Page 135 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 11 : Balance of Payments and Balance of Trade : Meaning and Components

It is useful to understand the broad trends and implications of Capital Account transactions in the Notes
BOP of countries of the World Developed Countries (DCs) are the net exporters of capital and
investment and the less developed countries (LDCs) are the net borrowers of foreign capital and
investment. From that it follows obviously that the DCs would experience deficits (or adverse trends)
in their BOP capital accounts; the LDCs, on the other hand, would “enjoy” capital account surpluses
in their BOP. The questions that arise here are : Is this capital account surplus good ? And is this
capital account deficit bad for the countries ? The answers are somewhat as follows :
LDCs are net borrowers of foreign capital and recipients of foreign investment, and to that extent
they would “enjoy” favourable BOP trends. This is undoubtedly true. But sooner or later this foreign
capital and investment will leave the LDCs and go back. Whether they do or do not go back to their
home country, what is most certainly true is, that the returns on that capital and investment in the
form of profits, interest, dividends and royalties would be repatriated from the “host” countries to
the “home” countries (in this case from LDCs to DCs). And this sum would create deficit tendencies
in the Current Account of the BOP of the LDCs concerned. In other words, capital account surplus of
the present year will create current account deficits of a potential nature (in the form of investment
income outflows) for the years ahead. In that sense, the country which “enjoys’ a capital account
surplus today must get ready to “suffer” a current account deficit in future. The prognosis is entirely
correct but it may not result in a nightmare. Because by making productive use of foreign capital and
investment and increasing both the GNP and export capacity the LDC can avoid future BOP deficits
on current account i.e. they can offset investment income outflows and capital repatriation by increasing
merchandise exports as well as service exports. It does not, therefore, necessarily follow that a capital
account surplus today is a sure sign of current account deficit tomorrow (or in 10 years from now). It
much depends on the manner in which foreign capital and investment are put to use in the receiving
country. If they are put to unproductive use resulting in no expansion of real output of goods and
services, then of course, it would be true to say that today’s capital account surplus is tomorrow’s
current account deficit.
The countries which “suffer” capital account deficit today need not worry because it will automatically
result in BOP current account surpluses (arising out of investment income inflows) at a future date.
Today’s deficit (in capital account) is truely tomorrow’s surplus (in current account). There can be
little doubt in saying so. Only in the unlikely events where no investment income inflow ever
materialized (due to losses on investment) or permitted to materialize (due to host country
government’s radical policies like expropriation, nationalization etc.) would it be possible to argue
that today’s capital account surplus is no guarantee of tomorrow’s current account surplus?
However, the significance of BOP deficits and surpluses arising out of transactions in capital account
can, therefore, be seen only with a time perspective and future prospects clearly in mind. Only then,
can the significance of capital account in the BOP be fully understood.
Basic Balance

This is a relatively straightforward and simple concept. Basic balance in the BOP comprises of the
BOP on current account plus long-term capital account. The short term capital account balance is not
included in the basic balance. This is perhaps for two main reasons — (a) short term capital movements,
unlike long-term capital flows, are relatively volatile and unpredictable. They move in and out of a
country in a period of less than a year or even sooner than that. It would, therefore, be improper to
treat short term capital movements on the same footing as current account BOP transactions which
are extremely durable in nature. Long-term capital flows are relatively more durable and, therefore,
they qualify to be treated along side the current account transactions to constitute basic balance, (b) in
many cases countries do not have a separate short term capital account for reasons discussed earlier
in this chapter; in these countries, short term capital transactions constitute a part of the “Errors &
Omissions Account”. Hence the justification in excluding short term capital flows from the definition
of “Basic Balance”.
An active basic balance is a good sign and a passive basic balance is a bad sign for the reporting
country’s overall BOP picture.

LOVELY PROFESSIONAL UNIVERSITY 129