Ask Mint | How does a BoP crisis build up, and how is the balance restored?

Ask Mint | How does a BoP crisis build up, and how is the balance restored?
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First Published: Sun, Nov 09 2008. 10 19 PM IST

Updated: Sun, Nov 09 2008. 10 19 PM IST
Theoretically speaking, the balance of payment (BoP) account of a country is like a square, where all sides are of equal size. But in reality, countries do face situations in which the opposite sides of the BoP account don’t actually match up. This mismatch of size can lead to either a surplus or a deficit in the BoP account. A high surplus in the BoP account hardly makes headlines but a huge deficit and a mere likelihood of what is known as a balance of payment crisis, like any bad news, attracts news-hungry analysts from all sides. Leaving popular myths behind, let’s find out what are the factors that can lead to a BoP crisis for a country.
Johnny: How does a surplus in one component of the BoP account take care of a deficit in the other?
Jinny: In BoP accounts of countries, it is the overall balance that matters. A country seeing overall surplus in its BoP account will experience a rise in its foreign exchange (forex) reserves, whereas a country facing an overall deficit will see a decrease in its forex reserves. But the final picture of the BoP account emerges only after taking into account the deficits and surpluses of different components of the account. If the values of imports are higher than that of exports, then the balance in the visible trade account would be in deficit. But if the receipts in respect of invisible trade are higher than the payments, then the surplus in that account would take care of the deficit in our visible trade account.
Similarly, higher remittance from abroad would also help us in reducing our deficit. But sometimes, even after taking into account all surpluses, the overall balance in the current account may remain in deficit. In such a situation, the surplus in the capital account plays an important role in balancing the deficit in the current account.
But what’s the guarantee that the capital account would be in surplus when the current account is in deficit? In fact, there is no guarantee. Capital account includes transactions relating to short-term capital inflows, which can very well reverse at the first sign of trouble. So, we can actually face a situation in which a high current account deficit leads to flight of money under the capital account. In such a situation, the country can use its forex reserves to meet its obligations in foreign currency. In case the country does not have sufficient forex reserves, the situation may deteriorate into a full-blown balance of payment crisis. Many countries have actually gone through such a situation. But many countries have still managed robust capital account inflows right in the face of a high current account deficit.
Johnny: How do some countries manage to do that, whereas others fail?
Jinny: That is possible because international investors know very well that a high current account deficit in itself need not be a sign of trouble in the first place. Investors look closely at all fundamentals. Growth of the gross domestic product, inflation, forex reserves, exchange rates... They all play an important role in influencing investors’ sentiments. If you are importing capital goods for building dams and factories, then you are laying the foundation for future prosperity, albeit at the cost of the present current account deficit. Any long-term investor would love to invest in such a country.
Also, the world economy, much like Pavlov’s dog, works on incentives. A high domestic interest rate is surely a plus with international investors as long as they are sure of your capacity to repay. It makes it easier for countries to borrow money from the international market to increase their capital receipts. Many countries manage to survive a high current account deficit because of a long queue of lenders ready to pour in their money.
A favourable exchange rate could be another incentive for international investors. But these incentives can work only in the short run. In the long run, only strong economic fundamentals, coupled with the tendency of an economy to correct itself, can save a country from a full-blown balance of payment crisis.
Johnny: How does an economy facing a huge current account deficit correct itself?
Jinny: No human force can immediately change a deficit of the current account into a surplus, but if left alone, the forces of economic demand and supply constantly work to bring an economy to its natural state of equilibrium.
Let’s try to understand how it happens. In case of a huge current account deficit, the demand for foreign currency is higher than that for the domestic currency. This pull of demand in a free market would lead to depreciation of the domestic currency in terms of foreign currency.
The depreciation of the currency would make imports costlier and exports cheaper. This means that importing goods would become less profitable, whereas exporting goods would become more profitable. In short, imports would decrease and exports would increase; this would ultimately restore the balance in the trade account. This is how the imbalance starts correcting itself.
Johnny: That sounds interesting. The economy knows how to correct itself.
What: A large deficit in the balance of payment (BoP) account may lead to a BoP crisis for a country.
Why: An imbalance in the BoP account can turn into a BoP crisis if other economic fundamentals are also weak.
How: The forces of demand and supply help in correcting the imbalance in the BoP account.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Nov 09 2008. 10 19 PM IST