ICAI Notes 6.7 - Balance of Payments | Business Economics for CA Foundation PDF Download

Learning Objectives

• understand the meaning of Balance of Payments.
• know the difference between Balance of Payments and Balance of Trade.
• know of the developments in Balance of Payments situation in India since Independence.

7.0 MEANING OF BALANCE OF PAYMENTS AND BALANCE OF TRADE

The Balance of Payments (BOP) is one of the oldest and most important statistical statements for any country. It is a systematic record of all economic transactions between the residents of one country and the residents of the rest of the world in a year. Since we merely record all receipts and payments in international transactions using double entry system, the balance of payments always balance in an accounting sense.

Balance of Trade : Balance of Trade may be defined as the difference between the value of goods sold to foreigners by the residents and firms of the home country and the value of goods purchased by them from foreigners. If value of exports of goods is equal to the value of imports of goods, we say that there is balance of trade equilibrium and if the latter exceeds the former, then we say that there is balance of trade deficit. But if the former exceeds the latter, i.e., if value of exports of goods is more than the value of imports of goods, we say there is surplus balance of trade.

Balance of Current Account : Balance of current account is a broader concept than the balance of trade. It includes balance of services and balance of unilateral transfers (i.e., unrequited transfers) besides including balance of trade. Balance of services records all the services exported and imported by a country in a year. Unlike goods which are visible and tangible, services are invisible and are not tangible. The services transactions basically include:
(i) transportation, banking and insurance receipts and payments from and to the foreign countries,
(ii) tourism, travel services and tourist purchases of goods and services received from foreign visitors to home country and paid out in foreign countries by home country citizens,
(iii) expense of diplomatic and military personnel from overseas as well as receipts from similar personnel from overseas who are stationed in the home country, and
(iv) interest, profits, dividends and royalties received and paid from and to the foreigners. Balance of services is the sum of all invisible service receipts and payments which could be zero, positive or negative. Balance of unrequited transfers includes all gifts, donations, grants and reparation, receipts and payments to foreign countries. All these balances, i.e., balance of trade, balance of services and balance of unrequited transfers constitute balance of current account. It could again be positive, negative or zero depending upon the values of these balances. It is worth noting that balance of payments on current account covers all receipts on account of earnings (as opposed to borrowings) and all the payments arising out of spending (as opposed to lending). This is in sharp contrast to balance of payments on capital account. 

Balance of Payment on capital account : Balance of payments on capital account includes balances of private direct investments, private portfolio investments and government loans to foreign governments. Balance of capital account basically deals with debts and claims of the country in question or we say it deals with borrowings or lending of the country in question.

Balance of Payments : Overall balance of payments is the sum of balance of current account and balance of capital account. It includes all international monetary transactions of the reporting country vis-à-vis the rest of the world. The balance of payments must always balance in a book-keeping sense. This is because for any surplus (or deficit) in the overall balance of payments there must be a corresponding debit (or credit) entry in the net changes in external reserves. In other words, if there is a surplus it adds to external reserves of the country and if there is a deficit, it reduces down the external reserves of the country.

7.1 TRENDS IN BALANCE OF PAYMENTS OF INDIA

A country, like India, which is on the path of development generally, experiences a deficit in balance of payments situation. This is because such a country requires imported machines, technology and capital equipments in order to successfully launch and carry out the programme of industrialisation. Also, since initially it has only primary goods to offer as exports, it generally has an unfavourable balance of payments position. As pace of development picks up it has to have ‘maintenance imports’ although it has now more sophisticated goods to offer for exports. But the situation remains the same i.e., deficit balance of payments.

This has exactly happened in India. Over the period of planning India’s balance of payments has generally remained unfavourable. However, deficit in balance of payments sharply increased after the Fifth Plan. During the whole of the Fifth Plan, India experienced surplus in the balance of payments due to a sharp increase in the export surpl.us on account of invisible remittances (money sent by a foreign worker to his home country) From 1979-80 onwards, India started experiencing very adverse balance of payments. This happened because growing trade deficits, which till then were offset by net receipts could not be made good by them in spite of the fact that the rising trends in the net receipts on account of invisibles noticed in the past few years continued in 1980-81 to 1985-86. Apart from external assistance, India had to meet this huge deficit in the current account through withdrawals and borrowings from IMF. It also used up a part of its foreign exchange reserves.

The Sixth Plan characterised the balance of payments position as ‘acute’. During the Sixth Plan, the trade deficit was 3.3 per cent of GDP and current account deficit was 1.4 per cent of GDP. Exports performance substantially improved in the Seventh Plan with average volume growth exceeding 7 per cent. However, the balance of payments continued to be under strain on account of a combination of several medium and short term adverse factors. There was no significant growth in indigenous oil production while domestic demand for petroleum products went on rising. There was a steep rise in debt services payments. The share of net invisible earnings in financing trade deficit declined from 63 per cent during the Sixth Plan to 29.5 per cent during the Seventh Plan. The average current account deficit as a per cent of GDP increased to 2.4 per cent in the Seventh Plan. The large and sustained current account deficit in the BOP had to be financed by substantial inflow of capital in the form of loans from various sources, commercial borrowings and inflow of funds from NRIs. In early 1990-91, the already poor BOP position worsened because of Gulf war and further deterioration in invisible remittances.

An immediate response to the BOP crisis was introduction of several restrictions on import in 1990-91. In 1992-93, many important changes such as a new system of exchange rate management, liberalisation of import licensing and tariff reductions were introduced. Data of 1992-93 show that there has been significant revival of imports and exports during the year with the result that the current account deficit came down to 2.1 per cent of GDP in 1992-93.

In the year 1993-94, India saw a remarkable turnaround from a foreign exchange constrained control regime to a more open, market driven and liberalised economy. This has been facilitated by the structural changes in the country’s balance of payments. The trade liberalisation and a shift to a market-determined exchange rate regime have had a significant positive impact on the country’s balance of payments.

Exports recorded a growth of 20 per cent in dollar terms. The surplus on the invisible account doubled. The current account deficit shrank, and the capital account was strengthened by sharp increase in direct foreign investments and portfolio investments. Not only this, foreign currency reserves which were just $1205 million in 1990 reached the level of $19,386 million in 1994. The balance of payments position further consolidated in 1994-95. The build up in foreign currency reserves which reached a level of $19.6 billion at the end of January 1995, the economy thus moved to a more stable and sustainable balance of payments position.

The balance of payments situation remained comfortable in 1995-96, 1996-97 and 1997-98. In 1998-99, despite the continuing slow down of exports and a marked deceleration in capital flows, the BOP situation was not unmanageable. Exports during 1999-2000 showed a welcome recovery. Similarly, imports also picked up. The current account deficit in the year 2000-01 was 0.5 per cent of GDP. It was 1.1 per cent in 1999-2000. This improvement in current account deficit was made possible largely because of the dynamism in export performance, sustained buoyancy in invisible receipts and subdued non-oil import demand. The BOP position remained comfortable during 2001-02. In the Tenth plan total exports grew at about 24 per cent per annum. This was largely due to the impressive growth of petroleum products which grew at more than 50 per cent during the Plan. Manufactured goods recorded an impressive growth of about 20 per cent per annum and exports of agricultural and allied products also rose at a healthy rate of more than 16 per cent.

North America (occupying first place) continued to be an important destination of India’s exports. During the Tenth Plan nearly 16 per cent of India’s exports went to North America. European Union countries (27 in number) had a combined share of more than 21 per cent in India’s exports during the Tenth Plan. The share of Asia and ASEAN countries steadily increased during the Tenth Plan and the region accounted for nearly half of India’s exports during the Plan. Imports recorded a compound annual growth rate of around 30 per cent during the Tenth Plan. The high growth was mainly due to increase in oil prices. The crude oil and petroleum products taken together were the single most important category of imports during the Plan. This group accounted for nearly 30 per cent of the total value of imports by India during the Plan. The share of machinery and project goods registered a significant increase during the plan increasing from 11.3 per cent in 2002-03 to 18 per cent in 2006-07. Asian countries remained our main supplier of imports during the Plan. Their share increased from around 30 per cent in 2002-03 to more than 57 per cent in 2006-07.

The merchandise trade deficit widened sharply during the Tenth Plan mainly on account of the growing oil import bill. We had a current account surplus for three successive years (2001-04). Buoyant invisible flows, particularly private transfers comprising remittances, along with software services exports, have been instrumental in creating and sustaining current account surpluses for India for the above period. However, since 2003-04 trade deficit has widended sharply, particularly in 2004-06, because of higher outgo on import of petroleum, oil and lubricants.

As a result, current account surpluses have once again turned into deficits inspite of the fact that invisibles flows have continued to swell. For the years 2004-05, 2005-06 and 2006-07 the current account deficits were (-) 0.4 per cent and (-) 1.1 per cent and (-) 1 per cent respectively. In the Eleventh Plan exports are projected to grow at about 20 per cent per year in US dollar terms, the imports are projected to grow at 23 per cent, current account deficit could range between 1.2 per cent to 2 per cent and trade deficit could reach 16 per cent at the end of the Plan. During the first year of the Eleventh Plan, export increased by around 30 per cent, imports increased by 35 per cent, current account balance was (-) 1.5 per cent of GDP and trade balance was (-) 7.8 per cent of GDP. The year 2008-09 was marked by adverse development in the external sector of the economy, particularly during the second half of the year, reflecting the impact of global financial crisis. Exports grew by 17.5 per cent and imports by 30.6 per cent during April - December 2008-09. Despite higher invisible surplus, the trade deficit widened mainly because of higher growth of imports and slower growth of exports. The current account deficit ratio to GDP reached 4.1 per cent during April-December 2008-09.

Foreign direct investment (FDI) has grown significantly on net (inward minus outward) basis. The year to year growth (net) was 154 per cent in 2006-07 and 100 per cent in 2007-08. During April-December 2008, net FDI remained buoyant at US $ 15.4 billion as compared to US $ 6.9 billion in April-December 2007. Considering global FDI inflows in various countries, India ranked ninth. Foreign exchange reserves declined from US $ 309.7 billion in 2007-08 to US $ 252 billion in 2008-09. The United States of America continued to be the principal destination accounting for 12 per cent of India’s total exports in 2008-09, followed by UAE(10.8 per cent), China(5.1 per cent), Singapore (4.8 per cent), Hong Kong (3.7 per cent) and UK (3.6 per cent). In 2008-09, Asia and ASEAN continued to be the major source of India’s imports accounting for more than 61 per cent of total imports.

Thus, we find that there has been a significant improvement in the structure of India’s balance of payments since the economic crisis of 1991. Comparing the pre-crisis with the post-crisis data we find that exports grew at an annual average of 7.6 per cent during 1980 to 1992 and at an annual average of 10 per cent 1992-93 to 2000-2001. Similarly, imports grew at 13.7 per cent per annum during 1992-93 to 2000-2001 compared with just 8.5 per cent growth rate during 1980-1992. Moreover, the current account deficit, as percentage of GDP has declined from 1.9 per cent during pre-crisis period to around 1 per cent during post-crisis period and during 2001-04 we even had surplus in the current account. Since then also, the external sector has shown resilience despite slow down in the global economy.

SUMMARY

No country is self-sufficient today. It has to depend upon other countries for its imports and exports. For evaluating its performance on the international front it prepares ‘Balance of Trade’ and ‘Balance of Payments’ statements. Balance of trade is the statement showing balance of merchandise trade only. In Balance of payments we have other transactions such as capital transactions, balance on account of service transactions, gold transactions, etc. A country could be having a surplus in balance of trade and a deficit in balance of payments simultaneously.

While analysing India’s balance of payments situation we find that it started deteriorating since 1979-80. This happened because growing trade deficits which till Fifth Plan were offset by net receipts could not be made good by them in spite of the fact that the rising trend in the net receipts continued till early 80’s. The current account deficit which was 1.3 per cent of GDP in the Sixth Plan stood at 2.2 per cent during the Seventh Plan. This large and sustained current account deficit had to be financed by substantial inflow of capital in the form of loans, commercial borrowings and inflow of funds from NRIs. The Gulf crisis further deteriorated our balance of payments position. Our reserves touched very low levels. In order to combat all these problems and to boost exports and curb imports changes were made from time to time in our foreign trade policy. Many schemes were started and incentives were given for improving exports. Devaluation (reducing the value of local currency vis-a-vis other currencies) of rupee was carried out, loan was sought from the IMF and new trade policy was announced. As a result, we now have quite comfortable balance of payments situation.