Balance of Payment Crisis

Balance of Payment Crisis: Meaning

A Balance of Payment crisis is a situation when a country is not in a position to pay even for its basic imports. And it becomes extremely tough for it to meet its external debt obligations. Gradually, the country starts faltering or missing on debt installments. Moreover, such a crisis is usually the result of strong macroeconomic imbalances such as high current account and fiscal account deficits. And we also call the Balance of Payment crisis the currency crisis.

BOP crisis is a serious financial crisis for any country. It has a direct impact on the foreign exchange market. And the currency of the country sees a severe hit, and its prevailing rates in the foreign exchange markets go down substantially. This directly impacts the world’s confidence in the country’s currency and countries stop accepting it as a medium of exchange. Moreover, capital starts flowing out of the country rapidly as the confidence of the investors in the country is shaken, and they start withdrawing their investments. It results in a spiral-like situation, with the value of the currency falling further down.

Balance of Payment Crisis – Reasons

Some factors and events can lead to a BOP crisis. Let us have a look at a few of them.

Fiscal Deficit

A fiscal deficit is a situation when the government’s spending target is more than what it expects to receive. And it could be because revenues fall short of the target or the budget. The reasons for this can be due to a natural calamity, market inefficiencies, or simply poor planning. Further, it may also happen that the government makes new capital expenditures that were not budgeted for initially. Or the government is planning to have major welfare spending or large debt obligations are to be paid.

The gap or difference between income and expenditure is met by borrowing more money. If the borrowing goes beyond control, the country starts finding tough repayment of principal amount and the interest. This results in missed installment payments and a downgrade of investor confidence in the international market.

Current Account Deficit

A high fiscal deficit directly impacts the current account deficit of the BoP account. Higher expenditure than income impacts the exports of the country. Limited availability of financial resources hits the production, and gradually exports. And the country starts importing more and becomes dependent upon foreign countries for fulfilling its demand. Moreover, it leads to a trade deficit build-up, resulting in a Balance of Payment crisis.

Rise in Prices in the International Market

A significant rise in the price of an important commodity such as crude oil in the international markets directly results in a BOP crisis. Governments across the world are usually not in a position to fully pass on hikes in international prices to the residents or domestic consumers, especially when the rise is steep. The foreign currency reserves start depleting, with little remaining for meeting the imports bill. Also, the domestic currency starts falling in value. These events gradually cause a Bop crisis.

Balance of Payment Crisis

Withdrawal of Foreign Investment

Whenever a country faces a prolonged fiscal and trade deficit, or a situation of political turmoil, the international investors also become wary of the situation. They start withdrawing their investments from the country. The drain of foreign capital further deepens the crisis of shortage of funds. Repayment of debt obligations worsens as the country is already short of resources to pay back its debt.

Payments for imports also start getting late. The availability of short–term credit from exporters of other countries also comes to an end because they lose confidence in the repayment ability of the importers and the country. This results in a BoP crisis.

Inflation as a Cause of Balance of Payment Crisis

High inflation rates can result in a BOP crisis if the country does not control it in time. It increases imports because foreign products become comparatively cheaper when compared to their domestic substitutes. The exports start to shrink because the domestic products become relatively expensive, and there are no takers for them in the international market. This situation can lead to a BoP crisis if the rising gap between imports and exports is prolonged.

Measures to Rectify a Balance of Payment Crisis

Exchange Rate Management

A government facing a BOP crisis can alter the exchange rates of its currency to normalize the crisis. And this can be done by using its monetary policy to control its current account deficit. It can use its powers to issue new currency, alter rates of interest and foreign exchange reserves, perform open market operations, etc., to temporarily devalue its currency.

Devaluation of the domestic currency will help curb the imports as they will become expensive regarding the substitutes available in the domestic market. Also, this will give a push to exports as they will become more attractive and generate more revenue for the exporters. And this policy tweak will help in correcting the current account deficit and make it surplus in some time or narrow down the imbalance gap.

Higher exports will mean higher demand for the domestic currency in the international market. Buyers from other countries will require domestic currency for making payments to the sellers. This, in turn, will again push the value of the domestic currency up.

Import Restrictions and Export Promotion

Governments can decide to restrict imports from foreign countries by implementing quotas, customs duties, and tariffs or by imposing restrictive orders. The policy changes can take place to promote exports by easing licensing controls and restrictions or by granting export subsidies. And this will help to bring down imports of the country while increasing exports at the same time. Further, the current account deficit will soon come down or even become a surplus with the increase in exports and a fall in imports.

Interest Rates Management

Another way to tackle the BOP crisis is by an active interest rates management policy. Through the Central bank of the country, the government can raise the interest rates in the economy. And high rates of interest act as a deterrent to spending in the economy while promoting savings. Thus, lower spending will automatically mean lower imports. At the same time, high-interest rates can also be a tool for bringing down the inflation rates in the economy. And this will make the exports competitive in the international market and promote them. The effects will help the country create a current account surplus and tide over the BoP crisis.

However, high-interest rates can attract more foreign capital to the country too. This will again lead to an increase in demand for the domestic currency. And this can further lead to its appreciation which can result in higher imports and lesser exports. Therefore, a government should use interest rates as a tool to check the BOP crisis judiciously and in combination with other policy measures.

External Borrowing

A country can opt for an increase in foreign borrowing to manage its BOP crisis. External borrowings will provide more capital for government spending and investment in the economy. This will result in higher production that can push up the exports in the economy. Also, these productive investments will bring down imports as the country will start becoming self-sufficient. And all this will result in correcting the current account deficit and timely repayment of the country’s debt obligations. Moreover, an overall positive scenario will also boost international confidence in the domestic economy and bring in more investments, helping to tame the Balance of Payment crisis.

Frequently Asked Questions (FAQs)

Explain what do you understand by a balance of payment crisis?

A Balance of Payment crisis is a situation when a country is not in a position to pay even for its basic imports. It becomes tough for it to meet its external debt obligations.

What causes a balance of payment crisis?

Causes of a balance of payment crisis include:
• Fiscal deficit
• Current account deficit
• Price Increase in the key imported goods.
• Foreign investment withdrawal
• Inflation

What are the measures to rectify a Balance of Payment crisis?

• Exchange rate management
• Import restriction & export promotion
• Interest rate management
• External borrowings

How does the withdrawal of foreign investment cause a balance of payment crisis?

Whenever a country faces a prolonged fiscal and trade deficit, or a situation of political turmoil, the international investors start withdrawing their investments from the country. The drain of foreign capital further deepens the crisis of shortage of funds.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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