What is Balance of Payments and how is it affected?

“No Power on Earth can stop an Idea whose time has come”- Manmohan Singh during the  presentation of the historic 1991 budget that aimed to remedy the balance of payments crisis.

 

The term Balance of Payments refers to the inflow and outflow of any form of capital between two countries. According to Britannica, it is the record of economic transactions between the residents of two countries and is a form of double entry bookkeeping.

 

Balance of Payments became relevant to India in particular after the devastating 1991 economic crisis and the subsequent reforms. When a government transports nearly 50 tonnes of India’s favourite metal, Indians tend to be curious as to why. 

 

The 1991 Crisis, also known as the balance of payments crisis, was a situation where Indian foreign reserves were severely depleted, putting India in a situation of defaulting their international debt obligations. The entire crisis was based around the concept of balance of Payments, but what exactly is it?

 

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In Short, balance of Payments refers to the transaction between countries. The beauty of balance of payments is that it is not positive or negative like Balance of Trade is. Since any money coming into a country will involve goods or services going out, it is a net zero cost. 

 

 

Components of Balance of Payments

 

The concept has three spheres- goods and services, capital transactions and Investment/ Intangibles. Since Balance of Payments does not just suggest purely monetary payments or investments alone, it is divided into three types of accounts. They are as follows:

 

1. Current Account

 

The current account refers to the account of a country’s input and output of goods and services alone. Any transaction made with the object of the transaction being raw materials or finished goods would come under the current account.

 

A country's foreign dealings with the rest of the world are recorded in the current account balance of payments. 

All transactions involving economic values that occur between resident and non-resident entities are included in the current account (except from those in financial items). 

 

Offsets to current economic values that are offered or obtained without a cost are also addressed. This metric is expressed as a percentage of GDP.
 

 

2. Capital Account

 

The capital account keeps track of all capital transactions between countries. The acquisition and selling of non-financial assets such as land and properties are examples of capital transactions

 

The capital account also covers the flow of taxes, the acquisition and sale of fixed assets, and other transactions involving migrants moving out of/into another nation. 

 

Finance from the capital account is used to manage the current account deficit or surplus, and vice versa.

 

 

3. Financial Account

 

The financial account tracks the movement of cash from and to other nations through diverse investments in real estate, commercial endeavours, and foreign direct investments, among other things. 

The changes in foreign ownership of domestic assets and domestic ownership of foreign assets are tracked in this account. It is possible to determine if the country is selling or purchasing more assets by examining these developments (like gold, stocks, equity etc). 

 

Based on the type of transfer whether its goods or investments, it falls under one of the three accounts as mentioned above. In short, Balance of payments represents the transfer of money in various forms between two countries. 

 

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Types of Balance of Payments

 

Similar to Balance of Trade, balance of Payments also consists of favourable and unfavourable Balance of Payments. The beauty of balance of payments is that ultimately it is a zero sum game. 

 

Since inflow of some form of money into the country would involve sale of some form of commodity to an entity outside the country, the books would cancel each other out.

However, this is shaken when a country uses too much of its own currency and values it in a manner contradictory to the demand for the currency, it causes imbalance in the payments books. The two types are as follows:

 

1. Favourable Balance of Payments

 

An imbalance in a country's balance of payments in which the country's payments are fewer than the payments it receives.

A surplus in the balance of payments is another name for this. It's regarded as beneficial since more money is coming in than going out of the nation. Such an uneven flow of cash will increase the nation's money supply, resulting in a drop in the exchange rate relative to other countries' currencies. 

 

Inflation, unemployment, output, and other aspects of the domestic economy are all affected as a result. A balance of trade surplus is frequently the source of a balance of payments surplus, although additional payments can change a balance of trade surplus into a deficit.

 

 

2. Unfavourable Balance of Payments

 

Payments made by a country exceed payments received by the country, resulting in a balance of payments imbalance. A balance of payments deficit is another word for this. It's negative because the country's currency is going out faster than it's coming in. 

As a result of the uneven flow of cash, the nation's money supply will be reduced, causing an increase in the country's exchange rate relative to other currencies. Inflation, unemployment, output, and other aspects of the domestic economy are all affected as a result. 

A balance of trade deficit is a common cause of a balance of payments deficit, although other payments can change a balance of trade deficit into a surplus.

 

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Factors Affecting Balance of Payments

 

Just like any macroeconomic concept, Balance of Payments too has a set of factors that govern its extent and whether or not it is favourable or unfavourable. Just like Balance of Trade, Balance of Payments has various inputting factors including foreign trade and internal production, The chief of the factors are as follows:

 

1. Imports: The biggest factor affecting a nation’s balance sheet is imports. When a country imports a good or service, a portion of the country’s foreign exchange is used up.  Since imports involve payment in a foreign currency, the valuation of a currency comes into play. This is discussed later in the article.

Due to this subsequent drain of foreign reserves due to excessive imports, countries have a system where money is flowing outwards. Since goods often lose their resale value post use, this puts the ledger in the red. Imports tie into another concept- currency valuation.

 

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2. Currency Valuation: Since imports are paid back in foreign currency, for local consumers, money must first be converted from local currency to an accepted international currency. The most common measure used is the United States dollar.

 

For example, if a buyer in India wishes to import a consignment of machines worth a hundred thousand American dollars, he must first find the current value of the Indian rupee against the american dollar and pay accordingly. The lower the value of the rupee, the bigger chance of incurring debt. 

 

This was seen in the Balance of Payments crisis of 1991. Excessive Indian imports accompanied by a currency propped up by the government resulted in rupee overvaluation.

Since the country did not have a standard or a type to assign its currency any value, there was not adequate demand for the Indian rupee and many entities would not accept the Indian rupee as payment.

This left the Indian government in a crisis as they could not afford to simply print more money especially when they did not have the value of the money as a reserve. A common practice for nations was to keep a certain value of their currency in gold as a reserve in case of a forex requirement, and India did not have sufficient reserves.

 

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Thus came about India’s most dramatic economic turnaround. With the Chandrashekar Government airlifting 50 tonnes of gold to ensure India's balance of payments did not turn unfavourable as a collateral to the bank of England and obtaining subsequent loans that allowed it to pay back its massive debts. Only then was the concept of Balance of Payments truly given its due.

 

Ultimately, Balance of Payments is a government controlled issue and its onus is on the Central Bank and the Union’s economic advisors to maintain. Since it is a macroeconomic concept involving both public and private expenditure, it is on the government to regulate and keep it favourable using measures such as tariffs, foreign reserve maintenance and other trade barriers.

Along with removal of forex regulations and promoting import substitution, an economy can prevent a Balance of Payments crisis. The wise are those who learn from their mistakes, and every government must note India’s fall and subsequent rise as a lesson in macroeconomic management.