Global Economy and International Financing - Research Paper Example

?Consider the consequences of reducing a balance of payments deficit Introduction It is not a secret for everybody that the more the country exports its production the better it is for country exporter. The benefits are obvious not only on microeconomic and macroeconomic levels but also on the international or even global arena. In order to measure export and import activity of each country, economists apply Balance of Payments (BOP). The goal of this paper is to give a brief understanding of what is the balance of payments and balance of payments deficit and to analyze what are the consequences of reducing a balance of payments deficit. So as the consequences are the results of relative actions/measures, it makes sense to review the measures of reducing the BOP deficit and consider the impact of each measure on economics. Definition of balance of payments and balance of payments deficit Pippenger (1973, p.6) defines balance of payments as a record of the value of all transactions between foreign and domestic residents over a certain period of time, usually one year; the balance of payments is based on the principle of double entry bookkeeping where the dollar value of every transaction is recorded as both a debit and a credit (Pippenger, 1973). Debit or minus entry in the balance of payments reflects the purchase or import of anything from a foreign partner, while a credit or plus item in the balance of payments reflects the sale or export of anything to a foreign partner (Pippenger, 1973). Applying double entry bookkeeping, the payments received for exports are recorded as debit and the payments made on imports are recorded as a credit (Pippenger, 1973). Balance of payments deficit is an imbalance in a nation’s balance of payments in which payments received by the country are less than the payments made by the country (Economic Glossary, n.d.). This term is also known as unfavorable balance of payments because less currency is flowing in to the country than is flowing out (Economic Glossary, n.d.). Thus, balance of payments deficit causes unequal flow of currency and results in reducing the supply of money in nation, imposing negative implications for unemployment, inflation, production, and other aspects of import-prevailing economy (Economic Glossary, n.d.). In order to minimize these implications it is necessary to understand better how balance of payments deficit can be reduced and what are the consequences of possible measures of reducing BOP? Measures of reducing BOP deficit and its consequences There exist different measures aimed at reducing balance of payments deficits; these measures are divided into two groups: automatic correction and deliberate correction of BOP disequilibrium. In this paper, we will review only deliberate measures as tools for reducing the deficit in BOP. Deliberate measures, broadly applied in different economics of the world, are differentiated by three main categories, including monetary measures, trade measures, and miscellaneous measures. Monetary measures – monetary contraction Monetary contraction or money supply allows a country to influence its level of aggregate domestic demand, demand for exports and imports, and price level of domestic production (Cherunilam, 2008). Contraction of money supply results is applied in order to reduce the purchasing power and consequently, aggregate demand of nation (Cherunilam, 2008). By adopting monetary contraction in the country, domestic output decreases, while domestic real interest increases. Increase of the rate of interest is caused in result of decrease in money supply (Dwivedi, 2010). Increase in interest rate leads to reduction of domestic investment, and fall of investment leads to reduction of income levels of population (Dwivedi, 2010). Additionally, increase in the interest rate leads to the inflow of foreign capital, which reduces deficits in capital account of BOP (Dwivedi, 2010). In result, demand for imports is reduced because of the fall in domestic prices and domestic aggregate demand, while demand for export increases (Cherunilam, 2008). Even though monetary restraint leads to an improvement in the current account by lowering domestic demand for import and reducing incomes, this effect is largely offset because of the appreciation in the exchange rate (Congress of the United States Congressional Budget office, 1989). Appreciation in the exchange rate would switch expenditures to goods and service produced abroad from those produced domestically (Congress of the United States Congressional Budget office, 1989). So as these measures have offsetting effects on the external balance, monetary policy is decided to be ineffective in efforts to reduce BOP deficit, mainly current account deficit (Congress of the United States Congressional Budget office, 1989). Additionally, monetary contraction policy will have a huge impact on businesses because a decrease in the money supply will cause decline in demand and an increase in the interest rate will influence the cost of capital of companies (Beenhakker, 2001). Thus, for example, government might impose a control over the cost, long-term capital and availability of domestic credit (Beenhakker, 2001). Monetary measures – Devaluation Devaluation is another type of monetary measures aimed at reduction of BOP deficit by reducing the official rate at which currency of domestic country is exchanged for the currency of foreign country (Cherunilam, 2008). Thus, export in domestic country is stimulated by monetary intrusion, while import on the contrary is discouraged (Cherunilam, 2008). When national currency is devalued, people buy less import goods/products for the same amount of money, and are more likely to choose domestic suppliers. Thus, money stays within a country at least not increasing a deficit. In order to apply devaluation measure effectively, it is necessary to consider the following conditions: the sum of price-elasticity of country A’s demand for imports and price elasticity of country B’s demand for A’s exportables, in absolute terms, is greater than unity (Dwivedi, 2010, p.556). Consequences of applying devaluation as a tool for reducing BOP deficit can have negative impact, for example: 1. People tend to have less confidence in domestic currency and this can result in outflow of capital (Preserve articles, n.d.). Thus, people massively may withdraw their deposits from banks, creating challenges for bank institutions. 2. Encouragement of inflation in the domestic country. 3. Increase of the foreign debt burden Devaluation, being a short-term “remedy” for reducing BOP deficit doesn’t provide a permanent solution for correcting BOP disequilibrium (Preserve articles, n.d.). By reducing BOP deficit through depreciation of an exchange rate, government should consider such serious consequences, as: Shift in resources as the demand for imports decreases, and the demand for both exports and import substitutes increases (Beenhakker, 2001); Change in distribution of income because those who was used to consume imports will have a fall in their incomes (Beenhakker, 2001); General effect of all prices in a country’s foreign trade sector because of ad valorem subsidy on all exports and ad valorem tax on all imports (Beenhakker, 2001). Monetary measures – Exchange control Exchange control is considered to be a popular method of influencing the BOP of a country. Central bank or government of domestic country takes a complete control over the reserves in foreign currency and earning of the country (Cherunilam, 2008). For example, exporters, who receive payments from foreign partners, should surrender foreign exchange to the central bank or government in exchange for domestic currency (Cherunilam, 2008). Imposing such a control, government can control imports and thus impact on BOP disequilibrium (Cherunilam, 2008). Government policies, mainly monetary policy, fiscal policy, economic protectionism, exchange rate policy may hinder operating performance of foreign-owned businesses (Beenhakker, 2001). An impact of reducing BOP deficit depends highly not only on the combination of adopted monetary and fiscal measures but also on the accompanying stance of other macroeconomic policies (IMF, 1995). Even though exchange control is considered to be the most direct method of reducing country’s import volumes, it doesn’t deal with the causes of problem, thus imposing a threat of aggravating these causes and increasing the BOP deficit in middle/long-term perspective (Preserve articles, n.d.). Import substitution Import substitution is another technique of reducing import’s volumes and making domestic country more self-reliant. It is type of government’s stimulation of industries to produce import substitutes. However, this method requires loyalty in relation to domestic produces, including subsidies, tax concession, providing scarce inputs, technical assistance and others (Kalyan City Life, n.d.). It is obvious that in a short-term perspective this measure requires more investment of time and money, however, in a long-term perspective domestic country may stabilize its economy, increase employment rates, and naturally lower volumes of import. However, planned promotion of import substitute industries contradicts with the comparative advantage theory (Kalyan City Life, n.d.). Trade measures Trade measures are focused on promoting export volumes and reducing import volumes. According to Beenhakker (2001, p.78), liberalization of domestic and external trade is considered to be an effective long term policy that might favor the reduction of BOP deficit by managing capital flows. Below are briefly discussed both trade policies: export promotion and import control. Export promotion Government of domestic country creates the most favorable conditions for exporting, by reducing or abolishing export duties, providing export subsidy and giving fiscal, monetary, institutional and physical facilities and incentives (Cherunilam, 2008). Thus, for instance, by eliminating tax for export, in a medium term perspective, domestic country may expand its output and increase earnings from export activity, thus increasing revenue from other tax sources (IMF, 1995). In result of such activity there might be fairly positive consequences of reducing BOP deficit in this way; exporters tend to develop more foreign partnerships, thus forming a basis for future cooperation. International Monetary Fund supports this point of view, commenting that: “particular fiscal instruments may, over time, induce an important enough supply response in the economy to reduce the magnitude by which the deficit needs to be shrunk” (IMF, 1995, p.25). However, it is necessary to introduce such measures as part of the whole process aimed at reducing BOP deficit. Import control Government can control import volumes by imposing import duties and tariffs, restricting imports through licensing, and various quotas on import. Sometimes, government can even prohibit the import of certain extraneous items (Cherunilam, 2008). So as a measure of imposing direct controls on imports strongly contradicts with the policy of free trade this policy requires a thorough approach with analyzing the impact on international arena (Beenhakker, 2001). In response to GATT regulations, many countries tend to apply nontariff barriers, which enable domestic countries to restrict its import by: requiring overburdensome documentation, restraining voluntary export by exporting country, levying administrative fees, introducing stringent labeling and packaging standards, imposing embargoes on the products originated in specific countries, etc (Beenhakker, 2001). Despite “quick” result of applying this method, domestic country doesn’t relief itself from the problem of disequilibrium in a long-term perspective. Also government is authorized to manage capital accounts; one of possible solutions to reduce BOP deficit is to impose a special tax on investments abroad made by domestic investors. Thus, investors will be much less interested in investing their funds to foreign assets. However, the consequences of such policy may impact BOP deficit more negatively because of potential lack of desire among foreign investors to direct their funds to the country imposed this tax (Beenhakker, 2001). Miscellaneous measures include: foreign loans, incentives for foreign investment and tourism development. Talking about foreign loans as a measure to reduce BOP deficit, it is necessary to differentiate between concessional external financing and nonconcessional. While concessionality plays a significant role for developing countries enabling the government to borrow without putting on risk sustainability of fiscal position, nonconcessional external borrowing accumulates the debt and imposes financial liabilities on the country (Beenhakker, 2001). Incentives for foreign investments as a measure for reducing BOP deficit contradicts with a monetary contraction measures, promulgating positive investment climate and imposing minimal restrictions of foreign ownerships of assets, providing support for strong financial sector with foreign participation, enabling free capital movement, and favoring dissemination of information by rating agencies and other means (Beenhakker, 2001). The consequences of these measures will enable the country manage effectively its capital flows, forming sound macroeconomic policy (Beenhakker, 2001). Summary Bu summing up everything what has been discussed above it may be concluded that monetary policies are relatively ineffective tools in the process of reducing the current account deficit because the net effect of these measures seems to be insignificant and results in only temporary effect. For example, devaluation, being a short-term “remedy” for reducing BOP deficit doesn’t provide a permanent solution for correcting BOP disequilibrium. The same conclusion can be referred to the restrictive trade policies such as import quotas and tariffs which being observed as effective measures for reducing BOP deficit also did not prove their effectiveness in a medium term perspective. Moreover, these policies might even lead to distortions and negatively impact international trade of the country. Unfortunately all these quick solutions enable government only to postpone the problem rather than to reduce its underlying balance of payments deficit. Thus we see that various short-term policies aimed at reducing BOP deficit require critical approach because these measures are more likely to have adverse effect on the domestic economy in a long-term perspective. Meanwhile, liberalization of domestic and external trade is considered to be an effective long term policy that might favor the reduction of BOP deficit by managing capital flows. Consequently, all potential measures need to be thoroughly analyzed and implemented as a part of an overall policy package that provides for an appropriate degree of reducing of government deficit in the short run (International Monetary Fund, 1995). . References: Beenhakker H. 2001. The global economy and international financing. United States: Greenwood Publishing Group. Cherunilam F. 2008. International Economics. 8th ed. New Delhi: Tata McGraw-Hill Publishing Company. Congress of the United States Congressional Budget office, 1989. Policies for reducing the current account deficit. [pdf] United Sates: CBO Publication Available at: [Accessed 05 Dec 2011]. Dwivedi D. 2010. Macroeconomics: Theory and Policy. 3rd ed. New Delhi: Tata McGraw-Hill Publishing Company. Economic Glossary, n.d. Economic Definition of balance of payments deficit. Available at http://glossary.econguru.com/economic- [Accessed 01 Dec 2011]. International Monetary Fund, 1995. Guidelines for Fiscal Adjustment. Pamphlet no. 49. [pdf] Available online at < http://www.imf.org/external/pubs/ft/pam/pam49/pam49.pdf> [Accessed 05 Dec 2011]. Kalyan City Life. 2010. Measures to correct deficit in the Balance of Payment BoP. Available online at < http://kalyan-city.blogspot.com/2010/12/measures-to-correct-deficit-in-balance.html>. Accessed [Accessed 04 Dec 2011]. Pippenger J. 1973. Balance-of-Payments deficits: measurement and interpretation. Federal Reserve Bank of St. Louis. Available at: [Accessed 01 Dec 2011]. Schmitt-Grohe S. and Uribe M. 2008. International economics. Duke University. Available at [Accessed 01 Dec 2011]. Preserve Articles, n.d. What are the Methods of Correcting Disequilibrium in the Balance of Payments? Available at: [Accessed 04 Dec 2011]. Read More