a2 econ the balance of payments

The Balance of Payments:

The Balance of Payments A2 Econ Chapter 17

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Balance of Payments account Records financial transactions between the UK and all other countries At AS you learned about the current account of which there are 4 main parts The balance of trade in goods (visible trade) The UK imports more than it exports - it runs a trade deficit The balance of trade in services UK comparative advantage in financial, insurance and ICT services has led to an overall balance of trade surplus This trade surplus is not large enough to cover the trade deficit Now many more services are imported because British firms are outsourcing services e.g. call centres to India

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Balance of Payments account Net income flows Not all flows of money are from trade in goods and services Income flow from use of factors of production overseas Interest, profits and dividends on UK assets abroad These also flow out of the country to overseas owners Net income flows are the difference between inward and outward flows These tend to be positive in the UK Current transfers Net current transfers consist mainly of government transfers to and from overseas organisations e.g. the EU

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The capital and financial accounts At A2 you are expected to have some knowledge of the other two accounts Capital account Financial account These record flows of financial capital arising from saving, investment and currency speculation Capital account is relatively unimportant Consists largely of repatriation of financial capital from people entering or leaving the UK Government transfers including some type of foreign aid Financial account records the vast majority of flows of financial capital into and out of the UK and has 3 main components Net FDI – difference between UK acquisitions abroad and Foreign acquisitions in the UK Net portfolio investment – purchase of financial assets e.g. shares Other capital flows – hot money

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Capital flows International Capital flows have grown very rapidly in recent decades reflecting the process of globalisation This growth brings the following benefits Promotes growth of world trade Source of finance for firms which is particularly important in less developed countries FDI facilitates the transfer of technology, information and best practice between firms and countries bringing about supply side improvements This growth in capital flows can bring the following disadvantages Difficulties in one sector of the financial systems can affect the whole global financial system Sub prime mortgage crisis in the USA in 2007 led to a UK ‘credit crunch’ where banks tightened lending criteria FDI may lead to global dominance by multinational firms Large scale hot money flow can destabilise exchange rates

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Financial Services and the City of London Financial services industry one of the UK’s largest industries Mostly based in the City of London Over a million people employed Nearly a quarter of London’s contribution to GDP is financial services See graph opposite to see growth of services in terms of their share of UK exports Read ‘the golden gateway’ on P200

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Causes of a trade (goods) deficit It is useful to group the explanations for a trade deficit in goods into short-term, medium-term and long-term factors Some relate to the demand-side of the economy and others to supply-side economic influences Short-term factors Strong consumer demand real household spending has grown more quickly than the supply-side of the economy can deliver, leading to a high level of demand for imported goods and services Research evidence suggests that UK consumers have a high income elasticity of demand for overseas-produced goods demand for imports grows quickly when consumer demand is robust Nicholas Fawcett and Professor Mike Kitson estimated that the income elasticity is around +2.3 suggesting that a 2% increase in real incomes boosts demand for imports by 4.6% Because the overseas demand for UK exports rarely keeps pace with the surging demand for imported products, so the trade deficit widens when the economy enjoys a period of consumption-led growth .

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Causes of a trade (goods) deficit The strong sterling exchange rate has helped to reduce the UK price of imports causing an expenditure-switching effect away from domestically produced output Consumers have taken advantage of the high pound! In technical terms, the high pound has improved the terms of trade between the UK and other countries, allowing the British people to buy and consume more imports with each pound they earn

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Causes of a trade (goods) deficit Medium-term factors UK trade balances have been affected by important shifts in comparative advantage in the international economy for example the rapid growth of China as a source of exports of household goods and other countries in South-east Asia who have a cost advantage in exporting manufactured products. The availability of imports from other countries at a relatively lower price inevitably causes a substitution effect from British consumers.

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Causes of a trade (goods) deficit Medium-term factors Much of the UK’s trade deficit is due to structural rather than cyclical factors Trade performance has been hindered by supply-side deficiencies which impact on the price and non-price competitiveness in global markets non-price competitiveness factors such as design and product quality are now more important for trade than merely price alone. A relatively low rate of capital investment compared to other industrialised countries The persistence of a productivity gap with major competitors linked to low investment and also to the existence of a skills-gap between UK workers and employees in many other countries A relatively weak performance in terms of product innovation – linked to a low rate of business sector spending on research and development

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Causes of a trade (goods) deficit Long-term factors The UK manufacturing sector has been in long-term decline for more than twenty years. Although there are some world class manufacturing companies, the size of the manufacturing sector is not large enough both to meet consumer demand in the UK and also to export sufficient volumes of products to pay for a growing demand for imports

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Does a current account deficit really matter? Should we be concerned if, as an economy, we are running a large current account deficit? The UK has run large current account deficits in recent years with barely any effect on the overall performance of the economy. The United States economy is also experiencing a huge trade deficit at the moment. What are the implications of this? In the 1950s, 60s and 70s, small balance of payments deficits in the UK caused economic crises with periods of strong speculative selling of sterling on the foreign exchange markets and much political instability. The devaluation of the pound in 1967 led directly to the resignation of the then Chancellor, James Callaghan. These days, trade deficits of enormous proportions seem to have little effect in global currency markets .

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Does a current account deficit really matter? Some policymakers and economists believe the balance of payments no longer matters because of globalisation and financial liberalisation trade and current account deficits can be more easily financed by globally integrated capital markets freed from the capital controls that have been dismantled since the end of the 1970s. This free movement of global financial capital has allowed countries, in principle, to increase their domestic investment beyond what could be financed by a country‘s own savings. Increasingly what we want to consume is produced abroad and if a country wants to operate with a sizeable current account deficit, then provided there is a capital account surplus , there is no fundamental economic constraint. Britain has been a favoured venue for inward investment (an inflow of capital) and our relatively high interest rates compared to the USA and the Euro Zone has also attracted large-scale inflows of money into our banking systems. In this way the current account has been financed with little economic pain.

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Evaluation

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Does a current account deficit really matter? – Arguments For The main arguments for being relaxed about a current account deficit are as follows: Partial auto-correction : If some of the deficit is due to strong consumer demand, the deficit will partially-self correct when the economic cycle turns and there is a slowdown in spending Investment and the supply-side : Some of the deficit may be due to increased imports of new capital and technology which will have a beneficial effect on productivity and competitiveness of producers in home and overseas markets

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Does a current account deficit really matter? – Arguments For Capital inflows balance the books - Providing a country has a stable economy and credible economic policies, it should be possible for the current account deficit to be financed by inflows of capital without the need for a sharp jump in interest rates. The UK has run an average annual current account deficit of £10 billion from 1992-2004 and yet the economy has also enjoyed one of the longest sustained periods of growth and falling unemployment during that time

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Does a current account deficit really matter? – Arguments Against Structural weaknesses - The trade / current account deficit may be a symptom of a wider structural economic problem such as a loss of competitiveness in overseas markets insufficient investment in new capital shift in comparative advantage towards other countries. An unbalanced economy – too much consumption A large deficit in trade is a sign of an unbalanced economy typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these ―macroeconomic imbalances have to be addressed Consumers cannot carry on spending beyond their means for the danger is that rising demand for imports will be accompanied by a surge in household debt.

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Does a current account deficit really matter? – Arguments Against Potential loss of output and employment A widening trade deficit may result in lost output and employment because it represents a net leakage from the circular flow of income and spending Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import penetration, may find it difficult to find new employment. Potential problems in financing a current account deficit Countries cannot always rely on inflows of financial capital into an economy to finance a current account deficit Foreign investors may eventually take fright, lose confidence and take their money out They may require higher interest rates to persuade them to keep investing in an economy Higher interest rates then have the effect of depressing domestic consumption and investment In the US the current account deficit is so large that the USA must rely on huge capital inflows each year eventually investors in other countries may decide to put their money elsewhere – this would put severe downward pressure on the US dollar

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Does a current account deficit really matter? – Arguments Against Downward pressure on the exchange rate A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp fall in the exchange rate This would then threaten an increase in imported inflation and might also cause a rise in interest rates from the central bank A declining currency would help stimulate exports but the rise in inflation and interest rates would have a negative effect on demand, output and employment.

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The UK The UK has run a current account deficit in each year since 1998 The size of the deficit expressed as a percentage of national income (GDP) has actually been falling in the last three years it is now less than 2% of GDP a manageable level with few obvious painful consequences The trade balances should improve if UK businesses successfully improve their cost and price competitiveness The exchange rate depreciates to provide the export sector with a competitive boost The UK manages to take advantage of a forecast acceleration in the rate of growth of world trade in the next few years

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Policies to control / reduce a BoP deficit Which policies are likely to be most effective in improving the current account deficit of the balance of payments? We need to make a distinction between demand and supply-side causes of the problem. If the root cause of a high trade deficit is an excessive level of aggregate demand the deficit may improve automatically in the event of an economic downturn or recession when real incomes and spending slow down. However the deficit could be largely due to weakness on the supply-side

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Policies to control / reduce a BoP deficit if the deficit is largely the consequence of supply-side economic weakness policies need to be effective in improving our cost and non-price competitiveness and expanding the economy's productive potential particularly the tradable sector to allow it to grow without its external position continuing to deteriorate. Central to improving the UK‘s trade performance is the health of the manufacturing sector Although services are a growing part of the economy, manufacturing still accounts for about 75% of exports The UK government's growth strategy is focused on improving the supply side of the economy Such policies may be effective but they will take time to work.

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Policies to control / reduce a BoP deficit Expenditure Reducing Policies These are policies that aim to reduce the real spending power of consumers Fiscal policy can be used (e.g. a rise income tax that reduces disposable income) Higher interest rates would dampen consumer spending and reduce economic growth Expenditure Switching Policies These are policies that attempt encourage consumers to switch their spending away from imports toward the output of domestic firms. Expenditure-switching‘ occurs if the relative price of imports can be raised or if the relative price of UK exports can be lowered.

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Policies to control / reduce a BoP deficit – Expenditure switching policies A depreciation of the exchange rate has the effect of increasing the UK cost of imports and reduces the foreign price of UK exported goods and services A lower exchange rate also increases the profitability of exporting products overseas this profit signal should, over time, act an as incentive for UK businesses to reallocate factor resources towards potential export markets Tariffs or other import controls But the UK is bound by its commitments to the World Trade Organisation Protectionist policies are not a viable option for an economy wishing to control its total trade deficit

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Policies to control / reduce a BoP deficit – Expenditure switching policies Policies that reduce the rate of inflation reducing inflation below that other international competitors leads to a gradual improvement in price competitiveness The key to controlling the BoP deficit in the long term is for the economy to achieve relatively low inflation with sufficient productive capacity to meet the domestic demand from consumers Often, price is not the deciding factor in winning the demand from buyers in highly competitive international markets Competitiveness in global markets is driven by many factors, one of which is the level of research and development spending, an area where the UK continues to lag behind.

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Limits to the impact of a depreciation of the currency The risks of inflation A lower exchange rate can lead to an increase in the costs of imported goods and services risking higher (cost-push inflation) It is important to remember that a depreciation or devaluation of the exchange rate will not normally be enough on its own to correct a balance of payments deficit for an economy This is particularly the case if the causes of the deficit are long term and structural Other policies are required that improve the supply-side performance of the economy and make domestically produced goods and services more competitive in international markets

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The J-Curve effect In the short term a depreciation of the exchange rate may not improve the current account deficit of the balance of payments This is due to the low price elasticity of demand for imports and exports in the immediate aftermath of an exchange rate change Initially the volume of imports will remain steady partly because contracts for imported goods will have been signed However, depreciation raises the sterling price of imports causing total spending on imports to rise Export demand will also be inelastic in response to the exchange rate change in the short term Therefore the earnings from exports may be insufficient to compensate for higher spending on imports The balance of trade may worsen in the immediate aftermath of a fall in the external value of the currency This is widely known as the J-Curve effect as seen in the diagram below