Balance of Payment & External Debt
18.1 Balance of Payment
The term Balance of
payments refers to economic transactions (involving foreign payment) between
one country and other countries. The Balance of payments is shown in the form
of an Account or Balance Sheet which shows how much has been received from
foreigners and how much has been paid to them during a particular financial
period. Generally such accounts are prepared on an annual basis. Balance of
payment includes visible exports as well as invisible exports. Imports of goods
and service. Balance of Payment is a wider terms than Balance of Trade.
Effects of Balance of Payments
If Balance of Payments is
in Surplus, then the Foreign Exchange Reserves of the country will Increase.
Equilibrium in balance of
payment makes no change in foreign exchange reserve.
Deficit in balance of
payment decreases foreign exchange reserve. Surplus in balance of payment
increases foreign exchange reserve.
In initial stage of
development, more maintenance related items are imported.
In the later stages of development,
Maintenance Imports will be high to maintain the capital items that were
imported in earlier stages of development.
Components of Balance of Payment
Balance of payments are
classified into two categories (1) Current account and (2) Capital account.
i.
Current account includes items such as
merchandise, non-monetary gold movements, transportation travel, insurance,
transfer payments etc.
ii. Capital account, on the other hand, includes items such as private and public loans
from abroad amortization, banking official reserves etc.
iii. The Balance of Payments
Account of a country exhibits, on its credit side (called Credit Items) the
different items for which it has received payment and the amount of such
payments. On the debit side, the Account shows the items for which the country
had paid to foreigners and the amount of such payments (Called Debit Items). If
the total of the debit items and the total of the credit items are equal, the
country’s international payments are balanced. If the credit items are larger,
so that there is a net balance due to it, the country is said to have a
Favourable Balance. If the debit items are larger, so that there is a net
balance due to foreigners, the country is said to have an Unfavourable Balance.
18.2 Causes for unfavourable balance of payments
i. Excessive population
growth: Population
of our country has been rising continuously. Since other resources such as
capital and land are not enough for surplus labour force and production has not
been increasing at the same rate, food grains had to be imported leading to
deficit in the Balance of Trade.
ii. Sharp rise in imports: The sharp increase imports
is the major reason of big deficits in the BOP requiring situation. The imports
mainly consists of capital goods larger payments. India
iii. Oil crisis: There has been eight fold
increase in the prices of petroleum since independence. The imports of these
products could not be reduced considerably. As a result the import bill for
petroleum products has been increasing very rapidly. Petroleum is a major item
of import for our country.
iv. Slow rise & export
earnings: Though exports of non-traditional items have been rising, two-third of
the exports, consists of traditional items like tea, jute, sugar and some
agricultural products. The income and price elasticities of most of these items
is low leading to poor export earnings. Much of exportable items of our country
are agricultural products, price of which are not so high. On the other hand
price of petroleum and capital goods is very high, so, import bill always
exceeds our export bills. It is one of the reasons for our unfavourable balance
of payments. To control this situation, government has recently started to
provide export incentives for expansion of exports of software and information
technology services.
18.2.1 Correcting adverse balance
of payments
A disequilibrium in the
balance of payments is rectified, in the long run, through an automatic
mechanism. According to the Classical theory, alterations in prices and costs
and according to the Keynesian theory, adjustments take place through changes
in the volume of employment and income. However, certain measures remedial may
be taken to correct the adverse balance of payments, as measures are discussed
below:
For removal of adverse
balance of payments, methods to be adopted should be determined after a careful
analysis of the factors that have produced the disequilibrium. If the
disequilibrium is a result of some structural maladjustment which hinders
exports or favours imports, steps should be taken to correct the maladjustment.
If disequilibrium in the
balance of payments is caused by monetary factors (e.g., inflation),
suitable measures must be applied to counteract the effects. If disequilibrium
is created by an over valuation of foreign exchange rates, the proper remedy
is devaluation.
a. Stimulation of exports. Exports may be stimulated by:
(i) introducing better
marketing
(ii) decreasing internal costs
by lowering wages. Rising hours of work, or enhancing the efficiency of labour
(iii) bounties on exports
(iv) relief of taxes
(v) easy availability of export
credit and finance
(vi) financial incentives in the
form of cash assistance for specified export promotional effects.
Increase of exports is equivalent to an increase of
domestic investment. It increases income and employment and has an positive
effect on the economy. Increase of exports first raises the income of the export
industries. Subsequently all incomes uplift through the operation of the
foreign trade multiplier. It is, however, not easy to enhance a country's
exports. Rise of exports depends on the foreign demand for the country's
products, her competitive position in the foreign markets and price-cost structure
of her industries as compared with the price-cost structure of the competing countries.
b. Import control. Imports may be controlled by various measures of which physical
controls through licencing is most effective. The methods include (i) tariff (ii)
import quotas (iii) exchange control, etc. The most common method to
restrict foreign trade is to impose duties or tariffs on the imports. The
import duties reduce the demand for foreign goods considerably and thus release
pressure on the foreign exchange. However import of essential consumer goods
and crucial raw material cannot be stopped unless the country is able to
produce them domestically. Domestic industries may also be protected through
tariff.
Decrease of imports, is extensively practiced by
all deficit countries through various kinds of import control. The import
control measures may, however, produce harmful effects. It may prevent a
country from obtaining imported capital goods, raw materials and essential
consumer goods, like foodstuffs. So, import control measures should be used
very intelligently.
c. Devaluation Reduction of the external value of money. This is achieved through :
(i) exchange depreciation and (ii) devaluation.
i. Devaluation means lowering
of the value of the domestic currency in terms of foreign currencies. When the
external value of a country's currency is reduced, imports become costly and
exports become cheaper. As a result import will start to decline and exports
tend to increase thereby decreasing or eliminating the adverse balance of
payments.
ii. Devaluation is generally
considered to be highly effective. But devaluation also has some adverse
effects. Devaluation makes foreign capital goods, raw materials and essential consumer
goods more expensive. High cost of capital goods may, in the case of
underdeveloped countries, retard their development because they have to import
some capital goods at high cost. Also, devaluation has an inflationary effect
on the economy. Devaluation does not always give a permanent solution for a
disequilibrium in the balance of payments. Devaluation expands exports because
it decreases export prices but if the internal price cost level subsequently
rises; the favourable effects will be wiped away. It should also be kept in
mind that the other countries should not devalue their currencies to
counteract.
d. Deflation: Deficits in balance of payments are caused by increase in imports. The
aim of deflation is to curtail the demand for foreign goods. Deflation causes
fall in prices and incomes. Reduction in money income will bring about a fall
in the demand for imported goods. Deflation should however be used very
cautiously because it leaves a trail of unemployment and fall in wages in the
economy.
e. Other remedial measures: When adverse balance of payments becomes acute,
the following measures of corrections are applied: (i) Export of gold (ii)
Borrowing from the International Monetary Fund (iii) Gift from
friendly countries (iv) Borrowing from friendly countries (v) Selling
securities from the reserves. These methods have immediate effect on correction
of adverse balance of payments.
18.2 Balance of Trade
Balance of Services is the
sum of all Invisible Service Receipts and payment. Such balance could be Zero,
Positive or Negative.
The balance of trade of a
country shows its trade transactions with the rest of the world during the course
of a year. It denotes the relationships between the value of visible exports
and the value of imports of the country. But the balance of trade takes into
account only visible export and imports (i.e. visible export and imports which
are recorded at the ports).
Favourable Balance of Trade : If the value of exports exceeds the value of
imports, the balance of trade is said to be favourable.
Unfavourable Balance of Trade : On the other hand, if the value of imports
exceeds the value of exports, the balance of trade is said to be unfavourable.
Under the system of gold
standard, the unfavourable balance of trade could be corrected by the outflow
of gold from the country whose balance of trade was unfavourable. In the
present system of paper currency, unfavourable balance of trade can be
corrected by contracting international loans. Unfavourable balance of trade cannot go on indefinitely.
The movement of gold and capital from one country to another has its impact on
international price level which ultimately affects exports and imports and rectify
the disequilibrium in the balance of trade.
18.3 Distinction between balance of trade & balance of payment
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Balance of Trade
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Balance of Payments
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a.
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Records only goods.
Invisible items are not part of balance of trade.
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Includes goods as well as
services.
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b.
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Does not record
transaction of capital nature.
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Records transaction of
capital nature
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c.
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It is a part of current
account of the Balance of Payment.
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It is much larger in
scope as it not only include Balance of Trade but also Balance of Services.
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18.4 Devaluation
Devaluation implies the
lowering the value of currency in terms of gold. Sometimes the extent of
devaluation is announced in terms of a currency which is regarded as equivalent
to gold e.g., the Dollar, Changes in the gold or dollar value of a currency are
made by the currency authorities of the country, usually after consultation
with and approval by the International Monetary Fund. Devaluation usually
refers to a alteration in a currency’s value relative to gold, and generally to
a notable and rare event of some magnitude rather than a day-to-day
fluctuations. Devaluation can take place as a general rule whereby the external
value of a country’s currency is lowered in terms of all the currencies of the
world. Sometimes partial devaluation is done with an objective of lowering the
external value of a country’s currency in relation to currency of a particular
country. As a consequence of devaluation, the external value of the domestic
currency depreciates, whereas the value of foreign currency in terms of the
domestic currency appreciates.
18.4.1 Favourable effect of devaluation
a. Decrease in import: As a result of devaluation,
the prices of imported goods increase. Rise of prices decreases demand.
Therefore devaluation decrease imports.
Consequently, industries
using importer items try to replace them by domestic products (known as Import Substitution).
b. Exports become more profitable. Devaluation
helps to expand exports. More investment occurs in the export industries and
employment increases.
c. Balance of payment: Reduction of imports and expansion of exports produce a favourable
effect on the balance of payment situation. Devaluation is the most effective
method for correction of adverse balance of payments.
d. Foreign Investment: Devaluation promotes investment in the country by foreigners, because
they get more local currency in exchange of their money after devaluation. For
the same reason, more tourists are attracted into the country. Thus invisible
exports are increased. Also, remittance of funds from the country is
discouraged because less foreign currency is received after devaluation.
18.4.2 Adverse effects of devaluation
a. Devaluation brings loss to
the foreign holders of the devalued currency, because the gold value of their
holding is immediately depreciated.
b. Devaluation increases the
burden of repayment of, and the increase in charges on, foreign loans.
c. The price level of exports
falls as a result of devaluation and therefore the Terms of Trade move against
the devaluation country.
18.4.3 When devaluation is justified
a. In case of countries
suffering from the problem of adverse balance of payment it is justified in
taking recourse to devaluation. Under the rules of the International Monetary
Fund, devaluation is approved as a method of correcting a fundamental
disequilibrium in the country’s trade. Increase in value of exports and
decreasing value of imports helps to restore the balance of payments
equilibrium.
b. Devaluation is sometimes
recommended as an anti-depression measure. During the Great Depression of the
19030’s some countries deliberately depreciated the foreign exchange value of
their currencies with a view to increase their exports at the cost of those of
other countries.
c. Devaluation is also supported
as a protective measure. For example, when Great Britain Sterling India Sterling India Sterling
But for success of
devaluation, the foreign country in terms of whose currency the domestic
currency is devaluated must fully agree with the policy of devaluation. It
should not devalue its currency as a retaliatory move, otherwise the very
purpose of devaluation will be defeated. The foreign country should also not
resort to other retaliatory tactics such as imposition and raising of tariffs,
fixation of quota, import restrictions etc.
18.5 External debt
(i) External
debt (International debt) means the money owed to the international community
for loans in the form of economic aid, mainly to developing countries to
finance their economic progress programmes and loans to cover balance of
payments deficits of countries. Loans are given both on a multilateral basis by
international institutions such as the World Bank and International Monetary
Fund and on a bilateral, country-to-country basis.
(ii) For
the most part, International loans incur interest charges and have to be repaid
in full over a certain redemption period. Economic aid may also be given
without interest charges or an obligation to repay on a soft loan basis (low
interest charges and long redemption period) or may be subject to more onerous
commercial terms.
Debt Trap : If external debt of a
country exceeds interest obligation, it is called debt trap.
External assistance to India
External assistance to
India is obtained in two forms
a.
Grants: Grants do not involve any
repayment obligation. It includes gift and donation etc. 10% of external
assistance is in form of grants.
b.
Loans: Loan carry an obligation
to pay interest and repay the principal. About 90% of the external assistance
received by India
The maximum aid to India is
provided by USA.
The share of concessional debt in total external
debt has decreased
India ranks 8th among the top 10 countries in the
world.
