ECONOMIC AND SOCIAL ISSUES (ESI)

- - CHAPTER-
BALANCE OF PAYMENTS

FOR RBI GRADE B AND NABARD GRADE

~/8 2019

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Contents
1 Balance of Paymellts (BoP) - What is it? ..............................................................................................................6

1.1 Why do we need to have this record? ................................................................................ .......................... 6

2 Components of India' s BOP Accou nt: ................................................................................................................... 7

2.1 Current Account of BoP: ............................................................................................................................... 7

2.1.1 Merchandise Transactions or Visible Trade: ........................................................................................ 7

2.1.2 Invisible Trade: ......................................................................................................................................8

2.1.3 Balance on current account : ...................................... ........................................................................... 9

2.1.4 Difference between Balance of Trade and Current Account: .............................................................. 9

2.2 Capital Account of BoP: ................................................................................................................................ 9

2.2.1 Debt-creating and non-debt creating capital inflows: ........................................................................ 10

2.2. 2 Foreign Investments: ........................................................................... ............................................... 10

2.2.3 Key points from Mayaram Committee Report: ................................... ............................................... 10

2.2.4 Lo ans: .................................................................................................................................................. 11

2.2.5 Banking Capital: ................................................................................... ............................................... 11

2.2.6 Balance on Capital Account: ............................................................................................................... 11

2.2.7 Basic BoP St at ement : .......................................................................................................................... 12

2.3 Foreign Exchange Reserves: ....................................................................................................................... 12

2.4 Errors and Om issions: ................................................................................................................................. 13

BoP Deficit or Surplus: .......................... ................................................................................................................. 13

3 Rupee Convertibility: .......................................................................................................................................... 14

3.1 Current Account Convertibility: .................................................................................................................. 14

3.2 Capital Account Convertibili ty: ................................................................................................................... 14

3.3 Basics of Capital Account Convertibil ity: .................................................................................................... 15

3.4 Restrictions under FEMA for Capital Account Convertibility: ...................... ............................................... 15

3.5 The Committee on Capital Account Convertibility (CAC) or Tarapore Committee: ................................... 15

3.6 The Second Tarapore Committee recommendations (2006): .................................................................... 16

3.7 Following we re some important recommendations of this committee: ................................................... 17

3.8 Tarapore Committee mentioned the following benefits of capita l account convertibility to India: ......... 17

3.8.1 Problems: ........................... ........... ...................................................................................................... 17

4 BoP Crisis ................................................. ........................................................................................................... 18

5 Balance of Payments Crisis of India 1990·9 l.. .................................................................................................... 18

5.1 M acroeconomic Indicators and Balance of Payments Situation in 1990-1991: ......................................... 18

5.2 Origin of the Crisis: ..................................................................................................................................... 19

5.3 What factors l'ed t o the culmination of t his crisis?..................................................................................... 19

5.4 Shocks: internal and external: ..................................... ................................ ............................................... 19

5.4.1 Soviet Block Breakup .......................................................................................................................... 19

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 5.4.2 The Iraq-Kuwait war ........................................................................................ ................................... 20

5.4.3 Political Uncertainty ........................................................................................................................... 20

5.4.4 Confidence .......................................................................................................................................... 20

5.4.5 Increase in Non-oil Imports: ...............................................................................................................20

6 Economic Reforms 1991 ..................................................................................................................................... 21

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In the chapters of 'Measurement of Growth and National Income' and Human Development, we
have looked into the various ways that are used to measure the economic growth of a nation.

We also realized the fact t hat economic growth of a nation does not essentially symbolize the
overall development of a country. We came to a conclusion that we require a different approach
that would give a true reflection of a country's progress.

The most appropriate approach is the Human Development Approach which was discussed in detail
as part of the 'Human Development' chapter.

There was a discussion regarding the Human Development Report which is brought out by the
UNDP. This report can be said to be a balance between the Income approach and the Human
Development approach which are at the two extremes.

The Human Development Report comes out with certain measurable parameters which gives us a
reflection of the country's overall progress.

Next, we moved on to the chapter 'Role of Economic Planning'. Here we underst ood the
importance of Planning to realize the dream of a prosperous nation.

The planning process becomes essential because the resources at our disposal are very limited and
the needs of the human beings are never ending. So, the judicial use of the resources and It s
effective allocation Is of prime Importance.

Resources are LIMITED

Resources have COMPETING USES
Human needs wants desires are UNLIMITED

Need to set up SYSTEMS to RATION/BUDGET the

LIMITED resources

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We have had an in-depth discussion regarding the importance of Planning, the types of economic
systems, the various types of planning, the history of planning in India.

There was also a discussion on the premier think tank in India taking care o·f planning process in
India 'NITI Aayog'.

Now, we have seen that In order to allocate the various resources effectively, we have certain
systems In place.

These systems would through various institutions come out with various processes to implement a
proper plan to meet the objective of effective allocation of resources.

In the figure above we can see that one among the various systems is t he ' Flscal System'. This
system deals with the budgeting of a country's economy.

This can be related to the budgeting of a household. In every household, there is planning done to
manage the expenses based on the income of the breadwinners of a household.

Similarly, to run an economy effectively, budgeting Is done, in which the Income and expenses are
analyzed, and the allocations made accordingly.

Now, the tool used in this fiscal system Is the Fiscal Policy.

We have already studied about this tool In the chapter 'Flscal Polley'.

There Is one another system t hat you can see In the picture above which is t he 'Monetary System'.

A monetary system is the set of Institutions by which a government provides money In a country's
economy.

In India, the lead role is taken by the Reserve Bank of India (the regulator of all the banks in India) in
running the country's monetary system.

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The Reserve Bank of India does this through an important tool, which is the monetary policy.

We have studied about this resource in the chapter 'Monetary Polley'.

Now if we realize the systems mentioned above deal with managing the activities and flow of
money within our country.

So, what about the transactions happening across the borders of our country?

We have studied in the chapter, 'Role of Economic Planning', how the economic reforms in India
have made India an open economy.

Keeping this mind, we need to understand that there must be systems in place that would manage
the flow of money as well materials in and out of our country.

The systemic records of all these economic transactions of residents of a country with the rest of
the world during a gi;ven period of time is known as Balance of Payments (BoP).

Let us understand this in detail in this chapter ' Balance of Payments'.

1 Balance of Payments (BoP) - What is it?

• In the modern world, there is hardly any country which is self-sufficient in the sense that it
produces all the goods and services it needs.
• Every country imports from other countries the goods that cannot be produced at all in the
country or can be produced only at an unduly high cost as compared to the foreign supplies.
• Similarly, a col\.Jntry exports to other countries the commodities which t hose countries prefer
to buy from abroad rather than producing at home.
• Besides, trade of goods and services, there are flows of capital.
• Foreign capital flows are in the form of portfolio investment by foreign unstitutional investors
or in the fo rm of foreign direct investment.
• The balance of payments is a systematic record of all economic transactions of residents of a
country with the rest of the world during a given period of t ime.

1.1 Why do we need to have this record?

• This record is so prepared as to measure the various components of a country's external
economic trarnsactions.
• Thus, the aim is to present an account of all receipts and payments on account of goods
exported, services rendered and capital received by the residents of a country, and goods
imported, services received and capital transferred by residents of the country.
• The main purpose of keeping these records is to know the international economic position of
a country which helps the Government in making decisions on monetary and fiscal policies
on the one hand, and trade and payments policies on the other.

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2 Components of lndla's BOP Account:

Balance of payment (BoP) comprises of curren t account, capital account, errors and omissions and
changes In foreign exchange reserves.

Note: The IMF accounting standards of the BOP statement divides international transactions into
three accounts: the current account, the capital account, and the financial account, where the
current account should be balanced by capital account and financial account transactions. But, in
countries like India, the financial account is included In the capital account Itself.

2.1 Current Account of BoP:

Under current account of the BoP, transactions are classified Into merchandise (exports and
imports) and invisibles.

2.1.1 Merchandise Transactions or Visible Trade:

• A major part of transactions in foreign trade Is in the form of export and Import of goods
(visible Items).
• The money earned from Indian exports of goods (e.g., cars sold to Nepal) Is credited (added)
to this account, whilst payments for Imported goods (e.g., American aircraft sold in India) are
debited.
• Balance of Trade: The difference between exports of goods and Imports of goods is known as
the Balance of Trade.

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 • If, export of goods (in terms of value) > import of goods (In terms of value), then we have a
Trade Surplus.
• If, export of goods (in terms of value) < import of goods (In terms of value), then we have a
Trade Deficit.

2.1.2 Invisible Trade:

Invisible transactions are further classified into three categories, namely Services, Income and
Transfers.

Let us see them one by one in detail:

2.1.2.1 Services:
It Includes a large variety of non- factor services (known as invisible items) sold and purchased by
the residents of a country, to and from the rest of the world. Payments are either received or made
to the ot her countries for use of t hese services.

For example: The Income earned from the sale of Indian services abroad is known as an Invisible
export, e.g., an insurance premium paid by a British ship-owner to an Indian broker. When Indian
residents spend money on foreign services, e.g., a week's accommodation in London, they are
creating invisible imports, because payment is going out of lndla.

2.1.2.2 Income:
It Includes Profits and Dividends earned by residents of India on their investments abroad and vice
versa. It also includes. Interest payments i.e. servicing of debt liabilities.

2.1.2.3 Transfers:
These are unilateral transfers which include gifts, donations, personal remittances and other 'one-
way' transactions. These refer to those receipts and payments, which take place without any service
in return.

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2.1.3 Balance on current account:
In the current account, receipts from export of goods, services and unilateral receipts are entered as
credit or positive Items and payments for Import of goods, services and uniilateral payments are
entered as debit or negative items. The net value of credit and debit balances is the balance on
current account.

• A current account deficit means the value of imports of goods/services / investment incomes
I transfers is greater than the value of exports. It indicates net outflow of foreign exchange.
• A current account surplus means the value of imports of goods/services / investment
incomes / transfers is less than the value of exports. It indicates net Inflow of foreign
exchange.

Note: A deficit on the current account Is a warning that the nation is spending more than it is
earning, in the short run.

2.1.4 Difference between Balance of Trade and Current Account:

Basis Balance of Trade (BOT) Current Account
Components Balance of trade includes only Current Account records both visible and
visible items. invisible items.
Scope It is a narrow concept as it is only a It is a wider concept and it includes BOT.
part of current account

2.2 Capital Account of BoP:

• Capital account of BOP records all those transactions, between the residents of a country
and the rest of the world, which cause a change in the assets or liabilities of the residents of
the country or its government.
• It is related to claims and liabilities of financial nature.
• Capital account is concerned with financial transfers. So, it does not have direct effect on
income, output and employment of the country.

Under the capital Account, capital inflows can be classified by instrument (debt or equity) and
maturity (short or long term).

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The main components of the capital account include foreign investment, loans and banking
capital.

2.2.1 Debt-creating and non-debt creating capital inflows:

Capital inflows In the capital account can be classified Into debt creating and non-debt creating.
Foreign investment (both direct and portfolio) represents non-debt creating capital inflows,
whereas external assistance (i.e. concessional loans taken from abroad), external commercial
borrowing (ECB) and non-resident deposits are debt-creating capital inflows.

2.2.2 Foreign Investments:

• Foreign Investment, comprising Foreign Direct Investment (FOi) and Portfolio Investment
consist ing of Foreign Institutional Investors (Flis) Investment, American Deposit ory
Receipts/Global Depository Receipts (ADRs/ GDRs) represents non-debt liabilities.
• FOi and FIi: Both are the forms of investment made in a foreign country. FOi is made to
acquire controlling ownership in an enterprise but FIi tends to invest in the foreign financial
market. In most cases, the former is given preference over the latter because it benefits the
whole economy.
• In June 2014, Government of India had accepted the recommendations Mayaram Committee
thereby accepting the definitions of FIi and FOi. The panel headed by Finance Secretary was
set up to rationalize the definitions of FOi and FIi.

2.2.3 Key points from Mayaram Committee Report:

• Foreign investment of 10 percent or more through eligible Instruments made In an Indian
list ed company would be treated as FOi.
• All existing foreign investments below the threshold limit made under the FOi Route shall
however, cont inue to be treated as FOi.
• Foreign Investment in an unlisted company Irrespective of threshold limit may be treated as
FOi.
• An investor may be allowed to invest below the 10 percent threshold and this can be treated
as FOi subject to the condition that the FOi stake is raised to 10 percent or beyond within
one year from the date of the first purchase. The obligation to do so will fall on the company.

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 • If the stake Is not raised to 10% or above, then the investment shall be t reated as portfolio
investment.
• In case an existing FDI fa lls to a level below 10 percent, it can continue to be treated as FDI,
without an obligation to restore It to 10% or more.
• In a particular company, an investor can hold the invest ments either under t he FPI route or
under the FDI route, but not both.
• The Committee has recommended the merger of the FIi and Qualified Foreign Investors (QFI)
regimes under the new "Foreign Portfolio Investors" (FPI) regime.

Note: The limit of FOi in each sector is given in detail In the Industrial Policy document.

2.2.4 Loans:
• Loans include external assistance, external commercial borrowings and trade credit.
• External assistance means borrowing from foreign countries under concessional rate of
interest.
• Commercial borrowing under which the Indian Government and the private sector borrow
funds from world money market at higher market rate of interest.

2.2.5 Banking Capital:

• Banking capital, including non-resident Indian (NRI) deposit s are debt liabilities.
• These are the deposits made by non-resident Indians (NRI) w ho keep their surplus funds w ith
Indian Banks.

2.2.6 Balance on Capital Account:

The transactions, which lead to inflow of foreign exchange (like receipt of loan1from abroad, sale of
assets or shares in foreign countries, etc.), are recorded on the credit or positive side of capital
account. Similarly, transactions, which lead to outflow of foreign exchange (like repayment of loans,
purchase of assets or shares in foreign countries, etc.), are recorded on the debit or negative side.
The net value of credit and debit balances is the balance on capital account.

• Surplus in capital account arises when credit Items are more than debit items. It indicates
net inflow of capital.
• Deficit in capital account arises when debit Items are more than credit items. It indicates net
outflow of capital.

The table below shows a very basic BOP Statement: This table clearly mentions the debit part and
credit part of the statement.

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2.2.7 Basic BoP Statement:
Payment
Receipts Balance Balance
s
Items (Credits) (Surplus) (Deficit)
(Debits) .
+ . +

1. Current Account
(Q Merchaldise E,cports lmportS Exports >lmpo,15 Exports<
(goods) Imports
(II) lnvlalble E,cports Imports Exports > Imports Exports<
(Services) Imports
2. Capital Account
(I) Fore91 Inflows Outflows lnflows>Outflows lnflOWS<
Investment Outflows
(ii) Loans Received S~ied Received> Received<S14>P
Supplied lied
3. Bankilg Capital Oeposks Deposb If deposks in If deposls from
- in India from Inda India is higher India is hla,er

Balance on Current Account Vs. Balance on Capital Account:

Balance on current account and balance on capital account are Interrelated.
• A deficit In the current account must be settled by a surplus on the capital account.
• A surplus In the current account must be matched by a deficit on the capital account.

2.3 Foreign Exchange Reserves:

• The foreign currency held in a country is also taken into account whil e maintaining the
balance of payments accounts.
• The components of India's Foreign Exchange Reserves Include: Foreign exchange (Foreign
Currency Assets), Gold, Special Drawing Rights (SOR) and Reserve Tranche Position in the
IMF.
(Note: More about this can be referred in the IMF document)
• Technically, when a country exports, it receives more foreign exchange or currency.
• It implies that if the current balance of payments account is in surplus, the country has a
potential to increase its foreign exchange reserves.
• The same is also true for capital account.
• On the other hand, if a country imports more, it has to pay from its foreign exchange
reserves.

Exchange Rate:
• Exchange rate is the price of one currency in terms of another currency.
• The exchange rate Is used when simply converting one currency to another (such as for the
purposes of travel to another country), or for engaging in speculation or trading in the foreign

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 exchange market.
• There are a wide variety of factors which influence the exchange rate, such as Interest
rates, inflation, and the state of politics and the economy In each country.
• Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central
banks of a country whereas floating exchange rates are decided by the mechanism of market
demand and s.upply.
• In a floating rate regime, an Increase in the value of the domestic currency against other
currencies is called an appreciation, while a decrease In value is called depreciation.
• In contrast, an increase In the exchange rate in a fixed rate regime is called a revaluation (for
an increase) and a decrease in the exchange value of the domestic currency Is referred to as
devaluation.
• In India, RBI follows a managed floating exchange rate system. Here, the RBI interferes to
manage volatility in floating exchange regime. To stop depreciation of r upee, RBI should sell
dollars from its forex reserve and to stop appreciation of rupee, RBI should purch ase dollars
from the market.
• Nominal exchange rate is the price of one currency in terms of number of units of some
other currency.
• It is 'nominal' because it measures only t he numerical exchange value, and does not say
anything about other aspects such as the purchasing power of that currency.
• To incorporate the purchasing power and competitiveness aspect and, therefore, make the
measure more meaningful, real exchange rates are used.
• The real exchange rates are nothing but the nominal exchange rates multiplied by the price
indices of the two countries.
• NEER and REER: NEER is the Nominal Effective Exchange Rate, and REEIR is the Real Effective
Exchange Rate.
• Unlike nominal and real exchange rates, NEER and REER are not determined for each foreign
currency separately. Rather, each is a single number (usually expressed as an index) that
expresses what is happening to the value of the domestic currency against a whole basket of
currencies.

2.4 Errors and Omissions:

Since BOP always balances in theory, all debits must be offset by all credits and vice versa. In
practice, rarely it happens particularly because stat istics are incomplete as well as imperfect. That Is
why errors and omissions are considered so that BOP account s are kept in balance.

The Balance of Payments can be summarized as:

Current account balaince + Capital account balance+ Reserve balance = Balance of Payments

BoP Deficit or Surplus:

• The decrease (increase) in official reserves is called the overall balance of payments deficit

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 (surplus).
• The balance of payments deficit or surplus is obtained after adding the current and capital
account balances.
• The balance of payments surplus will be considered as an addition to official reserves (reserve
use).

3 Rupee Convertibility:
Indian rupee is fully convertible only in the current account and not in the capital account. This
means one can import and export goods or receive or make payments for services
rendered. However, investments and borrowings are restricted.

3.1 Current Account Convertibility:

• Current account convertibility allows free inflows and outflows for all purposes other than
for capita l purposes such as investments and loans.
• In other words, it allows residents to make and receive trade-related payments -- receive
dollars (or any other foreign currency) for export of goods and services and pay dollars for
import of goods and services, make sundry remittances, access foreign currency for travel,
studies abroad, medical treatment and gifts, etc.
• Though Current account in India is fully convertible but still some restrictions from FEMA
(Foreign Exchange Management Act) viz.

■ Not com·ertible for betting, gambling, prohibited items

■ TraYel to Nepal, Bhutan-> Can carry Max. S 10 k II Max. Rs. 100 denomination
■ TraYel to other countries_. Can carry Max. $25 k per Yisit (beyond that need RBI permission)

■ For Education, Medical treatment, Employment purpose - limit is 1 lakh S

• Gift sending -> limit Rs. 5 lakh worth

Liberalized remittance scheme (2004): Indian residents may spend $2.5 lakh dollars per year per
person abroad apart from FEMA limit.

3.2 Capital Account Convertibility:

• It means the f reedom to convert local financial assets into foreign financial assets and vice
versa at market determined rates of exchange. This implies that Capital Account
Convertibility allows anyone to freely move from local currency into foreign currency and
back.
• It refers to the removal of restraints on international flows on a country's capital account,
enabling full currency convertibility and the opening of the financial system.

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 • Capital account convertibility Is considered to be one of the major features of a developed
economy. It helps attract foreign Investment.
• At the same time, capital account convertibility makes it easier for domestic companies to
tap foreign markets.
• It is sometimes referred to as Capital Asset Liberation.

3.3 Basics of Capital Account Convertibility:

• Capital account is made up of both the short-term and long-term capital transactions.
• The Capital Transaction may be Capital outflow or capital inflow.
• Convertibility on the capital account is usually introduced after a certain period of
introducing the Current account convertibility.
• The most important effect of introducing the capital account convertibility is that it
encourages the inflow of the foreign capital, because under certain conditions, the foreign
investors are enabled to repatriate their investments, wherever they want.
• However, the risk is that it may accelerate the flight of the capital from the country in
unfavorable circumstances.
• For instance, an Indian can sell property here and take the Capital outside during such
circumstances. This is the reason that Capital Account Convertibility is generally introduced
after experimenting with the convertibility on current account.

3.4 Restrictions under FEMA for Capital Account Convertibility:

• ECB

• Quota - 1 Bt.llloo S Ea.Lue Av ut.t1on scc to1

• Individual company - 300 m.tl4on S

• M.atw-ity - 3 y ears m.uwnum "'" Approval from R.Dl

■ FOi , Fil restrictions

• I0Oo/o for In vestment liberty in Bhutan
• Eve rywhere else -, $75 k investment per year by individuals e .g. buymg shares, openmgfore,gn bank accounts
• Financial Action Task Force (FATF) - "Non c,o-operative countries" [Iran, N Korea) - No investing in the se
countries

3.5 The Committee on Capital Account Convertibility (CAC) or Tarapore Committee:

• It was constituted by the Reserve Bank of India for suggesting a roadmap on full
convertibility of Rupee on Capital Account.
• The committee submitted its report in May 1997.
• The Tarapore committee observed that the Capital controls can be useful in insulating the
economy of the country from the volatile capital flows during the transitional periods and
also in providing time to the authorities, so that they can pursue discretionary domestic
policies to strengthen the initial conditions.
• The CAC Committee recommended the implementation of Capital Account Convertibility for
a 3 year period viz. 1997-98, 1998-99 and 1999-2000.

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But this committee had laid down some pre conditions as follows:

Gross fiscal deficit to GOP ratio has to come down from a budgeted 4.5 per cent In 1997-98 to 3.5%
in 1999-2000.

A consolidated sinking fund has to be set up to meet government's debt repayment needs; to be
financed by increased in RBl's profit transfer to the govt. and disinvestment proceeds. Inflation rate
should remain between an average 3-5 per cent for the 3-year period 1997-2000.

Gross NPAs of the public sector banking system needs to be brought down fro m the present 13.7%
to 5% by 2000.

At the same time, average effective CRR needs to be brought down from the current 9.3% to 3%

RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effect ive
Exchange Rate RBI should be transparent about the changes in REER External sector policies should
be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from
25%to 20%

Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard
against any cont ingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should
be prescribed by law in the RBI Act.

The above committee's report was not translated into any actions.

India is still a country with partial convertibility.

However, some important measures In "that direction" were taken and they are summarized as
below:

• The Indian Corporate were allowed full convertibility In an automatic route up to the $ 500
million overseas ventures.
• This means that the limited companies were allowed to invest in foreign countries.
• Indian corporate was allowed to prepay their external commercial borrowings via automatic
route if the loan is above $ 500 million. Individuals were allow ed to Invest In foreign assets,
shares up to$ 2, 00, 000 per year.
• Unlimited amount of Gold was allowed to be imported. "The last measure, i.e. allowing
unlimited amount of Gold is equal t o allowing the full convert ibility in capit al account via
current account route" .

3.6 The Second Tarapore Committee recommendations (2006):

• Reserve Bank of India appointed the second Tarapore committee to set out t he framework
for fuller Capital Account Convertibility.

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 • The committee was established by RBI In consultation with the Government to revisit the
subject of fuller capital account convertibility in the context of the progress in economic
reforms, the stability of the external and financial sectors, accelerated growth and global
integration.
• The report of t his committee was made public by RBI on 1st September 2006.
• In this report, the committee suggested 3 phases of adopting the full convertibility of rupee
In capital acoumt. First Phase in 2006-07; Second phase in 2007-09; Third Phase by 2011.

3.7 Following were some important recommendations of this committee:

• The ceiling for External Commercial Borrowings (ECB) should be raised for automatic
approval.
• NRI should be allowed to invest in capital markets NRI deposits should be given tax benefits.
• FIi (Foreign Institutional Investors) should be prohibited from investing fresh money raised to
participatory notes.
• Existing PN (Participatory notes) holders should be given an exit route to phase out
completely the PN notes. At present the rupee is fully convertible on the current account,
but only partially convertible on the capital account.

3.8 Tarapore Committee mentioned the following benefits of capital account

convertibility to India:

1. Availability of large funds to supplement domestic resources and thereby promote economic
growth.
2. Improved access to International financial markets and reduction in cost of capital.
3. Incentive for Indians to acquire and hold International securities and assets, and
4. Improvement of the financial system in the context of global competition.

3.8.1 Problems:
• It may be noted that convertibility of currency can give rise to some problems.
• Firstly, since market determined exchange rate is generally higher than the previous officially
fixed exchange rate, prices of essential Imports rise which may generate cost-push inflation
in the economy.
• Secondly, if current account convertibility is not properly managed and monitored, market
exchange rate may lead to the depreciation of domestic currency.
• If a currency depreciates heavily, the confidence in it is shaken and no one will accept It In its
t ransactions. As a result, trade and capit al flows in the country are adversely affected.
• Thirdly, convertibility of a currency sometimes makes it highly volatile. Further, operations by
speculators make it more volatile and unstable. When due to speculative activity, a currency
depreciates and confidence in it is shaken there is capital flight from the country as it
happened in 1997-98 in case of South East Asian economies such as Thailand, Malaysia,
Indonesia, Singapore and South Korea.

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 • This adversely affects economic growth of the economy. In the context of heavy depreciation
of the currency not only there is capital flight but inflow of capita1I in the economy is
discouraged as due to depreciation of the currency profitability of investment in an economy
is adversely affected.

4 BoP Crisis
• Countries with current account deficits can run into difficulties. If the deficit ls large and the
economy is not able to attract enough inflows of foreign investment, then their currency
reserves will dwindle.
• There may come a point when the country needs to seek emergency borrowing from
institutions such as the International Monet ary Fund that may lead to external debt.
• Countries with deficits in their current accounts will build up increasing debt and/or see
increased foreign ownership of their assets.
• BoP crisis Is also known as the currency crisi s.

India also faced BoP ,crisis in 1990-91. The following section gives an account of this.

5 Balance of Payments Crisis of India 1990-91.

To understand the crisis, we need to be aware of the condition that prevailed at that point of
time.

5.1 Macroeconomic Indicators and Balance of Payments Situation in 1990-1991:

• Trade deficit: The trade deficit increased from Rs. 12,400 crore in 1989-90 to Rs. 16,900 crore
in 1990-91.
• Current Account Deficit: The current account deficit increased from Rs. 11,350 crore in 1989-
90 to Rs. 17,350 crore in 1990-91 . The CAD/GDP ratio increased from 2.3 in 1989-90 to 3.1
percent in 1990-91.
• Fiscal Deficit to GDP ratio: Besides t his, the fiscal deficit to GDP ratio was more than 7
percent during the two years 1989-90 and 1990-91.
• Inflation: The average rate of Inflation was 7.5 percent in 1989-90, which went up to 10
percent in the year 1990-91. In 1991-92, it crossed 13 percent.
• GDP Growth r ate: The GDP growth rate which was 6.5 percent in 1989-90, went down to 5.5
percent in 1990-91.
• Industrial Sector: The Balance of Payments crisis also affected the performance of Industrial
sector. The average industrial growth rate was 8 percent in the second half of 1980s. In 1989-
90, it was 8.6 percent and in 1990-91 it was 8.2 percent.
• Foreign exchange reserves of India: The foreign exchange reserves, meant to cover import
costs for two years (1989-1991), were just sufficient to cover close to two and half months of
imports.
18 Pae WWW . E OUTA P . CO . I N UERY? HELLO E OU TA P . C O . I N 8146207241
 • India' s foreign exchange reserves stood at Rs. 5,277 crore on 31 December 1989, which
declined to Rs. 2,152 crore by the end of December 1990. Between May and July 1991, these
reserves ranged between Rs. 2,500 crore to 3,300 crore.
• As the value of the rupee was constantly dropping down to a new level, the current account
deficit was stuck at the highest position like forever it seemed.
• And the inflation rate of the country was running at nearly a ten percent annual clip and the
country was facing a serious economic trouble and downturn.
• Earlier an acute balance of payments crisis had forced New Delhi Into the indignity of
pawning its gold reserves in order to secure which created an urgent need for development
and funds from international financing.

5.2 Origin of the Crisis:

• It all began in the year 1985 and India had started having a balance of payment problems and
towards the end of the year 1990, it was in a serious economic crisis.
• The government was nearing to the line of t he default and the country's central bank was
refusing to give any credit or loan and fo reign exchange reserves had been reduced to such a
point that India could barely finance itself for even 20 days and the worth of imports which
led the Indian government to basically t ake away the national gold reserves as a pledge to
the International monetary fund (IMF) to get a loan or credit In order to overcome this
balance of payment crisis they had been suffering trough from the year 1985.
• And now the Indian economy would have failed a big time if they did not do this.

5.3 What factors led to the culmination of this crisis?

• The BOP crisis hit the country in the year 1990-1 but the journey of the crisis had been
building for at least a half a decade, preceeding the year of 1991.
• The rising of the fiscal deficit and gradually increasing overvaluation has all resulted and
contributed to the rising imbalance In the balance of payment of the country.
• Improper exchange rate adjustment with respect to the external and domestic shocks during
1990-91 was an add-on to the crisis.

5.4 Shocks: internal and external:

5.4 .1 Soviet Block Breakup

• Rupee trade was major with the Soviet bloc which was an Important part of total tradeoff
the country in the eighties.
• Exports to Eastern Europe comprised of 22.1% of the total exports in the year 1980 and
19.3% In the year 1989.
• From the year of 1960s India highly depended on the Soviet Union for the exports and It
failed to maintain rela tionship with the United states and west ern Europe and In the late
1980s, Soviet Union started to break and by 1991 they got subdivided into 15 nations
(Russia, Kazakhstan, Ukraine, etc) and this had created a major problem for the Indian
exports.

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5.4.2 The Iraq-Kuwait war
• The gulf crisis which had risen up after Iraq had invaded the Kuwait in the month of August in
the year 1990 and this led to an increase In prices of the crude oll.
• India was highly dependent on Kuwaiti and Iraq's crude oil which was a long-term supply for
the contract aind was In big trouble after this Invasion.
• The effect of the oil price Increase was therefore multiplied for India by a more permanent
disruption of o il supplies from Iraq.

5.4.3 Political Uncertainty

• In the late 1980s, the country's political base had shaken and the system was imploding and
the Prime M inister Rajiv Gandhi was involved In a number of troubles and cases with Bofors
scandal, IPKF misadventure, Shah Bano Case that ultimately led to his abolishment In the
year 1989.
• And this political imbalance had a huge effect on the economy of Indian which was left
unbothered b,ecause of the political crisis and in 1991 this stop-gap government crashed.
• Until Naraslmha Rao was sworn as Prime Minister in the year of 1991, Indian economy was
left in gross neglect.

5.4.4 Confidence
• From the per.spective of the market and the other importing markets of the country, this
entire period was to be known as a high degree of political uncerta inty intersected with
socio-economic vanished rule which had a usual Impact on the confidence level of the count.
• Given the non-economic preoccupation of the government, this inevitably raised questions
regarding the capability of the Indian government to manage the economy in such a way that
the economy comes out of this depression had now become a challenge which wa s more of
impossible to the country officials.

5.4.5 Increase in Non-oil Imports:

• The trends In Imports and exports show that imports rose much faster than exports during
the eighties.
• Imports Increased by 2.3 percent of GDP, while exports increased by onl,y 0.3 percent of GDP.
• As a consequence, trade deficit Increased from an average of 1.2 percent of GDP in the
seventies, to 3.2 percent of GDP in eighties.

Ptriod Oii lmportt No■ - Oil lmperts Total Imports

1981-Slto 26041.61 54491.03 80532.64
1985 • 86 (32.00) 161.001 1100.00)
1986-87 lO 28299.75 120796.18 149095.93
1990-91 119.001 181.00) (100.00\
Note: Figures in brackets are percent to tolAI .

S -: Racnt Bank of lndia-Haltdbook o/Slalbtla Olt lndiolt ~ .

100S-06

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6 Economic Reforms 1991
• India approached the International Bank for Reconstruction and Development (IBRD),
popularly known as World Bank and the International Monetary Fund (IMF) and received $7
billion as loan to manage the crisis.
• For availing the loan, these international agencies expected India to liberalize and open up
the economy by removing restrictions on the private sector, reduce the role of the
government in many areas and remove trade restrictions between India and other countries.
• India agreed to the conditionalities of World Bank and IMF and announced the New
Economic Policy (NEP).
• The NEP consisted of wide ranging economic reforms. The thrust of the policies was towards
creating a more competitive environment in the economy and removing the barriers to entry
and growth of firms.
• This set of policies can broadly be classified Into two groups: the Stabilizat ion measures and
the structural reform measures.
• Stabilization measures are short-term measures, intended to correct some of the
weaknesses t hat have developed in the balance of payments and to bring inflation under
control.
• In simple words, t his means that there w as a need to maintain sufficient foreign exchange
reserves and keep the rising prices under control.
• On the other hand, structural reform policies are long-term measures, aimed at improving
the effi ciency of the economy and increasing its international competitiveness by removing
the rigidities in various segments of the Indian economy.
• The government initiated a variety of policies which fall under three heads viz., liberalization,
privatization and globalization.

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 ECONOMIC AND SOCIAL ISSUES (ESI)
CHAPTER
BALANCE OF PAYMENTS
WORKSHEET

f OR RBI GRADE B AND NABARD GRADE

IA/B 201]

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Fill in the blanks:
1. The _ _ _ _ _ _is a systematic record of all economic transactions of residents of a country
w ith the rest of the world during a given period of time.
2. In India, the Balance of Payments statement is divided into two types of accounts - Current and
Capital Account. The financia l account is included In the _ _ _ _ _ _ account.
3. The export and Import of visible Items refers to the export and import of _ _ _ _ _ and forms
a part of _ _ _ _ _ account.
4. If the value of the Imports of goods Is greater than the value of exports of goods, then it resu lts
in _ _ __ _ deficit.
5. When Indian resident s spend money on foreign services, e.g., a week's accommodation in
M auritius, they are creating invisible _ _ _ __
6. Unilateral Transfers which include gifts, donations, personal remittances and other 'one-way'
t ransactions are included under _ _ __ _ account.
7. A _ _ _ _ _ _ means the value of imports of goods/services/ investment Incomes /
t ransfers is greater than the value of exports. It indicates net _ __ _ of foreign exchange.
8. A deficit on t he _ _ _ _ account is a warning t hat the nation is spending more than it is
earning, In the short run.
9. India has a current account _ _ _ _ and a capital account._ _ __
10. External assistance (i.e. concessional loans taken from abroad), external commercial borrowing
(ECB) and non-resident deposits are ____ creating capital inflows.
11. In _ _ _ _ Government of India had accepted the recommendations of Mayaram Committee
thereby accepting the definitions of FIi and FOi.

True/False
1. Foreign Investment in an unlisted company irrespective of threshold limit may be t reated as FOi
(True/ False).
2. Banking capital, including non-resident Indian (NRI) deposits are debt liabilities (True/False).
3. Surplus in capital account arises when credit items are less than debit items. It indicates net
outflow of capital (True/False).
4. A deficit in the current account must be settled by a surplus on the capital account (True/False).
5. Floating exchange rates are decided by central banks of a country whereas fixed exchange rates
are decided by the mechanism of market demand and supply (True/False).
6. In a floating rate regime, an increase in the value of the domestic currency against other
currencies Is called an appreciation (True/false).

Match the Following:

Term Meaning
Balance of Trade It records both visible and invisible Items.

Current Account It Includes only visible items (goods).

2 Pa WW W . ED U TAP . CO . I N UERY? H EL LO E D U TAP . C O . I N 8146207 4

Capital Account Value of imports of goods is greater than the value of exports
of goods for a country.

Trade Deficit It records all those transactions, between the residents of a

country and the rest of the world, which cause a change in
the assets or liabilities of the residents of the country or its
government.

Foreign Direct Investment Foreign investment of less than 10 percent through eligible
instruments made in an Indian listed company.

Foreign Inst it ut ional Invest ment Foreign investment of 10 percent or more through eligible
instruments made in an Indian listed company.

Answers:

Fill in the blanks:

1. Balance of Payments. This record is so prepared as to measure t he various components of a
count ry' s external economic transacti ons. The main purpose of keeping these records is to know
the international economic position of a country which helps t he Government In making
decisions on monetary and f iscal policies on t he one hand, and trade and payments policies on
the other.
2. Capital Account. The IM F accounting st andards of t he BOP statement divides international
transactions into t hree accounts: t he current account, the capital account, and the fin ancial
account, where t he current account should be balanced by capital account and financial account
t ransactions. But, in countries like India, t he financial account is included in the capital account
itself.
3. Goods and forms a part of Current Account.
4. Trade Deficit. On the contrary, If, export of goods (in terms of value) > import of goods (In terms
of value), then we have a Trade Surplus.
5. Imports. These are treated as imports because the payment is going out of India.
6. Current Account. These refer to those receipts and payments, which take place without any
service in return.
7. Current Account Deficit, net outflow of foreign exchange. On the other hand, a current account
surplus means the value of imports of goods/services / investment incomes/ transfers is less
than the value of exports. It indicates net inflow of foreign exchange.
8. Current account.
9. Current account Deficit, Capital account Surplus.
10. Debt-creating capital inflows.
11. 2014. The panel headed by Finance Secretary was set up to rationalize the defi nitions of FOi and
FIi.

3 Pa e WWW . E D UTA P . CO. I N UERY? H EL L O ED U TAP .CO . IN 24 1

True/False

1. True.
2. True. These are the deposits made by non-r,esident Indians (NRI) who keep their surplus funds
with Indian Banks. This is included under the Capital Account of the BoP.
3. False. Surplus in capital account arises when credit items are more than debit items. It indicates
net inflow of capital. Deficit in capital account arises when debit items are more than credit
items. It indicates net outflow of capital.
4. True. A surplus in the current account must be matched by a deficit on the capital account.
5. False. Fixed exchange rates are decided by central banks of a country whereas floating exchange
rates are decided by the mechanism of market demand and supply.
6. True. On the other hand, a decrease in the value of the domestic currency against other
currencies is called depreciat ion.

Match the Following:

Correct Order:

Term Meaning
Balance of Trade It includes only visible items (goods).

Current Account It records both visible and invisible items.

Capital Account It records all those transactions, between the residents of a

country and the rest of the world, which cause a change in
t he assets or liabilities of the residents of the country or its
government.

Trade Deficit Value of imports of goods is greater than the value of exports
of goods for a country.

Foreign Direct Investment Foreign investment of 10 percent or more through eligible

instruments made in an Indian listed company.

Foreign Institutional Investment Foreign i nvestment of less than 10 percent through eligible
instruments made in an Indian listed company,

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