Indian Economy | Balance of Payments of Economies (BOP) Download PDF
An open economy, as mentioned previously, will have a large component of trade and that trade would bring in foreign currencies to home country either for making payments for imports or receiving foreign currencies for exports. In addition, in a previous section on Exports, it was mentioned that an adverse feature of the Indian Economy has been year after year imports were more than exports.
What does it mean? It basically implies that India has never been able to earn foreign currency through exports to that extent to meet payment obligations in foreign currency for imports of goods. That is, the first thing to understand about open economies on their ability to ‘earn foreign currencies through exports to pay for the import needs of the economy i.e., the criticality of exports.
It is clearly known that India is an importer of crude petroleum and increased consumption of petro goods would require India tb export sufficiently to cover the import required of crude petroleum. Exports have been extensively addressed in the previous section.
Open economies would have both domestic as well as foreign currencies and as trade increases with more of exports and imports, there has to be a tracking mechanism in the economy of the foreign currencies going out on account of imports and other factors and the foreign currencies coming into the country on account of exports and other such factors.
This is what known as the ‘balance of payments’ (BOP) of a country, which is a separate and independent ‘record’ of all transactions being done in the foreign currencies in the country. The BOP of country assumes great significance for open economies. In India, the responsibility of maintaining the BOP lies with the Reserve Bank of India (RBI). RBI is not only the apex monetary authority, controller of liquidity but also has a larger role to play in open economies of maintaining the BOP How is the record of transactions maintained?
BOP—Kinds of Accounts
The balance of trade (BOT) or balance on merchanize goods: This account records all transaction of foreign currencies on account of export and import of ‘goods’ only. The BOT would be in surplus if inflows of foreign currencies in the economy through exports are more than outflow of foreign currencies on account of imports. Conversely, it would mean a deficit on the BOT. This is what has been referred earlier of a structural trade deficit in India, of insufficiency of foreign currencies through exports of goods to meet the foreign currency required to pay for critical imports.
The second kind of account is the balance on invisibles (BOI). Just as there are imports and exports of goods, there are also imports and exports of services such as banking, shipping, insurance, software, consultancy, etc. This account maintains records of transactions in foreign currencies resulting out of export and import of services.
What could be other types of transactions in foreign exchange other than for import and export of goods and services covered in balance of invisibles. These could be for the following:
(1) Inward and Outward Tourism—tourist arriving to India (inward) would require rupees to spend for which they would like to exchange their respective foreign currencies into rupees. Similarly, Indians going abroad (outward) would require foreign currency.
(2) Inward and Outward Remittances—many Indians about 35 million are settled overseas in different countries also known as the ‘Indian diaspora’. Many of them send money to their family. As they are earning in foreign currency they would send the money in foreign currency (inward remittance) which would be exchanged in rupees in India and given to the beneficiary. Similarly, Foreign residents in India may also like to remit money overseas (outward remittance).
(3) Inward and Outward Education—there is an increasing trend of Indian students seeking higher education abroad (outward education). They would need to cover for their fees in foreign currency.
(4) Similarly, foreign students wishing to study in India (inward education) would need Indian rupees to cover their expenses in India. Further, there may also be a need of foreign currency for overseas medical treatment.
In all the above transactions, there will thus be a ‘net effect’ which is either positive or negative depending on which transactions are more. For example, net tourism will be positive if foreign currencies being surrendered (by foreign tourist for rupees) is more than foreign currencies being demanded (by Indian tourists going abroad) and vice versa and similarly for remittances and education.
All the aforementioned transactions which are net tourism, net remittances, net education and for medical treatment are reflected in the ‘balance of invisibles’ (BOI) of the BOP. Thus, BOI records transactions in foreign currencies relating to export and import of services, net tourism, remittances, education and medical treatment. This could also be either positive or negative depending on which is more.
Both the BOT as well as the BOI constitute the balance on current account of the BOP. Accordingly, the BOP may have a current account surplus (CAS) or a current account deficit (CAD) and CAS will result in the following:
With both BOT and BOI in surplus or positive.
It can also be possible with a deficit on BOT but with a surplus on BOI sufficiently large enough to wipe out the deficit on BOT.
On the other CAD will result if there is
Deficit on BOT and BOI.
Deficit on BOT and a surplus on BOI but not sufficient enough to wipe out the BOT.
It appears to be complicated but there is requirement to understand these concepts failing which problems of open economies and crises may be difficult to comprehend. An illustration of an open economy, say A is explained below:
Exports of goods USD 100 Million
Imports of goods USD 250 Million
BOI USD 200 Million
Economy A has a deficit on BOT of USD 150 million but a CAS of USD 50 million. If the economy had a BOI of USD 100 million it would have a CAD of USD 50 million. A surplus on the current account can thus happen both with a surplus and also with deficit on BOT depending on the BOI.
Inflows of foreign currencies (coming into the country) are ‘more’ than the outflow of foreign currencies (going out of the country) in an economy. A CAD would imply the reverse i.e., outflows of foreign currencies are more than the inflows of foreign currencies in an economy.
How is the difference between outflows and inflows met? This would take us into the third account of BOP maintained by the RBI which is a record of transactions ‘other than’ those on the current account.
Transactions other than those on the current account is referred as capital account transactions and would comprise of the following:
(1) Foreign Investment—this will be discussed separately later. However, this represents inflows of foreign currencies into the economy for investment purposes.
(2) Deposits—many of the Indian diaspora settled abroad maintain deposits in foreign currencies in India known as NRI deposits.
(3) Borrowings—private sector can borrow in the international currency and so can the government bilaterally or from multilateral institutions such as the IMF, World Bank, etc.
(4) External Assistance and Grants—government can also receive assistance and grants from other countries in foreign currencies. But this was relevant in closed economies.
All the above transactions are known as capital account transactions and get reflected in the ‘capital account’ of the BOP. The balance on current account and capital account constitutes the BOP of the country. The BOP necessarily like a balance sheet has to balance, or no difference between assets and liabilities. Similarly in the case of BOP ‘inflows’ will have to be matched with ‘outflows’ one way or the other. Thus BOP has to be zero. That is, any CAD would have to be met out of capital foreign currency inflows of either foreign investment or NRI deposits and if not there, out of borrowings by the government to meet the CAD.
However, BOP can also be zero under:
(1) There is CAS. The excess inflows going to augment the foreign exchange reserves.
(2) There is a CAD but sufficient capital inflows other than borrowings to wipe the deficit.
Thus, by looking at the BOP it is not possible to comment on the health of the economy on the trade front of whether, there is CAD or CAS. BOP is solely an ‘account’ of inflows and outflows of foreign currencies and the manner in which inflows and outflows on the current account are matched. The true picture can, however, be seen from the current account of the BOP. As an open economy, the balances on current account of economies become extremely relevant.
Suppose an economy has CAD of USD 100 million. It does not have capital inflows. How does the government acquire foreign currencies to meet the deficit? Remember fiscal deficit, the government could print rupees to meet the deficit or borrow rupees from the market. The government can’never be a defaulter in borrowings given its sovereign powers to print home currency.
In the absence of capital inflows, the government would have to borrow from the international market. Any borrowing in the market for meeting CAD is crisis for the economy because how does the economy pay back the amount borrowed? It would amount to placing economic sovereignty at stake, leading to economic sub-judication.
A high CAD has been a common denominator in all the crisis-ridden economies in the past and as a parameter closely monitored by all open economies. Both the CAD as well as fiscal deficit are known as the ‘twin deficits’ that is necessary evils and little to choose between, in terms of damaging impact on economies.
Current Account Deficit (CAD)—The Indian Context
While discussing exports of India it was mentioned that an adverse feature of our economy is that imports have been more than exports, year after year ever since Independence i.e., India has had a chronic deficit on the BOT always.
However, the current account balance was favourable, i.e., a CAS between 2001/2002¬2003/2004 of an average of about 1.4 per cent of GDP. This was predominately because of the large surplus on the BOI, more than sufficient enough to wipe out the deficit on the BOT. Since 2004—2005 onwards, India had a CAD averaging about 4.1 per cent of GDP till December 2008. This was due to considerable widening of the BOT deficit because of increased imports in value terms, especially sharp increased international crude petroleum prices.
Post December 2008 and onwards, CAD has further worsened on account of global recession. However, since 2010, after signs of recovery, CAD has started to come down to about 3.7 per cent of GDP and during September 2010, with exports showing greater buoyancy, the CAD has come down from about USD 13 billion to USD 9 billion. However since the beginning of 2013, CAD has begun to widen due to increased imports of gold, crude petroleum and a near stagnant exports.
The global picture is no different, with most economies having CAD with the exception of Russia and China which are presently having CAS due to sustained increased exports. However, the silver lining for India has been the rapidly increasing capital inflows on the capital account due to increased foreign investment in recent times. These inflows constituted 3.1 per cent of GDP during 2005-2006, 5.1 per cent during 2006-2007 and rising further to 9.3 per cent of GDP during 2007-2008. These have not only been sufficient to meet the CAD but also given a surplus on the capital account. But the situation since 2012, has been of an ever ballooning of the CAD of reaching an all time high of 4.8 per cent in 2012—2013, on account of increasing imports of petroleum products and sharp increase in imports of gold, together with shrinking exports making matters more worse.
IS Current Account Surplus (CAS) Better for Open Economies?
So it appears that open economies should preferably have a CAS or should not have CAD given their vulnerability to crisis-like situations. The concept of CAS is explained briefly.
CAS typically represents surplus of outflows over inflows and where this surplus is going? It represents ‘idle’ money as it reaches the RBI instead of the economy. It is idle because it has not been absorbed in the economy, which is possible in an over-invested economy or economies with little investment opportunities. Any further investment in such economies, would not increase growth but only fuel inflation. Such economies need to cool. A CAS is helpful for them. It could also be if the government interferes in their absorption through policy interventions.
So a CAS in China is understandable as it needs to slowdown to prevent build-up of inflationary pressures in the economy*.
India is already running a high CAD, but then these are abnormal circumstances of shocks of global recession. It is also because of import of crude petroleum and in recent times a surge in import of gold. Despite the High levels of CAD it can be said to be manageable given the surplus on the capital account. However, the same levels can overnight become very disturbing and dangerous should the capital flows reverse, leaving no choice, other than borrowings to meet the deficit on the current account.
Rightfully, the RBI while maintaining the BOP keeps a close watch on the movements both on the current account as well as capital inflows. High CADs in relation to their GDP has been a common denominator for all the crises-ridden economies.
It is wrongly believed that openness has been responsible, rather it was the inability of these economies to see the widening CAD, plunging them into the gorge of crisis. It should also be kept in mind that ‘it is not CAD per se which is the problem, but the way CAD is meet, whether irreversible capital flows, reversible flows or borrowings’. Only if CAD is being met out of borrowing by a government can it be said to be a crisis or an unsustainable CAD. As long CAD is met out inflows on the capital account, other than borrowings which is through foreign investment, NRI deposits, it can be said to be manageable, not a serious cause of concern. Crisis on the current account is also known as ‘BOP crisis’.