Balance of trade and balance of payments: structure, disequilibrium and its correction

1. Balance of trade and balance of payments

The balance of trade is the difference between the value of a country’s merchandise (visible) exports and imports in a year. It is favourable (surplus) when exports exceed imports and unfavourable (deficit) when imports exceed exports.

The balance of payments is a systematic record of all economic transactions between the residents of a country and the rest of the world during a period, usually a year. Kindleberger: “a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period of time.” It includes visible trade, invisibles (services, income, transfers) and capital flows.

A country can have a trade deficit and still a sound balance of payments, if invisible earnings and capital inflows cover the deficit. India has long run a merchandise trade deficit, offset in large part by earnings from software services and remittances from Indians abroad.

2. Structure of the balance of payments

Each transaction is recorded by double entry: receipts from foreigners are credits (+), payments to foreigners are debits (−). The RBI publishes India’s balance of payments broadly in line with the IMF’s Balance of Payments Manual.

(a) Current account

• Merchandise: exports and imports of goods (the balance of trade).
• Invisibles:
  • services: travel, transport, insurance, software and business services;
  • primary income: investment income (interest, dividends, profits) and compensation of employees;
  • secondary income (transfers): private remittances, gifts, grants, without any return obligation.

(b) Capital (and financial) account

• Foreign investment: foreign direct investment and portfolio investment.
• Loans: external assistance, external commercial borrowings, short-term trade credit.
• Banking capital, including non-resident (NRI) deposits.
• Other capital.

(c) Errors and omissions

A balancing item for transactions that are missed or wrongly valued.

(d) Change in foreign exchange reserves

The overall surplus or deficit is settled by a change in official reserves (and, if necessary, IMF credit). An increase in reserves is shown as a debit (use of funds).

Worked statement (hypothetical, Rs. thousand crore)

The trade deficit of 250 is mostly covered by invisibles; the small current account deficit of 30 is more than financed by capital inflows; reserves rise by 62. Including the reserve entry, the account sums to zero.

3. Why the balance of payments always balances

Because of double entry, total credits equal total debits: any current account deficit must be financed by a capital inflow or a fall in reserves. “Disequilibrium” therefore refers not to the accounts as a whole but to the autonomous transactions (those undertaken for their own sake, such as trade and investment) as against accommodating transactions (reserve use and emergency borrowing to fill the gap). A deficit on autonomous transactions that persists is a fundamental disequilibrium.

4. Kinds of disequilibrium

• Cyclical: from trade cycles in different countries at different times.
• Secular (long-run): from the long process of development; a developing country imports capital goods for decades.
• Structural: from a change in demand or supply conditions for particular goods (a fall in world demand for jute, a rise in oil prices).
• Short-run and fundamental disequilibrium.

5. Causes of disequilibrium

(a) Economic

1. Development programmes: heavy imports of machinery, technology and raw materials.
2. Inflation: domestic prices higher than world prices make exports dear and imports cheap.
3. Population growth: more imports of food and consumer goods, less exportable surplus.
4. Cyclical fluctuations in income at home and abroad.
5. Structural changes: loss of export markets, new substitutes, changes in technology.
6. Overvalued exchange rate.
7. Natural factors: crop failure from drought or floods raises food imports.
8. Debt servicing: interest and repayment on foreign loans.
9. Oil and commodity price shocks (the 1973 and 1979 oil crises; the Gulf crisis of 1990–91 in India).

(b) Political

Wars, political instability (capital flight), and the cost of defence imports.

(c) Social

Demonstration effect: changes in tastes and imitation of foreign consumption raise imports.

6. Methods of correction

(a) Automatic adjustment

• Under the gold standard (Hume’s price-specie-flow mechanism): a deficit country loses gold, its money supply and prices fall, exports rise and imports fall until balance is restored.
• Under flexible exchange rates: a deficit lowers the value of the currency; exports become cheaper and imports dearer.
• Income adjustment (Keynesian): a deficit reduces income through the foreign trade multiplier, which reduces imports.

(b) Deliberate measures

1. Monetary measures:
   • deflation (tight money, higher interest rates) to lower prices and incomes and attract capital;
   • depreciation of the currency under a flexible rate;
   • devaluation, an official reduction of the external value of the currency under a fixed rate (India devalued in 1949, 1966 and 1991). It works only if the sum of the elasticities of demand for exports and imports exceeds one (the Marshall-Lerner condition);
   • exchange control: the State takes over and rations foreign exchange.
2. Trade measures: export promotion (incentives, export credit, trade fairs, export processing zones), import substitution, tariffs and quotas on imports.
3. Other measures: foreign loans and IMF assistance, encouraging FDI and remittances, promoting tourism, reducing debt.

How this is examined

For “structure of BOP” draw the statement above with your own round figures and explain each account. For “causes of disequilibrium” give the kinds in a line each and then the economic, political and social causes. For “methods of correction”, separate automatic from deliberate methods and mention the Marshall-Lerner condition under devaluation. The balance of trade distinction is a frequent opening sentence: put the table in.