Chapter 26 - The balance of payments Flashcards
What is balance of payments?
A set of accounts showing the transactions conducted between residents of a country and the rest of the world
What is current account of the balance of payments?
Account identifying transactions in goods and services between the residents of a country and the rest of the world, together with income payments and international transfers
What is financial account of the balance of payments?
Account identifying transactions in financial assets between the residents of a country and the rest of the world
What is capital account of the balance of payments?
Account identifying transactions in (physical) capital between the residents of a country and the rest of the world
What are the 3 main things that make up the current account?
- Trade in goods and services
- Primary income
- Secondary income (transfers)
How does trade in goods and services affect current account?
The balance of trade in goods and services is simply the balance between UK exports and imports of such goods and services. If UK residents buy German cars, this is an import and counts as a negative entry on the current account. On the other hand, if a German resident buys a British car, this is an export and constitutes a positive entry. Notice that not all of the trade carried on involves physical goods, and the trade in services is also important, especially for an economy like the UK.
The process of trading with other countries creates important connections across national borders. After all, UK exports become the imports of its trading partners. In principle, this suggests that overall the sum of all countries’ trade balances should be zero. In practice, this will not be the case - if only because of data inaccuracies and mis- recordings. However, it is important to realise that the demand for UK exports depends in part upon economic conditions in its trading partners.
How does primary income affect current account?
Primary income is the second important item in the current account. In addition to employment income from abroad, this comprises earnings accruing to domestic citizens on past investment abroad (less income earned by overseas residents who own assets in the UK). The largest item in this part of the account is earnings from direct investment, although there is also an element of portfolio investment - earnings from holdings of bonds and other securities.
How does secondary income affect current account?
Secondary income is made up of current transfers. These include taxes and social contributions received from non-resident workers and businesses, remittances, bilateral aid flows and military grants. However, the largest item is transfers with EU institutions, which showed a deficit of £9.4 billion in 2016.
What are the 4 categories that make up the financial account?
- Foreign direct investment
- Portfolio investment
- Transactions in other financial assets
- Reserve assets
How does financial account work?
The financial account shows transactions associated with changes in the ownership of the UK’s foreign financial assets and liabilities.
An important part of the financial account is where UK investors undertake investment overseas, and where overseas investors purchase assets in the UK. It is important to remember that although the net flows of such foreign direct investment are part of the financial account, the income received in future years appears in the current account.
Portfolio investment relates to equities and securities. However, other types of financial assets have become increasingly important, including various forms of financial derivatives such as options and financial futures. These make up the third category registered in the financial account.
The final category concerns reserve assets such as gold and foreign exchange held by the Bank of England. These were important when the country was operating a fixed exchange rate system, but transactions are infrequent in a system of floating exchange rates.
What are the causes of a deficit on the current account of the balance of payments?
The current account has been in deficit every year since 1984.
- Changes in the structure of economic activity affect the pattern of trade in goods and services.
- The competitiveness of domestic production relative to other countries is important. If productivity at home is weak, or if domestic firms are producing poor quality products, then the demand for exports will be relatively low.
- If inflation in the home country is high relative to elsewhere, this will again discourage exports and encourage imports. With high inflation, rising labour costs can fuel this process.
- Rapid economic growth can draw in imports and contribute to a current account deficit.
How is the financial account a cause and consequence of inbalances?
The trend towards globalisation means that both inward and outward investment increased substantially during the 1990s, although there was a dip after 2000. However, a graph shows that the financial account has been in strong surplus in the early part of the twenty-first century, although it dipped during the financial crisis of the late 2000s.
The surplus on the financial account is in part forced by the deficit on the current account. If an economy runs a current account deficit, it can do so only by running a surplus on the financial account. Effectively, what is happening is that, in order to fund the current account deficit, the UK is selling assets to foreign investors and borrowing abroad.
An important question is whether global trade imbalances like this are sustainable in the long run. Selling assets or borrowing abroad has future implications for the current account, as there will be outflows of investment income and debt repayments in the future following today’s financial surplus. It also has implications for interest rate policy. If the authorities were to hold interest rates high relative to the rest of the world, this would tend to attract inflows of investment, again with future implications for the current account.
How is the overall balance of payment a cause and consequence of inbalances?
Overall, the balance of payments must be maintained at zero, but imbalances on the current and financial accounts can be important.
The overall balance on the current account partly reflects changes in the pattern of economic activity, with manufacturing in decline and services expanding. This partly reflects changes in the international competitiveness of UK goods and services. Within the current account, the deficit in the trade in goods is partly offset by the surplus in services, but overall the current account shows a persistent deficit.
This deficit needs to be balanced by a surplus on the financial account, implying the sale of UK assets abroad. This then has long- term consequences for the current account, because of the outflow of income that is part of the current account, a consequence that may be of concern in the long term. However, changes in the exchange rate have an important impact on the relative competitiveness of UK goods and services.
