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Balance of payment chapter 5

Balance of payment, structure of balance of payment, difference between BOP and BOT, disequilibrium in BOP, Cause of disequilibrium, devaluation

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Balance of payment chapter 5

  1. 1. Balance of Payment SYBcom Sem IV SDJ International College Vaghela Nayan K
  2. 2. Meaning:  Balance of Payment is a statement of systematic record of all economic transactions between one country and the rest of the world.  It is a record pertaining to the period of time. Usually it is an annual statement.  It includes all transactions, current as well as capital.  The characteristics of Balance of Payment account are: 1. It is a way of listing receipts and payments in the international transactions of a country. 2. It adopts a double entry book keeping system. It has two sides: debit and credit. Payments are recorded on the debit side and receipts on the credit side. 3. In accounting sense, debit and credit side of the account is always balanced but in balance of payment account the credit and debit side do not balance, the balance is usually achieved by adding an item called errors and ommissions. 4. It contains two sets of accounts:  Current account  Capital account
  3. 3. Structure of Balance of Payment A.Current Account: 1. Merchandise- Exports and Imports:  Private  Government 2. Invisible items of exports (shipping, banking, Insurance), expenditure in country by foreign tourists and expenditure made by citizens in other countries, receipts and payments of interest, dividends and profits on investments. 3. Gifts grants, donations and war indemnities received and paid. 4. Inward and outward remittances 5. Miscellaneous receipts and payments on account of services rendered by experts in country and to other countries.
  4. 4. B. Capital Account: 1. Long term foreign investments made in other countries and received in the country in the forms of: a. Equity b. Investment in the form of foreign securities 2. Receipts and payments on account of short term loans from and to: a. International financial institutions b. Foreign governments c. Private foreign investors 3. Receipts and payments for sale and purchases of gold 4. Change in currency reserves including change in the foreign assets of the central bank of the country.
  5. 5. Difference Between Balance of Trade and Balance of Payment Balance of Trade (BOT) Balance of Payment (BOP) It records on merchandise transactions (goods). It records transactions related to both, goods and services. It does not record the transactions of Capital nature. It records the transactions of Capital nature. It is a part of Current Account of Balance of Payment It includes balance of trade, balance of services, balance of unilateral transfers and balance of capital transactions. It may be favourable, unfavourable or in equilibrium It always remains in balance as receipts equals to payments. Defects of balance of Trade cannot be met by Balance of Payment Defects in Balance of Payment can be met through Balance of Trade It is not true indicator of the economic relations or economic prosperity of the country. It is true indicator of the economic performance of the economy.
  6. 6. Disequilibrium in the Balance of Payments  There are two main types of disequilibrium in the Balance of Payment: 1. Temporary disequilibrium: this type of disequilibrium is purely of a temporary nature and is self-correcting. It does not involve the complex problem of adjustment. 2. Fundamental disequilibrium: when the Balance of Payments situation of a country progressively deteriorates and if it is chronic and long term, it is known as fundamental disequilibrium. Such a disequilibrium requires correction and adjustments.
  7. 7. Causes of Disequilibrium in BOP A. Economic Factors: the economic factor which cause disequilibrium in the balance of payment of the country are: 1. Cyclical fluctuations: Business fluctuations arises out of the occurrences of trade cycle cause disequilibrium in BOP of a country. If there is business recession in the foreign countries, it will result in fall in exports of the country concerned leading to disequilibrium in the balance of payment. 2. Inflationary pressures in the Economy: an inflationary rise in prices in the economy leads to disequilibrium in BOP. Due to rising money income of the people an increasing prices of the goods and services, exports tends to decline, import tends to rise for increased domestic demand and there by causes disequilibrium in BOP. 3. Capital Movements: if due to political instability and other factors, there is flight of capital from the country, it would cause disequilibrium in BOP. Likewise a country may tend to have an adverse balance when it borrows heavily from other countries, while the lending country will tend to have a favourable balance.
  8. 8. 4. Fall in Exports and Rise in Imports: A fall in exports and rise in imports of the country causes a disequilibrium in its BOP, the fall in exports and rise in imports may be due to: Contraction of economy Fall in domestic production and rising demand for imported goods Inferior quality and high prices of the goods to be exported Currency appreciation Obstructive government policies Demonstration effect Cheaper price and better quality of foreign goods Increase in money income due to inflation policy. B. Natural factors: Natural factors such as floods, famines, crop failure, etc. adversely affects agricultural and industrial production leading to fall in exports and rise in imports and hereby causing disequilibrium in BOP.
  9. 9. C. Political factors: Political instability, deteriorates in the law and order situation within the country, fear of foreign aggression, lack of confidence in the currency of the country, etc. disturbs the production process within the country leads to disequilibrium in BOP. D. Miscellaneous factors:  High population growth rate leads to increased imports  Increased demand of foreign goods due to structural changes  Change in the taste, preferences, habits, fashion, etc. of the people  Discovery of new substitutes for exports, and the development of alternative sources of supply may also cause disequilibrium in the BOP of a country.
  10. 10. Measures to correct disequilibrium in Balance of Payment A. Monetary measures: 1. Deflation: A country may adopt deflationary or dear money policy by raising the bank rate and restricting credit. Under deflation, prices of domestic goods fall which makes exports attractive and imports relatively costlier. Therefore, exports will increase. It also restricts home consumption through reduction of incomes; reduced income leads to lower domestic demand and there can be surplus production for the purpose of exports.  It should be noted that the ill effects of deflation policy for treating disequilibrium are dangerous for poor country. It creates more unemployment and poverty. 2. Exchange Depreciation: by depreciating the external value of the home currency, the adverse BOP situation can be corrected. In case if the country have adopted flexible exchange rate policy, then it is possible to adopt this method. It will tend to cheapen the domestic goods for the foreigner so that its exports will be boosted, while its imports will be costlier, so that they will tend to decline. However, this method is not suitable under the present system of IMF which prescribes a fixed exchange rate system.
  11. 11. 3. Devaluation: A most commonly adopted method consists in devaluation of currency of a country faced with an adverse BOP.  it is an alternative to exchange depreciation. It is suitable under the present IMF system. Devaluation means official decrease in external value of currency in terms of foreign currency or good or SDRs.  Conditions for Successful working of Devaluation: a) A fairly elastic demand: if the domestic demand for imports and exports is inelastic, devaluation will worsen the balance of payments position by increasing the total value of imports, while at the same time reducing the total value of exports. b) Structure of Imports and Exports: if the country’s exports are of primary goods and imports are of manufactured goods and industrial raw materials, devaluation will lead to unfavourable terms of trade. So it will lose under devaluation. c) Domestic Price Stability: success of devaluation requires that when the external value od currency is deliberately reduced, the internal value of the currency should not change, otherwise the whole purpose will be defeated. In other words, the cost-price structure of the devaluing country should not alter. There should be no inflation.
  12. 12. 4. Exchange control: Restriction on the use of foreign exchange by the central bank are called “exchange controls.” When an exchange control is adopted, all the exporters have to surrender their foreign exchange earrings to the central bank. Under exchange control, the central bank releases foreign exchange only for essential imports and conserves the rest of the balance. This is most direct method of curbing imports. B. Non-Monetary Measures: 1. Import Duties: Tariff is a fiscal device which may be used for correcting BOP position. It refers to custom duties levied on imports. A country having a deficit BOP will increase the amount of tax on imports, which will reduce the imports and foreign currency can be retained by the country. 2. Import Quotas: Under the quota system, the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, deficit is reduced or eliminated and thereby the BOP position is improved. 3. Export Promotion: to correct adverse BOP, government may adopt export promotion programmes for increasing the level of exports and earning excess foreign exchange. Certain facilities are also provoded to the exporters for this purpose. 4. Import substitutions: A series of activities will be started to reduce the level of imports to save foreign exchange payments.
  13. 13. THANK YOU

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