Balance of payments problems

What are balance of payments problems?

Balance of payments problems arise generally due to existence of deficits in the current and
capital accounts. The transactions that are in the capital and current accounts as autonomous
transactions or items above the line. They are known as such because the transactions are
being undertaken either in foreign exchange market or the commodity market without the
participants being aware of their actions the balance of payments effects e.g. when residents
transfer money abroad either as investment material or donations/ gifts have no clue
whatsoever of these balance of payments effects.

Causes of B.O.P problems

There are numerous factors that influence B.O.P problems in countries but the most common
of these is the use of the fixed exchange rate regime. In this case the foreign exchange rate is
usually se below the equilibrium exchange rate thus over valuing the local currency. As
consequence, it becomes the imports will be cheap as compared to the exports. This means
that the demand for imports will surpass that of exports bringing about a higher debit balance.
Other causes of inflation may include; high inflation rates, level of economic growth,
government borrowing habits, transfer money abroad, recession in other countries,
deterioration of the current account etc.

Adjustment of B.O.P deficits

It is only under a freely floating/ flexible exchange rate regime that the equilibrium exchange
rate is established, under the managed float and the fixed/ pegged exchange rate regimes, the
exchange rate will be set either above or below the equilibrium level bringing about a surplus or
a deficit in the balance of payments account. In this case we will only concentrate on the deficit
side and how to adjust it. The various ways of adjusting the deficit balance include;

Use of expenditure reducing policies

These policies include the monetary and the fiscal policies. Adjustments in the items of these
two components are what bring about changes in the deficit balances of the balance of
payments account. The basic items used when using the monetary policies are interest rates
and open market operations while when using fiscal policies the basic items are taxation and
direct government expenditures.

Expenditure switching policies

These policies work by either increasing or reducing the relative prices of imports and exports.
The main forms of these mechanisms are the exchange rate changes (devaluation of the
currency) and also the direct controls to restrict imports. As a consequence, the consumers will
be encouraged to switch from consumption of imported goods to consumption of domestically
produced goods. This is because devaluation of the currency will make imports expensive to
locals while at the same time making the exports cheaper to the foreigners. However, for this
policy to work the Marshall-Lerner condition must be complied with i.e. for a devaluation to be
effective in correcting a B.O.P deficit, the sum of elasticities of demand of the country’s
exports/ imports must be greater than one.

Direct controls

This usually comes into play when the expenditure reducing and switching policies are not
working or taking too long to bring about the desired change. However these controls interfere
with free markets by distorting commodity prices and resource allocation besides being
expensive to administer.