etc., which affect the supply of exports, also
cause structural disequilibrium.

Some of the important causes of structural disequilibrium are as follows :-

 If the foreign demand for a country's products decline due to the discovery of cheaper
substitutes abroad, then the country's export will decline causing a deficit.
  If the supply position of a country is affected due factors like crop failure, shortage of
raw-materials, strikes, political instability, etc, then there would be the deficit in the
balance of payments.

 A shift in demand due to the changes in tastes, fashions, income, etc, would increase or
decrease the demand for imported goods causing a disequilibrium in the balance of
payments.

 Changes in the rate of international capital movements may also cause structural
disequilibrium.

 A war also results in structural changes which may affect not only goods but also factor
of production causing a disequilibrium in balance of payments.

Monetary Disequilibrium

Monetary disequilibrium, takes place on account of inflation or deflation. Due to inflation. the
prices of the products in the domestic market rises, and therefore, export items will become
expensive. Such a situation may affect the BoP equilibrium. Inflation also results in to increase
in money income with the people, which in turn may increase demand for imported goods. As a
result imports may turn Bop position in disequilibrium.

1990-91 ECONOMIC CRISIS/BOP CRISIS

1991 CRISIS

Towards the end of 1980s, India was facing a Balance of Payments (BoP) crisis, due to
unsustainable borrowing and high expenditure. The Current Account Deficit (3.5 percent) in
1990-91 massively weakened the ability to finance deficit.
Macroeconomic Indicators and Balance of Payments Situation in 1990-1991:
The trade deficit increased from Rs. 12,400 crore in 1989-90 to Rs. 16,900 crore in 1990-91.
The current account deficit increased from Rs. 11,350 crore in 1989-90 to Rs. 17,350 crore in
1990-91.
The CAD/GDP ratio increased from 2.3 in 1989-90 to 3.1 percent in 1990-91. Besides this, the
fiscal deficit to GDP ratio was more than 7 percent during the two years 1989-90 and 1990-91.
The foreign exchange reserves, meant to cover import costs for two years (1989-1991),were just
sufficient to cover close to two and half months of imports.
The average rate of inflation was 7.5 percent in 1989-90, which went up to 10 percent in the year
1990-91. In 1991-92, it crossed 13 percent. The GDP growth rate which was 6.5 percent in 1989-
90, went down to 5.5 percent in 1990-91.
The Balance of Payments crisis also affected the performance of industrial sector. The average
industrial growth rate was 8 percent in the second half of 1980s. In 1989-90, it was 8.6 percent
and in 1990-91 it was 8.2 percent.
India’s foreign exchange reserves stood at Rs. 5,277 crore on 31 December 1989, which declined
to Rs. 2,152 crore by the end of December 1990. Between May and July 1991, these reserves
ranged between Rs. 2,500 crore to 3,300 crore.
1991 Economic Crisis:
The main causes behind the Balance of Payments crisis of 1990-91 were as follows:

 Break-up of the Soviet Bloc: Rupee trade (payment for trade was made in rupees) with
the Soviet Bloc was an important element of India’s total trade up to the 1980s. However,
the introduction of Glasnost and Perestroika and the break-up of the Eastern European
countries led to termination of several rupee payment agreements in 1990-91. As a
consequence, the flow of new rupee trade credits declined abruptly in 1990-91. Further,
there was also a decline in our exports to Eastern Europe—these exports constituted 22 .1
percent of total exports in 1980 and 19.3 percent in 1989; but they declined to 17.9
percent in 1990-91 and further to 10.9 percent in 1991-92.
 Iraq-Kuwait War: The Gulf crisis began with the invasion of Kuwait by Iraq at the
beginning of August 1990. Crude oil prices rose rapidly thereafter–from USD 15 per
barrel in July 1990 to USD 35 per barrel in October 1990. Iraq and Kuwait were the
major sources of India’s oil imports and the war made it necessary to buy oil from the
spot market. Short term purchases from the spot market had to be followed up by new
long term contracts at higher prices. As a result, the oil import bill increased by about 60
percent in 1990-91 and remained 40 percent above the 1989-90 level the next year.  As
noted in Economic Survey (1991-92):
"The immediate cause of the loss of reserves beginning in September 1990 was a sharp
rise in the imports of oil and petroleum products (from an average of $ 287 million in
June-August 1990, petroleum products imports rose sharply to $ 671 million in 6
months). This accounted for rise in trade deficit from an average of $ 356 million per
month in June-August 1990 to $ 677 million per month in the following 6 months."
 Slow Growth of Important Trading Partners: The deterioration of the current account
was also induced by slow growth in economies of important trading partners. Export
markets were weak in the period leading up to India’s crisis, as the world growth declined
steadily from 4.5 percent in 1988 to 2.25 percent in 1991. The decline was even greater
for the U.S., India’s single largest export destination. In the United States, growth fell
from 3.9 percent in 1988 to 0.8 percent in 1990 and to -1 percent in 1991.
 Political Uncertainty and Instability: The period from November 1989 to May 1991
was marked with political uncertainty and instability in India. In fact, within a span of
one and half years there were three coalition governments and three Prime Ministers.
This led to delay in tackling the ongoing balance of payment crisis, and also led to a loss
of investor confidence.
 Loss of Investors’ Confidence: The widening current account deficits and reserve losses
contributed to low investor confidence, which was further weakened by political
uncertainty. This was aggravated by the downgrade of India’s credit rating by credit
rating agencies. By March 1991, the International Credit Rating agencies Standard &
Poor’s, and Moody’s, had downgraded India’s long term foreign debt rating to the bottom
of investment grade. Due to the loss of investors’ confidence, commercial bank financing
became hard to obtain, and outflows began to take place on short-term external debt, as
creditors became reluctant to roll over maturing loans.
 Fiscal Indiscipline: The Economic Survey (1991-92) had categorically remarked that:
“Throughout the eighties, all the important indicators of fiscal imbalances were on the
rise. These were the conventional budgetary deficit, the revenue deficit, the monetized
deficit and gross fiscal deficit. Moreover, the concept of fiscal deficit is a more complete
measure of macroeconomic imbalance as it reflects the indebtedness of the Government.
This gross fiscal deficit of the Central Government has been more than 8 percent of GDP
since 1985 – 86, as compared with 6 percent in the beginning of 1980s and 4 percent in
the mid – 1970s.”
 Increase in Non-oil Imports: The trends in imports and exports show that imports rose
much faster than exports during the eighties. Imports increased by 2.3 percent of GDP,
while exports increased by only 0.3 percent of GDP. As a consequence, trade deficit
increased from an average of 1.2 percent of GDP in the seventies, to 3.2 percent of GDP
in eighties.

Oil and Non- Oil Imports (In Rs. Crores)

 Rise in External Debt: In the second half of the 1980s, the current account deficit was
showing a rising trend and was becoming unsustainable. An important issue was the way
in which this deficit was being financed. The current account deficit was mainly financed
with costly sources of external finance such as external commercial borrowings, NRI
deposits, etc.

In the context of external debt the following observations are worth considering:0

o The period of eighties was marked by a reduction in flows of concessional

assistance to India, principally from the World Bank Group. In 1980,
disbursements on concessional terms constituted more than 89 percent of
assistance to India from multilateral sources; in 1990, this proportion declined to
about 35 percent
o Due to a decline in concessional assistance there was a rise in average interest
cost of external borrowing
o There was a change in the composition of debt as it shifted from official (like
bilateral sources) to private sources like external commercial borrowings (ECBs)
and NRI deposits. These private sources were costlier
o The external debt was funneled into financing the government’s deficit
o India’s external debt increased from Rs. 194.70 crore (USD 23.50 billion) in
1980-81 to Rs. 459.61 crore (USD 37.50 billion) in 1985 – 86. It went up to Rs.
1,003.76 crore (USD 58.63 billion) in 1989-90. In 1990-91, it was Rs. 1,229.50
crore (USD 63.40 billion).