INTERNATIONAL TRADE

LESSON 14:
BALANCE OF PAYMENTS

Balance of Payment of a country is one of the important Current Account

indicators for International trade, which significantly affect the “The Current Account includes all transactions which give rise
economic policies of a government. As every country strives to to or use up national income.”
a have a favourable balance of payments, the trends in, and the The Current Account consists of two major items, namely:
position of, the balance of payments will significantly influence
i) Merchandise exports and imports, and
the nature and types of regulation of export and import
business in particular. ii) Invisible exports and imports.
Balance of Payments is a systematic and summary record of a Merchandise exports, i.e., the sale of goods abroad, are credit
country’s economic and financial transactions with the rest of entries because all transactions giving rise to monetary claims on
the world over a period of time. foreigners represent credits. On the other hand, merchandise
imports, i.e., purchase of goods from abroad, are debit entries
(a) Transactions in good and services and income between an
because all transactions giving rise to foreign money claims on
economy and the rest of the world,
the home country represent debits.
(b) Changes of ownership and other changes in that country’s
Merchandise imports and exports form the most important
monetary gold, SDRs, and claims on and liabilities to the
international transaction of most of the countries.
rest of the world, and
Invisible exports, i.e., sales of services, are credit entries and
(c) Unrequited transfers and counterpart entries that are
invisible imports, i.e. purchases of services, are debit entries.
needed to balance, in the accounting sense, any entries for
the foregoing transactions and changes which are not Important invisible exports include the sale abroad of such
mutually offsetting. services as transport, insurance, etc., foreign tourist expenditure
abroad and income paid on loans and investments (by foreign-
Balance of Trade and Balance of Payments ers) in the home country form the important invisible entries
The Balance of Trade takes into account only the transactions on the debit side.
arising out of the exports and imports of the visible terms; it
Capital Account
does not consider the exchange of invisible terms such as the
The Capital Account consists of short- terms and long-term
services rendered by shipping, insurance and banking; payment
capital transactions A capital outflow represents a debit and a
of interest, and dividend; expenditure by tourists, etc.
capital inflow represents a credit. For instance, if an American
The balance of payments takes into account the exchange of firm invests Rs.100 million in India, this transaction will be
both the visible and invisible terms. Hence, the balance of represented as a debit in the US balance of payments and a
payments presents a better picture of a country’s economic and credit in the balance of payments of India.
financial transactions with the rest of the world than the balance
The payment of interest on loans and dividend payments are
of trade.
recorded in the Current Account, since they are really payments
Nature of Balance of Payments Accounting for the services of capital. As has already been mentioned
The transactions that fall under Balance of Payments are above, the interest paid on loans given by foreigners of
recorded in the standard double-entry book-keeping form, dividend on foreign investments in the home country are debits
under which each international transaction undertaken by the for the home country, while, on the other hand, the interest
country results in a credit entry and a debit entry of equal size, received on loans given abroad and dividends on investments
As the international transactions are recored in the double-entry abroad are credits.
book-keeping form, the balance of payments must always
Unilateral Transfers Account
balance, i.e., the total amount of debits must equal the total
Unilateral transfers is another terms for gifts. These unilateral
amount of credits. Somethimes, the balancing item, error and
transfers include private remittances, government grants,
omissions, must be added to balance the balance of payments.
disaster relief, etc.
Components of Balance of Payments Unilateral payments received from abroad are credits and those
Balance of Payments is generally grouped under the following made
heads
abroad are debits.
i) Current Account
Official Settlements Accounts
ii) Capital Account
Official reserves represent the holdings by the government or
iii) Unilateral Payments Account official agencies of the means of payment that are generally
iv) Official Settlement Account. accepted for the settlement of international claims.

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 Balance of Payments Items equivalent to the supply of it. The balance of payments is in
INTERNATIONAL TRADE

Credits Debits. disequilibrium when there is either a surplus or a deficit in the

balance of payments. When there is a deficit in the balance of
Current Account Current Account
payments, the demand for foreign exchange exceeds the
1. Merchandise Exports 1.Merchandise Imports demand for it.
(Sale of Goods) (Purchaseof Goods) A number of factors may cause disequilibrium in the balance of
2. Invisible Exports 2.Invisible Imports payments. These various causes may be broadly categorized
(Sale of Services) (Purchase of Services) into:
(a) Transport Services (a) Transport Services (i) Economic factors ;
sold purchased from abroad (ii) Political factors; and
(b) Insurance services (b) Insurance Services (iii) Sociological factors.
sold abroad purchased from abroad Economic Factors
(c) Foreign tourist (c) Tourist Expenditure A number of economic factors may cause disequilibrium in the
expenditure in country abroad balance of payments. These are:
(d) Other services sold (d) Other services purchased Development Disequilibrium
abroad from abroad Large-scale development expenditures usually increase the
purchasing power, aggregate demand and prices, resulting in
(e) Incomes received on (e)Income paid on loans and
substantially large imports. The development disequilibrium is
loans and Investment in home country.
common in developing countries, because the above factors,
investments abroad.
and large-scale capital goods imports needed for carrying out the
Capital Account Capital Account various development programmes, give rise to a deficit in the
3. Foreign long-term 3. Long-term investments abroad. balance of payments.
investments in the home Capital Disequilibrium
(a) Direct investments in (a) Direct investments country. Cyclical fluctuations in general business activity are one of the
abroad the home prominent reasons for the balance of payments disequilibrium.
(b) Foreign investments (b)Investments in As Lawrance W. Towle points out, depression always brings
about a drastic shrinkage in world trade, while prosperity
securities in domestic foreign securities. stimulates it. A country enjoying a boom all by itselt ordinarily
(c) Other investments (c) Other investments abroad experiences more rapid growth in its imports than its exports,
of foreigners abroad. while the opposite is true of other countries. But production
(d) Foreign Government’s (d)Government to foreign country in the other countries will be activated as a result of the
loans to the loans to foreign increased exports to the boom country.
4. Foreign short-term 4. Short-term investments abroad Secular Disequilibrium
in home country. Sometimes, the balance of payments diequilibrium persists for
Unilateral Transfers Unilateral Transfers a long time because of certain secular trends in the economy.
For instance, in a developed country, the disposable income is
Account Account
generally very high and, therefore, the aggregate demand, too, is
5. Private remittances 5. Private remittances abroad very high. At the same time, production costs are very high
received from abroad because of the higher wages. This naturally results in higher
6. Pension Payments 6. Pension payments abroad. prices. These two factors – high aggregate demand and higher
received from abroad. domestic prices may result in the imports being much higher
7. Government grants 7. Government grants abroad than the exports. This could be one of the reasons for the
persistent balance of payments deficits of the USA.
Received from abroad
Structural Disequilibrium
Official Settlements Official Settlements
Structual changes in the economy may also cause balance of
Accounts Account payments disequilibrium. Such structural changes include the
8. Official sales of 8. Official purchases of development of alternative sources of supply, the development
foreign currencies foreign currencies of better substitutes, the exhaustion of productive resources,
or other reserve or other services abroad the changes in transport routes and costs, etc.
assets abroad
Political Factors
Total Credits Total Debits Certain political factors may also produce a balance of payments
Balance of Payments Disequilibirum disequilibrium. For instance, a country plagued with political
The balance of payments of a country is said to be in equilib- instability may experience large capital outflows, inadequacy of
rium when the demand for foreign exchange is exactly domestic investment and production, etc. These factors may,
sometimes, cause disequilibrium in the balance of payments.

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Further, factors like war, changes in world trade routes, etc., may payments may devalue its currency in order to stimulate its

INTERNATIONAL TRADE
also produce balance of payments difficulties. exports and discourage imports to correct the disequilibrium.
Social Factors To illustrate, let us take the example of the devaluation of the
Certain social factors influence the balance of payments. For Indian Rupee in 1966, Just before the devaluation of the
instance, changes in tastes, preferences, fashions, etc. may affect Rupees with effect from 6th June 1966, the exchange rate was $
imports and exports and thereby affect the balance of pay- I= Rs. 4.76. The devaluation of the Rupee by 36.5 per cent
ments. changed the exchange rate to $ I = Rs. 7.50. Before the
devaluation, the price of an imported commodity, which cost $
Correction Of Disequilibrium
I abroad, was Rs. 4.76 (assuming a costless free trade). But after
A country may not be bothered about a surplus in the balance
devaluation, the same commodity, which cost $ I abroad, cost
of payments; but every country strives to remove, or at least to
Rs. 7.50 when imported. Thus, devaluation makes foreign
reduce, a balance of payments deficit.
goods costlier in terms of the domestic currency, and this
A number of measures are available for correcting the balance would discourage imports. On the hand, devaluation makes
of payments disequilibrium. These various measures fall into exports (from the country that has devalued the currency)
measures. We outline below the important measures for cheaper in the foreign markets. For example, before the
correcting the disequilibrium caused by a deficit in the balance of devaluation, a commodity which cost Rs. 4.76 in India could be
payments. sold abroad at $ I (assuming a costless free trade); but after
Automatic Corrections devaluation, the landed cost abroad of the same commodity
The balance of payment disequilibrium may be automatically was only $ 0.64. This comparative cheapness of the Indian
corrected under the Paper Currency Standard. The theory of goods in the foreign markets was expected to stimulate demand
automatic correction is that if the market forces of demand and for Indian exports.
supply are allowed to have free play, the equilibrium will The success of devaluation, however, depends on a number of
automatically be restored in the course of time. For example, factors, such as the price elasticity of demand for exports and
assume that there is a deficit in the balance of payments. When imports.
there is a deficit, the demand for foreign exchange exceeds its Exchange Control: Exchange control is a popular method
supply, and this results in an increase in the exchange rate and a employed to influence the balance of payments position of a
fall in the external value of the domestic currency. This makes country. Under exchange control, the government or central
the exports of the country cheaper and its imports dearer than bank assumes complete control of the foreign exchange
before. Consequently, the increase in exports and the fall in reserves and earnings of the country. The recipients of foreign
imports will restore the balance of payments equilibrium. exchange such as exporters are required to surrender foreign
Deliberate Measures exchange to the government/central bank in exchange for
This measure is widely employed today. domestic currency. By the virtue of its control over the use of
foreign exchange, the government can control the imports.
The various deliberate measures may be broadly grouped into;
(a) Trade Measures
(a) Monetary measures
(b) Trade measures;and Trade measures include export promotion measures
and measures to reduce imports.
(c) Miscellaneous.
Export Promotion
(a) Monetary Measures
Exports may be encouraged by reducing or abolishing export
The important monetary measures are outlined below; duties, providing an export subsidy, and encouraging export
Monetary contraction; the level of aggregate domestic demand, production and export marketing by offering monetary, fiscal,
the domestic price level and the demand for imports and physical and institutional incentives and facilities.
exports may be influenced by a contraction or expansion in Import Control: Imports may be controlled by imposing or
money supply and correct the balance of payments enhancing import duties, restricting imports through import
disequilibrium.the measure required is a contraction in money quotas and licensing, and even by prohibiting altogether the
supply. A contraction in money supply is likely to reduce the import of certain inessential items.
purchasing power and thereby the aggregate demand. It is also
likely to bring about a fall domestic prices. The fall in the Miscellaneous Measures
domestic aggregate demand and domestic prices reduces for Apart from the measures mentioned above, there are a number
imports. The fall in the domestic aggregate demand and of other measures that can help make the Balance of Payments
domestic prices reduces the demand for imports. The fall in position more favourable, such as obtaining foreign loans,
domestic prices is likely to increase exports. Thus, the fall in encouraging foreign investment in the home country, develop-
imports and the rise in exports would help correct the disequi- ment of tourism to attract foreign tourists, providing incentives
librium. to enhance inward remittances, developing import substituting
industries, etc.
Devaluation : Devaluation means a reduction in the official rate
at which one currency is exchanged for another currency. A
country with a fundamental disequilibrium in the balance of

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