CHAPTER FOUR

INTERNATIONAL TRADE
What is Trade?

Trade refers to buying and selling of goods and services for money or money's worth. It
involves transfer or exchange of goods and services for money or money's worth. The
manufacturers or producer produces the goods, then moves on to the wholesaler, then to retailer
and finally to the ultimate consumer.

Trade is essential for satisfaction of human wants, Trade is conducted not only for the sake of
earning profit; it also provides service to the consumers. Trade is an important social activity
because the society needs uninterrupted supply of goods forever increasing and ever changing
but never ending human wants. Trade has taken birth with the beginning of human life and shall
continue as long as human life exists on the earth. It enhances the standard of living of
consumers. Thus we can say that trade is a very important social activity.
Different Types of Trade

Trade can be divided into following two types: Internal or Home or Domestic trade and
External or Foreign or International trade

1. Internal Trade

Internal trade is also known as Home trade. It is conducted within the political and geographical
boundaries of a country. It can be at local level, regional level or national level. Hence trade
carried on among traders of Bamenda, Douala, etc. is called home trade.

Internal trade can be further sub-divided into two groups:

Wholesale Trade: It involves buying in large quantities from producers or manufacturers and
selling in lots to retailers for resale to consumers. The wholesaler is a link between
manufacturer and retailer. A wholesaler occupies prominent position since manufacturers as
well as retailers both are dependent upon him. Wholesaler act as a intermediary between
producers and retailers.

Retail Trade: It involves buying in smaller lots from the wholesalers and selling in very small
quantities to the consumers for personal use. The retailer is the last link in the chain of
distribution. He establishes a link between wholesalers and consumers. There are different
types of retailers small as well as large. Small scale retailers includes hawkers, pedlars, general
shops, etc.

2. External Trade

External trade also called as Foreign trade. It refers to buying and selling between two or more
countries. For instance, If Mr.X who is a trader from Yaounde, sells his goods to Mr.Y another
trader from New York then this is an example of foreign trade.

External trade can be further sub-divided into three groups, viz.,

Export Trade: When a trader from home country sells his goods to a trader located in another
country, it is called export trade. For e.g. a trader from India sells his goods to a trader located
in China.

Import Trade: When a trader in home country obtains or purchase goods from a trader located
in another country, it is called import trade. For e.g. a trader from India purchase goods from a
trader located in China.

Entrepot Trade: When goods are imported from one country and then re-exported after doing
some processing, it is called entrepot trade. In brief, it can be also called as re-export of
processed imported goods. For e.g. an indian trader (from India) purchase some raw material or
spare parts from a japanese trader (from Japan), then assembles it i.e. convert into finished
goods and then re-export to an american trader (in U.S.A).

Need and Importance of Foreign Trade

Following points explain the need and importance of foreign trade to a nation.

1. Division of labour and specialization: Foreign trade leads to division of labour and
specialisation at the world level. Some countries have abundant natural resources. They should
export raw materials and import finished goods from countries which are advanced in skilled
manpower. This gives benefits to all the countries and thereby leading to division of labour and
specialization.

2. Optimum allocation and utilization of resources: Due to specialization, unproductive lines

can be eliminated and wastage of resources avoided. In other words, resources are channelized
for the production of only those goods which would give highest returns. Thus there is rational
allocation and utilization of resources at the international level due to foreign trade.

3. Equality of prices: Prices can be stabilized by foreign trade. It helps to keep the demand and
supply position stable, which in turn stabilizes the prices, making allowances for transport and
other marketing expenses.

4. Availability of multiple choices: Foreign trade helps in providing a better choice to the
consumers. It helps in making available new varieties to consumers all over the world.

5. Ensures quality and standard goods: Foreign trade is highly competitive. To maintain and
increase the demand for goods, the exporting countries have to keep up the quality of goods.
Thus quality and standardized goods are produced.

6. Raises standard of living of the people: Imports can facilitate standard of living of the people.
This is because people can have a choice of new and better varieties of goods and services. By
consuming new and better varieties of goods, people can improve their standard of living.

7. Generate employment opportunities: Foreign trade helps in generating employment

opportunities, by increasing the mobility of labour and resources. It generates direct
employment in import sector and indirect employment in other sector of the economy. Such as
Industry, Service Sector (insurance, banking, transport, communication), etc.

8. Facilitate economic development: Imports facilitate economic development of a nation. This

is because with the import of capital goods and technology, a country can generate growth in all
sectors of the economy, i.e. agriculture, industry and service sector.
9. Assistance during natural calamities: During natural calamities such as earthquakes, floods,
famines, etc., the affected countries face the problem of shortage of essential goods. Foreign
trade enables a country to import food grains and medicines from other countries to help the
affected people.

10. Maintains balance of payment position: Every country has to maintain its balance of
payment position. Since, every country has to import, which results in outflow of foreign
exchange, it also deals in export for the inflow of foreign exchange.

11. Brings reputation and helps earn goodwill: A country which is involved in exports earns
goodwill in the international market. For e.g. Japan has earned a lot of goodwill in foreign
markets due to its exports of quality electronic goods.

12. Promotes World Peace: Foreign trade brings countries closer. It facilitates transfer of
technology and other assistance from developed countries to developing countries. It brings
different countries closer due to economic relations arising out of trade agreements. Thus,
foreign trade creates a friendly atmosphere for avoiding wars and conflicts. It promotes world
peace as such countries try to maintain friendly relations among themselves.

Reasons for International Trade

No matter how attractive and ‘must have’ your product or service seems to be, a strictly
limiting yourself to your domestic market will have a finite capacity. And once you have
reached saturation point, what then? Because of these limitations wise business owners are
looking to go global and exploit the many international trade opportunities after all, in the
global economy; practically every country is a potential customer.

Here are seven reasons for international trade:

1- Reduced dependence on your local market: Your home market may be struggling due to
economic pressures, but if you go global, you will have immediate access to a practically
unlimited range of customers in areas where there is more money available to spend, and
because different cultures have different wants and needs, you can diversify your product range
to take advantage of these differences.

2- Increased chances of success: Unless you’ve got your pricing wrong, the higher the volume
of products you sell, the more profit you make, and overseas trade is an obvious way to increase
sales. In support of this, UK Trade and Investment (UKTI) claim that companies who go
global are 12% more likely to survive and excel than those who choose not to export.

3- Increased efficiency: Benefit from the economies of scale that the export of your goods can
bring – go global and profitably use up any excess capacity in your business, smoothing the
load and avoiding the seasonal peaks and troughs that are the bane of the production manager’s
life.

4- Increased productivity: Statistics from UK Trade and Investment (UKTI) state that
companies involved in overseas trade can improve their productivity by 34% – imagine that,
over a third more with no increase in plant.

5- Economic advantage: Take advantage of currency fluctuations – export when the value of
the pound sterling is low against other currencies, and reap the very real benefits. Words of
warning though; watch out for import tariffs in the country you are exporting to, and keep an
eye on the value of sterling. You don’t want to be caught out by any sudden upsurge in the
value of the pound, or you could lose all the profit you have worked so hard to gain.

6- Innovation: Because you are exporting to a wider range of customers, you will also gain a
wider range of feedback about your products, and this can lead to real benefits. In fact, UKTI
statistics show that businesses believe that exporting leads to innovation – increases in break-
through product development to solve problems and meet the needs of the wider customer base.
53% of businesses they spoke to said that a new product or service has evolved because of
their overseas trade.
7- Growth: The holy grail for any business, and something that has been lacking for a long
time in our manufacturing industries – more overseas trade = increased growth opportunities, to
benefit both your business and our economy as a whole.

International Trade Theories

For the success of business, it is important to understand all the key types of international trade
theories. The concept of international trading is not limited to, just sending and receiving
products and services and putting all of the profits in the pockets. Instead, it’s a lot more
complicated thing. In fact, its current shape is the result of many different types of international
trade theories that helped it in its evolution through various eras. Honestly saying, apart from
making your syllabus boring, these theories can be of great assist in the long run since most
parts of these ideas still, hold right. So in this article, we will go through each and every theory
and will provide you with a somewhat in-depth detail of these.

Types of International Trade Theories

The different types of international trade theories, which are presented by the various authors in
between 1630 and 1990:

1. Mercantilism

The oldest of all international trade theories, Mercantilism, dates back to 1630. At that time,
Thomas Mun stated that the economic strength of any country depends on the amounts of silver
and gold holdings. Greater are the holdings, more economically independent a country is.
Furthermore, the idea of favoring greater exports and promoting efforts to minimize imports
also belongs to the same theory. Well! The thinking behind this concept is evident since you
pay for the imports from the pay that you get from exports. So, if you a country has a lot to pay
for the imported products then it will get from exported products, its economy will get inclined
towards declination. Even though the view is old but the roots of modern thinking towards the
financials is deeply embedded in it.
 2. Absolute Advantage

The Theory of Absolute Advantage is based on the notion of increasing the efficiencies in the
production processes. In 1776, Adam Smith, a renowned financial expert of the time being,
proposed the theory that the manufacturing a product with high efficiency as compared to any
other country on the globe is highly advantageous. The concept can just be understood by the
idea that if two countries specialize in exactly same kind of product. But the product of one
country being better in quality or lower in price will bring tremendous absolute advantage to the
country as compared to the other one. From another point of view, if two countries specialize in
entirely different products, then they can quickly increase their influence in their localities by
having trade with each other (by creating absolute advantages at both ends).

3. Comparative Advantage

As compared to absolute advantage, Comparative Advantage favors relative productivity.

According to this concept, as put forward by David Ricardo in 1817, a country with maximum
absolute advantage in the creation of more than one product as compared to other, can still trade
with another country with less efficient ways to create that product, that’s readily available in
first, to boost its productivity. To illustrate this idea with an example, let’s say that I have
expertise in two fields like graphics designing and writing, where designing lets me earn a lot
more than writing. Keeping in mind that I can work on only one side at a time, I will most
likely hire a writer, and we both will work in a comparative atmosphere.

4. Heckscher-Ohlin Theory

Both the Absolute as well as Comparative international trade theories assume that the choice of
the product that can prove itself to be of great advantage is led by free and open markets instead
of using the resources available inland. That’s what caused Bertil Ohlin and Eli Heckscher to
put forward the idea of determination of the prices that relies on the differences in supply and
demands. This can just be understood as, if the supply of a product grows greater than it is in
demand in the market, its price falls and vice versa. So, export of a country should mainly
consist of the product that is abundantly available in it, and imports should count the products
that are in high demand. Since, this concept ensures utilization the country’s factors like labor,
land and funding sources for the purpose of product manufacturing that’s why it is also known
by the name of “factor proportion theory.”

5. Product Life Cycle Theory

In the 1970s, Raymond Vernon introduced the notion of using a product’s life cycle to explain
global trade patterns, in the field of marketing. According to theory, as the demand for a newly
created product grows, the home country starts exporting it to other nations. Where when the
demand grows, local manufacturing plants are opened to meet the request. And the scenario
covers the whole globe time to time, thus making that product a standardization. You can take
the example of computers in consideration to understand how this works. The earlier personal
computers appeared in 1970’s available only in a few countries and from 1980’s to 1990’s, the
product was moving through the stage of maturity where the production spread to many other
nations. And now in 21st century, every third house has a PC in it.

6. Global Strategic Rivalry Theory

The continuous evolutionary behavior of international trade theories brings us back in the
1980’s where Kalvin Lancaster and Paul Krugman introduced the concept of strategies,
based on global level rivalries, targeting multinational corporations and the struggle needed in
achieving higher advantages as compared to other international companies. According to the
concept, a new firm needs to optimize a few factors that will lead the brand in overcoming all
the barriers to success and gaining an influential recognition in that global market. In all these
factors, a thorough research and timed developmental steps are crucial. Whereas, having the
complete ownership rights of intellectual properties is also necessary. Furthermore, the
introduction of unique and useful methods for manufacturing as well as controlling the access
to raw material will also come handy in the way.

7. National Competitive Advantage Theory

Michael Porter in 1990’s suggested that the success of any business in international trade
depends on upgradable and innovational capacities of the industry as well as four other factors,
which determine how that firm is going to perform in this global level race. The main concept
behind this theory gives the feel of holding factor proportion as well as many other international
trade theories in it. One of those factors is the availability of resources in the local market and
their prices which are necessary for providing a sustainable and stable environment for the trade
to grow. Moreover, the ability of the firm to face competitors and its capacity to upgrade itself
also determines the success rate of that brand. Furthermore, keeping the track of the change in
demand and the behavior of local suppliers is also important.

Trade protectionism

Trade protection is the deliberate attempt to limit imports or promote exports by putting up
barriers to trade. Despite the arguments in favour of free trade and increasing trade openness,
protectionism is still widely practiced.

The motives for protection

The main arguments for protection are:

Protect sunrise industries: Barriers to trade can be used to protect sunrise industries, also
known as infant industries, such as those involving new technologies. This gives new firms the
chance to develop, grow, and become globally competitive. Protection of domestic industries
may allow they to develop a comparative advantage. For example, domestic firms may expand
when protected from competition and benefit from economies of scale. As firms grow they may
invest in real and human capital and develop new capabilities and skills. Once these skills and
capabilities are developed there is less need for trade protection, and barriers may be eventually
removed.

Protect sunset industries: At the other end of scale are sunset industries, also known as
declining industries, which might need some support to enable them to decline slowly, and
avoid some of the negative effects of such decline. For the UK, each generation throws up its
own declining industries, such as ship building in the 1950s, car production in the 1970s, and
steel production in the 1990s.

Protect strategic industries: Barriers may also be erected to protect strategic industries, such
as energy, water, steel, armaments, and food. The implicit aim of the EUs Common
Agricultural Policy is to create food security for Europe by protecting its agricultural sector.

Protect non-renewable resources: Non-renewable resources, including oil, are regarded as a

special case where the normal rules of free trade are often abandoned. For countries aiming to
rely on oil exports lasting into the long term, such as the oil-rich Middle Eastern economies,
limiting output in the short term through production quotas is one method employed to
conserve resources.

Deter unfair competition: Barriers may be erected to deter unfair competition, such as
dumping by foreign firms at prices below cost.

Save jobs: Protecting an industry may, in the short run, protect jobs, though in the long run it is
unlikely that jobs can be protected indefinitely.

Help the environment: Some countries may protect themselves from trade to help limit
damage to their environment, such as that arising from CO2 emissions caused by increased
production and transportation.
Limit over-specialization: Many economists point to the dangers of over-specialization, which
might occur as a result of taking the theory of comparative advantage to its extreme. Retaining
some self-sufficiency is seen as a sensible economic strategy given the risks of global
downturns, and an over-reliance on international trade. In addition to the economic arguments
for protection, some protection may be for political reasons.

Terms of trade

A country’s terms of trade measures a country’s export prices in relation to its import prices,
and is expressed as:

For example, if, over a given period, the index of export prices rises by 10% and the index of
import prices rises by 5%, the terms of trade are:

110 x 100 / 105 = 104.8.

This means that the terms of trade have improved by 4.8%. When the terms of trade rise above
100 they are said to be improving and when they fall below 100 they are said to be worsening.
The terms of trade can also be expressed in terms of the number 1, with figures above 1
indicating an improvement, and those below 1 a worsening. This is shown in the chart below.

Improving terms of trade

If a country's terms of trade improve, it means that for every unit of exports sold it can buy
more units of imported goods. So potentially, a rise in the terms of trade creates a benefit in
terms of how many goods need to be exported to buy a given amount of imports. It can also
have a beneficial effect on domestic cost-push inflation as an improvement indicates falling
import prices relative to export prices. However, countries may suffer in terms of falling export
volumes and a worsening balance of payments.

Balance of Trade

The balance of trade compares the value of a country's exports of goods and services against
its imports. When exports are greater than imports, that's a trade surplus. Most nations view that
as a favorable trade balance. The opposite, when the value of imports outweighs the value of
exports, is a trade deficit. Countries usually regard that as an unfavorable trade balance.

To determine whether a country truly has a favorable trade balance, you must answer three
questions: First, where is the country is in its business cycle? Second, how long has the deficit
or surplus been ongoing? Third, what are the reasons behind it?

What Exactly Is the Balance of Trade?

The trade balance subtracts imports from exports. Imports are any goods and services that are
made in a foreign country and bought by a country's residents. You may think of imports only
as items shipped in from a foreign country. But imports also include souvenirs purchased by
residents while traveling abroad. Citizens are importing the items in their suitcases. Services
provided while traveling, such as transportation, hotels and meals, are also imports. It doesn't
matter whether the company that makes the good or service is a domestic or foreign company.
If it was purchased or made in a foreign country, it's an import.

Exports are any goods or services made domestically and sold by a native resident or business
to a foreign one. That includes a pair of jeans you mail to a friend overseas. It could also be
signage a corporate headquarters transfers to its foreign office. If the foreigner pays for it, then
it's an export.
The balance of trade is the most significant component of the current account. That's what
measures a country's net income earned on international assets. It also includes all payments
across borders. The trade balance is the easiest to measure. That's because all goods and many
services must pass through the customs office.

The current account is itself part of a country's balance of payments, which measures
all international transactions.

Favorable Trade Balance

Countries try to create trade policies that encourage a trade surplus. They consider a surplus a
favorable trade balances because it's like making a profit as a country. Nations prefer to sell
more and receive more capital for their residents. It translates into a higher standard of living.
Their companies also gain a competitive advantage in expertise by producing all the exports.
They hire more workers, reducing unemployment and generating more income.

To maintain this favorable trade balance, leaders often resort to trade protectionism. They
protect domestic industries by levying tariffs, quotas or subsidies on imports. That doesn’t work
for long. Soon other countries retaliate with their protectionist measures. Sometimes a trade
deficit is the more favorable balance of trade. It depends on where the country is in its business
cycle. For example, Hong Kong has a trade deficit. But many of its imports are raw materials
that it converts into finished goods and then exports. That gives it a competitive advantage in
manufacturing and finance. It creates a higher standard of living. Canada's slight trade deficit is
a result of its economic growth. Its residents enjoy a better lifestyle afforded by diverse imports.

Unfavorable Trade Balance

Most of the time, trade deficits are an unfavorable balance of trade.

As a rule, countries with trade deficits export raw materials. They import a lot of consumer
products. Their domestic businesses don't gain the experience needed to make value-added
products. Their economies become dependent on global commodity prices. Such a strategy
also depletes their natural resources in the long run.

Once in a while, a trade surplus is an unfavorable trade balance. China and Japan have both
become dependent on exports to drive economic growth. They must purchase significant
amounts of U.S. Treasury to keep the dollar's value high and the value of their currencies low.
That's how they keep their exports competitively priced and maintain their trade surplus. But
this export-driven strategy means they rely on U.S. customers and U.S. foreign policy. In
addition, their domestic market is weak. Chinese and Japanese citizens must save to provide for
their old age, since the governments don't have strong social services.

Balance of Payments

We also know that in a country’s’ international economic transactions, there is not only visible
merchandise only, there are invisible merchandise as well which are commonly known as
services e.g., freights and fare of ships and planes, insurance and banking charges, foreign tours
and education in foreign countries, payments of interest and dividend on foreigners’
investments etc. both individual and Governments.

2. Types of Balance Payment:

Balance of payments is divided into two following ways:

(i) Vertically into credit and debit (according to the principals of double entry systems of book-
keeping)
(ii) Horizontally into two major categories (according to the nature of transactions).

It is interesting to note that the current account consists of all transactions which relate to the
current national income and current expenditure of the home country. It includes imports and
exports of goods and services, expenses on travel, transportation, insurance, investment
incomes and unilateral transfers. Similarly, capital account relates to capital transactions i.e.,
transactions in financial assets which directly affect wealth and debt and as such, it includes
only future income and not the current one. It includes borrowings and lending of capital
including repayments of capital, purchase and sale of securities and other assets to and from
foreigners, individuals as well as governments.

It is called overall balance of payments when both current and capital account are taken into
consideration.

Balance of payments is like the Balance Sheet of a company i.e., the left side of the accounts
shows receipts of the country during a particular period and right hand side shows the payments
made by the country on various items to other countries for the same period. The balance of
payments must always balance.

In short, the left hand side must be equal to right hand sight (at least in principle) although, in
reality, the two sides may not be exactly equal and as such, balance of payments may be
adverse one or in deficit or it may be favorable or surplus in the opposite case. We know that an
economic transaction relates to a receipt as well as a payment of money in exchange for the
economic goods and services or the assets. As such, in each case, an international economic
transaction exists and it becomes necessary to make appropriate entry in the balance of
payments.

3. Relationship between Balance of Trade and Balance of Payment:

The relationship between the balance of trade and the balance of payment is quite simple, i.e.,
when exports of goods and services rise more than or fall less than, imports of goods and
services, it is said to ‘improve’ and in the opposite care, it is said to ‘deteriorates’.

Similarly, when the balance of payments deficit gets smaller or the balance of payments surplus
gets trigger the balance of payments is said to ‘improve’ and in the opposite case, there is
‘deteriorates’.
It is to be noted in this connection that a balance of trade improvement must be accompanied by
the balance of payments improvement unless and until there is a corresponding change in the
long-term lending. For example, if our exports rise to 540F in this year in comparison with the
last year without changing our imports, our balance of trade, naturally, will improve by 60F.
However, if long-term lending remains constant, the balance of payment will also improve by
the like amount which reduces our deficit and comes to 20F. On the contrary, if our long-term
lending reduces from 120 to 40F, the balance of payments deficit deteriorates correspondingly.

It is interesting to note that there may be a balance of trade deficit, but still then there is a
balance of payments surplus or vice-versa. Thus, if we find any trade deficit, it does not mean
that the country is losing its reserves (foreign exchange etc.), the difference so happened due to
long-term capital movements. In short, the balance of payments account has two parts viz. the
current account and the capital account.

Balance of Payments must always Balance:

It has already been stated about that the balance of payments must always balance. It will be
balanced only when the total of credit items will exactly be equal to the total of debit items
which really happens. As such, there must be either a deficit or a surplus in the current account.
The deficit or surplus so created is met by transferring to capital account.

4. Equilibrium of Balance of Payments

Equilibrium is that state of the balance of payment over the relevant time period which makes it
possible to sustain an open economy without severe unemployment on a continuing basis.
Whether the Balance of Payments is in equilibrium or not, it can be justified with this help of
the three following test:

(i) Decrease in Foreign Exchange: If gold continuously flows from the country, it may be
assumed that the balance of payments is in disequilibrium. At present the decrease in foreign
exchange reserves of our country indicate such a situation.
(ii) Increase in Foreign Debts and Loans: If the amount of foreign debts and loans increase,
that indicates the balance of payment of the country is in disequilibrium i.e., exports are less
than imports,

(iii) Decrease in Foreign Exchange Rates: If the foreign exchange rates of a country decrease,
it may be said that the country is suffering from the disequilibrium in the balance of payments
position.

5. Causes of Disequilibrium of Balance of Payments

Disequilibrium in the balance of payments the product of so many factors, e.g. the prices of
goods and services, national incomes at home or abroad, the rate of interest, the supply of
money, the state of technology, tastes, the distribution of incomes etc. Now, if any of the above
factors change without a corresponding change in other factors there must be a case of
disequilibrium in the balance of payment position.

We know that the exports and imports of a country are influenced by a number of factors. It is
hardly possible that equilibrium in balance of trade of a country is possible at fixed exchange in
rate over a long period of time. The balance of payments is quite disturbed by the factors which
affect and change imports and exports continuously.

Reasons for the Cause of Disequilibrium in Balance of Payments

(a) Domestic Inflation: The greater bulk of balance of payments difficulties are the result of
domestic inflation and the same can be corrected by disinflation i.e., eliminating the
inflationary gap and reducing demand to the level of full employment. It is possible by
increasing exports and reducing imports. Similarly halting of inflation and correction of
exchange rate may also help in this regard.

(b) Technological Changes: No doubt, these are other significant reasons for disequilibrium in
balance of payments positions. It is quite known that every change in technology brings some
comparative advantages which the other country tries to adjust, but the adjustment process itself
brings a deficit in balance of payments. Thus, the innovation, whatever form it is, invites
disequilibrium. So, a new equilibrium requires either to reduce exports or to increase imports.

(c) Short Supply: Disequilibrium of balance of payment arises due to a fall in supply. For
example, due to industrial strike the sugar production of India fall which affect the supply and
as a result there is a corresponding shortfall in exports and consequently increases the amount
of imports which is the result of disequilibrium.

(d) Fall in Demand or Structural Disequilibrium: Disequilibrium also arises out of a fall in
demand of the export product. For example, if the demand of the Indian jute product decreases
in the world due to a change in taste or what so ever, the resources which are engaged in jute
production must be shifted to other lines of activity. In such a situation, we are to restrict our
imports and our resources must be diverted into another export line product. If the same is not
possible, there must be a structural disequilibrium in balance of payment position. Of the other
causes, the deficit in current account due to the loss of service incomes creates disequilibrium
position which may arise through the bankruptcy of direct investment abroad or nationalization
etc.

Methods of Correcting Disequilibrium in Balance of Payments:

In order to maintain a country’s sound economic condition, its disequilibrium in balance of

payment position (if any) must be corrected. Naturally, the reasons for creating such a situation
must be removed. Otherwise if the situation continues for a long, the country will exhaust its
foreign exchange reserves. If such a situation arises the country concerned will have to
depreciate its currency below par. We describe hereunder, certain measures to correct or
improve the adverse balance of payments position.

(a) Stimulating exports or to check imports: If there is a declining trend in exports, various
steps must be taken to improve it. In other words, the total cost of the product must be brought
down to encourage export which may require cutting down of wages and rate of interest etc.
Exports may be also encouraged by granting bounties to exporters and to manufacturers also.
Similarly, imports must be discouraged by:
(i) Imposing import duty,
(ii) Prohibiting the product totally or
(iii) Adopting quota system,
(iv) Manufacturing the equivalent product within the country etc.

(b) Depreciate the External Exchange value: Another measure to correct the disequilibrium
is to depreciate the external (exchange) value of the home currency, which brings domestic
goods cheaper to the foreigner. It must be remembered in this respect that the rate of exchange
serves as an equilibrating factor between the balance of payments positions.

(c) To deflate the Currency: It is quite known to us that if our currency contracts, no doubt,
prices will fall which will check imports and stimulate exports, although the method of
deflation is not even free from snags. Because, if the prices of the product are forced to come
down while the cost of the same is rigid, these two do not follow suit. As a result, the country
concerned may have to face a serious depression as well as unemployment.

(d) Exchange Control: Under exchange control, all the exporters are directed to surrender their
foreign exchange to the central bank or to sell it at the official rate to the government. Then it is
rationed out among the licensed importers i.e., the government will allocate the scarce foreign
exchange among the importers on the basis of some non-price criteria. No importer is allowed
to import goods without a license. In this way, the balance of payment is to some extent
rectified by reducing the imports.

(e) Devaluation: The effect of devaluation is almost same like depreciation. In other words,
when a currency is devalued its values are decreased in terms of foreign currency. It means, the
foreigners can buy more goods than before with the same amount of currency which no doubt,
stimulates exports and check imports. Since the imports are discouraged and exports are
encouraged, a time will come when the adverse balance of payment will be corrected and will
turn in our favour. From the decision made so far, we can draw a conclusion about the
correction of adverse balance of payment position on the basis of the judicious combination of
the following:

(i) Adjustment of exchange rate (i.e. appreciation/depreciation of the home currency).

(ii) Movement of Capital (i.e., lending/borrowing abroad).
(iii) Fiscal and Monetary changes that affect prices and incomes.
(iv) Trade restrictions (quotas/tariffs).

Thus, in order to correct the adverse balance of payments no single method is found suitable.
We should try to implement all the methods stated above although the application of the factor
depends on the nature and type of disequilibrium in balance of payments, (e.g., exchange rate
will play a significant role in structural disequilibrium).