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8/6/2019 Arun Jeet Balance of Payment
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ANANDPUR SAHIB
Seminar:
INTERNATIONAL BUSINESS
ENVIRONMENT & MANAGEMENT
SUBMITTED TO SUBMITTED BY
LECT. PARUL SHARMA GAGAN DEEP KAUR
M.B.A SEM 2
ROLL NO. 1487
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ACKNOWLEDGEMENT
First and foremost, I would like to express my sincere gratitude to my
Project Guide
LECT: PARUL SHARMA
I was privileged to experience a sustained enthusiastic & involved
interest from her side. She was always ready with a positive comment
all the time, whether it was an off-hand comment to encourage me. SHe
has taken pain to go through the project and make necessary correction
as and when needed.
And special thank to library staff who arranged a good books for us.
Last but not the least; I would like to thank the institute, in general, forextending a helping hand at every juncture of need.
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S. No. TOPICS PG.No. SIGNATURE
1. Introduction Tballance of payment 4-11
2. Eis balance of payment is always inequilibrium
11-13
3. Measuring deficit orsurplus in the
balance of payment
13-14
4. Balance of trade & balance of payment 14-15
5. CAUSE OF DISEQUILIBRIUM 16-19
6. IMPLICATIONS OF DISEQUILIBRIUM 19-20
7. MEASURES TO CORRECT DEFICIT IN
BALANCE OF PAYMENT
21-23
8. THE BALANCE OF PAYMENT STANDARD
OF LEAVIING
24-25
9. CAUSE OF BOP IN BALANCES 25-32
10. CASE STUDY 32-33
11. WHY PAKISTAN FACING DEFICIT
BALANCE OF PAYMENT
33-35
12. CONCLUSION 35
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BALANCE OF PAYMENT
MEANING
The balance of payment of the country is a systematic record of
all its economic transactions with the outside world in a given
year. It is the Statistical record of the character and dimensions of
the countrys economic relationships with the rest of the world.
According to Bo Sodersten,
The balance of payment is merely the way of Listing
receipts and payments in the international transactions for a
country.
According to B.J. Cohen,
It shows countries trading position, changes in its net
Position as foreign lender or borrower, and changes in its official
reserve holding.
STRUCTURE OF BALANCE OF PAYMENT ACCOUNTS
The balance of payments account of a country is constructed on
the principles of double-entry book-keeping. Each transaction is
entered on the credit and the debit side of the balance sheet. But
balance of payment accounting differs from business accounting
in one respect:
In Business accounting, (-) debits are shown on the left side and
(+) credits are shown on the right side of the balance sheet.
Whereas, in balance of payment accounting, the practice is to
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show credits on the left side and debit in the right side of the
balance sheet.
When a payment is received from a foreign country, it is a
credit transaction while Payment to a foreign country is a debittransaction.
The principal items shown on the credit side (+) are exports of
goods and services, unrequited (or transfer) receipts in the form
of gifts, grants etc from foreigners, borrowings from abroad,
investments by foreigners in the country and official sale of
receiver assets including gold to foreign countries and
international agencies. The principal items on the Debit side (-)
include imports of goods and services transfer (or unrequitedpayments to foreigners as gifts, grants, etc., leading to foreign
countries investments by residents to foreign countries and
official purchase of reserve assets or Gold from foreign countries
and international agencies.
These credit and debit items are shown vertically in the balance
of Payments account of country according to the principle of
double-entry book-keeping. Horizontally, they are divided into
three categories:
The Current account, the Capital account, and the Official
settlement account or the official reserve assets account.
The balance of payment of the country is constructed as:
CREDITS (+)DEBITS (-)
1.Current Account
Exports Imports
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Goods (a) Goods
Services (b) Services
Transfer Payments (c) Tran
Payments
2.Capital Account
(a)Borrowing from Foreign (a) Lending toForeign Countries.
Countries.
(b)Direct Investments by (b) Directinvestment in Foreign
Foreign Countries. Countries.
3.Official Settlement Account
Increase in Foreign (a) Increase inOfficial Reserve of
Official Holdings Gold and Foreign
Currencies.
1. CURRENT ACCOUNT: The current account of a countryconsists of all transactions relating to trade in goods and services
and unilateral transfers. Service transactions include costs of
travel and transportation, insurance, income and payments of
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foreign investments ect. Transfer payments relate to gifts, foreign
aid, pensions, private remittances, charitable donations, ect.
Received from foreign individuals and governments to foreigners.
In the current account, merchandise exports and
imports are the most important items. Exports are shown as a
positive item and are calculated f.o.b. (free from board) which
means that cost of transportation, insurance, etc. are excluded.
On the other side, imports are shown as a negative item and are
calculated in which costs, insurance and fright are included. The
difference between imports and exports of the country is its
balance of visible trade or merchandise trade or simply balance of
trade. If visible exports exceed visible imports, the balance of
trade is favourable. In the opposite case when imports exceed
exports, it is unfavourable.
It is, however, services and transfer payments or
invisible items of the current account that reflect the true picture
of the balance of payment account. The balance of exports and
imports of the services and transfer payments is called the
balance of invisible trade. The invisible items along with the
visible items determine the actual current account position. If
exports of goods and services exceed imports of goods and
services, the balance of payments is said to be favourable. In the
opposite case, it is unfavourable.
In the current account, the exports of goods and services and thereceipts of transfer payments are entered as (+) because they
represent receipts from foreigners. On the Other hand, the
imports of goods and services and grant of transfer payments to
foreigners are entred as debit (-) because they represent
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payments to foreigners. The net value of these visible and
invisible trade balances is the balance on current account.
2. CAPITAL ACCOUNT: The capital account of a countryconsists of its transactions in financial assets in the form of short-
term and long-term lendings and borrowings, and private and
official investments. In other words, the capital account showsinternational flow of loans and investments and represents a
change in the countrys foreign assets and liabilities. Long term
capital transactions relate to international capital movements
with maturity of one year or more and include direct investments
like building of a foreign plant, portfolio investment like purchase
of foreign bonds and stocks, and international loans. On the other
hand, short term international capital transactions are for a period
ranging between 3 months and less than 1 year.
There are two types of transactions in the capital account-
private and government. Private transactions include all types of
investments: direct, portfolio and short-term. Government
transactions consist of loans to and from foreign official agencies.
In the Capital account, borrowings from foreign countries
and direct investment by foreign countries represent capitalinflows. They are positive items or credits because these are
receipts from foreigners. On the other hand, lending to foreign
countries and direct investments in foreign countries represent
capital outflows. They are negative items or debits because they
are payments to foreigners. The net value of the balance of short-
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term and long-term direct and portfolio investments is the
balance on capital account.
Sodersten and Reed refer to the external wealth account of a
country which shows the stocks of foreign assets held by thecountry(positive items) and of domestic assets held by foreign
investors (liabilities or negative item). The net value of a
countrys assets and liabilities is its balance of indebtedness. If its
assets are more than its liabilities, then it is a net creditor. If its
liabilities are more than its assets, then it is a net debtor.
BASIC BALANCE. The sum of current account and capitalaccount is known as the basic balance.
3.THE OFFICIAL SETTLEMENTS ACCOUNT: The officialsettlements account or official reserve assets account is, in fact, a
part of the capital account. But the U.K. and U.S. balance of
payments accounts shows it as a separate account. The official
settlement account measures the change in nations liquidity andnon-liquid liabilities to foreign official holders and the change in a
nations official reserve assets during the year. The official
reserve assets of a country include its Gold stock, holdings of its
convertible foreign currencies and SDRs, and its net position in
the IMF. It shows transactions in a countrys net official reserve
assets.
Errors and Omissions. Errors and omissions is a balancingitem so that total credits and debits of the three accounts must
equal in accordance with the principles of double entry book-
keeping so that the balance of payments of a country always
balances in the accounting sense.
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Standard definitionSince 1974, the two principal divisions on the BOP have been
the current account and the capital account.
The current account shows the net amount a country is earning if
it is in surplus, or spending if it is in deficit. It is the sum of
the balance of trade (net earnings on exports payments for
imports) , factor income (earnings on foreign investments
payments made to foreign investors) and cash transfers. Its
called the current account as it covers transactions in the "here
and now" - those that don't give rise to future claims.
The capital account records the net change in ownership of
foreign assets. It includes the reserve account (the international
operations of a nation's central bank), along with loans and
investments between the country and the rest of world (but not
the future regular repayments / dividends that the loans and
investments yield, those are earnings and will be recorded in the
current account).
Expressed with the standard meaning for the capital account, the
BOP identity is:
BOP = Current account Capital account +- Balancing
item
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The balancing item is simply an amount that accounts for any
statistical errors and assures that the current and capital
accounts sum to zero. At high level, by the principles ofdouble
entry accounting, an entry in the current account gives rise to an
entry in the capital account, and in aggregate the two accounts
should balance. A balance isn't always reflected in reported
figures, which might, for example, report a surplus for accounts,
but when this happens it always means something has been
missedmost commonly, the operations of the country's central
bank.
An actual balance sheet will typically have numerous sub
headings under the principal divisions. For example, entries
under Current account might include:
Trade buying and selling of goods and services
Exports a credit entry
Imports a debit entry
Trade balance the sum of Exports and Imports
Factor income repayments and dividends from loans and
investments
Factor earnings a credit entry
Factor payments a debit entry
Factor income balance the sum of earnings and
payments.
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Especially in older balance sheets, a common division was
between visible and invisible entries. Visible trade recorded
imports and exports of physical goods (entries for trade in
physical goods excluding services is now often called the
merchandise balance). Invisible trade would record international
buying and selling of services, and sometimes would be grouped
with transfer and factor income as invisible earnings.
IS BALANCE OF PAYMENTS ALWAYS IN
EQUILIBIRIUM?
Balance of payments always balances means that algebraic sum of the net. Credit
and debit balances of current account, capital account and official settlements
account must equal zero. Balance of payments is written as
B=R-P
Where, B represents balance of payments,
R receipts from foreigners,
P payments made to foreigners.
When B=R-P=0, the balance of payments is in the equilibrium.
When R-P>0, it implies receipts from foreigners exceed payments made to
foreigners and there is surplus in the balance of payments. On the other hand, when
R P < 0 or R < P there is deficit in the balance of payments as the payments made
to foreigners exceed receipts from foreigners.
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If net foreign lending and investment abroad are taken, a flexible exchange rate
creates an excess of exports over imports. The domestic currency depreciates in
terms of other currencies. The exports become cheaper relatively to imports. It can
be shown in equation form:
X + B = M + I
Where X represents exports, M imports, I foreign investment, B foreign borrowing
Or X M = I B
Or (X M) (I B) = 0
The equation shows the balance of payments in equilibrium. Any positive
balance in its current account is exactly offset by negative balance on its capital
account and vice versa. In the accounting sense, the balance of payments always
balances. This can be shown with the help of the following equations:
C + S + T = C + I + G + (X M)
Or Y = C + I + G + (X - M)
Where C represents consumption expenditure, S domestic saving, T tax receipts, I
investment expenditures, G government expenditures, X exports of goods and
services, and M imports of goods and services.
In the above equation
C+S+T is GNI or national income (Y), and
C+I+G = A
Where A is called absorption.
In the accounting sense, total domestic expenditures (C+I+G) must equal current
income (C+S+T) that is A=Y. Moreover, domestic saving (S) must equal domestic
investment (I). Similarly, an export surplus on current account (X>M)
Must be offset by an excess of domestic savings over investments (S>I). Thus the
balance of payment always balances in the accounting sense, according to the basic
principals of accounting. In the accounting system, the inflow and the outflow of
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the transactions are recorded on the credit and debit side respectively. Therefore,
debit and credit side always balance. If there is a deficit in the current account, it is
offset by a matching surplus in the capital account by borrowings from abroad
or/and withdrawing out of its gold and foreign exchange reserves, and vice versa.
Thus, the balance of payments always balances in this sense also.
MEASURING DEFICIT OR SURPLUS IN THE BALANCE OF
PAYMENTS
If the balance of payment always balances, then why a deficit or surplus do does
arises in the balance of payment of the country? It is only when all items in the
balance of payments are included that there is no possibility of a deficit or surplus.
But if some items are excluded from a countrys balance of payments and then a
balance is struck, it may show a deficit or surplus.
There are three ways of measuring deficit or surplus in the balance of
payments.
First, there is the basic balance which includes the current account balance and
the long-term capital account balance.
Second, there is the net liquidity balance which includes the basic balance andthe short-term private non-liquid capital balance, allocation of SDRs, and errors
and omissions.
Third, there is the official settlement balance which includes the total net liquid
balance and short-term private liquid capital balance.
If the total debits are more than total credits in the current and capital accounts,
including errors and omission, the net debit balance measures the deficits in the
balance of payments of a country. This deficit can be settled with an equal amount
of the net credit balance in the official settlements account. On the countrary, iftotal credits are more than debit in the current and capital accounts, including
errors and omissions, the net debit balance measure the surplus in the balance of
payments of a country. This surplus can be settled with an equal amount of net
debit balance in the official settlements account.
The relationship between these balances is summarised in
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TABLE 2
Trade balance ..a
Transfer payments balance.......b Autonomous
Current Account Balance...c (= a+b) Items
BALANCE OF TRADE AND BALANCE OF PAYMENTS
The balance of a country is a systematic record of its receipts and payments in
international transactions in a given year. Each transaction is entered on the credit
and debit side of the balance sheet. The principal items on the credits side are:
(1) Visible exports which relate to the goods exported for which the country
receives payments.
(2) Invisible exports which refer to the services rendered by the country to other
countries. Such services consist of banking, insurance, shipping and other services
rendered in the form of technical know-how, etc., money spent by tourists and
students visiting the country for travel and education, etc.
(3) Transfer receipts in the form of gifts received from foreigners.
(4) Borrowings from abroad and investments by foreigners in the country.
(5) The official sale of reserve assets including gold to foreign countries and
international institutions.
The principal items on the debits side are:
(1) Visible imports relating to goods imported for which the country makes
payments to foreign countries.
(2) Invisible imports in the form of payments made by the home country for
services rendered by foreign countries.
(3) Transfer payments to foreigners in the form of gifts ect.
(4) Loans to foreign countries, investments by residents in foreign countries, and
debt repayments to foreign countries.
(5) Official purchase of reserve assets or gold from foreign countries and
international institutions.
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If the total receipts from foreigners on the credit side exceed the total payments to
foreigners on the debit side, the balance of payments is said to befavourable.
On the Other hand, if the total payments to foreigners exceed the total receipts
from foreigners, the balance of payment is Unfavourable.
The balance of trade is the difference between the value of goods and services
exported and imported. In contains the first two items of the balance of payment
account on the credit and debit side. This is known as Balance of Payment on
Current account. Some writers define the balance of trade as the difference
between the value of merchandise exports and imports. Prof. Meade regards this
way of defining the balance of trade as wrong and of minor economic significance
from the point of view of the national income of the country. In equation form, the
balance of payments of Y=C+I+G+(X-M) which includes all transactions which
give rise to or exhaust national income. In the equation, Y refer to national income,
C to consumption expenditure, I to investment expenditure, G to governmentexpenditure, X to exports of goods and services and M to imports of goods and
services. The expression (X-M) denotes the balance of trade. If the difference
between X and M is Zero, the balance of trade balances. If X is Greater than M, the
balance of Trade is favourable, or there is Surplus balance of trade. On the other
hand, if X is less than M, the balance of trade is in deficit or is unfavourable.
DISEQUILIBRIUM IN BALANCE OF PAYMENTS
Disequilibrium in the BOP of a country may be either a deficit or a
Surplus. A deficit or surplus in BOP of a Country appears when it
autonomous receipts (Credits) dont match its autonomous
payments (debits). If autonomous credit receipts exceed
autonomous debits payments, there is a Surplus in a BOP and the
disequilibrium is said to be favourable. On the other hand, if
autonomous debits and payments exceed autonomous creditreceipts, there is a deficit in the BOP and the disequilibrium is
Said to be Unfavourable or adverse.
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CAUSES OF DISEQULIBRIUM
There are many factors that may lead to a BOP deficit or
surplus:
Temporary Changes.(Or Disequilibrium).There may bea temporary disequilibrium caused by random variations in
trade, seasonal fluctuations, the effects of weather on
agricultural production, etc. Deficits or surpluses arising from
such temporary causes are expected to correct themselveswithin a short time.
Fundamental Disequilibrium.Fundamentaldisequilibrium refers to persistent and long run BOP
disequilibrium of a country. It is a chronic BOP deficit,
according to IMF. It is caused by such dynamic factors as:
Changes in consumer taste within the country or
abroad which reduces the countrys exports andincreases its imports.
Continuous fall in the countrys foreign exchange
reserves due to supply inelasticity of exports and
excessive demand for foreign goods and services.
Excessive capital outflows due to massive imports of
capital goods, raw materials, essential consumer goods,
technology and external indebtedness.
Low competitive strength in world markets which
adversely affect exports.
Inflationary pressures within the economy which make
exports dearer.
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3. Structural changes (or Disequilibrium). Structuralchanges bring about disequilibrium in BOP Over the long run.
They may result from the following factors: (a) technologicalchanges in method of production of products in domestic
industries or in the industries of other countries. They lead to
changes in costs, prices and quality of products. (b) Import
restrictions of all kinds bring about disequilibrium in BOP.
(c)Deficit in BOP also arises when a country suffers from
deficiency of resources which it is required to import from other
countries. (d) Disequilibrium in BOP may also be caused by
changes in the in the supply or direction of long-term capital
flows. More and regular flow of long=term capital may lead to
BOP surplus, while an irregular and short supply of capital brings
BOP deficit.
4. Changes in Exchange Rates. Changes in foreignexchange rate in the form of overvaluation or undervaluation of
foreign currency lead to BOP disequilibrium. When a value of
currency is higher in relating to other currencies, it is said to be
overvalued. Opposite is the case of an undervalued currency.
Overvaluation of the domestic currency makes foreign goods
cheaper and export dearer in foreign countries. As a result, the
country imports more and exports less of goods. There is also out
flow of capital. This leads to unfavourable BOP. On the contrary,
undervaluation of the currency makes BOP favourable for the
country by encouraging exports and inflow of capital and reducing
imports.
5. Cyclical fluctuation (or disequilibrium). Cyclicalfluctuation in business activities also lead to BOP disequilibrium.
When there is depression in a country, volumes of both exports
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and imports fall drastically in relation to other countries. But the
fall in exports may be more than that of imports due to decline in
domestic production. Therefore, there is an adverse BOP
situation. On the other hand, when there is boom in a country in
relation to other countries, both export and import may increase.But there can be either a deficit or surplus in BOP situation
depending upon whether the country exports more than imports
or imports more than exports. In both the cases, there will be
disequilibrium in BOP.
6. Changes in national income. Another case in the
change in the countrys national income. If the national income ofa country increases, it will lead to an increase in imports thereby
creating a deficit in its balance of payments, other things
remaining the same. If the country is already at full employment
level, an increase in income will lead to inflationary rise in prices
which may increase its imports and thus bring disequilibrium in
the balance of payments.
7. Price changes. Inflation or deflation is another cause ofdisequilibrium in the balance of payments. If there is inflation in
the country, prices of exports increase. As a result, exports fall. At
the same time, the demand for imports increases. Thus increase
in exports prices leading to decline in exports and rise in imports
results in adverse balance of payments.
8. Stage of Economic Development. A countrys balanceof payments also depends on its stage of economic development.
If a country is developing, it will have a deficit in its balance of
payment because it imports raw material, machinery, capital
equipment, and services associated with the development
process and exports primary products. The country has to pay
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more for costly imports and gets less for its cheap exports. This
leads to disequilibrium in its balance of Payments.
9. Capital Movements. Borrowings and lendings ormovements of capital by countries also results in disequilibrium in
BOP. A country which gives loans and grants on a large scale to
other countries has a deficit in its BOP on capital account. If it is
also importing more, as is the case with the USA, it will have
chronic deficit. On the other hand, a developing country
borrowing large fund from other countries and international
institutions may have a favourable BOP. But such a possibility is
remote because these countries usually imports huge quantise offood, raw materials, capital goods, etc. and exports primary
products. Such borrowings simply help in reducing BOP deficit.
10. Political conditions. Political condition of a country isanother cause of disequilibrium in BOP. Political instability in a
country creates uncertainty among foreign investors which leads
to the outflow of capital and retards its inflow. This causesdisequilibrium in BOP of the country. Disequilibrium in BOP also
occurs in the events of war with some other country.
Implications of Disequilibrium
A disequilibrium in the balance of payments whether a deficit or
surplus has important implications for a country.
A deficit in the combined current and capital accounts is
regarded as undesirable for the country. This is because such a
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deficit has to be covered by borrowing from abroad or attracting
foreign exchange or capital from abroad. This may require paying
high interest rates. There is also the danger of withdrawing
money by foreigners as happened in the case of the Asian crisis in
the late 1990s. An alternative may be to draw on the reserves ofthe country which may also lead to a financial crisis. Moreover,
the reserves of a country being limited, they can be used to pay
for BOP deficit up to a limit.
But the above analysis of a combined current and capital
account deficit is not correct in practice. The reason being that a
current account deficit is the same thing as a capital account
surplus. However, it is beneficial for a country to have a current
account deficit even if it equals capital account surplus in BOP. In
the short run, the country may benefit from a higher level of
consumption through import of goods and consequently a higher
standard of living. But the excess of imports over exports may be
financed by foreign investments in the country. These may lead
to increase production, employment and income in the country. In
the long run, foreign investors may purchase large assets in the
country and thus adversely affect domestic industry as in the
case with MNCs (multinational corporations).
The current account deficit in BOP of a country may have either
good or bad effects depending on the nature of an economy.
Take a country where domestic industries are rapidly growing
and it has current account BOP deficit. Theses industries offer a
high rate of return on their investment. This would, in return,
attract foreign investments. As a result, the country would have a
capital account surplus due to the inflow of capital and a currentaccount deficit. This current account deficit is good for the
economy. No doubt, the external debt of the country increases,
but this debt is being utilised to finance the rapid growth of the
economy. The real burden of this debt will be very low because it
can be repaid out of higher income in the future.
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On the contrary, a country having a inefficient and unproductive
domestic industry will be adversely affected by its current
account BOP deficit. The country borrows from abroad to finance
the excess of spending over consumption. To attract foreign
borrowings the country will have to pay high interest rates. Thesewill increase the money burden of the debt. The real burdens of
the debt swill also increase because of the low productive
capacity of domestic industries. If the current consumption is
being financed by foreign borrowings, the wealth of the economy
will decline. This, in turn, will lead to either a reduction in
domestic expenditure or a change in government policy so as to
control the rising debt.
On the other hand if foreign borrowings are being used
to finance real investment, the current account BOP deficit will be
beneficial for the economy. A higher rate of return on real
investment than the interest on foreign borrowings would
increase the countries wealth over time through arises in its
national income. Thus a current account BOP deficit is not always
undesirable for a country.
MEASURES TO CORRECT DEFICIT IN BALANCEOF
PAYMENTS
When there is a deficit in the balance of payments of a country, adjustment
is brought about automatically through price and income changes or by
adopting certain policy measures like export promotion, monetary and fiscal
policies, devaluation and direct controls. We study these as follows:
1. Adjustment through Exchange Depreciation (Price Effect)
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Under flexible exchange rates, the disequilibrium in the
balance of payments is automatically solved by the forces of
demand and supply for foreign exchange. An exchange rate is
price of a currency which is determined, like any other
commodity, by demand and supply. The exchange rate varieswith varying supply and demand conditions, but it is always
possible to find an equilibrium exchange rate which clears the
foreign exchange market and creates external equilibrium. This
is automatically achieved by depreciation of a countrys currency
in case of deficit in its balance of payments. Depreciation of a
currency means that its relative value decreases. Depreciation
has the effect of encouraging exports and discouraging imports.
When exchange depreciation takes place, foreign prices aretranslated in domestic prices. Suppose the dollar depreciates in
relation to the pound. It means that the price of dollar falls in
relation to the pound. It means that the price of dollar falls in
relation to the pound in the foreign exchange market. This leads
to the lowering of the prices of U.S. exports in Britain and raising
of the prises of British imports in the U.S. When import prices are
higher in the U.S., the Americans will purchase less goods from
the Britishers. On the other hand, lower prices of U.S. exports willincrease exports and diminish imports, thereby bringing
equilibrium in the balance of payments.
2. Devaluation or Expenditure-Switching Policy
Devaluation raises the domestic price of imports and
reduces the foreign price of exports of a country devaluing its
currency in relation to the currency of another country.
Devaluation is referred to as expenditure switching policybecause it switches expenditure from imported to domestic goods
and services. When a country devalues its currency, the price of
foreign currency increases which makes imports dearer and
exports cheaper. This causes expenditure to be switches from
foreign to domestic goods as the countrys exports rise and the
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country produces more to meet the domestic and foreign demand
for goods with reduction in imports. Consequently, the balance of
payments deficit is eliminated.
Direct Controls
To correct disequilibrium in the balance of
payments, government also adopts direct controls which aim at
limiting the volume of imports. The government restricts the import
of undesirable or unimportant items by levying heavy import duties,
fixation of quotas, etc. At the same time, it may allow imports of
essential goods duty free or at lower import duties, or fix liberalimport quotas for them. For instance, the government may allow
free entry of capital goods, but impose heavy import duties on
luxuries. Import quotas are also fixed and the importers are
required to take licenses from the authorities in order to import
certain essential commodities in fixed quantise. In these ways,
imports are reduced in order to correct an adverse balance of
payments. The government also imposes exchange control and
regulate the foreign exchange. With reduction in imports and
control of foreign exchange, visible and invisible imports are
reduced. Consequently, an adverse balance of payment is
corrected.
Adjustment through Capital Movements
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A country can use capital imports to correct a deficit in its
balance of payments. A deficit can be financed by capital inflows.
When capital is perfectly mobile within countries, a small rise in the
domestic rate of interest brings a large inflow of capital. The
balance of payments is said to be in equilibrium when the domesticinterest rate equals the world rate. If the domestic interest rate is
higher than the world rate, there will be capital inflows and the
balance of payments deficit is corrected.
Adjustment through income changes
Given the foreign exchange rate and prices in a country,
an increase in the value of exports, causes an increase in the
incomes of all persons associated with the export industries.
These, in turn, create demand for other goods and services within
the country. This will raise the income of the persons engaged in
the latter industries and services. This process will continue and
the national income increases by the value of the multiplier.
Stimulation of Exports and Import Substitutes
A deficit in the balance of Payments can also be corrected
by encouraging exports. Exports can be encouraged by producing
quality products, by increasing exports through increased
production and productivity, and by better marketing. They canalso be increased by the balanced policy of import substitution. It
means that the country produces those goods which it imports. In
the beginning, imports are reduced by in the long run exports of
such goods start. An increase in exports causes the national
income to rise by many times through the operation of the foreign
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trade multiplier. The foreign trade multiplier expresses the
change in income caused by a change in exports. Ultimately, the
deficit in the balance of payments is removed when exports rise
faster than imports.
The Balance of Payments and the
Standard of Living
A common misconception is that balance of payments deficits are always bad forthe economy. This is not necessarily true. In the short term if a country is
importing a high volume of goods and services this is a boost to living standards
because it allows consumers to buy more consumer durables. However, in the long
term if the trade deficit is a symptom of a weak economy and a lack of
competitiveness then living standards may decline.
Imbalances
While the BOP has to balance overall, surpluses or deficits on its
individual elements can lead to imbalances between countries. In
general there is concern over deficits in the current
account. Countries with deficits in their current accounts will build
up increasing debt and/or see increased foreign ownership of
their assets. The types of deficits that typically raise concern are :
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A visible trade deficitwhere a nation is importing more
physical goods than it exports (even if this is balanced by the
other components of the current account.)
An overall current account deficit.
A basic deficitwhich is the current account plus foreign
direct investment (but excluding other elements of the capital
account like short terms loans and the reserve account.)
As discussed in the history section below, the Washington
Consensus period saw a swing of opinion towards the view that
there is no need to worry about imbalances. Opinion swung back
in the opposite direction in the wake offinancial crisis of 2007
2009. Mainstream opinion expressed by the leading financial
press and economists, international bodies like the IMFas well
as leaders of surplus and deficit countrieshas returned to the
view that large current account imbalances do matter. Some
economists do, however, remain relatively unconcerned about
imbalancesand there have been assertions, such as by Michael P.
Dooley, David Folkerts-Landau and Peter Garber, that nations
need to avoid temptation to switch to protectionism as a means
to correct imbalances.
Causes of BOP imbalances
There are conflicting views as to the primary cause of BOP
imbalances, with much attention on the US which currently has by
far the biggest deficit. The conventional view is that current
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account factors are the primary cause - these include the
exchange rate, the government's fiscal deficit, business
competitiveness , and private behaviour such as the willingness of
consumers to go into debt to finance extra consumption. An
alternative view, argued at length in a 2005 paper by Ben
Bernanke , is that the primary driver is the capital account, where
a global savings glut caused by savers in surplus countries, runs
ahead of the available investment opportunities, and is pushed
into the US resulting in excess consumption and asset price
inflation.
Reserve asset
The US dollar has been the leading reserve asset since the end ofthe gold standard.
In the context of BOP and international monetary systems, the
reserve asset is the currency or other store of value that is
primarily used by nations for their foreign reserves. BOP
imbalances tend to manifest as hoards of the reserve asset being
amassed by surplus countries, with deficit countries building
debts denominated in the reserve asset or at least depleting their
supply. Under a gold standard, the reserve asset for all members
of the standard is gold. In the Bretton Woods system , either gold
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is typically mostly derived domestically but their debts are often
denominated in a reserve currency. Once the nation's
government has exhausted its foreign reserves trying to support
the value of the domestic currency, its policy options are very
limited. It can raise its interest rates to try to prevent further
declines in the value of its currency, but while this can help those
with debts in denominated in foreign currencies, it generally
further depresses the local economy.
Balancing mechanisms
One of the three fundamental functions of an international
monetary system is to provide mechanisms to correct
imbalances.
Broadly speaking, there are three possible methods to correct
BOP imbalances, though in practice a mixture including some
degree of at least the first two methods tends to be used. These
methods are adjustments of exchange rates; adjustment of a
nations internal price along with its levels of demand; and rules
based adjustment. Improving productivity and hence
competitiveness can also help, as can increasing the desirability
of exports through other means, though it is generally assumed a
nation is always trying to develop and sell its products to the best
of its abilities.
Rebalancing by changing the exchange rate:
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An upwards shift in the value of a nation's currency relative to
others will make a nation's exports less competitive and make
imports cheaper and so will tend to correct a current account
surplus. It also tends to make investment flows into the capital
account less attractive so will help with a surplus there too.
Conversely a downward shift in the value of a nation's currency
makes it more expensive for its citizens to buy imports and
increases the competitiveness of their exports, thus helping to
correct a deficit (though the solution often doesn't have a positive
impact immediately due to the Marshall.
Exchange rates can be adjusted by government in a rules based
or managed currency regime, and when left to float freely in the
market they also tend to change in the direction that will restore
balance. When a country is selling more than it imports, the
demand for its currency will tend to increase as other countries
ultimately need the selling country's currency to make paymentsfor the exports. The extra demand tends to cause a rise of the
currency's price relative to others. When a country is importing
more than it exports, the supply of its own currency on the
international market tends to increase as it tries to exchange it
for foreign currency to pay for its imports, and this extra supply
tends to cause the price to fall. BOP effects are not the only
market influence on exchange rates however; they are also
influenced by differences in national interest rates and by
speculation.
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Rebalancing by adjusting internal prices anddemand:
When exchange rates are fixed by a rigid gold standard, or when
imbalances exist between members of a currency union such asthe Euro zone, the standard approach to correct imbalances is by
making changes to the domestic economy. To a large degree, the
change is optional for the surplus country, but compulsory for the
deficit country. In the case of a gold standard, the mechanism is
largely automatic. When a country has a favourable trade
balance, as a consequence of selling more than it buys it will
experience a net inflow of gold. The natural effect of this will be to
increase the money supply, which leads to inflation and an
increase in prices, which then tends to make its goods less
competitive and so will decrease its trade surplus. However the
nation has the option of taking the gold out of economy
(sterilising the inflationary effect) thus building up a hoard of gold
and retaining its favourable balance of payments. On the other
hand, if a country has an adverse BOP its will experience a net
loss of gold, which will automatically have a deflationary effect,
unless it chooses to leave the gold standard. Prices will be
reduced, making its exports more competitive, and thus
correcting the imbalance. While the gold standard is generally
considered to have been successful up until 1914, correction by
deflation to the degree required by the large imbalances that
arose after WWI proved painful, with deflationary policies
contributing to prolonged unemployment but not re-establishing
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balance. Apart from the US most former members had left the
gold standard by the mid 1930s.
A possible method for surplus countries such as Germany to
contribute to re-balancing efforts when exchange rate adjustment
is not suitable is to increase its level of internal demand (i.e. its
spending on goods). While a current account surplus is commonly
understood as the excess of earnings over spending, an
alternative expression is that it is the excess of savings over
investment. That is:
Where CA = current account, NS = national savings (private plus
government sector), NI = national investment.
If a nation is earning more than it spends the net effect will be to
build up savings, except to the extent that those savings are
being used for investment. If consumers can be encouraged to
spend more instead of saving; or if the government runs a fiscal
deficit to offset private savings; or if the corporate sector divert
more of their profits to investment, then any current account
surplus will tend to be reduced. However in 2009 Germany
amended its constitution to prohibit running a deficit greater than
0.35% of its GDP and calls to reduce its surplus by increasing
demand have not been welcome by officials, adding to fears that
the 2010s will not be an easy decade for the euro zone. In
theirApril 2010 world economic outlook report, the IMF presented
a study showing how with the right choice of policy options
governments can transition out of a sustained current account
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surplus with no negative effect on growth and with a positive
impact on unemployment.
Rules based rebalancing mechanisms
Nations can agree to fix their exchange rates against each other,
and then correct any imbalances that arise by rules based and
negotiated exchange rate changes and other methods. The
Bretton Woods system of fixed but adjustable exchange rates was
an example of a rules based system, though it still relied primarilyon the two traditional mechanisms. Keynes, one of the architects
of the Bretton Woods system had wanted additional rules to
encourage surplus countries to share the burden of rebalancing,
as he argued that they were in a stronger position to do so and as
he regarded their surpluses as negative externalities imposed
on the global economy. Keynes suggested that traditional
balancing mechanisms should be supplemented by the threat of
confiscation of a portion of excess revenue if the surplus country
did not choose to spend it on additional imports. However his
ideas were not accepted by the Americans at the time. In 2008
and 2009, American economist Paul Davidson had been
promoting his revamped form of Keynes's plan as a possible
solution to global imbalances which in his opinion would expand
growth all rounds without the downside risk of other rebalancing
methods.
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CASE STUDY: Recently
Balance of Payment is the difference between Current Accountand Capital account of a country. The Current Account furtherincludes Trading Account, Service Account, Income Account andunilateral transfers and other related items. The Capital accountincludes Loan transactions, inward or outward Investments, short-term capital and other related items. The actual figures forbalance of payment can be obtained at the year end therefore itis projected based on the previous data and assisting facts andfigures.
Pakistans current account balance in the fiscal year 2008-2009was USD 8,547 unfavourable, debit or negative. In the same yearthe capital and financial account balance was USD 3,608favourable or positive which lead to the Balance of payment to beUSD 4,939 deficit. In fiscal year 2009-10, current account balanceis projected to be USD 4,911 unfavourable or negative. Thismeans that we are going to face deficit balance of payment thisyear as well.
Why Pakistan is facing deficit balance ofpayment?
The major reason is and has always been the imports ofluxurious and high cost goods for the elite class of the countrythat increases the import bill to the dangerous level where ason the other hand the exports are on decreasing day by day.
The textile industry was the backbone of our exports but nowits suffering from various crises among them the power crisissthe major issue.
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Apart from import bill, the global recession in the recent yearhas severely affected the business and trade all over the worldwhich also affected Pakistan.
The investments in the country have declined to the lowestand the major reason is the law and order situation prevailingin the country. The self-imposed war against terrorism hasmade our situation worse as no one is willing to makeinvestments in the country.
The local industry is facing hard times as we dont havesufficient energy resources available. It has decreased theproduction of goods and ultimately we have to buy them fromother countries which add to our import bill and increase thesupply of our currency.
Pakistan is agriculture based country and we have one of thefinest and largest canal system. But would you believe that we
need to import sugar, wheat and other basic crops to meet thedemand in the country? In recent year Pakistan needed toimport tons of sugar and wheat just because of themismanagement of resources and water shortage created byIndia by building dams on rivers which are flowing towardsPakistan.
Energy crisis needs to be separately mentioned because it not
only affected the Textile industry but overall the economicactivities in the country are paralyzed. And we need to putsome serious efforts to eliminate it otherwise theconsequences will be dangerous.
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Political instability in the country has always affected thegrowth of the country and it does affect the trade andultimately the current account of the country.
The government policies are the tools to take correctiveactions to make the things stable and on the track but wrongpolicies may lead to adverse affects. We have been lacking ingood policies regarding the economy of the country.
Inflation, as weve discussed in class is a factor which affectnot only the trade but the foreign exchange as well. The
increasing rate of inflation will lead to the surplus supply of thecurrency and it would depreciate the currency value. Once thecurrency
Is depreciated our current account will suffer as wehave to pay more to buy the same commodities and our importbill will rise.
Conclusion:
When we look at the figures of Balance of Payment, weobserve that the Exports are decreasing and Imports areincreasing. The income from service sector has also declinedin recent times for some reasons. The foreign remittances orunilateral transfers has also decreased as the people haveno more trust on the Pakistan and increasing rates of taxesare also a reason for people to avoid sending money back toPakistan instead invest it in foreign country. The FDI hastrembled down as the law and order condition is gettingworse day by day. Our current account balance is apparently
better than the previous year but we should not ignore thatfact that it is projected data and real figures could shufflearound due to several reasons.
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