Balance of Payments and Foreign Trade: Key Concepts

The balance of payments is the account a country keeps of every economic transaction between its residents and the rest of the world in a year. Foreign trade, the buying and selling of goods and services across borders, is the largest single entry in that account. Together the two explain why the rupee moves, why the government worries about the oil bill and why a country can grow fast and still run short of dollars. For exam purposes the topic is a set of definitions that must be kept apart from one another, and a handful of dates.

Structure of the balance of payments

The balance of payments is drawn up on the double entry principle, so in a bookkeeping sense it always balances. It has two main parts. The current account records the flow of goods, services and income, and the capital account, called the capital and financial account in modern presentations, records changes in the ownership of assets and liabilities. Errors and omissions absorb the statistical gap between them.

Balance of trade and current account deficit

The balance of trade counts only visible items, that is, exports minus imports of goods. When imports of goods exceed exports the country has a trade deficit. The current account balance is wider: it takes the trade balance and adds the invisibles. India usually runs a trade deficit because of crude oil, gold and electronic goods, but a large part of it is covered by software exports and by remittances from Indians working abroad, so the current account deficit is smaller than the trade deficit. A current account deficit is not in itself a disease; it becomes one when the capital account cannot finance it.

Economists also divide the entries another way. Autonomous transactions, said to be above the line, are undertaken for their own sake, for profit or for consumption. Accommodating transactions, below the line, are undertaken to settle the gap left by the autonomous ones, chiefly by drawing down or adding to reserves. A balance of payments deficit means the autonomous receipts fall short, and the difference must be financed.

The crisis of 1991 and after

By the middle of 1991 India's foreign exchange reserves had fallen to about a fortnight of imports. The government pledged gold abroad, borrowed from the International Monetary Fund and devalued the rupee in two steps in July 1991. The crisis opened the way to liberalisation, privatisation and globalisation: industrial licensing was largely abolished, tariffs were cut and the exchange rate was reformed through the dual rate of 1992 and unification in 1993. India accepted full current account convertibility in August 1994 under Article VIII of the IMF. Capital account convertibility remains partial, and the two Tarapore Committees of 1997 and 2006 laid down the road map for moving further.

Exchange rate and convertibility

A fixed exchange rate is set by the authorities, a floating rate is set by demand and supply, and a managed float, which India follows, lets the market decide while the Reserve Bank intervenes to smooth sharp swings. Under a floating system a fall in the external value of the rupee is called depreciation and a rise appreciation; under a fixed system the same changes ordered by the government are called devaluation and revaluation. A weaker rupee makes exports cheaper abroad and imports dearer at home.

Foreign trade: policy and institutions

India's foreign trade is governed by the Foreign Trade (Development and Regulation) Act of 1992 and is administered by the Directorate General of Foreign Trade under the Ministry of Commerce and Industry, which issues the Foreign Trade Policy and the importer-exporter code. Exports are supported by the Export-Import Bank of India, set up in 1982, by the Export Credit Guarantee Corporation, by Export Promotion Councils and by special economic zones created under the Special Economic Zones Act of 2005.

Trade barriers and the World Trade Organization

Countries protect domestic industry in two ways. Tariff barriers are taxes on trade, chiefly customs duty, which raise the price of the imported good. Non-tariff barriers restrict quantity or entry instead: quotas fix how much may come in, an embargo bans trade with a country altogether, and licensing, standards and sanitary rules work in the same direction. An inward-looking strategy of import substitution relies mainly on tariffs and quotas.

The World Trade Organization came into being on 1 January 1995, replacing the General Agreement on Tariffs and Trade of 1947, and has its headquarters at Geneva. India is a founder member. Its rules rest on the most favoured nation principle, under which a concession given to one member must be given to all, and on national treatment, under which imported goods must not be treated worse than domestic ones once they have entered. The main agreements to remember are TRIPS on intellectual property, TRIMS on investment measures, GATS on services and the Agreement on Agriculture.

Terms examiners like

An export is valued FOB, free on board, and an import CIF, cost, insurance and freight, which is one reason import figures look larger. The terms of trade is the ratio of export prices to import prices; it improves when export prices rise faster. Special Drawing Rights are the reserve asset created by the IMF, whose value rests on a basket of major currencies. Finally, self-reliance in trade policy means avoiding imports of goods that the country can itself produce, not shutting out trade altogether.