Causes of Balance of Payment Problems in Emerging and Developing Economies Essay Example

Of The Standard Components

The standard components are grouped under two major heading: the current account and the capital and financial account. The current account is further subdivided into three broad categories: goods and services (which is subdivided into goods and services), income and current transfers. The capital and financial account includes, in the capital account, capital transfers and transactions (purchased/sales) in an economy’s non-produced, non financial assets (such as patents and copyrights), and the financial account contain transactions in an economy’s external financial assets and liabilities.

The balance of payment of Pakistan is shown in the table below. TABLE 1: Balance of Payments: 2000-2001 Trade Balance -1269 Merchandize Exports (f. o. b) 8933 Merchandize Imports (f. o. b) -10202 Non-factor Services (Net) -981 Investment Income (Net) -2161 Receipt 113 Payments -2274 Private Transfers (Net) 3898 (Workers’ Remittances) (1087) Current Account Balance -513 Private Capital (Net) -380 Direct Investment 146 Other Long Term -214 Short Term -312 Public Capital (Net) 577 Long Term Disbursements 2302 Less Repayments Long Term 1795

Other Short Term and Long Term 70 Changes in Reserves -1001 Errors and Omissions 625 Financing Accumulation of Arrears 692 Source: Pakistan Economic Survey-2002-03. Deficits arise on the current account of the Balance of payment as a result of the combination of these three (3): Shifts In Is: Absorption Approach

If the domestic expenditure increases, it leads to a rightward shift in the IS curve which tends to weaken the balance of payment. The overall move into deficit represents the outcome of two (2) opposing forces.

First, as expenditure increases, there’s a corresponding increment in imports and deterioration in the current account (assuming that a movement into deficit or towards

a larger deficit may legitimately be regarded as deterioration). Second, an increase in income also induces an increase in the demand for money. With a given money supply, interest rate rises which generates a capital inflow and an improvement in the capital account. Effects of change in domestic expenditure on the current account are conventionally analysed within the context of the absorption approach.

This may be conveniently described using the income-expenditure equation of an open economy: Y= C + I + G + X – M

This equation can be re-arranged as: M + Y = C + I + G + X

The LHS shows the total resources available to a country due to importation and domestic production. While on the RHS, shows total expenditure, both from domestic and foreign sources.

The above equation can further be formulated as: X – M = Y – (C + I + G)

The LHS provides a statement of the balance of payment, whereas the RHS shows how this depends on the difference between domestic output (Y) and domestic expenditure.

Starting off from a situation of payment equilibrium, an increase in domestic absorption relative to domestic output results in a payment deficit.

More generally: Change in BP = Change in Y – Change in A.

Shifts In Lm: Monetary Approach:

The monetary sector is largely ignored when discussing the absorption approach to the balance of payment, although it may be included on the basic assumption which says that money supply policy is used to stabilise interest rates. However, the monetary approach explains changes in the overall balance of payment exclusively in terms of domestic monetary disequilibria.

It incorporates both the current and the capital account. There is

a rightward shift in the LM as a result of increases in the domestic credit which causes payment deficit. Not only does this expansion cause nominal income and imports to rise, it also causes a fall in the interest rate, which leads to outflow of capital. This approach holds that there is a perfect relationship that’s exists between balance of payment and the imbalances between domestic demand and supply of money.

If supply exceeds demand, this will be reflected as a payment deficit, as the excess supply spreads through an increase in the demand for foreign exchange and a reduction in reserves.

Shifts In Bp: Structural Approach:

A shift in the BP schedule will occur where for any specific level of income; a different rate of interest is required in order to ensure a balance of payment equilibrium. This approach lays emphasis on the importance of goods produced and the efficiency with which they are produced.

In a dynamic setting, countries which produce and export goods that have low income elasticity of demand, and at the same time do not produce but relies on goods that have a high income elasticity of demand, tends to encounter a secular deterioration in their balance of payments as their income terms of trade decline. The BP curve can also shift if the perceptions of the investors changes due to the credit worthiness of countries.

The nature of the B. O. P difficulties experienced in developing countries particularly the poorest ones is totally different from those of developed countries. The B. O. P in developing countries are structural in the sense that they reflect the original imbalances, bottleneck and obstacles in the composition of

these economies. Some of these obstacles include: dominance of subsistence and commercial activities, a narrow productive base, particularly industrial base, with weak inter-sectoral linkages and ill adapted technology, openness and external interdependence, weak institutions, rudimentary money & capital markets.

In taking the reflections of some of these structural imbalances upon the B. O. P, it would be easy to note that these countries generally have weak structures of foreign trade (imports & exports) in the form of limited number of primary commodities and low levels of income and saving makes the overseas investment income received by these countries insignificant against high levels of investment income commitments for bridging saving-investment gap. In the capital account, many of these countries are not competitors in attracting foreign investment, either direct or portfolio investment.

Meanwhile, the phenomenon of domestic flight is exacerbating. Moreover, the political and economic environment is discouraging, the institutions dealing with investors suffer from corruption and old methods of management in the financial systems are simple and inefficient in playing the presumed role in financing economic activities. Balance of payment problems of most developing countries in Africa is the result of structural disequilibrium, and hence they are persistent and chronic. The shortfall in the current foreign receipts is neither temporary nor sporadic.

Furthermore, the gap between receipts and payments is generally widening. It is of importance to know what is meant by ‘planned deficit’, i. e the deficit which would have been incurred in the absence of ‘exchange controls’, import restrictions, or other governmental measures specially devised to restrict the demand for foreign currencies. The actual deficits in developing countries in Africa is smaller than this, since their potential

deficit is repressed, usually to a considerable extent, by foreign exchange and import controls, which are not only widespread but are increasing in intensity.

So also, Balance of payment problem can also be caused by exogenous shocks, this range from disasters to terms of trade or foreign demand shocks are common causes of economic distress. This is especially true in low income countries, which have limited capacity to invest in disaster prevention, and are dependent on a narrow range of export of mostly primary goods that have low income elasticity. The problems can be in form of: Economic: this can be characterized by severe B. O. P problems which often lead to pressure on the currency, a decline in consumer demand and investment by firms, higher unemployment and lower incomes.

These crises are often accompanied by heightened uncertainty in financial markets and declines in the prices of stocks, bonds & quite frequently, the value of the domestic currency. Some of these points will be discussed later in the essay. Financial: this can originate in or affect the financial sector and can be caused by or accompanied by heightened uncertainty in financial markets leading to difficulties in banks and payment system, causing damage to the real sector and to economic activity more generally.

A balance of payment problem occurs when a drop in the demand for a country’s currency is so steep that it creates a downward pressure on its currency value. This resulting depreciation destabilizes market transactions and renders its citizens unable to purchase everyday necessities. Governments often make measures to counterbalance this downward pressure, especially fi they have committed to maintain a rigid exchange rate. Secondly, a

traditional cause of B. O. P is a sudden and severe increase in a country’s trade deficit.

Such an increase might occur for example, if bad weather drastically reduces production of key export earnings. Another classic case is one in which a steep rise in oil prices dramatically increases a country’s import bill. An ‘oil shock’ of this kind occurred in 1990 & 1991 as a result of the Gulf war. This Gulf war played an important role in the B. O. P problem experienced by India. Whether the suddenly increased trade deficit is due to lower export earnings or a higher import bill, it creates the same effect: a sharp drop in demand for domestic currency relative to foreign currency.

In addition, in recent years, the capital account side has become an increasing frequent source of B. O. P difficulties for developing countries. A sudden reduction of foreign investment, typically short term portfolio investment in domestic assets can also produce a drop in the currency, which is a cause of B. O. P problem. Furthermore, capital and current accounts can work in tandem to create B. O. P problems, particularly under a rigid exchange rate regime. In Thailand, during the 1990’s for example, large capital inflows created a booming investment sector.

This sector increased demand for imports, particularly capital goods. At the same time, government policy of maintaining a strong currency made exports less competitive and created trade deficits in the mid 1990’s. CONCLUSION: The general objective of this paper has been to discuss the causes of balance of payment problems. A clear definition of the term ‘B. O. P’ and the causes of the problems have

been presented. This was explained using three (3) approaches. Undoubtedly, a B. O. P problem is a serious concern to developing and emerging countries.

Financial assistance could be sought from the International Monetary Fund (IMF), which is normally granted if the government implements an economic reform program designed to eliminate the underlying problems over time. Another alternative would be for the country to devalue its currency, which leads to lower prices of a country’s export. In other words, it is hoped that all this will improve the B. O. P situation.