Chapter 4.1.7 Balance of Payments

Question 1

Define the ‘Balance of Payments’

Answer 1

A record of all the money flowing into and out of a country.

Money flowing into the country (inflows) are known as debit items.

Money flowing out of the country (outflows) are known as credit items.

Question 2

What 3 accounts does the BoP account consist of?

Answer 2

The Current Account
The Financial Account
The Capital Account

Question 3

Why does the BoP always balance?

Answer 3

Because if we are to spend more money (imports) than we earn (exports), we must pay for this by:

Selling assets to foreign residents and/or borrowing money from abroad.

Question 4

Define the ‘Current Account’

Answer 4

The part of the BoP account where payments for the purchase and sale of goods and services are recorded.

Question 5

What is the Trade in Goods (visible trade) element of the CA?

Answer 5

Exports are the sale of goods to other countries, for which payment is received in home currency; therefore, exports are a credit item (inflow).

Imports of goods are the purchase of goods from other countries, for which payment is made in foreign currencies (generating a supply of home currency); imports are therefore a debit and represent money flowing out.

Question 6

What is the Trade in Services element of the CA?

Answer 6

Services include a variety of activities, such as insurance, tourism, transportation, and consulting.

When foreigners visit as tourists, the country is exporting tourism services; similarly, when foreigners purchase insurance from home companies, this represents exports of insurance services.

When home citizens visit other countries as tourists, or purchase insurance from other countries, they are importing tourism and insurance.

Question 7

What is the Current Transfers element of the CA?

Answer 7

Refers to the inflows into a country due to transfers from abroad like gifts, foreign aid, pensions, minus outflows of such transfers to other countries.

Question 8

What is the Income element of the CA?

Answer 8

All inflows of wages, rents, interest and profits from abroad subtract all outflows of wags, rents, interest and profits:

Citizens may earn income abroad, such as from wages if they work abroad and send their wages home.

Or if they own property abroad that earns rental income.

Or if they have have bank accounts abroad that earn interest.

Or if they own stocks in another country that earn dividends.

This income is ‘repatriated’ to the home country of the person who earned it.

Question 9

What calculations can be used to analyse the CA?

Answer 9

Balance of trade: X-M

Balance of Trade in Goods:
Exports of Goods-Imports of Goods

Balance of Trade in Services:
Exports of Services-Imports of Services

Current Account Balance:
Trade in Goods+Trade in Services+Current Transfers+Income

Question 10

What does the ‘Financial Account’ consist of?

Answer 10

Portfolio Investment: This includes inflows and outflows of debt and equity (bonds and shares)

Direct Investment: FDI undertaken by MNCs.

Reserve Assets: The CB’s foreign currency reserves, which they can purchase or sell to influence the value of the currency.

Question 11

What does the ‘Capital Account’ consist of?

Answer 11

Capital transfers: inflows subtract outflows of things such as debt forgiveness, non-life insurance claims, and government grants (money given as a gift by governments to finance physical capital).

Transactions in non-produced, non-financial assets: consists mainly of the purchase or use of natural resources that have not been produced (land, mineral rights, forestry rights, water).

Question 12

Define the ‘Marshall-Lerner Condition’

Answer 12

Devaluation will lead to an improvement in the current account so long as the combined price elasticities of exports and imports are greater than 1.

The greater the elasticities, the greater the scope for improvement of the trade balance and the smaller the devaluation/depreciation required.

Question 13

What happens if PEDm < 1?

Answer 13

A % increase in price leads to a less than proportionate decrease in the quantity of imports, so the value of M still increases, worsening the trade deficit.

Question 14

What happens if PEDm > 1?

Answer 14

The value of imports will fall, reducing the trade deficit.

Question 15

Explain PEDx

Answer 15

The greater the PEDx, the greater the increase in X and the greater the positive effect on the trade balance following devaluation/deflation.

Question 16

Define a ‘Current Account Deficit’

Answer 16

Exists when imports are greater than exports.

Question 17

Define a ‘Current Account Surplus’

Answer 17

Exists when exports are greater than imports.

Question 18

What is important about the short-run in terms of CA deficits and surpluses?

Answer 18

The CA is composed of millions of transactions (both inflows and outflows), which are extremely unlikely to balance to exactly 0. Countries expect deficits and surpluses in the SR.

Question 19

What is important about the long-run in terms of CA deficits and surpluses?

Answer 19

Countries divide into 3 broad groups:

Persistent CA surpluses (Norway and China)

Persistent CA deficits (UK or the US)

A CA which is broadly in balance (France or Chile)

Question 20

What are the causes of current account deficits?

Answer 20

Strong currency:
If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of imports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports. Countries in the Eurozone (e.g. Greece, Portugal and Spain) experienced an overvalued exchange rate (and they couldn’t devalue). In 2007, these three countries had a current account deficit equal to 10% of GDP.

High relative inflation:
If UK inflation rises faster than our main competitors then it will make UK exports less competitive and imports more competitive. This will lead to deterioration in the current account. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness.

Rapid economic growth resulting in increased imports:
If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. In the UK we have a high marginal propensity to imports (MPM) because we do not have a comparative advantage in the production of manufactured goods. Therefore if there is fast economic growth there tends to be a significant increase in the quantity of imports and a deterioration in the current account.

Recession in other countries:
If the UK’s main trading partners experience negative economic growth, then they will buy less of our exports, worsening the UK current account.

Question 21

What are the causes of current account surpluses?

Answer 21

High productivity

Weak currency

Low relative inflation

Weak economic growth

Non-price factors such as high quality and design of exported goods

Question 22

Define ‘FDI’

Answer 22

Investment into the productive activities of another country, either through purchases of physical capital or significant (>10%) and long-term investment in shares.

Question 23

What is the difference between structural and cyclical deficits?

Answer 23

Structural: persistent for a very long-time.

Cyclical: Returning to original place a few years later.

Question 24

How do governments correct CA deficits?

Answer 24

Expenditure switching policies
Expenditure returning policies
Supply-side policies.

Question 25

Define ‘Expenditure Switching policies’

Answer 25

Policies aimed to encourage consumers to reduce imports and switch instead to purchasing domestically produced goods and services.

Question 26

Define ‘Expenditure Reducing policies’

Answer 26

Policies aimed to make domestic consumers consume less overall and, by extension, to spend less on imports.

This can also reduce the amount of borrowing needed, which can be the reason for CA deficits.

Question 27

Define ‘Supply-side policies’

Answer 27

Aim to address the long-run underlying issue behind a deficit, a lack of international competitiveness, due to perhaps expensive and/or poor-quality domestic goods and services.

Question 28

List of ‘Expenditure Switching Policies’

Answer 28

Exchange rate manipulation: artificially devaluing the currency by supplying pounds onto forex markets.

EVALUATION: Depends on PEDm and PEDx (Marshall-Lerner Condition)

Protectionism: Increasing tariffs and quotas can both have a significant impact in the short-term.

EVALUATION: The country is likely to find itself becoming even more internationally uncompetitive in the long-run as its domestic industries have no incentive to improve their efficiency.

Also, protectionism can induce retaliatory protectionist measures from other countries.

Overall, the ability to use this method depends on the extent to which the country is free to pursue their own free trade policies (trading bloc membership, WTO regulations).

Question 29

List of ‘Expenditure Reducing Policies’

Answer 29

Contractionary monetary policy and/or fiscal policy: increasing IR means lower disposable income, and so fewer imports, and so fewer outflows.

EVALUATION: Depends on the MPM. If it is low overall, contractionary monetary policy would not work as imports are little effected and UK consumers become worse off overall.

Also depends on the extent to which these policies have a deflationary effect: Paradox of thrift

Question 30

List of ‘Supply-side policies’

Answer 30

Education to increase the skills of the labour force and improve the quality and design of products; this would lead to increased exports and lower imports.

EVALUATION: Long-term (decades to improve the competitiveness of the economy) policies whist currency devaluation or economy deflation can affect the CA within a few years.

Question 31

What are the consequences of persistent CA deficits?

Answer 31

Unsustainable:
If a current account deficit is financed through borrowing it is said to be more unsustainable in the long-term due to the burden of high interest rate payments. E.g. Russia was unable to pay its foreign debt back in 1998. Countries with large interest payments have little left over to spend on investment.

Risk of capital flight:
A very high balance of payments deficit may, at some point, cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of your currency (devaluation). This can lead to a decline in living standards and lower confidence for investment. E.g. Asian Crisis of 1997.

An indication of an unbalanced economy:
A persistent current account deficit may imply that you are relying on consumer spending, and the economy is becoming unbalanced between different sectors and between short-term consumption and long-term investment. For example, the UK has had a high share of GDP focused on consumer spending and relatively low levels of investment – especially in the manufacturing sector. This focus on domestic consumption can have adverse effects in the long-term with less investment in productivity.

An indication of an uncompetitive economy:
A current account deficit may imply the economy is becoming uncompetitive and the exchange rate relatively overvalued.
For countries with floating exchange rate – e.g. Pound Sterling, this is not so serious because market forces will cause a depreciation to restore competitiveness. However, a current account deficit can be a real problem for countries in the Euro – who cannot devalue to restore competitiveness. For example, 2000-2007, a divergence in inflation rates caused very large current account deficits in southern Eurozone economies. This lack of competitiveness and low level of export demand was a factor behind the weak domestic demand 2008-13 of Greece, Portugal, Spain during the Eurozone recession of 2008-13.

Risk of depreciation:
A country running large current account deficit is always at risk of seeing the value of the currency fall. If there is insufficient capital flows to finance the deficit, the exchange rate will fall to reflect the imbalance of foreign flows of funds. A depreciation in the exchange rate will cause imported inflation for consumers and firms who rely on imports of raw materials.

Question 32

Can the consequences of persistent CA deficits be avoided?

Answer 32

Borrowing can lead to economic growth if:

The CA deficit remains relatively small.

Borrowed funds are used to finance imports of capital goods instead of consumer goods.

Some production is geared towards export industries.

Question 33

What are consequences of persistent CA surpluses?

Answer 33

Low domestic consumption:
A country may have a large current account surplus because of relatively weak domestic demand. This weak demand leads to lower consumer spending and lower spending on imports. Therefore, in this case, domestic employment will suffer from a weak economy.

Insufficient domestic investment

Appreciation of the domestic currency

Reduced export competitiveness

Question 34

Why should persistent CA deficits not be a cause for concern?

Answer 34

The UK has had a persistent CA deficit since the mid-1980s. Countries with large CA surpluses have not necessarily done better (e.g. Japan had a long period of stagnation).

In an era of globalisation, financial flows are easier to attract and therefore the deficit is financed by these capital flows.

If the deficit was too large, there should be a depreciation in the ER to restore the balance. A CA deficit is a bigger concern in a fixed ER (like the Euro) because there is no option of depreciation

Question 35

What is an example of a CA surplus?

Answer 35

Japan’s current account surplus was due to weak domestic demand, and a reluctance to buy imports.

Japan’s export sector was still one of strongest sectors of the economy, but this period of a current account surplus was a period of low growth and weak employment growth.

Question 36

What is a ‘tariff’?

Answer 36

A tax on imported goods which has the effects of raising the domestic price of imports and thus restricting demand for them.

Question 37

What is the impact of a tariff?

Answer 37

Domestic demand contracts

Consumer surplus reduces

Domestic supply extends

Imports fall

Producer surplus increases

Tax revenue raised by the government

Net welfare-loss