6. Economics Notes 05

Elaborate Notes

Balance of Payment (BoP)

The Balance of Payments (BoP) of a country is a systematic and summary record of all economic transactions between its residents and the residents of the rest of the world during a specific period, typically a year. It is prepared based on a double-entry bookkeeping system, where every transaction has two entries (a credit and a debit) of equal value. Theoretically, the BoP should always balance, but imbalances (surplus or deficit) arise in practice, particularly within its sub-accounts. The BoP account is broadly divided into the Current Account and the Capital Account.

• Current Account: This account records transactions in goods, services, and transfer payments. These transactions do not create future claims and are generally settled simultaneously.

  • Trade Account: This component deals with the import and export of goods, also known as merchandise trade. Since goods are tangible and can be physically seen crossing borders, this is referred to as the ‘visible’ account. A trade deficit occurs when the value of imports exceeds the value of exports. India has historically run a trade deficit, largely driven by significant imports of crude oil and gold.
  • Invisibles Account: This account records transactions that are not tangible. It has three main components:
    1. Services: This includes the export and import of services like software services, tourism, transportation, banking, and insurance. Post the 1991 reforms, India has developed a significant competitive advantage in the IT and IT-enabled services (ITES) sector, leading to a consistent surplus in the services account.
    2. Factor Income: This refers to the net income received from (or paid to) the rest of the world from factors of production—land, labour, capital, and entrepreneurship. It primarily includes profits, interest, and dividends on investments made by residents abroad (inflow) and by non-residents in the domestic economy (outflow). For India, this account is typically in a slight deficit because outflows on account of interest payments on foreign loans and dividends on foreign investments are greater than the inflows from Indian investments abroad.
    3. Transfer Payments: These are unilateral transfers that do not involve a quid pro quo. They include private remittances (money sent by non-resident Indians), gifts, and official grants. India is the world’s largest recipient of remittances, which provides a strong cushion to the current account. This results in a significant positive balance under this head.

• Capital Account: This account records all international transactions that involve a change in the assets or liabilities of a country’s residents. These transactions create future claims.

  • Investments: This is a major component and is further divided into:
    1. Foreign Direct Investment (FDI): FDI represents a long-term investment by a foreign entity with the intention of establishing a lasting interest, such as setting up a business, a subsidiary firm, or acquiring a substantial stake in an existing firm.
       • As per the definition rationalized by the Arvind Mayaram Committee (2014), an investment is considered FDI if a foreign entity acquires 10% or more of the shares in a listed company. Any subsequent investment, even if less than 10%, by the same investor is also treated as FDI. For an unlisted company, all foreign investment is treated as FDI.
       • FDI is considered stable (‘non-debt creating capital’) and beneficial as it brings not just capital but also modern technology, managerial skills, and access to new markets. It creates jobs and establishes backward and forward linkages in the economy. The motivation for FDI into a country like India includes factors like access to a large domestic market, cheap and skilled labor, pro-business government policies (as seen in the post-1991 Liberalisation, Privatisation, Globalisation or LPG reforms), and improvements in the ‘Ease of Doing Business’ index.
    2. Foreign Institutional Investment (FII) / Foreign Portfolio Investment (FPI): FIIs (now largely subsumed under FPIs) are investments made by foreign institutions (like pension funds, mutual funds, and investment banks) in the financial assets of a country, such as stocks and bonds.
       • The primary intent of FPI is to earn returns on financial assets rather than to exercise management control over a company. These investments are regulated by the Securities and Exchange Board of India (SEBI).
       • FPIs are highly liquid and can be withdrawn quickly, making them volatile. This volatility has earned them the moniker “Hot Money”. A sudden outflow of FPI can destabilize the stock market and the currency, as witnessed during the ‘Taper Tantrum’ in 2013 when the US Federal Reserve hinted at winding down its quantitative easing policy.
  • Borrowings:
    1. External Commercial Borrowings (ECB): These are loans raised by Indian corporates and public sector undertakings from non-resident lenders. They are used to access cheaper and larger pools of capital from global markets. The government and RBI regulate ECBs to manage the country’s external debt profile.
    2. External Assistance: These are typically concessional or ‘soft’ loans provided by foreign governments (bilateral aid) or multilateral institutions like the World Bank and IMF. They usually have long maturity periods and subsidized interest rates, and are primarily availed by the government for developmental projects.

• Bonds in the Capital Account:

  • When a company raises money from abroad by issuing bonds, it is recorded as a Borrowing under the capital account.
  • Convertible Bonds: These are debt instruments that can be converted into a pre-determined number of equity shares of the issuing company. They offer lower interest rates as the holder has the potential benefit of capital appreciation if the company’s stock price rises. If a portion of such a bond is converted into equity, that part is reclassified from Borrowing to Investment (FDI/FPI, depending on the stake).
  • Non-Convertible Bonds: These are traditional bonds that cannot be converted into equity. They typically offer a higher interest rate to compensate the investor for the lack of conversion option and the associated inflation risk over the bond’s tenure.

Keywords and Concepts related to Balance of Payment

• Current Account Deficit (CAD): A CAD occurs when the total value of imports of goods and services plus net transfer payments and factor income outflows exceeds the total value of exports of goods and services plus inflows. A manageable CAD (often cited as 2.5-3% of GDP) is not necessarily problematic if it is financed by stable capital inflows like FDI.
• Twin Deficits: This term refers to the close linkage between a country’s Current Account Deficit and its Fiscal Deficit (the gap between government’s total expenditure and its total revenue, excluding borrowings).
  • How CAD affects Fiscal Deficit: A rising CAD often leads to the depreciation of the domestic currency (e.g., the Rupee). This makes imports costlier. For a country like India, which imports essential commodities like crude oil and fertilizers, this increases the government’s subsidy bill, thereby widening the fiscal deficit.
  • How Fiscal Deficit affects CAD: A high fiscal deficit, often financed by borrowing, can lead to higher aggregate demand in the economy. If domestic production cannot meet this demand, it spills over into higher imports, thus widening the CAD. Government subsidies and stimulus can also fuel consumption of imported goods, further exacerbating the trade deficit. This creates a vicious cycle. The Vijay Kelkar Committee (2012) on fiscal consolidation highlighted the importance of controlling the fiscal deficit to ensure macroeconomic stability, which includes managing the CAD.

Situation Post-1991: Economic Reforms

Prior to 1991, India followed a policy of import substitution and had a largely closed economy, often termed the ‘License Raj’. This led to inefficiencies, a persistent trade deficit, and a fragile BoP position. The immediate trigger for the 1991 crisis was the Gulf War (1990-91), which led to a spike in oil prices and a decline in remittances from the Middle East. India’s foreign exchange reserves dwindled to a point where they could cover only about three weeks of essential imports.

To avert a sovereign default, India approached the IMF and the World Bank for a bailout loan, which came with conditionalities requiring significant structural adjustments. This led to the launch of the LPG reforms under Prime Minister P.V. Narasimha Rao and Finance Minister Dr. Manmohan Singh.

• First-Generation Reforms (approx. 1991-2000): These reforms were focused on stabilizing the economy and opening it up. The primary focus was on the product market.

  • Industrial Policy Reforms: Abolition of industrial licensing for most industries.
  • Trade Policy Reforms: Reduction of tariffs and dismantling of quantitative restrictions on imports.
  • Financial Sector Reforms: Based on the recommendations of the Narasimham Committee (1991, 1998), these included measures to improve the efficiency and profitability of the banking sector.
  • Tax Reforms: The Raja Chelliah Committee (1991) recommended simplifying the tax structure, lowering tax rates, and widening the tax base.
  • Foreign Exchange Reforms: Introduction of a market-determined exchange rate and reforms in foreign exchange regulations, culminating in the replacement of the restrictive Foreign Exchange Regulation Act (FERA) with the more liberal Foreign Exchange Management Act (FEMA) in 1999.

• Second-Generation Reforms (approx. 2000 onwards): These reforms were aimed at deepening the reform process and were considered more difficult to implement due to their political sensitivity. The focus shifted to the factor market (land, labour, capital).

  • Factor Market Reforms: This included attempts to reform labour laws (to provide more flexibility in hiring and firing, which faced strong opposition from trade unions), land acquisition laws, and further opening of the capital account.
  • Legal and Institutional Reforms: Strengthening regulatory bodies, improving governance, and reforming the legal system to support a market-based economy.
  • Agricultural Reforms: Addressing issues in the agricultural sector, which was largely untouched by the first-generation reforms.

Currency Convertibility

Currency convertibility refers to the freedom to convert a domestic currency into foreign currencies and vice versa at market-determined exchange rates.

• Current Account Convertibility: This allows for free conversion of currency for transactions related to trade in goods and services, and invisibles. India made the Rupee fully convertible on the current account in 1994.
• Capital Account Convertibility (CAC): This allows for free conversion of currency for transactions related to capital assets, such as buying property or shares abroad. India has adopted a cautious and gradual approach to CAC.
  • The Tarapore Committee (1997) recommended a phased implementation of CAC. However, the plan was shelved following the 1997 East Asian Financial Crisis, which demonstrated how countries with full CAC were vulnerable to sudden capital flight.
  • Another committee headed by S.S. Tarapore (2006) again laid out a roadmap for CAC, but the 2008 Global Financial Crisis once again highlighted the risks of premature and complete capital account liberalisation.
  • Consequently, India’s Rupee remains partially convertible on the capital account, with restrictions on certain types of capital flows (e.g., limits on ECB, caps on outward remittances).

Taxation

Taxation is a primary source of government revenue. The government can increase its tax revenue through several means:

1. Increasing Tax Rates: In the short term, this can boost revenue. However, beyond a certain point, it can be counterproductive.
2. Widening the Tax Base: This involves bringing more people and economic activities into the tax net. Greater formalization of the economy, for instance through the Goods and Services Tax (GST) network, helps in widening the tax base. This is generally considered a more sustainable and equitable approach than merely increasing rates.
3. Improving Tax Efficiency: This involves plugging loopholes, reducing compliance costs, and streamlining the tax administration to reduce tax evasion and avoidance.

• Laffer Curve: Proposed by economist Arthur Laffer, this curve illustrates the theoretical relationship between tax rates and the amount of tax revenue collected by governments. It suggests that as tax rates increase from 0%, tax revenue will increase up to a certain point (T*), after which further increases in tax rates will cause a decline in tax revenue. This is because excessively high rates disincentivize work and investment, and encourage tax evasion (illegal non-payment of tax) and tax avoidance (legal methods to reduce tax liability).

• Direct vs. Indirect Taxes:

  • Direct Tax: A tax where the ‘impact’ (initial burden) and ‘incidence’ (final burden) fall on the same person. Examples include Income Tax and Corporate Tax. These are generally considered progressive as they are linked to the ability to pay.
  • Indirect Tax: A tax where the impact and incidence fall on different persons. The producer or seller pays the tax to the government (impact) but passes on the burden to the final consumer in the form of higher prices (incidence). Examples include GST, Customs Duty. These are often regressive as they affect the poor and rich alike, forming a larger proportion of a poor person’s income. In a welfare state, the ideal is to have a higher share of direct taxes in the total tax revenue.

• Cascading Effect (Tax on Tax): This was a major inefficiency in India’s pre-GST indirect tax structure. It occurred when a tax was levied on a value that already included a previously paid tax.

  • Example: Before GST, the Centre levied Excise Duty (Union List) on manufacturing, and the States levied Sales Tax/VAT (State List) on the sale of goods. If a phone’s factory price was ₹20,000, and a 10% excise duty (₹2,000) was levied, the price became ₹22,000. The state would then levy its 10% sales tax not on the original ₹20,000 but on the post-excise duty price of ₹22,000. The sales tax would be ₹2,200. The extra ₹200 was a tax on the already paid excise duty of ₹2,000. This inflated the final price for the consumer and made Indian goods less competitive. GST, with its provision for input tax credit, was introduced to eliminate this cascading effect.

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Prelims Pointers

• Balance of Payment (BoP): A record of economic transactions between residents of a country and the rest of the world.
• Current Account Components:
  • Visibles: Goods/Merchandise Trade.
  • Invisibles: Services, Factor Income (profits, interest, dividends), and Transfer Payments (remittances, gifts).
• Capital Account Components:
  • Investments: Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
  • Borrowings: External Commercial Borrowings (ECB) and External Assistance.
• FDI vs. FPI Distinction: An investment of 10% or more in a listed company by a foreign entity is classified as FDI. In an unlisted company, all foreign investment is FDI.
• “Hot Money”: A term used for Foreign Institutional Investment (FII/FPI) due to its volatile nature and tendency for rapid outflow.
• Stock Market Regulator: Securities and Exchange Board of India (SEBI).
• Twin Deficits: Refers to the simultaneous occurrence of a Current Account Deficit (CAD) and a Fiscal Deficit.
• Important Committees:
  1. Arvind Mayaram Committee: Rationalized the definitions of FDI and FPI.
  2. Narasimham Committee: Recommended reforms in the financial and banking sectors.
  3. Raja Chelliah Committee: Recommended comprehensive tax reforms in 1991.
  4. S.S. Tarapore Committee: Provided roadmaps for Capital Account Convertibility (in 1997 and 2006).
• Economic Reforms:
  • First-Generation (1991-2000): Focused on the product market (de-licensing, trade liberalisation).
  • Second-Generation (2000 onwards): Focused on the factor market (land, labour, capital).
• Currency Convertibility Status: The Indian Rupee is fully convertible on the current account but only partially convertible on the capital account.
• Laffer Curve: Shows the relationship between tax rates and tax revenue, suggesting an optimal tax rate that maximizes revenue.
• Cascading Effect: A ‘tax on tax’ situation, which was a major flaw of the pre-GST indirect tax system.
• FERA vs. FEMA: The restrictive Foreign Exchange Regulation Act (FERA) was replaced by the liberal Foreign Exchange Management Act (FEMA) in 1999.

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Mains Insights

1. Managing the Balance of Payments: A Persistent Policy Challenge

• Cause-Effect: A persistent and high Current Account Deficit (CAD) is a sign of macroeconomic vulnerability. It can lead to currency depreciation, drain foreign exchange reserves, and increase external debt. The quality of financing the CAD is crucial. Financing through stable, non-debt creating inflows like FDI is sustainable, whereas reliance on volatile FPI or debt-creating ECBs can expose the economy to external shocks and capital flight.
• Debate: The debate revolves around whether to control the CAD by compressing imports (through tariffs and non-tariff barriers) or by boosting exports (through better infrastructure, competitiveness, and integration into global value chains). While import compression offers a short-term fix, it can hurt industrial growth and is against the spirit of free trade. A long-term strategy must focus on enhancing export competitiveness.

2. The FDI vs. FPI Dilemma for Developing Economies

• Analytical Perspective: While FDI is universally preferred for its stability and positive spillovers (technology transfer, job creation), FPI also plays a vital role. FPI provides liquidity to capital markets, helps in efficient price discovery, and disciplines corporate governance.
• Historiographical Viewpoint: The narrative has shifted from viewing FPI as purely “hot money” to recognizing its benefits. The policy challenge is not to discourage FPI, but to build a resilient domestic financial system that can absorb its volatility. Measures like maintaining adequate forex reserves and sound macroeconomic fundamentals are key to managing the risks associated with FPI.

3. Economic Reforms: An Unfinished Agenda

• Critical Analysis: The first-generation reforms of 1991 were highly successful in averting the crisis and putting India on a high-growth trajectory. However, they are often criticized for increasing income inequality and neglecting the agricultural sector. The benefits were concentrated in the services sector and urban areas.
• Second-Generation Reforms: The difficulty in implementing second-generation reforms, particularly in land and labour markets, highlights the deep-seated political and social challenges in India. These factor market rigidities are often cited as the primary reason why India has not been able to fully leverage its demographic dividend and develop a robust manufacturing sector comparable to China. The debate continues on the pace and nature of these reforms.

4. The Capital Account Convertibility (CAC) Conundrum

• The Trilemma: India’s cautious approach to CAC is a practical response to the ‘Impossible Trinity’ in international economics, which posits that a country cannot simultaneously have an independent monetary policy, a fixed exchange rate, and free movement of capital. By restricting capital flows, India retains greater control over its monetary policy and exchange rate.
• Debate: Proponents of full CAC argue it would attract more investment, lower the cost of capital for Indian firms, and lead to deeper, more efficient financial markets. Opponents, citing the East Asian (1997) and Global Financial (2008) crises, warn of heightened vulnerability to global financial shocks and speculative attacks. India’s current policy of gradual and calibrated liberalisation of the capital account represents a pragmatic middle path.

5. Taxation Policy: Balancing Revenue, Equity, and Efficiency

• Cause-Effect: The structure of a country’s tax system has profound implications for economic growth and social equity. A system with high rates, a narrow base, and multiple exemptions (pre-1991) leads to evasion, avoidance, and low revenue. Reforms aimed at lower rates, a wider base, and fewer exemptions (as suggested by the Laffer Curve principle and Chelliah Committee) can improve compliance and boost revenue.
• Debate: A key debate in India is the over-reliance on indirect taxes, which are regressive. While GST has improved efficiency by eliminating the cascading effect, it still disproportionately burdens the poor. The long-term policy goal should be to widen the direct tax base through greater formalization of the economy, thus improving the direct-to-indirect tax ratio and making the tax system more progressive and equitable.