What are the causes of balance of payment crisis?

Answer 1

The balance of payments of a country is said to be in equilibrium

when the demand for foreign exchange is exactly

equivalent to the supply of it. The balance of payments is in

disequilibrium when there is either a surplus or a deficit in the

balance of payments. When there is a deficit in the balance of

payments, the demand for foreign exchange exceeds the

demand for it.

A number of factors may cause disequilibrium in the balance of

payments. These various causes may be broadly categorized

into:

(i) Economic factors ;

(ii) Political factors; and

(iii) Sociological factors.

Economic Factors:

A number of economic factors may cause disequilibrium in the

balance of payments. These are:

Development Disequilibrium:

Large-scale development expenditures usually increase the

purchasing power, aggregate demand and prices, resulting in

substantially large imports. The development disequilibrium is

common in developing countries, because the above factors,

and large-scale capital goods imports needed for carrying out the

various development programmes, give rise to a deficit in the

balance of payments.

Capital Disequilibrium:

Cyclical fluctuations in general business activity are one of the

prominent reasons for the balance of payments disequilibrium.

As Lawrance W. Towle points out, depression always brings

about a drastic shrinkage in world trade, while prosperity

stimulates it. A country enjoying a boom all by itselt ordinarily

experiences more rapid growth in its imports than its exports,

while the opposite is true of other countries. But production

in the other countries will be activated as a result of the

increased exports to the boom country.

Secular Disequilibrium:

Sometimes, the balance of payments diequilibrium persists for

a long time because of certain secular trends in the economy.

For instance, in a developed country, the disposable income is

generally very high and, therefore, the aggregate demand, too, is

very high. At the same time, production costs are very high

because of the higher wages. This naturally results in higher

prices. These two factors - high aggregate demand and higher

domestic prices may result in the imports being much higher

than the exports. This could be one of the reasons for the

persistent balance of payments deficits of the USA.

Structural Disequilibrium:

Structual changes in the economy may also cause balance of

payments disequilibrium. Such structural changes include the

development of alternative sources of supply, the development

of better substitutes, the exhaustion of productive resources,

the changes in transport routes and costs, etc.

Political Factors:

Certain political factors may also produce a balance of payments

disequilibrium. For instance, a country plagued with political

instability may experience large capital outflows, inadequacy of

domestic investment and production, etc. These factors may,

sometimes, cause disequilibrium in the balance of payments.

Further, factors like war, changes in world trade routes, etc., may

also produce balance of payments difficulties.

Social Factors:

Certain social factors influence the balance of payments. For

instance, changes in tastes, preferences, fashions, etc. may affect

imports and exports and thereby affect the balance of payments

Answer 2

Factors which cause a current account deficit

A current account deficit occurs when the value of imports (of goods, services and investment income) is greater than the value of exports.

There are various factors which could cause a current account deficit:

1. Overvalued exchange rate

If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of imports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports. Countries in the Eurozone (e.g. Greece, Portugal and Spain) experienced an overvalued exchange rate (and they couldn’t devalue). In 2007, these three countries had a current account deficit equal to 10% of GDP.

2. Economic growth

If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. In the UK we have a high marginal propensity to imports (mpm) because we do not have a comparative advantage in the production of manufactured goods. Therefore if there is fast economic growth there tends to be a significant increase in the quantity of imports and a deterioration in the current account.

3. Decline in competitiveness/export sector

In the UK, there has been a decline in the exporting manufacturing sector because it has struggled to compete with developing countries in the far east. This has led to a persistent deficit in the balance of trade.

4. Higher inflation

If UK inflation rises faster than our main competitors then it will make UK exports less competitive and imports more competitive. This will lead to deterioration in the current account. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness.

5. Recession in other countries

If the UK’s main trading partners experience negative economic growth, then they will buy less of our exports, worsening the UK current account.

6. Borrowing money

If countries are borrowing money to invest e.g. third world countries, then this will lead to deterioration in current account position.

7. Financial flows to finance current account deficit.

If a country can attract more financial flows (either short-term portfolio investment or long-term direct investment), then these flows on the financial account will enable the country to run a larger current account deficit. For example, the UK has run a persistent current account deficit since the 1980s; this reflects the fact the UK has attracted capital flows to finance this current account deficit. Without financial flows, the currency would depreciate until equilibrium is restored.

Answer 3

When a country that has a large budget deficit, it has difficulty maintaining a fixed exchange rate, ultimately facing a balance of payments crisis.

Answer 4

consequences of disequilibrium of balance of payments