Balance of payments difficulties may develop slowly over time and can result from developments such as a progressive loss of key export markets, high and rising import dependency, declining capital inflows, rising foreign debt, unsustainable current account deficits, sustained currency overvaluation and banking sector weaknesses. These difficulties can become acute where foreign loans become inaccessible and international reserves fall to such a low level that they cannot cope with import and export fluctuations or reductions in net capital inflow.
Growing current account deficits are usually a precursor to balance of payments difficulties. Funding of current account deficits requires capital inflows, other net currency inflows or a drawdown in foreign currency reserves. Some Pacific island microstates are heavily dependent on imports (including necessities, food and fuel) which far outstrip their export capacity.16 As well, microstates often have small public and private domestic savings relative to investment needs. To compensate for inadequate domestic savings and to maintain standards of living, foreign borrowings may rise, current account deficits may increase and there may be greater reliance on foreign aid flows. These savings-and-capital-poor countries may have difficulty in financing current account deficits if foreign currency inflows are disrupted. Internal and external economic shocks may also bring underlying financing difficulties to a head by reducing foreign investment, exports, remittances and tourist receipts; impacting adversely on domestic savings; or requiring increased imports. In these circumstances, the capacity of governments to increase foreign currency borrowings from private sources and other governments usually diminishes (and borrowing costs escalate) as credit ratings17 decline and sovereign risk increases.
In one respect Pacific island microstates have some protection against balance of payments and currency crises as their currencies are generally not heavily traded internationally, and there is normally an absence of substantial speculative, short-term, cross-border capital flows. Currency attacks are relatively rare in microstates.18 That said, reversals of net capital inflow can occur, for example due to confidence effects or if domestic interest rates get substantially out of line with foreign interest rates, or if domestic savings and unremitted profits of foreign-owned banks and other companies are sent offshore, draining foreign currency reserves. If difficulties become acute and foreign reserves drop down below safe levels a crisis can ensue, investor sentiment can plunge, capital flight can gain momentum and confidence in the exchange rate can collapse, undermining the credibility of the fixed exchange rate regime and the ability of the currency to serve as a medium of exchange or a store of value.
As balance of payments difficulties intensify, and the scope for monetary policy action becomes increasingly constrained by the need to protect foreign currency reserves, countries with fixed exchange rates may decide to ration imports or impose or strengthen capital and foreign exchange controls on outflows (including, for example, limits on profit, dividend and capital remittances abroad). Directives may also be issued to repatriate funds and assets held offshore. In the short-term, the tightening of foreign exchange and import controls may retain local savings for domestic use, protect the fixed exchange rate and foreign currency reserves, and take some pressure off the need for monetary policy adjustment. However, aggressive, extensive and long-lasting controls are generally undesirable, as they can deter foreign investment; cause infrastructure to be run down (as imports of machinery and spare parts are cut-back) with additional consequences for exports; reduce business confidence; cause distortions in the pattern of imports according to the pattern of government controls and, in extreme cases, lead to currency inconvertibility. Other potential costs with capital, import and foreign exchange controls include a loss of economic efficiency, an on-going contraction in economic activity, a decline in living standards and an increase in poverty. If conditions continued to deteriorate and the exchange rate remained fixed then exchange rate pressures are likely to precipitate the development of a black market in the currency, and (often related to this), an official exchange rate that is out of line with economic fundamentals if the controls are sufficiently broad to disrupt the demand and supply of foreign currency.
Foreign currency reserve levels fell below target minimum levels for both Fiji and Solomon Islands in early 2009 (see Table 1 Box 1). Fiji’s foreign currency reserves fell to around one month of import cover in April 2009. In Solomon Islands reserves fell to 2.5 months of import cover in February 2009. To address this situation in Fiji, the Fiji dollar was devalued by 20 per cent, foreign currency controls were tightened and import restrictions applied.
Foreign currency reserve levels subsequently increased in both Fiji (equivalent to one month of import cover) and Solomon Islands (by half a month of import cover) as a direct consequence of a general allocation of Special Drawing Rights (SDRs) made by the IMF in August/September 2009 as part of the international response to the global financial crisis. Reserves have since risen strongly in Solomon Islands due partly to strong donor aid flows and weaker import demand, but the current account deficit is expected to increase very substantially in the years ahead to reach 31 per cent of GDP in 2010 and 35 per cent of GDP in 201419. Reserves remain below their raised target level in Fiji (see Box 1). The balance of payments outlook for both of these countries remains fragile, and their ability to cope with further shocks is limited.
When facing severe balance of payments difficulties (see Box 3), and assuming that foreign currency borrowing is not an option (because of high default risk), decisions are required on the extent to which reliance will be placed on:
- expenditure-reduction policies (restrictive monetary and fiscal policies) to lower domestic expenditure, consumption and investment relative to domestic savings, and to reduce the demand for imports, or
- expenditure-switching policies (for example, devaluation, import tariffs, import rationing, and import replacement and export subsidies) designed to stimulate exports and economic growth, reduce import dependency and lower the trade and current account deficits.
For countries with a fixed (pegged) exchange rate regime devaluation may be warranted as a means to attempt to avoid a looming balance of payments crisis. In this case the exchange rate adjustment could work to reduce the prices of all domestic goods to foreigners, increase exports and reduce some of the volatility in foreign currency reserves, and conserve reserves. If the devaluation is successful, the authorities may eventually have greater independence in the conduct of macroeconomic policies. However, for maximum success from devaluation, unit wage costs need to be kept stable and monetary policy should remain tight to avoid any second round inflation consequences arising from the devaluation. Where unit wage costs are kept stable, real unit wage cost levels fall to the extent that imported inflation (from the devaluation) is passed through into higher general inflation. If unit wage costs are increased and inflation is boosted then the competitiveness gains from the devaluation will be undone.
If an IMF-member country is experiencing severe balance of payments difficulties and reserve depletion is ad
vanced that country may request assistance from the IMF. Under this approach the IMF may provide a loan to the country in exchange for macroeconomic policy conditionality. IMF financing, usually with structural adjustment-related financing support from the multilateral development banks or other donors, involves commitment to appropriate economic stabilisation policy objectives, provides for economic and balance of payments adjustment and seeks to avoid a crisis, allowing the capacity for loan repayment to develop within a reasonable period of time.
Box 3: Balance of payments problems
- In 2008, as they entered the global crisis, Fiji and Solomon Islands had the largest current account deficits among Pacific island countries (around 18 per cent of GDP). The adverse effects of the global economic recession on foreign currency earnings exacerbated and exposed underlying weaknesses in their balance of payments.
- Fiji’s terms-of-trade have been in continuous decline since 2003. Fiji is losing EU trade (price) preferences that it previously relied upon for sugar export income. Some sugar mills are dysfunctional and loss-making, sugar sector reforms have been inadequate, many sugar cane land leases have not been renewed, and both output and productivity in the sugar sector have been falling. Sugar exports are at historically low levels. The garment industry is in decline due to World Trade Organization requirements. Tourism receipts and exports of gold have fallen. Remittances fell substantially during 2008.20
- Heightened political and economic uncertainty following the coup d’ etat in 2006 and the later abrogation of the Constitution, the introduction of emergency regulations, the revocation of all political appointments and subsequent credit downgrades detracted from underlying competitiveness and the attractiveness of Fiji for tourism and foreign investment. Foreign investment in Fiji has been adversely impacted with the number of foreign investment registrations falling from 441 in 2006 to 245 in 2008, representing a sharp decline (around FJ$600 million21) in the value of possible foreign investments. It is uncertain how many registrations will be implemented.
- In the case of Solomon Islands there is a de facto peg to the US dollar. The foreign currency reserves of Solomon Islands were adversely impacted when the US dollar appreciated during 2008 and the revaluation effects took their toll on non-US dollar denominated holdings. Solomon Islands is facing lower timber production and exports due to resource depletion. Private capital inflow fell and profit repatriation by foreign-owned companies has risen significantly. The current account deficit is expected to rise from around 20 per cent of GDP in 2009 to more than 30 per cent of GDP in 2010.22 Solomon Islands also faces a serious budget problem.
- Both Fiji and Solomon Islands maintain fixed nominal exchange rates, which became increasingly overvalued during 2008 and into 2009.
16 For example, Tonga’s exports were $US 12 million in 2007/2008 but imports were $US 138 million. For Samoa, merchandise exports were $US 11 million in 2007/2008 but merchandise imports were $US 204 million. For Fiji, exports were $US 944 million in 2008 but imports were $US 2052 million.
17 Some Pacific island countries (for instance, Solomon Islands, Vanuatu and Samoa) had no country or government bond credit ratings by Moody’s in 2008. See P. Imam, ‘Rapid Current Account Adjustments: Are Microstates Different’, IMF Working Paper, WP/08/233.
18 See ‘Exchange Rate Choices in Microstates’, P. Imam, IMF Working Paper, WP/10/12, January 2010.
19 See IMF Article IV Staff Report, Solomon Islands, November 2009.
20 The causes of the slump and subsequent rise in remittances in Fiji are unclear. It is conceivable that growing expectations of devaluation during 2008 led to remittances being held back until after the devaluation.
21 See Republic of Fiji, Economic and Fiscal Update: Supplement to the 2010 Budget Address, ‘Strengthening the Foundation for Economic Growth and Prospects’, November 2009.
22 See IMF, Regional Economic Outlook: Asia and the Pacific, April 2010.