UNIT 3 INDIA’S BALANCE OF PAYMENTS

3.0 Objectives
3.1 Introduction
3.2 Concept of Balance of Payments
3.2.1. Balance of Trade and Balance of Payments
3.2.2. Balance of Payments Accounting
3.2.3 Balance of Payments Deficits
3.2.4 Balance of Payments and Emerging Economics
3.3. Current Account Deficit
3.4. Trends in India’s Balance of Payments
3.5. Problems of Deficit and Trade Policy
3.6. Deficit and Surplus in Balance of Payments
3.7. Balance of Payments Disequilibrium
3.8 Factors Affecting Balance of Payments
3.9 Methods of Correcting Disequilibrium
3.10. Let Us Sum Up
3.11. Key Words
3.12. Terminal Questions
Select References

3.0 OBJECTIVES
After you have studied well this unit, you will be able to:
1. Discuss the concept of balance of payments
2. Identify the current account and capital account components of balance of payments
3. Analyse long term trends in India’s balance of payments
4. Explain how the balance of payments always appears in balance
5. Explain the concept of disequilibrium in balance of payments
6. Discuss the measures that can be taken to correct the balance of payments

3.1. INTRODUCTION

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Balance of payments refers to all economic transactions between domestic and foreign residents
over a stipulated period. The balance of payments of a country provides an overall view of its
international economic position. It is very much helpful for the policy makers and the business
communities. In this unit, you will learn the concept of balance of payments, the balance of
payments accounting procedure, trends in India’s balance of payments. You will be further
familiarized with the concept of disequilibrium in the balance of payments, factors affecting
balance of payments and the methods of correcting disequilibrium.

3.2. CONCEPT OF BALANCE OF PAYMENTS

Balance of payments refers to all economic transactions between domestic and foreign residents
over a stipulated period, generally one year. The analysis of balance of payments is immensely
useful for the policy makers and business communities. Moreover, it is an important instrument
for maintaining external economic stability. A close understanding of dependence of
international business upon balance of payments is necessary for successful strategy of
international business.

Balance of Payments is an annual statement of accounts. This statement pertains to the

transactions that take place between an economy and rest of the world. This statement looks at
the monetary aspect of these transactions. All the goods and services that are sold by a country to
all other nations constitute exports. A country gains foreign exchange of equivalent value.
Similarly all imports from rest of the world carry an obligation of making payments in foreign
exchange. Likewise capital inflows and outflows take place between different countries.

The principal tool for the analysis of the monetary aspects of international trade is the balance of
international payments settlement. This statement, also simply known as the 'balance of
payments' (BOP), is a systematic record of all international economic transactions, visible and
invisible, of a country during a given period, usually a year. In other words, the statement is a
device for recording all the economic transactions within a given period between the residents of
a country and the residents of other countries. The BOP of each of the individual countries,
technically speaking, always ‘balances'. Such equality in the debit and credit sides of the BOP,
known as equilibrium, has no economic significance. It simply results from the double entry
book-keeping procedure which is used to record the transactions.

3.2.1 Balance of Trade and Balance of Payments

Before proceeding further we should make clear the balance of trade and balance of payments,
and balance of payments accounting. Let us learn these aspects of balance of payments in detail.

Export and import of goods and services between two countries are classified respectively as
‘visible’ and ‘invisible’ exports and imports. Visible items are those which are physically
exported and imported, like merchandise, gold, silver and other commodities. Balance of trade
refers to the difference between physical imports and exports, i.e. visible items only for a period

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say, a year. During a given period of time, exports and imports may be exactly equal in which
case, the balance of trade is said to be balanced. If the value of exports of a country exceeds the
value of imports, the country is said to have an export surplus or a favourable balance of trade.
When the value of imports coming to a country is greater than the value of exports, the balance
of trade is said to be unfavorable.

International trade includes not only import and export of goods but also services. The exchange
of services between countries is called invisible exports and imports such as air and ocean
shipping, financial and other services like banking, insurance, travel, investment income, etc.
Export and import of goods are treated as visible trade as they are physically recorded at the
customs barriers of the country. Receipts and payments for services are items of invisible trade.

The balance of payments is broader than the balance of trade for it includes not only visible
items but also invisible items. Hence, the balance of payments presents a better picture of a
country's economic and financial transactions with the rest of world than the balance of trade.
Balance of payments is a comprehensive and systematic record of all economic transactions
between the residents of a country and the rest of the world. It presents an account of all receipts
and payments on account of goods exported, services rendered and capital received by
residents/Government of a country (inflows from abroad) and goods imported, services received
and capital transferred by the residents/ Government of a country (outflows abroad).

3.2.2 Balance of Payments Accounting

In balance of payments accounting the balance of payments should be zero because every
transaction is two-sided with debits balancing credits. But in practice, the balance of payments
will not always be equal to zero. This can be due to, among other things, a country's central bank
engaging in transactions that are not counted towards the country's balance of payments, or the
lack of available statistical data to record all transactions. Balance of payments is classified as:
(i) balance of payment on current account, and (ii) balance of payment on capital account.

Current Account: The balance of payments on current account records the current position of
the country in the transfer of goods, services, and merchandise as well as invisible items,
donations, unilateral transfers, etc. Current account is like an income and expenditure account.
Surplus or deficit in current account is transferred to capital account which is like a balance sheet
and thus balances itself in historic sense.

Capital Account: Balance of payments on capital account shows the country's financial position
in the international scenario, the extent of accumulated foreign exchange reserves, foreign assets
and liabilities and the impact of current transactions on international financial positions.

The changes in foreign exchange reserves arising out of current account transactions are included
in the capital account in order to find out the exact foreign exchange reserve. The capital account
provides relief to deteriorating balance of payments positions. Its favourable effect depends upon
the availability of net capital transfers, i.e., gross inflow, of capital minus payment by way of
amortization. In short, capital account reflect, changes in foreign assets and liabilities of the
country and affects its creditor/debtor, position. Net changes in current account are reflected by a

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corresponding opposite change in the capital account, changing the foreign assets and liabilities
position of the country, Look at Table 2.1 which shows various items of balance of payments.

Table 3.1: Main Items in the Balance of Payments.

Items Definition
A. Current Account (1+2)
(a) Merchandise exports Sales of goods abroad
(b) Merchandise imports Purchase of foreign goods
1. Trade balance (a-b) Goods trade balance
2. Invisibles (a+b+c+d) (i) Sales of services, e.g. insurance, software plus spending
(a) Non Factor Services of foreign visitors (tourists)
(ii) Purchase of foreign services
(b) Investment Income (i) Dividends, interest, etc. received from abroad.
(ii) Payment of dividends, interest, etc.
Net private payments, e.g. remittance from workers abroad.
(c) Private Transfers Net official payments, e.g. overseas aid.

(d) Official Transfers - Grants

B. Capital Account (1+2+3+4)
1. Foreign Investment
(a) Direct Investment Net direct investment in plant and machinery, etc.
(b) Portfolio Investment Net purchases/sales of shares, bonds, etc.
2. Others flows Sum of other items, including delayed export receipts and E
&O
3. Comm. & other borrowings Official borrowing and lending.
4. Non-resident deposits (net)
C. Reserves and Monetary
Gold

The analysis of the BOP can be done in terms of its two major sub-divisions: (a) Current
Account, and (b) Capital Account.
Current Account
The Current Account can be broken down into two parts, viz., one, balance on trade, and, two,
balance on invisibles. The Balance of Trade (BOT) deals only with exports and imports of
merchandise (or visible items). The Balance on Invisibles (BOI) shows net receipts on account of
invisibles. These include the remittances, net service payments, etc. Conceptually, invisible
earnings can be classified in two components—factor income and non-factor income. The former
includes remittances of interest, dividends and work compensation. In the case of India, interest
and dividends constitute a net outflow, while work compensation (termed 'private remittances')
form an important net inflow. Trade in non-factor services includes tourism and travel, air and

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marine transportation, insurance, consultancy and software. The RBI classifies non-factor
services into travel, transportation, insurance, government and miscellaneous services. Software,
global back-offices, media, consultancy and other technology- related services would fall under
'miscellaneous services' and to the extent that the activity is of a 'body-shopping' character, it
would also fall under 'private remittances'.
It is not necessary that the BOT should always balance; more often than not, it will show either a
surplus or a deficit. Similarly, the BOI will always show either a surplus or a deficit. A surplus
on BOT may be matched with a surplus or deficit on BOI. If the surplus on BOI equals the
deficit on BOT the current account will show a net balance. But then there is no reason why
these two balances should always be equal, again, always in opposite directions. As a matter of
fact, the balance on current account can always show a deficit or a surplus. A surplus on current
account leads to an acquisition of assets or repayment of debts previously contracted, and a
deficit involves withdrawal of previously accumulated assets or is met by borrowings.
Capital Account
The capital account presents transfers of money and other capital items and changes in the
country's foreign assets and liabilities resulting from the transactions recorded in the current
account. The deficit on the current account and on account of capital transactions can be financed
by external assistance (loans and grants), drawings from the International Monetary Fund and
allocation of the Special Drawing Rights.
The BOP equation is:
current account + capital account + official reserve account = 0
The BOP accounts provide a link between the increase in gross external debt and the portfolio
and spending decisions of the economy.
Thus,
Increase in gross external debt
= Current account deficit (CAD) - Direct and long-term portfolio capital inflows + Official
reserve increases + Other private capital outflows
The above equation shows that an increase in external debt can have three broad sources:
current account deficits not financed by long-term capital inflows, borrowing to finance a reserve
build-up or private outflows of capital.

3.3.3 Balance of Payments Deficits

In India, balance of payments deficits have been largely caused by excess of imports over
exports in merchandise. At times and to a small extent the deficits have been in invisible trade
also. The major source of deficits has been the rising obligations to meet amortization payments.
This has involved large sums on the return of loans which became due and the large interest
payments thereon. Large withdrawals from non-resident accounts also contributed to deficits.

On June 21, 1991 when the new Government took the office, it inherited the economy in deep
crisis. The balance of payments situation was precarious, with reserves at a low level and the
weakening of international confidence having resulted in a sharp decline in capital inflows

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through commercial borrowing and non-resident deposits. The crisis in the Middle East had
exacerbated the situation by contributing to higher oil import bill in 1990-91 and the temporary
loss of exports markets and remittance earnings.

Structural reforms encompassing the industrial sector, the foreign trade and foreign investment
were taken. From 1991 the country embarked on a liberalised trade regime with a short negative
list of imports, removal of quantitative restrictions for all goods except consumer goods, a
phased reduction in customs duties, an adjustment in the exchange rate through a two-step
devaluation of the rupee in July 1991 and the movement to a market determined exchange rate.
The policy towards foreign portfolio investment has also been substantially liberalised. Foreign
investment policy was modified to eliminate barriers, alignment of taxes with international levels
and transparency with full repatriation benefits and investor protection.

The structural reforms were aimed at integrating industrial, trade and exchange rate policies to
enhance the efficiency in the economy. The beneficial effects of these measures are reflected in a
robust export and invisible growth. The post 1991 period has seen a Surge in capital inflows
resulting in growth of foreign exchange reserves.

3.3.4 Balance of Payments and Emerging Economies

It is well known in development economics that EEs invariably start as debtor economies. In the
process of development itself, these economies have to import a great deal of capital goods,
consumer goods, food and raw materials and spares and components. They also have to import
some new technologies and, hence, the total exchange outgo cannot be matched by export
earnings. But as the new capital goods and technologies begin to become effective and their
products are directed towards exports, export goods and services become competitive in cost and
quality. In that case, the volume of exports expands and, in due course, begins to overtake
imports. A developing economy then moves on from being a debtor economy to a balanced one
in terms of BOP and, finally, becomes a creditor economy, exporting more than it imports and
giving credit to buyers. Thus, from being a net debtor in the beginning, it becomes a net creditor
in the end and, in fact, begins to invest abroad rather than have others lending to and investing in
it.

3.3 CURRENT ACCOUNT DEFICIT

The general belief is that high CADs are dangerous. In general, this is correct. But the
converse—that low CADs are good —is not.
The role of CADs can be rightly, in brief, put in the following perspective:
One, running current account deficits is a good thing as long as foreign savings are invested,
since this can, ceteris paribus, raise rates of economic growth. Such deficits should be
sustainable over the medium to long-term. Two, since FDI goes directly into investment, these
should be encouraged without limits and restrictions, some strategic, brown-field areas excepted.
Three, external debt, especially the more volatile short-term component, needs to be limited to

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productive investment or variable capital to finance production. If external debt tends to
imprudent levels, it should be further restricted to financing the foreign exchange compo-nent of
investment and variable capital. Four, portfolio flows need not be actively encouraged beyond
what is necessary to fund the current account deficit. Such flows can be volatile, can inflate asset
prices, lead to sudden, sharp appreciation of the currency, and queer the pitch for monetary
policy.
The right CAD for any country, therefore, depends on its ability to absorb and service capital
inflows. If these resources can be deployed productively and in ways that enhance its ability to
repay, a high CAD to GDP ratio is nothing to worry about. But if they cannot, then it is inviting
trouble. Too high a ratio can prove unsustainable in the long run as it did in East Asian
economies in 1998 and in Mexico earlier. To that extent low ratio has its advantages.
But, too low a ratio carries with it an opportunity cost—of not being able to benefit from
resources that could be drawn from outside.

3.4 TRENDS IN INDIA'S BALANCE OF PAYMENTS

India had faced pressures on BOP from time to time either due to certain domestic compulsions
or due to external factors. The whole period, covering nearly six decades, can be divided into
two sub-periods, viz. (i) Before 1991, and (n) since 1991.

Period I (Before 1991)

The entire period was very difficult for India's BOP, partly because of slow growth of exports in
relation to import requirements and partly because of adverse external factors. Foreign exchange
reserves were at a low level, generally less than necessary to cover three months’ imports.
Almost the entire CAD (92 per cent) was financed by inflows of external assistance.
Factors Responsible for BOP Deficits
1. Widening trade deficits that were caused mainly by the fact that the import requirements of
the economy increased at a much faster rate than the rate of growth of exports.
2. Gradual decline in net receipts from invisibles with the result that the contribution of net
invisibles in financing the deficit declined, leading to a greater dependence on inflows of
external capital. Thus, net invisibles, which financed nearly half of the trade deficit during
1981-82 to 1984-85, contributed only 8 per cent to meeting the financial requirements in
1990-91.
3. Reduction in inflows of concessional assistance to India, principally from the World Bank
Group; as a result, India had to take recourse to large commercial borrowings on relatively
hard terms. The hardening of terms had an important impact on India's debt service
obligations on multilateral loans.
The BOP crisis reached its climax during 1990-91 —CAD reached the high of 3.3 per
cent of the GDP during this year.
Period II (Since 1991)
In 1991, a comprehensive strategy to deal with the BOP situation was put in practice. The
principal elements of the BOP strategy can be summarised as follows:

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 1. Preference to Non-debt Creating Capital Flows: Non-debt creating capital inflows,
specially FDI, are being encouraged on account of their positive impact both in terms of
technology and the stabilising role in external sustainability. The policy has, therefore, been
to gradually liberalise capital account.
2. Exchange Rate Policy: All payments and receipts of foreign exchange to be converted in
rupees at market-determined rate of exchange.
3. Liberalised Import Policy: In a burst of liberalisation in 1991-92, some 3,000 tariff lines
that covered raw materials, intermediates and capital goods were freed from licensing
restrictions.
Other measures taken during the period included considerable reductions in peak tariffs.
Cash margins and interest surcharge on import credit abolished, harmonised system of
customs classification introduced.
4. Structural Reforms: Substantial deregulation of industry and trade.
As a result of the pursuance of this strategy, the BOP situation underwent a dramatic change
during the decade of 1990s. BOP was no more being perceived as a constraint on macro-
economic policy; both the current account and the capital account have contributed to this
change in perception.
The prominent features of the BOP situation as it has emerged over the last three decades can
be briefly summarised as follows:
1. On the current account, two important features have been as follows:
(i) Trade deficits have been widening. Both exports and imports have multiplied fast, but
imports have risen at a faster rate than exports. Expanding imports in turn reflect (a) the
impact of liberalisation measures, and (b) increasing manufacturing activity in the
domestic economy,
(ii) There has been a phenomenal increase in net surplus on account of invisibles. This, in
turn, is principally due to (a) buoyancy in private transfers (i.e., inward remittances), and
fast expansion in exports of services, especially software. India is unique among emerging
economies to have a sizable invisible surplus that substantially offsets the merchandise
trade deficit. As a result, although India has been running a current account deficit, the
deficit has been conveniently manageable, largely because of huge surplus on capital
account.

2. On the capital account, India has been running a big surplus. The size of surplus has been
much more than what is required to finance the current account deficit. As a result, India
has been rapidly building up its foreign exchange reserves. The capital account
demonstrates following features:
(i) Both inflows and outflows of capital have increased,
(ii) The composition of capital flows is undergoing a change:
(a) Official external assistance has been gradually losing out its significance;
(b) FDI and portfolio investment have surged, and among the two the inflows on account
of FDI have been more than on account of portfolio investment;
s(c) With easing of controls external commercial borrowings have been coming back into
prominence. Gold imports are classified as current account transactions, though for all practical
purposes it is a capital account transaction. It is equivalent to Indians buying an overseas asset. Its

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 impact might be the same in terms of cash flow or liquidity, but in terms of the trade deficit it has a
crucial role of play. If gold imports are classified as capital account transactions India's trade deficit
will not exceed 1% of GDP.

After a sharp increase to 4.8% of GDP in 2012-13 from 2.8% in 2009-10, the current account
deficit declined dramatically to 2% in 2015-16. With the resumption of capital flows, both as a
result of the special measures taken by the RBI and the general improvement in the global
climate, capital flows were adequate and the pressure on the rupee eased.

TABLE 3.2 : INDIA’S OVERALL BALANCE OF PAYMENTS

(US$ million)
2017-18 2018-19 2019-20 2020-21 2021-22 (P)
1 2 3 4 5 6
A. CURRENT ACCOUNT
1 Exports, f.o.b. 3,08,970 3,37,237 3,20,431 2,96,300 3,11,191
2 Imports, c.i.f. 4,69,006 5,17,519 4,77,937 3,98,452 4,46,835
3 Trade Balance -1,60,036 -1,80,283 -1,57,506 -1,02,152 -1,35,644
4 Invisibles, Net 1,11,319 1,23,026 1,32,850 1,26,065 1,09,077
a) ‘Non-Factor’ Services of which : 77,562 81,941 84,922 88,565 79,203
Software Services 72,186 77,654 84,643 89,741 80,274
b) Income -28,681 -28,861 -27,281 -35,960 -29,441
c) Private Transfers 62,949 70,601 76,217 74,439 59,880
5 Current Account Balance -48,717 -57,256 -24,656 23,912 -26,567
B. CAPITAL ACCOUNT
1 Foreign Investment, Net (a+b) 52,401 30,094 44,417 80,092 24,947
a) Direct Investment 30,286 30,712 43,013 43,955 26,509
b) Portfolio Investment 22,115 -618 1,403 36,137 -1,562
2 External Assistance, Net 2,944 3,413 3,751 11,167 2,709
3 Commercial Borrowings, Net -183 10,416 22,960 -134 4,863
4 Short Term Credit, Net 13,900 2,021 -1,026 -4,130 13,284
5 Banking Capital of which : 16,190 7,433 -5,315 -21,067 12,631
NRI Deposits, Net 9,676 10,387 8,627 7,364 3,075
6 Rupee Debt Service -75 -31 -69 -64 -59
7 Other Capital, Net& 6,213 1,057 18,462 -2,143 30,935
8 Total Capital Account 91,390 54,403 83,180 63,721 89,309
C. Errors & Omissions 902 -486 974 -347 782
D. Overall Balance [A(5)+B(8)+C] 43,574 -3,339 59,498 87,286 63,524
E. Monetary Movements (F+G) -43,574 3,339 -59,498 -87,286 -63,524
F. IMF, Net 0 0 0 0 0
G. Reserves and Monetary Gold
-43,574 3,339 -59,498 -87,286 -63,524
(Increase -, Decrease +)
of which: SDR allocation 0 0 0 0 -17,862
Memo: As a ratio to GDP
1 Trade Balance -6.0 -6.7 -5.6 -3.8 -5.9
2 Net Services 2.9 3.0 3.0 3.3 3.4
3 Net Income -1.1 -1.1 -1.0 -1.3 -1.3
4 Current Account Balance -1.8 -2.1 -0.9 0.9 -1.2
5 Capital Account, Net 3.4 2.0 2.9 2.4 3.9

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 6 Foreign Investment, Net 2.0 1.1 1.6 3.0 1.1
P: Data are provisional and pertain to April-December 2021.
& : Includes delayed export receipts, advance payments against imports, net funds held abroad and advances received pending issue of
shares under FDI.
Note: 1. Gold and silver brought by returning Indians have been included under imports, with a contra entry in private transfer receipts.
2. Data on exports and imports differ from those given by DGCI&S on account of differences in coverage, valuation and timing.
Source: RBI.

Look at Table 8, it shows the details of the various items of Balance of payments. In the year
2020-21, the trade balance has a negative balance of (-1, 02,152 US $ millions), while invisibles
stood at 1, 26,065 US $ millions. The current account has a balance of 23,912 US $ millions and
capital account has a balance of 63,721 US $ millions. Errors and omissions constitute -347 US $
millions. The overall balance stood at 87,286 US $ millions. In the year 2021-22, the trade
balance has a negative balance of (-1, 35,644 US $ millions), while invisibles stood at 1, 09,077
US $ millions, current account has a balance of (-26,567 US $ millions) and capital account has a
balance of 89,309 US $ millions. Errors and omissions constitute 782. The overall balance stood
at 63,524 US $ millions.
As the Table 8 shows, Invisible exports i.e. services have been increasing from the year 2017-18
to 2019-20. The exports have decreased during the year 2020-21 to 2021-22. The increasing
services trade has been able to offset the negative trade balance. Therefore, efforts should be
made to promote exports of goods and services to bridge the deficits of the current account
balance of BOP. Similarly capital account balance of BOP may be improved by increasing the
foreign capital inflows as well as productive use of foreign investment.

According to Economic Times February 09, 2023 the current account deficit in the world’s fifth
largest economy (India) was at3.3% of GDP for the first half of Financial Year 2023. Services
exports rose about a fifth year on year in the third quarter, largely driven by software, businesses
and travel. The net balance under services and remittances are expected to remain in large
surplus partly offsetting the trade deficit.
The overall balance stood at 87,286 US $ millions for the year 2020-21 and 63,524 US $
millions for the year 2021-22. In the year 2020-21, trade balance constitutes -3.8% of the total
GDP while net services hold 3.3%, net income has -1.3%, current account balance has 0.9%,
capital account has 2.4 % and foreign investment constitutes 3.0%. In the year 2021-22, trade
balance constitutes -5.9% of total GDP, while net services hold 3.4%, net income has -1.3%,
current account balance has -1.2%, capital account has 3.9% and foreign investment constitutes
1.1%.

3.4.1 Reversal of Trend 2020-21

In a reversal of the trend, Indian Balance of Payments has become critical. If the Great Recession
of the West slowed globalization, the covid pandemic snapped supply chains and showed the
perils of import over-reliance. Meanwhile, the Ukraine war has joined US-China trade tensions
to reveal the frailty of economic ties that girdle the globe. Long-uphold norms of cross-border
commerce have failed to survive contact with this year’s hostilities. Supply embargoes have

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arisen amid a scenario of rising import tariffs and mercantilist attitudes. Main features of this
situation are as follows:

1. FPI Unreliability
On the capital account, the most volatile component, foreign portfolio investments (FPIs),
showed net outflows until the June-ended quarter in response to rising US interest rates, higher
geopolitical risk, and central bank tightening around the world FP1 flows are notoriously volatile
and shift nimbly from one country to another in search of returns. India has suffered portly
because FPIs tend to lump all emerging market assets together and sell them off in a risk-averse
scenario. However, Indian assets, both debt and equity, face another disadvantage. Not only has
the rate gap between India and the US narrowed, the weaker rupee has also reduced dollar
returns for investors. If the current fiscal ends up with a net pullout of FPI flows, it would reduce
dollar inflows available to finance the CAD. India then has to look to other sources of funding,
such as the special foreign currency non-resident account (FCNR) deposits launched in 2013, or
run down its forex reserves.

2. CAD Breaches
CAD has breached the 3% mark only twice since 1990. In 1991, it was because of an oil price
rise triggered by Iraq’s invasion of Kuwait, which increased India’s crude bill so much that its
forex reserves were not enough to cover even one month of imports. ’Die country was forced
to seek funding from the International Monetary Fund, devalue the rupee, and implement
economic reforms. During 2011-13, supply disruption in West Asia pushed oil over $100 per
barrel, resulting in 4%-plus levels of CAD. By the time of the famous "taper tantrum" speech
in May 2013, India’s external position was so fragile that the rupee lost 20% within four
months. These events reinforce the role of CAD as a red flag. Investors tend to associate a
CAD spike wit h exchange rate weakening and market volatility. Hence, any development that
could push CAD beyond the 3% threshold would weaken investor sentiments, leading to dollar
outflow s and a weaker rupee.

Source: RBI
Fig. 3.3

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3. External Risk
However, this time, India is unlikely to see a repeat of past crises. India is one of the few
economies expected to grow at 7% this fiscal and is thus an attractive investment destination.
Despite recent depletion, its forex reserves are still healthy and the national debt is largely in
rupees, which makes a panicky scramble for dollars to honour debts less likely.
The rising CAD need not be seen as a predictor of an external crisis, but rather an indicator of
increased external risk, which can be mitigated by reducing the deficit or improving inflows. The
former is tough in the current global scenario, but the latter is achievable. If India can keep its
fundamentals strong, it may attract enough investments on a sustained basis to not just finance an
occasionally higher CAD but to be able to raise the red mark itself above 3%.

Check Your Progress 1

1. What do you mean by Balance of payments on current account ?
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2. What do you mean by Balance of capital account?
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3. Distinguish between balance of trade and balance of payments.

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3.5. PROBLEMS OF DEFICIT AND TRADE POLICY

The measures embodied in our Plans to meet payment deficits can be conveniently classified in
two parts, viz., import substitution and export promotion.

Import Substitution
Import substitution implies indigenous production of raw materials, intermediate goods and final
consumer and capital goods that had hitherto been imported. Import substitution was the major
plank of India's foreign trade policy during first fifteen years of economic planning. It was
visualised that large imports of capital goods and equipment would help the country build up
sufficient domestic production capacity to meet the internal requirements. This presumption was
in-built in the Mahalanobis strategy of heavy-industry-led growth. A further assumption of the
strategy was that once the production capacity within the country had been built up it would be
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possible to give up imports to a large extent. Working on this hypothesis, our Plans provided for
the required large imports, financed largely by external assistance.
The progress of import substitution in the country has been quite satisfactory. In the sphere of
consumer goods, we have the capacity to produce exportable surplus and are competing
effectively in the international markets. Likewise, indigenous production of capital goods has
also expanded very fast and the country is gradually becoming self- sufficient in their production
too, as would be seen from the fact that the share of imports in the total estimated supplies has
been gradually falling over the years.
But all this does not mean that country's import requirements have decreased or show signs of
falling. India's imports have been mounting. As a percentage of national income they are about
25 per cent presently thus falsifying the Mahalanobis assumption that these would fall.
So far as containing the growth rate of imports is concerned prospects do not seem to be bright
on several grounds.
(a) A sizable chunk of imports is accounted for by items whose imports cannot be reduced as
it could disturb the current price stability, unless their domestic output is increased.
(b) Any attempt to curb imports of petroleum, fertilisers, capital goods and other essential
goods could only hamstrung the pace of economic growth of the country. Such attempts
could also frustrate the current phase of liberalisation aimed at pushing up the growth rate
of industrial economy. In this context it may be noted that with the growth of economy the
country's imports are likely to escalate.
More importantly, imports keep our industry on its toes—price-wise, quality-wise and
technologywise. Hence, our policies and efforts should be geared to earn means with which to
finance the rising needs of imports in the economy. That takes us to the sphere of export
promotion.
Export Promotion

The terms 'outer-oriented', 'export promotion', 'export substitution' and 'export-led growth' have
all been used interchangeably to describe the policies adopted in the successful exporting
countries
Exports are to growth what oxygen is to human organism, and, therefore, the export sector is
being regarded 'second only to defence'. This expresses the need for a vigorous export drive.
A look at the overall exports data shows that there are many sectors where growth is flagging:
from vehicles to machinery and commodity exports. It also shows that even after a dozen years
of reform, India is still largely a commodities exporter, with its information technology services
classified as invisibles. Even though we manage to sell some manufactured goods overseas, their
share is still lower than what could have been expected in a large country like India. Even for
relatively unsophisticated products such as refrigerators and flat panel television screens, India
relies on imports, not domestic production.
India must increase the share of manufacturing in its economy. Eventually, this will lead to
India becoming an exporter of manufactured goods. That will help us narrow the current account

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deficit in two ways: by substituting imported manufactures with domestic ones and by exporting
some of the locally-made goods overseas. In order for this to happen, India must clear the decks
for large investments by global manufacturing companies that now prefer to operate in south-east
Asia or China. The government must cut through the maze of red tape of clearances, licences and
permissions that entangle projects and rationalise labour laws.

3.6 DEFICIT AND SURPLUS IN BALANCE OF PAYMENTS

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

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

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

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

3.7 BALANCE OF PAYMENTS DISEQUILIBRIUM

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

A disequilibrium in balance of payments may be short term or long term in nature. Short term
disequilibrium arises largely on account of cyclical factors or unexpected developments. A crop

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failure or earthquake may lead to a sudden decline in export earnings and consequently a
disequilibrium.

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

3.8 FACTORS-AFFECTING BALANCE OF PAYMENTS

3.8.1 Current Account

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

i) Inflation
ii) National Income
ii) Government Restructures
iv) Exchange Rate.

Let us discuss them one by one.

Inflation: If a country’s inflation rate increases relative to the countries with which it trades, its
current account balance would be expected to turn adverse. Due to higher prices at home,
consumers and corporations within the country are likely to purchase more goods overseas
leading to rise in imports, while the country’s exports may decline.

National Income: If a country’s national income rises at a higher rate than those of other
countries, its current account is expected to decrease, other things being equal. As real income
(adjusted for inflation) rises, so does consumption of goods. Part of the increase in consumption
may be met by imported goods.

Government Restrictions: If a country’s government imposes a tax (often referred to as a tariff)

on imported goods, the prices of foreign goods will increase. An increase in prices of imported
goods relative to goods produced at home may discourage imports and improve the current
account balance. In addition to tariffs, a government may restrict imports by other measures such
as total ban or quota restrictions.

Exchange Rate: The value of a country’s currency in terms of other currencies is called the
exchange rate. Changes in a currency’s exchange rate brought about by market forces or actions
by national government or governments of other countries will influence a country’s current
account balance. An appreciation in a country’s exchange rate vis-a-vis another country’s
currency, other things being equal, is likely to lead to decline in the country’s exports and
increase in imports Thus, if Rupee appreciates in value vis-a-vis US Dollar, exports are likely to
be hit and imports are likely to grow. The opposite will be the impact of depreciation in

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exchange rate of a country’s currency, i.e. it is likely to lead to growth in exports and decline in
imports.

However, according to J-curve theory, a country’s trade deficit worsens just after its currency
depreciates because price effects will dominate the effect on volume of imports in the short run.
That is the higher costs of imports will more than offset the reduced volume of imports. Thus,
the J-curve theory, states that a decline in the value of home currency should be followed by a
temporary worsening in the trade deficit before its longer term improvement,

3.8.2 Capital Account

As with current flows, government policies affect the capital account as well. A country’s
government could, for example, impose a special tax on income derived by local investors from
foreign investments. A tax would discourage people from investing abroad and could therefore,
increase the country’s capital account. Capital flows are also influenced by capital controls of
various types. Interest rates also affect the capital flows. A hike in interest rates relative to other
countries may attract capital flows from abroad. Conversely, a reduction in domestic rates may
induce people to invest abroad.

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

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

3.9 METHODS OF CORRECTING DISEQUILIBRIUM

When disequilibrium arises, the following measures are usually adopted.

i) Use of past reserves
ii) Borrowings from IMF
iii) Monetary and fiscal policy measures
iv) Exchange rate adjustments.

Let us learn them in detail.

Use of Past Reserves: A country may make use of past reserves to finance the BOP deficit
provided such reserves are available. Such reserves consist of gold, foreign currencies and fund
related assets i.e. reserve position with the IMF and holdings of special drawing rights. In recent

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years, increase in quotas and additional allocations of SDRs and expanded private capital flows
have contributed to an overall increase in national reserves of several countries.

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

i) Stand by loans
ii) Extended Fund Facilities (EFF)
iii) Structure Adjustment Facilities (SAF)
iv) Enlarged Structural Adjustment Facilities (ESAF).
v) Compensatory and Contingency Financing Facilities (CCFF)
vi) Systemic Transformation Facilities (STF).

Monetary and Fiscal Policy Measures: Monetary and fiscal policies are also important tools
for influencing BOP conditions. A change in money supply brought about either through fiscal
or monetary policies can bring about the required change in the level of total demand, including
demand for imported goods and services.

Exchange Rate Adjustments: Adjustments in exchange rate is an effective tool. A downward

adjustment in exchange rate will make exports cheaper and imports dearer. In other words, as a
result of such a policy, exports will be encouraged and imports will be discouraged and
equilibrium will be restored.

All these measures, however; suffer from certain limitations. Hence, managing disequilibrium in
BOP continues to be a major problem with any country. A policy initiative taken for the sake of
achieving equilibrium in BOP may come into conflict with other, rather more endearing
objectives, such as, economic growth, employment and price stability. Reconciling such conflicts
is the challenge to policy makers.

Check your progress. 2

1. What is Official Reserve Account?
………………………………………………………………………………………………
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………………………………………………………………………………………………

2. What do you mean by current account deficit?

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………………………………………………………………………………………………
………………………………………………………………………………………………

3. What are capital flows?

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 ………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

Check Your Progress C

1. Distinguish between import substitution and export promotion.

………………………………………………………………………………………………
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………………………………………………………………………………………………

2. What do you mean by disequilibrium in balance of payments?

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

3. Write four factors affecting balance of payments.

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

3.10 LET US SUM UP

Balance of payments is an annual statement of accounts of monetary transactions of a country
with rest of the world. These monetary transactions arise out of the flows of goods, services and
capital.
Our goods and services are paid by overseas buyers, and we pay when we demand their goods
and services. Balance of Payments thus is an indicator of the state and structure of an economy in
relation to the rest of the world. Current account deficits are made use of to finance the
developmental needs of an economy. To that extent deficits play a positive role in the process of
economic development. But too much of a dependence on deficits may cause instability and
prove disruptive. Thus there is a need to adapt a balanced view over these deficits. India has been
by and large successful in coining and following such a balanced approach.

3.11 TERM - END EXERCISES

1. Explain the term Balance of Payments. Also distinguish between balance of payments and
balance of trade.

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2. Explain the relationship between balance of payments deficit and fiscal deficit.
3. Discuss the importance of balance of payments in an emerging economy.
4. Why should balance of payments of a country should always balance? Discuss the
significance of this equality.
5. Outline policy measures to meet balance of payments deficits in an emerging economy like
India.
6. Discuss the trade challenges being faced by India in its strategy to meet balance of payments
deficits.

3. 12 .KEY TERMS
1. Balance of Trade: Statement of monetary transactions of a country on account of exports and
imports of merchandise.
2. Balance on Invisibles: Statement of monetary transactions of a country on account of trade in
services.
3. Balance of Payments: Statement of accounts of all types of monetary transactions of a
country with rest of the world.
4. Balance of Payments on Current Account: Statement of Accounts of monetary transactions of
a country on account of exchange of merchandise and invisibles.
5. Balance of Payments on Capital Account: Statement of Accounts of monetary transactions on
account of inflow and outflow of capital from a country.
6. Disequilibrium in Balance of Payments: it arises when aggregate inflows of foreign exchange
do not match aggregate outflows of foreign exchange.
7. Depreciation of a currency. It takes place when the exchange value of domestic currency falls
in terms of a foreign currency.
8. Appreciation of a Currency. It is a situation in which the exchange value of domestic
currency rises in terms of a foreign currency.

SELECT REFERENCES
1. Govt. of India, Economic Survey Annual
2. Reserve Bank of India Annual Report
3. Reserve Bank of India, Balance of Payments Manual
4. World Bank, World Development Report Annual

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