Disequilibrium in Balance of Payments

19/UECA/042

Normally, the balance of payments of a country should be in equilibrium, i.e., the

imports and exports of goods and services should be equal. But it is not so. Disequilibrium
generally arises in the balance of payments account. Balance of payments may be
unfavourable when there is an excess of imports over exports (deficit balance); it may be
favourable when there, is an excess of exports over imports (surplus balance).

The phenomenon of disequilibrium is particularly related to the current account of the

balance of the payments statement; the capital account is used to settle the imbalance in the
current account through changes in the financial flows of funds. Viewed in this sense, a
disequilibrium in the balance of payments (deficit or surplus) affects the fundamental
economic relationships among the nations and reflects a country’s economic weakness or
strength relative to others.

Types of Disequilibrium
The main types of disequilibrium in the balance of payments:

I. Cyclical Disequilibrium:

Cyclical disequilibrium in the balance of payments arises due to business cycles. It is caused:

(a) by cyclical patterns of income

(b) by different income elasticity’s
(c) by different price elasticity’s.

These factors bring changes in the terms of trade as well as the growth of trade which,
in turn, lead to a deficit or surplus in the balance of payments. When prices rise in prosperity,
a country with more elastic demand for imports will experience a decline in the value of
imports, thus leading to a surplus in the balance of payments. Conversely, as prices decline in
depression, more elastic demand will increase imports and cause a deficit in the balance of
payments. These tendencies may, however, be offset by the effects of income changes. High
incomes during prosperity increase imports and low incomes during depression reduce
imports.

II. Secular Disequilibrium:

Secular or long-term disequilibrium in the balance of payments occurs because of

long-seated and deep-rooted changes in the economy as it moves from one stage of growth to
another-
(a) In the initial stages of economic development, domestic investment exceeds savings and
imports exceed exports. Disequilibrium occurs due to a lack of funds to finance the import
surplus.

(b) Then comes a stage when domestic savings tend to exceed domestic investment and
exports exceed imports. Disequilibrium arises because the surplus savings exceed investment
opportunities abroad,

(c) At a still later stage, domestic savings tend to equal domestic investment and long-term
capital movements on balance become zero.

III. Structural Disequilibrium:

Structural disequilibrium in the balance of payments occurs when structural changes

in some sectors of the economy alter the demand and supply forces influencing exports and
imports. Structural disequilibrium is caused by changes in technology, tastes and attitude
towards foreign investment, Political disturbances, strikes, lockouts, etc., which affect the
supply of exports, also cause structural disequilibrium.

IV. Fundamental Disequilibrium:

The term fundamental disequilibrium has been originally used by the I.M.F., to indicate a
persistent and long-term disequilibrium in a country’s balance of payments. Fundamental
disequilibrium is generally caused by dynamic factors and particularly lead to a chronic
deficit in the balance. The main causes of fundamental disequilibrium are

(a) excessive or inadequate internal demand for foreign goods

(b) excessive or inadequate competitive strength in the world market
(c) excessive capital movements.

Causes of disequilibrium in the Balance of Payments

1. The burden of Payment of Foreign Debt

One important reason for a surplus or deficit in the Balance of payments may arise out of
international borrowing and investment. A country may tend to have an adverse balance
when it borrows heavily from another country, while the lending country will tend to have a
favourable balance and a deficit balance when the loan is Rapid.

2. Cyclical Fluctuations, their Phases, and Amplitudes

Business or cyclical fluctuations induced by the operations of the trade cycle, their phases
and amplitudes differ in different countries, which generally produce cyclical disequilibrium
in a country’s BOP. For example, if there occurs a Business Recession in foreign countries it
may easily cause a fall in the exports and exchange earnings of the country concerned
resulting in disequilibrium in the BOP.
 3. Speedy Economic Development

Due to rapid economic development, the resulting income and price effects will adversely
affect the balance of payments position of a developing country. With an increase in income,
the marginal propensity to import is high in these countries, their demand for imported
products will also increase in these countries, people’s demand for domestic goods also be
the rise, and hence less may be spread for export. Moreover, a huge investment in heavy
industries in the developing Nations may have an inflationary impact, as the output of these
industries will not be nearing immediately, whereas money income will have been already
expended. Thus, there will be an excess of the monetary demand for goods and services, in
general, which will push up the price level resulting in a deficit Balance of payments.

4. Inadequate Promotion of Exports

A vast increase in the domestic production of foodstuff, raw material, substitute

goods, etc. In advanced countries has decreased their need for imports from the agrarian
underdeveloped Nations. Thus, export demand has considerably changed, resulting
in structural disequilibrium in these Nations. Similarly, advanced nations also have suffered
in their exports because of the loss of their colonial markets, the tendency of poor nations for
self-reliance and their ways and means of curtailing their imports. But disequilibrium (deficit)
Balance of payments seems to persist in the underdeveloped or developing nations than in the
advanced rich Nations.

5. High Population Growth

A huge population and its high rate of growth in poor countries also have adversely affected
their BOP position. It is easy to see that an increase in population increases the need for these
countries for imports and decrease the capacity to export.

6. Political Factors

The political factors may also produce serious disequilibrium in the country’s BOP. For
example – The existence of political instability may result in disrupting the productive
apparatus within the country, causing a decline in exports and an increase in imports.
Likewise, the payments of war reparations or indemnities may also cause serious
disequilibrium in the country’s BOP. The imposition of heavy war reparations on Germany
after the first world war produced a serious disequilibrium in its away.

Reasons for poor performance of India’s export trade

1. Good Domestic Market Sellers find a ready market for their goods within the country,
so they do not take parts to get orders from overseas markets.
2. Number of formalities: There is many documentation & other formalities due to
which some marketers do not enter the export field. So, there is a need to simplify
formalities.
3. Problem of Trading Blocs: Trading blocs reduce trade barriers on member nations,
but they impose trade barriers on non-members. As India is not a member of some
powerful trading blocs, it must face some problems.
 4. Negative Attitude: Some of the overseas buyers have a negative attitude towards
Indian goods. They feel that Indian goods are inferior goods. Thus, there is a need to
correct this attitude.
5. Poor Infrastructure: Indian infrastructure for trading for middle and small-scale
producers is poor. Indian exporters find it difficult to get orders & also to deliver them
on time.

Monetary measures for correcting the Balance of Payments

The monetary methods for correcting disequilibrium in the balance of payment are as follows

1. Deflation

Deflation means falling prices. Deflation has been used as a measure to correct deficit
disequilibrium. A country faces a deficit when its imports exceed exports.
Deflation is brought through monetary measures like bank rate policy, open market
operations, etc or fiscal measures like higher taxation, reduction in public expenditure, etc.
Deflation would make our items cheaper in the foreign market resulting in a rise in our
exports. At the same time, the demands for imports fall due to higher taxation and reduced
income. This would build a favourable atmosphere in the balance of payment position.
However, Deflation can be successful when the exchange rate remains fixed.

2. Exchange Depreciation

Exchange depreciation means a decline in the rate of exchange of domestic currency in

terms of foreign currency. This device implies that a country has adopted a flexible exchange
rate policy.
Suppose the rate of exchange between the Indian rupee and US dollar is $1 = Rs. 40. If
India experiences an adverse balance of payments with regard to the U.S.A, the Indian
demand for the US dollar will rise. The price of the dollar in terms of the rupee will rise.
Hence, the dollar will appreciate in external value and the rupee will depreciate in external
value. The new rate of exchange may be say $1 = Rs. 50. This means 25% exchange
depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will
become cheaper and imports costlier. Hence, a favourable balance of payments would emerge
to pay off the deficit.

3. Devaluation

Devaluation refers to deliberate attempts made by monetary authorities to bring down the
value of the home currency against foreign currency. While depreciation is a spontaneous fall
due to interactions of market forces, devaluation is an official act enforced by the monetary
authority. Generally, the international monetary fund advocates the policy of devaluation as a
corrective measure of disequilibrium for the countries facing adverse balance of payment
positions. When India's balance of payment worsened in 1991, IMF suggested devaluation.
Accordingly, the value of Indian currency has been reduced by 18 to 20% in terms of various
currencies. The 1991 devaluation brought the desired effect. The very next year the import
declined while exports picked up.
 When devaluation is affected, the value of the home currency goes down against foreign
currency. After such a change our goods become cheap in a foreign market. This is because,
after devaluation, a dollar is exchanged for more Indian currencies which push up the demand
for exports. At the same time, imports become costlier as Indians have to pay more currencies
to obtain one dollar. Thus, the demand for imports is reduced.
Generally, devaluation is resorted to where there is a serious adverse balance of payment
problem.

4. Exchange Control

It is an extreme step taken by the monetary authority to enjoy complete control over the
exchange dealings. Under such a measure, the central bank directs all exporters to surrender
their foreign exchange to the central authority. Thus, it leads to the concentration of exchange
reserves in the hands of central authority. At the same time, the supply of foreign exchange is
restricted only for essential goods. It can only help control the situation from turning worse.
In short, it is only a temporary measure and not a permanent remedy.

Non-Monetary measures for correcting the Balance of Payments

A deficit country along with Monetary measures may adopt the following non-
monetary measures too which will either restrict imports or promote exports.

1. Tariffs

Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of
imports would increase to the extent of tariffs. The increased prices will reduce the demand
for imported goods and at the same time induce domestic producers to produce more import
substitutes. Non-essential imports can be drastically reduced by imposing a very high rate of
tariff.

Drawbacks of Tariffs:

a) Tariffs bring equilibrium by reducing the volume of trade.

b) Tariffs obstruct the expansion of world trade and prosperity.
c) Tariffs need not necessarily reduce imports. Hence the effects of a tariff on the
balance of payment position are uncertain.
d) Tariffs seek to establish equilibrium without removing the root causes of
disequilibrium.
e) A new or a higher tariff may aggravate the disequilibrium in the balance of payments
of a country already having a surplus.
f) Tariffs to be successful require an efficient & honest administration which
unfortunately is difficult to have in most of the countries. Corruption among the
administrative staff will render tariffs ineffective.

2. Quotas

Under the quota system, the government may fix and permit the maximum quantity or
value of a commodity to be imported during a given period. By restricting imports through
the quota system, the deficit is reduced, and the balance of payments position is improved.
Types of Quotas:
a) the tariff or custom quota,
b) the unilateral quota,
c) the bilateral quota,
d) the mixing quota, and
e) import licensing.

Merits of Quotas:
i. Quotas are more effective than tariffs as they are certain.
ii. They are easy to implement.
iii. They are more effective even when demand is inelastic, as no imports are possible
above the quotas.
iv. More flexible than tariffs as they are subject to administrative decisions. Tariffs
on the other hand are subject to legislative sanction.

3. Export Promotion

The government can adopt export promotion measures to correct disequilibrium in the
balance of payments. This includes substitutes, tax concessions to exporters, marketing
facilities, credit and incentives to exporters, etc.
The government may also help to promote export through exhibitions, trade fairs; conducting
marketing research & providing the required administrative and diplomatic help to tap the
potential markets.

4. Import Substitution

A country may resort to importing substitution to reduce the volume of imports and make
it self-reliant. Fiscal and monetary measures may be adopted to encourage industries to
produce import substitutes. Industries that produce import substitutes require special attention
in the form of various concessions, which include tax concession, technical assistance,
subsidies, providing scarce inputs, etc.
Non-monetary methods are more effective than monetary methods and are normally
applicable in correcting an adverse balance of payments.

Drawbacks of Import Substitution:

a) Such industries may lose the spirit of competitiveness.

b) Domestic industries enjoying various incentives will develop vested interests and ask
for such concessions all the time.
c) Deliberate promotion of import substitute industries goes against the principle of
comparative advantage.