Chapter 6-4: Balance of Trade Flashcards
Balance of Payments
The Balance of Payments (BOP) for a country is a record or overall statement of all economic transactions between residents of a country with the rest of the world, usually over a year.
Pay attention to
Current account - BOT
Capital and Financial Account - FDI, Portfolio investments (gov bonds, company shares), Short-term capital flow
BOT
Visible vs Invisible trade
Export revenue - Import expenditure
Capital and Financial Account
- The Financial Account - This is another important sub-account within the BOP which records all cross-border investment flows.
- There are essentially 3 main types of cross border investments as explained below:
- Direct Investment (DI)
- Real or tangible assets like setting up businesses abroad e.g. building factories and offices, shopping malls and hotels. This account covers the flow of FDls.
- For example, when foreign MNCs build plants / malls etc in Singapore, it is an inflow of foreign direct investment into Singapore. When Singapore companies build plants overseas, it is an outflow of direct investment from Singapore.
- Portfolio Investment
- This refers to the purchase of company shares and government bonds.
- For example, a Singaporean may purchase Apple Inc (US) shares and the Chinese government can purchase the US bonds.
- Other Investment (‘Hot Money’)
- These are cash deposits and loans with commercial banks and generally known as ‘hot money’ flows.
- The ‘hot money’ is a metaphor used to refer to the transfer of short-term funds (cash) from one country to another in order to take advantage of better interest rates or more favourable exchange rates.
- Such transfers occur frequently whenever fund managers expect interest rates or exchange changes. Hence, such funds are always moved around or kept on the run and often not long enough
in one place for it to “cool down”. - Note: Candidates are required to have knowledge of the key components of the balance of payment accounts, but the accounting process is not required.
- Direct Investment (DI)
Improvement in BOT - Gov
Expansionary Effect on Economy
- Assume there is an increase in the real trade balance (e.g. rise in BOT due to a rise in the demand for exports). This will in turn increase the aggregate demand since net export is a component of the aggregate demand and national income will increase through the multiplier process.
- Refer to Figure 1, a rise in the net exports will shift the aggregate demand from AD0 to AD1. Through the multiplier process, it will lead to a more than proportionate increase in national income, from Y0 to Y1. At the same time, cyclical unemployment will decrease due to the rise in real output from Y0 to Y1 as more resources are hired to increase production. General price level rises from Po to PI.
Improvement in BOT - Producer
Increase in I
- With an increase in incomes, demand for goods and services increases and firms hire more workers and increase production. They gain greater revenue and profits. The macroeconomic effects of a rise in AD due the increase in trade balance boosts investor confidence, leading to greater investments by the firms.
- Increase revenue = Increase profit
Improvement in BOT - Consumer
Increased C, Higher material SOL
- With economic growth due to an increase in the trade balance, consumers’ income and purchasing power increases. This increases consumers’ demand for goods and services which in turn increase consumption and reduces savings. The purchase of more goods and services increases the material standard of living of consumers.
- Increased RNI per capita = Increase material SOL
Capital Inflows - I
Inflow of FDI
- Gov: Non-inflationary EG, increased employment
Foreign Direct Investment (FDI) is an important factor which helps to create jobs in an economy. An increase in net borrowing in financial account associated with an inflow of foreign direct investment, will result in transfer of technology and more job opportunities. This will cause a rise in both AD and AS of the host country.
Cannot rely too much as foreign firms tend to remit profits back home
- Consumers’ and Producers’ Perspective is similar to ‘Consequences of an improvement in the BOT’ as the rise in AD will similarly increase incomes of consumers and hence consumption and material standard of living while lowering savings. Producers will similarly be encouraged to increase output level and investment.
Inflow of ‘Hot Money’ and Portfolio Investment
- Governments’ perspective: Impact of Currency Appreciation
- ‘Hot money’ inflows can be due to relatively higher domestic interest rates of domestic interest-bearing assets such as fixed deposits or bonds.
- Financial flows into the stock market can be due to positive expectations on the performance of the companies that issued the stocks or actual improvements in their performance.
- The inflow of hot money would exert an upward pressure on the external value of the country’s currency, resulting in an appreciation.
- Since local stocks or interest-bearing assets are often transacted in the domestic currency, such inflows will lead to an increase in demand for the domestic currency, thus exerting an upward pressure on its exchange rate.
- However, an appreciation of the currency, in turn may dampen a country’s export competitiveness and adversely affects its balance of trade.
Deterioration in BOT - Gov
Contractionary Effect on Economy
- A growing deficit in the current account that stems from a fall in net exports for example reduces aggregate demand and national income through the multiplier process.
- [Graph]
- With reference to Figure 3, a fall in the net exports can decrease the aggregate demand (AD) from AD0 to AD1. Through the multiplier process, it will lead to a more than proportionate decrease in national income, from Y0 to Y1. At the same time, cyclical unemployment will increase as seen from the increase in output gap from Y0YF to Y1YF since the lack of demand for output will mean lesser factors of production are needed and thus workers are retrenched.
- At the same time, the deficit in current account will result in a drawing down of foreign reserves.
- Can ease demand pull inflation
Deterioration in BOT - Producers
With a fall in incomes, demand for goods and services decreases and firms hire less workers and reduce production. The macroeconomic effects of a fall in AD reduce investor confidence, leading to fewer investments by the firms.
Deterioration in BOT - Consumers
With the contractionary effect on the economy due to the fall in net exports, consumers’ income falls and purchasing power shrinks. This reduces consumers’ demand for goods and services which in turn reduce consumption and increase savings. The purchase of fewer goods and services also lowers the material standard of living of consumers.
Capital Outflows - Outflow of DI
Outflow of DI
- Governments’ Perspective: Slow or negative growth, slow increase in productive capacity, loss of jobs
- FDI is an important source for creating employment. The outflow in the financial account is due to a re-direction of investments away from domestic economy towards lower labour costs countries, i.e. offshoring/relocation of the factories, will lead to a fall in her AD and a cause a multiple fall in her national income through the reverse multiplier process.
- The fall in national output will thus reduce the demand for labour and result in a rise in unemployment in the domestic economy. The productive capacity of the economy will grow at a slower pace.
- Note: There will be a decrease in a country’s productive capacity if its factors of production are destroyed by natural calamities or war.
- The Producers’ and Consumers’ Perspective is similar to ‘Consequences in a deterioration in the BOT’.
Capital Outflows - Outflow of ‘Hot Money’ and Portfolio Investment Leading to Depreciation
- Governments’ Perspective: impact of Currency Depreciation
- ‘Hot money’ inflows can be due to relatively higher foreign interest rates of foreign interest-bearing assets such as fixed deposits or bonds.
- Financial flows out of the stock market can be due to negative expectations on the performance of the companies that issued the stocks or actual worsening of their performance.
- These outflows would lead to local currencies being sold and converted to foreign currencies, causing the supply for the local currencies to rise. This exerts a downward pressure on the external value of the country’s currency, resulting in a depreciation.
- A depreciation of a country’s currency may in turn improve its export competitiveness and generate actual growth and employment opportunities through an increase in net exports and hence AD.
- However sudden depreciation destabilises the exchange rate - affects investor confidence.
- Producers’ Perspective
- The depreciation of the exchange rate will affect producers’ dependence on imported raw materials and capital to produce goods and services as the more expensive imports increases the cost of production and reduce profit margins.
- At the same time, the destabilising effect on the exchange rate will discourage investment
- Consumers’ Perspective:
- The depreciation of currency will make imports more expensive and consumers are likely to reduce consumption of imported goods. If there are no locally produced substitutes available, consumers’ material standard of living is likely to fall.
Persistent Trade Deficit
A country that is facing a persistent trade deficit is not earning enough from its exports to pay for its imports.
If a trade deficit is financed through borrowing, it is unsustainable in the long term as the country will be burdened with interest payments. Countries with large interest payments have little left over to spend on Investment. E.g. Russia, Brazil and African countries had experienced repayment problems.
If the deficit is financed by foreign multinationals investing in a country or purchasing assets, more of the country’s future income will flow out to foreigners in the form of interests, rents, go dividends and profits (via the primary income balance on the current account).
If there is a depletion of foreign reserves, this means that these reserves are unavailable for future purchase of imports for consumption. Hence, a country that is facing a persistent current account deficit is merely enjoying higher current consumption at the expense of the welfare of future generations.
However, a trade deficit may not always be a cause of concern. If the deficit is financed from long term capital inflow (FDI), it can increase the productive capacity of the country and create jobs.
E.g. Japanese investment has been good for the UK economy as the economy benefited from increased investment and the Japanese firms also helped bring in new working practices to increase labour productivity.
Moreover, for a developing country, a persistent current account deficit in the initial years of development could be due to imports of capital goods (rather than consumption goods). This facilitates capital accumulation and contributes to the growth of productive capacity and exports in the long run.
With the eventual rise in exports, the current account should improve over time, possibly transforming from a deficit to a surplus.
Unlike a persistent trade deficit, countries are less concerned about a persistent trade surplus as a surplus means that the country is saving some of its current income to finance future spending. However, if a country is running very large surpluses, then the question will be whether the current generation is sacrificing too much for the future generation.
Increase in Trade Deficit - Reduction in Export Revenue
- Loss in Comparative Advantage due to Emergence of Low-Cost Competitors
- The law of comparative advantage states that countries should specialise in the production of goods for which it has a lower opportunity cost.
- Many developed countries have lost their comparative advantage in the production of low-end manufacturing goods with the emergence of low-cost economies like China. Her abundance in cheap labour, vast land and other resources, resulted in China having a lower opportunity cost in the production of such goods relative to the developed countries. China will thus specialise in mass production of these goods and enjoys cost sayings via economies of scale. This will then translate to lower price.
- This results in a loss in export competitiveness of the developed countries as the Chinese products are preferred due to their lower price. When the price of China’s export is cheaper, importers will import from China and their demand for the developed economies’ exports will fall, assuming a high degree of substitutability between these exports.
- Developed countries’ imports will also increase as their residents switch their expenditure to the relatively cheaper imported goods. Assuming that the demand for imports is price elastic, there will be a more than proportionate increase in quantity demanded for imports and import expenditure increases.
- Hence, the fall in exports revenue, coupled with a rise in imports expenditure will result in a worsening balance of trade and even a deficit.
- Many Multi-nationals Companies (MNCs) have outsourced and/or offshored their production to these emerging economies to take advantage of their comparative advantage. As a result, the developed countries lost their export revenue to the emerging economies.
- Higher inflation rate RELATIVE to other trading partners
- A rise in a country’s inflation rate relative to others will cause her exports to be relatively expensive and imports to be relatively cheap.
- Assume demand for exports is price-elastic due to the availability of substitutes, a rise in price of exports will cause quantity demanded to fall more than proportionate and the export revenue will fall.
- The effect is exacerbated if the country’s inflation rate is higher than other countries as the country’s exports will be relatively expensive and its trading partners will switch to the relatively cheap exports from other countries, leading to a fall in the demand for the country’s exports and a further fall in export revenue.
- Assume domestic goods and imports are substitutes deemed by consumers to be alternatives to satisfy similar wants, with a higher inflation rate, a rise in the price of domestic goods will cause demand for imports to rise as consumers switch to the relatively cheaper imports, leading to a higher import expenditure.
- As a result, a fall in export revenue together with a rise in import expenditure will worsen the balance of trade.
- Unfair Trade Practice
- It is a cyclical factor (temporary) if countries resort to unfair trade practices to boost their exports in times of an economic downturn/recession. However, it is a structural factor (long term) if countries adopt unfair trade practices as a normal trade policy.
- Trading partners under-value their currencies
- Countries like US have accused its trading partners, particularly China of keeping the Yuan undervalued.
- Practice of Protectionism through Erection of Trade Barriers like Tariffs
- To protect the home industry, the government levies a specific tariff on imports, raising the price of imports. As a result, the locals may switch back to the domestic goods.
- Affluence & Industrialisation
Increase in Trade Deficit - Increase in Import Expenditure
- Affluence leading to High Imports for Consumption + Industrialisation leading to Higher Imports for Machines and Raw Material
- Higher growth rate together with increasing consumerism will result in a larger import expenditure on consumer goods. Emerging economies like China and India have been enjoying high growth rates and this resulted in a growing middle class who demanded for goods such as cars and conditioner units. These countries which are undergoing the industrialisation phase have a huge appetite for imports especially in capital goods and raw materials to support production.
- Assuming most of the imports they purchase are positive income elastic, the demand will increase more than proportionate when income increases. This higher demand for imports will worsen the trade balance, ceteris paribus.
