Download pdf - BOP Crisis explained

A View of the household/Country

• Let us assume an economy where a country is represented by a household

• The Man (corporate) of the house sells vegetables which are grown in the garden

• The Woman (government) of the house manages the upkeep of the house and associated infrastructure


• The Man (corporate) buys supplies (fertilizer, seeds) to produce the vegetables

• The income generated from selling vegetables (GDP) is then shared with the woman (tax)

• The woman's share (tax) is used to then buy supplies necessary for the running of the household (government spending)


• Internal mechanics of household– The man (corporate) has to ensure that he produces maximum

vegetables with minimum production supplies (profit motive)– The woman (government) has to ensure that she creates a conducive

living environment with minimum House supplies. (government budget)


• External mechanics of household

– The sale of vegetables is nothing but the exports of a country

– The purchase of house supplies and farming supplies are the importsof the country


• External mechanics of household

– When Imports > Exports ; We have a Current Account Deficit. The household/Country has to find ways to finance this gap. It is typically done through foreign debt.

– When Imports < Exports; We have a Current Account Surplus. The savings of the household can be used to invest in other households/countries

The Beginning of a BOP crisis

• Let us assume a world economy with 2 countries/households.

• Household ‘T’ produces tomatoes

• House hold ‘C’ produces carrots


• These 2 households engage in trade

• For the sake of simplicity, let us assume that 1 carrot = 1 tomato

• They sell 3 units of each to the other household


• Initially , household ‘C’ cannot produce 3 carrots and gives an IOU note to compensate for the shortfall

• Household ‘T’ has a Current account surplus ( more exports than imports)• Household ‘C’ has a Current account deficit (more imports than exports)• The gap is funded by foreign capital/debt (The IOU note)


• This continues for many years, until household ‘T’ no longer has faith in the capacity of ‘C’ to make good on the IOU notes

• The cumulative value of the IOU notes is sovereign debt

• This will result in a BOP crisis

• In real life this is what has happened betwen US-China; Dubai-AbuDhabi; PIIGS-Germany. Where one side has behaved like the ‘C’ household, running up deficits until they are no longer sustainable

The Crisis

• This typically results in ‘T’ saying that if ‘C’ wanted tomatoes they would have to sell them at a discount.

• In other words start paying back the mounting debt

• Now ‘T’ sells only one tomato but gets 2 carrots in return (the extra carrot is repayment of existing loans/IOU)

The Crisis

• In real life this manifests through a currency devaluation• The currency becomes weak, this results in exports becoming cheaper

(more carrots) and imports becoming dearer (less tomatoes). • A few examples are the Asian Tigers devaluation (1997); Mexican Peso

crisis etc.

The Aftermath

• After the short term pain subsides, the country/household starts the healing process

• The household adjusts to become more efficient and can produce 2 carrots with just one tomato

• In a few years the household ‘C’ produces 4 carrots and trades it for 3 tomatoes and an IOU note from household ‘T’

The Aftermath

• The roles have now been reversed

• Household ‘T’ is a Current account deficit country

• Household ‘C’ is a Current account surplus country

• In a few years the BOP crisis strikes again

Deviations/Distortions in cycle

• The previous chain of events would imply that the countries will keep oscillating between surplus and deficit as long as market forces are allowed to correct unsustainable imbalances

• However short term pain is always the enemy of political motives. The government is heavily incentivized to distort this economic cycle

• A few methods employed are explained in the next slide


• Monetary stimulus: – this is where the government prints money.

– This is the equivalent of the woman in the household injecting hormones in the carrot to make it look bigger/ more valuable

– In the long run household ‘T’ will call this bluff and there will be no change in the trading terms of the economy


• Fiscal stimulus : – this is where the government spends on infrastructure hoping to

revive the economy.

– The household equivalent is , the woman using her share of the money (tax) to embellish the house / make fancy dinners

– This gives the impression that there is nothing wrong with the household even though the economy is now facing a BOP crisis.