The Balance of Payments and Borrowing Constraints - Literature review Example

Imagine that every economy is like a person who has to consider his financial needs. He has to consider that in as much as possible his financial aspect is in good shape. To make it so, he has to control the flow of his cash, by taking into account the fundamental principle of debit and credit in the balance account (Needles, 2008, p.70; Vyas and Dave, 2007, p.11; Needless et al., 2010, p.147). In the same way, every economy has to consider the flow of its money or currency. This flow of cash can remarkably be observed within the balance of payments (BOP). The BOP is the country’s way of monitoring the international trading of its product and service offerings, and financial assets (Melvin and Norrbin, 2013, p.59; Cool and Goddard, 2006, p.92, Stovel, 1959, p.21). When a country receives money, it is automatically credited to its account, and it is debited from its account once it has paid or given money. BOP is therefore the inflows and outflows of cash. Inflows are credit and outflows are debit. The work at hand establishes the discussion of the three essential components of the BOP and the issues pertaining to its equilibrium. Three essential components There are three main parts of the BOP, the current account, financial/capital account and the official reserves (Mayo, 2011, p.84). The current account consists of merchandise exports and imports and invisible exports and imports (OECD, 2000, p.151; Rana and Alburo, 1987, p.50). It is technically the flow of product and service offerings into a country. This also includes revenue on investments done publicly or privately. Generally, the current account consists of three essential components too. The first component is the net export. This is the biggest part of the current account, because it is around 80 to 90 percent. The next component is the net foreign income. This may be the income payment on stocks and bonds. Thus, at some point the net foreign income may be the interest payment on the bond or the dividend payment. Aside from the two components mentioned so far, the other part of current account is the foreign aid (Gaspar et al., 2013, p.93; Eicher et al., 2009, p.352; Clarida, 2007, p.38). Foreign aids are amount of money that the other economies may have directly transferred to a certain economy for the purpose of providing aid. This can also take place when a worker sends money home. Financial account is the next relevant component of BOP. It is the International transfer of capital, and attainment and clearance of assets that are non-financial and non-produced (OECD, 2005, p.45; International Monetary Fund, 2000, p.50). The financial account consists of real assets and financial assets. The real asset is composed of buildings, assembly lines, and any other tangible assets of the government. The financial asset is composed of stocks and bonds. In this account, there is an inclusion of direct foreign investment. Official reserves on the other hand may be in a form of gold or currencies. Here where the government has to initiate actual activities pertaining to its foreign reserve transactions. The ultimate point of this is to at least intervene in the economic activity, in order to ensure the healthy flow of domestic currency both in the internal and external context. BOP and its equilibrium In theory, the total between the current and financial accounts is zero (Wang, 2009, p.80; Van den Verg, 2010, p.67; Snowdon and Vane, 2002, p.28). This only means that adding these two components should zero each other out. However, this is not usually met in the real world considering the point that the current account will either reach a point of deficit or surplus. If they cannot balance each other, the official reserves will be to the rescue in order to obtain the balance. However, theoretically, the BOP will always reach its balance. The surplus in BOP corresponds to the current account surplus (Daniels and VanHoose, 2012, p.164; Moosa, 2012, p.16; Glanville and Glanville, 2011, p.384). The BOP deficit also implies current account deficit (Tragakes, 2011, p.400; Wang, 2009, Reddy, 2004, p.42). If deficit takes place in the current account, BOP deficit is therefore remarkable. This implies that there is excess of domestic currency. In other way of saying it, the domestic currency is losing its value. This further means that the government is buying its own currency and it is selling foreign currency (Levi, 2009, p.157; Carbaugh, 2013, p.406; Somanath, 2011, p.52). On the other hand, if there is surplus in the BOP, there must be a deficit supply of domestic currency. The domestic currency is therefore appreciating its value if one will base it on the law of supply and demand. The government is therefore selling its own currency and it is buying foreign currency reserves (Whittington and Delaney, 2007, p.140; MacDonald, 1999, p.308; Gamber and Colander, 2006, p.197). The current account is therefore an interesting indicator as to what courses of actions the government will take in order to maintain a healthy exchange rate in the international market, and to ensure high value for its prevailing currency. As stated and from an accounting perspective, BOP leads the current and capital accounts to zero when added up together. Concerning this, there must be no significant impact on the exchange rate (Charusheela, 2013, p.142). However, in the real world exchange rate is a fundamental determining factor how healthy an economy is, and how promising it is to invest in it (Henning, 2008, p.100). The payment flows actually affect the demands for different currencies in the market for foreign exchange (Madura, 2012, p.108). In reality, countries have fundamental ways of restricting their capital inflows and outflows (Platenberg, 2010, p.46). This is common to take place in major industrial countries and even in economies hit by currency crises (Platenberg, 2010, p.46). The actual restriction leads to the interaction between the international payments and exchange rates. For example, as product of the regulation of monopoly of trade in East India Company, the UK balance of payments was affected; serving UK’s interest primarily when wars in France took place (Esteban, 2007, p.154). The other resulting benefit of this was evident on British’s remarkable trade with India and into the other surrounding Asian countries. In addition, the BOP crisis in Mexico was said to be due to a high level of capital and global financial entry, leading to further more imbalances, because of the banking system that was seeking the actual healthy flow of foreign capital (Calvo and Mendoza, 1996, p.235). It is clear that an economy may face balance of payments crisis if it comes across problems especially on its international borrowings (Atkeson and Rull, 1996, p.331). However, it is clear that there are varying economic models and theories that attempt to understand BOP and other factors that will most probably have potential impact on its equilibrium (Pitchford, 1991, p.285; Kumah and Ibrahim, 1996, p.383; Horne, 1983, p.89; Claessens, 1988, p.363; Claessens, 1991, p.81; Lemelin et al., 2013, p.146; Saez et al., 2012, p.5160; Gosse and Serranito, 2014, p.451; Chernyak et al., 2013, p.47; Gokce and Cankal, 2013, p.140; Kwack, 1971, p.215; Pitchford, 1991, p.285; Velasco, 1987, p.263; Lee, 1982, p.433; Argy and Murray, 1985, p.223; Bazdarich, 1978, p.425; Hahn, 1977, p.231). Things such as exchange rate, internal barriers, and policies are considered to improve the equilibrium of the balance of payment of the country as observed in the case of Mexico together with its trade liberalisation (Blecker and Ibarra, 2013, p.33). The liquidity of the foreign reserves in the central banks ensures that an economy can daily cope with trade and currency exchange to eliminate the possibility of problems in line with liquidity crisis (Zhang et al., 2013, p.138). In the case of the US, based on its history the regulation of financial capital had significant impact on its BOP current account (Morawetz, 1971, p.417). A significant study reveals that the net inflow of capital may provide a meaningful insight of the balance of payments crises, but that has to be decomposed into four rather than the standard way of decomposing it into two to make it more informative at some point (Janus and Crichton, 2013, p.16). Also, another study reveals that the devaluation can be an effective means to enrich exports and improve current account balance and BOP, reducing the future exchange rate appreciation particularly in Vietnam’s case (Thanh and Kalirajan, 2006, p.467). Devaluation can actually help in encouraging exports and so as to improve the current account balance and the BOP in particular. Another study found that those reserve-accumulating countries have higher current account balances, leading to the point that global imbalances were caused by worldwide creation of demand for international reserves (Steiner, 2014, p.65). In this finding, dollar is found to be one of the main global reserve currencies that created significant contribution to the continuing current account imbalances. In the case of low-income economies, financing and adjustment policies were common to be employed in order to address the prevailing issue of balance of payments deficit (Bird, 1997, p.1409). However, these moves need to be reevaluated, which means that structural adjustments have to be followed by external financing that has to be substantially increased from short to medium term. Money-financed spending of the government provided a significant impact on the country’s current account, however, a temporary inching of it will only leave the current account unchanged (Cuddington and Vinals, 1986, p.1). The government must therefore continue to improve its money-financed spending to provide current account adjustment, as interesting point especially in the achievement of BOP equilibrium (Thomson, 2001, p.338). The temporary capital control has also been found to provide a significant impact on the prevailing crisis in BOP, which only means that government has a relevant control in order to anticipate a remarkable BOP equilibrium (Bacchetta, 1990, p.246). The mobility in the capital could trigger emerging economies’ state of imbalance in its current account, which means that to allow financial account to influence especially the developing economy’s current account imbalance is a must (Yan, 2007, p.1). Economies may be interrelated, especially in cases concerning a certain industry that will depend on the health of other existing economies. For instance, in the case of the problem linked to the deteriorating balance of payments in Mexico from 1970 to 1983, the prevailing North America’s and Western Europe’s depressed economy led to the unhealthy number of international travellers in Mexico, which even further had exaggerated the country’s problem with its prevailing balance of payments deficit (Fish and Gibbons, 1985, p.106). Generally, the basic structure of international economies has corresponding impact on the country’s BOP (Ohyama, 1990, p.292). However, current account balances are found to be positively associated with the country’s prevailing budget balances and foreign assets particularly on its initial stocks (Chinn and Prasad, 2003, p.47). This only means that the country’s current account has much to say about the economy’s prevailing balance of payments. As stated in the above cases and relevant findings of some studies in line with understanding the economy’s BOP, it is clear that everything points down to the current account as the relevant indicator whether there is a remarkable deficit or surplus in the BOP. It is indirectly shown or stated that while the current account remains higher or under deficit, the BOP should substantially reflect on the prevailing standing of the current account. In theory, it is already stated that the BOP should remarkably has a zero value, but because the current account may be deficit or under surplus, the BOP may not be balance at all. However, as already shown, there are corresponding activities or courses of actions that can be taken into account in order to consider BOP under balance and the ultimate measure of it is to continuously promote a substantial balance of demand for a domestic currency and foreign currency in an economy. There is a remarkable deficit in the BOP if the economy has excess supply of domestic currency. In this regard, the government should create relevant courses of actions such as some of those presented earlier in this section. In this regard, the government may be able to manipulate something within the capital account and in the foreign reserve account. This is to ensure that the domestic currency will not lose its value in the international market. For this reason, the government must not buy too much of its own currency or sell too much of the foreign currency reserve. These are eventually the relevant point of consideration with respect to those identified actions and theoretical frameworks stated earlier. The bottom line of this is therefore to maintain the corresponding idea relevant to the demand and supply of both the domestic and foreign currency. In reality, the domestic currency will have to compete with the foreign currency. For the healthy flow of money in an economy, it always makes sense that the domestic currency will have to create a high demand in the international market. However, this is usually harder to set, knowing that each individual economy will also have to achieve equilibrium in their BOP. For this reason, each currency will have to compete with each other in terms of consideration of both the demand and supply for each. In this regard, the government will have at least a certain level of control, and that is as already stated, to optimise its moves with the consideration of the foreign reserve account. Here, the government will have to take into account either decrease or increase of its foreign reserve account, so that at some point this will remarkably ensure balance between the ongoing transactions under the three essential components of the BOP. The above arguments only show the point that the BOP account is balance in theory, but because the current account has strong influence on the BOP, dis-equilibrium of this account is a great possibility. However, using the relevant examples initiated by the economies in order to ensure balance of the BOP, it is shown that BOP can be brought into balance. However, this at some point is a choice of the government. The government will have to remarkably consider formulating strategies that will regulate the flow of currency within the three essential components of the BOP. In other words, the BOP determines how healthy an economy is when it comes to the flow and demand of its currency, both in the internal and external context. The BOP’s essential components are other important indicators that will guide to what relevant courses of actions the government should undertake. Conclusion The work at hand establishes the concept of balance of payments (BOP) account and the idea linked to its being balance both in theory and in the actual setting. Furthermore, the work at hand also builds up the idea that BOP at some point will reach to its dis-equilibrium, because it is directly linked to the surplus and deficit within the current account. However, there are essential moves that can be taken into account when the current account is under crisis, may it either be under deficit or surplus. In reality, the three essential components of the BOP, the current account, financial account and foreign reserve account can work hand in hand under the government’s control in order to generate a remarkable balance that will address the prevailing deficit or surplus in the current account. 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