Arun Jeet Balance of Payment

8/6/2019 Arun Jeet Balance of Payment

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ANANDPUR SAHIB

Seminar:

INTERNATIONAL BUSINESS

ENVIRONMENT & MANAGEMENT

SUBMITTED TO SUBMITTED BY

LECT. PARUL SHARMA GAGAN DEEP KAUR

M.B.A SEM 2

ROLL NO. 1487

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ACKNOWLEDGEMENT

First and foremost, I would like to express my sincere gratitude to my

Project Guide

LECT: PARUL SHARMA

I was privileged to experience a sustained enthusiastic & involved

interest from her side. She was always ready with a positive comment

all the time, whether it was an off-hand comment to encourage me. SHe

has taken pain to go through the project and make necessary correction

as and when needed.

And special thank to library staff who arranged a good books for us.

Last but not the least; I would like to thank the institute, in general, forextending a helping hand at every juncture of need.

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S. No. TOPICS PG.No. SIGNATURE

1. Introduction Tballance of payment 4-11

2. Eis balance of payment is always inequilibrium

11-13

3. Measuring deficit orsurplus in the

balance of payment

13-14

4. Balance of trade & balance of payment 14-15

5. CAUSE OF DISEQUILIBRIUM 16-19

6. IMPLICATIONS OF DISEQUILIBRIUM 19-20

7. MEASURES TO CORRECT DEFICIT IN

BALANCE OF PAYMENT

21-23

8. THE BALANCE OF PAYMENT STANDARD

OF LEAVIING

24-25

9. CAUSE OF BOP IN BALANCES 25-32

10. CASE STUDY 32-33

11. WHY PAKISTAN FACING DEFICIT

BALANCE OF PAYMENT

33-35

12. CONCLUSION 35

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BALANCE OF PAYMENT

MEANING

The balance of payment of the country is a systematic record of

all its economic transactions with the outside world in a given

year. It is the Statistical record of the character and dimensions of

the countrys economic relationships with the rest of the world.

According to Bo Sodersten,

The balance of payment is merely the way of Listing

receipts and payments in the international transactions for a

country.

According to B.J. Cohen,

It shows countries trading position, changes in its net

Position as foreign lender or borrower, and changes in its official

reserve holding.

STRUCTURE OF BALANCE OF PAYMENT ACCOUNTS

The balance of payments account of a country is constructed on

the principles of double-entry book-keeping. Each transaction is

entered on the credit and the debit side of the balance sheet. But

balance of payment accounting differs from business accounting

in one respect:

In Business accounting, (-) debits are shown on the left side and

(+) credits are shown on the right side of the balance sheet.

Whereas, in balance of payment accounting, the practice is to

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show credits on the left side and debit in the right side of the

balance sheet.

When a payment is received from a foreign country, it is a

credit transaction while Payment to a foreign country is a debittransaction.

The principal items shown on the credit side (+) are exports of

goods and services, unrequited (or transfer) receipts in the form

of gifts, grants etc from foreigners, borrowings from abroad,

investments by foreigners in the country and official sale of

receiver assets including gold to foreign countries and

international agencies. The principal items on the Debit side (-)

include imports of goods and services transfer (or unrequitedpayments to foreigners as gifts, grants, etc., leading to foreign

countries investments by residents to foreign countries and

official purchase of reserve assets or Gold from foreign countries

and international agencies.

These credit and debit items are shown vertically in the balance

of Payments account of country according to the principle of

double-entry book-keeping. Horizontally, they are divided into

three categories:

The Current account, the Capital account, and the Official

settlement account or the official reserve assets account.

The balance of payment of the country is constructed as:

CREDITS (+)DEBITS (-)

1.Current Account

Exports Imports

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Goods (a) Goods

Services (b) Services

Transfer Payments (c) Tran

Payments

2.Capital Account

(a)Borrowing from Foreign (a) Lending toForeign Countries.

Countries.

(b)Direct Investments by (b) Directinvestment in Foreign

Foreign Countries. Countries.

3.Official Settlement Account

Increase in Foreign (a) Increase inOfficial Reserve of

Official Holdings Gold and Foreign

Currencies.

1. CURRENT ACCOUNT: The current account of a countryconsists of all transactions relating to trade in goods and services

and unilateral transfers. Service transactions include costs of

travel and transportation, insurance, income and payments of

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foreign investments ect. Transfer payments relate to gifts, foreign

aid, pensions, private remittances, charitable donations, ect.

Received from foreign individuals and governments to foreigners.

In the current account, merchandise exports and

imports are the most important items. Exports are shown as a

positive item and are calculated f.o.b. (free from board) which

means that cost of transportation, insurance, etc. are excluded.

On the other side, imports are shown as a negative item and are

calculated in which costs, insurance and fright are included. The

difference between imports and exports of the country is its

balance of visible trade or merchandise trade or simply balance of

trade. If visible exports exceed visible imports, the balance of

trade is favourable. In the opposite case when imports exceed

exports, it is unfavourable.

It is, however, services and transfer payments or

invisible items of the current account that reflect the true picture

of the balance of payment account. The balance of exports and

imports of the services and transfer payments is called the

balance of invisible trade. The invisible items along with the

visible items determine the actual current account position. If

exports of goods and services exceed imports of goods and

services, the balance of payments is said to be favourable. In the

opposite case, it is unfavourable.

In the current account, the exports of goods and services and thereceipts of transfer payments are entered as (+) because they

represent receipts from foreigners. On the Other hand, the

imports of goods and services and grant of transfer payments to

foreigners are entred as debit (-) because they represent

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payments to foreigners. The net value of these visible and

invisible trade balances is the balance on current account.

2. CAPITAL ACCOUNT: The capital account of a countryconsists of its transactions in financial assets in the form of short-

term and long-term lendings and borrowings, and private and

official investments. In other words, the capital account showsinternational flow of loans and investments and represents a

change in the countrys foreign assets and liabilities. Long term

capital transactions relate to international capital movements

with maturity of one year or more and include direct investments

like building of a foreign plant, portfolio investment like purchase

of foreign bonds and stocks, and international loans. On the other

hand, short term international capital transactions are for a period

ranging between 3 months and less than 1 year.

There are two types of transactions in the capital account-

private and government. Private transactions include all types of

investments: direct, portfolio and short-term. Government

transactions consist of loans to and from foreign official agencies.

In the Capital account, borrowings from foreign countries

and direct investment by foreign countries represent capitalinflows. They are positive items or credits because these are

receipts from foreigners. On the other hand, lending to foreign

countries and direct investments in foreign countries represent

capital outflows. They are negative items or debits because they

are payments to foreigners. The net value of the balance of short-

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term and long-term direct and portfolio investments is the

balance on capital account.

Sodersten and Reed refer to the external wealth account of a

country which shows the stocks of foreign assets held by thecountry(positive items) and of domestic assets held by foreign

investors (liabilities or negative item). The net value of a

countrys assets and liabilities is its balance of indebtedness. If its

assets are more than its liabilities, then it is a net creditor. If its

liabilities are more than its assets, then it is a net debtor.

BASIC BALANCE. The sum of current account and capitalaccount is known as the basic balance.

3.THE OFFICIAL SETTLEMENTS ACCOUNT: The officialsettlements account or official reserve assets account is, in fact, a

part of the capital account. But the U.K. and U.S. balance of

payments accounts shows it as a separate account. The official

settlement account measures the change in nations liquidity andnon-liquid liabilities to foreign official holders and the change in a

nations official reserve assets during the year. The official

reserve assets of a country include its Gold stock, holdings of its

convertible foreign currencies and SDRs, and its net position in

the IMF. It shows transactions in a countrys net official reserve

assets.

Errors and Omissions. Errors and omissions is a balancingitem so that total credits and debits of the three accounts must

equal in accordance with the principles of double entry book-

keeping so that the balance of payments of a country always

balances in the accounting sense.

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Standard definitionSince 1974, the two principal divisions on the BOP have been

the current account and the capital 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 payments for

imports) , factor income (earnings on foreign investments

payments made to foreign investors) and cash transfers. Its

called the current account as it covers transactions in the "here

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

The capital account records the net change in ownership of

foreign assets. It includes the reserve account (the international

operations of a nation's central bank), along with loans and

investments between the country and the rest of world (but not

the future regular repayments / dividends that the loans and

investments yield, those are earnings and will be recorded in the

current account).

Expressed with the standard meaning for the capital account, the

BOP identity is:

BOP = Current account Capital account +- Balancing

item

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http://en.wikipedia.org/wiki/Current_accounthttp://en.wikipedia.org/wiki/Capital_accounthttp://en.wikipedia.org/wiki/Balance_of_tradehttp://en.wikipedia.org/wiki/Factor_incomehttp://en.wikipedia.org/wiki/Transfer_paymentshttp://en.wikipedia.org/wiki/Capital_accounthttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Accounting_identityhttp://en.wikipedia.org/wiki/Capital_accounthttp://en.wikipedia.org/wiki/Balance_of_tradehttp://en.wikipedia.org/wiki/Factor_incomehttp://en.wikipedia.org/wiki/Transfer_paymentshttp://en.wikipedia.org/wiki/Capital_accounthttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Accounting_identityhttp://en.wikipedia.org/wiki/Current_account


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The balancing item is simply an amount that accounts for any

statistical errors and assures that the current and capital

accounts sum to zero. At high level, by the principles ofdouble

entry accounting, an entry in the current account gives rise to an

entry in the capital account, and in aggregate the two accounts

should balance. A balance isn't always reflected in reported

figures, which might, for example, report a surplus for accounts,

but when this happens it always means something has been

missedmost commonly, the operations of the country's central

bank.

An actual balance sheet will typically have numerous sub

headings under the principal divisions. For example, entries

under Current account might include:

Trade buying and selling of goods and services

Exports a credit entry

Imports a debit entry

Trade balance the sum of Exports and Imports

Factor income repayments and dividends from loans and

investments

Factor earnings a credit entry

Factor payments a debit entry

Factor income balance the sum of earnings and

payments.

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Especially in older balance sheets, a common division was

between visible and invisible entries. Visible trade recorded

imports and exports of physical goods (entries for trade in

physical goods excluding services is now often called the

merchandise balance). Invisible trade would record international

buying and selling of services, and sometimes would be grouped

with transfer and factor income as invisible earnings.

IS BALANCE OF PAYMENTS ALWAYS IN

EQUILIBIRIUM?

Balance of payments always balances means that algebraic sum of the net. Credit

and debit balances of current account, capital account and official settlements

account must equal zero. Balance of payments is written as

B=R-P

Where, B represents balance of payments,

R receipts from foreigners,

P payments made to foreigners.

When B=R-P=0, the balance of payments is in the equilibrium.

When R-P>0, it implies receipts from foreigners exceed payments made to

foreigners and there is surplus in the balance of payments. On the other hand, when

R P < 0 or R < P there is deficit in the balance of payments as the payments made

to foreigners exceed receipts from foreigners.

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If net foreign lending and investment abroad are taken, a flexible exchange rate

creates an excess of exports over imports. The domestic currency depreciates in

terms of other currencies. The exports become cheaper relatively to imports. It can

be shown in equation form:

X + B = M + I

Where X represents exports, M imports, I foreign investment, B foreign borrowing

Or X M = I B

Or (X M) (I B) = 0

The equation shows the balance of payments in equilibrium. Any positive

balance in its current account is exactly offset by negative balance on its capital

account and vice versa. In the accounting sense, the balance of payments always

balances. This can be shown with the help of the following equations:

C + S + T = C + I + G + (X M)

Or Y = C + I + G + (X - M)

Where C represents consumption expenditure, S domestic saving, T tax receipts, I

investment expenditures, G government expenditures, X exports of goods and

services, and M imports of goods and services.

In the above equation

C+S+T is GNI or national income (Y), and

C+I+G = A

Where A is called absorption.

In the accounting sense, total domestic expenditures (C+I+G) must equal current

income (C+S+T) that is A=Y. Moreover, domestic saving (S) must equal domestic

investment (I). Similarly, an export surplus on current account (X>M)

Must be offset by an excess of domestic savings over investments (S>I). Thus the

balance of payment always balances in the accounting sense, according to the basic

principals of accounting. In the accounting system, the inflow and the outflow of

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the transactions are recorded on the credit and debit side respectively. Therefore,

debit and credit side always balance. If there is a deficit in the current account, it is

offset by a matching surplus in the capital account by borrowings from abroad

or/and withdrawing out of its gold and foreign exchange reserves, and vice versa.

Thus, the balance of payments always balances in this sense also.

MEASURING DEFICIT OR SURPLUS IN THE BALANCE OF

PAYMENTS

If the balance of payment always balances, then why a deficit or surplus do does

arises in the balance of payment of the country? It is only when all items in the

balance of payments are included that there is no possibility of a deficit or surplus.

But if some items are excluded from a countrys balance of payments and then a

balance is struck, it may show a deficit or surplus.

There are three ways of measuring deficit or surplus in the balance of

payments.

First, there is the basic balance which includes the current account balance and

the long-term capital account balance.

Second, there is the net liquidity balance which includes the basic balance andthe short-term private non-liquid capital balance, allocation of SDRs, and errors

and omissions.

Third, there is the official settlement balance which includes the total net liquid

balance and short-term private liquid capital balance.

If the total debits are more than total credits in the current and capital accounts,

including errors and omission, the net debit balance measures the deficits in the

balance of payments of a country. This deficit can be settled with an equal amount

of the net credit balance in the official settlements account. On the countrary, iftotal credits are more than debit in the current and capital accounts, including

errors and omissions, the net debit balance measure the surplus in the balance of

payments of a country. This surplus can be settled with an equal amount of net

debit balance in the official settlements account.

The relationship between these balances is summarised in

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TABLE 2

Trade balance ..a

Transfer payments balance.......b Autonomous

Current Account Balance...c (= a+b) Items

BALANCE OF TRADE AND BALANCE OF PAYMENTS

The balance of a country is a systematic record of its receipts and payments in

international transactions in a given year. Each transaction is entered on the credit

and debit side of the balance sheet. The principal items on the credits side are:

(1) Visible exports which relate to the goods exported for which the country

receives payments.

(2) Invisible exports which refer to the services rendered by the country to other

countries. Such services consist of banking, insurance, shipping and other services

rendered in the form of technical know-how, etc., money spent by tourists and

students visiting the country for travel and education, etc.

(3) Transfer receipts in the form of gifts received from foreigners.

(4) Borrowings from abroad and investments by foreigners in the country.

(5) The official sale of reserve assets including gold to foreign countries and

international institutions.

The principal items on the debits side are:

(1) Visible imports relating to goods imported for which the country makes

payments to foreign countries.

(2) Invisible imports in the form of payments made by the home country for

services rendered by foreign countries.

(3) Transfer payments to foreigners in the form of gifts ect.

(4) Loans to foreign countries, investments by residents in foreign countries, and

debt repayments to foreign countries.

(5) Official purchase of reserve assets or gold from foreign countries and

international institutions.

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If the total receipts from foreigners on the credit side exceed the total payments to

foreigners on the debit side, the balance of payments is said to befavourable.

On the Other hand, if the total payments to foreigners exceed the total receipts

from foreigners, the balance of payment is Unfavourable.

The balance of trade is the difference between the value of goods and services

exported and imported. In contains the first two items of the balance of payment

account on the credit and debit side. This is known as Balance of Payment on

Current account. Some writers define the balance of trade as the difference

between the value of merchandise exports and imports. Prof. Meade regards this

way of defining the balance of trade as wrong and of minor economic significance

from the point of view of the national income of the country. In equation form, the

balance of payments of Y=C+I+G+(X-M) which includes all transactions which

give rise to or exhaust national income. In the equation, Y refer to national income,

C to consumption expenditure, I to investment expenditure, G to governmentexpenditure, X to exports of goods and services and M to imports of goods and

services. The expression (X-M) denotes the balance of trade. If the difference

between X and M is Zero, the balance of trade balances. If X is Greater than M, the

balance of Trade is favourable, or there is Surplus balance of trade. On the other

hand, if X is less than M, the balance of trade is in deficit or is unfavourable.

DISEQUILIBRIUM IN BALANCE OF PAYMENTS

Disequilibrium in the BOP of a country may be either a deficit or a

Surplus. A deficit or surplus in BOP of a Country appears when it

autonomous receipts (Credits) dont match its autonomous

payments (debits). If autonomous credit receipts exceed

autonomous debits payments, there is a Surplus in a BOP and the

disequilibrium is said to be favourable. On the other hand, if

autonomous debits and payments exceed autonomous creditreceipts, there is a deficit in the BOP and the disequilibrium is

Said to be Unfavourable or adverse.

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CAUSES OF DISEQULIBRIUM

There are many factors that may lead to a BOP deficit or

surplus:

Temporary Changes.(Or Disequilibrium).There may bea temporary disequilibrium caused by random variations in

trade, seasonal fluctuations, the effects of weather on

agricultural production, etc. Deficits or surpluses arising from

such temporary causes are expected to correct themselveswithin a short time.

Fundamental Disequilibrium.Fundamentaldisequilibrium refers to persistent and long run BOP

disequilibrium of a country. It is a chronic BOP deficit,

according to IMF. It is caused by such dynamic factors as:

Changes in consumer taste within the country or

abroad which reduces the countrys exports andincreases its imports.

Continuous fall in the countrys foreign exchange

reserves due to supply inelasticity of exports and

excessive demand for foreign goods and services.

Excessive capital outflows due to massive imports of

capital goods, raw materials, essential consumer goods,

technology and external indebtedness.

Low competitive strength in world markets which

adversely affect exports.

Inflationary pressures within the economy which make

exports dearer.

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3. Structural changes (or Disequilibrium). Structuralchanges bring about disequilibrium in BOP Over the long run.

They may result from the following factors: (a) technologicalchanges in method of production of products in domestic

industries or in the industries of other countries. They lead to

changes in costs, prices and quality of products. (b) Import

restrictions of all kinds bring about disequilibrium in BOP.

(c)Deficit in BOP also arises when a country suffers from

deficiency of resources which it is required to import from other

countries. (d) Disequilibrium in BOP may also be caused by

changes in the in the supply or direction of long-term capital

flows. More and regular flow of long=term capital may lead to

BOP surplus, while an irregular and short supply of capital brings

BOP deficit.

4. Changes in Exchange Rates. Changes in foreignexchange rate in the form of overvaluation or undervaluation of

foreign currency lead to BOP disequilibrium. When a value of

currency is higher in relating to other currencies, it is said to be

overvalued. Opposite is the case of an undervalued currency.

Overvaluation of the domestic currency makes foreign goods

cheaper and export dearer in foreign countries. As a result, the

country imports more and exports less of goods. There is also out

flow of capital. This leads to unfavourable BOP. On the contrary,

undervaluation of the currency makes BOP favourable for the

country by encouraging exports and inflow of capital and reducing

imports.

5. Cyclical fluctuation (or disequilibrium). Cyclicalfluctuation in business activities also lead to BOP disequilibrium.

When there is depression in a country, volumes of both exports

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and imports fall drastically in relation to other countries. But the

fall in exports may be more than that of imports due to decline in

domestic production. Therefore, there is an adverse BOP

situation. On the other hand, when there is boom in a country in

relation to other countries, both export and import may increase.But there can be either a deficit or surplus in BOP situation

depending upon whether the country exports more than imports

or imports more than exports. In both the cases, there will be

disequilibrium in BOP.

6. Changes in national income. Another case in the

change in the countrys national income. If the national income ofa country increases, it will lead to an increase in imports thereby

creating a deficit in its balance of payments, other things

remaining the same. If the country is already at full employment

level, an increase in income will lead to inflationary rise in prices

which may increase its imports and thus bring disequilibrium in

the balance of payments.

7. Price changes. Inflation or deflation is another cause ofdisequilibrium in the balance of payments. If there is inflation in

the country, prices of exports increase. As a result, exports fall. At

the same time, the demand for imports increases. Thus increase

in exports prices leading to decline in exports and rise in imports

results in adverse balance of payments.

8. Stage of Economic Development. A countrys balanceof payments also depends on its stage of economic development.

If a country is developing, it will have a deficit in its balance of

payment because it imports raw material, machinery, capital

equipment, and services associated with the development

process and exports primary products. The country has to pay

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more for costly imports and gets less for its cheap exports. This

leads to disequilibrium in its balance of Payments.

9. Capital Movements. Borrowings and lendings ormovements of capital by countries also results in disequilibrium in

BOP. A country which gives loans and grants on a large scale to

other countries has a deficit in its BOP on capital account. If it is

also importing more, as is the case with the USA, it will have

chronic deficit. On the other hand, a developing country

borrowing large fund from other countries and international

institutions may have a favourable BOP. But such a possibility is

remote because these countries usually imports huge quantise offood, raw materials, capital goods, etc. and exports primary

products. Such borrowings simply help in reducing BOP deficit.

10. Political conditions. Political condition of a country isanother cause of disequilibrium in BOP. Political instability in a

country creates uncertainty among foreign investors which leads

to the outflow of capital and retards its inflow. This causesdisequilibrium in BOP of the country. Disequilibrium in BOP also

occurs in the events of war with some other country.

Implications of Disequilibrium

A disequilibrium in the balance of payments whether a deficit or

surplus has important implications for a country.

A deficit in the combined current and capital accounts is

regarded as undesirable for the country. This is because such a

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deficit has to be covered by borrowing from abroad or attracting

foreign exchange or capital from abroad. This may require paying

high interest rates. There is also the danger of withdrawing

money by foreigners as happened in the case of the Asian crisis in

the late 1990s. An alternative may be to draw on the reserves ofthe country which may also lead to a financial crisis. Moreover,

the reserves of a country being limited, they can be used to pay

for BOP deficit up to a limit.

But the above analysis of a combined current and capital

account deficit is not correct in practice. The reason being that a

current account deficit is the same thing as a capital account

surplus. However, it is beneficial for a country to have a current

account deficit even if it equals capital account surplus in BOP. In

the short run, the country may benefit from a higher level of

consumption through import of goods and consequently a higher

standard of living. But the excess of imports over exports may be

financed by foreign investments in the country. These may lead

to increase production, employment and income in the country. In

the long run, foreign investors may purchase large assets in the

country and thus adversely affect domestic industry as in the

case with MNCs (multinational corporations).

The current account deficit in BOP of a country may have either

good or bad effects depending on the nature of an economy.

Take a country where domestic industries are rapidly growing

and it has current account BOP deficit. Theses industries offer a

high rate of return on their investment. This would, in return,

attract foreign investments. As a result, the country would have a

capital account surplus due to the inflow of capital and a currentaccount deficit. This current account deficit is good for the

economy. No doubt, the external debt of the country increases,

but this debt is being utilised to finance the rapid growth of the

economy. The real burden of this debt will be very low because it

can be repaid out of higher income in the future.

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On the contrary, a country having a inefficient and unproductive

domestic industry will be adversely affected by its current

account BOP deficit. The country borrows from abroad to finance

the excess of spending over consumption. To attract foreign

borrowings the country will have to pay high interest rates. Thesewill increase the money burden of the debt. The real burdens of

the debt swill also increase because of the low productive

capacity of domestic industries. If the current consumption is

being financed by foreign borrowings, the wealth of the economy

will decline. This, in turn, will lead to either a reduction in

domestic expenditure or a change in government policy so as to

control the rising debt.

On the other hand if foreign borrowings are being used

to finance real investment, the current account BOP deficit will be

beneficial for the economy. A higher rate of return on real

investment than the interest on foreign borrowings would

increase the countries wealth over time through arises in its

national income. Thus a current account BOP deficit is not always

undesirable for a country.

MEASURES TO CORRECT DEFICIT IN BALANCEOF

PAYMENTS

When there is a deficit in the balance of payments of a country, adjustment

is brought about automatically through price and income changes or by

adopting certain policy measures like export promotion, monetary and fiscal

policies, devaluation and direct controls. We study these as follows:

1. Adjustment through Exchange Depreciation (Price Effect)

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Under flexible exchange rates, the disequilibrium in the

balance of payments is automatically solved by the forces of

demand and supply for foreign exchange. An exchange rate is

price of a currency which is determined, like any other

commodity, by demand and supply. The exchange rate varieswith varying supply and demand conditions, but it is always

possible to find an equilibrium exchange rate which clears the

foreign exchange market and creates external equilibrium. This

is automatically achieved by depreciation of a countrys currency

in case of deficit in its balance of payments. Depreciation of a

currency means that its relative value decreases. Depreciation

has the effect of encouraging exports and discouraging imports.

When exchange depreciation takes place, foreign prices aretranslated in domestic prices. Suppose the dollar depreciates in

relation to the pound. It means that the price of dollar falls in

relation to the pound. It means that the price of dollar falls in

relation to the pound in the foreign exchange market. This leads

to the lowering of the prices of U.S. exports in Britain and raising

of the prises of British imports in the U.S. When import prices are

higher in the U.S., the Americans will purchase less goods from

the Britishers. On the other hand, lower prices of U.S. exports willincrease exports and diminish imports, thereby bringing

equilibrium in the balance of payments.

2. Devaluation or Expenditure-Switching Policy

Devaluation raises the domestic price of imports and

reduces the foreign price of exports of a country devaluing its

currency in relation to the currency of another country.

Devaluation is referred to as expenditure switching policybecause it switches expenditure from imported to domestic goods

and services. When a country devalues its currency, the price of

foreign currency increases which makes imports dearer and

exports cheaper. This causes expenditure to be switches from

foreign to domestic goods as the countrys exports rise and the

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country produces more to meet the domestic and foreign demand

for goods with reduction in imports. Consequently, the balance of

payments deficit is eliminated.

Direct Controls

To correct disequilibrium in the balance of

payments, government also adopts direct controls which aim at

limiting the volume of imports. The government restricts the import

of undesirable or unimportant items by levying heavy import duties,

fixation of quotas, etc. At the same time, it may allow imports of

essential goods duty free or at lower import duties, or fix liberalimport quotas for them. For instance, the government may allow

free entry of capital goods, but impose heavy import duties on

luxuries. Import quotas are also fixed and the importers are

required to take licenses from the authorities in order to import

certain essential commodities in fixed quantise. In these ways,

imports are reduced in order to correct an adverse balance of

payments. The government also imposes exchange control and

regulate the foreign exchange. With reduction in imports and

control of foreign exchange, visible and invisible imports are

reduced. Consequently, an adverse balance of payment is

corrected.

Adjustment through Capital Movements

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A country can use capital imports to correct a deficit in its

balance of payments. A deficit can be financed by capital inflows.

When capital is perfectly mobile within countries, a small rise in the

domestic rate of interest brings a large inflow of capital. The

balance of payments is said to be in equilibrium when the domesticinterest rate equals the world rate. If the domestic interest rate is

higher than the world rate, there will be capital inflows and the

balance of payments deficit is corrected.

Adjustment through income changes

Given the foreign exchange rate and prices in a country,

an increase in the value of exports, causes an increase in the

incomes of all persons associated with the export industries.

These, in turn, create demand for other goods and services within

the country. This will raise the income of the persons engaged in

the latter industries and services. This process will continue and

the national income increases by the value of the multiplier.

Stimulation of Exports and Import Substitutes

A deficit in the balance of Payments can also be corrected

by encouraging exports. Exports can be encouraged by producing

quality products, by increasing exports through increased

production and productivity, and by better marketing. They canalso be increased by the balanced policy of import substitution. It

means that the country produces those goods which it imports. In

the beginning, imports are reduced by in the long run exports of

such goods start. An increase in exports causes the national

income to rise by many times through the operation of the foreign

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trade multiplier. The foreign trade multiplier expresses the

change in income caused by a change in exports. Ultimately, the

deficit in the balance of payments is removed when exports rise

faster than imports.

The Balance of Payments and the

Standard of Living

A common misconception is that balance of payments deficits are always bad forthe economy. This is not necessarily true. In the short term if a country is

importing a high volume of goods and services this is a boost to living standards

because it allows consumers to buy more consumer durables. However, in the long

term if the trade deficit is a symptom of a weak economy and a lack of

competitiveness then living standards may decline.

Imbalances

While the BOP has to balance overall, surpluses or deficits on its

individual elements can lead to imbalances between countries. In

general there is concern over deficits in the current

account. Countries with deficits in their current accounts will build

up increasing debt and/or see increased foreign ownership of

their assets. The types of deficits that typically raise concern are :

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A visible trade deficitwhere a nation is importing more

physical goods than it exports (even if this is balanced by the

other components of the current account.)

An overall current account deficit.

A basic deficitwhich is the current account plus foreign

direct investment (but excluding other elements of the capital

account like short terms loans and the reserve account.)

As discussed in the history section below, the Washington

Consensus period saw a swing of opinion towards the view that

there is no need to worry about imbalances. Opinion swung back

in the opposite direction in the wake offinancial crisis of 2007

2009. Mainstream opinion expressed by the leading financial

press and economists, international bodies like the IMFas well

as leaders of surplus and deficit countrieshas returned to the

view that large current account imbalances do matter. Some

economists do, however, remain relatively unconcerned about

imbalancesand there have been assertions, such as by Michael P.

Dooley, David Folkerts-Landau and Peter Garber, that nations

need to avoid temptation to switch to protectionism as a means

to correct imbalances.

Causes of BOP imbalances

There are conflicting views as to the primary cause of BOP

imbalances, with much attention on the US which currently has by

far the biggest deficit. The conventional view is that current

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account factors are the primary cause - these include the

exchange rate, the government's fiscal deficit, business

competitiveness , and private behaviour such as the willingness of

consumers to go into debt to finance extra consumption. An

alternative view, argued at length in a 2005 paper by Ben

Bernanke , is that the primary driver is the capital account, where

a global savings glut caused by savers in surplus countries, runs

ahead of the available investment opportunities, and is pushed

into the US resulting in excess consumption and asset price

inflation.

Reserve asset

The US dollar has been the leading reserve asset since the end ofthe gold standard.

In the context of BOP and international monetary systems, the

reserve asset is the currency or other store of value that is

primarily used by nations for their foreign reserves. BOP

imbalances tend to manifest as hoards of the reserve asset being

amassed by surplus countries, with deficit countries building

debts denominated in the reserve asset or at least depleting their

supply. Under a gold standard, the reserve asset for all members

of the standard is gold. In the Bretton Woods system , either gold

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is typically mostly derived domestically but their debts are often

denominated in a reserve currency. Once the nation's

government has exhausted its foreign reserves trying to support

the value of the domestic currency, its policy options are very

limited. It can raise its interest rates to try to prevent further

declines in the value of its currency, but while this can help those

with debts in denominated in foreign currencies, it generally

further depresses the local economy.

Balancing mechanisms

One of the three fundamental functions of an international

monetary system is to provide mechanisms to correct

imbalances.

Broadly speaking, there are three possible methods to correct

BOP imbalances, though in practice a mixture including some

degree of at least the first two methods tends to be used. These

methods are adjustments of exchange rates; adjustment of a

nations internal price along with its levels of demand; and rules

based adjustment. Improving productivity and hence

competitiveness can also help, as can increasing the desirability

of exports through other means, though it is generally assumed a

nation is always trying to develop and sell its products to the best

of its abilities.

Rebalancing by changing the exchange rate:

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An upwards shift in the value of a nation's currency relative to

others will make a nation's exports less competitive and make

imports cheaper and so will tend to correct a current account

surplus. It also tends to make investment flows into the capital

account less attractive so will help with a surplus there too.

Conversely a downward shift in the value of a nation's currency

makes it more expensive for its citizens to buy imports and

increases the competitiveness of their exports, thus helping to

correct a deficit (though the solution often doesn't have a positive

impact immediately due to the Marshall.

Exchange rates can be adjusted by government in a rules based

or managed currency regime, and when left to float freely in the

market they also tend to change in the direction that will restore

balance. When a country is selling more than it imports, the

demand for its currency will tend to increase as other countries

ultimately need the selling country's currency to make paymentsfor the exports. The extra demand tends to cause a rise of the

currency's price relative to others. When a country is importing

more than it exports, the supply of its own currency on the

international market tends to increase as it tries to exchange it

for foreign currency to pay for its imports, and this extra supply

tends to cause the price to fall. BOP effects are not the only

market influence on exchange rates however; they are also

influenced by differences in national interest rates and by

speculation.

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Rebalancing by adjusting internal prices anddemand:

When exchange rates are fixed by a rigid gold standard, or when

imbalances exist between members of a currency union such asthe Euro zone, the standard approach to correct imbalances is by

making changes to the domestic economy. To a large degree, the

change is optional for the surplus country, but compulsory for the

deficit country. In the case of a gold standard, the mechanism is

largely automatic. When a country has a favourable trade

balance, as a consequence of selling more than it buys it will

experience a net inflow of gold. The natural effect of this will be to

increase the money supply, which leads to inflation and an

increase in prices, which then tends to make its goods less

competitive and so will decrease its trade surplus. However the

nation has the option of taking the gold out of economy

(sterilising the inflationary effect) thus building up a hoard of gold

and retaining its favourable balance of payments. On the other

hand, if a country has an adverse BOP its will experience a net

loss of gold, which will automatically have a deflationary effect,

unless it chooses to leave the gold standard. Prices will be

reduced, making its exports more competitive, and thus

correcting the imbalance. While the gold standard is generally

considered to have been successful up until 1914, correction by

deflation to the degree required by the large imbalances that

arose after WWI proved painful, with deflationary policies

contributing to prolonged unemployment but not re-establishing

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balance. Apart from the US most former members had left the

gold standard by the mid 1930s.

A possible method for surplus countries such as Germany to

contribute to re-balancing efforts when exchange rate adjustment

is not suitable is to increase its level of internal demand (i.e. its

spending on goods). While a current account surplus is commonly

understood as the excess of earnings over spending, an

alternative expression is that it is the excess of savings over

investment. That is:

Where CA = current account, NS = national savings (private plus

government sector), NI = national investment.

If a nation is earning more than it spends the net effect will be to

build up savings, except to the extent that those savings are

being used for investment. If consumers can be encouraged to

spend more instead of saving; or if the government runs a fiscal

deficit to offset private savings; or if the corporate sector divert

more of their profits to investment, then any current account

surplus will tend to be reduced. However in 2009 Germany

amended its constitution to prohibit running a deficit greater than

0.35% of its GDP and calls to reduce its surplus by increasing

demand have not been welcome by officials, adding to fears that

the 2010s will not be an easy decade for the euro zone. In

theirApril 2010 world economic outlook report, the IMF presented

a study showing how with the right choice of policy options

governments can transition out of a sustained current account

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surplus with no negative effect on growth and with a positive

impact on unemployment.

Rules based rebalancing mechanisms

Nations can agree to fix their exchange rates against each other,

and then correct any imbalances that arise by rules based and

negotiated exchange rate changes and other methods. The

Bretton Woods system of fixed but adjustable exchange rates was

an example of a rules based system, though it still relied primarilyon the two traditional mechanisms. Keynes, one of the architects

of the Bretton Woods system had wanted additional rules to

encourage surplus countries to share the burden of rebalancing,

as he argued that they were in a stronger position to do so and as

he regarded their surpluses as negative externalities imposed

on the global economy. Keynes suggested that traditional

balancing mechanisms should be supplemented by the threat of

confiscation of a portion of excess revenue if the surplus country

did not choose to spend it on additional imports. However his

ideas were not accepted by the Americans at the time. In 2008

and 2009, American economist Paul Davidson had been

promoting his revamped form of Keynes's plan as a possible

solution to global imbalances which in his opinion would expand

growth all rounds without the downside risk of other rebalancing

methods.

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CASE STUDY: Recently

Balance of Payment is the difference between Current Accountand Capital account of a country. The Current Account furtherincludes Trading Account, Service Account, Income Account andunilateral transfers and other related items. The Capital accountincludes Loan transactions, inward or outward Investments, short-term capital and other related items. The actual figures forbalance of payment can be obtained at the year end therefore itis projected based on the previous data and assisting facts andfigures.

Pakistans current account balance in the fiscal year 2008-2009was USD 8,547 unfavourable, debit or negative. In the same yearthe capital and financial account balance was USD 3,608favourable or positive which lead to the Balance of payment to beUSD 4,939 deficit. In fiscal year 2009-10, current account balanceis projected to be USD 4,911 unfavourable or negative. Thismeans that we are going to face deficit balance of payment thisyear as well.

Why Pakistan is facing deficit balance ofpayment?

The major reason is and has always been the imports ofluxurious and high cost goods for the elite class of the countrythat increases the import bill to the dangerous level where ason the other hand the exports are on decreasing day by day.

The textile industry was the backbone of our exports but nowits suffering from various crises among them the power crisissthe major issue.

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Apart from import bill, the global recession in the recent yearhas severely affected the business and trade all over the worldwhich also affected Pakistan.

The investments in the country have declined to the lowestand the major reason is the law and order situation prevailingin the country. The self-imposed war against terrorism hasmade our situation worse as no one is willing to makeinvestments in the country.

The local industry is facing hard times as we dont havesufficient energy resources available. It has decreased theproduction of goods and ultimately we have to buy them fromother countries which add to our import bill and increase thesupply of our currency.

Pakistan is agriculture based country and we have one of thefinest and largest canal system. But would you believe that we

need to import sugar, wheat and other basic crops to meet thedemand in the country? In recent year Pakistan needed toimport tons of sugar and wheat just because of themismanagement of resources and water shortage created byIndia by building dams on rivers which are flowing towardsPakistan.

Energy crisis needs to be separately mentioned because it not

only affected the Textile industry but overall the economicactivities in the country are paralyzed. And we need to putsome serious efforts to eliminate it otherwise theconsequences will be dangerous.

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Political instability in the country has always affected thegrowth of the country and it does affect the trade andultimately the current account of the country.

The government policies are the tools to take correctiveactions to make the things stable and on the track but wrongpolicies may lead to adverse affects. We have been lacking ingood policies regarding the economy of the country.

Inflation, as weve discussed in class is a factor which affectnot only the trade but the foreign exchange as well. The

increasing rate of inflation will lead to the surplus supply of thecurrency and it would depreciate the currency value. Once thecurrency

Is depreciated our current account will suffer as wehave to pay more to buy the same commodities and our importbill will rise.

Conclusion:

When we look at the figures of Balance of Payment, weobserve that the Exports are decreasing and Imports areincreasing. The income from service sector has also declinedin recent times for some reasons. The foreign remittances orunilateral transfers has also decreased as the people haveno more trust on the Pakistan and increasing rates of taxesare also a reason for people to avoid sending money back toPakistan instead invest it in foreign country. The FDI hastrembled down as the law and order condition is gettingworse day by day. Our current account balance is apparently

better than the previous year but we should not ignore thatfact that it is projected data and real figures could shufflearound due to several reasons.

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Documents

Arun Jeet Balance of Payment