When a country’s balance of payments shows a deficit, which indicates that its expenditures exceed its income, it must take corrective action. Ethiopia was in deficit for a very long time, with imports exceeding exports by twofold and the amount of money leaving the country greater than that which entered.
The major factor that can cause a balance of payment deficit is inflation, which encourages imports and discourages exports by deteriorating the power of the local currency. As the country depends more on imports than exports, the balance of payments becomes deficit. Another one can be the instability of the corresponding country’s economy, which has an impact on the price of imported goods, which in turn causes inflation in the local economy and as a result the balance of payment stay in deficit.
The most common mechanism to correct the balance of payment includes adjustments through exchange depreciation. Under a flexible exchange rate, a deficit in the balance of payments is automatically solved by the forces of demand and supply for foreign exchange. The depreciation of a country’s currency in the event of a deficit in its balance of payments encourages exports and discourages imports. This leads to the lowering of the prices of exports and the raising of the prices of imports, thereby bringing equilibrium to the balance of payments.
Another mechanism is a devaluation or expenditure-switching policy. Devaluation raises the domestic price of imports and reduces the foreign price of exports when a country devalues its currency in relation to the currency of another country.
Devaluation is referred to as an expenditure switching policy because it switches expenditure from imported to domestic goods and services. When a country devalues its currency, the price of foreign currency increases, which makes imports dearer and exports cheaper. This causes expenditures to be switched from foreign to domestic goods as the country’s exports rise and the country produces more to meet the domestic and foreign demand for goods with a reduction in imports. Consequently, the balance of payments deficit is eliminated.
The government can also limit the volume of imports to correct the disequilibrium in the balance of payments. The government restricts the import of undesirable or unimportant items by levying heavy import duties, fixing quotas, etc. At the same time, it may allow imports of essential goods duty-free or at lower import duties or fix liberal import quotas for them. In these ways, imports are reduced in order to correct an adverse balance of payments.
The government also imposes exchange controls to restrict imports and regulate foreign exchange. With a reduction in imports and control of foreign exchange, both visible and invisible imports are reduced. Consequently, an adverse balance of payment is corrected.
Adjustments made through capital movements can also address the balance of payment deficit. A country can use capital imports to correct a deficit, which can be financed by capital inflows. When capital is perfectly mobile within countries, a small rise in the domestic rate of interest leads to a large inflow of capital.
The balance of payments is said to be in equilibrium when the domestic interest rate equals the world rate. If the domestic interest rate is higher than the world rate, there will be capital inflows, and the balance of payments deficit will be corrected.
Adjustment through income changes is another mechanism. An increase in the value of exports causes an increase in the incomes of all those associated with the export industries. These, in turn, create demand for other goods and services within the country. This will raise the incomes of those engaged in the latter industries and services. This process will continue, and the national income will increase by the value of the multiplier.
A deficit in the balance of payments can also be corrected by encouraging exports, i.e., the stimulation of exports and import substitutes. Producing high-quality products, increasing exports through increased production and productivity, and improving marketing can all encourage exports. They can also be increased by a policy of import substitution. It means that the country produces the goods that it imports.
In the beginning, imports are reduced, but in the long run, exports of such goods start. An increase in exports causes the national income to rise many times through the operation of the foreign trade multiplier. The foreign trade multiplier expresses the change in income due to a change in exports. Ultimately, the deficit in the balance of payments is removed when exports rise faster than imports.
Lastly, expenditure-reducing policies are necessary to correct a deficit in the balance of payments; expenditure and income should be brought into equality. For this, expenditure-reducing monetary and fiscal policies can be used. A contractionary or tight monetary policy relates to an increase in interest rates to reduce the money supply, and a contractionary fiscal policy relates to a reduction in government expenditure and/or an increase in taxes.
Thus, the policies reduce aggregate demand through higher taxes and interest rates, thereby reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price level, giving rise to the switching of expenditure from foreign to domestic goods. Consequently, the country’s imports are reduced, and the balance of payments deficit is corrected.
A balance of payment deficit can be corrected by applying an interest rate commission agent banking system (AIRCABS). It is a system where the bank acts as an agent for investors’ loan funding to entrepreneurs by setting up an agreement between the fund seller and buyer and administering the loan after disbursement. The bank then retains a reasonable commission from the agreed-upon investor’s loan funding price.
The purpose of AIRCABS is to produce investors and entrepreneurs and thereby increase investment in the country to reduce imports and increase exports. As the number of entrepreneurs and investors increases at AIRCABS agent bank, local production will meet local demand, and as a result, inflation will be manageable. Since AIRCABS improves exports, the cash inflow will be greater than the cash outflow, and in this case, the balance of payments will be positive.
The major factor in the balance of payment deficit is a lack of inland production that matches the demand of society. Even though raw materials are abundant in the country, the country is forced to import major finished products from outside the country unless otherwise processed raw materials are processed inland.
However, the purpose of an interest rate commission agent banking system is to produce import substitution products through entrepreneurs as much as the level of consumption of society, and this gradually leads the country to export more and import less, which in turn corrects the balance of payment deficit.
Ameha Tefera (PhD) is an expert in finance. He can be reached at [email protected].
Contributed by Ameha Tefera (PhD)