Month: December 2020

A Customs Union is generally defined as a type of trade bloc which is composed of a free trade area with a common external tariff. Customs unions are established through trade pacts where the participant countries set up common external trade policy. Common competition policy is also helpful to avoid competition deficiency.

Purposes for establishing a customs union normally include increasing economic efficiency and establishing closer political and cultural ties between the member countries. It is the third stage of economic integration. Every economic union, customs and monetary union and economic and monetary union includes a customs union.

The purpose of a customs union is to make it easier for member countries to trade freely with each other. The union reduces the administrative and financial burden of barrier trading and fosters economic cooperation among nations.

However, member countries do not enjoy the liberty to form their own trade deals. The countries in the customs union usually restructure their domestic economy and economic policies in order to maximize their gain from membership in the union. The European Union is the largest customs union in the world in terms of the economic output of its members.

A customs union generates trade creation and diversion that helps with economic integration. Below are the advantages and disadvantages of customs unions.

Meaning

It avoids the problem that the free trade zone needs to be supplemented by the principle of origin to maintain the normal flow of commodities. Here, instead of the principle of origin, a common ‘foreign barrier’ is built. In this sense, the customs union is more exclusive than the free trade zone.

It makes the ‘national sovereignty’ of the member countries to be transferred to the economic integration organization to a greater extent, so that once a country joins a customs union, it loses its right to autonomous tariffs. In reality, the more typical customs union is the European Economic Community established in 1958.

Main feature

The main feature of the Customs Union is that the member countries have not only eliminated trade barriers and implemented free trade, but also established a common external tariff. In other words, in addition to agreeing to eliminate each other ‘s trade barriers, members of the Customs Union also adopt common external tariff and trade policies. GATT stipulates that if the customs union is not established immediately, but is gradually completed over a period of time, it should be completed within a reasonable period, which generally does not exceed 10 years.

Protect measures

The exclusive protection measures of the Customs Union mainly include the following:

• Reduce tariffs until the tariffs within the union are cancelled. In order to achieve this goal, the alliance often stipulates that the member countries must transition from their current external tariff rates to the unified tariff rates stipulated by the alliance in stages within a certain period of time, until finally canceling tariff.
• Formulate a unified foreign trade policy and foreign tariff rates. In terms of foreign affairs, allied members must increase or decrease their original foreign tariff rates within the prescribed time, and eventually establish a common external tariff rate; and gradually unify their foreign trade policies, such as foreign discrimination policies and import quantities.
• For goods imported from outside the alliance, common different tariffs are levied, such as preferential tax rates, agreed national tax rates, most-favored nation tax rates, ordinary preferential tax rates, and ordinary tax rates, according to the types of commodities and the provider countries.
• Formulate unified protective measures, such as import quotas, health and epidemic prevention standards, etc.

Advantages of Custom Unions

1. Increase in trade flows and economic integration

The main effect of a free-trade agreement is that it increases trade between member countries. It helps improve the allocation of scarce resources that satisfy the wants and needs of consumers and boosts foreign direct investment (FDI).

Customs unions lead to better economic integration and political cooperation between nations and the creation of a common market, monetary union, and fiscal union.

2. Trade creation and trade diversion

The effectiveness of a customs union is measured in terms of trade creation and trade diversion. Trade creation occurs when the more efficient members of the union sell to less efficient members, leading to a better allocation of resources.

Trade diversion occurs when efficient non-member countries sell fewer goods to member countries because of external tariffs. It gives less efficient countries in the union the opportunity to capitalize on their position and sell more goods within the union.

If the gains from trade creation exceed the losses from trade diversion, that leads to increased economic welfare among member countries.

3. Reduces trade deflection

One of the main reasons a customs union is favored over a free trade agreement is because the former solves the problem of trade deflection. This occurs when a non-member country sells its goods to a low-tariff FTA (free trade agreement) country, which then resells to a high-tariff FTA country, leading to trade distortions. The presence of a common external tariff in customs unions helps avoid problems that arise from tariff differentials.

Disadvantages of Customs Unions

1. Loss of economic sovereignty

Members of a customs union are required to negotiate with non-member countries and organizations such as the WTO. This is necessary to maintain a customs union; however, it also means that individual member countries are not free to negotiate their own deals.

If a country wants to protect an infant industry in its market, it is unable to do so by imposing tariffs or other protective barriers due to the liberal trading policies. Similarly, if a country wants to liberalize its trade outside the union, it is unable to do this due to the common external tariff.

2. Distribution of tariff revenues

Some countries in the union do not receive a fair share of tariff revenues. This is common among countries like the UK that trade relatively more with countries outside the union. Around 20%-25% of the tariff revenue is retained by the member who collects the revenue. It is estimated that the cost of collecting this revenue exceeds the actual revenue collected.

3. Complexity of setting the tariff rate

A common problem faced by customs unions is the complexity of setting the applicable tariff rate. The process is very costly and time-consuming. Member countries often find it hard to forgo the trade of certain goods or services because another country in the union is producing it more efficiently. The problem is usually faced by developing countries and is a major issue that the UK is dealing with during Brexit.

Economic Effects

The Customs Union started in Europe and is one of the organizational forms of economic integration. The customs union has two economic effects, static effects and dynamic effects.

Static effect

There are trade creation effects and trade diversion effects. The trade creation effect refers to the benefits generated by products from domestic production with higher production costs to the production of customs union countries with lower costs. The trade diversion effect refers to the loss incurred when a product is imported from a non-member country with lower production costs to a member country with a higher cost. This is the price of joining the customs union. When the trade creation effect is greater than the transfer effect, the combined effect of joining the Customs Union on the member countries is net profit, which means an increase in the economic welfare level of the member countries; otherwise, it is a net loss and a decline in the economic welfare level.

The trade creation effect is usually regarded as a positive effect. This is because the domestic production cost of country A is higher than the production cost of country A ‘s imports from country B. The Customs Union made Country A give up the domestic production of some commodities and change it to Country B to produce these commodities. From a worldwide perspective, this kind of production conversion improves the efficiency of resource allocation.

Dynamic effect

The customs union will not only bring static effects to member states, but also bring some dynamic effects to them. Sometimes, this dynamic effect is more important than its static effect, which has an important impact on the economic growth of member countries.

• The first dynamic effect of the customs union is the large market effect (or economies of scale effect). After the establishment of the customs union, good conditions have been created for the mutual export of products between member countries. This expansion of the market has promoted the development of enterprise production, allowing producers to continuously expand production scale, reduce costs, enjoy the benefits of economies of scale, and can further enhance the externality of enterprises within the alliance, especially for non-member company’s competitive power. Therefore, the large market effect created by the Customs Union has triggered the realization of economies of scale.
• The establishment of the Customs Union has promoted competition among enterprises among member countries. Before the member states formed a customs union, many sectors had formed domestic monopolies, and several enterprises had occupied the domestic market for a long time and obtained excessive monopoly profits. Therefore, it is not conducive to the resource allocation and technological progress of various countries. After the formation of the customs union, due to the mutual openness of the markets of various countries, enterprises of various countries face competition from similar enterprises in other member countries. As a result, in order to gain a favorable position in the competition, enterprises will inevitably increase research and development investment and continuously reduce production costs, thereby creating a strong competitive atmosphere within the alliance, improving economic efficiency, and promoting technological progress.
• The establishment of a customs union helps to attract external investment. The establishment of a customs union implies the exclusion of products from non-members. In order to counteract such adverse effects, countries outside the alliance may transfer enterprises to some countries within the customs union to directly produce and sell locally in order to bypass uniform tariff and non-tariff barriers. This objectively generates capital inflows that accompany the transfer of production, attracting large amounts of foreign direct investment.

The Economic and Monetary Union (EMU) represents a major step in the integration of EU economies. Launched in 1992, EMU involves the coordination of economic and fiscal policies, a common monetary policy, and a common currency, the euro. Whilst all 27 EU Member States take part in the economic union, some countries have taken integration further and adopted the euro. Together, these countries make up the euro area.

An economic and monetary union (EMU) is a type of trade bloc that features a combination of a common market, customs union, and monetary union. Established via a trade pact, an EMU constitutes the sixth of seven stages in the process of economic integration.

An EMU agreement usually combines a customs union with a common market. A typical EMU establishes free trade and a common external tariff throughout its jurisdiction. It is also designed to protect freedom in the movement of goods, services, and people. This arrangement is distinct from a monetary union (e.g., the Latin Monetary Union), which does not usually involve a common market. As with the economic and monetary union established among the 27 member states of the European Union (EU), an EMU may affect different parts of its jurisdiction in different ways.

Some areas are subject to separate customs regulations from other areas subject to the EMU. These various arrangements may be established in a formal agreement, or they may exist on a de facto basis. For example, not all EU member states use the Euro established by its currency union, and not all EU member states are part of the Schengen Area. Some EU members participate in both unions, and some in neither.

Territories of the United States, Australian External Territories and New Zealand territories each share a currency and, for the most part, the market of their respective mainland states. However, they are generally not part of the same customs territories.

Roles of national governments

• Control fiscal policy that concerns government budgets
• Control tax policies that determine how income is raised
• Control structural policies that determine pension systems, labor, and capital-market regulations

The decision to form an Economic and Monetary Union was taken by the European Council in the Dutch city of Maastricht in December 1991, and was later enshrined in the Treaty on European Union (the Maastricht Treaty). Economic and Monetary Union takes the EU one step further in its process of economic integration, which started in 1957 when it was founded. Economic integration brings the benefits of greater size, internal efficiency and robustness to the EU economy as a whole and to the economies of the individual Member States. This, in turn, offers opportunities for economic stability, higher growth and more employment – outcomes of direct benefit to EU citizens. In practical terms, EMU means:

• Coordination of economic policy-making between Member States
• Coordination of fiscal policies, notably through limits on government debt and deficit
• An independent monetary policy run by the European Central Bank (ECB)
• Single rules and supervision of financial Institutions within the euro area
• The single currency and the euro area

Foreign trade policy of India is very important from the viewpoint of developing economies. For example, in India, we have a strong Iron and Coal reserve, these are established industry opportunities, However, for the growth of this industry, we need to import the technical know-how from other countries who pioneer in it. Assuming that we as a country, did not have a foreign trade policy, then it would become both, a daunting task and an expensive effort.

Another area which would bring our country to a standstill is the inability to fulfil the demands of the petroleum products. An absence of a foreign trade policy would massively hinder the economic development of our country.

Appropriate Distribution of labor: Through the Foreign trade policy, a country can create a division of expertise and specialization over a global platform. It assists in producing commodities at a lesser cost, so assume a country has huge natural resources, it can outsource the labor, which means export raw material and import finished goods to countries which have skilled labor. Thus they reduce the cost of production.

Stable Pricing: With the help of Foreign trade policy a country can lead to equality of pricing, to ensure a stable demand and supply situation. A foreign trade policy also enables us to import certain products at the time of a natural calamity when demand is high, this ensures the scarcity is managed without taxing the end consumer.

Consumer Advantage: By proving better quality and quantity of goods. It also assists in raising the standard of living especially for underdeveloped countries.

• It makes full use of natural resources. If some resourcesare in surplus in a country then by foreign trade it can be sold in those countries from where it gets its highest price.
• As a foreign trade we can get cheap and quality goods from other countries.
• It promotes cultural cooperation and mutual confidence among the people of different countries.
• This is the most important source of foreign exchange.
• By imposing the import and export duties government earns revenue.

There are many factors contributing to this, the present trade policies, economic reforms, also India’s intrinsic strengths are most sought after in the global space. The country is also promoting infrastructure and technological developments, which are promising for the economic sector in the years to come. With the forthcoming foreign trade policy, our exports are expected to reach US$ 1000 billion by the year 2022-2023.

Changes in Income and Balance of Payments Adjustment:

Just as the exchange rate and price changes can influence the balance of payments situation of a country, the variations in income too can affect balance of payments disequilibrium in a very significant way.

Given the domestic price level and exchange rate, higher incomes at home tend to raise the imports, while the higher incomes abroad result in an increase in the volume of exports of the country. Thus, an improvement in the balance of payments deficit can be affected either through a contraction in domestic income or an expansion in incomes in foreign countries.

In an open economic system, the income- expenditure identity can be stated as:

Y ≡ C_d + I_d + X_d ….(i)

The subscript d in the equation denotes production out of domestic resources. The income in an open economy can also be visualised as the sum of consumption of domestic goods (C_d), the amount spent on imports (M) and the saving (S).

Y ≡ C_d + M + S ….(ii)

From (i) and (ii) we get-

C_d + I_d + X_d ≡ C_d + M + S

Or I_d + X_d ≡ M + S

Or X_d – M ≡ S – I_d

Assuming that exports and investment are autonomous and imports and saving are the direct functions of income, the impact of income changes upon the balance of payments can be shown through Fig. 21.12.

Initially, the equilibrium determined by the intersection between (X_d – M) and (S – I_d) function is at Y₀ level of income with the balance of payments deficit equal to OB. A fall in the level of income from Y₀ to Y₁ will bring about a decline in the amount of saving.

Consequently, (S – I_d) function will shift to the left and the equilibrium between (X_d – M) and (S – I_d)’ takes place at Y₁ lower level of income where the payments deficit has completely disappeared. Thus the appropriate changes in income can ensure an improvement in the balance of payments situation of a country.

Balance of Payments Adjustment through Capital Movements:

The international capital movements can significantly influence the balance of payments situation of a country. Kindelberger has made a distinction between the short-term and long-term capital movements.

According to him, “A capital movement is short term, if it is embodied in a credit instrument of less than a year’s maturity. If the instrument has a duration of more than a year or consists of a title to ownership, such as a share or stock or a deed to property, the capital movement is long term.” But the distinction, according to instrument, does not really indicate whether a capital movement is temporary or quasi- permanent.

The European speculators in the New York Stock Market in the 1920’s used the instruments of long-term investment equity shares in companies but these demonstrated a high rate of turnover and only a brief loss of liquidity.

Similarly, a European central bank that buys United States government bonds rather than short term bills is still holding monetary reserves and not making a real long-term investment. The short- term instruments are typically the Central Bank deposits, commercial bank deposits, bills, acceptances, overdrafts, open book credit, and even bank notes.

Under the nineteenth century gold standard, the rate of interest caused the movement of short- term capital and played a considerable part in bringing about adjustment in the balance of payments. During the inter-war period, however, the short term capital movements came to be regarded as a menace to the international stability rather than as an instrument of adjustment.

Under the conditions similar to those which prevailed during that period, the import surplus leads to capital outflow and increased loss of reserves rather than to the inflow which can finance the balance of payments on current account. Conversely, an export surplus, through a rising exchange rate and reduced rate of interest, leads not to the off-setting capital outflow, but to a capital inflow that brings about an embarrassing addition to gold and exchange reserves, excess banking reserves and monetary super-abundance.

The short-term capital movements cannot resolve the balance of payments difficulties. They can only provide a temporary relief. But even such relief is extremely useful since it provides a cushion; while the changes that can provide a permanent remedy are brought about. The long term capital includes bonds, bank loans and direct investments. The movements of long term capital of a normal character are required to achieve the long term balance of payments equilibrium.

A young debtor country borrows; imports more than it exports ; maintains a foreign exchange rate over-valued in terms of static equilibrium and has too high a level of national money income ; too large a money supply, too much investment in relation to domestic saving, too high prices, too low a rate of interest.

The equilibrium in respect of international payments requires that the capital movements take the form and direction which are appropriate to time period. If a young borrowing country borrows short-term capital and adjusts to the flow as if it were a long-term capital movement, the national income, foreign exchange rate and other variables may be in equilibrium except the balance of payments.

In this situation, imports exceed exports and domestic investment is larger than savings by this amount. If long-term capital movements are called for but only short-term capital is available, the dynamic balance of payments equilibrium cannot be achieved. Such an equilibrium is possible, if the balance of trade deficit is bridged up by an appropriate inflow of autonomous long-term capital.

Domestic Price Changes and Balance of Payments Adjustment:

In the analysis concerning the changes in exchange rates, we took an over-simplified assumption that the home prices of depreciating country’s exports and foreign prices of her imports do not undergo changes as a result of depreciation.

In fact depreciation or devaluation amounts to the lowering of the domestic price level relative to the foreign level. It is actually such changes in the relative price level at home and abroad that cause, in a large or small measure, an increase in exports and a contraction in imports.

Similar changes can definitely be effected through the differential rates of absolute price changes at home and abroad, while maintaining the foreign exchange rate stable. A decline in the domestic price level to the extent of, say 10 percent, the exchange rate remaining unchanged, has the same effect as the devaluation of the home currency vis-a-vis foreign currencies by 10 percent.

It, however, does not mean that devaluation and internal deflation have exactly similar effects in other respects too. The two are certainly different in their effects upon the economic system in the short and long periods. The intensity of their impact upon the general economic activity within the economy is likely to be vastly different.

The degree by which changes in absolute domestic price level can be successful in reducing the balance of payments deficit is contingent upon the elasticities of demand for imports at home and abroad. With the fall in the prices of export goods, given an elastic demand for imports of these products in foreign countries, the increase in exports will be relatively large. The increased receipts now available from exports will tend to improve the payments deficit.

A fall in the internal price level vis-a-vis price level abroad leads invariably to some decline in imports which by reducing the demand for foreign exchange also contributes in the reduction of payments deficit. But the extent to which internal deflation lowers the demand for foreign products depends upon the cross elasticity of demand between the foreign and the domestic products. Greater this elasticity co­efficient, more sizeable will be the contraction in imports and vice-versa.

Balance of Payments Adjustment through Expenditure Policies:

A deficit in the balance of payments entails an excess of expenditure over income. In order to correct it, there is a need to equalise the two.

Two types of policies concerning expenditure can be adopted to this end:

(a) Expenditure-reduction policies; and

(b) Expenditure-switching policies.

(a) Expenditure-Reduction Policies:

A policy of expenditure-reduction or a reduction in aggregate demand can be implemented through taxes or higher interest rates. As the expenditure is lowered, a part of reduction in expenditure affects the domestic production. This brings multiplier in operation, through which the expenditure and output get further reduced.

A policy of expenditure-reduction can have both direct and induced effects. The direct effect of such policies is favourable. The induced effect through lower output and consequently lower expenditure, however, will be unfavourable so long as a reduction in income reduces expenditure by a smaller amount, that is, if the marginal propensity to spend is less than one. Greater the initial reduction in expenditure falls on imports, smaller will be adverse effect of such policies.

Thus, so long as the marginal propensity to spend is less than unity, the net effect of an expenditure-reduction policy will be an improvement in the balance of payments deficit.

The expenditure reduction policies may include:

(i) Expenditure reducing monetary policy which is comprised of reduction in the supply of money and credit and increase in interest rates.

(ii) Expenditure reducing fiscal policy which is comprised of reduced government spending and increase in taxes.

As the central bank restricts money supply and raises interest rates, there is reduction in investment and income. It leads to a fall in aggregate demand for imported goods. A higher structure of interest rates also induces inflow of capital from abroad and restricts outflow of capital from the home country. Thus the expenditure-reduction monetary policy can result in the off-setting of BOP deficit.

The elimination of BOP deficit may also be brought through reduced government expenditure on imports and increase in import duties and other taxes lowering the aggregate demand. The restrictive fiscal policy will cause a decline in investment and consequent decline also in income and aggregate demand. Thus expenditure reducing fiscal policies will remove the deficit in the international payments.

The effect of expenditure reducing monetary and fiscal policy on BOP deficit is explained through Figs. 21.13 and 21.14.

In Fig. 21.13, given originally IS₀ and LM₀ functions, the equilibrium income is Y₀ and rate of interest is r₀. B = 0 is the balance of payments line. The equilibrium takes place below the BOP line signifying the BOP deficit.

The adoption of expenditure reducing monetary policy including reduction in the supply of money and increase in interest rates causes the shift in LM function to LM₁. The equilibrium between IS₀ and LM₁ takes place exactly at the balance of payments line with lower income Y₀ and higher rule of interest r₀.

In Fig. 21.14, IS₀ and LM₀ determine originally the equilibrium income Y₀ and rate of interest r₀. The equilibrium takes place below the BOP line (B = 0) indicating deficit in the BOP. The government follows the policies of expenditure reduction and higher taxes.

Consequently, the IS function shifts to the left to IS₁. The intersection of IS₁ and LM₀ takes place exactly at the balance of payments line (B = 0). Thus the BOP deficit gets removed and the new equilibrium takes place at the lower level of income Y₁.

In this connection, two further points should also be made. Firstly, an expenditure reduction, by reducing the country’s imports, will bring about multiple reduction in incomes abroad which in turn will reduce the foreign spending on the country’s exports.

As a result, the domestic output will decline. This is generally known as repercussion effect. It was analysed by F. Machlup in his work, International Trade and the National Income Multiplier. Secondly, the reduction in expenditure and output may bring down the domestic price level. It may cause a switch of spending between the foreign and domestic goods.

(b) Expenditure-Switching Policies:

The policy of switching expenditure away from the foreign produced goods towards the home produced goods will have the effect of raising the level of domestic production. So long as the marginal propensity to spend is less than unity, it will bring about an improvement in the payments deficit.

We can make a distinction between two types of expenditure-switching policies. One is devaluation, which by making the country’s goods relatively cheaper compared with foreign goods, will tend to switch both domestic and foreign expenditures towards the home-produced goods.

The other is the use of import restrictions, which tends to divert the spending of domestic consumers, now unable to buy foreign-produced goods, towards the home-produced substitutes of foreign products. The controls may also be imposed sometimes to stimulate exports or, in other words, to induce the foreigners to switch their spending towards domestic output.

Whatever is the expenditure-switching policy, the aim always is to raise the demand for domestic output. This poses the questions- wherefrom will come the additional output to meet the requirements of additional demand? This problem can be investigated in relation to three possible cases.

The first is the case in which domestic economy is afflicted by wide-spread unemployment. In such a case, a switch of demand towards home-produced goods will ensure an increase in domestic output and income through the increased utilization of unemployed resources.

The second case is one in which, there is a state of full employment in the economy and the policy of expenditure-switching is backed by a policy of reducing the aggregate demand. This combination of policies can ensure the balance of payments equilibrium without sacrificing full employment.

However, a policy of reduction in aggregate demand can result in unemployment at home. In that case, the accompanying policy of switch of expenditure from foreign-produced goods to home-produced goods is employed to remove any such possibility of unemployment.

The third case is one in which the expenditure- switching policy is adopted in a state of full employment. In this case, the switch policy is not supplemented by the expenditure-reducing policy and, therefore, the inflationary consequences will follow.

Balance of Payments Adjustment through Capital Movements:

The international capital movements can significantly influence the balance of payments situation of a country. Kindelberger has made a distinction between the short-term and long-term capital movements.

According to him, “A capital movement is short term, if it is embodied in a credit instrument of less than a year’s maturity. If the instrument has a duration of more than a year or consists of a title to ownership, such as a share or stock or a deed to property, the capital movement is long term.” But the distinction, according to instrument, does not really indicate whether a capital movement is temporary or quasi- permanent.

The European speculators in the New York Stock Market in the 1920’s used the instruments of long term investment equity shares in companies but these demonstrated a high rate of turnover and only a brief loss of liquidity.

Similarly a European central bank that buys United States government bonds rather than short term bills is still holding monetary reserves and not making a real long-term investment. The short- term instruments are typically the Central Bank deposits, commercial bank deposits, bills, acceptances, overdrafts, open book credit, and even bank notes.

Under the nineteenth century gold standard, the rate of interest caused the movement of short- term capital and played a considerable part in bringing about adjustment in the balance of payments. During the inter-war period, however, the short term capital movements came to be regarded as a menace to the international stability rather than as an instrument of adjustment.

Under the conditions similar to those which prevailed during that period, the import surplus leads to capital outflow and increased loss of reserves rather than to the inflow which can finance the balance of payments on current account. Conversely, an export surplus, through a rising exchange rate and reduced rate of interest, leads not to the off-setting capital outflow, but to a capital inflow that brings about an embarrassing addition to gold and exchange reserves, excess banking reserves and monetary super-abundance.

The short-term capital movements cannot resolve the balance of payments difficulties. They can only provide a temporary relief. But even such relief is extremely useful since it provides a cushion; while the changes that can provide a permanent remedy are brought about. The long term capital includes bonds, bank loans and direct investments. The movements of long term capital of a normal character are required to achieve the long term balance of payments equilibrium.

A young debtor country borrows; imports more than it exports ; maintains a foreign exchange rate over-valued in terms of static equilibrium and has too high a level of national money income ; too large a money supply, too much investment in relation to domestic saving, too high prices, too low a rate of interest.

The equilibrium in respect of international payments requires that the capital movements take the form and direction which are appropriate to time period. If a young borrowing country borrows short-term capital and adjusts to the flow as if it were a long-term capital movement, the national income, foreign exchange rate and other variables may be in equilibrium except the balance of payments.

In this situation, imports exceed exports and domestic investment is larger than savings by this amount. If long-term capital movements are called for but only short-term capital is available, the dynamic balance of payments equilibrium cannot be achieved. Such an equilibrium is possible, if the balance of trade deficit is bridged up by an appropriate inflow of autonomous long-term capital.

Balance of Payments Adjustment through Controls:

The improvement in the balance of payments deficit may be effected through controls which can be classified under two heads financial controls and commercial controls. According to H.G. Johnson, “Financial controls operate through control over the use of money, by restricting the freedom of use of domestic money either through regulation of certain uses (as in the case of multiple exchange rates) or by making some uses of money more expensive than others. Commercial controls, on the other hand, operate on the goods side of transactions by preventing people from buying certain goods or forcing them to buy others, or providing financial incentives (tariffs, subsidies) for certain kinds of sales or purchases.”

Whatever the character of controls and whether these are applied to exports or imports, their major effect is to create a divergence between the internal and external values of commodities. While export restrictions reduce the internal values of goods relatively to the external values, import restraints act in the opposite manner.As compared with devaluation, controls raise two important questions. The first is concerned with the effectiveness of controls in increasing net foreign exchange earnings.

H.G. Johnson evaluates the relative effectiveness of the two in the following words, “Roughly we can think of devaluation as being the equivalent of an import duty and an export subsidy and an import duty is bound to save foreign exchange, whereas an export subsidy will save foreign exchange or not according to whether the elasticity of demand for the country’s exports is greater or less than one. Thus an import duty by itself will only save foreign exchange to a lesser extent than devaluation, if an export subsidy would actually reduce the country’s earnings from exports that is, if the foreign elasticity of demand for exports were less than unity, the country should of course restrict rather than encourage exports. An export subsidy by itself would always be worse than a devaluation, since it would fail to obtain the necessarily favourable effect of devaluation in reducing the amount spent on imports.”

The second question is concerned with the welfare implication of controls versus devaluation. The choice between the two, H.G. Johnson holds, depends on the relation between the existing degree of controls and the optimum degree of trade restraints. In a situation when a country has unexploited monopoly or monopsony power, it stands to be benefitted through the exploitation of this power and through further trade restrictions.

If the restrictions have already been carried beyond the optimum level, the benefit will accrue through the liberalisation of trade restrictions. The controls can also provoke the retaliation from other countries which may nullify any beneficial effect of such controls either upon the balance of payments or upon the welfare of the community.

Considering retaliatory trade restrictions completely futile, H.G. Johnson records “….it is obvious that it will never pay two countries to have trade barriers against each other. Such barriers could always be cleared down to a barrier on the part of one country only, to the benefit of both, and possibly they could be completely eliminated. If international income transfers were possible, freedom of trade could always be more beneficial than the preservation of barriers.”

To sum up, an appropriate blend of all the measures can ensure improvement in the balance of payments situation of a country.

(i) Economic Factors:

(a) Imbalance between exports and imports. (It is the main cause of disequilibrium in BOR)

(b) Large scale development expenditure which causes large imports

(c) High domestic prices which lead to imports

(d) Cyclical fluctuations (like recession or depression) in general business activity

(e) New sources of supply and new substitutes.

(ii) Political Factors:

Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.

(iii) Social Factors:

(a) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports; (b) High population growth in poor countries adversely affects their BOP because it increases the needs of the countries for imports and decreases their capacity to export.

Measures to correct disequilibrium in BOP:

Sustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve of foreign exchange and gold.

(i) Export promotion:

Exports should be encouraged by granting various bounties to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs.

(ii) Import:

Restrictions and Import Substitution are other measures of correcting disequilibrium.

(iii) Reducing inflation:

Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore, government should check inflation and lower the prices in the country.

(iv) Exchange control:

Government should control foreign exchange by ordering all exporters to surrender their foreign exchange to the central bank and then ration out among licensed importers.

(v) Devaluation of domestic currency:

It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level.

(vi) Depreciation:

Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)