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Unit4:Balance of Payment (BOP)

  • Unit4:Balance of Payment (BOP)

    Key unit competence: Learners will be able to analyse the balance of payment position of LDCs.

    My goals

    By the end of this unit, I will be able to:

    ⦿ Explain the terminologies used in BOP.

    ⦿ Distinguish between BOP equilibrium and disequilibrium.

    ⦿ Describe the structure of BOP accounts.

    ⦿ Analyse the causes of BOP deficit in LDCs.

    ⦿ Account for the causes of BOP problems in Rwanda.

    ⦿ Design BOP accounts.

    ⦿ Design measures to offset BOP deficit/surplus on the BOP accounts.

    ⦿ Suggest possible solutions to BOP problems in Rwanda.

    Activity 1

    A cooperative of fruit farmers in Remera sector in Ngoma district normally export their fruits to other countries and in turn receive payments against their sales. They too import different commodities
    from other countries where they have to spend on them. Some years ago, earnings from their export sales would be equal to their expenditure on imports. However, of recent, receipts from their fruit exports year after year have been less than expenditure outside on imports. Through research either from the library or the internet, using the case study above, discuss the following:

    (a) What term is given to the relationship between earnings from abroad and expenditure abroad as seen in the above case study?

    (b) What economic term do we call situations when earnings from abroad are equal and when they are not equal to expenditure abroad?

    (c) What is the difference between balance of trade and balance of payment?

    Facts

    4.1 Meaning of Balance of Payment (BOP)

    Balance of Payment (BOP) is a statement that summarises an economy’s transactions with the rest of the world for a specified period of time. It is a summary statement of a nation’s financial transactions with the outside world. It shows the relationships between a country’s total expenditure
    abroad with its total income from abroad.

    The balance of payments, also known as balance of international payments, encompasses all transactions between a country’s residents and its nonresidents
    involving goods, services and income; financial claims on and liabilities to the rest of the world; and transfers such as gifts.

    These transactions are made by individuals, firms and government bodies. Thus the balance of payments includes all external visible and non-visible transactions of a country. It represents a summation of a country’s current demand and supply of the claims on foreign currencies and of foreign claims
    on its currency.

    These transactions include payments for the country’s exports and imports of goods, services, financial capital, and financial transfers. It is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and
    investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.

    Thus earnings from both visible and invisible exports and expenditures on both visible and invisible imports are recorded. The difference between visible exports and imports is known as balance of trade while the difference between invisible exports and imports is known as balance of invisible
    trade. Therefore, that is why BOP earnings from both visible and invisible exports and expenditure on both visible and invisible imports are recorded.

    If total expenditure abroad is greater than total receipts from abroad, there is a BOP deficit or unfavourable BOP. If total receipts from abroad are greater than total expenditure abroad, there is BOP surplus or favourable BOP. Therefore, a BOP deficit and BOP surplus represent BOP disequilibrium.

    4.1.1 Difference between balance of trade and balance of payment

    Table 1: Difference between Balance of Trade and Balance of Payment

    4.2 Terminologies used in BOP
    BOP deficit or unfavourable BOP: This is where total expenditure abroad is greater than total receipts from abroad.

    BOP surplus or favourable BOP: This is where total receipts from abroad are greater than total expenditure abroad.

    BOP disequilibrium: This is where receipts from abroad are not equal to expenditures abroad i.e. there is a BOP deficit or a BOP surplus.

    BOP equilibrium: This is a situation where revenues from abroad are equal to expenditures abroad.

    BOP accounts: It is a statistical record of the character and dimensions of the country’s economic relationships with the rest of the world.

    4.3 Structure of BOP Accounts
    Activity 2

    Using the library or the internet, research more on Balance of Payments and

    (a) Describe the structure of the BOP of an economy.

    (b) Describe the structure of BOP accounts.

    (c) Using card sort game, group the following items under credit and debit items

      Imports of goods and services, exports of goods and services, transfer (or unrequited) payments to  foreigners as gifts, grants, etc., unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, lending to foreign countries, borrowings from abroad, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and international agencies, investments by foreigners in the country and official sale of reserve assets including
    gold to foreign countries and international agencies.

    Facts

    The balance of payments account of a country is a systematic record of all its economic transactions with the outside world in a given year. It is a statistical record of the character and dimensions of the country’s economic relationships with the rest of the world.

    The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. In balance of payments accounting, the practice is to show credits on the left side and debits on the right side
    of the balance sheet.

    When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit transaction. The principal items shown on the credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, borrowings
    from abroad, investments by foreigners in the country and official sale of reserve assets including gold to foreign countries and international agencies.
    The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and
    international agencies.

    These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry bookkeeping. Horizontally, they are divided into three categories: the current account, the capital account, the official settlements account or the official
    reserve assets account and the errors and omission account.

    4.3.1 Balance of payments account

    A balance of payments account is broken down into the current account,
    the capital account and the official settlements balance.

    1. Current account

    The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation, insurance, income and payments of foreign investments, etc. Transfer payments relate to gifts,

    foreign aid, pensions, private remittances, charitable donations, etc. received
    from foreign individuals and governments to foreigners.

    In the current account, merchandise exports and imports are the most important items. Exports are shown as a positive item and are calculated f.o.b. (free on board) which means that costs of transportation, insurance, etc. are excluded. On the other side, imports are shown as a negative item
    and are calculated c.i.f. (costs, insurance and freight) are included.

    The difference between exports and imports of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is favourable. In the opposite case when imports exceed exports, it is unfavourable.

    It is, however, services and transfer payments or invisible items of the current account that reflect the true picture of the balance of payments account. The balance of exports and imports of services and transfer payments is called the balance of invisible trade.
    The invisible items along with the visible items determine the actual current
    account position. If exports of goods and services exceed imports of goods
    and services, the balance of payments is said to be favourable. In the opposite
    case, it is unfavourable.

    In the current account, the exports of goods and services and the receipts of transfer payments (unrequited receipts) are entered as credits (+) because they represent receipts from foreigners. On the other hand, the imports of goods and services and grant of transfer payments to foreigners are entered
    as debits (-) because they represent payments to foreigners. The net value of these visible and invisible trade balances is the balance on current account.

    2. Capital account

    The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lendings and borrowings and private and official investments. In other words, the capital account shows international flows of loans and investments, and represents a change in the
    country’s foreign assets and liabilities.

    Long-term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investment like the purchase of foreign bonds and stocks and international loans. On the other hand, short- term international
    capital transactions are for a period ranging between three months and less than one year.

    There are two types of transactions in the capital account—private and government. Private transactions include all types of investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.

    In the capital account, borrowing from foreign countries and direct investment by foreign countries represent capital inflows. They are positive items or credits because these are receipts from foreigners. On the other hand, lending to foreign countries and direct investments in foreign countries
    represent capital outflows. They are negative items or debits because they are payments to foreigners. The net value of the balances of short-term and long-term direct and portfolio investments is the balance on capital account. The sum of current account and capital account is known as the
    basic balance.

    3. The official settlements account or official financing account (cash or monetary account)

    The official settlements account or official reserve assets account is, in fact, a part of the capital account. “The official settlements account measures the change in nations’ liquidity and non-liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year.
    The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF”. It shows transactions in a country’s net official reserve assets. This account records all the transactions related to the change in the country’s
    foreign exchange reserves. It shows the official foreign reserves in response to current and capital accounts. If there is a surplus on the combined current and capital accounts, this means that the foreign exchange reserves of a country have increased. If there is a deficit on the combined current and

    capital accounts, this means that the foreign exchange reserves of a country
    have decreased.

    4. Errors and omissions

    Errors and omissions is a balancing item so that total credits and debits of the three accounts must equal in accordance with the principles of double entry book-keeping so that the balance of payments of a country always balances in the accounting sense.

    In theory, the Capital and Financial Account balance should be equal and ‘opposite’ to the Current Account balance so that the overall Account balances, but in practice this is only achieved by the use of a balancing item called net errors and omissions. This device compensates for various errors
    and omissions in the balance of payments data, and which brings the final balance of payments account to zero.

    The errors may be due to statistical discrepancies & omission may be due to certain transactions not recorded. For example, a remittance by a Rwandan working abroad to Rwanda may not get recorded, or a payment of dividend abroad by an MNC operating in Rwanda may not get recorded and so on.
    The errors and omissions amount equals to the amount necessary to balance both the sides.
    4.3.2 Financing deficits/how to correct a BOP deficit

    Activity 3

    Having researched more on Balance of Payment, using the gained knowledge and from your own understanding, share the following among yourselves in class.

    (a) The measures that should be taken to

    (i) offset a BOP deficit

    (ii) correct a BOP surplus.

    (b) …………… are items/measures used to correct BOP deficit  while ……………are items used to offset BOP surplus.

    (c) Establishing BOP balance by using the above measures is called …………. while the expenditure    aiming at getting
    rid of the BOP surplus through the above means is known  as ……………………..

    Facts

    A BOP deficit is a situation where aggregate demand for foreign exchange exceeds aggregate supply for foreign exchange. Methods to offset a BOP deficit should aim at reducing foreign exchange expenditure, increasing foreign exchange earnings and simultaneous reducing foreign exchange
    expenditure and increasing foreign exchange earnings. The financing of a deficit is achieved by:

    1. Selling gold or holdings of foreign exchange, such as US dollars, yen or euros, etc.

    2. Borrowing from other Central Banks or the International Monetary Fund (IMF).

    3. Using the foreign exchange reserves available.

    4. Sale of public assets abroad .

    5. Seeking aid and grants from other countries.

    6. Attracting foreign investments into the country.

    7. Import substitution strategy.

    8. Restrictive monetary policy i.e. reduces the amount of money in circulation.

    9. Improving the service industry e.g. tourism.

    10. Devaluation.
    11. Export promotion strategy — increasing the volume of exports and
    improving the quality of exports.
    12. Increasing taxes and reducing government expenditure i.e. fiscal
    policy.
    13. Direct control — tariffs; quotas; exchange controls; complete ban,
    i.e. import restrictions.
    Establishing BOP balance by using the above measures is called
    accommodating BOP and the items used to get rid of a BOP deficit are
    known as accommodating items.
    4.3.3 Financing surplus/ how to offset a BOP surplus
    A BOP surplus is a situation where aggregate supply of foreign exchange
    exceeds aggregate demand for it. A surplus will be disposed off by:
    1. Buying gold or currencies.
    2. Paying off debts.
    3. Building a stock of foreign exchange reserves.
    4. Lending to foreign countries.
    5. Providing aid and grants to other countries.
    6. Purchase and storage of durable goods.
    7. Opening current account deposits in foreign banks.
    8. Purchase of short and long term securities from abroad.
    9. Direct investments abroad.
    The expenditure aiming at getting rid of the BOP surplus through the above
    means is known as autonomous expenditure and the items used are known
    as autonomous items.

    4.3.4 Why does the balance of payments always balance?

    When all components of the BOP accounts are included, they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned
    from its foreign investments, by running down Central bank reserves or by receiving loans from other countries.

    Current account balance + Capital account balance + net errors and
    omissions = 0
    Net errors and omissions simply reflect mistakes. Assuming no mistakes
    are made, then the formula will look like this.

    Current account + Capital account = 0, hence Current account = Capital
    account    .

    In other words, if a country has a deficit on the current account (more imports than exports) then it must have an equal and opposite surplus on the capital account (and vice versa).

    While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the Central bank’s reserve account, or the sum of the two. Imbalances in the
    latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted.

    The term balance of payments often refers to this sum: a country’s balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a specific amount if sources of funds (such as export goods and bonds sold) exceed uses of funds (such as paying for imported goods
    and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter. A BOP surplus (or deficit) is accompanied by an accumulation (or decumulation) of foreign exchange
    reserves by the Central bank.

    Under a fixed exchange rate system, the Central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from
    affecting the exchange rate between the country’s currency and other currencies. Then the net change per year in the Central bank’s foreign exchange reserves is sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a managed float
    where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange

    rate). With a pure float, the Central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the Central bank’s foreign exchange reserves do not change, and the balance of payments is always zero.

    However, during transactions, a country may register a deficit or surplus. If a country runs a deficit for a long time and for successive years, such a country is said to face BOP problems and this is common in LDCs.

    4.3.5 Causes of BOP deficits in LDCs

    Activity 4

    Basing on the case study in Activity 1 of this unit, and using round table techniques, analyse the causes, effects and solutions to BOP deficits in LDCs.

    Facts

    BOP deficits in LDCs are caused by both socio-economic and political
    factors as below:

    1. Narrow export base

    Most LDCs, Rwanda inclusive, are basically agricultural countries. Their export base is narrow. Major exports are coffee, rice, cotton, raw wool, leather, fish etc. They concentrate in relatively low value added products which fetch low prices hence less earnings in return.

    2. Consumption oriented society

    Most people in LDCs are consumption oriented. Due to rapid rise in population and increased consumption habits, the domestic manufactured goods are mostly consumed in the country. The exportable surplus is declining. Governments have to import more in order to support the alarming
    population thus causing much expenditure abroad leading to BOP deficits.

    3. Poor technology in less developed countries

    There is less modernisation, balancing and replacement of machinery in the industrial sector in most LDCs’ economies. This has led to a fall in

    production and decline in the quality of products that has adversely affected
    exports.

    4. Production of primary products

    Most LDCs produce and export primary products which are both price and income inelastic thus earning less from international trade. The share of value added goods must increase to earn foreign exchange and turn the trend of adverse balance of payment. The production of value added goods
    is at basic stage in developing countries that leads to adverse BOP.

    5. Devaluation

    The repeated devaluation of developing countries’ currencies has not helped in the increase of exports. It has made the imported inputs more costly. The demand for their goods in the international market is inelastic. As such, devaluation as a tool for boosting exports is not effective
    .
    6. Tough competition

    Stiff competition from the foreign value added goods has reduced the volume of foreign trade in developing countries. There is availability of higher standard goods at lower prices in international market. It causes reduction in LDCs’ exports, which result in deficit in BOP.

    7. Increase in prices of inputs

    The increase in the prices of fuel, electricity, high capital costs of imported machinery, exchange rates etc, have inflated LDCs’ product prices. The high costs of both imported capital goods and industrial raw materials, on which domestic industries are heavily dependent, and the inflationary impact of
    the rise in the prices of inputs are not helping in achieving the export targets set in each financial year and this results into deficit in BOP.

    8. Heavy protectionist policies by MDCs

    Protectionist policies by developed countries on LDCs like imposition of tariff and non-tariff barriers have adversely affected LDCs’ exports. The advanced countries of the world have imposed technical barriers such as patents, copyrights, trade-marks and designs etc. on their imports. LDCs have to upgrade the standard of purity and quality to compete for their products in the international market thereby leading to less foreign exchange earnings by LDCs and consequently BOP deficits.

    9. Fall in terms of trade

    The import unit values are higher than the export unit values for most LDCs.
    A decline in terms of trade causes imbalance in the balance of payment.

    10. Foreign debts servicing

    High expenditure on debt servicing since most countries in LDCs are poor
    and mostly rely on foreign resources especially through borrowing.

    11. Importation of capital goods

    Most LDCs import expensive capital goods for rapid industrialisation of their countries in order to build up the economy. The heavy import of machinery has considerably increased the import bill and has adversely affected balance of payment.

    12. High demonstration effect

    Most LDCs have import oriented economies through demonstration effect leading to high demand for capital and luxurious goods thus leading to high foreign exchange expenditure which adversely affect BOP position.

    13. Rise in oil prices

    The sharp rise in the prices of oil in the recent past is taking a big amount of the foreign exchange earnings. LDCs import bill of petroleum group increases year after year leading to BOP problems in LDCs.

    14. Political instabilities and insecurity

    Experience shows that political instability and disturbances in LDCS cause large capital outflows and hinder inflows of foreign capital. For example, the wide spread political instabilities and insecurity in most LDCs discourage production which reduces on the volume of exports. On the other hand,
    LDCs have to purchase modern weapons for their defense at a very high cost from different countries, this increases burden on their BOP and it becomes adverse.

    15. Fluctuations in the prices of exports of LDCs

    Since LDCs normally export primary products, their prices keep on fluctuating in the international market. This causes BOP deficit when export prices fall.

    16. Imported inflation

    Since most LDCs import expensive capital goods, it makes production expensive, leading to expensive exports which reduces their demand in the external markets. Thus, less foreign exchange is earned from them.

    17. High population growth in LDCs

    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.

    18. Natural calamities in LDCs

    Natural calamities like bad weather reduce the yields from the agricultural sector as their dominant export sector thus leading to adverse BOP.

    19. Poor infrastructure in most LDCs

    Most LDCs have poorly developed and insufficient socio-economic infrastructure which causes supply rigidities (difficulties). This lessens export volume and consequently less earnings from them.

    20. Changes in fashions, tastes and preferences in the world market.

    This has reduced on the demand for LDCs exports thus adversely affecting their BOP position.

    21. Unfair International Commodity Agreement (ICA)

    Weak ICA has less bargaining powers in the international markets leading to low export prices and low earnings from exports hence BOP deficits.

    22. Insufficient export promotion institutions

    Institutions to promote export sector through encouraging vent for surplus in most LDCs are so insufficient.

    23. Inflation in most LDCs’ economies

    Most LDCs’ economies are hit by inflation which makes their exports expensive leading to low demand for them in the international markets thus earning less from them.

    24. Depreciation of LDCs currencies

    Persistent depreciation of LDC’s currencies has made their products (exports) cheap and made imports expensive thus high foreign exchange expenditure.

    4.3.6 Effects of BOP deficits

    1. If a BOP deficit is financed through borrowing, it is said to be more unsustainable. This is because borrowing is unsustainable in the long term and countries will be burdened with high interest payments.
    Countries with large interest payments have little left over to spend on investment.

    2. If a country runs a BOP deficit on the current account, it has to run a surplus on the financial / capital account. This means foreigners have an increasing claim on your assets, which they could desire to
    be returned at any time. For example, if you run a current account deficit, it could be financed by foreign multinationals investing in your country or the purchase of assets. There is a risk that your best assets
    could be bought by foreigners, reducing long term income.


    3. A current account deficit may imply that you are relying on consumer spending, and are becoming uncompetitive. This leads to lower growth of the export sector.

    4. A Balance of payments deficit may cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors  will remove their investments causing a big fall in the value of your
    currency (devaluation). This can lead to decline in living standards  and lower confidence for investment.

    5. A trade deficit can lead to currency weakness and higher imported inflation which worsens the BOP   position further.

    6. Deficit countries need to import financial capital to achieve balance. This in the long run leads to capital flight in form of profit repatriation.

    7. Trade deficit can lead to loss of jobs in home-based industries as investors are discouraged from investing in the country.

    8. Countries may run short of vital foreign currency reserves. This worsens the value of the local currency and people would lack confidence in it and resort to investing in foreign countries. As a result,
    economic development is retarded.


    9. Currency weakness can lead to capital flight / loss of investor confidence. This creates savings-investment gap which calls for seeking aid and grants, and its negative consequences, that hinders
    further long term investments in the country thus underdevelopment.

    10. A deficit leads to lower aggregate demand and therefore slower growth in development. This is due to the fact that people are earning less from their exports which reduces their purchasing power.

    11. In the long run, persistent trade deficits undermine the standard of living. As it becomes less profitable to export, importing would also be problematic due to less earnings from trade thus worsening the standard of living of people.

    12. A trade deficit is a reflection of lack of price / non-price competitiveness.

    4.3.7 Measures to correct disequilibrium in BOP in LDCS

    Sustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve of foreign exchange and gold. The following remedial measures are recommended:

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

    2. Import restrictions and Import substitution i.e. by increasing import duties on commodities similar to those produced at home, encouraging domestic industries to use local raw materials.

    3. Controlling inflation through restrictive monetary policy: Inflation (continuous rise in general price levels) discourages exports and encourages imports. Therefore, government should check inflation
    and lower the prices in the country.

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

    5. Devaluation of domestic currency: It means legal reduction in the external (exchange) value of domestic currency in terms of a unit of foreign exchange. This 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.

    6. Depreciation: Like devaluation, depreciation leads to a fall in external purchasing power of home currency. Depreciation occurs in a free market system where 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.)

    7. Encouraging investors through establishing institutions that help and advise them on investment prospects in the country.

    8. Opening new markets and making regional groupings to widen markets for their exports.

    9. Ensuring political stability and security so as to ensure a conducive investment climate and a reduction on military expenditure.

    10. Training local manpower e.g. through universal primary and secondary education and setting up different training institutions so as to increase skills of indigenous manpower and to reduce foreign expatriates.

    11. Rehabilitation and construction of socio-economic infrastructure to increase supply of exports.

    12. Seeking and being granted a debt relief so as to reduce expenditure on debt servicing.

    13. Population control programmes should be enforced so as to reduce on dependence burden and import expenditure.

    14. Innovations and inventions to improve on technology so as to improve on productivity increase the volume of exports and foreign exchange earnings as well.

    15. The tourism industry should be strengthened as an export diversifier.

    16. Strengthening the ICA so as to increase the export volume and bargaining power as well.

    17. Economic legalisation so as to increase domestic productivity and export volume.

    4.4 BOP Position in Rwanda
    The current account balance in relation to GDP was consistently negative throughout the 1990s, not only because of the 1994 genocide. Although the economy improved dramatically post-1994, export earnings in the early 2000s were hindered by low international coffee prices, depriving

    the country of hard currency. Rwanda’s external debt stood at 1.3 billion dollar in 2000. In the same year, Rwanda became eligible for 810 million dollars in debt service relief from the IMF/World Bank Heavily Indebted Poor Countries (HIPC) initiative. In 2002, the IMF approved a three-year 5 million dollar loan to Rwanda.

    The US Central Intelligence Agency (CIA) reports that in 2001, the purchasing power of Rwanda’s exports was 61 million USD while imports totaled 248 million USD resulting in a trade deficit of 187 million USD.
    The International Monetary Fund (IMF) reports that in 2001 Rwanda had exports of goods totaling 93 million USD and imports totaling 245 million USD. The services credit totaled 50 million USD and debit 189 million USD. The following table summarises Rwanda’s balance of payments as
    reported by the IMF for 2001 in millions of US dollars.

    In 2014, Rwanda’s overall balance of payments recorded a deficit of 185.7 million USD as a result of a 15.3 percent increase in imports of goods which more than offset an increase of 6.8 percent in exports. Capital grants increased from 234.5 million USD in 2013 to 306.9 million USD in 2014.

    Current account balance (% of GDP) in Rwanda

    Current account balance (% of GDP) in Rwanda was last measured at -7.47 in 2013, according to the World Bank. Current account balance is the sum of net exports of goods, services, net income, and net current transfers.

    4.4.1 Causes of BOP deficits in Rwanda

    Activity 5

    Basing on the knowledge gained from your previous research on international trade and BOP specifically and from your own analysis, what do you think are the causes, effects of B.O.P problems in Rwanda?
    Which measures should be used to correct the adverse B.O.P problems in Rwanda?

    Facts

    BOP deficits in Rwanda are caused by both socio-economic and political factors as below;

    1. Narrow export base: Rwanda, like any other LDC, is basically an agricultural country. Thus her export    base is narrow. Major exports are coffee, rice, cotton, raw wool, leather, fish etc. she concentrates in relatively low value added products which fetch low prices hence less earnings in return.

    2. Consumption oriented society: Most people in Rwanda are mostly consumption oriented. Due to rapid rise in population and increased consumption habits, the domestic manufactured goods are mostly
    consumed in the country. The exportable surplus is going on declining. The government has to import more in order to support the alarming population thus causing much expenditure abroad leading to BOP
    deficits.

    3. Poor technology in less developed countries: There is less modernisation, balancing and replacement of machinery in the industrial sector in Rwanda. This has led to a fall in production and
    decline in the quality of products and this has adversely affected exports.

    4. Less income from international trade: Rwanda produces and exports primary products which are both price and income inelastic thus earning less from international trade. The share of value added goods must increase to earn foreign exchange and turn the trend of adverse balance of payment. The production of value added goods is at basic stage in Rwanda that leads to adverse BOP.

    5. Rwanda faces stiff competition from the foreign value added goods which has reduced the volume of her foreign trade. There is availability of higher standard goods at lower prices in international market. It causes reduction in Rwanda’s exports, which result in deficit in BOP.

    6. Foreign debts servicing: There is high expenditure on debt servicing since Rwanda is among the poor countries and it mostly relies on foreign resources especially through borrowing.

    7. Importation of expensive capital goods: For rapid industrialisation of her economy, Rwanda imports expensive capital goods in order to build her economy to build up the economy. The heavy import ofmachinery has considerably increased the import bill and has adversely affected her balance of payment position.

    8. Most Rwandans prefer more of imported commodities than homemade commodities. This implies that Rwanda has an import oriented economy through demonstration effect leading to high demand for
    capital and luxurious goods. This leads to high foreign exchange expenditure which adversely affects it’s BOP position.

    9. The sharp rise in the prices of oil in the recent past is taking a big amount of the foreign exchange earnings. Rwanda’s import bill of petroleum goods increases year after year leading to BOP problems

    10. Fluctuations in the prices of Rwanda’s exports: Rwanda, like any other LDCs normally exports primary products whose prices keep on fluctuating on the international market. When export prices fall,
    she faces BOP deficit.

    11. High expenditure in production: Rwanda imports expensive capital goods which make her to produce expensively. This makes their exports expensive reducing their demand in the external markets, thus
    less foreign exchange earnings from them.

    12. High population growth in Rwanda adversely affects her BOP position. It increases the needs for imports and decreases her capacity to export.

    13. Natural calamities like bad weather reduce the yields from the agricultural sector as Rwanda’s dominant export sector thus leading to adverse BOP.

    14. Poor infrastructure: Rwanda has poorly developed and insufficient socio-economic infrastructure. This has led to supply rigidities thus less export volume and therefore less earnings from them.

    15. Changes in fashions, tastes and preferences in the world market. This has reduced on the demand for Rwanda’s exports thus adversely affecting her BOP position.

    16. Unfair International Commodity Agreement (ICA): Weak ICA has less bargaining powers in the international markets leading to low export prices and low earnings from exports hence BOP deficits.

    17. Insufficient export promotion institutions to promote export sector through encouraging vent for surplus in Rwanda.

    18. Rwanda’s economy has been hit by inflation in the recent past which has made her exports expensive leading to low demand for them in the international markets thus earning less from them.

    19. Persistent depreciation of Rwanda’s currency has made its products (exports) cheap while her imports are expensive and this leads to high foreign exchange expenditure.

    4.4.2 Effects of BOP deficits in Rwanda

    1. Rwanda’s BOP deficit financed through borrowing has left little capital to spend on investment. This has left Rwanda’s economy to be more unsustainable since it is burdened with high interest payments.

    2. Rwanda in trying to correct her BOP deficit has attracted foreign multinationals to invest in the country or to purchase assets. This means that foreigners have an increasing claim on Rwanda’s assets,
    which they could desire to be retained at any time. This risks her best assets to be bought by foreigners, thus reducing long term income.

    3. A Balance of payments deficit has caused foreign investors to lose confidence in Rwanda. This has put Rwanda at a risk that investors will remove their investments causing a big fall in the value of her
    currency. This may lead to decline in living standards and lower confidence for investment.

    4. A trade deficit has led to currency weakness and higher imported inflation which may worsen the BOP position further.

    5. Rwanda has imported financial capital to achieve balance of payment and this in the long run may lead to capital flight in form of profit repatriation.

    6. Trade deficit has led to loss of jobs in home-based industries as investors are discouraged from investing in the country.

    7. Rwanda has run short of vital foreign currency reserves which has worsened the value of her local currency and this has made people lack confidence in it and resorted to investing in foreign countries.
    As a result, economic development has been retarded.

    8. Currency weakness has led to capital flight / loss of investor confidence. This has created savings-investment gap which has called for seeking aid and grants, and its negative consequences, that hinders further long term investments in the country thus underdevelopment.

    9. Trade deficit has led to lower aggregate demand and therefore slower economic growth. This is due to the fact that people are earning less from their exports which has reduced their purchasing power.

    10. BOP deficit has undermined the standard of living of people in Rwanda as it has become less profitable to export, importing also has become problematic due to less earnings from trade thus worsening the standard of living of people.

    4.4.3 Measures to correct adverse BOP in Rwanda

    1. Labour intensive industries

    Labour intensive industries should be established, because labour is cheaper in Rwanda, these industries can be set up at lower cost. The products of these industries can be exported.

    2. Manufactured goods

    Instead of exporting primary goods like raw cotton, coffee tea etc., Rwanda should export manufactured goods like textiles and garments, leather goods, food products and electrical goods which earn more foreign exchange. Or should process their primary products which adds value to them thus more
    foreign exchange earnings.

    3. Reduction in export duties

    This step will make our export competitive in the international market. Foreigners will prefer to import from Rwanda because of low prices.

    4. Quality products

    Many of our goods cannot be exported because of poor quality. Rwanda should improve the quality of its products according to international standard. This can be done by improving on technology and training of labour-force to improve on their skills

    5. Export marketing

    Export promotion agencies should be made more active. Rwanda has already done this. There are Export Promotion Agencies, Export Development Fund and Export Processing Zones etc. All these are playing their effective role to increase export and to correct the BOP deficits.

    6. Pricing of goods

    It is necessary for increasing exports that goods should be produced under optimal conditions and offered at competitive prices in international market.

    8. Packing

    High quality packing is essential for promoting exports. If packing is not attractive and durable, it will not capture foreign market. Thus packaging should be improved to make our exports more attractive and gain market on top of their good quality.

    9. Joint venture

    Establishing industries with joint venture of foreign investors can also push up the export sector. The products of these industries can be sold in the foreign market.

    10. Import of only essential items

    Only essential items should be imported which are needed for our industrial production. Import of luxuries should be banned. People should be educated to come out from the complex of foreign goods.

    11. Exchange control

    Exchange control is also an important step to minimise the imports. Exchange control should be followed, so that there is no wastage of foreign exchange to importation of un-necessary commodities and luxuries.

    12. Substitutes for imported items

    Import substitutes should be manufactured in the country through setting up of import substitution industries. If home production of chalk, fertilisers, paper, steel, edible oil and electrical goods are increased, there will be less need for such imports.

    13. Decrease in consumption

    Taxes should be imposed to reduce the consumption of many imported items. Rich people in our country are spending freely on unnecessary imported consumer items. So, foreign exchange reserves are wasted.

    14. Control of smuggling

    Black markets should be eliminated. The government of Rwanda should take strong and strict measures to eliminate markets of smuggled goods through anti-smuggling units.

    15. Population control

    Many of our problems are arising due to fast increase in population. Sincere efforts should be made to decrease population growth rate. People should be educated in this regard. This is aimed at reducing on foreign exchange expenditure on imported commodities to cater for the alarming population.

    16. Infrastructural development

    Rwanda should rehabilitate and develop socio-economic infrastructure to increase production and exchange of goods and services across national borders to increase foreign exchange earnings.

    17. Political stability and security

    Rwanda should ensure peace and security in all parts of the country so as to attract investors, exploitation of resources which increases production activities. This will increase the volume of exports and it will also reduce on the expenditure on importation of military hard ware.

    Unit assessment

    1. (a) To what extent is inflation a cause of the BOP problem in LDCs?

    (b) What policy measure would you suggest to reduce BOP
    problems in Rwanda?

    2. (a) What fiscal and monetary measures may be employed to reduce inflationary pressures on the   external balance of payments?

    (b) What is the relationship between the domestic economy and the balance of payments?

    3. Balance of payments must always “balance”. With reference to your country, explain the existence of either “favourable or unfavourable” balance of payments position.

    Glossary

    ཀྵཀྵ Absorption approach: The analysis in the BOP based on comparing expenditure with domesticoutput.

    ཀྵཀྵ Accommodating items in BOP: The different items on the BOP account that are used to curb short term deficits.

    ཀྵཀྵ Autonomous items: Items / measures to offset a BOP surplus on the BOP account.

    ཀྵཀྵ Balance of payment: This is a relationship between a country’s foreign exchange expenditure and her   foreign exchange earnings in any given year.

    ཀྵཀྵ Balance of payment accounts: A summary record of a country’s transactions that involve payments or receipts of foreign exchange.

    ཀྵཀྵ Balance of trade: Relationship between a country’s visible exports and visible imports.

    ཀྵཀྵ Balancing item: Is one which appears in figures of BOP explaining the discrepancy between the current and long term capital account and the net change in reserves, overseas holdings
    and other items that make up the balance of monetary movements.

    ཀྵཀྵ BB line: A locus of levels of the interest rate and real national income for which the desired current account Balance of Payment surplus just equals the desired capital account deficit.

    ཀྵཀྵ Capital account: This refers to the record of international transactions related to movement of long and short term
    capital.
    ཀྵཀྵ Capital movement: Movement of money capital from one country to another.
    Balance of Payment (BOP) 129

    ཀྵཀྵ Capital account: The part of the balance of payment accounts
    which shows the movement of capital over a period of time.

    ཀྵཀྵ Capital stock: The total amount of physical goods existing at a particular time period which have been produced for use in the production of other goods.

    ཀྵཀྵ Current account: The portion of a balance of payments which shows the market value of a country’s visible and invisible exports and imports with the rest of the world.

    ཀྵཀྵ Economic sanction: Coercive measures of an economic nature adopted in international affairs to enforce collective decisions.

    ཀྵཀྵ Embargo: Any prohibition imposed by government upon commerce or freight.

    ཀྵཀྵ Exports: Goods and services produced in one country and sold to another country. They are a source of foreign exchange.

    ཀྵཀྵ Export promotions: An outward-looking policy. It refers to deliberate government policies to expand the volume of exports.

    ཀྵཀྵ Favourable balance of trade: When the value of visible goods exported by a country is higher than that of the goodsimported.

    ཀྵཀྵ Import surplus: A situation that exists when the value of imports exceeds that of imports (unfavourable trade balance).

    ཀྵཀྵ Individualism: A belief that individuals are the best judges of their own interests.

    ཀྵཀྵ Official financing: This means items that represent international transactions involving the Central bank of a country whose BOP are being recorded.

    ཀྵཀྵ Price- specie-mechanism: Automatic BOP adjustments mechanism under gold standard.

    ཀྵཀྵ Trade gap: This occurs when the quantity of imported goods exceeds that of visible exports. It is the amount by which visible imports exceed visible exports.

    ཀྵཀྵ Unfavourable balance of trade: This is when the visible goods imported by a country are greater in value than those exported.

    Unit summary

    • Balance of payment

    • Meaning

        • Terminologies used

       • Equilibrium and disequilibrium BOP

       • Structure of BOP accounts

        • How to offset BOP deficit or surplus

        • Causes of BOP deficit

         • Effects of BOP deficit

         • Possible solutions to BOP deficits in LDCs

    • A case study of Rwanda
       

    • Causes of BOP deficits 

    • Effects of BOP deficits
        • Policy measures to overcome BOP deficits

    ◄Unit3:Free Trade and Trade ProtectionismUnit5:Exchange Rates►