Balance of Payments: Definition, Example, Problems & Solutions

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What is Balance of Payments?

Balance of payments is a systematic record or summary statement of accounts of all the major economic or trading transactions between a reporting country and the rest of the world, during a specific period, usually one year.

Balance of Payments: Definition, Example, Problems & Solutions
Balance of Payments

Balance of payment is a summary of receipts (income) and payments (expenditure) of a country in the international accounts.

Components of Balance of Payments

  • Current account: This consists of the visible trade account (balance of trade) and the invisible trade account. The balance of trade shows the relationship between the receipts (for imports) and payments (for exports) for tangible goods, during a period of one year. The invisible trade account deals with receipts and payments for services such as banking, transportation etc.
  • Capital account: This account deals with capital inflows and outflows. It consists of items such as direct investments, long-term loans and loan repayments.
  • Monetary movement account: This is the residual or balancing segment of the balance of payments account. It shows how short-term deficits in the combined current and capital accounts are financed and how short-term surpluses are used up.

Balance of Payments Disequilibrium

A balance of payments disequilibrium exists if the total receipts of a reporting country on the combined current and capital accounts is not equal to total payments made to all other countries, during a given period, usually one year. Such a disequilibrium could be a deficit or a surplus.

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A balance of payments deficit occurs if the total receipts from all other countries are less than the total payments to the other countries within the accounting period.

This situation implies that the reporting country is weak in its international trade transactions.

Balance of Payments Adjustments

1. Short-term measures

Short-term balance of payments dis-equilibrium, does not cause serious problems.

A short-term balance of payments deficit can be financed or paid for by:

  • Short-tenn borrowing from abroad e.g. the IMF or other countries.
  • Importing goods on credit.
  • Using up foreign exchange reserves.
  • Selling foreign investments.
  • Recalling foreign loans.
  • Exporting gold.
  • Limiting debit items and promoting credit items.

2. Long-term measures for correcting balance of payments deficit

A chronic (long-tenn or fundamental) balance of payments deficit is what causes serious concern to countries. Long-term measures are used to correct a persistent balance of payments deficit.

These include:

  • Export promotion (export drive): A deliberate policy should be undertaken to increase the production and exportation of both invisible and visible items. Export promotion could be encouraged through export subsidies, granting tax concessions to export-based industries and the development of tourism etc.
  • Fiscal policy: Government could use tariffs (impon duties) as a corrective measure. An increase in tariffs would increase import prices, thereby lowering the demand for imports. A decrease in payments to other countries would improve the balance which can be used, export prices would fall, leading to increased demand for them by other countries. Receipts would increase and help to improve the balance of payments.
  • Quantitative control of imports: A number of administrative measures can be put in place to reduce the volume of imports. These include the use of import quotas, embargoes, import licensing etc. and reduced payments to other countries would help to remedy the balance of payments.
  • Increased domestic production: Vigorous attempts should be made to produce more of the goods and services at home which would otherwise be imported. Foreign exchange would be conserved and this would help to improve the balance of payments.
  • Foreign exchange control: The government could directly control foreign exchange usage. Stringent regulations regarding the buying and selling of foreign currencies would help to reduce the volume of imports.
  • The use of restrictive monetary policy: The availability and use of credit should be reduced to create a situation of a liquidity squeeze.
  • Devaluation of domestic currency: Devaluation is a deliberate and legally prescribed reduction of the value of a country’s currency in relation to other countries’ currencies and to gold. It has the effect of making imports to be relatively more expensive than exports. The increase in exports relative to the demand for imports would make receipts to increase while payments to other countries would decrease. The balance of payments would therefore improve.
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Devaluation would be effective if

  • demand for import is elastic.
  • demand for export is elastic.
  • supply of export is elastic.
  • other countries do not retaliate through competitive devaluation.
  • there is no rise in the cost of production.
  • a vigorous income policy is maintained.

Devaluation & Depreciation Definition

Devaluation: This is the official lowering of the exchange rate of a country’s currency by the monetary authorities in terms of other currencies. For example, if currency X and currency Y used to exchange at 1:1, there is a devaluation of currency X if the exchange rate is now 1:0.5.

Depreciation: This is a term used in economics to refer to the fall in the value of something. It is used mainly in connection with capital and currency. In this context, it is used in connection with currency.

In a free Foreign Exchange Market, a downward movement in the value of a currency would normally be called ‘depreciation’. It is thus the reduction of the exchange value of a national currency in relation to other currencies as a result of changes in its demand and supply in the Foreign Exchange Market.

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Currency redenomination: is the process where a new unit of money in a countiy replaces the old unit within a certain ratio, usually by a factor of 10.

It is achieved by removing zeros from a currency or removing some decimal points to the left, with the aim of correcting perceived misalignment in the currency and pricing structure, and enhancing the credibility of the local currency.

For example, in July 2007, Ghana decided to implement a redenomination policy by replacing the old 10,000 cedi with a new one called Ghana Cedi, i.e. four zeros were removed from the old currency to arrive at the new one.

When implemented, redenomination usually results in the birth of an entirely new currency with a new symbol. In the case of Ghana, for example, the currency changed from cedi (¢) to Ghana Cedi (GH¢). Redenomination isa symbolic reform without guaranteed benefits.

Note that redenomination is not the same as revaluation of a currency. They are two different things.

Revaluation is the opposite of devaluation i.e. the restoration of a value of a currency lost by devaluation.