Disequilibrium in the Balance of Payments

A deficit is not necessarily bad.

• A developing country importing capital goods to build industry should run a current account deficit, because it is importing real resources and financing them with foreign capital. The deficit measures investment exceeding domestic saving, and the assets built will service the borrowing.
• A deficit financed by long term direct investment is entirely different from the same deficit financed by short term deposits that can be withdrawn.

A surplus is not necessarily good.

• India's only recent current account surplus was in 2020-21: plus 24,011 million dollars. It occurred because the pandemic collapsed demand, so imports fell far more than exports and the goods deficit halved. That surplus was a symptom of a contracting economy.
• A surplus also means the country is lending its savings to the rest of the world instead of investing them at home, which for a capital scarce country is a strange thing to be proud of.
• The compression of 1991-92, when imports fell 19.4 per cent and the trade deficit fell from 5,932 to 1,546 million dollars, improved every ratio on the page and was the consequence of a crisis.

The honest formulation. What matters is not the sign of the balance but why it is what it is and how it is financed. A deficit of 0.8 per cent of gross domestic product financed by direct investment, which is India's present position, is not a problem; a deficit of the same size financed by short term deposits that can be withdrawn in a week, which was India's position in 1990, is a crisis waiting for its occasion.

The kinds of disequilibrium

1. Cyclical disequilibrium. Caused by the trade cycle described in [Why Trade Cycles Happen, and What Governments Do About Them]. In a boom, incomes rise, imports rise with them and the current account worsens; in a recession the reverse. Trading partners' cycles matter as much as one's own, since a recession abroad reduces demand for exports. Characteristic: it is self correcting, because the cycle turns. It calls for financing, not for structural action.

2. Structural disequilibrium. Caused by a lasting change in the underlying structure of production or demand: the exhaustion of a resource, the loss of a market to a new competitor, a technology that makes an export obsolete, or a shift in the pattern of world demand. India's jute exports, more than a fifth of all exports in 1960-61 and now too small to carry a line, were destroyed by synthetic packaging, and no exchange rate would have saved them. Characteristic: it does not correct itself, and needs the country to produce different things.

3. Secular or long run disequilibrium. Persists over decades and reflects a country's stage of development. A young developing economy imports capital and runs deficits; a mature economy with accumulated foreign assets runs surpluses on income. This is the kind that is not a pathology at all, and the deficit a developing country runs while it is building is of this kind.

4. Temporary or short run disequilibrium. A crop failure, a strike, a single very large import such as an aircraft or a defence purchase, a one off movement of capital. It calls for reserves and nothing else.

5. Fundamental disequilibrium, a term from the Bretton Woods system, meaning a deficit or surplus so persistent and so large that it cannot be cured without changing the exchange rate itself. Under the original International Monetary Fund rules a country could alter its par value only on a showing of fundamental disequilibrium, and the phrase survives in examination papers.

The causes

The standard classification is economic, political and sociological, and every one of the three carries marks.

Economic causes

1. Development. A developing country importing machinery, technology and intermediate goods must import more than it exports for a period. India's capital goods imports were 24.2 per cent of all imports in 1990-91 for exactly this reason.

2. Inflation at home. If domestic prices rise faster than those of trading partners, exports become dearer abroad and imports cheaper at home, so the current account worsens. This is why price stability is a balance of payments policy as well as a monetary one.

3. Cyclical fluctuations, at home and among trading partners, as above.

4. Adverse terms of trade. The terms of trade are the ratio of export prices to import prices. If export prices fall relative to import prices, a country must sell more to buy the same, and the balance worsens even though its physical exports have grown. This is the mechanism the 1950s export pessimism feared, and it is a real one: India's export earnings from petroleum products fell 24.7 per cent in 2024-25 because the crude price fell 15.4 per cent, not because it refined less.

5. Import dependence on a single commodity. India buys about a quarter of its imports as petroleum, and has done since 1990-91. A rise in the world crude price is therefore an immediate deterioration of the current account, over which India has no control at all.

6. Structural change abroad: new competitors, changes in technology, the reorganisation of production into supply chains, and protectionist measures such as the 50 per cent tariff currently applied to Indian goods entering the United States.

7. Capital flight and short term capital movements. Money that came in as portfolio investment or as deposits can leave suddenly, and the departure itself is a balance of payments problem.

8. Servicing past borrowing. Interest and dividends payable abroad are a standing debit in primary income, and India's primary income deficit is 48,340 million dollars, which must be earned every year before anything else is paid.

9. An overvalued exchange rate, which taxes exports and subsidises imports, as [India's Foreign Trade Before 1991] describes.

Political causes

1. Political instability, which frightens investors and provokes capital flight. It was one of the three shocks of 1991. 2. War and conflict, which raise defence imports, disrupt trade routes and raise commodity prices. The Gulf conflict of 1990 raised India's oil bill and stopped remittances from West Asia at the same time. 3. Sanctions and trade restrictions imposed by others. 4. Changes in another country's immigration policy, which for India directly affects remittances of 135.4 billion dollars a year.

Sociological causes

1. Changes in taste and consumption habits, particularly a preference for imported goods as incomes rise. 2. The demonstration effect, the term for the tendency of consumers in poorer countries to imitate the consumption standards of richer ones once they can see them. It raises the demand for imports without any rise in productive capacity, and modern communications have made it far stronger than when the term was coined. 3. Population growth, which raises the demand for food, energy and consumer goods. 4. Culturally determined demand with no productive use, of which India's gold imports at 8.7 per cent of the import bill are the standing example.

A worked example: diagnosing three Indian years

The third row is the one students get wrong, because it has a minus sign in front of it. A deficit financed entirely by autonomous inflows, with reserves rising, is a country attracting capital, not a country in trouble.

What beginners get wrong

"The balance of payments is in disequilibrium when it does not balance." It always balances. Disequilibrium is an imbalance in the autonomous transactions closed by accommodating ones.

"A surplus is favourable." India's only recent surplus, 2020-21, came from a pandemic collapse in imports.

"A deficit means a country is living beyond its means." It may mean it is importing capital goods to build with, which is what a developing country is supposed to do.

"Cyclical and structural disequilibrium call for the same remedy." Cyclical corrects itself and needs financing. Structural does not correct itself and needs the country to produce different things.

"The demonstration effect is an old idea with no application now." Modern media has strengthened it enormously.

"Terms of trade means the volume of trade." It is the ratio of export prices to import prices, and it can move against a country whose exports are growing.

Limits

The autonomous and accommodating distinction is not always clean. Whether a particular capital inflow was undertaken for its own sake or arranged to close a gap is a question of motive, and motives are not printed in the accounts.

The classifications overlap. A single episode may be cyclical in its trigger and structural in its persistence, and the 1991 crisis is usually described as all three at once.

Percentages of gross domestic product require a gross domestic product figure, and the ratio changes with the exchange rate used.

Contemporary practice is moving away from the vocabulary. International institutions speak of external imbalance and of sustainability rather than of favourable and adverse balances, and an answer should give the traditional terms and note their weakness.

Quick revision

1. The account always balances; disequilibrium means the autonomous transactions did not, and accommodating transactions closed the gap.
2. Autonomous: undertaken for their own sake. Accommodating: undertaken to close the gap, chiefly a change in reserves and official borrowing.
3. Practical test: are reserves falling and is the government arranging credits.
4. Favourable and adverse mislead. A developing country should run a current account deficit while importing capital goods; India's only recent surplus, 2020-21 at plus 24,011 million dollars, came from a pandemic collapse in imports.
5. What matters: why the balance is what it is, and how it is financed. Direct investment is stable; short term deposits are not.
6. Kinds: cyclical, self correcting; structural, needs a change in what is produced, as with jute; secular or long run, a stage of development; temporary, a crop failure or one large purchase; fundamental, the Bretton Woods term for an imbalance curable only by changing the exchange rate.
7. Economic causes: development and capital goods imports; domestic inflation; cyclical fluctuation; adverse terms of trade; dependence on a single import, India's petroleum at about a quarter of imports; structural change and protection abroad; capital flight; servicing past borrowing, India's primary income deficit of 48,340 million dollars; an overvalued exchange rate.
8. Political causes: instability; war, as in the Gulf conflict of 1990; sanctions; another country's immigration policy.
9. Sociological causes: changing tastes; the demonstration effect; population growth; gold, at 8.7 per cent of imports.
10. Diagnose, do not label: 1990-91 acute deficit disequilibrium; 2020-21 a cyclical surplus that was a symptom; 2024-25 a small deficit financed by autonomous inflows with reserves rising, which is equilibrium.

Test yourself

1. What is meant by disequilibrium in the balance of payments, given that the account always balances? Since every transaction produces a credit and a debit of equal value, total credits necessarily equal total debits and the account cannot fail to balance. Disequilibrium therefore refers not to the arithmetic but to the character of the transactions that produced it, and rests on the distinction between autonomous and accommodating transactions. Autonomous transactions, sometimes called transactions above the line, are undertaken for their own sake: goods are exported because a buyer wanted them, machinery is imported because a firm needed it, an investment is made because a return is expected, a remittance is sent out of family obligation. Accommodating transactions, or transactions below the line, exist only to close the gap the autonomous transactions leave: the central bank sells foreign exchange from its reserves, or the government borrows from the International Monetary Fund or arranges an official credit.

A country is in deficit disequilibrium when its autonomous transactions do not balance and accommodating transactions have had to be used, and in surplus disequilibrium when it has received more than it spent autonomously and has accumulated reserves or claims. The practical test is what is happening to reserves and to official borrowing: India in 1990-91 published an account that balanced, but its foreign currency assets had fallen to 2,236 million US dollars and it had drawn 1,858 million from the Fund, which is a deficit disequilibrium of the most acute kind.

2. "A surplus in the balance of payments is favourable and a deficit adverse." Discuss. The labels are traditional and both are unsound. A deficit is not necessarily adverse. A developing country that imports machinery, technology and intermediate inputs in order to build industry must import more than it exports for a period; its current account deficit measures investment exceeding domestic saving, it is importing real resources from abroad, and the assets it builds will in time service the borrowing that financed them. What matters is how the deficit is financed: a deficit met by long term direct investment, which cannot be withdrawn quickly and which brings technology and management with it, is quite different from an identical deficit met by short term deposits repayable on demand, which is what India had in 1990 and which is why the crisis came when confidence failed.

Nor is a surplus necessarily favourable. India's only recent current account surplus, of 24,011 million US dollars in 2020-21, arose because the pandemic collapsed domestic demand so that imports fell far more than exports and the goods deficit halved; a surplus produced by a slump is a symptom of contraction, not of competitiveness. The compression of 1991-92, when imports fell 19.4 per cent and the trade deficit fell from 5,932 to 1,546 million dollars, is the same phenomenon in a more brutal form. A surplus also means that a country is lending its savings to the rest of the world rather than investing them at home, which for a capital scarce economy is an odd thing to celebrate. The sound formulation is that neither the sign of the balance nor its size determines whether there is a problem: what determines it is why the balance is what it is and how it is being financed.

3. Distinguish cyclical, structural and secular disequilibrium. Cyclical disequilibrium arises from the trade cycle. In a boom, incomes and therefore imports rise and the current account worsens; in a recession the opposite occurs; and the cycles of trading partners matter as much as a country's own, since a recession abroad reduces demand for its exports. Its distinguishing feature is that it is self correcting, because the cycle turns, so the right response is to finance it from reserves rather than to take structural measures which will be wrong by the time they operate. India's 2020-21 surplus is an instance.

Structural disequilibrium arises from a lasting change in the underlying pattern of production or demand: the exhaustion of a resource, the capture of a market by a new competitor, a technology that renders an export obsolete, or a change in the composition of world demand. It does not correct itself and can be cured only by producing different things. India's jute exports, which were more than a fifth of all exports in 1960-61 and are now too small to carry a line in the tables, were destroyed by synthetic packaging materials, and no exchange rate or import control could have saved them.

Secular or long run disequilibrium persists over decades and reflects a country's stage of development rather than any failure: a young developing economy imports capital and runs current account deficits, while a mature economy with a large stock of accumulated foreign assets runs surpluses on income. This is the kind that is not a pathology at all, and confusing it with the other two is the commonest error in policy.

4. Discuss the causes of disequilibrium in the balance of payments. They are conventionally grouped as economic, political and sociological. The economic causes are the most numerous. Development itself creates a deficit, since a country building industry must import machinery, technology and intermediate goods; capital goods were 24.2 per cent of India's imports in 1990-91 for that reason. Domestic inflation running faster than that of trading partners makes exports dear abroad and imports cheap at home. Cyclical fluctuations at home and abroad move the balance in both directions. Adverse terms of trade, that is a fall in export prices relative to import prices, worsen the balance even when physical exports are growing, as when India's petroleum product export earnings fell 24.7 per cent in 2024-25 on a 15.4 per cent fall in the crude price. Dependence on a single large import is a permanent exposure, and petroleum has been about a quarter of India's import bill since 1990-91. Structural change and protection abroad, such as the 50 per cent tariff currently applied to Indian goods entering the United States, close markets. Short term capital can leave suddenly. Servicing past borrowing is a standing debit, and India's primary income deficit is 48,340 million dollars a year. And an overvalued exchange rate taxes exports while subsidising imports.

The political causes are instability, which provokes capital flight and was one of the three shocks of 1991; war and conflict, which raise defence and commodity import bills and disrupt trade, the Gulf conflict of 1990 having simultaneously raised India's oil bill and stopped remittances from West Asia; sanctions imposed by others; and changes in other countries' immigration policies, which for India bear directly on remittances of 135.4 billion dollars a year. The sociological causes are changes in taste and consumption habits as incomes rise; the demonstration effect, by which consumers in poorer countries imitate the consumption standards of richer ones, which modern communications have made far stronger than when the term was coined; population growth, which raises the demand for food and energy; and culturally rooted demand with no productive use, of which India's gold imports at 8.7 per cent of the import bill are the standing example.

5. Diagnose India's external position in 1990-91, 2020-21 and 2024-25. In 1990-91 the position was one of acute deficit disequilibrium. The Reserve Bank's foreign currency assets had fallen to 2,236 million US dollars against imports of 24,075 million, or roughly five weeks of cover; 1,858 million dollars was drawn from the International Monetary Fund; and non resident depositors were withdrawing. The autonomous transactions did not balance and the accommodating finance was nearly exhausted, so the printed account balanced only because the country was borrowing from the Fund. The immediate causes were political and economic, namely instability, the Gulf conflict and the loss of confidence, but the underlying cause was structural: an export base too small to pay for the imports a growing economy needed.

In 2020-21 the current account was in surplus by 24,011 million dollars, and the diagnosis is cyclical. Demand collapsed in the pandemic, imports fell far faster than exports and the goods deficit halved to 102,152 million dollars. The surplus was a symptom of contraction and it corrected itself as activity resumed, which is what cyclical disequilibrium does.

In 2024-25 the current account was in deficit by 22,947 million dollars, which is a small figure relative to the economy, and it was financed by an autonomous inflow of 21,738 million on the financial account while foreign exchange reserves continued to rise, reaching 701.4 billion dollars by January 2026. On the autonomous and accommodating test this is not a disequilibrium at all: the deficit is financed by capital that came in because it wanted to, no accommodating finance was needed, and reserves accumulated. A minus sign in front of the current account balance is not by itself evidence of a problem, and the third case is the one students most often misdiagnose.