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BASIC BALANCE

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Abhijeet S
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BASIC BALANCE - September 13th, 2010

BASIC BALANCE
The basic balance was regarded as the best indicator of the economy’s position vis--vis other countries in the 1950’s and the 1960’s. It is defined as the sum of the BOP on current account and the net balance on long term capital, which were considered as the most stable elements in the balance of payments.


A worsening of the basic balance an increase in a deficit or a reduction in a surplus or even a move from the surplus to deficit] was seen as an indication of deterioration in the [relative] state of the economy.



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 movements are relatively volatile and unpredictable. They move in and out of the 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 don’t have a separate short term capital account as they constitute a part of the “Errors and Omissions Account.”

A deficit on the basic balance could come about in various ways, which are not mutually equivalent. E.g. suppose that the basic balance is in deficit because a current account deficit is accompanied by a deficit on the long term capital account.

The long term capital outflow will, in the future, generate profits, dividends and interest payments which will improve the current account and so, ceteris paribus, will reduce or perhaps reduce the deficit.

On the other hand, a basic balance surplus consisting of a deficit on current account that is more than covered by long term borrowings from abroad may lead to problems in future, when profits, dividends etc are paid to foreign investors.
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