Balance of Payments Crisis: Definition and Examples

A balance of payments crisis occurs when a country is unable to pay for essential imports or service its external debt payments due to a shortage of foreign exchange reserves. The key characteristics of a balance of payments crisis are:

• Rapidly falling foreign exchange reserves or reserves being maintained only by high levels of foreign borrowing
• Inability to pay for imports of essential goods
• Difficulty servicing external debt payments
• Investors pulling out money and short-term credit drying up
• Depletion of foreign exchange reserves to the point of being insufficient to cover import requirements for even a few weeks

The causes of balance of payments crises in developing countries often stem from obstacles in industrialization and integration with the global economy. Specific factors that can trigger a crisis include:

• High fiscal deficits and rising government debt
• Current account deficits due to importing more than exporting
• Sudden spikes in global oil prices or other imports
• Loss of investor confidence, often after a change in government policies
• Contagion effects from crises in other countries

Resolving a balance of payments crisis typically requires securing emergency foreign loans, restricting imports, devaluing the currency, cutting government spending, and implementing structural reforms to boost exports and attract investment. However, the crisis itself can cause economic disruption and welfare losses beyond what the fundamentals justify.

Examples of Balance of Payments Crises

Throughout history, governments often fall into balance of payments crises. Below are a few modern examples.

Argentina (2018): Argentina has a long history of economic instability, and in 2018, it faced another balance of payments crisis. The crisis was caused by a combination of factors, including:

• Large current account deficit: Argentina was importing more goods and services than it was exporting, leading to a drain on foreign reserves.
• Loss of investor confidence: Investors became worried about Argentina's ability to repay its debts, which led to capital flight (investors removing their money from the country).
• Overvalued peso: The Argentine peso was fixed to the US dollar at an artificially high rate. This made Argentine exports more expensive and imports cheaper, further worsening the current account deficit.

Turkey (2018): In 2018, Turkey also experienced a balance of payments crisis. The crisis was triggered by a sharp depreciation of the Turkish lira (the Turkish currency). The depreciation was caused by several factors, including:

• Rising US interest rates: When US interest rates rise, it becomes more attractive for investors to hold US dollars. This can lead to capital flight from emerging markets like Turkey.
• Political instability: Investors became concerned about the political situation in Turkey, which further weakened confidence in the economy.
• Large current account deficit: Similar to Argentina, Turkey was also running a large current account deficit, making it vulnerable to external shocks.

India (1991): India faced a major balance of payments crisis in 1991. This crisis stemmed from a combination of factors:

• Large fiscal deficit: The Indian government had been spending more than it was collecting in revenue for several years. This led to a buildup of government debt.
• Declining foreign exchange reserves: As a result of the fiscal deficit, India's foreign exchange reserves dwindled significantly. This made it difficult for the country to import essential goods and services.
• Gulf War: The 1990 Gulf War caused a spike in oil prices, which further strained India's import bill.

Measures Taken by Countries To Prevent a Balance of Payments Crisis

Countries have taken several measures to prevent or resolve balance of payments crises, including:

• Devaluing the currency: Reducing the value of the domestic currency makes exports more competitive and imports more expensive, helping to improve the trade balance. For example, India devalued the rupee by 20% in 1991 and Argentina devalued the peso by 50% in 2023 to make exports more competitive.
• Reducing government spending: Cutting fiscal deficits through spending cuts and tax increases helps reduce the current account deficit and reliance on foreign borrowing. India implemented fiscal tightening measures in 1991 to address its high fiscal deficit.
• Attracting foreign investment: Liberalizing foreign direct investment (FDI) rules and offering incentives can help attract more stable foreign capital inflows.
• Implementing structural reforms: Deregulating industries, privatizing state-owned enterprises, and improving productivity can boost exports and make the economy more competitive in the long run. India removed the "license raj" and gave public sector companies more operational freedom in 1991.
• Securing emergency financing: Obtaining short-term loans from the IMF or other sources can provide breathing room to implement reforms and stabilize the economy. For example, Egypt secured a $8 billion IMF bailout loan in 2024 to avert its economic crisis.
• Restricting imports: Raising tariffs, imposing quotas, or banning certain imports can reduce the trade deficit in the short term, but risks retaliation from trading partners. India restricted imports as a crisis response measure in 1991.
• Debt restructuring: Renegotiating the terms of external debt, such as extending maturities or reducing interest rates, can ease debt servicing pressures. However, this is a complex process that requires cooperation from creditors.
• The specific mix of policies depends on the country's circumstances, but the overall goal is to restore confidence, improve competitiveness, and attract stable foreign capital to resolve the balance of payments crisis in a sustainable manner.