Balance of Payments

A balance of payment (BoP) is a summary statement that lists all of the transactions that took place within a specific period between the resident and the outside world. The Balance of Payment indicates the extent to which a country saves enough money to cover its imports. It also reveals whether the country produces adequate economic output to fund its expansion. Usually, BoP is in equilibrium, which means that all the debit items are equal to the credit items. In equilibrium, the total of current and capital accounts are equal to 0, as they balance each other out. 

Capital Account + Current Account = 0

But, sometimes there are cases when it is not balanced. This means that either credit items > debit items or debit items > credit items. It is called disequilibrium in BoP. It can either be in the form of a surplus or deficit. In that case, the capital and current accounts can not balance each other out. If the total of the current and capital accounts is a positive number i.e., greater than 0, then it indicates a BoP Surplus. If the total of the current and capital accounts is a negative number, i.e., smaller than 0, then it indicates a BoP Deficit.

BoP Surplus	Capital Account + Current Account > 0
BoP Deficit	Capital Account + Current Account < 0

Balance of Payments: Surplus and Deficit

In reality, international payments are similar to that of individuals who spend more than they earn and finance the gap by borrowing money or selling assets. A country can sell assets or borrow money from overseas to cover a gap in its current account (spending more than it brings in from sales to the outside world). Therefore, any current account shortfall must be covered by a capital account surplus or net inflow of capital into the country.

Balance of Payments: Surplus

It is a favourable situation when the country’s export is more than its import. The country can create more capital to pay for its domestic productions. An increase in the level of production will ultimately help in the short-term growth of a country. Under this:

• Payment made by the country is certainly less than the receipts received by the country.
• This means that a country’s foreign currency inflows exceed its outflows within a specific period.
• In simple words, Credit Side > Debit Side

Balance is in surplus when:

(Current Account + Capital Account Total Receipts) > (Current Account + Capital Account Total Payments)

For example, If Export = ₹500 lakh and Import= ₹250 lakh, then there is a trade surplus of ₹ 250 lakh.

Balance of Payments: Deficit

It is an unfavourable situation when the country’s import is more than its export of goods and services. It means that a country is spending money more than it earns. In this case, it has to borrow to pay for its imports. Thus, it creates a problem for the economy. Under this:

• Payment made by the country is certainly more than the receipts received by the country.
• This means that a country’s foreign currency outflows exceed its inflows within a specific period.
• In simple words, Credit Side < Debit Side

Balance is in deficit when:

(Current Account + Capital Account Total Receipts) < (Current Account + Capital Account Total Payments)

For example, If Export= ₹150 lakh and Import= ₹ 250 lakh, then there is a trade deficit of ₹ 100 lakh.

In the case of BoP Deficit, it must be noted that:

1. The official reserves can be used to amend the BoP deficit. But, the decision regarding this lies with the Reserve Bank of India. This is because RBI acts as a custodian of foreign reserves and all foreign transactions are managed by the RBI. The official reserves mean the overall balance of the Balance of Payment account. ( Overall balance is the total of the Current account, Capital account, and Errors and Omissions).
2. The decrease in the official reserves account signifies the BoP deficit (for this reason the overall balance is negative).
3. The Reserve Bank of India (RBI) has the authority to manage the currency and money supply. This authority is known as the Monetary Authority. This final decision to finance the deficit that arises in the country’s BoP lies with the RBI. 
4. The official reserves can only be used to settle the deficit when there are pegged exchange rates (fixed). In floating exchange rates, it can not be considered. 

When the Balance of Payment is balanced, it is said to be in equilibrium. But when the country is either in surplus or deficit, then it is said to be in disequilibrium. Disequilibrium is a major concern for the government, thus it is necessary to understand its cause and effects on the country.

Causes of BoP Disequilibrium

1. Economic Factors

(i) Inflation: Generally, the country’s price and cost structure affect the volume of exports and the BoP position. Inflation means a persistent rise in the price of goods and services over a period of time. This increases the cost of living. For example, in the 90s, a movie ticket cost around ₹20, but now the average price is ₹200, thus, it shows a continuous increase in the price. In the context of BoP, it increases the price, due to higher salaries, and higher prices for raw materials, which makes export expensive and imports cheaper; eventually resulting in a BoP deficit.

(ii) Trade Cycles: There are four phases in the business/ trade cycle, i.e., Boom, Recession, Depression, and Recovery. Boom and Recovery bring positive changes in the economy; in terms of an increase in the level of investment, income, and production. However, recession and depression bring negative changes to the organization in terms of a decrease in the level of investment, revenue, and production. In the context of BoP; in case of recession or depression, production within boundaries may not be able to accomplish the demand in the domestic market, which eventually leads to the BoP Deficit, due to higher imports. On the other hand, if there is a boom or recovery there is a demand for goods in the foreign market, which increase the export and ultimately leads to a BoP Surplus.

(iii) Developmental Activities: Usually, developing countries, like India depend upon developed countries, like the USA for certain imports of goods and services. This leads to an increase in the level of imports, which results in the deficit of the BoP account of developing countries. In case imports fall then the deficit may reduce.

(iv) Change in the Cost Structure of the Business Partner: Cost of production plays an important role in deciding whether the country will export its goods and services or not. The company can reduce its cost with the help of the latest technology available in the market. Due to the latest technology, production cost fall, and then the price of the goods and services fall, which leads to a rise in the exports, which results in a BoP Surplus. On the other hand, the domestic cost of production rise, and the price of the goods and services rise, which leads to an increase in the imports which results in a BoP Deficit.

(v) Availability of Import Substitute: Import substitution refers to the blocking of the imported goods in the country so that there is a boost of domestically produced goods in the economy. If the country can develop a substitute, then there will be a BoP Surplus due to lessor imports. But in case, the country can substitute its imports then there will be a BoP Deficit. 

2. Political Factors 

(i) Government Policies: Policy is the plan of action chosen by the government. The main purpose of making policies is that it provides directions on how things should be done and the reason why it is done. In case government makes policies that favour imports, then there is a BoP Deficit. But in case government makes policies that favour exports, then there will be a BoP Surplus.

(ii) Political Instability: It is a situation in which there is an imbalance in the structure of the government. There is a chance of government collapse in a short time. This instability may lead to an increase in the payments, and it will reduce the capital receipts, thus it will initiate a BoP Deficit. However, if the economy is stable, then receipts are more than payments causing a BoP Surplus.

3. Social Factors

(i) Demonstration Effect: It is human nature, that a person is attracted to the things that he/she does not have. Generally, humans observe the action and behaviour of others and try to imitate them. In economics, the demonstration effect means the habit of the individual to consume the things consumed by others. In case Indians want to imitate western culture, then there will be a rise in the imports, which will result in an adverse level of BoP for the country. But if Indians prefer domestically produced goods over foreign goods then there will be a BoP Surplus.  

(ii) Cross-border Bias: In case of bias, there will be cheaper exports and expensive imports, which will cause a BoP Deficit.

(iii) Change in the Taste and Preferences, Fashion: It means special liking of one thing over the other. For example, some people may prefer western clothes, like jeans and tops, while others prefer traditional clothes like saree and suits. Thus, taste and preference depend upon the individual to individual. In case favourable changes in demand for a domestic product take place in the foreign market, then it will increase the rise in exports and will ultimately cause a BoP Surplus. On the other hand, if unfavourable changes in demand for a domestic product take place in the foreign market, then it will increase the rise in imports and will ultimately cause a BoP Deficit.

There are some effects of the BoP deficit on the country:

• Foreign dependence gradually increases.
• There is a reduction in the foreign reserves of the country.
• It slows the development of the country.

Thus, it arises a need to correct it. The BoP Deficit can be corrected through export promotion, reducing inflation, devaluation of the currency, and promoting import substitution, and vice-versa in the case of the BoP Surplus.

Usually, the transactions involve an agreement in which there is an exchange of goods and services in return for money. The transactions in BoP involve the transfer of goods and services or borrowings for foreign currency in return. The transactions are generally for a specific purpose, in BoP, the transactions are made either to earn profits or to correct BoP disequilibrium (deficit or surplus). These transactions are called autonomous and accommodating transactions. 

Autonomous and Accommodating Transactions

The transaction made in the Balance of Payments can be categorized into two parts: Autonomous Transactions and Accommodating Transactions. 

Autonomous Transactions

These are economic transactions that are made to earn profits, not to bridge the gap in the BoP. In simple words, sometimes there are situations when there is a BoP deficit in that case the government has to make certain transactions to correct it, but the autonomous transactions are not made for that purpose. The purpose here is to maximize profits.

• Thus, it can be said that these transactions are independent of BoP. 
• These transactions are also called “above the lines”, as they are made to earn profit.
• These transactions can be made by the private sector and the government.
• Depending on the type of transaction, autonomous transactions occur on both current and capital accounts. In the case of the current account, merchandise imports and exports are autonomous items and in the capital account receipts and payments of long-term loan taken or provided by private individuals comes under autonomous items.
• When the autonomous receipts exceed the payments, the BoP balance is considered to be in surplus. When autonomous payments exceed receipts, the BoP is considered to be in deficit. 
• For example, if a Multinational Company (MNC) makes Foreign Direct Investment (FDI) in our country, the main purpose behind this is to earn profit. This transaction is not made to correct the balance and is independent of BoP.

The main autonomous items are as follows:

1. Trade in Goods and Services
2. One-sided Transactions
3. Capital Transfers

Accommodating Transactions 

These are economic transactions that are made to bridge the gap in the BoP. In simple words, sometimes there are situations when there is a BoP deficit in that case the government has to make certain transactions to correct the BoP, these transactions are called accommodating transactions. Thus, it is undertaken to establish the balance of payments identity.

• It can be said that these transactions are dependent on BoP. It means that these are based on the state of BoP and not made for the profit motive.
• These transactions are undertaken as the result of autonomous transactions, this means that it is made to correct the disequilibrium caused by the autonomous transactions. Thus, it is also called “below the lines”.
• These transactions can only be made by the country’s government.
• Autonomous transactions take place on capital accounts. It can take place in the form of borrowings from international institutions and official foreign reserves of the country.
• It must be noted that there is no movement of goods and services across the borders in this case. It takes place by the movement of official reserves of the country.
• For example, if there arises a deficit in the BoP, then it is corrected by the borrowings from the outside world.

The main accommodating items are as follows:

1. Borrowing of government from the International Monetary Fund (IMF) or other Foreign Financial Institutions
2. Foreign Exchange Reserves

Difference between Autonomous and Accommodating Items 

Basis	Autonomous Items	Accommodating Items
Meaning	Economic transactions occur due to economic motives or are determined by the maximization of profits.	Economic transactions take place to correct the BoP imbalances. These are not undertaken to earn profit.
BoP Identity	These transactions do not help in maintaining BoP identity; i.e., are not affected by positive or negative BoP.	These transactions help in maintaining BoP identity; i.e., is affected by positive or negative BoP.
Undertaken by	Both government and private sector can undertake these transactions.	Only the government can undertake these transactions.
Current or Capital Account	These take place in both the Current and Capital accounts.	These take place in the Capital Account only.
Also known as	It is also known as Above the line.	It is also known as Below the line.
Movement of Goods and Services	These transactions involve movement of goods and services across borders.	These transactions do not involve movement of goods and services across borders.
Cause of BoP Imbalances	Autonomous items cause BoP imbalances (surplus or deficit).	Accommodating items are made to correct the disequilibrium (surplus or deficit) caused by autonomous transactions.

While preparing the Balance of the Payment account, it must be ensured that the BoP balances, i.e., all the credit items are equal to the debit items. But when international transactions are not recorded accurately, there arise some errors and omissions in BoP. For example, there is an error in converting the price of one currency into another currency, i.e., conversion of dollars into rupees. The error may arise due to compiling or collecting the data from different sources. Thus, there is a need to understand these errors and the reasons for these errors and omissions.

Errors and Omissions

The double entry system followed in the BoP ensures that debit is equal to credit items. But, sometimes, the record of all the international transactions can not be made accurately. In that case along with current and capital accounts, there arises a third element in the Balance of payment account which is Errors and Omissions.

“Errors and omissions reflect the imbalances resulting from imperfections in source data and compilation of the Balance of Payments Accounts.”

 These errors occur due to inaccurate or unreported data in the BoP, which may include:

1. Unrecorded Capital Flows
2. Unmarked Goods Transactions
3. Remittances of Workers

Therefore, the items must be recorded carefully to reduce the errors and omissions in the Balance of the Payment Account.