International Financial Flows

International Financial Flows

• Introduction

Funds flowing into, or out of, a country on account of various types of international transactions are recorded by the monetary authorities of that country in a prescribed statement that is known as the balance of payments. You find an individual maintaining an account of his/her cash receipts and payments. A company prepares a cash-flow statement that shows incoming and outgoing of cash. Similarly, a country records the inflows and outflows of funds in a statement known as the balance of payments. In other words, balance of payments is a statement that records all different forms of funds inflow and outflow and arrives at a conclusion whether there is a net inflow in the country/outflow out of the country influencing, in turn, the foreign exchange reserves possessed by the country.

Thus any discussion of the balance of payments embraces the explanation of what the different forms of international financial flows are and how they are recorded in the balance of payments. It also involves the discussion of whether the balance of payments experiences any disequilibrium, and if it is there, what would be the ways to make necessary adjustments. These issues form the subject-matter of the present unit. However, the learners shall be acquainted with the recent trends in India’s balance of payments in order to make the discussion even more meaningful.

 

• Forms Of International Financial Flows

The various types of transactions leading to International Financial Flows need some discussion here. Trade Flows, Invisibles, Foreign Direct and Portfolio Investment, External Assistance and External Commercial Borrowings and some Short-Term Flows.

1- Merchandise Trade Flows: Trade may be related to goods. Alternatively, it may be related to services. The merchandise trade has two sides. While one is export, the other is import. If India exports various goods, it will get convertible currencies and that will be an inflow of funds. On the contrary, it has to make payments in convertible currencies for the imports it makes. Thus export and import of goods lead to international financial flows.

2- Invisibles: Invisibles include, broadly, trade in services, investment income and unilateral transfers. If an Indian shipping company carries goods of a foreign exporter/importer and gets the freight charges, it will be treated as inflow of funds on account of trade in services. Similarly, if a foreign shipping company carries goods of an Indian exporter, there will be outflow of funds in form of freight charges. There are many examples of international flow of funds on account of trade in services.

Investment income relates to the receipt and payment of dividend, technical service, fees, royalty, interest on loan, etc. A foreign company operating in India remits dividend, etc. to its home country that will represent an outflow of funds. Similarly, an Indian company operating abroad remits to India the dividend and other fees that will represent inflow of funds. Likewise, payment of interest on foreign borrowings represents outflow of funds. Any receipt of interest manifests in inflow of funds.

Unilateral transfers are unidirectional. They represent international financial flows without any services rendered. If an Indian makes a gift to his/her friend in England, it will be a case of outflow of funds on account of unilateral transfer. Similarly, a large number of Indians living abroad remit a part of their income to their family members living in India. This is a case of inflow of funds on account of unilateral transfer.

3- Foreign Investment: Foreign Investment may be of two kinds. While one is direct, the other is portfolio. Foreign Direct Investment [FDI] occurs when a firm moves abroad for the production of goods or provision of services and participates in the management of that company located abroad. On the contrary, Foreign Portfolio Investment [FPI] is not at all concerned with the production of goods and rendering of services. The sole purpose of a foreign portfolio investor is to earn a return through investment in foreign securities without any intention of grabbing the voting power in the company whose securities it purchases. In case of FDI too, an investor invests in the shares of a foreign company, but the sole objective is to enjoy the voting power and thereby a say in the management of the foreign company. Thus, it is primarily the voting right that differentiates between FDI and FPI.

Whatever the forms may be, inflow of funds occurs when a foreign investor makes investment in the country. On the contrary, outflow of funds occurs when the domestic investor invests in a foreign country.

4- External Assistance And External Commercial Borrowings: External assistance and external commercial borrowings are different in the sense that while the former flows normally from an official institution – bilateral or multilateral, the latter flows from international banks or other private lenders. The rate of interest in the former is usually low along with a longer maturity period. The latter carries market rate of interest and a shorter maturity. Last but not least, external assistance is manifest often in outright grant that does not require repayment of principal/interest payment.

Whatever may be the difference between the two, any borrowing from abroad is treated as inflow of funds lending abroad, on the other hand, represents outflow of funds, however, repayment of loads is treated just the other way,

4- Short-Term Flow Of Funds: Normally loans and foreign direct investment are meant for a period exceeding one year but there are financial flows that occur for less than a year. Movement of funds relating to banking channels, euro notes, speculative and arbitrage activities, etc. are the examples of Short-Term Funds that move across countries.

 

• Structure Of Balance Of Payments

1- Basic Principles: While recording the international financial flows in the balance of payments, a couple of norms need to be followed. One is that the structure of the balance of payments is based just on the principles of the double-entry book-keeping. It means that all the inflows of funds are put on the credit side and all the outflows of funds are debited; and ultimately, the two sides are balanced.

The second norm is that since the different forms of the financial flows vary in nature, they are to be entered accordingly in the two compartments of the balance of payments. It may be mentioned that the balance of payments statement is divided into two compartments. One is known as the current account followed by the other known as the capital account. Those transactions that represent earning or spending are recorded in the current account. For example, when a country earns foreign exchange through export, the amount is entered in the current account. On the other hand, if the financial flow does not represent earning, it is entered in the capital account. For example, Foreign Direct Investment or Foreign Portfolio Investment is entered in the capital account. Thus, it is on this basis that the different types of financial flows are recorded in the current and the capital accounts.

2- Prescribed Format For Recording Transactions

Current Account: As per the prescribed format adopted by the Reserve Bank of India, in the current account, first, merchandise trade is entered. Export receipts are entered on the credit side and the imports are entered on the debit side. And then, the balance is found out. The difference between the export and the import is known as the balance of trade. Excess of export over import is known as the surplus balance of trade and, on the contrary, the excess of import over export is known as the deficit balance of trade.

The second item to be entered in the current account is nothing but invisibles. Invisibles, as mentioned earlier, include primarily:

• • • Trade In Services
    • Investment Income
    • Unilateral Transfers

There are both inflows and outflows on account of invisibles. The inflows are entered on the credit side and the outflows are entered on the debit side. However, a common practice is that only the net amount is written in the current account.

After entering the invisibles, balancing is done for the whole of the current account. This balance is known as the balance of current account. The debit side being bigger than the credit side shows a deficit balance of current account. On the contrary, the excess of credit side over the debit side for the whole of the current account shows a surplus balance of current account.

Capital Account: In the capital account, foreign investment – both direct and portfolio – is entered, sometimes, a part of the investment is taken back by the investors which is known as disinvestment; The usual practice is that the disinvestment are not shown, rather the foreign investment, net of disinterment, is shown in the capital account.

Similarly, External Assistance and External Commercial Borrowing are also shown net repayment. Here the readers must be aware of the fact the repayment is subject matter of capital account whereas the interest payment showing a sort of earning is a part of invisibles. Again, the banking capital is inclusive of both Short-Term and Long-Term funds. Short-term credits are purely short-term funds. Finally, the two sides of long-term and short-term funds are balanced that is known as balance of capital account.

3- Statistical Discrepancy: After recording different forms of International Financial Flows in the balance of payments, the Statistical Discrepancy, often known as errors and omissions, is also recorded. The Statistical Discrepancy arises on different accounts. Firstly, it arises because of difficulties involved in collecting balance of payments data. There are different sources of data that sometimes differ in their approach. In India, the trade figures differ between those compiled by the Reserve Bank of India and those compiled by the Director-General of Commercial Intelligence and Statistics. Secondly, the movement of funds may lead or lag the transactions that they [funds] are supposed to finance. For example, goods are shipped in March, but the payments are received in April. If figures are compiled on the 31st March, the figures may differ if the shipment is the basis of collecting data from those which are based on the actual payment. Such differences lead to the emergence of statistical discrepancy. Thirdly, certain figures are derived on the basis of estimates. For example, figures for earning on travel and tourism account are estimated on the basis of sample cases. If the sample is defective, there is every possibility for the emergence of errors and omissions. Fourthly, errors and omissions are explained by unrecorded illegal transactions that may be either on debit side or on credit side or on both sides. Only the net amount is written on the balance of payments.

4- The Overall Balance: After the statistical discrepancy is located, the overall balance is arrived at. The overall balance represents the balancing between the credit items and the debit items appearing on the Current Account, Capital Account and the Statistical Discrepancy.

5- Official Reserve Account: If the overall balance is surplus, the surplus amount is transferred to the official reserves account that increases the foreign exchange reserves held by the monetary authorities. They comprise of monetary gold, SDR allocations by the IMF and the foreign currency assets. The foreign currency assets are normally held in the form of deposits with foreign central banks and investment in foreign government securities.

If there is deficit, an amount equivalent to the deficit is drawn from the official reserves account bringing the balance of payments into equilibrium. Again, if the amount of foreign exchange reserves is not sufficient to meet the deficit, the government approaches the International Monetary Fund for the balance of payments support.

 

• Equilibrium, Disequilibrium And Adjustment

1- Accounting And Economic Equilibrium: Since the balance of payments is constructed on the basis of double-entry book keeping, credit is always equal to debit. If debit on current account is greater than the credit side, funds flow into the country that are recorded on the credit side of the capital account. The excess of debit is wiped out. It means that the balance of payments is always in accounting equilibrium.

The accounting balance is an ex-post concept. It describes what has actually happened over a specific past period. There may be accounting disequilibrium for a short period when the two sides of the autonomous flows differ in size. But in such cases, accommodating flows bring the balance of payments back to equilibrium. To make the distinction between the autonomous flow and accommodating flow more clear, it can be said that foreign investment, external assistance and commercial borrowings are autonomous capital flow because they flows in normal course of business. But when the country borrows from the International Monetary Fund to meet the overall deficit, such borrowings represent accommodating capital flow.

However, in real life, economic equilibrium is not found because the two sides of the current account are seldom equal. Rather it is the economic disequilibrium in the balance of payments that is a normal phenomenon.

2- Process Of Adjustment: The focus of adjustment lies primary on the trade account, although the size of adjusting deficit is sometimes reduced by the net inflow on the invisible account. There are different views on adjustment that need a brief discussion here.

The Classical Approach: The classical economists were of the view that the balance of payments was self adjusting due to the price-specie-flow mechanism. The mechanism stated that an increase in money supply raises domestic prices. Exports become uncompetitive. Export earnings drop. Foreign goods become cheaper. Imports rise. Current account balance goes deficit in the sequel. Precious metal flows outside the country in order to finance imports. As a result, quantity of money lessens that lowers the price level. Lower prices in the economy lead to greater export. Trade balance reaches back to equilibrium.

Elasticity Approach: The adjustment in the balance of payments disequilibrium is thought of in terms of changes in the fixed exchange rate, that is through devaluation or upward revaluation. But its success is dependent upon the elasticity of demand for export and import. Marshall [1924] and Lerner [1944] explained this phenomenon through the “Elasticity” Approach.

The elasticity approach is based on partial equilibrium analysis where everything is held constant except for the effects of exchange rate changes on export or import. It is also assumed that elasticity of supply of output is infinite so that the price of export in home currency does not rise as demand increases, nor the price of import falls with a squeeze in demand for imports. Again, the approach ignores the monetary effects of variation in exchange rates.

If the elasticity of demand is greater than unity, the import bill will contract and export earnings will increase as a sequel to devaluation. Trade deficit will be removed. However, the problem is that the trade partner may also devalue its own currency as a retaliatory measure. Moreover, there may be a long lapse of time before the quantities adjust sufficiently to changes in price. Till then, trade balance will be even worse than that before devaluation.

Stem [1973] incorporated the concept of supply elasticity in the elasticity approach. Based on the figures of British exports and imports, Stem has come to a conclusion that the balance of trade should improve if:

1. 1. Elasticity of demand for exports and imports is high and is equal to one coupled with elasticity of supply both for imports and exports which is either high or low.
   2. Elasticity of demand for imports and exports is low but the elasticity of supply for imports and exports is lower.

On the contrary, if the elasticity of demand is low matched with high elasticity of supply, the balance of trade should worsen.

The Keynesian Approach: The Keynesian view takes into consideration primarily the income effect that was ignored under the elasticity approach. There are various versions of the Keynesian approach. One is the absorption approach that explains the relationship between domestic output and trade balance and conceives of adjustment. Sidney A. Alexander [1959] treats balance of trade as a residual given by the difference between what the economy produces and what it takes for domestic use or what it absorbs. He begins with the contention that the total output, Y is equal to the sum of Consumption, C, Investment, I, Government spending, G, and net export (X-M). In form of an equation, Y=C+I+G+(X-M) Substituting C +l+ G by absorption, A, it can be rewritten as: Y=A +X-M or Y – A=X- M

This means that the amount, by which total output exceeds total spending or absorption is represented by export over import or the net export which means a surplus balance of trade. This also means that if A > Y, deficit balance of trade will occur. This is because excess absorption in absence of desired output will cause imports. Thus in order to bring equilibrium in the balance of trade, the government has to increase output or income. Increase in income without corresponding and equal increase in absorption will lead to improvement in balance of trade.

In case of full employment, where resources are fully employed, output cannot be expanded. Balance of trade deficit can be remedied through decreasing absorption without equal fall in output. It may be noted that validity of absorption approach depends upon the operation of the multiplier effect that is essential for accelerating output generation, It also depends on the marginal propensity to absorb that determines the rate of absorption.

J. Black [1959] explains the absorption in a slightly different way. He ignores the governmental expenditure, G and equates X – M with S – I [where S is Saving and I is Investment]. He is of the opinion that when balance of trade is negative, the country has to increase saving on the one hand and to reduce investment, on the other. In case of full employment, he suggests for redistribution of national income in favor of profit earners who possess greater propensity to save.

Again, Mundell [1968] incorporates also interest rate and capital account in the ambit of discussion. In his view, it is not only the government spending but also the interest rate that does have an influence on income as well on the balance of payments. While larger government spending increases income, an increase in income leads to rise in import. With a positive marginal propensity to import, any rise in income as a sequel to increase in government spending will lead to greater imports and worsen the current account. However, changes in interest rate influence both the capital account and the current account. A higher interest rate will lead to improvement in current account through lowering of income. At the same time, a higher interest rate will improve the capital account through attracting the flow of foreign investment.

Yet again, the New Cambridge School approach takes into account Savings (S) and Investment (I), Taxes (T) and Government spending (G) and their impact on the trade account. In form of equation, it can be written as: S + T + M = G + X + I Or ( S – I ) + ( T-G ) +( M-X ) =0 Or ( X – M ) = ( S – I ) + ( T – G )

The theory assumes that (S – I) and (T – G) are determined independently of each other and of the trade gap. (S – I) is normally fixed as the private sector has a fixed net level of saving. And so the balance of payments deficit or surplus is dependent upon (T – G) and the constant (S – I). In other words, with constant (S – I), it is only the manipulation of (T – G) which is a necessary and sufficient tool for balance of payments adjustment.

Monetary Approach: The monetarists believe that the balance of payments disequilibrium is a monetary phenomenon and not structural [Connolly, 1978]. The adjustment is automatic unless the government is intentionally following an inflationary policy for quite a long period. Adjustment is brought about through making changes in monetary variables.

The process of adjustment varies among the types of exchange rate regime the country has opted for. In a fixed exchange rate regime or in gold standard, if the demand for money, that is the amount of money people wish to hold is greater than the supply of money, the excess demand would be met through the inflow of money from abroad. On the contrary, with the supply of money being in excess of the demand for it, the excess supply is eliminated through the outflow of money to other countries. The inflow and the outflow influence the balance of payments. To explain it further, with constant prices and income and thus constant demand for money, any increase in domestic credit will lead to outflow of foreign exchange as the people will import more to lower the excessive cash balances. In the sequel, the balance of payments will turn deficit. Conversely a decrease in domestic credit would lead to an excess demand for money. International reserves will flow in to meet the excess demand. Balance of payments will improve.

However, in a floating-rate regime, the demand for money is adjusted to the supply of money via changes in exchange rate. Especially in a situation when the central bank makes no market intervention, the international reserves component of the monetary base remains unchanged. The balance of payments remains in equilibrium with neither surplus nor deficit. The spot exchange rate is determined by the quantity of money supplied and the quantity of money demanded.

When the central bank increases domestic credit through open market operations, supply of money is greater than the demand for it. The households increase their imports. With increased demand for imports, the domestic currency will depreciate and it will continue depreciating until supply of money equals the demand for money. Conversely, with decrease in domestic credit, the households reduce their import. Domestic currency will appreciate and it will continue appreciating until supply of money equals demand for money.

In case of managed floating, the central bank often intervenes to peg the rates at some desired level. And so this case is a mix of fixed and floating rate regimes. It means that changes in the monetary supply and demand do influence the exchange rate but also the quantum of international reserves.

 

• India’s Balance Of Payments During The Period Of Economic Reform

An analysis of the trends in India’s balance of payments is very much relevant in view of the fact that during 1990-91, the financial year preceding the period of economic reform, size of current account deficit was unprecedented amounting to over $ 9.6 billion. The Indian Government initiated reforms in many sectors and especially the external sector. It reformed the trade and foreign investment policies. Imports were liberalized. Export promotion schemes were implemented. Exchange rate policies were restructured. Foreign investment policy was liberalized in order to attract foreign direct investment and foreign portfolio investment. India’s overseas investment was encouraged. All this made an impact on the country’s balance of payments.

Current Account: During 1991-94, the trade deficit shrank to US $ 2.8 – 5.4 billion annually from a figure of US $ 9.4 billion during 1990-91. The net invisible earnings too improved. The deficit on current account was slightly over one billion US dollar in 1991-92 and 1993-94, although it was around US $ 3.5 billion in 1992-93. However, since 1994-95, with slow pace of export, trade deficit began to grow and touched US $ 14.3 billion during 1996-97 and US $ 16.3 billion during 1997-98. The fast rising earnings on invisible account mainly due to spurt in remittances saved the position from going worse and the deficit on current account moved in the range of US $ 3.4 to 6.5 billion annually. During 1998-99, imports fell reducing in turn the trade deficit to $ 13.2 billion; and considering invisibles, the current account deficit was also lower. But in the following year, trade deficit increased, but since the invisibles were large, the current account deficit rose barely to $ 4.2 billion. In 2000-01, the trade deficit was lower reducing in turn the current account deficit to $ 2.3 billion. During the following three-year period, the trade deficit moved between $ 12 billion and $ 17 billion, but since the invisibles showed larger earnings, the current account turned surplus that was as large as $ 8.7 billion during 2003-04. In 2004-05, large growth in imports led to deficit on current account amounting to over $ 6.4 billion.

Capital Account: The picture of capital account transactions was satisfactory to a great extent. The net inflow of foreign investment was sizeable – rising from US $ 133 million in 1991-92 to over US $ 5.8 billion in 1996-97. The amount dropped to US $ 5.0 billion in 1997-98 and to US $ 2.3 billion in 1998-99, but again crossed the US $ 5-billion mark in 1999-2000. During 2000-01, net foreign investment inflow was lower and stood at US $ 2.9 billion. But thereafter, it took a great jump touching $ 14.5 billion in 2003.04, although in 2004-05, it shrank to $ 11.9 billion.

Net external assistance showed on the whole a declining trend, except for some marginal rise in a few years. Almost similar was the case with the commercial borrowings that remained confined within a low range, except for 1997-99 and for 2000-01 when they were large. Owing to strong capital account position, the IMF funds that were borrowed in the initial phases of economic reform, were repaid in installments. Moreover, the deficit on current account was met by the capital account transactions. The rest of the flow added to the official reserves. The size of the foreign currency assets that was just over one billion US dollar during May-June 1991, inflated to US $ 42.3 billion at the end of March 2001 and as large as $ 141 billion by March 2005.

 

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