(1) Historical Background:
BOP adjustment theories do not cover the entire range of external transactions of an economy. This stand could be justified till the Second World War because, till then, international capital flows played a limited role in BOP issues and its adjustment. They were primarily meant to “settle” the accounts relating to trading in goods and services.
Accordingly, balance on current account was taken to represent entire BOP position; a disequilibrium in the former was taken to represent disequilibrium in the latter; and correcting imbalance in the former was taken to mean correcting the entire BOP imbalance.
(2) Changed Reality:
But the period after the Second World War has witnessed a fundamental transformation with the following salient features:
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i. International capital flows that are meant to settle the payments on current account deficit (or surplus) have become a small portion of the total capital flows.
ii. In contrast, capital flows that take place on account of other reasons have become an overwhelmingly large portion of the total. Moreover, these flows are rapidly increasing with the passage of time.
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Occasionally, these capital flows take place for purely speculative reasons. In that case, they can destabilize the foreign exchange markets accompanied with violent fluctuations in exchange rates and other forms of financial and trade crises. As such, speculative flows of capital can themselves become a major source of a BOP crisis.
iii. By itself, the direction of a capital flow does not tell us whether it is strengthening or weakening the BOP position of a country. That can be determined only on the basis of additional information.
(3) Justifying Incomplete Coverage:
As yet, we do not have an integrated and comprehensive theory of BOP adjustment mechanism covering both trade and capital flows.
This is because it is not easy to have a theory of BOP adjustment which is simultaneously comprehensive, simple and realistic. Innumerable causes, including a variety of external shocks and internal disturbances, can force a country into a BOP deficit.
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They include phenomena like global recessions, political hostility, and natural calamities. A theory that can simultaneously take into account all the determining variables has yet to emerge. Till then, we have to live with a partial analysis approach.