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Development Barriers - Foreign Currency Gaps

Level:
A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 24 Jan 2023

Many developing countries face a big imbalance between inflows and outflows of foreign currencies. A foreign exchange gap happens when currency outflows persistently exceed currency inflows

Development Barriers - Foreign Currency Gaps

This can occur when:

  • A country is running a persistent current account deficit on their balance of payments
  • There is an outflow of capital from investors in money and capital markets (this is known as capital flight)
  • There is a fall in the value of inflows of remittances from nationals living and working overseas

One measure of the extent of foreign-exchange cover for a country is the value of a nation’s foreign currency reserves measured in terms of the number of months of imports that this currency could finance (this is known as import cover).

A key consequence of a foreign currency gap can be that a nation does not have enough foreign currency to pay for essential imports such as medicines, foodstuffs and critical raw materials and replacement component parts for machinery. In this way, a foreign currency shortage can severely hamper short run economic growth.

Some countries resort to devaluing their exchange rates in a bid to improve the competitiveness of export industries but there is no guarantee that a weaker currency will help to resolve a foreign currency gap. Indeed, the threat of a currency devaluation might prompt a further outflow of currency from a country as investors get nervous.

Explain with examples why a shortage of foreign currency can be an economic problem for developing countries

A shortage of foreign currency can be an economic problem for developing countries for several reasons. One of the main problems is that it can make it difficult for a country to pay for essential imports such as food, fuel, and raw materials. This can lead to shortages of these goods, which can result in higher prices and inflation. For example, in Venezuela, a shortage of foreign currency has led to a shortage of essential imports and hyperinflation, which has caused significant economic and social problems for the country.

Another problem is that a shortage of foreign currency can make it difficult for a country to service its foreign debt. This can lead to a debt crisis and a potential default on loans. For example, in Greece, a shortage of foreign currency during the sovereign debt crisis made it difficult for the country to service its debt, which led to a financial crisis and a bailout by the European Union.

A shortage of foreign currency can also make it difficult for a country to maintain a stable exchange rate. For example, in Argentina, a shortage of foreign currency has led to a decline in the value of the Argentine peso, making it difficult for the country to maintain a stable exchange rate, which has contributed to the country's economic problems.

Additionally, a shortage of foreign currency can also lead to a lack of investor confidence, which can make it difficult for a country to attract foreign investment.

Lastly, a shortage of foreign currency can also lead to a decline in the standard of living for the population, as it makes it difficult for people to afford the imported goods and services that are essential for a decent standard of living.

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