FACULTY OF MANAGEMENT STUDIES

International Economics Write-up on

Disequilibrium in Balance of Payment And Methods to Correct it

Submitted to: Dr. Madan Lal Faculty of Management Studies BHU, Varanasi. Submitted by: SHIVANK

Introduction

The study of the balance of payments was of great importance for the mercantilists. This term made its entry into English economic literature during mercantilist period. The balance of payment of a country is a systematic record of all its economic transactions with the outside world in a given year. In the language of International Monetary Fund, the balance of payment for a given period is defined...as a systematic record of all economic transactions during the period between residents of the reporting countries... 1 According to Bo Soderson, The balance of payment is merely a way of listing receipts and payments in international transactions for a contry.2 Thus it reveals various aspects of countrys international economic position. A nations international balance of payment is in equilibrium when the autonomous supply of and the autonomous demand for foreign exchange are equal. When a countrys autonomous receipts (credits) do not match its autonomous payments (debits), disequilibrium situation arises. A disequilibrium in the BOP of a country may be either a deficit or a surplus. If autonomous credit receipts exceed autonomous debit payments, there is a surplus in the BOP and the disequilibrium is said to be favourable. On the other hand, if autonomous debit payments exceed autonomous debit receipts, there is a deficit in the BOP and the disequilibrium is said to be unfavourable or adverse. Disequilibrium in a countrys external BOP may be caused by various factors: temporal, functional, etc. And it has important implications on a countrys economic status in the world. Various measures are employed to correct deficit in balance of payments. All these things will be covered in this presentation and subsequent discussion.

1. International Monetary Fund, Balance of Payments Manual, January 1950, p. 1. 2. Bo Soderson, International Economics, 1980, 2/e.

Balance of Payments
Structure and Accounts:
The balance of payment account of a country is constructed on a double entry bookkeeping. Each transaction is entered on the credit and debit side of the balance sheet. But in balance of payments accounting, the practise is to show credits on the left side and debits on the right side of the balance sheet. The credit and debit items are shown vertically in the balance of payments account of a country. Horizontally, they are divided into three categories: the Current Account, the Capital Account, and the Official Settlement Account or the Official Reserve Assets Account. Errors and Omissions also become a part of it. The balance of payment of Current Account includes items like import and exports, expenses on travel, transportation, insurance, investment income, etc. These relate to current transactions. Both commodities and services are part of it. The difference between exports and imports of a country is its balance of visible trade. If visible export exceeds visible imports, the balance of trade is favourable and vice-versa. The balance of exports and imports of services and transfer payments is called balance of invisible trade. The net value of these visible and invisible trade balances is the balance on current account. The Capital Account, on the other hand, is made up of capital transactions - Private and Government, e.g., borrowing and lending of capital, repayment of capital, sale and purchase of securities and other assets to and from foreigners-individuals and governments. The net value of the balances of short-term and long-term direct and portfolio investments is the balance on capital account. The Official Settlements Account is, in fact, a part of capital account, But the U.K. and U.S. show it as a separate account. The official settlements accont measures the change in a nations official liquidity and non-liquid liabilities to foreign official holders and the change in a nations official reserve assets during a year. The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF. It shows transactions in a countrys net official reserve assets.

Errors and Omissions is a balancing item so that total credits and debits of the three accounts must equal in accordance with the principles of double entry book-keeping so that the balance of payments of a country always balances in the accounting sense.

E.g. The balance of payments account of a country

Credits(+) (Receipts)

Debits(-) (Payments)

Exports (a) Goods (b) Services (c) Transfer Payments

1. Current Account Imports (a) Goods (b) Services (c) Transfer Payments 2. Capital Account (a) Lending to Foreign Countries (b) Direct Investments in Foreign Countries 3. Official Settlements Account (a) Increase in Official Reserve of Gold and Foreign Currencies Errors and Omissions

(a) Borrowing from Foreign Countries (b) Direct Investments by Foreign Countries (a) Increase in Foreign Official Holdings

Equilibrium in Balance of Payments

The balance of payments (on current account) is said to balance when the total of the credit items is exactly equal to the total of debit items. But, it is seldom so. Hence, there is either a deficit or a surplus in the current account of the balance of payments. This deficit or surplus is met by transfers in the capital account. In other words, the balance of payments is made to balance through the capital account. Suppose there is a deficit in the current account of the balance of payment. This deficit will be covered by (a) Drawing upon the countrys foreign exchange reserve. (b) By borrowing from abroad. (c) By exporting gold. Now the IMF grants temporary accommodation to bridge the gap. Balance means that the algebraic sum of the net credit and debit balances of current account, capital account, capital account and official settlements account must equal zero. Balance of payments is written as B = Rf - Pf Where, B represents balance of payments, Rf receipts from foreigners, Pf payments from foreigners. When B = Rf - Pf = 0, the balance of payments is in equilibrium. When Rf - Pf > 0, there is surplus in the balance of payments When Rf - Pf < 0, there is deficit in the balance of payments Further, say X represents exports, M imports, If foreign investment, B foreign borrowing Then if (X - M) (If B) = 0 The balance of payments is said to be in equilibrium

Disequilibrium in Balance of Payments

A disequilibrium in the BOP of a country may be either a deficit or a surplus. A deficit or surplus in BOP of a country appears when its autonomous receipts(credits) do not match its autonomous payments(debits). If autonomous credit receipts exceed autonomous debit payments, there is a surplus in the BOP and the disequilibrium is said to be favourable. On the other hand, if autonomous debit payments exceed autonomous debit receipts, there is a deficit in the BOP and the disequilibrium is said to be unfavourable or adverse.

Types and Causes of Disequilibrium

1. Temporary Changes ( or Disequilibrium) : There may be temporary disequilibrium due to random variables in trade, seasonal fluctuations, the effects of weather on agricultural production, etc. Deficits or surplus arising from such causes are expected to correct themselves within a short time. 2. Fundamental Disequilibrium : It refers to persistent and long run BOP disequilibrium of a country. It is a chronic BOP deficit, according to IMF. It is caused by dynamic factors as: a) Change of consumer taste within the country or abroad which leads to increase on imports and decrease in exports. b) Continuous fall in countrys foreign exchange reserves due to supply inelasticity of export and excessive demand for foreign goods. c) Excessive capital outflow due to massive imports of capital goods, raw materials, technology, essential consumer goods, and external indebtedness. d) Low competitive strengths in world markets which adversely affects exports. e) Inflationary pressures within the economy which makes exports dearer.

3. Structural Changes (or Disequilibrium) : Structural disequilibrium can be further Bifurcated into: a) Structural Disequilibrium at Goods Level: Structural disequilibrium at goods level occurs when a change in demand or supply of exports or imports alters a previously existing equilibrium, or when a change occurs in the basic circumstances under which income is earned or spent abroad, in both cases without the requisite parallel changes elsewhere in the economy. b) Structural Disequilibrium at Factors Level: Structural disequilibrium at the factor level results from factor prices which fall to reflect accurately factor endowments, i.e., when factor prices are out of line with factor endowments, distort the structure of production from the allocation of resources which appropriate factor prices would have indicated. 4. Cyclical Fluctuations (or disequilibrium) : Cyclical disequilibrium occurs because of two reasons. First, two countries may be passing through different paths of business cycle. Second, the countries may be following the same path but the income elasticity of demand or price elasticity of demand is different. If prices rise in prosperity and decline in depression, a country with a price elasticity for imports greater than unity will experience a tendency for decline in the value of imports in prosperity; while those for which import price elasticity is less than one will experience a tendency for increase. (These tendencies may be overshadowed by the effects of income changes, of course. Conversely, as prices decline in depression, the elastic demand will bring about an increase in imports, the inelastic demand a decrease. ) 5. Changes in Exchange rate: Changes in forex rate due to over or under valuation of foreign currency leads to BOP disequilibrium. When the value of a currency is higher in relation to foreign currency, it is said to be overvalued and vice-versa. Overvaluation of domestic currency makes foreign goods cheaper and exports dearer in foreign countries. As a result, country imports more and exports less of
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goods. There is also outflow of capital. This leads to unfavourable BOP. On the contrary, undervaluation makes BOP favourable by encouraging exports and inflow of capital and reducing imports. 6. Changes in National Income : If the national income increases, it will lead to an increase in imports thereby creating a deficit in balance of payments, other things remaining the same. If the country is already at full employment level, an increase in incomes will lead to inflationary pressure which may increase its imports resulting in adverse balance of payments. 7. Price Changes: If there is inflation in the country, price of exports increase. As a result, exports fall and at the same time, the demand for imports increases. Thus again leading to an adverse balance of payments situation. 8. Stage of Economic Development: If a country is developing, it will have a deficit in its BOP because its imports raw material, machinery, capital equipment and services associated with the development process. It exports only primary products, thus it has to pay more for costly imports and gets less for basic exports. 9. Capital Movements: Borrowing and lending also result in disequilibrium of BOP. A country which gives loans and grants on a large scale to other countries has a deficit in its BOP on capital account. If it is also importing more, as is the case with the USA, it will have chror deficit. On the other hand, a developing country borrowing large funds from other countries and international institutions may have a favourable BOP. But such a case is remotely possible because these countries usually imports huge quantities of food, raw materials and capital goods, etc and export primary products. Such borrowings simply help in reducing BOP deficit. 10. Political Conditions: Political instability in a country creates uncertainty in foreign investors which leads to the outflow of capital and retards its inflows thus creating disequilibrium. It may also occur in case of war or fear of war.

Measures to Correct Deficit in Balanced of Payments

To correct the different types of disequilibrium in BOP the following general measures are used: 1) Exchange depreciation (price effect) or devaluation (by government), 2) Deflate the currency, 3) Tariffs, 4) Import quotas, and 5) Export duties.

1)

Exchange Depreciation (Price Effect) or Devaluation (by Government): Exchange depreciation means a reduction in the value of a currency in terms of gold or other currencies under free market conditions and coming about through a decline in the demand for that currency in relation to the supply. This is usually applied to floating exchange rates. The purpose of this method is to depreciate the external exchange value of the home currency, thus cheapening the domestic goods for the foreigner. Whereas, under fixed-parity system or fixed exchange rate, the reduction of currency value in against the gold or other currencies is official and not market based. This official reduction of exchange rate is called devaluation. The purpose of both depreciation and devaluation is to cheapen the domestic goods and boost up the exports. (But the governments regarded devaluation as a means of correcting a balance of payments deficit only as a measure of last resort. They predominantly relied on deflation of the home market and international borrowing. Devaluation or depreciation of the exchange rate can correct a balance of payment deficit because it lowers the price of exports in terms of foreign currencies and raises the price of imports on the home market. This does not necessarily succeed in its purpose. The immediate effect is similar to an unfavourable change in the TOT. For the resources devoted to the production of exports, less foreign exchange is earned with which to pay for imports. If the level of imports remained the same, more output would have
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to be diverted to exports and away from home consumption and investment simply to maintain the status quo. Devaluation or depreciation could lead to a loss of real income without any benefit to the balance of payments. ) Pakistan has always faced negative BOT except for three years, i.e. 1947-48, 1950-51 and 1972-73. The newly born Pakistan had a quite high exports and a handsome balance of trade (US $ 42 million). With the Korean War boom in 1950-51, once again Pakistan gained a surplus in BOT (US $ 53 million). However, the reason for 1972-73s positive BOT ($ 20 million) was the massive currency devaluation in 1972 when the rupee was devalued from Rs. 4.76 to 2.3 times higher level of Rs. 11 per US dollar. The exports increased significantly and the share of exports in GDP rose to 14.9%.

2) Deflate the Currency: According to this method, the currency is deflated. As the currency contracts, prices will fall, which will stimulate exports and check imports. But the method of deflation is also full of dangers. If prices are forced down while costs, which are proverbially rigid (especially as regards wages in countries where trade unions are well organised), do not follow suit, the country may face a serious depression and unemployment. Correcting the balance of payments, therefore, once a disequilibrium has arisen is not an easy matter.

3)

Tariffs: Tariff is a tax levied on imports. It is synonymous with import duties or custom duties. Tariffs are used for two different purposes; for revenue and for protection. Revenue Tariffs are a source of government revenue Protective Tariffs are meant to maintain and encourage those branches of home industry protected by the duties.

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Tariff duties are of four types: Ad Valorem Tariff: It is levied as a percentage of the total value of the imported commodity. Specific Duties: These are levied per unit of the imported commodity. Compound Duties: These are a mixture of above two. Sliding Scale Duties: These vary with the prices of commodities imported.

4)

Import Quotas: As a protective device, import quotas are alternative to tariffs. Under an import quota, fixed amount of a commodity in volume or value is allowed to be imported into the country during a specified period of time. The major objectives of import quotas are: to avoid foreign competition, to provide greater administrative flexibility, to solve the problem of BOP and BOT.

Import quotas are of the following five types: Tariff quota, Unilateral quota, Mixing quota, Bilateral quota, and Import licensing.

5)

Export Duties: When world prices are higher than domestic prices, there is an incentive to export. In such a situation, a government may levy export duties. Export duties are used to prevent exports. The reason may be that exported commodities are required domestically.

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Conclusion
In short, correction of disequilibrium calls for a judicious mix of the following methods: a) Monetary and fiscal changes affecting income and price in the country; b) Exchange rate adjustment, i.e., depreciation or appreciation of the home currency; c) Trade restrictions, i.e., tariffs, quotas, etc.; d) Capital Movements, i.e., borrowing or lending abroad. No reliance can be placed on any single tool. There is room for more than one approach and for more than one device. But the application of the tool depends on the nature of disequilibrium. There are four types of disequilibrium, two in income (cyclical and secular) and two in prices or structural (at the goods and factor level). It is more appropriate that the cyclical and secular disequilibria be tackled by monetary and fiscal measures. In structural disequilibria, exchange rate adjustment plays a greater role. Generally, trade restrictions should be avoided. Capital movements by time in short-run disturbances and are needed to offset deep-seated forces in secular disequilibrium. The main methods of desirable adjustments are, therefore, a monetary and fiscal policy which directly affects income, and exchange depreciation which affects prices in the first instance. It can also have income effect through price effects. Monetary and fiscal policies affect relative prices also.

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Multiple Choice Questions

1. A nation has a surplus in its balance of payments if its total credits exceed its total ________ in its current and capital accounts. a) Debits b) Reserves c) Exports d) Imports 2. A deficit in a nations balance of payments is corrected by a depreciation of its currency under a ____________? a) Fixed-parity exchange-rate system b) Floating exchange-rate system c) Both (a) and (b) d) None of these. 3. A current account deficit is financed through ___________? a) Exports b) Lending money to foreign countries c) borrowing or foreign investment d) All of the above 4. Transaction are said to be autonomous if their value is determined ____ of the BOP. a) Independently b) Dependently c) Accommodating d) Exclusive

Answers:

1) a

2) b

3) c

4) a
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Short Answer Type Questions

1) What happens to the equilibrium rate of exchange and to the equilibrium Quantity of foreign exchange if the nations demand for the foreign currency Decreases? Why? 1) Given the nations supply curve of the foreign currency, a downward shift in the nations demand curve for the foreign currency will determine a new and lower equilibrium exchange rate and equilibrium quantity. A decrease in the nations demand for a foreign currency may result from a change in tastes for less imported goods and services. It may also occur if the nation decreases its investments and loans abroad in the expectation of decreased returns.

2) How is a deficit or a surplus in a nations balance of payments corrected Under a flexible-exchange-rate system? 2) A deficit in a nations balance of payments means that at a given rate of exchange, there is a shortage (an excess of quantity demanded over quantity supplied) of the foreign currency. If the exchange rate is freely flexible or floating, the exchange rate will rise until the quantity demanded of the foreign currency equals the quantity supplied and the deficit is completely eliminated. This rise in the exchange rate means that the relative value of the domestic currency is falling or depreciating. The Exact opposite occurs when there is a surplus and the nations currency appreciates (Or increases) in relative value.

3) What is a Balance of payments crisis 3) A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential imports and/or service its debt repayments. Typically, this is accompanied by a rapid decline in the value of the affected nation's currency. Crises are generally preceded by large capital inflows, which are associated at first with rapid economic growth. However a point is reached where overseas investors become concerned about the level of debt their inbound capital is generating, and decide to pull out
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their funds. The resulting outbound capital flows are associated with a rapid drop in the value of the affected nation's currency. This causes issues for firms of the affected nation who have received the inbound investments and loans, as the revenue of those firms is typically mostly derived domestically but their debts are often denominated in a reserve currency. Once the nation's government has exhausted its foreign reserves trying to support the value of the domestic currency, its policy options are very limited. It can raise its interest rates to try to prevent further declines in the value of its currency, but while this can help those with debts in denominated in foreign currencies, it generally further depresses the local economy.

4) Is a Current Account Deficit a bad Thing? 4) A Current account is considered harmful to the economy because: a. A current account deficit is financed through borrowing or foreign investment b. Borrowing is unsustainable in the long term and countries will be burdened with high interest payments. E.g Russia was unable to pay its foreign debt back in 1998. Other developing countries have experience similar repayment problems Brazil, African countries (3rd World debt) c. Foreigners have an increasing claim on countrys assets, which they could desire to be returned at any time. E.g. a severe financial crisis in Japan may cause them to repatriate their investments. d. Export sector may be better at creating jobs e. A Balance of Payments deficit may cause a loss of confidence However a current account deficit is not necessarily harmful a. Current Account deficit could be used to finance investment e.g. US ran a Current account deficit for a long time as it borrowed to invest in its economy. This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US money. b. With a floating exchange rate a large current account deficit should cause a devaluation which will help reduce the level of the deficit. Thus, It depend on the size of the budget deficit as a % of GDP.
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Bibliography

Schaums Outline of Theory and Problems of Principles of Economics (Second Edition) By Dominick Salvatore , Eugene A . Diulio International Economics (Sixth Edition) By M.L. Jhingan Modern Economic Theory (23rd Edition) By Dr. K.K. Dewett and M.H. Navalur International Economics By M.C. Vaish and S Singh

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