Balance of Payment Disequilibrium & Adjustment of BoP

The most important feature of the Balance of Payments Accounts is that it is a double-entry system of accounts: a credit entry in the BOP accounts has a corresponding debit entry elsewhere in the BOP accounts. This implies that for a BoP Equilibrium, the current and capital accounts must sum to zero. We can understand it very easily. The current account balance is the difference between current income and current expenditures. A current account deficit implies that expenditures exceed revenues. If expenditures exceed revenues, from where the money would come to finance that extra expenditure? This means that the country would need to finance the additional expenditure form either internal sources or external sources. When the expenditure is financed via external sources, there would be some corresponding entry in the Balance of payments. For example, the additional expenditure can be financed by any one or more than one of the following:

• Through FDI inflows
• Through portfolio inflows
• By increased loans from foreigners / reduced holdings of foreign currency / increased foreign holdings of domestic currency; by acquiring foreign currency from the government (lower reserves)
• or lastly by hoping that the foreign government forgives the debt, if it is so, it would be a unilateral flow in capital account.

The foreign funding has to be returned in the form of foreign exchange only. That is why the Foreign Currency is the backbone of a country’s economic relations with other countries. In other words, the balance of payments of a country is said to be in equilibrium when the demand for foreign exchange in exactly equivalent to the supply of it. There will be a deficit in the balance of payments when the demand for foreign exchange exceeds its supply, and three will be a surplus when the supply of foreign exchange exceeds the demand. A number of factors may cause disequilibrium in the balance of payments.

Some of the causes and types of the BoP disequilibrium

Development Programmes

The direct impact of large scale development expenditures is seen in increase the purchasing power, aggregate demand and prices. This results in large scale imports. This phenomenon is common in developing countries where large scale import of capital goods needed for carrying out various development programmes and it will raisethe deficit in their balance of payments. These developmental imports cause BoP disequilibrium.

Cyclical Fluctuations

Cyclical fluctuations in the business activity bring depression, stagnant and boom stage in world trade. Whenever there is a depression/recession in foreign countries, our exports will fall due to low demand and there will be reduction in foreign exchange earnings. This will cause BoP disequilibrium. Similarly, the boom condition in foreign countries will increase our exports and our capacity to earn foreign exchange will increase.

Population growth

The high population growth of a country may lead to increased imports due to increased demand. This will naturally cause the BoP disequilibrium.

Natural factors

Natural calamities in the form of floods, no rains may affect the agricultural and industrial production of a country. Then the country will go for increased imports and reduced exports. This will cause discrepancy in the equilibrium of the BoP.

Political Factors

A country with political instability may experience large capital outflow and inadequacy of domestic investment and production.

Sustained Disequilibrium

The sustained or secular disequilibrium refers to a situation when, the BoP disequilibrium persists for long periods due to certain secular trends in the economy. It is seen in the developed countries where, the disposable income is generally very high and so the aggregate demand is also very high. But due to higher aggregate demands, the production costs are also very high. This would result in higher prices, which may result in the imports being much higher than exports.

Structural Disequilibrium

Structural Disequilibrium occurs due to changes in some sectors of the economy at home country or foreign country which may alter the demand-supply relations of exports or imports or both. The changes may include development of alternative source of supply, development of better substitutes, exhaustion of productive resources or change in transport routes and costs etc.

Adjustment of BoP

There is not much bothering if there is a surplus in the balance of payments, however, every country strives to remove or at least reduce a balance of payments deficit. There are a number of adjustments, which are done to correct the balance of payments disequilibrium. There are two categories of measures to correct the BoP disequilibrium:

Automatic Measures

The Automatic measures were useful and relevant when there was Gold Standard. Since, now the Gold Standard is not there, the whole mechanism is irrelevant, yet it works in Paper currency environment on the basis of the fact that if the market forces of demand and supply are allowed to have free play, in course of time, equilibrium will be automatically restored.

This can be understood by a simple example. Whenever there is a deficit, demand for foreign exchange exceeds its supply and this result in an increase in the exchange rate and a fall in the external value of the domestic currency. This would result in the exports of the country go cheaper and imports dearer than before. Consequently, the increase in exports and fall in imports restore the balance of payments equilibrium.

Deliberate measures

Deliberate Measures refer to the correction of disequilibrium by means of measures taken deliberately with this end in view. There are various deliberate measures such as

• Monetary measures such as Monetary Contraction, Devaluation, Exchange Control
• Trade measures : Export Promotion, Import Control
• Miscellaneous measures

These various measures have been shown in the following graphics:

Monetary Contraction

The contraction or expansion of money supply affect the level of aggregate domestic demand, domestic price level and the demand for imports and exports, and this intervention can be used to correct the disequilibrium of the BoP.

We take an example:

We assume there is a situation of balance of payments deficit. The BoP deficit means that there is an increased level of aggregate demand that have led to the increased imports. When the money supply is contracted, it would leave less money in the system and finally would reduce the purchasing power.

• The reduced purchasing power would reduce the aggregate demand.
• The reduced aggregate demand also reduced the domestic prices.
• The reduced domestic prices also reduced the demand for the imports. The fall in the domestic prices’ would encourage more exports, to earn better money.
• Thus, the overall result in case of monetary contraction is that Imports decrease and Exports Increase. This results in the correction of a BoP deficit situation.

Devaluation

Devaluation is defined as a reduction of the official rate at which the currency is exchanged for another currency. The idea behind currency devaluation is to stimulate its exports and discourage imports to correct the disequilibrium. The direct impact of devaluation is that it makes the export goods cheaper and imports dearer. How? Let’s understand:

We assume that Current Rate of Dollar is Rs. 55.

In this situation, an exporter in India would realize Rs. 5500 for an export worth 100 Dollars.

We assume that the Rupee is devalued and now a Dollar becomes of Rs. 65

In this situation, the same exporter would realize Rs. 6500. The result is that Export earnings would increase and export of good would become cheaper.

We again assume that there is an importer who needs to make a payment of $ 100 to a party sitting abroad.

At Rs. 55, this importer would need Rs. 5500 to make payment.

At Rs. 65, this importer would need Rs. 6500 to make payment. The result is the import becomes dearer. So, most commonly, the Currency devaluation takes place to correct the BoP deficit.

Exchange Control

This is yet another popular measure of correcting the BoP deficit. Under the exchange control, the government via the RBI assumes complete control over the foreign exchange reserves and earnings of the country. The recipients of foreign exchange, like exporters, are required to surrender foreign exchange to the government/central bank in exchange for domestic currency. By virtue of its control over the use of foreign exchange, the government can control imports and also increase its foreign currency reserves.

Export Promotion

This may include the reduction and abolition of the export duties, providing export subsidy, encouraging export production and export marketing by giving monetary, fiscal, physical and institutional incentives and facilities.

Import Control:

‘This may be done by improving or enhancing import duties, restricting imports through import quotas, licensing and even prohibiting altogether the import of certain inessential items.

Miscellaneous Measures

Other measures are promotion of tourism to attract foreigners and providing incentives to enhance inward remittances.

What is the best way to fund the Current Account Deficit (CAD)?

One of the best ways to fund the CAD is through non-debt creating and long-term inflows such as FDI. Volatile inflows like portfolio investment also referred as hot money can threaten the stability of the economy.