What is the Balance of Payments? Describe the main components of the UK balance of payments.
What is the Current Account? Explain the pattern of the UK’s Balance of Payments in recent years.
What is visible trade and invisible trade?
What are current account deficits and current account surpluses? Evaluate the importance of current account deficits and current account surpluses.
Explain policies to reduce a long run current account deficit.
What is the Balance of Payments?
The record of all financial transactions that take place between one country and all other countries. The balance of Payment is split into two separate parts:
- Capital Account. Measures flows of capital, or investment money, between countries
- Current Account. Measures flows of money for goods and services between countries.
Flows of money into the country are calculated as positive. Flows of money out of the country are calculated as negative.
The Balance of Payments measures the inward flow minus the outward flow of money. The Balance of Payments can therefore be positive or negative:
- Surplus. If inward flow is greater than outward flow there is a current account surplus.
- Deficit. If outward flow is greater than inward there is a current account deficit.
Current Account
The Current Account is split again into two separate parts including Visible Trade (Visible) and Invisible Trade (Invisibles).
1. Visible Trade. This is about trade in goods. The export of goods leads to money flowing into the economy (positive). The import of goods leads to money flowing out of the economy (negative). The difference between these two is called the ‘balance of visible trade’. The Visibles section contains all tangible goods which may be traded between countries including:
- Manufactured and work-in-progress (unfinished components) goods.
- Energy products and raw materials.
- Consumer goods including both durable and non-durable.
When China trades silk or tea with other countries, it receives an inflow of money from exporting (positive). If the UK is the purchaser of these products then money is flowing out of the UK (negative).
2. Invisible Trade. This is about trade in services. The export of services leads to money flowing into the economy (positive). The import of services leads to money flowing out of the economy (negative). The difference between these two is the ‘balance of invisible trade’. The Invisibles section contains all intangible goods which may be traded between countries including:
- Banking, insurance and consultancy services.
- Tourism and the arts.
- Healthcare.
- Research and Development (R&D).
- Education.
- Transportation and shipping.
The UK has a comparative advantage in selling financial services abroad. Banks such as HSBC bring in money from abroad, from foreign and domestic customers, including both business and private citizens.
A. Current Account surplus
A surplus is generally seen as a good thing as there will be an increase in the country’s net foreign wealth. This means assets owned overseas increase in relation to assets owned by foreigners within the country. This net foreign wealth can be used in the future when it is needed. A surplus for foreign trade, however, will reduce what is available now for consumption. In other words, resources could have been used to produce goods for the domestic market.
For example, Chinese laborers producing surplus textiles could be involved in the production of building materials to help modernize the country, such as better quality housing. Further problems may be that long-term surpluses may cause political problems between countries leading to protectionist measures. For instance, China’s surplus is the USA’s deficit, and, as a result, the US government may impose trade barriers on Chinese products, or put pressure on the Chinese government to let its currency (RMB) appreciate (get stronger).
B. Current Account deficit
A deficit is generally seen as a bad thing as the deficit has to be financed. This finance will come in the form of borrowing in many possible guises. We cannot be certain how as the deficit is the result in millions of transactions made by millions of individuals. However, if Gross Domestic Product (GDP) is growing faster than a deficit, financing the debt is possible, even over a long period of time.
If you look below at the balance of trade in goods (visible), the UK has a deficit of £60.9 billion for 2004.
However, UK services (invisible) had a surplus of £25.9 billion in 2004 (the highest year). The result was a total deficit of £35 billion that year.
During this period, the UK had stable growth and low unemployment and had done so for a long period of time. The deficit was smaller than the growth of Gross Domestic Product (GDP), therefore it was sustainable.
The total Gross Domestic Product (GDP) for the UK in 2004 was £1,176,527,000,000. The deficit of £35,000,000,000 was less than 3% of GDP. The good news for the UK is that total Gross Domestic Product (GDP) growth was over 5% that year. Lenders would feel confident in the ability of the UK’s economic agents to repay debt.
Policies to reduce a long term current account deficit
There are various measures a government can take to ensure the current account does not damage the economy:
- Import controls
- Currency evaluation
- Deflation
1. Import controls
Government can reduce imports by introducing trade barriers, such as tariffs, quotas and embargoes. The use of trade barriers may lead to retaliation from other countries as they may also use protectionist measures themselves.
2. Currency devaluation
If the value of the currency is decreased then exports will be relatively cheaper and imports relatively more expensive. This will result in Exports (X) increasing and Imports (M) decreasing. The current account deficit will therefore become smaller so long as total PED>1. This means the majority of products need to be elastic, e.g. luxuries/have appropriate substitutes. This is sometimes referred to as the Marshall-Lerner Condition. Most countries ‘float’ currencies on international money markets; therefore, few governments will actively try to devalue their currency.
3. Deflation
Deflation, or relatively lower inflation, will reduce prices relative to other countries. This makes exports relatively cheaper and imports relatively more expensive. This means domestic industries will become more competitive in international markets. A manner of doing this could be by raising the interest rate. This policy is likely if a nation is experiencing high inflation. Also, it may have a knock-on effect of increasing exports, as they may become relatively cheaper for overseas buyers. Again this will result in Exports (X) increasing and Imports (M) will decreasing. The current account deficit will therefore become smaller.
Summary
The Balance of Payments is a record of total imports and exports. The current account is a measure of tangible and intangible goods. Continued deficits can be damaging to economies, but so can surpluses. The Marshall-Lerner Condition is when devaluation of a currency allows a deficit to balance out.
