Balance Of Payments

Question 1

The current account on the balance of payments measures:

Answer 1

• Trade in goods / services
• Investment incomes
• Transfer flows

Question 2

Current account deficit

Answer 2

Since the late 1980s, the UK has had a persistent current account deficit
A deficit means the value of imports is greater than exports.
A deterioration in the current account means the deficit gets bigger or we move from surplus to deficit.

Question 3

Reasons for a current account deficit

Answer 3

• Overvalued exchange rate, making exports more expensive and imports cheaper.
• Declining competitiveness, leading to lower demand for exports.
• Growth in consumer spending, leading to higher imports.
• Low savings ratio which leads to higher consumer spending on imports
• Large inflows of foreign capital enabling the country to afford more imports.

Question 4

financing a current account deficit

Answer 4

A current account deficit needs to be financed by a surplus on financial / capital account. This could involve:
• Attracting direct foreign investment into the economy. (Long term capital flows)
• Attracting short-term flows of money into the banking sector, e.g. hot money flows.

Question 5

Potential problems of current account deficit 1

Answer 5

1. If a current account deficit is financed through borrowing this can be unsustainable in the long term and countries will be burdened with a high interest payments.
2. If the deficit is financed by attracting long-term investment, foreigners will have an increasing claim on UK assets, which they could desire to return at any time.
3. A current account deficit is likely to cause a depreciation in the exchange rate, leading to higher import prices and lower living standards.

Question 6

Potential problems of current account deficit 2

Answer 6

4. A large current account deficit may cause a loss of confidence.
5. It could be argued the persistent deficit in the current account suggests fundamental weaknesses in the economy such as:
   i) Declining competitiveness
   i) Lack of productive capacity in the UK
   ii) Declining comparative advantage in many manufactured goods
   These factors could adversely effect job creation in the UK and lead to lower growth.

Question 7

However a current account deficit is not necessarily harmful

Answer 7

1. A current account deficit can be used to finance investment, e.g. the US ran a current account deficit for a long time as it borrowed to invest in its economy. This enabled higher growth and so it was able to pay its debts back.
2. Inward investment can be beneficial for the economy. It creates jobs and more output; in the UK, inward investment by Japanese firms has helped increase productivity.
3. With a floating exchange rate, a large current account deficit should be reduced over time by a depreciation in the exchange rate which restores competitiveness. (Note: countries in the Euro cannot devalue to restore competitiveness and reduce current account deficit.)
4. It depends on the size of the deficit as a % of GDP, for example the US trade deficit reached 6% of GDP (2007); at this level it is a problem.

Question 8

Global imblances - UK and US current account deficit with china

Answer 8

In the past 10 years, the UK and US have had a persistent current account deficit with China. China, by contrast, has had a surplus with the rest of the world. Some economists fear this reflects an unbalanced global economy.
• China has high savings, relatively low consumption and high exports.
• The West - high consumption and low savings.

Question 9

Global imblances - UK and US current account deficit with china - due to (this relates to ways to improve current account deficit)

Answer 9

This pattern of trade is due to:
• China more competitive due to lower labour costs. This gives them a comparative advantage in many manufactured goods.
• Chinese currency undervalued. China has often sought to maintain an undervalued currency to make exports cheaper.
• Some in US have criticised this policy for giving them an unfair advantage.
• Higher marginal propensity to consume in UK and US.

Question 10

Capital account

Answer 10

A capital account shows the net change in physical or financial asset ownership for a nation and, together with the current account, constitutes a nation’s balance of payments. The capital account includes foreign direct investment (FDI), portfolio and other investments, plus changes in the reserve account.

Question 11

Financial account

Answer 11

Financial account components include direct investment, portfolio investment and reserve assets, and are broken down by sector. The financial account differs from the capital account in that the capital account deals with transfers of capital assets.