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Balance of Payments: Genesis, problems and solutions

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For cracking CAT 2012, besides preparing  two sections , it  is must for you to be well versed with  general awareness. Today you will read general awareness topic:

Balance of Payments: Genesis, problems and solutions
 
Balance of Payment (BOP) is a record of all transactions made between one particular country and all other countries during a time period. BOP compares the difference of the amount of exports and imports, including all financial exports and imports. A negative balance of payments means that more money is flowing out of the country than coming in, and vice versa. 
BOP usually composed of two sub-accounts –
 
1) Current Account
2) Capital Account
 
Current account is further divided into Balance of Trade (BOT) and Invisible account. BOT is takes into account only those transactions arising out of the exports and imports of goods (the visible items). It does not consider the exchange of services rendered such as shipping. An invisible account includes exports and imports of services.
 
The capital account of the balance of payments is record of the flow of payments between one country and other countries that result from: (1) domestic purchases of financial and physical capital from the foreign sector and (2) foreign purchases of financial and physical capital from the domestic sector. In essence, the capital account tracks investment by the domestic sector in foreign assets going in one direction and investment by the foreign sector in domestic assets going in the other direction.
 
When a country’s imports are more than that of its exports, there is a deficit in its current account which is financed by surplus on capital account. Foreign borrowings, FDIs and FII are included in the capital account and therefore, there inflow in crucial for ameliorating the BOP crisis arising due to high current account deficit (CAD). Since FDI and FII do not create debt, they are preferable mode of increasing investment. However, in recent times, Balance of trade account and CAD are exhibiting huge deficits to the tune of 8 and 4.3 percent respectively in 2011-12. Rising deficit in current account coupled with falling FDI and FII, depreciating Rupee and high rate of inflation were reason why global investment bank Morgan Stanley had warned that India faces a high risk of stress on the balance of payment. Stressed Balance of payment account of India is because of both internal and external factors.
 
No country in today’s globalized world can be fully insulated from what happens in the global economy and India is no exception to the rule. As the country is increasingly integrated into the world, it cannot remain impervious to developments abroad. The unfolding of the euro zone crisis and uncertainty surrounding the global economy have impacted the Indian economy causing drop in growth, higher current account deficit (CAD) and declining capital inflows.
 
Although, one of the measure of correcting BOP imbalance is devaluing/depreciating one’s currency which is seen in India’s case during steep depreciation of Rupee. However, in order to correct BOP imbalance permanently, structural changes and reforms are needed to be incorporated. A sharp fall in rupee value may be explained by the supply-demand imbalance in the domestic foreign exchange market on account of slowdown in FII inflows, strengthening of the US dollar in the international market due to the safe haven status of the US treasury, and heightened risk aversion and deleveraging due to the euro area crisis that impacted financial markets across emerging market economies (EMEs). Apart from the global factors, there were several domestic factors that have added to the weakening trend of the rupee, which include increasing CAD and high inflation.
 
A trade deficit of more than 8 per cent of GDP and CAD of more than 3 per cent is a sign of growing imbalance in the country’s balance of payments. There is scope therefore to discourage unproductive imports like gold and consumer goods to restore balance. In this respect, some weakening of the rupee is a positive development, as it improves trade balance in the long run by increasing export competitiveness and lowering imports. High trade and current account deficits, together with high share of volatile FII flows are making India’s BoP vulnerable to external shocks. Greater attention therefore has to be given to improving the composition of capital flows towards FDI. 
 
Today’s risk of BOP is nowhere near to the one which India faced in 1991-92 when the country was on the brink of default with a meager forex reserves. Today, India has comfortable level of reserves and 1991 type risk is unthinkable. Nevertheless, exports in June 2012 registered a decline of more than 4 percent which is indicating the need of urgent measure for further stimulating the economy.
 
Though external factors have their share in declining growth, but in view of huge domestic market, internal factors are more important than the external ones. Policy makers must not wait for another 1991 like crisis to take corrective measures and initiate them on urgent basis.   
 
Stay tuned to MBA Rendezvous and read general awareness articles.
 
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