IAS Gyan

Daily News Analysis

Balance of Payments

8th July, 2024 Economy

Balance of Payments

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  • RBI data revealed that India’s current account posted a surplus in the fourth quarter (Jan-Mar) of the 2023-24 financial year.
  • This was the first time in 11 quarters that India had witnessed a surplus.

Current Account Movements

  • Current account movements impact the rupee's exchange rate and India's sovereign ratings.
  • These movements indicate the overall health of the economy.

What is Balance of Payments?

  • The Balance of Payments (BoP) is essentially a ledger of a country’s transactions with the rest of the world.
  • As Indians trade and transact with the rest of the world, money flows in and out of the country.
  • The BoP shows how much money (shown here in billions of US dollars) went out of the country and how much money came in.
  • All the money coming into the country is marked positive and all the money going out is marked negative.
  • As such, in the BoP table, a minus sign points to a deficit.

Importance of Balance of Payments (BoP)

Capturing Currency Demand

  • BoP reflects the relative demand for rupees versus foreign currencies (e.g., US dollar).
  • Transactions such as buying US goods/services or investing in the US involve rupees being exchanged for dollars.

Exchange Rate Dynamics

  • Exchange rates are influenced by the balance of demand between rupees and foreign currencies.
  • If Indians demand more dollars than Americans demand rupees, the dollar's exchange rate relative to the rupee strengthens.

Economic Implications

  • BoP data informs economic policies and forecasts.
  • It highlights international trade and financial health indicators crucial for economic stability.

What are the constituents of the BoP?

The BoP has two main ‘accounts’ — Current Account, and Capital Account.

Current Account

  • Nature of Transactions: The current account of a country records its transactions in goods, services, income, and current transfers with the rest of the world during a specific period, typically a quarter or a year.
  • Subdivisions:
    • Trade of Goods (Merchandise Account): This refers to the export and import of physical goods such as cars, wheat, electronics, etc. It determines the balance of trade, where a deficit (imports exceeding exports) is indicated by a negative value.
    • Trade of Services (Invisibles): Known as 'invisibles' because these transactions are not physical goods, this category includes services like banking, insurance, IT, tourism, transport, etc. It also includes transfers such as remittances sent by Indians working abroad and incomes earned from foreign investments.

Performance in Q4 2023-24 Financial Year

During the fourth quarter (Q4) of the 2023-24 financial year:

  • Current Account Surplus: India reported a surplus on its current account.
  • Components:
    • Invisibles: The surplus in the invisibles category indicates that India earned more from services, transfers, and incomes than it paid out.
    • Trade Account: Despite the surplus in invisibles, India experienced a deficit in the trade of goods, implying that imports of physical goods exceeded exports during this period.

Economic Implications

  • The current account balance is a critical indicator of a country's economic health and its transactions with the rest of the world.
  • A surplus in the current account can indicate strong international competitiveness in services or a high level of foreign investment income, while a deficit may suggest a reliance on imports or a lack of competitiveness in goods trade.

Capital Account

  • Nature of Transactions: The capital account of a country records transactions related to investments rather than current consumption. It includes inflows and outflows of capital such as Foreign Direct Investment (FDI), Foreign Institutional Investments (FII), loans, and other financial transfers.
  • Examples: Foreign investors buying Indian stocks (FII), foreign companies establishing factories in India (FDI), or loans and grants received from international organizations.

Performance in Q4 2023-24:

  • The capital account for Q4 of the 2023-24 financial year showed a net surplus of $25 billion. This surplus indicates that there was a net inflow of capital into India during this period, reflecting investor confidence and financial activity.

Balance of Payments (BoP) and Foreign Exchange Reserves

  • BoP Balance Mechanism: The BoP always balances through changes in the foreign exchange reserves of the country.
  • Surplus Implication: When there is a BoP surplus, indicating that more funds are coming into the country than going out, the Reserve Bank of India (RBI) accumulates these excess dollars and adds them to its foreign exchange reserves. This helps stabilize the value of the rupee in the foreign exchange market and supports the competitiveness of Indian exports by preventing excessive appreciation of the rupee.

Interpreting BoP Data

  • Deficit vs. Surplus: It's important to note that terms like 'deficit' and 'surplus' do not always signify negative or positive economic conditions universally.
  • Current Account Analysis:
    • Q4 vs. FY2023-24: While Q4 showed a surplus on the current account, the full year (FY2023-24) recorded a deficit. This difference can be attributed to various factors such as seasonal fluctuations, economic policies, and global economic conditions.
    • Reasons for Deficit: A current account deficit in a developing economy like India may indicate the need to import capital goods (machinery, technology) to enhance production capabilities and support economic growth. It can also signify strong domestic demand and consumption.
  • Historical Context: For instance, the FY2020-21 saw a current account surplus mainly due to Covid-induced lockdowns that reduced imports significantly. However, this surplus was not necessarily a positive indicator of economic health.
  • Implications of Current Account Deficit: According to NR Bhanumurthy from the National Institute of Public Finance and Policy (NIPFP), a current account deficit of 1.5%-2% of GDP is considered sustainable and compatible with GDP growth rates of 7%-8%. This suggests that deficits within this range can support economic expansion and investment.

CURRENT ACCOUNT DEFICIT: https://www.iasgyan.in/daily-current-affairs/current-account-deficit-34#:~:text=Current%20Account%20Deficit%20or%20CAD,money%20flowing%20out%20on%20imports.


Q. Explain the significance of Balance of Payments (BoP) for economic management and international trade. Discuss how surpluses or deficits in the current account and capital account affect a country's economic stability and growth prospects, with specific reference to developing economies.