Policies to correct disequilibrium in the balance of payments

The balance of payments (BoP) records all transactions between a country and the rest of the world, and has three accounts.

The current account records trade in goods and services, plus primary income (investment income and wages from abroad) and secondary income (transfers such as aid and remittances). The financial account records flows of investment and financial capital — foreign direct investment (FDI), portfolio investment in shares and bonds, and changes in official reserves. The capital account (usually small) records transfers of capital assets, such as debt forgiveness. Crucially, the overall balance of payments must balance, so a current-account deficit is matched by a net inflow on the financial (and capital) account — the country attracts foreign investment or borrows to finance the deficit.

Policies to correct a current-account deficit fall into two types. Expenditure-reducing policies reduce total domestic spending (AD) to cut imports — for example contractionary fiscal policy (higher taxes, lower government spending) or contractionary monetary policy (higher interest rates). Because lower AD reduces import spending, the deficit narrows; but the cost is lower output, growth and employment, and the policy treats the symptom (high spending) rather than the cause.

Expenditure-switching policies switch spending away from imports toward domestic goods by changing relative prices — for example a depreciation/devaluation (making exports cheaper and imports dearer) or protectionism (tariffs/quotas making imports dearer or scarcer). These redirect demand to domestic producers, improving the current account; but a depreciation causes inflation and only works if demand is price-elastic (Marshall-Lerner), and protection risks retaliation and inefficiency.

So the key difference is that expenditure-reducing policies lower total spending (cutting all spending, including on imports), whereas expenditure-switching policies redirect spending from foreign to domestic goods. Supply-side policy is a third route, raising competitiveness to improve the current account sustainably, though slowly.

A large current-account deficit means the country spends far more abroad (on imports and income) than it earns, financed by net inflows on the financial account. A government can use expenditure-reducing, expenditure-switching, supply-side or financing approaches, each with strengths and weaknesses.

Expenditure-reducing (demand-side) policy. Contractionary fiscal or monetary policy cuts AD and so cuts imports, narrowing the deficit relatively quickly. However, lower AD reduces output, growth and employment — a serious conflict with other objectives — and it treats only the symptom (high spending), so the deficit returns once demand recovers. Higher interest rates may also appreciate the currency, worsening competitiveness.

Expenditure-switching policy. A depreciation/devaluation makes exports cheaper and imports dearer, switching spending to domestic goods and improving the current account — but it causes cost-push inflation and only improves the balance if demand is price-elastic (the Marshall-Lerner condition; there may be a J-curve worsening at first). Protectionism (tariffs/quotas) cuts imports directly and quickly, but risks retaliation (cutting exports), raises prices and protects inefficiency, and may breach trade agreements.

Supply-side policy. Raising productivity and competitiveness (training, infrastructure, technology) increases exports and reduces imports by making domestic goods genuinely more competitive. This corrects a deficit sustainably and without the inflation, growth loss or retaliation of the other policies, and tackles the root cause of a competitiveness-driven deficit. Its drawback is that it is slow and costly.

Financing and judgement. A deficit can also be financed by attracting stable FDI (financial account), which is sustainable if the deficit reflects productive investment. Judgement: the best policy depends on the cause and the time horizon. A deficit from excess demand can be tackled by expenditure-reducing policy in the short run; but a large, persistent deficit usually reflects lost competitiveness, for which supply-side policy is the most effective long-run cure, despite being slow. Expenditure-switching (especially a depreciation) can help in the short run but carries inflation/elasticity risks, and protection risks retaliation. The most defensible conclusion is that a government should diagnose the cause and use supply-side policy at the core for a persistent deficit, supported by short-term measures if needed, while ensuring the deficit is financed by stable inflows — rather than relying on any single policy. Each option also conflicts with other objectives, so trade-offs must be weighed.

Because the overall balance of payments must balance, the $30bn current-account deficit must be matched by net inflows on the financial account — and the figures show exactly how it is financed.

The country attracts $25bn of foreign direct investment (FDI) — a financial-account inflow — and runs down its reserves by $5bn (using past savings of foreign currency). Together these provide the $30bn needed to finance the current-account deficit (25 + 5 = 30), so the overall BoP balances.

Sustainability. This financing is partly sustainable, partly not:

• The $25bn of FDI is a relatively stable, long-term inflow that reflects confidence in the economy and can build productive capacity — a fairly sustainable way to finance a deficit (especially if the imports are capital goods that raise future exports).
• However, running down reserves by $5bn is not sustainable indefinitely — reserves are finite. If the country has to keep using reserves each year, it will eventually exhaust them and face a crisis.

So the deficit is largely financed by stable FDI, which is reasonably sustainable, but the reliance on reserves is a warning sign. To be sustainable in the long run, the country should reduce the deficit (e.g. via supply-side policy to improve competitiveness) or continue attracting enough stable FDI, rather than depending on running down reserves.

Expenditure-reducing policies cut total spending (AD) to reduce imports; expenditure-switching policies redirect spending from imports to domestic goods. Their relative effectiveness depends on the cause of the deficit and the costs involved.

The case for expenditure-switching. A depreciation makes exports cheaper and imports dearer, improving the current account without having to cut total demand — so it avoids the output and employment loss of expenditure-reducing policy. It can correct the deficit while the economy keeps growing. Protection likewise reduces imports directly. So switching policies seem to avoid the main drawback of reducing policies.

The case against / for expenditure-reducing. Expenditure-switching has its own costs. A depreciation causes inflation (dearer imports) and only improves the current account if demand for exports/imports is price-elastic (the Marshall-Lerner condition); if demand is inelastic, it may fail or worsen the deficit (the J-curve, at least initially). Protection risks retaliation (cutting exports) and protects inefficiency. Expenditure-reducing policy, by contrast, reliably cuts imports by cutting demand and avoids inflation/retaliation, which may be necessary if the deficit stems from excess domestic demand (overheating).

Judgement. Neither is universally more effective — it depends on the cause of the deficit and the costs a government will accept. If the deficit is caused by excess demand, expenditure-reducing policy is appropriate (and avoids inflation). If the economy needs to maintain growth, expenditure-switching (a depreciation) may be better, provided demand is elastic and the inflation cost is acceptable. Crucially, both treat symptoms; a large, persistent deficit from lost competitiveness is best corrected by supply-side policy, which improves competitiveness sustainably without the costs of either. The most defensible conclusion is that expenditure-switching is preferable when maintaining demand matters and demand is elastic, expenditure-reducing when the deficit stems from excess demand, but supply-side policy is the most effective for a persistent, competitiveness-driven deficit.