A REPORT

ON

PRECARIOUS POSITION OF INDIAS BALANCE OF PAYMENTS

BY
Taijas Malpani
2008B3A3521G

Report submitted in partial fulfillment of the requirements of course

ECON C421: Issues in Indian Economy

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE-PILANI

20th Nov, 2011

Table of Contents
1 ACKNOWLEDGEMENTS.....................................................................................................
3

INTRODUCTION....................................................................................................................

SIGNIFICANCE OF THE STUDY.........................................................................................

OBJECTIVE AND PERIOD OF THE STUDY.......................................................................

REVIEW OF LITERATURE...................................................................................................

UNDERSTANDING BALANCE OF PAYMENTS................................................................

HISTORY OF INDIAS BOP SINCE INDEPENDENCE.......................................................

8.1

Period from 1949-1991:....................................................................................................

8.2

Period from 1990-99:........................................................................................................

8.3

Period from 2000-present:..............................................................................................

CAUSES OF BOP DISEQUILIBRIA WITH SPECIAL REFERENCE TO INDIA.............

9.1

Structural changes in the economy..................................................................................

9.2

Cyclical changes in the economy....................................................................................

9.3

Changes in exchange rate................................................................................................

9.4

Changes in National Income...........................................................................................

9.5

Price changes...................................................................................................................

9.6

Capital movements..........................................................................................................

9.7

Other factors....................................................................................................................

10
ANALYSIS OF THE CURRENT BOP POSITION AND ITS IMPACT ON THE
ECONOMY...................................................................................................................................
10.1

Merits of CA Deficit.......................................................................................................

10.1.1

Sound Capital Market..............................................................................................

10.1.2

Current Account financed by foreign investment....................................................

10.1.3

Benefits of Long term Investment...........................................................................

10.1.4

CA deficit as an engine of growth...........................................................................

10.2

Demerits of CA Deficit...................................................................................................

10.2.1

Financing of CA deficit by Borrowing....................................................................

10.2.2

Low Competitiveness..............................................................................................

10.2.3

Increasing claim on Indian assets by foreigners......................................................

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10.2.4

Drying up of Capital Flows.....................................................................................

10.2.5

Lower Economic Growth........................................................................................

10.2.6

Replacement of Domestic Products with Imported Goods......................................

11

POLICY SUGGESTIONS AND RECOMMENDATIONS...............................................

12

CONCLUSION...................................................................................................................

13

BIBLIOGRAPHY...............................................................................................................

ACKNOWLEDGEMENTS

I would like to thank our course instructor, Mr. N. Kubendran, without whose support,
this report couldnt have been completed. Id also like to thank our other instructor, Mr.
Ashwini Kumar Mishra, whose deep insights into this topic have proven useful to me in
the completion of this report.
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INTRODUCTION

The international Balance of Payments (BOP) of any country is a measure of its

economic performance as compared to the rest of the world. In this regard, it becomes
imperative to study the nations Balance of Payments trends, so that necessary corrective
policies and actions may be taken to improve the nations economic standing in the
world.
With respect to India, its BOP situation is quite delicate now. The problem of BOP
disequilibrium has been persisting in India right since independence, which led to the
BOP crisis of 1990-91. Even though the BOP situation has improved since then, BOP
management still remains one of the main concerns for Indian policy makers.
This report describes ,firstly, the structure of BOP (the manner in which BOP is
calculated) so that it is easier for the reader to appreciate the significance and
implications of the BOP trends and it then moves on to describe in detail the trends of
BOP in India right from Independence till today. Secondly, a list of all internal and
external factors for BOP disequilibria problem have also been listed as well as the
impacts of the various policies on Indias BOP, that the Government of India has
implemented. Both pros and cons of such policies have been evaluated. Lastly, further
policy recommendations have been made to further improve the current BOP scenario
and reduce the BOP deficits.

SIGNIFICANCE OF THE STUDY

Since the BOP of a nation is a measure of its economic strengths and weaknesses, the
study of BOP trends and its implications is very vital to gauge the growth and
development of various trade and financial transactions of the nation with the rest of the
world. Naturally, for any nation, its economy will thrive if it has a healthy BOP.
Generally, for nations, a healthy BOP indicates surplus in the overall trade balance, as
this maintains confidence in the economy and among investors.
India right now, is suffering from a Current Account (one of the components of BOP)
deficit. The following questions arise: Should Indian policy makers focus on narrowing
the Current Account deficit or should they maintain the same amount of deficit so as to
ensure long term local productivity and increased exports in the future? What strategies
are to be implemented by the policy makers to reduce the Current Account deficit? What
should be the optimum amount of Current Account deficit that a developing country like
India can handle? These questions clearly indicate that the BOP position plays a
significant role in governing the decisions of policy makers, which are crucial for any
economy.
Also, since credit ratings are based on BOP positions, flows of credit to businesses may
be affected because of them. Furthermore, predictions regarding foreign exchange rates
can also be made by studying BOP positions.

OBJECTIVE AND PERIOD OF THE STUDY

As seen above, the BOP positions of a country can have significant impact on its
economy, through the decisions of policy makers. The objective of this study is to
investigate the causes of BOP disequilibria prevailing in India and its various
consequences on the Indian economy. To accomplish this, the various merits and demerits
of the Indian BOP position on the economy are analyzed in detail, along with the BOP
trends in India. Based on this analysis, various policies are recommended to strengthen
the Indian economy. This has been the primary focus of this study.
The period of this study stretches from 1949 till present.

REVIEW OF LITERATURE

The problem regarding the current BOP scenario of India is of significant importance.
According to Anita Chanda (Indias Balance of Payments-2010), Indias poor BOP
situation during the post independence period right till the 1990s was because of the
protectionist policies that India implemented. She also maintains that it was only because
of the New Economic Policy (NEP) regime that Indias BOP situation improved. She also
says that even though India has maintained a decent BOP position, BOP management still
remains an issue of concern for policy makers, as now India is exposed to every change
in the global scenario.
Manu Gupta (What is Balance of Payments and what does it mean for your business2009) is of the opinion that healthy BOP position term is relative to every country. While
developed countries have surplus in Current Account, developing countries like India
place more importance on Capital Account surplus. He also says that BOP position of a
country is of prime importance for a countrys trade as it influences the decisions of
policy makers.
Richard Pettiger (Is a Current Account deficit harmful? 2005) says that a current
account deficit can prove to be harmful only if the deficit is financed by borrowing or by
running down reserves as this leads to depreciation of the currency. He further says that if
however, the deficit is financed by long term investment; it can lead to increased
productive capacity and more exports and help in the growth of the economy.

UNDERSTANDING BALANCE OF PAYMENTS

A countrys Balance of Payments (BOP), also referred to as the Statement of

International Transactions is basically a summary statement, in which, all the
transactions of the residents of the nation with the rest of the world are recorded during a
particular period of time, usually a calendar year. The BOP employs the double entry
bookkeeping accounting technique.
In general, the BOPs comprise of the two main components:

Current Account (CA) This includes transactions of goods and services,

income on foreign investments and unilateral transfers. It consists of two main
subheads Merchandise and Invisibles. The Invisibles can be divided into
Services, Transfers and Income.

Capital Account (KA) This measures the change in the domestic countrys
assets abroad and foreign assets owned in the domestic country. It includes the
following subheads Foreign Investment (FIIs and FDIs), Loans, Banking
Capital, Rupee Debt Service and Other Capital.

The Foreign Exchange Reserves of a country can be measured as the negative of the
sum of the Current Account and the Capital Account, that is,
R = - (CA+KA)

HISTORY OF INDIAS BOP SINCE INDEPENDENCE

8.1

Period from 1949-1991:

8.2

Throughout this period, the BOP situation of India remained weak, because of the
protectionist policies that were implemented by the Indian government. The
Current Account was in excess of 3% of GDP during this period. Under Capital
Account, foreign aid and commercial borrowings were used to balance the CA
deficit.
Indias main aim after attaining independence was to achieve self-reliance. This
was the main objective of the Second Five-year Plan. It implemented
protectionist policies like import substitution, with gross neglect on exports. The
capital goods industry remained, to a large extent, import intensive. The Indian
economy was put under further strain because of the increasing petroleum
products demand, domestic inflation, the two oil shocks and harvest failure.
Because of this and also because of the recession in the 1980s, Indias BOP
situation deteriorated.
This BOP deterioration saw the External Debt situation of India change from bad
to worse because the government resorted to large borrowings to rectify the BOP
situation in the short run. The constant depreciation of the Rupee to promote
exports also raised the amount of External Debt. The country was on the verge of
defaulting.
Although the process of liberalization began from the mid 1980s, the situation
was already very bad, and all this mismanagement ultimately culminated in the
1990-91 BOP crisis.

Period from 1990-99:

The BOP crisis of 1990-91
The triggering factors for this crisis were primarily the growing fiscal deficits,
rapid accumulation of external debt, the Gulf War and the Oil Price Shock, very
low foreign currency reserves and threat of default on external debt repayments.
The New Economic Policy (NEP) was implemented to combat this BOP crisis,
which focused on liberalization and globalization of the economy. This opened up
the Indian economy and lifted the restrictions on free trade, allowed foreign
investments and introduced a new Liberalized Exchange Management System to
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8.3

avail the benefits and advantages of a competitive market. Apart from this, other
economic restructuring was done to counter the weak BOP position of India.
Some of them were float of the Rupee, Industrial delicensing, fiscal adjustment,
tight caps on external borrowing and lowering of direct and indirect taxes.
The BOP position of India steadily became more stable, after overseeing the
initial doubts during the period 1991-99.

Period from 2000-present:

Since 2000, the BOP position of India went through ups and downs until 2008.
The Current Account (CA) balance was positive till 2004, after which it started
decreasing and the CA balance became negative. The Capital Account (KA)
increased gradually till 2008. This was possible because of the liberalized policy
that India implemented.
The CA balance widened in 2008-09 (-2.4% of GDP) as compared to 2007-08 (1.3% of GDP). The overall balance went into negative figures, and the KA
balance decreased substantially as well. This happened because of the global
recession that took place during that period.
After the recession, as the economy improved and picked up momentum again,
the BOP position improved. Both the overall and KA balance continued to
improve. However, the CA balance still continued to deteriorate.

Currently, Indias foreign exchange reserves are quite comfortable, exchange rate is
pretty competitive and exports and capital inflow through FDIs are also encouraging.
The BOP situation of India is fairly well managed, although it rests on a very precarious
position. The main concern for India now, is the increasing Current Account deficit.

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CAUSES OF BOP DISEQUILIBRIA WITH SPECIAL REFERENCE TO

INDIA

There are many varied reasons for BOP disequilibria in an economy. The major ones are
listed below:

9.1

Structural changes in the economy

Structural changes in an economy can lead to a BOP deficit or surplus. For example, right
after independence, India followed protectionist policies that curbed exports, leading to
huge BOP deficits. After the BOP crisis of 1990-91, India opted for a more liberalized
and globalized policy. Such a policy improved significantly the previously poor BOP
position.

9.2

Cyclical changes in the economy

Cyclical changes like the expansion of an economy lead to a BOP surplus, while
recession leads to a BOP deficit. The 2008 global recession saw the BOP position of
India for 2008-09 deteriorate as compared to the period 2007-08.

9.3

Changes in exchange rate

A competitive or floating exchange rate can lead to a better BOP while a fixed exchange
rate may lead to a BOP deficit. In Indias case, India had a fixed exchange rate until 1990,
and this period saw poor BOP positions. After liberalization, since the exchange rate
became floating, the BOP situation became much better.

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9.4

Changes in National Income

Increase in national income through income earned on investments on foreign goods

abroad, strengthens the CA balance and improves the BOP position of a country. After the
BOP crisis in India, the CA balances improved because of the increase in the returns on
foreign investments.

9.5

Price changes

An increase in prices indicates a weak BOP for a nation, while a decrease in prices
indicate a healthy BOP for a nation. During the 1980s continued inflation saw the BOP
condition in India deteriorate from bad to worse.

9.6

Capital movements

An increase in capital inflow leads to a KA surplus thus strengthening the BOP position,
while an increase in capital outflow leads to a KA deficit, which in turn weakens the BOP
position of a nation. In Indias case, with increasing globalization, the FIIs and the FDIs
increased during the mid 1990s, eventually leading to a better BOP.

9.7

Other factors

Other factors that led to a weak BOP position in Indias case include large population and
the ever-increasing consumption, dependence on Petroleum, Oil and Lubricants imports,
unfavourable political conditions, ability of domestic investment to absorb large foreign
currency inflows, fiscal deficit and increase in public debt.

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10 ANALYSIS OF THE CURRENT BOP POSITION AND ITS IMPACT ON THE

ECONOMY
As mentioned earlier, BOP of any nation has two components:

Current Account (CA)

Capital Account (KA)

Currently, India has a CA deficit and a KA surplus. Its BOP situation is precarious and
unless India treads with caution, it might worsen again.
A Current Account deficit can have both favourable and unfavourable impacts on the
Indian economy. Both the merits and the demerits of a CA deficit have been presented
below, through a detailed analysis.

10.1 Merits of CA Deficit

A Current Account deficit is not necessarily harmful to certain economies. For
developing countries like India, a CA deficit may prove itself useful to the economy in
the long run. Following are the advantages of a CA deficit:

10.1.1 Sound Capital Market

India is emerging as one of the most favoured venues for overseas investments, especially
after the global recession of 2008. It has one of the most open and sound capital markets
in the world, and since so far, after 2008, financing a trade deficit in goods and services
has not led to a sharp decline in the value of the Rupee, there is little need to be
concerned about the CA deficit. In such a case, a CA deficit will only serve to strengthen
a developing economy like India.

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10.1.2 Current Account financed by foreign investment

A Current Account deficit can be considered to be a by-product of Indias rapid economic
growth and its appeal as a hot destination for foreign investment.
CA = S I, where
S = Savings &
I = investments
According to this relation, a CA deficit exists when I>S, as a result of which foreign
investment occurs. Whenever I>S, the overspending or the investments abroad must be
financed by foreign investment. This implies that there will exist a KA surplus, because
more and more foreign firms will invest capital in India, thus making up for the CA
deficit. India currently has a CA deficit; this simply indicates that India is importing
capital from abroad. This can in turn allow India to increase its exports and eventually,
reverse its deficit.

10.1.3 Benefits of Long term Investment

CA deficit is financed partly by long term investment. In such a scenario, India stands to
gain a lot from the benefits of long term investment, which include:

Increased productive capacity

Favourable working practices of foreign firms
More jobs
Increased exports in the distant future

10.1.4 CA deficit as an engine of growth

A Current Account deficit for India indicates a growing demand for imports, and only if
Indias economy is growing and expanding as well as creating jobs and Disposable
Income can there be an increase in the demand for imports. This clearly shows that there
is a direct coherence to Indias CA deficit and its economic growth.

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10.2 Demerits of CA Deficit

There are a number of reasons why a CA deficit can prove detrimental to Indias
economy. Some of them are:

10.2.1 Financing of CA deficit by Borrowing

Financing of CA deficit through borrowing or running down reserves will prove
unsustainable in the long run. This in turn would lead to depreciation of the Rupee as the
supply of the Rupee would exceed it demand. Such a rapid depreciation will in turn lead
to problems like inflation and falling confidence in India. Imported good will become
more expensive and depreciation of the Rupee will reduce the living standards.

10.2.2 Low Competitiveness

Indias CA deficit has been persisting since 2004 and has been increasing since then.
Such a persisting deficit suggests a fundamental weakness in the Indian economy. It may
lead to:

Decreasing competitiveness
Decreasing productive capacity
Declining comparative advantage in various manufactured goods

These factors could have a profound and adverse impact on job creation in India, leading
to unemployment, thereby worsening the situation and leading to lower growth and
development of the economy.

10.2.3 Increasing claim on Indian assets by foreigners

India has primarily relied upon attracting foreign investment in the form of FDIs and
FIIs to finance the CA deficit. This means that foreigners now have an increasing claim
on Indian assets. If the foreigners were to withdraw their investment from India due to
some economic crisis, it would leave India highly vulnerable.

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10.2.4 Drying up of Capital Flows

Since the rates of borrowing from other countries is pretty high, Capital flows may dry up
and India will no longer be able to finance its CA deficit by attracting capital flows from
different countries. This will in turn pile up the external debt burden of India.

10.2.5 Lower Economic Growth

If the Indian CA deficit is due to excessive consumer demand, a recession or slowdown
will help to resolve the problem. As consumers cannot go on spending far in excess of
their income forever, they have to start saving and controlling their expenditure to
improve their own finances. To accomplish this, both high interest rates and significant
reductions in consumer spending will be required, and this could ultimately push India
into recession or slowdown of the economy, leading to overall lower economic growth.

10.2.6 Replacement of Domestic Products with Imported Goods

Since India faces a CA deficit, most often domestic products are replaced by imported
goods, and thus, when the imported goods are growing, it signals a weakening Indian
economy.

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11 POLICY SUGGESTIONS AND RECOMMENDATIONS

Based on the merits and demerits of the current BOP situation in which the Current
Account deficit has deteriorated since 2004, as a result of the overheating of the Indian
economy, and keeping in mind the various factors responsible for the current BOP
situation in India, the following policy suggestions have been made:

Devalue the Rupee by lowering the interest rates. This will make exports cheaper
to foreign buyers; while at the same time make foreign goods more expensive.
Such a policy would increase the exports and at the same time lead to a reduction
in imports, thus ensuring that CA deficit is reduced. However, such a policy
measure can also lead to inflation. So care must be taken as to not lower the
interest rates too much that it puts an inflationary pressure on the Indian economy.

Lower aggregate demand by raising taxes or cutting down on spending. This will
decrease the demand for imports, thus ensuring that CA deficit is reduced.

Raise import tariffs, import quotas and other non-tariff barriers so as to decrease
the demand for imports and keep the foreign goods out. This would also lead to a
reduction in Indias CA deficit.

Set up tax-free export processing zones and subsidize capital to exporting sectors.
Such policies will channel resources to the exporting sectors and therefore the
exports will rise, thus correcting the CA deficit problem in India.

Build an infrastructure that makes it conducive and far easier to export.

Implement policies that attract direct foreign investment into the Indian economy
as well as those policies that attract short term flows of money in the Indian
banking sector.

Contract the money supply as this will reduce consumption and reduce the
demand for imports, thereby improving Indias current BOP situation.

Implement policies that provide subsidies or incentives to export producers. This

will ensure large volume of exports and will help in combating the CA deficit.

Adopt import substitution and introduce QRs thereby prohibiting imports and
solving Indias current CA deficit.

17

The CA deficit of India can also be corrected to a large extent by taking loans,
attracting FDIs and FIIs and through Tourism and Transportation development
as well.

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12 CONCLUSION
The volume of a countrys current account (one of the two main components of BOP) is a
good sign of economic activity. By analyzing the current account, one can get a clear
picture of the extent of economic activity of a country- including its industries and its
capital markets. However, depending on whether the nation is a developed or a
developing nation and its goals, the state of the current account decides whether the
economy is prospering or not.
Since India is a developing country, a Current Account deficit works well for Indias
economic progress as long as it is kept in check. However, since 2004, the Current
Account deficit of India has been increasing continuously and if it continues to increase,
Indias economic growth might become unsustainable. When analyzing the Current
Account of India, it is important to know what is fueling the extra deficit and what is
being done to counter the effects and whether the actions being taken are providing
results or not. The primary aim for India is to control this deficit before it gets out of
hand.
This report has dealt exclusively with the causal factors of BOP disequilibria in India and
various policy measures that reduce the demand for imports and increase exports have
been suggested that can combat the Current Account deficit of India.

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13 BIBLIOGRAPHY

Article by Richard Pettinger on the topic Is Current Account Deficit Harmful

(2005)

Pierre-Olivier Gourinchas, Olivier Jeanne.2002. On the benefits of Capital

Account Liberalization for Emerging Economies June 2002.

Article by Manu Gupta on the topic What is Balance of Payments and What
does it mean for your Business? (2009)

Article by Anita Chanda on the topic Indias Balance of Payments (July 2010)

Dominick Salvatore.2004. International Economics 8th edition by John Wiley &

Sons, Inc.

http://www.preservearticles.com/2011092013745/what-are-themethods-of-correcting-disequilibrium-in-the-balance-of-payments.html

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