Explain the reasons behind the BOP deficit and discuss the other policy approaches for a country to achieve healthy BOP amidst slow economic recovery.

The slow economic recovery from the worldwide financial crisis has caused emerging countries that exports commodities to suffer from currency depreciation and an unsustainable balance of payments deficit. The growth of advanced economies is in turn affected by the lower growth in commodities exporters, and productivity growth remains weak. Amid slowing international trade growth, countries have turned to mega-regional trade agreements like the Transpacific Partnership (TTP) and the Transatlantic Trade and Investment Partnership (TTIP).

Explain the reasons behind the balance of payments deficit and discuss the other policy approaches that may be appropriate for a country to achieve healthy balance of payments amidst slow economic recovery. [25]

Introduction

Balance of Payments is a record of all economictransactions between the residents of the country and the rest of world in a particular period of time.

BOP deficit is a situation in which the imports of goods, services, investment income and transfers exceed the exports of them. 

LIKELY CAUSES OF BOP DEFICIT

A BOP deficit can be caused by either a worsening of the current account or capital account, or both. In this case, the likely causes of a BOP deficit are likely to be due to a current account deficit. A current account deficit happens when import expenditure exceeds export revenue. (we must also take note that net income from investments and unilateral transfers are also part of the current account)

02 Fall in exports competitiveness

·       A country could also be experiencing a fall in exports competitiveness relative to trading partners when there is weak productivity growth. 

·       Since competitiveness is relative to trading partners, if trading partners are reducing costs through rising productivity, the lower productivity growth will then affect the ability of the country to compete in terms of pricing of their exports. If exports are less competitive, demand for exports would fall, causing a worsening of the current account deficit, affecting the BOP.

01 Fall in trading partners’ incomes

·      When trading partners’ incomes fall, it will result in a fall in their purchasing power, which will affect their abilities to purchase imports. 

·      This will then affect the country’s ability to sell exports to trading partners, leading to a fall in demand in exports. The fall in export revenue will then contribute to the current account deficit, which contributes to the BOP deficit.

03 Strong currency compared to trading partners

·      If the currency is very strong compared to other currencies, exports could be relatively expensive for foreigners to purchase. At the same time, locals will find imports cheap to buy. 

·      This will result in both a rise in import expenditure and a fall in export revenue, possibly worsening the current account position, leading to a BOP deficit.

02 Devaluation of the exchange rate

·       The central bank can carry out a devaluation of the exchange rate by selling domestic currency on the foreign exchange market. 

·       As the currency depreciates, it makes imported goods more expensive, so consumers will reduce spending on imported goods. At the same time, exports will become more price competitive as the pricing in foreign currency will become cheaper. This will bring about an improvement in the BOT and therefore improves the BOP as well.

·       This is of course, subject to the Marshall-Lerner condition, which states that for a depreciation to bring about an improvement of the BOT, the sum of the PEDx and PEDm must greater than 1. 

·       Countries like Singapore that import most of its inputs might also find that devaluation may not be a useful policy considering that an depreciation of the exchange rate will make imported inputs more expensive, raising cost of production in the process and this could negate any gains in price competitiveness brought about by the devaluation.

ALTERNATIVE POLICY APPROACHES

01 Contractionary demand management policy such as fiscal policy

·      Cutting government expenditure will directly reduce AD. 

·      Increasing personal income taxes will reduce Consumption since disposable income will fall while increasing corporate income taxes will reduce after-tax profits and therefore reduce Investment spending. 

·      When AD is reduced, there will be a multiplied fall in national income. The lower income will result in consumers having less ability to buy imports. Lower demand for imports will improve the BOT since (X – M) will improve, therefore improving the BOP as well.

·      Amidst slow economic recovery, it may not be appropriate to carry out contractionary fiscal policy to address a BOP deficit considering that it will cause real national income to fall and cause economic growth to worsen. 

03 Supply side policies

·      Supply side policies should be targeted at either improving the price competitiveness or the quality of the exports to encourage an increase in demand for the country’s exports.

·      This can include providing subsidies for firms to carry out retraining and upgrading of workers, or investment in machinery or automation processes in order to increase productivity. Productivity gains will reduce the cost of production, which may then improve the price competitiveness of the exports. The government can also encourage firms to carry out research and development by providing grants to do so. This can improve the quality of the exports, which serves to increase the demand for the country’s exports.

·      These policies are however long term and do not address the immediate issues associated with a slow economic recovery.

Conclusion

During a period of slow economic recovery, it may be challenging for a country to achieve a healthy balance of payments if it was initially in a huge deficit. The government, if set on achieving a healthy balance of payments, must definitely implement multiple policies that complement each other to ensure economic recovery as well.