Disequilibrium in Balance of Payments: Causes and Implications

In this article we will discuss about the causes and implications of disequilibrium in balance of payments.

Causes of Disequilibrium:

There are many factors that may lead to a BOP deficit or surplus:

1. Temporary Changes (or Disequilibrium):

There may be a temporary disequilibrium caused by random variations in trade, seasonal fluctuations, the effects of weather on agricultural production, etc. Deficits or surpluses arising from such temporary causes are expected to correct themselves within a short time.

2. Fundamental Disequilibrium:

Fundamental disequilibrium refers to a persistent and long-run BOP disequilibrium of a country. It is a chronic BOP deficit, according to IMF.

It is caused by such dynamic factors as:

(1) Changes in consumer tastes within the country or abroad which reduce the country’s exports and increase its imports.

(2) Continuous fall in the country’s foreign exchange reserves due to supply in-elasticities of exports and excessive demand for foreign goods and services.

(3) Excessive capital outflows due to massive imports of capital goods, raw materials, essential consumer goods, technology and external indebtedness.

(4) Low competitive strength in world markets which adversely affects exports.

(5) Inflationary pressures within the economy which make exports dearer.

3. Structural Changes (or Disequilibrium):

Structural changes bring about disequilibrium in BOP over the long run.

They may result from the following factors:

(a) Technological changes in methods of production of products in domestic industries or in the industries of other countries. They lead to changes in costs, prices and quality of products.

(b) Import restrictions of all kinds bring about disequilibrium in BOP.

(c) Deficit in BOP also arises when a country suffers from deficiency of resources which it is required to import from other countries.

(d) Disequilibrium in BOP may also be caused by changes in the supply or direction of long-term capital flows. More and regular flow of long-term capital may lead to BOP surplus, while an irregular and short supply of capital brings BOP deficit.

4. Changes in Exchange Rates:

Changes in foreign exchange rate in the form of overvaluation or undervaluation of foreign currency lead to BOP disequilibrium. When the value of currency is higher in relation to other currencies, it is said to be overvalued.

Opposite is the case of an undervalued currency. Overvaluation of the domestic currency makes foreign goods cheaper and exports dearer in foreign countries. As a result, the country imports more and exports less of goods. There is also outflow of capital. This leads to unfavourable BOP. On the contrary, undervaluation of the currency makes BOP favourable for the country by encouraging exports and inflow of capital and reducing imports.

5. Cyclical Fluctuations (or Disequilibrium):

Cyclical fluctuations in business activity also lead to BOP disequilibrium. When there is depression in a country, volumes of both exports and imports fall drastically in relation to other countries. But the fall in exports may be more than that of imports due to decline in domestic production.

Therefore, there is an adverse BOP situation. On the other hand, when there is boom in a country in relation to other countries, both exports and imports may increase. But there can be either a surplus or deficit in BOP situation depending upon whether the country exports more than imports or imports more than exports. In both the cases, there will be disequilibrium in BOP.

6. Changes in National Income:

Another cause is the change in the country’s national income. If the national income of a country increases, it will lead to an increase in imports thereby creating a deficit in its balance of payments, other things remaining the same. If the country is already at full employment level, an increase in income will lead to inflationary rise in prices which may increase its imports and thus bring disequilibrium in the balance of payments.

7. Price Changes:

Inflation or deflation is another cause of disequilibrium in the balance of payments. If there is inflation in the country, prices of exports increase. As a result, exports fall. At the same time, the demand for imports increase. Thus increase in export prices leading to decline in exports and rise in imports results in adverse balance of payments.

8. Stage of Economic Development:

A country’s balance of payments also depends on its stage of economic development. If a country is developing it will have a deficit in its balance of payments because it imports raw materials, machinery, capital equipment, and services associated with the development process and exports primary products. The country has to pay more for costly imports and gets less for its cheap exports. This leads to disequilibrium in its balance of payments.

9. Capital Movements:

Borrowings and lendings or movements of capital by countries also result in disequilibrium in 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 chronic 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 possibility is remote because these countries usually import huge quantity of food, raw materials, capital goods, etc. and export primary products. Such borrowings simply help in reducing BOP deficit.

10. Political Conditions:

Political condition of a country is another cause of disequilibrium in BOP. Political instability in a country creates uncertainty among foreign investors which leads to the outflow of capital and retards its inflow. This causes disequilibrium in BOP of the country. Disequilibrium in BOP also occurs in the event of war or fear of war with some other country.

Implications of Disequilibrium:

A disequilibrium in the balance of payments whether a deficit or surplus has important implications for a country. A deficit in the combined current and capital accounts is regarded as undesirable for the country. This is because such a deficit has to be covered by borrowing from abroad or attracting foreign exchange or capital from abroad. This may require paying high interest rates.

There is also the danger of withdrawing money by foreigners, as happened in the case of the Asian crisis in the late 1990s. An alternative may be to draw on the reserves of the country which may also lead to a financial crises. Moreover, the reserves of a country being limited, they can be used to pay for BOP deficit up to a limit. But the above analysis of a combined current and capital account deficit is not correct in practice.

The reason being that a current account deficit is the same thing as a capital account surplus. However, it is beneficial for a country to have a current account deficit even if it equals capital account surplus in BOP. In the short-run, the country may benefit from a higher level of consumption through import of goods and consequently a higher standard of living.

But the excess of imports over exports may be financed by foreign investments in the country. These may lead to increased production, employment and income in the country. In the long-run, foreign investors may purchase large assets in the country and thus adversely affect domestic industry as is the case with MNCs (multinational corporations).

The current account deficit in BOP of a country may have either good or bad effects depending on the nature of an economy. Take a country where domestic industries are rapidly growing and it has current account BOP deficit. These industries offer a high rate of return on their investment. This would, in return, attract foreign investments. As a result, the country would have a capital account surplus due to the inflow of capital and a current account deficit.

This current account deficit is good for the economy. No doubt, the external debt of the country increases, but this debt is being utilised to finance the rapid growth of the economy. The real burden of this debt will be very low because it can be repaid out of higher income in the future.

On the contrary, a country having an inefficient and unproductive domestic industry will be adversely affected by its current account BOP deficit. The country borrows from abroad to finance the excess of spending over consumption. To attract foreign borrowings, the country will have to pay high interest rates. These will increase the money burden of the debt.

The real burden of the debt will also increase because of the low productive capacity of domestic industries. If the current consumption is being financed by foreign borrowings, the wealth of the economy will decline. This, in turn, will lead to either a reduction in domestic expenditure or a change in government policy so as to control the rising debt.

On the other hand, if foreign borrowings are being used to finance real investment, the current account BOP deficit will be beneficial for the economy. A higher rate of return on real investment than the interest on foreign borrowings would increase the country’s wealth over time through rise in its national income. Thus a current account BOP deficit is not always undesirable for a country.