Question

Explain the factors which give rise to a deficit in the balance of payments.

Answer 1

A deficit in the balance of payments (adverse BOP) arises when autonomous payments exceed autonomous receipts. The main factors giving rise to such a deficit are:

1. Fall in Foreign Demand: If foreign buyers shift their demand away from a country's goods due to changes in tastes, cheaper alternatives, or recession abroad, exports fall and the BOP becomes unfavourable.
2. Inflationary Pressures: High domestic inflation makes imported goods relatively cheaper and domestic goods less competitive in world markets. Thus imports rise and exports fall, causing a deficit.
3. Developmental Expenditures: Developing countries need to import machinery, raw materials and technical know-how for development. Their exports cannot rise fast enough to finance these imports, creating a structural deficit.
4. Increase in Cost Structure of Export Industries: Higher wages, dearer raw materials, or inflation raise production costs. This reduces export competitiveness, lowers exports, and worsens the BOP.
5. Decrease in Supply: Crop failures, strikes, or shortages of raw materials and power reduce domestic output. Exports fall and imports rise to meet domestic needs, adversely affecting the BOP.
6. Appreciation in the Exchange Rate: When the domestic currency appreciates, imports become cheaper and exports more expensive. Hence imports increase while exports decrease, leading to a deficit.
7. Increased Debt Burden: Developing countries often borrow abroad and must make large interest and debt-service payments. These outflows of foreign currency create BOP difficulties.
8. Demonstration Effect: People in developing countries imitate the consumption patterns of developed nations, especially for luxuries like cars and air-conditioners. This raises imports of consumer durables and causes a deficit.
9. Population Pressure: Rapid population growth raises domestic demand for consumer goods, reduces the exportable surplus, and forces larger imports, worsening the BOP.
10. Political Factors: Political instability and turmoil disrupt production and trade, while international economic sanctions reduce export earnings. Both factors contribute to an adverse BOP.

A balance of payments deficit is generally caused by a combination of external demand shocks, domestic inflation and supply constraints, structural weaknesses, and exchange-rate or political factors.