4 Main Causes of Balance of Payment

The following points will highlight the four main causes of balance of payment policies.

Cause # 1. Devaluation or Depreciation:

These mean a reduction in the foreign exchange value of a nation’s currency. Thus, in 1949, 1966 and 1991, the rupee value was lowered in terms of pound when there was a system of fixed exchange rates — in this case there was a devaluation.

The effects of devaluation and depreciation are the same—cheaper exports and dearer imports.

The following example illustrates how this results:

At the exchange rate of £1=$2, a British export priced at £5 sells for $ 10 in USA, and

an American import costing $20 sells for £10 in Britain.

If the exchange rate falls to £1=$1, the British export now sells for $5 (i.e., $5 cheaper) and the American import is priced at £20 in Britain (i.e., £10 dearer). Thus devaluation/depreciation makes a nation’s goods more competitive.

However, the balance of payments only benefits if proportionately more exports are sold and many fewer imports are bought. The chance of this occurring depends on the elas­ticity of demand of the goods being traded.

Devaluation/Depreciation is only effective if the demand for exports is relatively elastic and the demand for imports is also fairly elastic. This is because in these cases, the total revenue from exports will increase and the total spending on imports will fall, giving a net gain.

The effectiveness of depreciation/devaluation is further limited by four other factors. These are the following:

1. The ability of domestic suppliers to meet the extra demand created by cheaper exports and home consumers switching away from imports to Indian goods. If home supply is inelastic, then the advantage of depreciation may be lost.

2. If the costs of production in India are rising faster than elsewhere, the price advantage from devaluation may be lost.

3. Price is just one factor. The conditions of demand might change, or be more important in some markets, e.g., in engineering the design, safety and efficiency of a product may be more important than its price.

4. Other nations may retaliate by lowering their exchange rates, thus offsetting the impact.

Cause # 2. Deflation:

This is a general policy designed to reduce the level of spending in the economy. In doing so it will curb the demand for imports in par­ticular, as India tends to reduce imports during boom periods. It can be operated through fiscal and monetary policies. The government can cut its own public spending, raise taxation and introduce compulsory deposit scheme for income tax payers so that less money is available for spending on imports.

Alter­natively, a policy of monetary (credit) control can be introduced to curb spending. It is further argued that the fall in purchasing power will affect domestic producers who may switch resources towards seeking export markets, thereby further benefiting the balance of pay­ments.

Deflation tends to be a short-term policy. As balance of payments crises occur, it becomes clear that deflation is not a long- term solution, and not effective either. The costs of deflation make it unpopular because spending cuts lead to unemployment and fall in output.

In turn, these changes make it self – defeating because tax revenue falls and public spending and the country, import bill increases — which is not desirable. Also, it clearly conflicts with policies designed to stimulate growth by depressing business opti­mism and lowering investment — both public and private.

Cause # 3. Control of Money Supply:

The monetarist economists believe that un- competitiveness in international trade can result from domestic inflation caused by an excessive growth in the supply of money in the economy. If India’s inflation rate exceeds that of her trading rivals, then our imports will increase and exports will fall, thereby probably creating a deficit.

Thus, the supply of money could be con­trolled by raising interest rates, to deter borro­wing, and restricting credit, using the usual monetary weapons. Both policies would reduce spending on imports and strengthen employers’ resistance to wage demands — thereby lowering domestic costs of production and making Indian goods more competitive.

In addition, higher interest rates attract capital inflows and tem­porarily strengthen the capital account. How­ever, they may raise the exchange rate and make our goods less competitive too! This policy has similar consequences to deflation — namely lower output and increased unemployment.

Cause # 4. Trade Controls/Incentives:

The policy is less general and more spe­cific. It involves direct measures aimed in certain areas.

Tariffs:

These can be used to raise the price of imports and, if demand is elastic, and re­duce the demand for imports.

Quotas:

These can be introduced to limit the quantity of imports, thereby strengthening the balance of trade. However, the World Trade Organisation (WTO) does allow the imposition of quotas on a temporary basis for a nation facing balance of payments difficulties.

Exchange control:

Capital account deficits created by investment outflows can be countered by exchange controls. In 1947, the Government of India introduced controls over overseas transactions, restricting the amount of currency available for investment abroad. This meant that Indian citizens buying shares and Indian companies building factories over­seas needed government permission to obtain the necessary foreign currency.

Administrative controls:

There are many non-tariff barriers to trade which are not easily dealt with under the WTO rules. Frequent changes in a country’s laws and administrative procedures on health standards, invoicing procedures, safety specifications and product designs can be used by unscrupulous governments to keep out competitive imports.

Subsidies:

Governments may subsidise exports to make them more competitive. This is not allowed by WTO rules, but the subsi­dies may be disguised as payments for services. Thus Germany subsidises its steel industry in particular and industry fuel bills in general. Indian exports are exempted from excise duty—which is a subsidy as it reduces the costs of production. Export credits (lending funds to process buyers of goods) are subsi­dised by most governments.

Apart from direct help, the government, through the Department of Trade and Commerce, can promote trade fairs, exhibitions and publicity to aid Indian exporters. There is a good case for raising this currently low-budget activity, so that more indirect financial and advisory help can be given.