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Introduction
The balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given year. It is a statistical record of the character and dimensions of the country's economic relationships with the rest of the world. According to Bo Sodersten, "The balance of payments is merely a way of listing receipts and payments in international transactions for a country."B. J. Cohen says, "It showsthe country's trading position, changes in its net position as foreign lender or borrower, and changes in its official reserve holding."
Objectives of the lesson
In this lesson we will study the structure of balance of payments account and different policies, exchange rate and determination of equilibrium exchange rate.
Structure of Balance of Payments Accounts
The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. But balance of payments accounting differs from business accounting in one respect. In business accounting, debits (-) are shown on the left side and credits ('+) on the right side of the balance sheet. But in balance of payments accounting, the practice is to show credits on the left side and debits on 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 debit transaction. 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 reserve assets including gold to foreign countries and international agencies. The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending 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 a 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 settlements account or the official reserve assets The balance of payments account of a country is constructed in Table 1:
1. Current Account. The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation, insurance,
income and payments of foreign investments etc. Transfer payments relate to gifts,foreign aid, pensions, private remittances, charitable donations etc. 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 on board) which means that costs of transportation, insurance, etc. are excluded. On
the other side, imports are shown as a negative item and are calculated c.i.f. which means that costs, insurance and freight are included. The difference between exports and imports of a 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.
2. Capital Account. The capital account of a country consists 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 shows international flow of loans and investments, and represents a change in the country's 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 the purchase of foreign bonds and stocks, and international loans. On the other hand, short-term international capital transactions are for a period ranging between three months and less than one
year.
There are two types of transactions in the capital account—private and government. Private transactions include all types of investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.
3. The Official Settlements Account.
The official settlements account or official
reserve assets account is, in fact, a part of the capital account. But the U.K. and U.S. balance of payment accounts show it as a separate account. "The official settlements account measures the change in nation's liquidity and non-liquid liabilities to foreign official holders and the change in a nation's 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 country's net official reserve assets.
Errors and Omissions.
Errors and omissions is a balancing item so that total credits and debits of the three accounts must be 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.
Equilibrium in Balance of Payments
Balance of payments always balances means that the 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 = Rf-Pf
Where
B represents balance of payments, R receipts from foreigners, P payments made to foreigners.
When B = Rf – Pf = 0, the balance of payments is in 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 Rf- Pf < 0 or Rf < P there is deficit in the balance of payments as the payments made to foreigners exceed receipts from foreigners. 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 = If-B
or (X-M)-I,-B) = Q
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 equation : C + S + T = C +
I + G + (X-M)
or Y- C + I + G + (X-M) [ Y = C + S +T]
where C represents consumption exepnditure, S domestic saving, T tax receipts, / 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 + GNI or national income (K) 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 (Sd) must equal domestic investment (Id). Similarly, an export surplus on current account (X > M) must be offset by an excess of domestic savings over investment (Sd > Id). Thus, the balance of payments always balances in the accounting sense, according to the basic principle of accounting. In the accounting system, the inflow and outflow of a transaction are recorded on the credit and debit sides respectively. Therefore, credit and debit sides 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.
Disequilibrium in Balance of Payments
A 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 its autonomous receipts (credits) do not match its autonomous payments (debits). If autonomous credit receipts exceed autonomous debit payments, there is a surplus in the BOP and the disequilibrium is said to be favourable. On the other hand, if autonomous debit payments exceed autonomous credit receipts, there is a deficit in the BOP and the disequilibrium is said to be unfavourable or adverse.
Causes of Disequilibrium
There are many factors that may lead to a BOP deficit or surplus:
1. Temporary Changes: There may be a 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 causese are expected to correct themselves within a short time.
2. Fundamental Disequilibrium: Fundamental disequilibrium refers to a persistent and long-run BOP disequilibrium of a country. It is a chronic BOP deficit,caused by such dynamic factors as changes in consumer tastes within the country or abroad which reduce the country's exports and increase its imports, continuous fall in the country's foreign exchange reserves due to supply inelasticities 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 affects exports and inflationary pressures within the economy which make exports dearer.
3. Structural Changes: Structural changes bring about disequilibrium in BOP over the long-run. They may result from the following factors: (a) Technological changes in methods 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 supply 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 foreign exchange rate in the form of over-valuation or under-valuation of foreign currency lead to BOP disequilibrium. When the value of currency is higher in relation to other currencies, it is said to be overvalued. Opposite is the case of an undervalued currency. Over-valuation of the domestic currency makes foreign goods cheaper and exports dearer in foreign countries. As a result, the country imports more and exports less of goods. There is also outflow of capital. This leads to unfavourable BOP. On the contrary,
under-valuation of the currency makes BOP favourable for the country by encouraging exports and inflow of capital and reducing imports.
5. Cyclical Fluctuations: Cyclical fluctuations in business activity also lead to BOP disequilibrium. When there is depression in a country, volumes of both exports 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 exports and imports may increase. But there can be either a surplus or deficit 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 cause is the change in the country's national income. If the national income of a 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 of disequilibrium 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 increase. Thus, increase in export prices leading to decline in exports and rise in imports results in adverse balance of payments.
Measures to Correct Deficit in Balance of 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.
1. 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 policy because 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 expenditures to be switched from foreign to domestic goods.
2. 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 liberal import 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 quantities. In these ways, imports are reduced in order to correct an adverse balance of payments.
3. Adjustment through Capital Movements
A country can use capital import 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 domestic interest 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.
4. 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 theexport industries. These, in turn, create demand for goods and services within the country. This will raise the incomes of persons engaged in the latter industries and services. This process will continue and the national income increases by value of the multiplier.
5. 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 reducing exports through increased production and productivity and by better marketing. They
can also be increased by a policy of import substitution. It means that the country produces those goods which it imports. In the beginning, imports are reduced but 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 trade multiplier.
Foreign Exchange Rate
The foreign exchange rate or exchange rate is the rate at which one currency is exchanged for another. It is the price of one currency in terms of another currency. It is customary to define the exchange rate as the price of one unit of the foreign currency in terms of the domestic currency. The exchange rate between the dollar and the pound refers to the number of dollars required to purchase a pound. Thus, the exchange rate between the dollar and the pound from the US viewpoint is expressed as $ 2.50 = £ 1.
The Britishers would express it as the number of pounds required to get one dollar, and the above exchange rate would be shown as £0.40 = $ I. Theexchange rate of $ 2.50 = £ 1 or £ 0.40 = $ 1 will be maintained in the world foreign exchange market by arbitrage. Arbitrage refers to the purchase of a foreign currency in a market where its price is low and to sell it in some other market where its price is high. The effect of arbitrage is to remove differences in the foreign exchange rate of currencies so that there is a single exchange rate in the world foreignexchange market. If the exchange rate is $ 2.48 in the London exchange market and $ 2.50 in the New York exchange market, foreign exchange speculators, known as arbitrageurs, will buy pounds in London and sell them in New York, thereby making a profit of 2 cents on each pound. As a result, the price of pounds in terms of dollars rises in the London market and falls in the New York market. Ultimately, it will equal in both the markets and arbitrage comes to an end. If the exchange rate between the dollar and the pound rises to $ 2,60 = £ 1 through time, the dollar is said to depreciate with respect to the pound, because now more dollars are needed to buy one pound. When the rate of exchange between the dollar and the pound falls to $ 2.40 = £ 1, the value of the dollar is said to appreciate because now less dollars are required to purchase one pound. If the value of the first currency depreciates that of the other appreciates, and vice versa. Thus, a depreciation of the dollar against the pound is the same thing as the appreciation of the pound against the dollar and vice versa.
Determination of Equilibrium Exchange Rate
The exchange rate in a free market is determined by the demand for and the supply of foreign exchange. The equilibrium exchange rate is the rate at which the demand for foreign exchange equals to supply of foreign exchange. In other words, it is the rate which clears the market for foreign exchange. There are two ways of determining the equilibrium exchange rate. The rate of exchange between dollars and pounds can be determined either by the demand and supply of dollars with the price of dollars in pounds, or by the demand and supply of pounds with the price of pounds in dollars. Whatever method is adopted, it yields the same result. The analysis that follows is based on the dollar price in terms of pounds.
The demand for foreign exchange is a derived demand from pounds. It arises from import of British goods and services into the US and from capital movements from the US to Britain. In fact, the demand for pounds implies a supply of dollars. When the US businessmen buy British goods and services and make capital transfers to Britain, they create demand for British pounds in exchange for US dollars because they cannot make payments to Britain in their currency, the US dollars.
The demand curve for pounds DD. is downward sloping from left to right in Figure 1. It implies that the lower the exchange rate on pounds, the larger will be the quantity of pounds demanded in the foreign exchange (US) market, and vice versa. This is because a lower exchange rate on pounds make British exports of goods and services cheaper in terms of dollars. The opposite happens if the exchange rate on pound is higher. It will make British goods and services dearer in terms of dollars, and the demand for pounds will fall in the foreign exchange (US) market. But the shape of the demand curve for foreign exchange will depend on the elasticity of demand for imports. If a country imports necessities and raw materials,
we may expect the elasticity of demand for imports to be low and the quantity imported to be insensitive to price changes. If, on the other hand, the country imported luxury goods and goods for which suitable substitutes exist, demand elasticities for imports might be high. If the country has many well-developed import competing industries, the elasticity of demand for imports most certainly is high. In the short-run, elasticity of demand for imports may not be very high. In the long-run, however, it is much more probable that the production pattern will alter according to price changes and the demand for imports, therefore, will be more elastic.
The supply of foreign exchange in our case is the supply of pounds. It arises from the US exports of goods and services and from capital movements from the US to Britain. Pounds are offered in exchange for dollars because British holders of pounds wish to make payments in dollars. Thus, the supply of foreign exchange reflects the quantities of pounds that would be supplied in the foreign exchange market at various
dollar prices of pounds.
The supply curve for pounds SS is an upward sloping curve as shown in Fig. 58.1. It is a positive function of the exchange rate on pounds. As the exchange rate on pounds increases, the greater is the quantity of pounds supplied in the foreign exchange market. This is because with increase in the dollar price of pounds (lower pounds price of dollars), US goods, services and capital funds become better bargains to holders of pounds. Therefore, the holders of pounds will offer larger quantities of pounds with the increase in the exchange rate.
Equilibrium Exchange Rate
Given the demand and supply curves of foreign exchange, the equilibrium exchange rate is determined where DD, the demand curve for pounds intersects SS, the supply curve of pounds. They cut each other at point E in Figure 1. The equilibrium rate is OR and OQ of foreign exchange is demanded and supplied. At OR exchange rate the US demand for pounds equals the British supply of pounds and the foreign exchange market is cleared. At any higher rate than this, the supply of pounds would be larger than the demand for pounds so that some people who wish to convert pounds into dollars will be unable to do so. The price of pounds will fall, less pounds will be supplied and more will be demanded. Ultimately, the equilibrium rate of exchange will be re-established. In Fig. when the exchange rate increases to OR2, the supply of pounds is more than the demand for pounds. With the fall in the price of pounds, the equilibrium exchange rate OR2 is again established at point E. On the contrary, at an exchange rate lower than this, say OR1 the demand for pounds is greater than the supply of pounds. Some people who want pounds will not be able to get them. The price of pounds will rise which will reduce the demand and increase the supply of pounds so that the equilibrium exchange rate OR is re-established at point E where the two curves DD and SS intersect.
Thus, under flexible exchange rates equilibriumrate of exchange will prevail which will clear the market and keep the balance of payments in equilibrium.
The Balance of Payments Theory
According to this theory, under free exchange rates the exchange rate of the currency of a country depends upon its balance of payments. A favourable balance of payments raises the exchange rate, while an unfavourable balance of payments reduces the exchange rate. Thus, the theory implies that the exchange rate is
determined by the demand for the supply of foreign exchange.
The demand for foreign exchange arises from the debit side of the balance of payments. It is equal to the value of payments made to the foreign country for goods and services purchased from it plus loans and investments made abroad. The supply of foreign exchange arises from the credit side of the balance of payments. It equals all payments made by the foreign country to our country for goods and services purchased from us plus loans disbursed and investments made in this country. The balance of payments balances if debits and credits are equal. If debits exceed credits, the balance of payments is unfavourable. On the contrary, if credits exceed debits it is
favourable. When the balance of payments is unfavourable, it means that the demand for foreign currency is more than its supply. This causes the external value of the domestic currency to fall in relation to the foreign currency. Consequently, the
exchange rate falls. On the other hand, in case the balance of payments is favourable, the demand for foreign currency is less than its supply at a given exchange rate. This causes the external value of the domestic currency to rise in relation to the foreign currency. Consequently, the exchange rate rises.
When the exchange rate falls below the equilibrium exchange rate in a situation of adverse balance of payments, exports increase and the adverse balance of payments is eliminated, and the equilibrium exchange rate is re-established. On the other hand, when under a favourable balance of payment situation, the exchange rate rises above the equilibrium exchange rate, exports decline, the favourable balance ofpayments disappears and the equilibrium exchange rate is re-established. Thus, at any point of time, the rate of exchange is determined by the demand for and the supply of foreign exchange as represented by the debit and credit side of the balance of payments. "Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate, and at the ruling rate the balance of payments balances from day to day or from moment to moment.
Consequently, the demand for foreign exchange will rise and the supply will fall. Ultimately, the equilibrium exchange rate OR will be restored where demand and supply of foreign exchange equals at point E. In the opposite case, when the exchange rate falls below the equilibrium rate to OR2, the demand for foreign exchange is greater than its supply. It implies an unfavourable balance of payments. But fall in the exchange rate leads to increase in exports and decline in imports. As a result, the demand for foreign currency starts falling and the supply starts rising till the equilibrium exchange rate OR is re-established with the equality of demand and supply of foreign exchange at point E.
Criticism of the Theory
The balance of payments theory has been criticised by economists on the following counts:
1. Balance of Payments Independent of Exchange Rate: The main defect of the theory is that the balance of payments is independent of the exchange rate. In other words, the theory states that the balance of payments determines the exchange rate. This is not wholly true because it is changes in the exchange rate that bring about equilibrium in the balance of payments.
2. Neglects the Role of Price Level : The theory neglects the role of the price level in influencing the balance of payments of a country and hence its exchange rate. But the fact is that price changes do affect the balance of payments and the exchange rates between countries.
3. No Free Trade and Perfect Competition: The theory is based on assumptions of free trade and perfect competition . This is unrealistic because free trade is not practised these days. Governments impose a number of restrictions to reduce imports and adopt measures to encourage exports. This is how they try to correct disequilibrium in the balance of payments.
4. Truism: The theory presupposes that there is an equilibrium exchange rate where balance of payments balances. This is a truism. But the equilibrium exchange rate may not be one of balance of payments equilibrium. In fact, exchange rates between countries continue to prevail under conditions of surplus or deficit in the
balance of payments and there is no tendency for the balance of payments to be in equilibrium over the long-run.
5. Demand for Imported Raw Materials not Inelastic: The theory has been criticised for the assumption that the demand for imported raw materials is inelastic. There is no raw material in the world the demand for which is perfectly inelastic.
Conclusion
The above analysis is based on the assumption of fixed exchange rates. Thus, a deficit (or surplus) in the balance of payments is possible under a system of fixed exchange rates. But under freely floating exchange rates, there can in principle be no deficit (or surplus) in the balance of payments. The country can prevent a deficit (or surplus) by depreciating (or appreciating) its currency. Further, balance of payments always balances in an ex-post accounting sense, according to the basic principle of accounting.
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