Balance Of Payments Flashcards
What is the balance of payments?
The Balance of Payments is a record of the total value of a currency (I’ll use pounds) bought and sold. By definition since for every pound bought (a positive on the BoP) there must have been a pound sold (a negative on the BoP) then the BoP will always be zero!
Since the BoP is zero we are really interested in WHY are people buying/selling pounds and so we break the BoP into 2 main parts:
The Current Account - where pounds are bought to buy UK products (exports) or sold to buy foreign products (imports). This is the part we are familiar with.
The Capital & Financial Accounts (CFA) - where pounds are bought or sold to save, invest or speculate.
What is buying and selling of the currency in terms of C&FA?
Buying of pounds (to save in a UK bank, or to invest in a UK company or speculate on the pound) is a positive or “credit” & selling pounds (to save in a non-UK bank…) is a negative or “debit”
What does the capital account include?
Capital Account: This includes money for the transfer of ownership of assets and transfer payments, such as money transferred by immigrants/emigrants into or our of the UK. It also includes debt forgiveness, although it is very small,about 0.5% of the C&FA (as both a credit and debit)
What does the financial account include?
Financial Account: Includes-
- Foreign Direct Investment: This long-term capital investment, such as the purchase of construction of machinery, buildings, or whole manufacturing plants. It is money purchasing (or setting up) a controlling interest in a firm. This is usually defined as a stake of 10% or more. It also includes reinvested profits by “foreign owned” companies.
- Portfolio Investment: This is ‘savings’ (ie buying financial assets, such as stocks and debt). It includes flows of money to purchases of a non-controlling interest (ie less than 10%) of a firm; in other words share dealing. Over 90% of Portfolio Investment, in the UK, is buying debt securities (i.e. bonds or long term loans issued by governments or large firms).
Other Investment: This includes capital flows into bank accounts or provided as loans. Large short term flows between accounts in different nations commonly occur when the market can take advantage of fluctuations in interest rate and/or the exchange rate between currencies.
Reserve Account: The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital flows to counteract those originating from the market.
What are the causes of a current account deficit(5) plus evaluation(2)
Causes of Current Account Deficit:
- Relative increase in economic growth/real incomes: increase in real incomes -> increase in M (size depends on MPM) therefore (X-M) decreases - CA deficit
- Appreciation of a currency: “SPICED” increase in price of pound -> increase in price of X & decrease in quantity of X, decrease in price of M & increase in quantity of M… CA deficit.
- High relative rate of inflation = relative increase in price of domestic goods leading to a CA deficit. This can happen for 2 reasons:
i) Low relative products -> increase in ULC -> increase in inflation/price of X
ii) Relatively higher wage and non wage labour costs - Worsening relative non-price competitiveness (brand image, quality etc.). May be linked to human capital, R&D spending.
- Protectionism by other countries
Evaluation:
- If X/M are inelastic the effect may be reversed. This may occur (a) In the SR: it takes time to find new suppliers/negotiate new contracts/be convinced pound won’t change again etc. This is called the J-curve (shows impact of a depreciation on X-M)
Diagram:
y-axis: X-M; x-axis: time
At firsts straight line below x-axis, then Nike tick
(b) If the country’s exports and imports have few substitutes. The “Marshall-Lerner Condition” says that a depreciation will improve the CA if PEDx+PEDm > 1(elastic). LEDCs sometimes of not meet this condition (X = primary products, M = capital goods) - SR vs LR. In SR the main factor is currency changes, in LR it is the productivity, and economic growth is cyclical.
Why is a current account deficit ‘bad’?(5)
- A CA Deficit implies a net withdrawal from the circular flow and downward pressure on AD. This means lower GDP (and so increased unemployment etc)
- Puts downward on the value of your currency. This may lead to ‘imported inflation’ (increase in costs of import lead to increased costs for firms/decrease in SRAS -> increase in price level and decrease in GDP)
- A CA Deficit requires financing = need to run a C&FA surplus. IF the exchange rate was fixed this may not be possible and you would be unable to ‘afford imports’
- A CA Deficit may be a symptom of an underlying problem: low productivity and a lack of competitiveness = lack of LR growth.
- A CA Deficit = a C&FA Surplus. This may be a problem because it means more foreign money coming in to your country for savings, which can (did) cause an “asset price bubble” (most obviously rising house prices) OR an over-reliance on foreign savings to fund domestic investment. However, if the foreigners panic and pull their savings there is then a financial crash.
This happened in UK/Spain (2008 crash) and in Mexico (early 1990s - Mex gov had relied on foreign savings)
Why is a current account deficit not ‘bad’?(4)
- Depends on the cause of the deficit. IF the deficit is cause by an increase in imports, due to an increase in national incomes then it is hard to argue this (people getting richer and so buying more imports) is bad
- May be self-correcting. A fall in the currency (see yes) should lead to an increase in exports and a decrease in imports (WPIDEC) and so reduce the deficit. (BUT J Curve/Marshall-Lerner)
- Shouldn’t be a problem to finance CA deficit with C&FA surplus. A C&FA surplus could be generated by allowing the currency to float or high interest rates
- Surplus in C&FA may be a good thing. It makes it easier (cheaper) for firms to borrow for I therefore an increase in investment which leads to and increase in AD and LRAS. May also include an increase in FDI which has benefits (transfer of knowledge)
How can a government correct a current account deficit?(5)
- Increase Productivity/Competitiveness. This could be done by using SSPs:
- improved training
- deregulation/non-wage costs
- reduce NMW
- encourage I (decrease corporation tax)
BUT There are issues such as time lag, may involve Gov spending (opportunity cost), effectiveness (‘encourage’), negative side effects - Devalue/Depreciate your currency. This should increase price of imports and decrease price of exports so increase current account. It could be done by reducing interest rates (or a ‘loose’ monetary policy, so also quantitive easing) and reducing hot money flows/demand for your currency
BUT - J Curve/Marshall Lerner; - ‘imported inflation’ - Reduce the rate of inflation. This could be done via monetary policy (increase interest rates will lead to a fall in AD and PL) and in the LR, SSPs (increase in AS leads to lower PL). It may also involve a contractionary/deflationary fiscal policy (decrease in G or increase in T, leads to less AD and less PL)
BUT increase in interest rates also leads to an increase in demand for pound (hot money) -> increase in the price of pound -> SPICED -> worsening of CA - Increased protectionism. Tariffs/non-tariff barriers -> less M (see tariff diagram) -> increase in CA
BUT other countries are likely to retaliate and put barriers up against your exports, so overall impact is debatable - ‘Expenditure reducing policies’. If you reduce people’s income (real GDP per capita) then they’ll import less. Most obvious this could be done by and increase in (income) tax and/or decrease in government spending (including benefits). This would be especially useful in YED of imported goods was high (luxury goods)
BUT There is clearly a large negative impact: you are deliberate making people poorer/increasing poverty/reducing living standards
What is the exchange rate and what are the two variations?
An exchange rate is the value of a currency in terms of another. A government has 2 choices:
- Floating exchange rate: where the gov allows ‘the market’ to set the exchange rate
- Fixed exchange rate: where the government fixes the exchange rate, usually against another currency, a basket of currencies or gold (a “peg”)
There are variations on these. In a “managed float” the gov might intervene if the exchange rate varied by ‘too much’. A fixed rate might be a range of +/- % (like a buffer stock scheme), or an adjustable peg, where the fixed rate changes more often.
Why do people want to buy/sell a currency?
- Exports - I need $ to buy US goods, so more exports = more D for $
- Imports - As an American I need to sell $ to buy the foreign currency require to pay for imports. More imports = more S of $
The above equates (approximately) to the current account - a worsening current account = less X, more M, = less D, more S of $ = fall in price of $
- Savings/Interest rates - many institutions hold cash in accounts (or bonds). To get the highest possible return they move this cash into high interest countries currency. So falling interest rates should lead to outflow of money = fall in D/increase in S = fall in price.
- Investment (FDI) abroad - if US banks etc want to save or lend abroad, or if US companies want to invest abroad this means they need to sell $ to by foreign currency. Meanwhile foreigners wanting to save (or even buy shares on the New York stock exchange) or invest in the US will demand $.
The above equates (approximately) to the capital & financial account
In other words anything which effects the current account OR the capital & financial account will then effect the value of a currency.
What affects the value of the currency on short term and what are the specific factors(9)?
In the short term much of the supply/demand comes from speculation. Therefore “the market’s” expectations about future changes in the current account or capital & financial account will also affect the value of a currency!
Specific factors may include:
- Inflation - higher inflation is likely to have a negative impact on X (ie reduces D for $) and increase M (ie increased S of $) as US goods become relatively more expensive. Both of these will push the value of a currency down. In addition it may mean future increases in production costs, so makes FDI less likely, again reducing D for $.
- Interest rates (& future interest rates!) - low interest rates make savings less attractive (C&FA)=fall in D for $ and possibly cause of inflation (affecting X&M) = fall in D and increase in S of $.
- Quantitative Easing (QE) - reduces bond yields (via increased demand for bonds, as QE money is used to buy bonds!), so reduces demand for bonds = fall in D for $ (to buy bonds)/increase in S of $ (as people sell bonds), both leading to a fall in the value of the $. Like lower interest rates QE could cause future inflation (see above)
- Government Borrowing - as the government borrows more this requires more bonds to be issued (& may even have to offer higher yields). For foreigners to buy these bonds they require $, so it increases the D for $. NOTE: This is a key factor in the US/Chinese relationship. Since 86% of trade with China is done in “hard currency” (usually $) then the Chinese government hold huge quantities of $. They don’t want to exchange these for RMB (increased D for RMB/increased S of $ = RMB rises against $), so they buy “safe” US assets: US government bonds
- Recession - there is an expectation that in a recession the government will cut interest rates (loose/expansionary monetary policy) see above
- LR changes in “competitiveness” and productivity - improvements in productivity should mean an improved current account in the future, meaning more X (increased D for $) and fewer M (reduced S of $), both pushing the value of the currency up
- Fear of a government default - in this case government bond holders will sell bonds (as they fear these bonds will become worthless). This increases the S of $, as US bond holders look to sell and buy non-US bonds! This pushes the value of the $ down
- Direct Government intervention (not a completely floating exchange rate) - some governments may intervene in the marker to maintain their currency’s value. This can be from extreme cases, like China where most trade is in $ and Chinese firms have to exchange these $ at government run banks, to softer cases, where the government buys/sells a currency in a ‘buffer stock’ scheme to maintain its value. The Swiss Franc and the Danish Krone are pegged to the euro, many South American countries peg their currency to the US $
NOTE: While the US accuse the Chinese of using ‘currency manipulation’ as a form of protectionism (& some call for retaliatory tariffs), the Chinese claim the US low interest rate/QE policies amount to the same thing
- Reserve Currencies - many firms like to hold a ‘safe’ currency and many commodities are priced in US $, making the $ the worlds reserve currency. This itself increases demand for $, even though no US good is being purchased (ie a power station in the UK may buy coal from Poland and pay in US $). In the future there is the possibility the euro or the RMB (if it becomes more widely traded) could become reserve currencies to rival the $
How do fixed exchange rates work?(3)
Fixed exchange rate is ‘pegged’ to another currency (or basket of, or gold). To keep this peg the gov must offer to buy/sell the currency at the fixed rate. To keep the peg the gov has to counter-act market forces, pushing the S or D up or down. eg If a country faced falling X -> decreased demand for currency -> decreased price of currency, the gov must intervene to somehow increase the price (increase demand or decrease supply). The gov has 3 main ways of doing this:
- “Open market operations” - selling or buying currency itself
- Monetary policy - using interest rates (or QE) to change demand
- Capital controls - limiting the amount of money that can be exchanged or the types of assets foreigners can buy
What are the advantages(5) and disadvantages(4) of fixed exchange rates?
Advantages:
- Creates certainty. Firms know what the exchange rate will be and this encourages international trade and especially encourages investment (FDI).
- Helps control inflation. Since firms know that rising costs will mean they become less internationally competitive (and that the currency won’t depreciate to counteract inflation) then it increases the incentive to keep costs under control and increase productivity.
- Helps control inflation. Similar to above, the government also has additional responsibility to provide a stable macro environment (ie prevent high inflation), since the currency can’t depreciate to compensate for inflation/lower productivity.
- Helps control inflation. If the government commits to buying its currency at the set rate then it needs foreign currency to gold reserves to fund this. This limits the quantity of money the government can print.
- Easier and lower borrowing costs. If a currency could depreciate, then people who had lent will receive less than they lent, in their own currency. This means lenders are less willing to lend/want a higher interest rate to cover the high risk. A fixed currency removes the risk and makes it easier/cheaper to borrow.
Disadvantages:
- In order to maintain the fixed rate the government may need higher levels of foreign currency reserves (to buy the currency when there is excess supply/the fixed rate is above the market rate). There is an opportunity cost in ‘tying up’ government finance in this way. In the worst cases the government may need to borrow foreign currency to maintain the fixed rate. The IMF was set up as such a lender, but may insist on the government adopting certain policies (usually to control inflation).
- Another way to maintain the rate would be through interest rates. Again if the currency was fixed at above the market price then interest rates would need to be raised. This would have a negative impact on Consumption, Investment and so GDP.
- If the currency was fixed below the market price the government would constantly need to sell its own currency and would build up reserves of foreign currencies, which it couldn’t change back without pushing up the value of their own currency! They may also be accused on protectionism/currency manipulation and so face retaliatory measures, reducing exports.
- The bottom line is if an exchange rate differs from the market rate by a significant amount/for a significant amount of time then it may be impossible to maintain a fixed rate. In this situation there would need to be a devaluation or a revaluation of the currency and so a large change in the exchange rate. The possibility of this reduces certainty! In addition, if the market things the government may have to de/revaluate then it will speculate and this makes the de/revaluation even more likely!
What are the advantages(4) and disadvantages(2) of floating exchange rates?
Advantages:
- The exchange rate will vary slowly, rather than sudden changes when a de/revaluation occurs.
- A deficit on the current account becomes self-correcting, so there is no need to focus on this as a macro objective.
- The government can follow monetary (and fiscal) policies appropriate for the economy, without having to subordinate things like interest rates to fixing the exchange rate. This means that it can focus on achieving other macro objectives.
- For economies dependant on one main export it protects against external shocks. If, for example, an oil exporter faced falling global oil prices this would reduce the demand and so depreciate their currency. This depreciation would make oil, but also other exports, more competitive and so dampen the impact of falling oil prices.
Disadvantages:
- There is more likely to be speculation and this can exaggerate what would otherwise be small changes in the currency’s value
- Creates exchange rate uncertainty!
