An Analogy
Let us take an analogy of 2 people A and B (the only two people in the macro-universe).
A has been buying an item from B and in return has been handing out an “IOU”. A has however reached a point where B refuses to give him anything until debts are paid.
The only possibility A now has is to work to produce an item and sell it to B. A portion of the sale price will be discounted to recover the earlier debts.
When you replace people, debts, items and discount by words like country, sovereign debts, exports and exchange rate we have articulated the core (albeit oversimplified) of a balance of payment crisis.
The Crisis
A Balance of Payment (BOP) Crisis can be termed as one of the oldest crisis in the book (more than 80 episodes in last 35 years). It would seem almost foolish to say that we have not perfected a mechanism to deal with it
Eco-101 states that trade balance (exports minus imports) + Capital balance (net foreign capital flows) is zero. i e BOP is zero.
So a country with a trade deficit (net imports) will bring an equal amount of capital surplus (inflow) to fund it. And a country with a trade surplus (net exports) will have an equal amount of capital deficit (outflow)
A typical BOP crisis can broadly happen in two ways
- Current account crisis: In a Non-liberalized economy like the pre 1990 India there is a trade deficit. The government has to finance this deficit with Foreign exchange reserves. This goes on until there is no reserve to pay for basic imports. This is a relatively archaic model, because of the increasingly globalized nature of economies.
- Capital Account Crisis: A more common model is what happened with Mexico, Asian tigers. Mexico was a running a trade deficit that was financed by foreign investor inflows. A series of political events reduced foreign investor faith in the economy. This should have caused the peso to depreciate. The Central bank tried to fix the exchange rate by using reserves. However the day the reserves depleted the peso devalued.
In the second model, the money coming in as capital flows can come to the private sector (Asian tigers) or to government (Greece). In South East Asia it was the banks that were taking commercial dollar loans and lending locally, whereas in Greece the deficit was funded by issuing government bonds.
The reversal of the capital can be because of unsustainable government deficits, political events, bad governance etc. Anything that causes foreign investors to lose faith in the economy can cause capital inflow to dry up. This depletion is typically followed by an asset bubble bursting and/or banking crisis.
While in the short term there is some value in providing succor through capital support (IMF funding), the long term route out of a BOP is the devaluation of currency and moving to a trade surplus. This means the goods of the debtor country become cheap and it starts paying off debt (think analogy)
Special cases happening together
Euro zone: There is an internal BOP crisis. The peripherals have been running trade deficits primarily financed by the capital inflows from core. Greek Tragedy
.
The debts of the periphery have become unsustainable and like in a Capital Account Crisis (version 2 of BOP crisis) there is no more capital flowing to these countries. However they are a part of the same currency union and cannot devalue.
The proposed methods a
- Internal exchange rate devaluation: If the periphery discounts wages and consequently prices (think analogy), they can become export competitive. However such a labor market reform will not only be politically untenable but also cause a GDP implosion. This means that Debt to GDP will still remain very high.
- Printing: The other possibility is to monetize debts which will cause domestic inflation. Inflation can help erode the value of the debts and also stimulate consumption in Germany. This will also have the effect of depreciating the Euro which can be beneficial for peripherals. This solution is a curious mixture of the creditors (Germany) forgiving a portion of the debt through inflation and Peripherals selling their goods at a discount through devaluation (think analogy).
- Greece moves out of the Euro and the drachma depreciates to help them export their way to a surplus. This is the most complicated and has many ramifications. How will other Euro investors behave? What will happen to existing contracts in Euro? Can a country making Drachma pay-of Euro denominated debts?
Triffins dilemma: the same BOP exists between US and ROW. A consistent trade deficit has been financed by the surplus capital from China (T-bill inflow). Now the debts look unsustainable. Triffin had predicted this after Bretton woods agreement (link to gold). The world can only expand as long as US runs trade deficit to supply dollars.
Now the rebalancing (Think analogy) is nothing but devaluation of dollar and US becoming a surplus country. The devaluation can happen only if they are no longer viewed as a reserve currency. This can lead to high temporary inflation. Sophies Choice.