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MBARendezvous.com -India's content lead MBA website has started series of articles to equip MBA aspirants with general awareness with the hope that you would get success in various MBA entrance exams
Following article on”Balance of Payments” is part of our series on general awareness:
Balance of Payment is the systemic record of a country’s economic transactions with the rest of the world. The balance of payment account of a country is constructed on the principle of double entry book keeping. The difference between the BoP account and the business account is that in business account, debits (-) are shown on left side and credits (+) are shown on the right side while in the BoP account, credits are shown on left side and the debits are shown on the right side.
The BoP account is divided into three categories-
3)Official Reserve Account
The current account is the account of country’s trade in the goods and services with the rest of the world and the unilateral transfers in and out of the country. The current account is further divided into trade account and invisible account. Trade account includes the trade in the tangible goods like iron and steel, automobiles, food grains, textiles etc while the invisible account includes the trade in services like transport, tourism, software, telecommunications, healthcare etc. The unilateral transfers include the payments related to the gifts, foreign aid, pension, private remittances, charitable donations etc received from foreign individuals and governments. The balance of trade account and the balance of the invisible account are collectively called as current account balance.
The capital account of a country consists of transactions in the financial assets in the form of short term and long term lending and borrowings, and private and official investments. In other words, capital account depicts the international flow of funds and investments.
The official reserve account in Bop depicts the change in the official reserves of the country during a year. In India, such reserves often called as foreign exchange reserves or forex reserves are maintained with the Reserve Bank of India. In few countries, the official reserve account is the part of capital account
It is said that the balance of payment account is always balanced but still we often hear about the countries going through the balance of payment crisis. Balance of payment account is always balanced because the deficit in the current account is financed by the surplus in the capital account. The foreign borrowings and foreign investments are regarded as the receipts in the capital account and these receipts balance the deficit in the current account. Similarly if there is a surplus in the current account, the surplus is balanced by the deficit in the capital account. But there are countries like China where both the current and the capital account have a surplus. In such cases, the BoP account is balanced by way of foreign exchange reserves where the surplus funds are parked. The surplus in both accounts leads to the swelling of forex reserves while the vice versa leads to their depletion. The persistent depletion of reserves leads to the BoP crisis and the countries in such situations are assisted by the International Monetary Fund as happened to India in 1991.
Since 1991, India’s BoP situation has consistently improved and India has accumulated the forex reserves to the tune of $300 billion. For all these 20 years after liberalisation, tha balance of trade account of India has been in deficit while the invisible account has a surplus. The mineral oil and other bulk imports are the major factors behind the deficit in trade account while the foreign remittances and software exports accounts for most of the receipts of the invisible account. Except for the years between 2001-2004,India’s deficit in trade account has been larger than the surplus in the invisible account resulting in the overall current account deficit except for the said years in the post liberalisation era. India generated a consistent capital account surplus all these years due to liberalised norms for foreign borrowings and huge FDI and FII inflows. The capital account surplus in India not only financed the current account deficit but also resulted in the accumulation of the foreign exchange reserves.
Whether the current account deficit is good or bad for the country depends on the level of the deficit and its constituents. If the current account deficit is less than 2.5 -3.0 percent of GDP, it is considered safe as the financing of such amount of deficit does not require policy reformulation and doesn’t impact the debt, exchange rate and interest rate adversely. The constituents of current account deficit or to be more precise, the constituents of imports are important factors determining the quality of current account deficit. If the trade deficit is due to the surge of luxury consumption imports, in is indeed not very beneficial for the health of the economy but if the import surge is due to the surge in demand for investment goods like capital, machinery, technology, engineering goods, it leads to the expansion of the productive capacity of the economy. In fact such type of current account deficit is considered good for a growing economy and is also a characteristic of India’s deficit.
In the fiscal year 2010-11, trade deficit rose to $130.5 billion from $118 billion in 2009-10 but in terms of GDP, it reduced from 8.6 percent of GDP to 7.2 percent of GDP. The deficit rose in absolute terms due to the rise in the world oil prices apart from the surge in the demand for the intermediate goods. In percentage terms, the deficit reduced due to the relatively higher growth of domestic GDP. In the same period, the surplus from the net invisibles rose from $80 billion to $86.2 billion. The current account deficit which includes the balance of trade account as well as invisible account was $38.4 billion in 2009-10 and rose to $44.3 billion in 2010-11. But in percentage terms, it reduced minutely to 2.6 percentage of GDP from 2.8 percent of GDP. The capital inflows increase by $59.7 billion during the same period. Out of this $59.7 billion, $44.3 billion financed the current account deficit while the $15.3 billion were added to the foreign exchange reserves. Thus in 2010-11, the net accretion to the foreign exchange reserves was comparatively lower as the increased capital inflows were absorbed to fund the current account deficit.
Though the current account deficit has not reached the level to create a panic but it is approaching towards that limit. If the current account deficit reached to the level of 4 to 5 percent of GDP, it may either lead to the depreciation of rupee, strengthening the inflationary forces or steep reduction of the forex reserves. If forex reserves got heavily depleted, economy may not cushion itself from the external shocks. Therefore policymakers must ensure that the current account deficit must be widened further. Already country is facing high inflation coupled with steep depreciation of Indian Rupee.
In the first quarter of the current fiscal year, i.e. in the months of April, May and June, exports grew by 47.1 percent and the imports grew by 33.2 percent. Thus it seems that the export sector is about to reach its pre-crisis levels. The trade deficit in the first quartile of 2011-12,rose to $35.4 billion from $32.3 billion in the corresponding period of 2010-11. Thus the increase in trade deficit is not very acute. The BoP date of the first quartile of the current fiscal doesn’t portray a very scary picture but gives the clear signs of requirement of attention. Therefore the measures to fuel the export growth must be undertaken on an urgent basis. The current fiscal has also witnessed the capital inflows lower than expected. Therefore in order to sustain the high growth of economy, reforms in every sector of economy must be undertaken as the growth with human face can be sustained in hassle free environment only.
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