In open world economy, International trade plays a dominant role in determining Balance of Payment of any country and become important part of UPSC syllabus. In this article we will try to understand international trade and Balance of Payment in depth.
What is International Trade?
International trade involves the exchange of goods and services among multiple nations, contributing to and bolstering the global economy. Commonly traded commodities include clothing, capital goods, raw materials, food, machinery, and more.
Over the years, international trade has witnessed an unexpected surge, encompassing services like travel and tourism, warehousing, banking, advertising, distribution, communication, and foreign transportation. It prompts an uptick in the production of foreign goods and services, as well as foreign investments in other countries.
International Trade comprises mainly three important aspects- volume, sectoral composition, and Direction of Trade.
Trade Volume
- Definition: Trade volume encompasses the quantity of goods and services exchanged, although services are not measured in tonnage.
- Measurement: The total volume of trade is determined by the combined amount of goods and services traded.
Trade Composition
- Historical Context: Trade compositions have evolved over time, transitioning from primarily primary goods to a focus on manufactured products.
- Contemporary Trends: Currently, while manufacturing remains a significant sector in global trade, the service industry, including transportation and travel, is experiencing growth.
Direction of Trade
- Early Dynamics: Initially, developing countries exported valuable artifacts and goods.
- 19th Century Shift: European nations began exporting manufactured goods in exchange for raw materials and foodstuffs from their colonies.
- Emergence of Trade Leaders: The USA and Europe emerged as dominant trade partners, leading in the international trade of manufactured goods, with Japan following closely.
- 20th Century Transformation: The latter half of the 20th century saw a significant shift in global trade patterns, with India, China, and other developing nations competing with developed countries, while Europe lost its colonial influence.
Type of International Trade
Bilateral Trade:
Bilateral trade occurs between two nations, wherein both parties agree to exchange specified goods and commodities. This involves a mutual agreement between Country X and Country Y to trade goods and raw materials, with each agreeing to purchase certain commodities from the other.
Multilateral Trade
Multilateral trade involves transactions among multiple trading countries. A single country can engage in trade with numerous other nations. Additionally, the country may grant Most Favoured Nation (MFN) status to select trading partners.
Free Trade:
Free trade, also known as trade liberalization, is a trade policy that eliminates restrictions on economies, allowing for unhindered trade. This entails reducing or eliminating trade barriers such as tariffs. Free trade facilitates the exchange of goods and services globally, enabling them to compete with domestic products and services.
India’s International Trade
Exports:
- Top Export Items: Petroleum products, precious stones, drug formulations & biologicals, gold, and other precious metals are the top exported commodities.
- India’s merchandise exports are less than its merchandise imports.
Top Export Commodities
- Petroleum Products
- Pearl, Precious, Semiprecious Stones
- Drug Formulations, Biologicals
- Gold and Other Precious Metal Jewellery
- Iron and Steel
Top exporting countries:
- U S A
- UAE
- China PRP
- Hong Kong
- Singapore
Imports:
- Top Import Items: Crude petroleum, gold, petroleum products, coal, coke & briquettes constitute top import items.
- India’s service exports are more than its service imports. This means that India has a net service surplus.
Top import Commodities
- Petroleum: Crude
- Gold
- Petroleum Products
- Coal, Coke Briquettes, etc.
- Pearl, Precious, Semiprecious Stones
Top countries india import from
- China PRP
- USA
- UAE
- Saudi Arabia
- Iraq
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Balance of Payment in International Trade
Definition: The BoP tracks transactions in goods, services, and assets between a country’s residents and the rest of the world over a specified period, typically a year. It provides a summary of a country’s current demand and supply of foreign currency claims and foreign claims on its currency.
Balance of Payment- Components:
- Current Account: This account documents exports and imports of goods, services trade, and transfer payments. It should be noted that Capital goods (like machinery) import or export are also recorded here and not in Capital Account.
- Capital Account: The capital account records all international transactions involving purchases and sales of assets such as money, stocks, bonds, etc., including foreign investments and loans. It is involved in transferring of ownership.
Balance of Trade
BOT represents the disparity between a country’s import and export values over a specified period and constitutes a significant segment of its Balance of Payments (BOP).
Solely examining a favorable balance of trade is inadequate for assessing economic well-being. It is crucial to analyze the balance of trade in conjunction with other economic indicators, business cycles, and relevant factors.
Balance of Payment- Balance and Imbalance
BoP can be Balanced or Imbalanced. For Balanced BoP the exports balances imports, and the account shows a 0 balance. For Imbalance BoP either there is a surplus or a deficit.
Balance of Payment- Deficit
A Balance of Payments (BOP) Deficit occurs when a country’s total payments to the rest of the world surpass its total receipts. This signifies either higher imports of goods and services, increased payments for income and capital abroad, or a net outflow of financial assistance.
Components leading to a BOP deficit include a trade deficit (excess of imports over exports), negative net income from foreign investments, and a net capital outflow. Such situations can deplete a nation’s foreign currency reserves.
While a BOP deficit may be manageable temporarily, especially if driven by increased imports due to economic expansion, persistent or deepening deficits can pose challenges such as currency devaluation, inflation, and the necessity to borrow to cover the deficit.
Balance of Payment- Surplus
A Balance of Payments Surplus indicates that a country’s total receipts from the rest of the world exceed its total payments. This implies higher exports of goods and services, increased receipts of income and capital from abroad, or a net inflow of financial aid.
Elements contributing to a BOP surplus may include a trade surplus (excess of exports over imports), positive net income from foreign investments, and a net capital inflow. Surpluses can bolster a nation’s foreign currency reserves.
Generally viewed as a positive economic indicator in the short term, a BOP surplus can bolster a nation’s foreign exchange reserves, strengthen its currency, and foster economic growth. However, prolonged or excessive surpluses may lead to an overvalued currency, potential trade imbalances, and tensions with trading partners.
Balance of Payment Crisis
Countries experiencing current account deficits may encounter challenges. If the deficit is substantial and the economy fails to attract sufficient foreign investment inflows, their currency reserves will diminish. At this juncture, the country may have to resort to emergency borrowing from institutions like the International Monetary Fund, potentially escalating external debt. Moreover, nations with current account deficits will accumulate mounting debt and/or witness heightened foreign ownership of their assets. This situation, known as a Balance of Payments (BoP) crisis, is also referred to as a currency crisis.
Is BoP Deficit always bad?
In theory, the balance of payments represents a monetary phenomenon and signifies the presence and worth of currency. According to this theory, a deficit in the balance of payments functions as a mechanism to correct an oversupply of money between the occurrence and recording of transactions.
In the short term, a balance of payments deficit is not inherently positive or negative. It simply indicates that, in practical terms, there is a higher level of imports than exports until the value of money is adjusted.
Autonomous and Accommodating transactions:
Autonomous Transactions:
- Economic transactions conducted primarily to generate profits rather than rectify imbalances in the Balance of Payments (BoP). These transactions are independent of BoP considerations and are commonly referred to as “above the lines” due to their profit-driven nature.
- Both the private sector and government engage in autonomous transactions, which can occur in both the current and capital accounts. Examples include merchandise imports and exports on the current account and long-term loan receipts and payments on the capital account.
- When autonomous receipts exceed payments, the BoP registers a surplus, whereas if payments exceed receipts, a deficit is recorded. For instance, a Multinational Company’s (MNC) Foreign Direct Investment (FDI) in a country is aimed at maximizing profit and is not intended to correct BoP imbalances.
- Items: Trade in Goods and Services, One-sided Transactions, Capital Transfers d. Accommodating Transactions
Accommodating Transactions
- Economic transactions initiated to rectify imbalances in the BoP, also known as “below the lines” transactions. These are contingent on the state of the BoP and are undertaken by the government to restore equilibrium.
- Accommodating transactions are intrinsically linked to the BoP and are designed to offset imbalances caused by autonomous transactions. They are made with the aim of establishing the BoP identity.
- Only the government can conduct accommodating transactions, typically on the capital account. This may involve borrowing from international institutions or utilizing official foreign reserves.
- Accommodating transactions do not involve the movement of goods and services across borders but rather involve the movement of a country’s official reserves to correct BoP deficits.
- Main Accommodating Items: Borrowing of government from the International Monetary Fund (IMF) or other Foreign Financial Institutions, Utilization of Foreign Exchange Reserves.
Errors and Omission
In the Balance of Payments (BoP) account, Errors and Omissions represent discrepancies that arise when the total debits do not equal the total credits, despite the double-entry system being followed. This occurs due to inaccuracies or omissions in recording international transactions.
Causes of Errors:
a. Unrecorded Capital Flows: Transactions involving capital movements that are not properly documented or reported.
b. Unmarked Goods Transactions: Instances where goods transactions are not correctly recorded or accounted for.
c. Remittances of Workers: Payments sent by migrant workers to their home countries that may not be accurately accounted for in the BoP.
Significance: Errors and omissions reflect the imbalances resulting from imperfections in data sourcing and compilation in the BoP accounts. These discrepancies can affect the accuracy and reliability of the BoP data.
To minimize errors and omissions in the BoP, it is essential to record transactions accurately and comprehensively. Careful monitoring and validation of data sources can help reduce inaccuracies and improve the integrity of the BoP account.
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