BALANCE OF PAYMENTS PROBLEMS

1. BALANCE OF PAYMENTS PROBLEMS

2. Current Account Deficit • Current Account Deficit-net outflows on current account greater than net inflows. • Made up on the capital account (since current account deficit=capital account surplus…current account + capital account=0 {theoretically}) • Current account deficit can be covered by (i) loans from abroad and (ii) investment from abroad. • There are several negative effects of having current account deficits in the long run for a debtor nation.

3. Negative effects • To cover the current account deficit, the country can take loans from abroad. However, by borrowing from abroad, the loans will have to be paid back with interest. • Continuous current account deficits will be looked upon harshly by the international business and financial community. The ability to pay off foreign debts will be questioned. Investors choose to avoid weak economy. In such a scenario, foreign countries would be unwilling to give loans to the domestic country thereby making covering current account deficits difficult. • Downward pressure on currency. • Domestic economy vulnerable to international business cycles and interest rates.

4. Negative Effects • Country may be forced to raise interest rates to attract more foreign investment and to keep a desired exchange rate. • Foreign firms ultimately fund more and more of domestic investment, making the domestic economy vulnerable. • Sale of domestic assets to foreigners causes outflow (in the form of repatriated incomes, dividends etc) thereby intensifying current account deficit even further. • Increasing interest rates deflationary effect on domestic economy.

5. Negative effects • Incoming funds on capital account may be speculative inflows in which case recipient country headed for trouble. • Risk of foreign capital exiting- if this happens in domestic economy unemployment rises as capital leaves. Significant reduction in imports.

6. Benefits • A current account deficit allows a country to enjoy greater consumption than production-even on borrowed money. • If deficit is relatively short-lived-less chance of damage ,if inflows on capital account are used for investments. • For example; The difference with the USA capital account deficit is that it does not threaten to collapse the American economy. • As long as the funds go towards investment, the debt will have to be paid by future generations of Americans who enjoy increased living standards as a result of using the loans.

7. Current Account Surplus • Current Account Surplus  net outflow in capital account. • Gains: • The increase in foreign holdings will in time generate income in the forms of profits, interest received and dividends. • Enabled future consumption the net foreign assets are another form of saving which can be used in the future. • Enhanced resource allocation and increased profits for domestic firms Capital will flow to countries with a higher rate of return than home country. Thus, less competition in domestic market.

8. Current Account Surplus • Possible disadvantages: • Current investment possibilities for the home country decrease as resources as diverted abroad. • Diverting investment from the domestic to foreign market leading to loss of jobs (contentious), skills and technology gains. • Degree of tax loss as portion of tax bases taxed outside country.

9. Methods of correction (of current account deficits) • Current account deficit is looked upon as a balance of payments disequilibrium, thus it needs to be corrected using economic policies. • Short run policies intervene on the market to lower the ratio of price of domestic goods to imported goods-take up protectionist methods so that import spending falls, deficit is corrected. • Long run policies enhancing domestic competitive abilities i.e. increasing R&D, productivity and introducing innovation and improvements in quality etc.

10. Managing changes in exchange rates • A country operating under a managed currency regime can devalue its currency to correct the current account deficit. • Devaluation Px  X volume  X revenue (assuming price elastic exports) • Devaluation PM  M volume  M spending (assuming price elastic imports) • Thus, devaluation can correct a current account deficit.

11. Expenditure switching policies • Policies which divert/substitute expenditure away from imports towards domestically produced goods are expenditure-switching policies. Trade barriers and/or intentionally lowering the exchange rate (devaluation or depreciation) are examples of such policies. • Disadvantages: retaliatory protectionism and reciprocal devaluations.

12. Expenditure reducing policies • Contractionary policies such as increased interest rates and/or decreased government spending will cause a reduction in expenditure (national income) and lower the demand for imports. • Disadvantages: possibility of a trade off in accomplishing both macro goals of high growth/employment and external balance.

13. Change in supply side policies to increase competitiveness • Reducing labor costs, adding to labor skills, creating incentives for investment in technology and generally increasing productivity will increase international competitiveness. • Ultimately, increased imports and diverted spending also towards domestic goods. • However, these policies take time to show an effect on the balance of payments.

14. MARSHALL-LEARNER CONDITION • A devaluation would help improve the current account only when P. e. d x + P .e. d m>1

15. J-CURVE • A devaluation might actually worsen the current account initially because; • Exports and imports are likely to be inelastic in the short run. • Firms are locked into contracts. • What about elasticity of supply of exports and imports.