Balance of Payments Disequilibrium

Balance of Payments Disequilibrium

One of the macroeconomic objectives of the government is to maintain a Balance of Payments (BOP) equilibrium. BOP equilibrium occurs when a country’s receipts and payments from its international transactions are equal. The overall balance in the BOP account is zero, i.e. total debits and total credits are equal. BOP comprises the current account, capital account and financial account.

If the total money inflow is greater than the total money outflow, there is a BOP surplus. A BOP deficit occurs when the total money outflow exceeds the total inflow of money. A BOP surplus is a positive balance while a BOP deficit is a negative balance. 

Current account disequilibrium

The current account is part of the BOP and comprises trade in goods, trade in services, incomes and current transfers. A deficit on the current account means the total outflow from its components exceeds the total inflow. The overall balance in the account is negative when there is a current account deficit. It means that there is a net outflow of currency from the country and the country may run into a problem if the deficit is large. It may may have to draw down its foreign reserve or borrow form the International Monetary Fund (IMF) unless it can attract a lot of foreign funds.

A surplus means that the current account has a positive balance as the total inflow is greater than the total outflow. A surplus is an indication that there is a net inflow of money and the country has a surplus to boost the  financial account section of its balance of payments.  A country can also build up its foreign reserve from the surplus. However, a current account surplus may suggest that a country’s standard of living is low as rising income necessitates importation of variety of products that can improve the citizens’ living standards.

Reasons for current account deficit 

Some of the causes of a deficit in the current account are temporary and self-correcting while others are severe requiring government intervention through policies. Policies, however, can interfere with other government objectives. For example, a deficit caused by a recession in trading partners is not a serious problem because recession is temporary. But a loss of competitiveness of a country’s exports requires government attention because it could be a long-term problem. If the deficit is one-off or forms a small percentage of the country’s Gross Domestic Product (GDP), it is not a cause for concern. 

Rising income
A rising income due to economic prosperity or growth fuels demand for many consumer goods more than what can be produced locally. Increased demand for goods and services would grow a country’s imports. Imports may exceed exports, thereby causing a current account deficit.

Raw materials and components requirements
A country that is experiencing economic growth would need to import raw materials, machinery, spare parts and other components. This massive importation would produce a deficit in the current account even though it is temporary. A reversal of the deficit will begin after production for both domestic use and export.

Lack of competitiveness
A relatively high inflation rate in the domestic economy reduces the price competitiveness of its products in the international market. Besides, lower quality products causes a decrease in the  demand for its products in foreign markets. Less exports could lead to a current account deficit. This is a serious problem requiring government actions.

Slowdown in trading partner
A temporary decline in economic activities in a trading partner due to  recession would reduce the demand for a country’s exports. This could lead to a current account deficit. But the situation would improve as soon as the recession is over.

Overvalued exchange rate
An overvalued exchange rate occurs when the relative value of a currency is more than what it should be. One way to determine whether a currency is overvalued is by comparing the cost of the same basket of goods in two countries (Purchasing Power Parity). For example, if the same basket of goods cost $10 in the US and £2 in the UK the exchange rate should be $10 to £2 or $5 to £1. But if the actual exchange rate is $6 to £1, the pound is overvalued because it can buy more dollars than it should buy. An overvalued exchange rate  makes imports cheaper and exports more expensive. A rise in imports coupled with a fall in exports would cause a current account deficit.  This often requires the attention of the government.

The continuous decline in manufacturing activities is a reason for the fall in exports and a rise in imports in many developed countries. It is relatively cheaper to produce in less developed countries of Asia and Africa. This explains why a lot of the developed countries record deficits in their current accounts.  Deindustrialisation is a long-term problem.

Capital account deficit

A deficit in the capital account means that there is more money going out of the country than coming in due to a rise in the purchase of assets in other countries. There will be an inflow of money when those foreign assets are sold.  If non-financial assets like copyrights and patents are bought in other countries, there is a possibility of an income inflow into the country later. But if it is due to grants for capital projects abroad or money taken out by migrants, there is no future income inflow expected by the country.

The currency of a country could depreciate due to money outflow. Depreciation encourages exports as they are cheaper. This will correct the deficit in the current account and create job opportunities.

Financial account deficit
An increase in investments overseas will result in a deficit in the financial account. There is a net outflow of money due to investments. This is good because those investments will yield income in the future. The incomes, such as profits and dividends, will increase the inflow of income in the current account in the future. But if there is  net outflow due to the inability of the country to attract investments, there is a problem. Government would need to work on creating enabling environment that can attract foreign investors.