The following article will guide you about when a country’s balance of payments is said to be in equilibrium.
Before we analyse the causes of disequilibrium in the balance of payments, we would like to explain what is meant by equilibrium in the balance of payments.
We know that when we add up all the demand for foreign currency and all the sources from which it comes, these two amounts are necessarily equal and thus the overall account of the balance of payments necessarily balance or must always be in equilibrium.
What then do we mean by when we say that the balance of payments of a country is in equilibrium or disequilibrium. As a matter of fact, when we speak of equilibrium or disequilibrium in the balance of payments we refer to the balance on those parts of the account which do not include the accommodating items such as borrowing from the IMF, use of SDRs, drawing from the reserves of foreign currencies held by the Central Bank, etc.
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When excluding these accommodating items there is neither deficit nor surplus in the overall balance of payments, it is said to be in equilibrium. When in this sense, there is either deficit or surplus, the balance of payments is said to be in disequilibrium.
The deficit in balance of payments can be financed by drawings from the IMF, use of SDRs, drawings from the reserves of foreign currencies and loan and aid received from abroad. For example in 2001-02, we added to our foreign exchange reserves to the tune of 11757 million US dollars. However for previous several years India’s balance of payment on current account was in deficit. To finance the deficits’ India borrowed from IMF or from other countries or even resorted to commercial borrowing from abroad. But India’s balance of payments for the year 2001-02 was favourable.
Basic Balance of Payments, Autonomous Items and Accommodating Items:
However, a more important and popular concept of balance of payments equilibrium has been of basic balance. The concept of basic balance is based upon the idea of autonomous items in the balance of payments. The autonomous items in the balance of payments are those items which cannot be influenced or changed so easily or quickly by the Government and they are determined by some long-term factors.
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In this concept of basic balance, besides the items in the current account, the long-term capital movements both on private or Government account contained in the capital- account balance of payments are regarded as autonomous.
On the other hand, in the capital account short-term capital movements such as borrowing from IMF or Central Banks of other countries, drawings from SDR, change in foreign exchange reserves are transitory and of accommodating nature and are therefore excluded from the concept of basic balance or of de-equilibrium.
The recourse has to be made to these accommodating items (also called compensatory items) so as to ensure equality between payments and receipts of foreign exchange. Changes in the compensatory items are made so as to offset the surplus or deficit in the autonomous items. Thus, “when autonomous movements cancel out over some appropriate time period and there is no need for compensatory movements, the balance of payments is in equilibrium.” Note that the equilibrium is a state of balance which can be sustained without intervention by the Government.
The concept of balance of payments in the sense of basic balance can be represented by the following equation:
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(X – M) + LTC = 0
where
X stands for exports including invisible items,
M stands for imports including invisible items,
LTC stands for long-term capital movements.
If (X – M) is positive (i.e., X > M), then for balance of payments to be in equilibrium, LTC will be negative and equal to (X – M). This implies that there will be net capital outflow. On the other hand, if M > X, then for the balance of payments to be in equilibrium LTC must be positive (that is, there will be net capital inflow to offset the deficit in the current account).
When the balance of payments of a country is in equilibrium, the demand for the domestic currency is equal to its supply. The demand and supply situation is thus neither favourable nor unfavourable. If the balance of payments moves against a country, adjustments must be made by encouraging exports of goods, services or other forms of exports, or by discouraging imports of all kinds. No country can have a permanently unfavourable balance of payments. Total liabilities and total assets of nations, as of individuals, must balance in the long run.
This does not mean that the balance of payments of a country should be in equilibrium individually with every other country with which she has trade relations. This is not necessary, nor is it the case in the real world. Trade relations are multilateral. India, for instance, may have balance of payments deficit with the United States and surplus with the United Kingdom and/or other countries, but each country, in the long run, cannot receive more value than she has exported to other countries taken together.
Equilibrium in the balance of payments, therefore, is a sign of the soundness of a country’s economy. But disequilibrium may arise either for short or for long periods. A continued disequilibrium indicates that the country is heading towards economic and financial bankruptcy. Every country, therefore, must try to maintain balance of payments in equilibrium. To know how this can be done involves the study of the causes of disequilibrium.