Factors Affecting Balance of Payments

By | February 28, 2017

The balance of payments can be affected two accounts:

  1. Current Account
  2. Capital Account

1. Factors Affecting the Current Account:

A country’s current account balance can significantly change its national economy. Therefore, it is important to identify the factors that influence current account.

The most important factors affecting current account are:

  1. Inflation
  2. National Income
  3. Government Restructures
  4. Exchange Rates.

Above factors are described below one by one.

Inflation: If a country’s inflation rate increases relative to the other countries with which it trades, its current account would be expected to decline. Due to higher prices at home, consumers and corporations within the country are most likely to purchase more goods and services overseas (due to high local inflation), while the country’s exports to other countries will fall.

National Income: If the national income of a country rises by a higher percentage than those of other nations, its current account is expected to decline, other things being same. As the real income level (adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in consumption of goods will most likely reflect an increase in demand for the foreign nation goods.

Government Restrictions: If a country’s government imposes a particular type of tax (often referred to as a tariff tax) on imported goods from foreign countries, the prices of foreign goods to consumers effectively increases. An increase in prices of imported goods relative to goods produced at domestic country will discourage imports and is expected to increase its current account balance. In addition to tariffs, a government may reduce its imports by enforcing a quota, or a maximum limit on imports.

Exchange Rates: The value of a country’s currency regarding other currencies is called the exchange rate. Changes in a currency’s exchange rate brought about by market forces or actions by national government or government of other countries will influence a country’s current account balance. An appreciation in a country’s exchange rate vis-a-vis another country’s currency, other things being equal, is likely to lead to a decline in the country’s exports and increase in imports.

For example, if the exchange rate between Indian Rupee and US Dollar changes from Rs. 50 to $1 to Rs. 40= $1, the US importer has to pay $25, whereas earlier he would have paid only Rs. 800 to buy $20 worth of US goods, whereas earlier he would have paid only Rs. 800 to buy $20 worth of goods, whereas earlier he would have spent Rs. 1000. Thus, if Rupee appreciates in value in vis-a-vis US Dollar, exports are likely to be hit, and imports are likely to grow. The opposite will be the impact of depreciation on the exchange rate of a country’s currency, i.e. it is likely to lead to growth in exports and decline in imports.

However, according to J-curve theory, a country’s trade deficit worsens just after its currency depreciates because price effects will dominate the effect on the volume of imports in the short run. That is the higher costs of imports will more than offset the reduced volume of imports. Thus, the J-curve theory states that a decline in the value of the domestic currency should be followed by a temporary worsening in the trade deficit before its longer term improvement.

2. Factors affecting the Capital Account:

As with the current flows, government policies will also change the capital account. A country’s government could, for example, impose a special tax on income account by local investors who invested in foreign markets. A tax would discourage people from investing abroad and could, therefore, increase the country’s capital account. Capital flows are also influenced by capital controls of various types. Interest rates also affect the capital flows. A hike in interest rates relative to other countries may affect capital inflows from overseas countries. Conversely, a reduction in domestic interest rates may induce people to invest overseas.

The anticipated exchange rate movements by investors in securities can affect the capital account of the country. If a home currency is expected to strengthen, foreign investors may be willing to invest in the country’s securities to benefit from the currency government. Conversely, a country’s capital account balance is expected to decrease, if its home currency is expected to weaken, other things being equal.

When attempting to assess why a nation’s capital account changed and how it will change in future, all factors must be considered all together. A country may experience a reduction in capital account even when its interest rates are attractive to the public if the domestic currency is expected to depreciate its value.