Trends and challenges of BOP of India

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Balance Of Payments Position in India

BALANCE OF PAYMENTS

Definition:

Balance of payments accounts are an accounting record of all monetary transactions between a

country and the rest of the world. These transactions include payments for the country's exports

and imports of goods, services, financial capital, and financial transfers.

In simple words, it is the method countries use to monitor all international monetary transactions

at a specific period of time. Usually, the BOP is calculated every quarter and every calendar

year. All trades conducted by both the private and public sectors are accounted for in the BOP in

order to determine how much money is going in and out of a country. If a country has received

money, this is known as a credit, and if a country has paid or given money, the transaction is

counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and

liabilities (debits) should balance, but in practice this is rarely the case. Thus, the BOP can tell

the observer if a country has a deficit or a surplus and from which part of the economy the

discrepancies are stemming.

In other words:

The balance of payments of a country is a systematic record of all economic transactions

between the residents of a country and the rest of the world. It presents a classified record of all

receipts on account of goods exported, services rendered and capital received by residents and

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payments made by theme on account of goods imported and services received from the capital

transferred to non-residents or foreigners.

- Reserve Bank of India

The above definition can be summed up as following: - Balance of Payments is the summary of

all the transactions between the residents of one country and rest of the world for a given period

of time, usually one year.

Purpose:

The BOP is an important indicator of pressure on a country’s foreign exchange rate, and

thus on the potential for a firm trading with or investing in that country to experience

foreign exchange gains or losses. Changes in the BOP may predict the imposition or

removal of foreign exchange controls.

Changes in a country’s BOP may signal the imposition or removal of controls over

payment of dividends and interest, license fees, royalty fees, or other cash disbursements

to foreign firms or investors.

The BOP helps to forecast a country’s market potential, especially in the short run. A

country experiencing a serious trade deficit is not likely to expand imports as it would if

running a surplus. It may, however, welcome investments that increase its exports.

Terminologies:

a. Favorable Balance Of Payments

Value of total receipts more than total payments

b. Adverse Balance Of Payments

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Value of total receipts less than total payments

c. Balanced Balance Of Payments:

Value of total receipts equals total payments.

d. Unrequited receipts:

Receipts for which nothing has to be paid in return.

e. Unrequited payments:

Payments for which nothing is received in return.

The definition given by RBI needs to be clarified further for the following points:

A. Economic Transactions

An economic transaction is an exchange of value, typically an act in which there is transfer of

title to an economic good the rendering of an economic service, or the transfer of title to assets

from one economic agent (individual, business, government, etc) to another. An international

economic transaction evidently involves such transfer of title or rendering of service from

residents of one country to another. Such a transfer may be a requited transfer (the transferee

gives something of an economic value to the transferor in return) or an unrequited transfer (a

unilateral gift). The following are the basic types of economic transactions that can be easily

identified:

1. Purchase or sale of goods or services with a financial quid pro quo – cash or a promise to

pay. [One real and one financial transfer].

2. Purchase or sale of goods or services in return for goods or services or a barter transaction.

[Two real transfers].

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3. An exchange of financial items e.g. – purchase of foreign securities with payment in cash or

by a cheque drawn on a foreign deposit. [Two financial transfers].

4. A unilateral gift in kind [One real transfer].

5. A unilateral financial gift. [One financial transfer].

B. Resident

The term resident is not identical with “citizen” though normally there is a substantial overlap.

As regards individuals, residents are those individuals whose general centre of interest can be

said to rest in the given economy. They consume goods and services; participate in economic

activity within the territory of the country on other than temporary basis. This definition may

turnout to be ambiguous in some cases. The “Balance of Payments Manual” published by the

“International Monetary Fund” provides a set of rules to resolve such ambiguities.

As regards non-individuals, a set of conventions have been evolved. E.g. – government and non

profit bodies serving resident individuals are residents of respective countries, for enterprises, the

rules are somewhat complex, particularly to those concerning unincorporated branches of foreign

multinationals. According to IMF rules these are considered to be residents of countries in which

they operate, although they are not a separate legal entity from the parent located abroad.

International organisations like the UN, the World Bank, and the IMF are not considered to be

residents of any national economy although their offices are located within the territories of any

number of countries.

To certain economists, the term BOP seems to be somewhat obscure. Yeager, for example, draws

attention to the word ‘payments’ in the term BOP; this gives a false impression that the set of

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BOP accounts records items that involve only payments. The truth is that the BOP statements

records both payments and receipts by a country. It is, as Yeager says, more appropriate to

regard the BOP as a “balance of international transactions” by a country. Similarly the word

‘balance’ in the term BOP does not imply that a situation of comfortable equilibrium; it means

that it is a balance sheet of receipts and payments having an accounting balance.

Like other accounts, the BOP records each transaction as either a plus or a minus. The general

rule in BOP accounting is the following:-

a) If a transaction earns foreign currency for the nation, it is a credit and is recorded as a plus

item.

b) If a transaction involves spending of foreign currency it is a debit and is recorded as a

negative item.

The BOP is a double entry accounting statement based on rules of debit and credit similar to

those of business accounting & book-keeping, since it records both transactions and the money

flows associated with those transactions. Also in case of statistical discrepancy the difference

amount is adjusted with errors and omissions account and thus in accounting sense the BOP

statement always balances.

The Various Components Of A BOP Statement

A. Current Account

B. Capital Account

C. Errors & Omissions

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Current Account

The current account shows the net amount a country is earning if it is in surplus, or spending if it

is in deficit. It is the sum of the balance of trade (net earnings on exports minus payments for

imports), factor income (earnings on foreign investments minus payments made to foreign

investors) and cash transfers. It is called the current account as it covers transactions in the "here

and now" – those that don't give rise to future claims.

It can be calculated by a formula:

Where,

CA: current account

X and M: export and import of goods and services respectively

NY: net income from abroad

NCT: net current transfers.

BALANCE OF CURRENT ACCOUNT

BOP on current account refers to the inclusion of three balances of namely – Merchandise

balance, Services balance and Unilateral Transfer balance. In other words it reflects the net flow

of goods, services and unilateral transfers (gifts). The net value of the balances of visible trade

and of invisible trade and of unilateral transfers defines the balance on current account.

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BOP on current account is also referred to as Net Foreign Investment because the sum represents

the contribution of Foreign Trade to GNP.

Thus the BOP on current account includes imports and exports of merchandise (trade balances),

military transactions and service transactions (invisibles). The service account includes

investment income (interests and dividends), tourism, financial charges (banking and insurances)

and transportation expenses (shipping and air travel). Unilateral transfers include pensions,

remittances and other transfers for which no specific services are rendered.

It is also worth remembering that BOP on current account covers all the receipts on account of

earnings (or opposed to borrowings) and all the payments arising out of spending (as opposed to

lending). There is no reverse flow entailed in the BOP on current account transactions.

STRUCTURE OF CURRENT ACCOUNT

Transactions Credit Debit Net Balance

1. Merchandise Export Import -

2. Foreign Travel Earning Payment -

3. Transportation Earning Payment -

4. Insurance (Premium) Receipt Payment -

5. Investment Income Dividend Receipt Dividend Payment -

6.Government (purchase of

goods & services)

Receipt Payment -

Current A/C Balance - - Surplus (+)

Deficit (-)

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THE CAPITAL ACCOUNT

The capital account records all international transactions that involve a resident of the country

concerned changing either his assets with or his liabilities to a resident of another country.

Transactions in the capital account reflect a change in a stock – either assets or liabilities.

It is often useful to make distinctions between various forms of capital account transactions. The

basic distinctions are between private and official transactions, between portfolio and direct

investment and by the term of the investment (i.e. short or long term). The distinction between

private and official transaction is fairly transparent, and need not concern us too much, except for

noting that the bulk of foreign investment is private.

Direct investment is the act of purchasing an asset and the same time acquiring control of it

(other than the ability to re-sell it). The acquisition of a firm resident in one country by a firm

resident in another is an example of such a transaction, as is the transfer of funds from the

‘parent company in order that the ‘subsidiary’ company may itself acquire assets in its own

country. Such business transactions form the major part of private direct investment in other

countries, multinational corporations being especially important. There are of course some

examples of such transactions by individuals, the most obvious being the purchase of the ‘second

home’ in another country.

Portfolio investment by contrast is the acquisition of an asset that does not give the purchaser

control. An obvious example is the purchase of shares in a foreign company or of bonds issued

by a foreign government. Loans made to foreign firms or governments come into the same broad

category. Such portfolio investment is often distinguished by the period of the loan (short,

medium or long are conventional distinctions, although in many cases only the short and long

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categories are used). The distinction between short term and long term investment is often

confusing, but usually relates to the specification of the asset rather than to the length of time of

which it is held. For example, a firm or individual that holds a bank account with another country

and increases its balance in that account will be engaging in short term investment, even if its

intention is to keep that money in that account for many years. On the other hand, an individual

buying a long term government bond in another country will be making a long term investment,

even if that bond has only one month to go before the maturity. Portfolio investments may also

be identified as either private or official, according to the sector from which they originate.

The purchase of an asset in another country, whether it is direct or portfolio investment, would

appear as a negative item in the capital account for the purchasing firm’s country, and as a

positive item in the capital account for the other country. That capital outflows appear as a

negative item in a country’s balance of payments, and capital inflows as positive items, often

causes confusions. One way of avoiding this is to consider that direction in which the payment

would go (if made directly). The purchase of a foreign asset would then involve the transfer of

money to the foreign country, as would the purchase of an (imported) good, and so must appear

as a negative item in the balance of payments of the purchaser’s country (and as a positive item

in the accounts of the seller’s country).

The net value of the balances of direct and portfolio investment defines the balance on capital

account.

Short term capital movement includes:

Purchase of short term securities

Speculative purchase of foreign currency

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Cash balances held by foreigners

Net balance of current account

Long term capital movement includes:

Investments in shares, bonds, physical assets etc.

Amortization of capital

CAPITAL ACCOUNT CONVERTIBILITY (CAC)

While there is no formal definition of Capital Account Convertibility, the committee under the

chairmanship of S.S. Tarapore has recommended a pragmatic working definition of CAC.

Accordingly CAC refers to the freedom to convert local financial assets into foreign financial

assets and vice – a – versa at market determined rates of exchange. It is associated with changes

of ownership in foreign / domestic financial assets and liabilities and embodies the creation and

liquidation of claims on, or by, the rest of the world. CAC is coexistent with restrictions other

than on external payments. It also does not preclude the imposition of monetary / fiscal measures

relating to foreign exchange transactions, which are of prudential nature.

Following are the prerequisites for CAC:

1. Maintenance of domestic economic stability.

2. Adequate foreign exchange reserves.

3. Restrictions on inessential imports as long as the foreign exchange position is not very

comfortable.

4. Comfortable current account position.

5. An appropriate industrial policy and a conducive investment climate.

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6. An outward oriented development strategy and sufficient incentives for export growth.

DIFFERENCE BETWEEN CURRENT ACCOUNT AND CAPITAL ACCOUNT

CURRENT ACCOUNT CAPITAL ACCOUNT

• Indicates flow aspect of

country’s national transactions

• Relates to goods , services and

unrequited transfers

• Indicates changes in stock magnitudes

• Relates to all transactions constituting

debts and transfer of ownership

STRUCTURE OF BALANCE OF PAYMENTS ACCOUNT

CREDITS DEBITS

Current A/c:

• Exports of goods(Visible items)

• Exports of services (Invisibles)

• Unrequited receipts(gifts , remittances,

indemnities, etc. from foreigners)

Capital A/c:

• Capital receipts (Borrowings from

abroad, capital repayments by, or sale

of assets to foreigners, increase in stock

of gold and reserves of foreign currency

etc.)

Current A/c:

• Imports of goods(Visible items)

• Imports of services(Invisibles)

• Unrequited payments( gifts,

remittance, indemnities etc. to

foreigners)

Capital A/c:

• Capital payments (lending to, capital

repayments to, or purchase of assets

from foreigners, reduction in stock of

gold and reserves of foreign currency

etc.)

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ERRORS AND OMISSIONS

Errors and omissions is a “statistical residue.” It is used to balance the statement because in

practice it is not possible to have complete and accurate data for reported items and because

these cannot, therefore, ordinarily have equal entries for debits and credits. The entry for net

errors and omissions often reflects unreported flows of private capital, although the conclusions

that can be drawn from them vary a great deal from country to country, and even in the same

country from time to time, depending on the reliability of the reported information. Developing

countries, in particular, usually experience great difficulty in providing reliable information.

Errors and omissions (or the balancing item) reflect the difficulties involved in recording

accurately, if at all, a wide variety of transactions that occur within a given period of (usually 12

months). In some cases there is such large number of transactions that a sample is taken rather

than recording each transaction, with the inevitable errors that occur when samples are used. In

others problems may arise when one or other of the parts of a transaction takes more than one

year: for example with a large export contract covering several years some payment may be

received by the exporter before any deliveries are made, but the last payment will not made until

the contract has been completed. Dishonesty may also play a part, as when goods are smuggled,

in which case the merchandise side of the transaction is unreported although payment will be

made somehow and will be reflected somewhere in the accounts. Similarly the desire to avoid

taxes may lead to under-reporting of some items in order to reduce tax liabilities.

Finally, there are changes in the reserves of the country whose balance of payments we are

considering, and changes in that part of the reserves of other countries that is held in the country

concerned. Reserves are held in three forms: in foreign currency, usually but always the US

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dollar, as gold, and as Special Deposit Receipts (SDR’s) borrowed from the IMF. Note that

reserves do not have to be held within the country. Indeed most countries hold a proportion of

their reserves in accounts with foreign central banks.

The changes in the country’s reserves must of course reflect the net value of all the other

recorded items in the balance of payments. These changes will of course be recorded accurately,

and it is the discrepancy between the changes in reserves and the net value of the other record

items that allows us to identify the errors and omissions.

Balance Of Payment in India

India’s balance of payment position was quite unfavorable during the time of country’s entry into

liberalized trade regime. Two decades of economic reforms and free trade opened several

opportunities that, of course, reflected in the balance of payments performance of the country.

India’s Balance of Payments picture since 1991

Independent India’s external trade and performance had faced severe threats many a times. The

most challenging one was that of 1991.The economic crisis of 1991 was primarily due to the

large and growing fiscal imbalances over the 1980s. India’s balance of payments in 1990-91 also

suffered from capital account problems due to a loss of investor confidence. The widening

current account imbalances and reserve losses contributed to low investor confidence putting the

external sector in deep dilemma. During 1990-91, the current account deficit steeply hiked to $-

9680 million while the capital account surplus was far below at $ 7188 million. This led to an

ever time high deficit in BOP position of India.

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India initiated economic reforms to find the way out of the growing crisis. Structural measures

emphasized accelerating the process of industrial and import delicensing and then shifted to

further trade liberalization, financial sector reform and tax reform. Prior to 1991, capital flows to

India predominately consisted of aid flows, commercial borrowings, and nonresident Indian

deposits. Direct investment was restricted, foreign portfolio investment was channeled almost

exclusively into a small number of public sector bond issues, and foreign equity holdings in

Indian companies were not permitted (Chopra and others, 1995). However, this development

strategy of both inward-looking and highly interventionist, consisting of import protection,

complex industrial licensing requirements etc underwent radical changes with the liberalization

policies of 1991.

The post reform period really eased India’s struggles with regard to external sector. This is

evident from the RBI data summarizing the BOP in current account and capital account. The

current account which measures all transactions including exports and imports of goods and

services, income receivable and payable abroad, and current transfers from and to abroad

remained almost negative throughout the post reform period except for the three financial years.

Until 2000-01, the current account deficit that comprises both trade balance and the invisible

balance, remained stagnant and stood around $ 5000 million. However, for the first time since

1991, the current account recorded surplus in its account during three consecutive financial years

from 2001-02. The deficit in current account continued to occur from 2004-05 onwards and the

growth rate was comparatively faster.

The recent crisis of 2008 affected the trade performance of India in a large way. Indian economy

had been growing robustly at an annual average rate of 8.8 per cent for the period 2003-04 to

2007-08. Concerned by the inflationary pressures, Reserve Bank of India (RBI) increased the

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interest rates, which resulted in a slowdown of India’s trade flows prior to the Lehman crisis

(Kumar and Alex, 2009). The trade flows, which are one of the important channels through

which India was affected during the recent global crisis of 2008, started to collapse from late

2008. Merchandise trade, software exports and remittances declined in absolute terms in

response to the exogenous external shock.

A sharp improvement was seen in the outcome during 2013-14 with the CAD being contained at

US$ 32.4 billion as against US$ 88.2 billion and US$ 78.2 billion respectively in 2012-13 and

2011-12. The stress in India’s BoP, which was observed during 2011-12 as a fallout of the euro

zone crisis and inelastic domestic demand for certain key imports, continued through 2012-13

and the first quarter of 2013-14. Capital flows (net) to India, however, remained high and were

sufficient to finance the elevated CAD in 2012-13, leading to a small accretion to reserves of

US$ 3.8 billion. A large part of the widening in the levels of the CAD in 2012-13 could be

attributed to a rise in trade deficit arising from a weaker level of exports and a relatively stable

level of imports. The rise in imports owed to India’s dependence on crude petroleum oil imports

and elevated levels of gold imports since the onset of the global financial crisis. The levels of

non-petroleum oil lubricant (PoL) and non-gold and silver imports declined in 2012-13 and

2013-14.

Capital flows (net) moderated sharply from US$ 65.3 billion in 2011-12 and US$ 92.0 billion in

2012-13 to US$ 47.9 billion in 2013-14. This moderation in levels essentially reflects a sharp

slowdown in portfolio investment and net outflow in ‘short-term credit’ and ‘other capital’.

However, there were large variations within quarters in the last f iscal, which is explained partly

by domestic and partly by external factors. In the latter half of May 2013, the communication by

US Fed about rolling back its programme of asset purchases was construed by markets as a sign

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of imminent action and funds began to be withdrawn from debt markets worldwide, leading to a

sharp depreciation in the currencies of EMEs. Those countries with large CADs saw larger

volumes of outflows and their currencies depreciated sharply. As India had a large trade def icit

in the first quarter, these negative market perceptions led to sharper outflows in the foreign

institutional investors (FIIs) investment debt segment leading to 13.0 per cent depreciation of the

rupee between May 2013 and August 2013.

The government swiftly moved to correct the situation through restrictions in non-essential

imports like gold, customs duty hike in gold and silver to a peak of 10 per cent, and measures to

augment capital flows through quasi-sovereign bonds and liberalization of external commercial

borrowings. The RBI also put in place a special swap window for foreign currency non-resident

deposit (banks) [(FCNR (B)] and banks’ overseas borrowings through which US$ 34 billion was

mobilized. Thus, excluding one-off receipts, moderation in net capital inflows was that much

greater in 2013-14.

The one-off flows arrested the negative market sentiments on the rupee and in tandem with

improvements in the BoP position, led to a sharp correction in the exchange rate and a net

accretion to reserves of US$ 15.5 billion for 2013-14.

Current account developments in 2012-13

After registering strong growth in both imports and exports in 2011-12, merchandise trade (on

BoP basis) evidenced a slowdown in 2012-13 consisting of a decline in the levels of exports

from US$ 309.8 billion in 2011-12 to US$ 306.6 billion and a modest rise in the level of imports

to reach US$ 502.2 billion. This resulted in a rise in trade def icit f rom US$ 189.8 billion in

2011-12 to US$ 195.7 billion in 2012-13. The decline in exports owed largely to weak global

demand arising from the slowdown in advanced economies following the euro zone crisis, which

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could only be partly compensated by diversification of trade. Non-PoL imports declined only

marginally whereas PoL imports held up resulting in relatively stronger imports. Net imports of

PoL shot up to US$ 99.0 billion in 2011-12 initially on account of a spurt in crude oil prices

(Indian basket) and remained elevated at US$ 103.1 billion and US$ 102.4 billion in the next two

years. Similarly, gold and silver imports rose to a peak of US$ 61.6 billion in 2011-12 and

moderated only somewhat in 2012-13. Hence the wider and record high trade deficit in 2012-13.

With relatively static levels of net inflow under services and transfers, which are the two major

components (at about US$ 64 billion each), it was the net outflow in income (mainly investment

income), which explained the diminution in level of overall net invisibles balance. Net invisibles

surplus was placed at US$ 107.5 billion in 2012-13 as against US$ 111.6 billion in 2011-12.

Software services continue to dominate the non-factor services account and in 2012-13 grew by

4.2 per cent on net basis to yield US$ 63.5 billion with other services broadly exhibiting no

major shifts. In 2012-13, private transfers remained broadly at about the same level as in 2011-

12. Investment income which comprises repatriation of profits/interest, etc., booked as outgo as

per standard accounting practice, has been growing at a fast clip reflecting the large

accumulation of external financing of the CAD since 2011-12. Investment income (net) outgo

constituted 25.4 per cent of the CAD in 2012-13.

With trade deficit continuing to be elevated and widening somewhat and net invisibles balance

going down, the CAD widened from US$ 78.2 billion in 2011-12 to US$ 88.2 billion in 2012-13.

As a proportion of GDP, the CAD widened from 4.2 per cent in 2011-12 to a historic peak of 4.7

per cent in 2012-13. This rise also owes to the fact that nominal GDP expressed in US dollar

terms remained at broadly the same level of US$ 1.8 trillion in both the years due to depreciation

in the exchange rate of the rupee.

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Current account developments in 2013-14

In terms of the major indicators, the broad trend witnessed since 2011-12 continued through to

the first quarter of 2013-14. With imports continuing to be at around US$ 120-130 billion per

quarter for nine quarters in a row and exports (except the last quarter of the two financial years)

below US$ 80 billion for most quarters, trade deficit remained elevated at around US$ 45 billion

or higher per quarter for nine quarters till April-June 2013. The widening of the trade deficit in

the first quarter mainly owed to larger imports of gold and silver in the first two months of 2013-

14. In tandem with developments in the globe of a market perception of imminence of tapering

of asset purchases by the US Fed, the widening of the trade deficit led to a sharp bout of

depreciation in the rupee. This essentially reflected concerns about the sustainability of the CAD

in India. The government and RBI took a series of coordinated measures to promote exports,

curb imports particularly those of gold and non-essential goods, and enhance capital f lows.

Consequently, there has been significant improvement on the external front. (The Mid-Year

Economic Analysis 2013-14 of the Ministry of Finance contains a detailed analysis of

sustainability concerns and measures taken.)

The measures taken led to a dramatic turnaround in the BoP position in the latter three quarters

and for the full fiscal 2013-14. There was significant pick-up in exports to about US$ 80 billion

per quarter and moderation in imports to US$ 114 billion per quarter in the latter three quarters.

This led to significant contraction in the trade deficit to US$ 30-33 billion per quarter in these

three quarters. Overall this resulted in an export performance of US$ 318.6 billion in 2013-14 as

against US$ 306.6 billion in 2012-13; a reduction in imports to US$ 466.2 billion from US$

502.2 billion in 2012-13; and a reduction in trade def icit to US$ 147.6 billion, which was lower

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by US$ 48 billion from the 2012-13 level. As a proportion of GDP, trade deficit on BoP basis

was 7.9 per cent of GDP in 2013-14 as against 10.5 per cent in 2012-13.

A decomposition of the performance of trade deficit in 2013-14 vis-à-vis 2012-13 indicates that

of the total reduction of US$ 48.0 billion in trade deficit on BoP basis, reduction in imports of

gold and silver contributed approximately 47 per cent, reduction in non- PoL and non-gold

imports constituted 40 per cent, and change in exports constituted 25 per cent. Higher imports

under PoL and non-DGCI&S (Directorate General of Commercial Intelligence and Statistics)

imports contributed negatively to the process of reduction to the extent of 12 per cent in 2013-14

over 2012-13.

Net invisibles surplus remained stable at US$ 28-29 billion per quarter resulting in overall net

surplus of US$ 115.2 for 2013-14. Software services improved modestly from US$ 63.5 billion

in 2012-13 to US$ 67.0 billion in 2013-14. Non-factor services however went up from US$ 64.9

billion in 2012-13 to US$ 73.0 billion partly on account of business services turning positive in

all quarters with net inflows of US$ 1.3 billion in 2013-14 as against an outflow of US$ 1.9

billion in 2012-13. Business services have earlier been positive in 2007-08 and 2008-09. Private

transfers improved marginally to US$ 65.5 billion in 2013-14 from US$ 64.3 billion in 2012-13.

However, investment income outgo was placed at US$ 23.5 billion in 2013-14 as against US$

22.4 billion in 2012-13. There has been an elevation in the levels of gross outflow in recent

quarters reflecting the large levels of net international investment position (IIP), which is an

outcome of elevated levels of net financing requirements in 2011-12 and 2012-13. As an

outcome of the foregoing development in the trade and invisibles accounts of the BoP, the CAD

moderated sharply in 2013-14 and was placed at US$ 32.4 billion as against US$ 88.2 billion in

2012-13. In terms of quarterly outcome, the CAD was US$ 21.8 billion in April-June 2013 and

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moderated to around US$ 5.2 billion in July-September 2013, US$ 4.1 billion in October-

December 2013, and further to US$ 1.3 billion in January-March 2014. As a proportion of GDP,

the CAD was 1.7 per cent in 2013-14, which when adjusted for exchange rate depreciation

compares favorably with the levels achieved in the pre-2008 crisis years.

In terms of macroeconomic identity, the resource expenditure imbalance in one sector needs to

be financed through recourse to borrowing from other sectors and the persistence of high CAD

requires adequate net capital/financial flows into India. Any imbalance in demand and supply of

foreign exchange, even if frictional or cyclical, would lead to a change in the exchange rate of

the rupee. For analytical purposes, it would be useful to classify these flows in a 2X2 scheme in

terms of short-term and long term, and debt and non-debt flows. This scheme of classification

can be analyzed in terms of the nature of flows as stable or volatile.

In the hierarchy of preference for financing stable investment flows like foreign direct

investment (FDI) and stable debt flows like external assistance, external commercial borrowings

(ECBs), and NRI deposits which entail rupee expenditure that is locally withdrawn rank high.

The most volatile flow is the FII variety of investment, followed by short-term debt and FCNR

deposits. While FII on a net yearly basis has remained more or less positive since the 2008 crisis,

it has large cyclical swings and entails large volumes in terms of gross flows to deliver one unit

of net inflow.

Given this, it can be seen that post-1990 and prior to the global financial crisis, broadly the CAD

remained at moderate levels and was easily financed. In fact the focus of the RBI immediately

prior to the crisis was on managing the exchange rate and mopping up excess capital flows. Post-

2008 crisis, the CAD has remained elevated at many times the pre-2008 levels.

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In 2012-13, net capital inflows were placed at US$ 92.0 billion and were led by FII inflows (net)

of US$ 27.6 billion and short-term debt (net) of US$ 21.7 billion. There were, besides, large

overseas borrowings by banks together indicating the dependence on volatile sources of

financing. On a yearly basis, FII (net) flows remained at high levels post-2008 crisis on account

of the fact that foreign investors had put faith in the returns from emerging economies, which

exhibited resilience to the global crisis in 2009. There was some diminution in net inflows in

2011-12 on account of the euro zone crisis. On an intra-year basis, there was significant change

in FII flows due to perceptions of changing risks which had a knock-on effect on the exchange

rate of the rupee given the large financing need.

While the declining trend in net flows under ECB since 2010-11 continued in 2012-13, growing

dependence on trade credit for imports was reflected in a sharp rise in net trade credit availed to

US$ 21.7 billion in 2012-13 from US$ 6.7 billion in 2011-12. In net terms, capital inflows

increased significantly by 40.9 per cent to US$ 92.0 billion (4.9 per cent of GDP) in 2012-13 as

compared to US$ 65.3 billion (3.5 per cent of GDP) during 2011-12. Capital inflows were

adequate for financing the higher CAD and there was net accretion to foreign exchange reserves

to the extent of US$ 3.8 billion in 2012-13. However, intra-year in the first three quarters, though

there were higher flows quarter-on-quarter, the levels of net capital flows fell short or were

barely adequate for financing the CAD but in the fourth quarter while the levels of net capital

flows plummeted, the CAD moderated relatively more sharply leading to a reserve accretion of

US$ 2.7 billion.

Capital/Finance account in 2013-14

Outcomes in 2013-14 were a mixed bag. The higher CAD in the first quarter of 2013-14 was

financed to a large extent by capital flows; but the moderation observed in the fourth quarter of

22 | P a g e

2012-13 continued through 2013-14. The communication by the US Fed in May 2013 about its

intent to roll back its assets purchases and market reaction thereto led to a sizeable capital

outflow from forex markets around the world. This was more pronounced in the debt segment of

FII. In the event, even though there was a drastic fall in the CAD in July-September 2013, net

capital inflows became negative leading to a large reserve drawdown of US$ 10.4 billion in that

quarter. FDI net inflows continued to be buoyant with steady inflows into India backed by low

outgo of outward FDI in the first two quarters. In the third quarter, while there was turnaround in

the flows of FIIs and copious inflows under NRI deposits in response to the special swap facility

of the RBI and banks’ overseas borrowing programme, there was some diminution in the levels

of other flows. This led to a reserve accretion of US$ 19.1 billion in the third quarter

notwithstanding that the copious proceeds of the special swap windows of the RBI directly

flowed to forex reserves of the RBI. In the fourth quarter, while FDI inflow slowed, higher

outflow on account of overseas FDI together with outflow of short term credit moderated the net

capital inflows into India. Thus for the year as a whole, net capital inflow was placed at US$

47.9 billion as against US$ 92.0 billion in the previous year.

While net FDI was placed at US$ 21.6 billion, portfolio investment (mainly FII) at US$ 4.8

billion, ECBs at US$ 11.8 billion, and NRI deposits at US$ 38.9 billion, there were signif icant

outflows on account of short-term credit at US$ 5.0 billion, banking capital assets at US$ 6.6

billion, and other capital at US$ 10.8 billion. The net capital inflows in tandem with the level of

CAD led to a reserve accretion of US$ 15.5 billion on BoP basis in 2013-14. The accretion to

reserves on BoP basis helped in increasing the level of foreign exchange reserves above the US$

300 billion mark at end March 2014.

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India’s BOP during 1990-91 to 2013-14 (value in US $ million)

Year Current account

balance

Capital Account

balance

Overall Balance

1990-91 -9680 7188 -2492

1991-92 -1178 3777 2599

1992-93 -3526 2936 -590

1993-94 -1159 9694 8535

1994-95 -3369 9156 5787

1995-96 -5912 4690 -1222

1996-97 -4619 11412 6793

1997-98 -5499 10010 4511

1998-99 -4038 8260 4222

1999-00 -4698 11100 6402

2000-01 -2666 8535 5868

2001-02 3400 8357 11757

2002-03 6345 10640 16985

2003-04 14083 17338 31421

2004-05 -2470 28629 26159

2005-06 -9902 24954 15052

2006-07 -9565 46171 36606

2007-08 -15737 107901 92164

2008-09 -27915 7835 -20079

2009-10 -38180 51622 13441

2010-11 -45945 58996 13050

2011-12 -78155 65324 -12832

2012-13 -88163 91989 -3826

2013-14 -32397 47905 -15508

Source: Reserve Bank of India, www.rbi.org

BOP CRISIS IN INDIA

Crisis of 1956-57

From 1947 till 1956-57, the India had a current account surplus. By the end of the first plan, the

Trade deficit was Rs. 542 Crore and Net Invisibles was Rs. 500 Crore, thus giving a BoP deficit

in Current Account worth Rs. 42 Crore. From this time onwards, the trade deficit increased from

3.8% of the GDP at market prices to 4.5% of GDP (at Market Prices). The result was an

24 | P a g e

imposition of the exchange controls. This was the first BoP crisis, ever India faced, after

independence.

Crisis of 1966

In 1965, when India was at War with Pakistan, the US responded by suspension of aid and

refusal to renew its PL-480 agreement on a long term basis. The idea of US as well as World

Bank was to induce India to adopt a new agricultural policy and devalue the rupee. Thus, the

Rupee was devalued by 36.5% in June 1966. This was followed by a substantial rationalization

of the tariffs and export subsidies in an expectation of inflow of the foreign aid. The BoP

improved, but not because of inflow of foreign aid but because of the decline in imports.

After the 1966-67, the BoP of India remained comfortable till 1970s. The first oil shock of 1973-

74 was absorbed by the Indian Economy due to buoyant exports. After that there was an

expansion of the international trade.

Crisis of 1990-91:

BoP crisis had its origin from the fiscal year 1979-80 onwards. By the end of the 6th plan,

India’s BoP deficit (Current account) rose to Rs. 11384 crore. It was the mid of 1980s when the

BoP issue occupied the centre position in India’s macroeconomic management policy. The

second Oil shock of 1979 was more severe and the value of the imports of India became almost

double between 1978-78 and 1981-82. From 1980 to 1983, there was global recession and

India’s exports suffered during this time.

The trade deficit was not been offset by the flow of the funds under net invisibles. Apart from the

external assistance, India had to meet its colossal deficit in the current account through the

withdrawal of SDR and borrowing from IMF under the extended facility arrangement. A large

part of the accumulated foreign exchange fund was used to offset the BoP.

25 | P a g e

During the 7th plan, between 1985-86 and 1989-90, India’s trade deficit amounted to Rs. 54, 204

Crore. The net invisible was Rs. 13157 Crore and India’s BoP was Rs. 41047 Crore. India was

under a sever BoP crisis. In 1991, India found itself in her worst payment crisis since 1947. The

things became worse by the 1990-91 Gulf war, which was accompanied by double digit inflation.

India’s credit rating got downgraded. The country was on the verge of defaulting on its

international commitments and was denied access to the external commercial credit markets. In

October 1990, a Net Outflow of NRI deposits started and continued till 1991.

The only option left to fulfil its international commitments was to borrow against the security of

India’s Gold Reserves. The prime Minister of the country was Chandra Shekhar and Finance

Minister was Yashwant Sinha. The immediate response of this Caretaker government was to

secure an emergency loan of $2.2 billion from the International Monetary Fund by pledging 67

tons of India’s gold reserves as collateral. This triggered the wave of the national sentiments

against the rulers of the country. India was called a “Caged Tiger”.

On 21 May 1991, Rajiv Gandhi was assassinated in an election rally and this triggered a

nationwide sympathy wave securing victory of the Congress.

The new Prime Minister was P V Narsimha Rao, who was Minister of Planning in the Rajiv

Gandhi Government and had been Deputy Chairman of the Planning Commission. He along with

Finance Minister Manmohan Singh started several reforms which are collectively called

“Liberalization”. This process brought the country back on the track and after that India’s

Foreign Currency reserves have never touched such a “brutal” low.

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In 1991, the following measures were taken:

In 1991, Rupee was once again devaluated.

Due to the currency devaluation the Indian Rupee fell from 17.50 per dollar in 1991 to 45

per dollar in 1992.

The Value of Rupee was devaluated 23%.

Industries were delicensed.

Import tariffs were lowered and import restrictions were dismantled.

Indian Economy was opened for foreign investments.

Market Determined exchange rate system was introduced.

LERMS

In the Union Budget 1992-93, a new system named LERMS was started. LERMS stands for

“Liberalized Exchange Rate Management”. The LERMS was introduced from March 1, 1992

and under this, a system of double exchange rates was adopted.

Under LERMS, the exporters could sell 60% of their foreign exchange earning to the authorized

Foreign Exchange dealers in the open market at the open market exchange rate while the

remaining 40% was to be sold compulsorily to RBI at the exchange rates decided by RBI.

Another important features of LERMS was that the Government was providing the foreign

exchange only for most essential imports. For less important imports, the importers had to

arrange themselves from the open market.

Thus, we see that LERMS was introduced with twin objectives of building up the Foreign

Exchange Reserves and discourage imports. The Government was successful in this.

27 | P a g e

Rangarajan Panel for Correcting BoP

The Report of the High Level Committee on Balance of Payments, of which Dr. Rangarajan was

the Chairman, was submitted in June 1993. The important recommendations of this panel were

as follows:

A realistic exchange rate and a gradual relaxation of the restrictions on the current account

should go hand in hand.

Current account deficit of 1.6% of GDP should be treated as a ceiling.

Government should be cautious of extending concessions or facilities to the Foreign Investors.

The concessions were more to the foreign investors than to the domestic players.

All external debts should be pursued on a prioritized on the basis of the Use on which the debt is

to be put.

No approval should be accorded for a commercial loan which has a maturity of less than 5 years.

There should be efforts so that Debt flows can be replaced by the equity flows.

The High Level Committee on Balance of Payments, 1993, chaired by Dr. C. Rangarajan,

recommended that the RBI should target a level of reserves that took into account liabilities that

may arise for debt servicing, in addition to imports of three months.

DEVELOPMENTS IN INDIA’S BOP DURING APRIL-JUNE 2014

• India’s current account deficit (CAD) narrowed sharply to US$ 7.8 billion (1.7 per cent

of GDP) in Q1 of 2014-15 from US$ 21.8 billion (4.8 per cent of GDP) in Q1 of 2013-14.

However, it was higher than US$ 1.2 billion (0.2 per cent of GDP) in Q4 of 2013-14. The lower

CAD was primarily on account of a contraction in the trade deficit contributed by both a rise in

exports and a decline in imports.

28 | P a g e

• On a BoP basis, merchandise exports at US$ 81.7 billion increased by 10.6 per cent in Q1

of 2014-15 as against a decline of 1.5 per cent in Q1 of 2013-14.

• On the other hand, merchandise imports (on BoP basis) at US$ 116.4 billion moderated

by 6.5 per cent in Q1 of 2014-15 as against an increase of 4.7 per cent in Q1 of 2013-14. Decline

in imports was primarily led by a steep decline of 57.2 per cent in gold imports, which amounted

to US$ 7.0 billion, significantly lower than US$ 16.5 billion in Q1 of 2013-14. Notably, non-

gold imports recorded a modest rise of 1.3 per cent as against decline of 0.6 per cent in

corresponding quarter of last year reflecting some revival in economic activity.

• As a result, the merchandise trade deficit (BoP basis) contracted by about 31.4 per cent to

US$ 34.6 billion in Q1 of 2014-15 from US$ 50.5 billion in the corresponding quarter a year

ago.

• Net services receipts improved marginally in Q1 of 2014-15 on account of higher exports

of services. Net services at US$ 17.1 billion recorded a growth of 1.2 per cent in Q1 of 2014-15.

• Net outflow on account of primary income (profit, dividend and interest) amounting to

US$ 6.7 billion in Q1 of 2014-15 was higher than that of US$ 4.8 billion in the Q1 of 2013-14 as

well as in the preceding quarter (US$ 6.4 billion). In Q1 of 2014-15, gross private transfer

receipts at US$ 17.5 billion, however, were marginally lower as compared with the

corresponding quarter of 2013-14. In fact, in Q1 of 2013-14, private transfers had shown a

significant increase of around 6 per cent over the preceding quarter, possibly responding

positively to the rupee depreciation.

• In the financial account, on net basis, both foreign direct investment and portfolio

investment recorded inflows in Q1 of 2014-15. While net inflow on account of portfolio

29 | P a g e

investment was US$ 12.4 billion as against an outflow of US$ 0.2 billion in Q1 of 2013-14, net

FDI inflow was substantially higher at US$ 8.2 billion (US$ 6.5 billion in Q1 of 2013-14).

• ‘Loans’(net) availed by deposit taking corporations (commercial banks) witnessed an

outflow of US$ 2.6 billion in Q1 of 2014-15 owing to higher repayments of overseas borrowings

and a build-up of their overseas foreign currency assets. Under ‘currency & deposits’, net

inflows of NRI deposits amounted to US$ 2.4 billion in Q1 of 2014-15 as compared to US$ 5.5

billion in Q1 of 2013-14. The amount of loans (net) of other sectors (i.e., external commercial

borrowings) at US$ 1.7 billion was much higher than US$ 0.9 billion in Q1 of 2013-14. After

recording a net outflow in the three preceding quarters, net trade credits and advances recorded a

net inflow of US$ 0.2 billion albeit lower than that of US$ 2.5 billion in Q1 of 2013-14.

• On a BoP basis, there was a net accretion of US$ 11.2 billion to India’s foreign exchange

reserves in Q1 of 2014-15 as against a drawdown of US$ 0.3 billion in Q1 of 2013-14 (Table 1).

Major Items of India's Balance of Payments

(US$ Billion)

Apr-Jun 2014 (P) Apr-Jun 2013 (PR)

Credit Debit Net Credit Debit Net

A. Current Account 139.2 147.0 -7.8 130.9 152.7 -21.8

1. Goods 81.7 116.4 -34.6 73.9 124.4 -50.5

Of which:

POL 15.8 40.8 -25.0 14.2 39.2 -25.0

2. Services 37.6 20.5 17.1 36.5 19.7 16.9

3. Primary Income 2.3 9.0 -6.7 2.5 7.4 -4.8

4. Secondary Income 17.6 1.1 16.4 18.0 1.3 16.7

B. Capital Account and Financial Account

147.3 138.6 8.6 135.1 114.2 20.9

Of which:

Change in Reserve (Increase (-)/Decrease (+))

11.2 -11.2 0.3 0.3

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C. Errors & Omissions (-) (A+B)

-0.8 0.9

P: Preliminary; PR: Partially Revised

Note: Total of subcomponents may not tally with aggregate due to rounding off.

Measures of Correcting in Adverse Balance of Payment

1. Trade Policy Measures: Expanding, Exports and Restraining Imports:

Trade policy measures to improve the balance of payments refer to the measures adopted to

promote exports and reduce imports. Exports may be encouraged by reducing or abolishing

export duties and lowering the interest rate on credit used for financing exports. Exports are also

encouraged by granting subsidies to manufacturers and exporters.

Besides, on export earnings lower income tax can be levied to provide incentives to the exporters

to produce and export more goods and services. By imposing lower excise duties, prices of

exports can be reduced to make then competitive in the world markets.

On the other hand, imports may be reduced by imposing or raising tariffs (i.e., import duties) on

imports of goods. Imports may also be restricted through imposing import quotas, introducing

licenses for imports. Imports of some inessential items may be totally prohibited.

Before the economic reforms carried out since 1991 India had been following all the above

policy measures to promote exports and restrict imports so as to improve its balance of payments

position. But they had not achieved much success in their aim to correct balance of payments

disequilibrium. Therefore, India had to face great difficulties with regard to balance of payments.

31 | P a g e

At long last, economic crisis caused by persistent deficits in balance of payments forced India to

introduce structural reforms to achieve a long-lasting solution of balance of payments problem.

2. Expenditure-Reducing Policies:

The important way to reduce imports and thereby reduce deficit in balance of payments is to

adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the economy.

The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports

and help in solving the balance of payments problem.

The two important tools of reducing aggregate expenditure are the use of:

(1) Tight monetary policy and (2) Contractionary fiscal policy.

Tight Monetary Policy:

Tight monetary is often used to check aggregate expenditure or demand by raising the cost of

bank credit and restricting the availability of credit. For this bank rate is raised by the Central

Bank of the country which leads to higher lending rates charged by the commercial banks.

This discourages businessmen to borrow for investment and consumers to borrow for buying

durable consumers goods. This therefore leads to the reduction in investment and consumption

expenditure. Besides, availability of credit to lend for investment and consumption purposes is

reduced by raising the cash reserve ratio (CRR) of the banks and also undertaking of open

market operations (selling Government securities in the open market) by the Central Bank of the

country.

32 | P a g e

This also tends to lower aggregate expenditure or demand which will helps in reducing imports.

But there are limitations of the successful use of monetary policy to check imports, especially in

a developing country like India.

This is because tight monetary policy adversely affects investment increase in which is necessary

for accelerating economic growth. If a developing country is experiencing inflation, tight

monetary policy is quite effective in curbing inflation by reducing aggregate demand.

This will help in reducing aggregate expenditure and, depending on the income propensity to

import, will curtail imports. Besides, tight monetary policy helps to reduce prices or lower the

rate of inflation. Lower price level-or lower inflation rate will curb the tendency to import, both

on the part of businessmen and consumers.

But when a developing country like India is experiencing recession or slowdown in economic

growth along with deficits in balance of payments, use of tight monetary policy that reduces

aggregate expenditure or demand will not help much as it will adversely affect economic growth

and deepen economic recession. Therefore, in a developing country, monetary policy has to be

used along with other policies such as an appropriate fiscal policy and trade policy to tackle the

problem of disequilibrium in the balance of payments.

Contractionary Fiscal Policy:

Appropriate fiscal policy is also an important means of reducing aggregate expenditure. An

increase in direct taxes such as income tax will reduce aggregate expenditure. A part of reduction

in expenditure may lead to decrease in imports. Increase in indirect taxes such as excise duties

and sales tax will also cause reduction in expenditure.

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The other fiscal policy measure is to reduce Government expenditure, especially unproductive or

non-developmental expenditure. The cut in Government expenditure will not only reduce

expenditure directly but also indirectly through the operation of multiplier.

It may be noted that if tight monetary and Contractionary fiscal policies succeed in lowering

aggregate expenditure which causes reduction in prices or lowering the rate of inflation, they will

work in two ways to improve the balance of payments.

First, fall in domestic prices or lower rate of inflation will induce people to buy domestic

products rather than imported goods.

Second, lower domestic prices or lower rate of inflation will stimulate exports. Fall in imports

and rise in exports will help in reducing deficit in balance of payments.

However, it may be emphasized again that the method of reducing expenditure through

Contractionary monetary and fiscal policies is not without limitations. If reduction in aggregate

demand lowers investment, this will adversely affect economic growth.

Thus, correction in balance of payments may be achieved at the expense of economic growth.

Further, it is not easy to reduce substantially government expenditure and impose heavy taxes as

they are likely to affect incentives to work and invest and invite public protest and opposition.

We thus see that correcting the balance of payments through Contractionary fiscal policy is not

an easy matter.

3. Expenditure – Switching Policies: Devaluation:

34 | P a g e

A significant method which is quite often used to correct fundamental disequilibrium in balance

of payments is the use of expenditure-switching policies. Expenditure switching policies work

through changes in relative prices. Prices of imports are increased by making domestically

produced goods relatively cheaper.

Expenditure switching policies may lower the prices of exports which will encourage exports of

a country. In this way by changing relative prices, expenditure-switching policies help in

correcting disequilibrium in balance of payments.

The important form of expenditure switching policy is the reduction in foreign exchange rate of

the national currency, namely, devaluation. By devaluation we mean reducing the value or

exchange rate of a national currency with respect to other foreign currencies. It should be

remembered that devaluation is made when a country is under fixed exchange rate system and

occasionally decides to lower the exchange rate of its currency to improve its balance of

payments.

However, even in the present flexible exchange rate system, the value of a currency or its

exchange rate as determined by demand for and supply of it can fall. Fall in the value of a

currency with respect to foreign currencies is described as depreciation. If a country permits its

currency to depreciate without taking effective steps to check it, it will have the same effects as

devaluation.

As a result of reduction in the exchange rate of a currency with respect to foreign currencies, the

prices of goods to be exported fall, whereas prices of imports go up. This encourages exports and

discourages imports.

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With exports so stimulated and imports discouraged, the deficit in the balance of payments will

tend to be reduced. Thus policy of devaluation is also referred to as expenditure switching policy

since as a result of reduction of imports, people of a country switches their expenditure on

imports to the domestically produced goods.

It may be noted that as a result of the lowering of prices of exports, export earnings will increase

if the demand for a country’s exports is price elastic (i.e., ep > 1). And also with the rise in prices

of imports the value of imports will fall if a country’s demand for imports is elastic. If demand of

a country for imports is inelastic, its expenditure on imports will rise instead of falling due to

higher prices of imports.

This is because the demand for bulk of our traditional exports was not very elastic and also we

could not reduce our imports despite their higher prices. However devaluation of July 1991

proved quite successful as after it our exports grew at a rapid rate for some years and growth of

imports remained within safe limits.

4. Exchange Control:

Finally, there is the method of exchange control. We know that deflation is dangerous; devalu-

ation has a temporary effect and may provoke others also to devalue. Devaluation also hits the

prestige of a country.

These methods are, therefore, avoided and instead foreign exchange is controlled by the

government. Under it, all the exporters are ordered to surrender their foreign exchange to the

central bank of a country and it is then rationed out among the licensed importers. None else is

36 | P a g e

allowed to import goods without a licence. The balance of payments is thus rectified by keeping

the imports within limits.

After the Second War World a new international institution ‘International Monetary Fund (IMF)’

was set up for maintaining equilibrium in the balance of payments of member countries for a

short term. IMF also advises member countries how to correct fundamental disequilibrium in the

balance of Payments when it does arise. It may, however, be mentioned here that no country now

needs to be forced into deflation (and so depression) to root out the causes underlying disequilib-

rium as had to be done under the gold standard. On the contrary, the IMF provides a mechanism

by which changes in the rates of foreign exchange can be made in an orderly fashion.

Conclusion:

In short, correction of disequilibrium calls for a judicious combination.

No reliance can be placed on any single tool. There is room for more than one approach and for

more than one device. But the application of the tools depends on the nature of the

disequilibrium.

References/Bibliography:

en.wikipedia.org/wiki/Balance_of_payments/

www.investopedia.com/articles/03/060403.asp

www.economicshelp.org/blog/glossary/balance-payments/

Economic Survey (2013-14), http://indiabudget.nic.in

Reserve Bank of India, www.rbi.org

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