Equilibrium, Disequilibrium and Adjustment in the Balance of Payments

Balance of Payments Equilibrium:

Before we analyse the conditions of disequilibrium, we would like to explain what is meant by equilibrium balance of payments.

“Equilibrium is that state of the balance of payments over the relevant time period which makes it possible to sustain an open economy without severe unemployment on a continuing basis”.

The essentials in this definition are:

(a) Relevant time period,

(b) Open-ness of economy (i.e., no undue restrictions on imports),

(c) Absence of unemp­loyment, and

(d) Continuing basis of the equilibrium (i.e.; it is capable of being sustained).

The period is generally one year. Thus, seasonal inequality between exports and imports is not a sign of disequilibrium. When the balance of payments of a country is in equilibrium, the demand for domestic currency is equal to its supply.

The demand and supply situation is thus neither favourable nor unfavorable. If the balance of payments moves against a country, adjustments must be made by encouraging exports of goods, services or other forms of exports, or by discouraging imports of all kinds. No country can have a permanently unfavorable balance of payments, though it is possible—and is quite common for some countries—to have a permanently un-favourable balance of trade. Total liabilities and total assets of nations, as of individuals, must balance in the long run.

This does not mean that the balance of payment of a country should be in equilibrium individually with every other country with which she has trade relations. This is not necessary nor is it the case in the real world. Trade rela­tions are multilateral. India, for instance, may have an active (i.e. surplus) balance of payments with the United States and passive balance with the United Kingdom and/or other countries. But each country, in the long run, cannot receive more value than she has exported to other countries taken together.

Equilibrium in the balance of payments, therefore, is a sign of the soundness of a country’s economy. But disequilibrium may arise either for short or long periods. A continued disequilibrium indicates that the country is heading towards economic and financial bankruptcy. Every country, therefore, must try to maintain balance of payments in equilibrium.

Correcting Disequilibrium in the Balance of Payments:

The balance of payments 01 India for 1982-83 gives above shows a heavily adverse balance of payments on current account. When the visible and invisible exports of a country are less than all her imports (or the imports exceed the exports) over a long period and the difference is big, steps have to be taken to bridge the gap. A number of methods are used.

They are:

Improving the balance of trade through import restrictions and measures of export promotion. Since balance of payments becomes adverse chiefly on account of excess of imports over exports, the most urgent steps are to be taken in this direction. A country having an adverse balance of payments must to check imports, or to stimulate exports, or do both. Imports can be checked either by total prohibition, or by levying import duties, or by a quota system.

Another method is adopting of measures of import substitutions, i.e., trying to produce in the country what it currently imports from abroad. Exports can be stimulated by measures of export promotion i.e. granting bounties or other concessions to industrialists and exporters.

Deflation:

Another method is deflation. Under this method, total money income in the economy is sought to be reduced, so that the aggregate demand in the country falls. As a result, the people tend to import less and their demand for home-produced goods too becomes less, releasing more of them for exports.

Owing to a fall in aggregate demand, prices also fall, so that the country becomes a good market to buy from and a bad market to sell in. In this way, imports get discouraged and exports are stimulated, thus correcting the adverse balance of payments. But deflation is not a healthy method, because the reduction of money incomes hits business, trade and industry hard and brings about depression and unemployment.

Exchange control:

Sometimes the adoption of any of the above methods is not “considered desirable. It is feared that the depreciation may lead to retaliatory depreciation by other countries. Devaluation is supposed to damage the prestige of a country. Deflation brings in its wake disastrous consequences in the form of depression and widespread unemployment.

It may, therefore, be considered necessary to avoid these methods and instead exchange control adopted. Under a system of exchange Control all exporters are asked to surrender their claims on foreign currencies to the central bank which pays in return home currency, which the exporters really want.

This available foreign exchange is rationed out by the central bank among me needed importers of the essential commodities. Thus, imports are restricted to the foreign exchange available. There is no danger of more goods being imported than exported.

Devaluation:

A very common method of correcting an adverse balance of payments is the devaluation of the home currency. The devalued currency falls in value against foreign currencies so that the foreigners have to pay less in terms of their own currencies for our goods.

The importers in the country, on the other hand, have now to pay more in terms of the devalued currency for foreign goods. Hence, they (i.e., foreigners) are induced to import more from such a country. Thus her imports decrease and exports increase, and the balance of payments is corrected. For example, India, following the U.K., devalued her currency in terms of the dollar in September 1949. Her trade balance had been very unfavorable.

There used to be a big gap between her exports and imports. After the devaluation, however, her balance of payments was set right. In June 1966, again, India had to devalue the rupee. This resulted in some improvement in the balance of payments position.

The success of devaluation in improving the balance of trade, and through it the balance of payments depends upon the demand elasticity’s of imports and exports of the devaluing country. In other words, an improvement in the balance of trade will depend upon whether the demand for imports and exports is elastic or inelastic. Devaluation makes the imports of the devaluing country costlier than before and in case her demand for imports is inelastic, a higher amount will be spent for the same imports, thereby worsening her balance of trade.

Similarly, if her export demand is inelastic, then, after devaluation, lesser amount will be spent by the foreigners thereby affecting adversely the balance of payments of the devaluing country. However, if her demand for exports is elastic then with a fall in the prices of the exports as a result of devaluation, more will be purchased by the foreigners, which, in turn, will help in restoring the equilibrium in her balance of payments. Likewise, if her demand for imports is elastic, then the imports of the country will be significantly reduced by devaluation, which in turn would improve the balance of payments of the devaluing country.

The success of devaluation in improving the balance of trade also depends on the reactions of her trading partners. If the trading partners retaliate, then devaluation will not make any impact on the imports or exports of the devaluing country, even though her demand of imports and exports may be elastic.