Correction of Balance of Payments (BoP) Deficit

Balance of Payments Adjustments

The short-term and small deficits in the balance of payments are quite likely to emerge in wide range of international transactions. These deficits do not call for immediate corrective actions. More importantly, irregular short-term changes in the domestic economic policies with a view to remove the short-term deficit in the balance of payments may do more harms than good to the economy. Since these changes cause dislocations in the process of reallocation of resources and short-term fluctuations in the economy. Therefore, short-term deficits of smaller magnitude are not a serious concern to the policy makers. A constant deficit indicates that the country’s imports dominates exports or depreciation of its foreign exchange and gold reserves. These countries lose their international liquidity and credibility. This situation often leads to compromise with economic and political independence of these countries.

India faced a similar situation in July 1990. Therefore, a country facing constant large deficits in in balance of payments is forced to adopt corrective measures, such as changes in its internal economic policies for wiping out the deficits, or at least to bring it in a manageable size. It is a widely accepted view that the conditions for an automatic corrective mechanism visualized under gold standard, based on international price mechanism do not exist. Therefore, the government has no option but to intervene with the market conditions of demand and supply with the policy measures available to them. It should be borne in mind that policy-mix in this regard may vary from country to country and from time to time depending on the prevailing economic conditions.

Measures used to Correct Deficits in Balance of Payments

The various measures used to correct deficits in balance of payments are as follows:

  • Indirect measures to correct adverse BoP: Under free trade system, the deficits in the balance of payments arise either due to greater aggregate domestic demand for goods and services than the total domestic supply of goods and services or domestic prices are significantly higher than the foreign prices. Thus, the deficit may be removed either by increasing domestic production at an internationally comparable cost of production or by reducing excess demand or by using the two methods simultaneously. It may be very difficult to increase the output in the short-run, specially when a country is close to full-employment or when there are other limiting factors to its industrial growth. Therefore the only way to reduce deficit is to reduce the demand for foreign goods.
  • Income and Expenditure Policies: Here we discuss how reduction in income can lead to reduction in demand and how it helps reducing the deficit in the balance of payments. The two policy tools to change disposable income are monetary and fiscal policies. Monetary policy operates on the demand for and supply of money while fiscal policy operates on the disposable income of the people. The working and efficacy on these policies as instruments of solving balance of payment problem is described below.

1. Monetary Policy

The instruments of monetary policy include discount and bank rate policy, open market operations, statutory reserve ratios and selective credit controls. Of these, first two instruments are adopted in the context of balance of payment policy. This however should not mean that other instruments are not relevant. The government is free to choose any or all of these instruments and adopt them simultaneously.

To solve the problem of deficit in the balance of payments, a ‘tight money policy’ or ‘dear money policy’  is adopted. Under ‘dear money’ policy, central bank raise the bank rates and discount rates. Consequently, under normal conditions, the demand for institutional funds for investment decreases. With the fall in investment and through its multiplier effect, income of the people decreases. If marginal propensity to consume is greater than zero, demand for goods and services decreases. The decrease in demand also implies a simultaneous decrease in imports while other things remain same. This is how ‘a tight money policy’ corrects deficit in balance of payments.

The efficiency of ‘tight money policy’ is however doubtful under following conditions: (i) when rates of returns are much higher than the increased bank rate due to inflationary conditions, (ii) when investors have already affected their investment in anticipation of increase in the rate of interest. The tight money policy is then combined with open market operation, i.e., sale of government bonds and securities. These two instruments together help to reduce demand for capital and other goods. Therefore, if all goes well then the deficit in the balance of payments is bound to decrease.

2. Fiscal Policy

Fiscal policy as a tool of income regulation includes intervention in taxation and public expenditure. Taxation reduces household disposable income. Direct taxes directly transfer the household income to the public reserves while indirect taxes serve the same purpose through increased prices of the taxed commodities. Direct taxes reduce personal savings directly in a greater amount while indirect taxes do it in a relatively smaller amount. Taxation reduces the disposable income of the household and thereby the aggregate demand including the demand for imports. Taxation also helps to curtail investment by taxing capital at progressive rates.

The government can reduce income and demand also by adopting the policy of surplus budgeting in which the government keeps its expenditure less than its revenue. Taxation reduces disposable income of household and public expenditure increases household’s income and their purchasing power. However, multiplier effect of public expenditure is greater by one than the multiplier effect of taxation. Therefore, while adopting surplus-budget policy due consideration should be given to this fact. To account for this fact, it is necessary that surplus is so large that the total cumulative effect of taxation on disposable income exceeds the effect of public expenditure. The reduction in income that will be necessary to achieve a certain given target of reducing balance of payments deficit depends on the rate foreign trade multiplier.

Exchange Depreciation and Devaluation

Reducing excess demand through price measures involves changing relative prices of imports and exports. Relative prices of imports and exports can be changed through exchange depreciation and devaluation. Exchange depreciation refers to fall in the value of home currency in terms of foreign currency and devaluation refers to fall in the value of home currency in terms of gold. However, ill terms of purchasing power, parity between devaluation and depreciation turns out to be the same and its impact on foreign demand is also the same. Therefore, we shall consider them as one in their role of correcting adverse balance of payments.

Devaluation and exchange depreciation change the relative prices of imports and exports, i.e., import prices increase and export prices decrease, though not necessarily in the proportion of devaluation. As a result of change in relative prices of exports and imports, the demand for imports decreases in the country, which devalues its currency and foreign demand for its goods increases provided foreign demand for imports is price elastic. Thus, if devaluation or exchange depreciation is effective, imports will decrease and exports will increase. Country’s payments for imports would decrease and export earnings would increase. This ultimately decreases the deficits in the balance of payments in due course of time. However, whether expected results of devaluation or exchange depreciation are achieved or not depends on the following conditions.

  • The most important condition in this regard is the Marshall-Lerner condition. The Marshall-Lerner condition states that devaluation will improve the balance of payments only if the sum of elasticities of home demand for imports and foreign demand for exports is greater than unity. If  the sum of elasticities is less than unity, the balance of payments can be improved through revaluation instead of devaluation.
  • Devaluation can be successful only if the affectcd countries do not devalue their currency in retaliation.
  • Devaluation must not change the cost-price structure in favor of imports.
  • Finally, the government ensures that inflation. which may be the result of devaluation, is kept under control, so that the effect of devaluation is not counter-balanced by the effect of inflation.

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