Effects of balance of payment deficit to a developing nation?

Answer 1

Pros:

• Partial auto-correction: If some of the deficit is due to strong consumer demand, the deficit will partially-self correct when the economic cycle turns and there is a slowdown in spending
• Investment and the supply-side: Some of the deficit may be due to increased imports of new capital and technology which will have a beneficial effect on productivity and competitiveness of producers in home and overseas markets
• Capital inflows balance the books: Providing a country has a stable economy and credible economic policies, it should be possible for the current account deficit to be financed by inflows of capital without the need for a sharp jump in interest rates. The UK has run an average annual current account deficit of £10 billion from 1992-2004 and yet the economy has also enjoyed one of the longest sustained periods of growth and falling unemployment during that time Cons:
  • Structural weaknesses: The trade / current account deficit may be a symptom of a wider structural economic problem i.e. a loss of competitiveness in overseas markets, insufficient investment in new capital or a shift in comparative advantage towards other countries.
  • An unbalanced economy - too much consumption: A large deficit in trade is a sign of an 'unbalanced economy' typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these "macroeconomic imbalances" have to be addressed. Consumers cannot carry on spending beyond their means for the danger is that rising demand for imports will be accompanied by a surge in household debt.
  • Potential loss of output and employment: A widening trade deficit may result in lost output and employment because it represents a net leakage from the circular flow of income and spending. Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import penetration, may find it difficult to find new employment.
  • Potential problems in financing a current account deficit: Countries cannot always rely on inflows of financial capital into an economy to finance a current account deficit. Foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. Higher interest rates then have the effect of depressing domestic consumption and investment. The current situation in the United States is very interesting in this respect. Such is the size of the current account deficit that the USA must rely on huge capital inflows each year and eventually investors in other countries may decide to put their money elsewhere - this would put severe downward pressure on the US dollar (see below)
  • Downward pressure on the exchange rate: A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp fall in the exchange rate. This would then threaten an increase in imported inflation and might also cause a rise in interest rates from the central bank. A declining currency would help stimulate exports but the rise in inflation and interest rates would have a negative effect on demand, output and employment.