During short periods the balance of payments may fluctuate between favorable and adverse balance. But a persistent disequilibrium in the balance, whether favorable or adverse, is undesirable. The aim of the monetary authorities would be to maintain an even balance of payments so as to ensure the consistent growth of the economy and world trade. Of the two, persistent favorable balance and persistent adverse balance, the latter has more serious repercussions and efforts should be made to correct it.
The following methods are generally employed, either in isolation or in combination, to correct adverse balance of payments:
1. Deflation, 2. Exchange depreciation, 3. Devaluation, 4. Exchange control, 5. Import restrictions and quotas, and 6. Export promotion.
1. Deflation. Deliberate attempt may be made by the government to bring down the domestic prices and income by adopting a policy of deflation. The policy of deflation may take the shape of raising the interest rate structure in the country through increasing the bank rate. The rise in interest rates is expected to correct the balance of payments in two ways. First, with the increase in interest rates on borrowings traders find that the cost of holding inventories goes up. So they try to curtail their holding by unloading inventories on the market.
Such unloading pushes down the prices in the country. But this also has the effect of reduction in production and consequently reduction in employment and in money income. The reduction in domestic price coupled with reduction in income would result in lowering the demand for imported goods, because they would now be costlier when compared to domestic goods and also because the fall in income makes payments for imports difficult. With the reduction in imports, the balance of payments position improves.
Secondly, the rise in interest rate in the country would induce foreign investors to invest in the country. The flow of foreign capital into the country also reduces the burden of balance of payments problem. The policy of deflation is not advocated as a method of correcting balance of payments disequilibrium because of the conditions required for its success and the adverse effects it has on the internal economy:
(a) Deflation leads to fall in production and employment in the country. This is against the policy of full employment, price stability and consistent growth adopted by governments.
(b) Deflation may lead to fall in wages which would be strongly resisted by trade unions.
(c) The success of the measure depends upon the elasticity of domestic demand for imports and foreign demand for exports to changes in price and income. Unless the reduction in domestic prices brings about the desired reduction in imports and increase in exports the policy would not be successful. In other words, deflation would fail if imports and exports of the country are inelastic to the change in price and income.
(d) Deflation would succeed only under fixed rate of exchange where the external value of the currency remains stable.
2. Exchange Depreciation. Exchange depreciation refers to reduction in the value of currency of one country in terms of another. Under flexible exchange rates, an adverse balance of payments, acting through market forces of demand and supply, would result in the depreciation of the currency. The depreciation in the value of the currency will have an automatic effect of correcting the balance of payments position. To illustrate, let us suppose that India has an adverse balance position in relation to its trade with the USA.
The excess supply of rupees will have the effect of reduction in their value in relation to US dollars. In other words, rupee depreciates vis-a-vis dollar. With the reduction in the value of rupee exports form India to the USA would become cheaper and, therefore, would rise. On the other hand, the American goods would become costlier to India and hence imports would fall. The increase in exports and fall in imports would correct the adverse balance of payments for India.
Depreciation as a method of correcting balance of payments has the following defects:
(a) The policy of depreciation requires constantly changing exchange rates. The frequent fluctuations in the exchange rates would destabilise the economy.
(b) The fluctuating exchange rates would have a speculative effect on the for-eign exchange market and hence will affect the smooth functioning of international trade and discourage investments.
(c) The terms of trade may go against the country adopting depreciation policy. That is, exports become cheaper and imports become costlier and thus the rate at which exports are exchanged for imports go adverse.
(d) Depreciation may lead to inflation in the country which adopts it. With increased exports and decreased imports, the domestic resources become scarce and push up the prices.
3. Devaluation. Devaluation means lowering the external value of the currency in relation to SDR or all other currencies or a few other currencies. Essen-tially both depreciation and devaluation mean the same thing, viz., reduction in the external value of the currency. While devaluation is reduction in the external value of the currency by the government, depreciation refers to the reduction in the external value due to market forces.
With the devaluation of the currency, exports from the country become cheaper and imports become costlier. Provided the demand for imports and exports is reasonably elastic, the exports tend to rise and imports fall. These pave the way for a favourable balance of payments. The success of devaluation depends upon the existence of a number of factors-
(a) The demand for goods exported as well as those imported should be elastic. That is, with the devaluation of the currency and prices of exports becoming cheaper, more goods than before should be purchased by foreign countries. Similarly, with imports becoming costlier the demand for imported goods should de-crease. On the other hand, if the demand is inelastic to price changes and there is no change or there is only a marginal change in the quantity imported and exported, the balance of payments would further worsen. If the same quantity is exported as before, its value would be reduced because the prices have decreased in relation to foreign currencies. Likewise, imports at the same previous level would entail more flow of foreign exchange from the country.
(b) Devaluation would be successful only where there is no change in the internal value of the currency. In other words, the internal prices should not change. An increase in the domestic prices of goods would take away the chances of exports becoming cheaper and thus the chances of increase in exports. The increase in domestic prices may be due to the fact that with the curtailment of imports goods may become scarce and hence their prices rise. Further increases in imports may result in reduction in domestic supply and increase in prices. Increase in the prices of imported goods may have a sympathetic change in the price of other goods. If the goods imported comprise a sizable portion of consumption of the working and middle classes, the cost of living may rise necessitating higher wages and prices.
(c) The success of devaluation depends upon the co-operation of other coun-tries whose currencies stand appreciated due to the devaluation by one country. In other countries the exports would fall and imports would rise, thus affecting their balance of payments. To control this they may encourage exports through grant of subsidies or curtail imports by imposing heavy tariff. Other countries may also devalue their currencies resulting in a series of devaluation.
4. Exchange Control: Exchange control refers to the regulation of foreign exchange transactions of the country by the government or any other authorised agency. Exchange control is practised especially by courtries with insufficient foreign exchange reserves. There are many ways of exchange control, but the main feature in all the cases is centralisation of exchange dealings in the hands of the government or the authorised agency. The residents of the country who come into possession of foreign exchange through exports or otherwise are expected to surrender it to the exchange control authorities. Similarly, those who want foreign exchange to pay for import or for other purposes should apply to exchange control authorities Thus, the exchange control authorities retain control over the entire foreign exchange transactions and it is rationed among those who need it.
5. Import Restriction. Restriction of imports may take the shape of increase in import duties or tarrifs or fixing quotas for impons. Stiff duties imposed on imports reduce demand for imported goods by increasing their cost and thereby correcting the adverse balance of payments. By protecting home industries against competition from imports, tariffs also help in increasing employment and stimulating investment in the country.
Import restrictions may also take the shape of axing up import quotas prescribed by the government in terms of quantity of goods that may be imported. Or, the government may prescribe the quantity that can be unported and also the country from which that could be imported. The restrictior may also be with respect to the value of the goods that can be imported.
6. Export Promotion. Concerted efforts may by; made towards promotion of exports. Various concessions and incentives may bo given by the government to encourage exports from the country. Measures adopted towards this end may include reduction of export duties, export incentives, facilities of commercial, technical and financial nature being made available at cheaper rates and in adequate measure to exportoriented projects, etc.
Of all the measures the direct methods in the form of import restrictions and export promotion are most desirable.