Balance of Payments & Currencies
Balance of Payments
Topic 4.1.7
Balance of Payments
Topic 4.1.7
Students should be able to know:
• Components of the balance of payments:
• The current account
• The capital and financial accounts
• Causes of deficits and surpluses on the current account
• Measures to reduce a country's imbalance on the current
account (be it a deficit or a surplus)
• Significance of global trade imbalances
Balance of Payments Key Terms
Brief definition
• The balance of payments
(BOP) records all financial
transactions
made between
consumers,
businesses
and
Balance
of Payments imbalances
Persistent deficits
or surpluses mainly
on the current account
the government in one
with
other
nations
The country
current account
measures
the difference
between money
Current account balance
and credit going in and out of an economy (through exports,
• Inflows of foreign currency
are
counted
asboth
a positive
entry
imports and
income
paid on assets
home and abroad)
(e.g.
exports
– they
credit
items
Current
account
surplus sold overseas)
When net external
tradeare
and income
is positive
When net external
trade
and incomeas
is negative
leading to a net
•Current
Outflows
of foreign currency
are
counted
a
negative
account deficit
outflow of demand from the circular flow
entry (e.g. imported goods and services) – they are debit
Effective exchange rate index
The trade-weighted external value of a currency
items
Financial flows
Flows of capital across national borders including debt and equity
• The current account of the balance of payments is the
Excess savings
When gross national savings > gross capital investment
main measure of external
trade performance
Capital (financial) account (BoP)
Balance of investment flows into and out of a country
•Depreciation
The financial accountFallmeasures
inflows and outflows of
in the external value of one currency against another
financial capital acrossA devaluation
national
boundaries
of a currency improves the BoP only if the
Key term
Marshall Lerner Condition
combined (or sum of) price elasticities of demand for imports &
exports are greater than one.
The Current Account
• Current Account
• (1) Balance of trade in goods
• (2) Balance of trade in services
• (3) Net primary income (interest, profits, dividends and
migrant remittances)
• (4) Net secondary income (transfers i.e. contributions
to EU, military aid, overseas aid)
Note: The X-M (trade balance) is the figure used when calculating
aggregate demand
Note: FDI coming into the country will be a surplus on the financial
account but the repatriation of that firm’s profits back to its home
country will be a deficit on the current account
Trade in Goods and Trade in Services
Trade in goods includes:
 Manufactured goods
 Semi-finished goods and
components
 Energy products
 Raw Materials
 Consumer goods
 (i) Durable goods
 (ii) Non-durables e.g. foods
 Capital goods
Trade in services includes:
 Banking, insurance and
consultancy
 Other financial services
including foreign exchange and
derivatives trading
 Tourism industry
 Transport and shipping
 Education and health services
 Research and development
 Cultural arts
The UK Trade Balance in Goods and Services
The UK’s trade balance – the difference between exports and imports – has been in deficit
(imports higher than exports) since 1998. The UK currently runs a deficit in trade in goods –
which is partly offset by a surplus in trade in services.
Items included in the current account of the BoP
Trade Balance in
Goods
• Finished manufactured goods, components,
raw materials
• Energy products, Capital technology
Trade Balance in
Services
•
•
•
•
Net Primary Income
from Overseas
Assets
Net Secondary
Income
Banking, Insurance, Consultancy
Tourism, Transport, Logistics
Shipping, Education, Health,
Research, Cultural Arts
• Profits, interest and dividends from investments
in other countries
Net remittance flows rom migrant workers
•Overseas aid / debt relief
•Military grants
•UK Payments to the European Union
The Capital Account
• Capital account
• Sale/transfer of patents, copyrights, franchises, leases
and other transferable contracts (example would be
international buying and selling of land by businesses)
• Debt forgiveness/cancellation (forgiving debt counted
as a negative)
• Capital transfers of ownership of fixed assets (i.e.
international death duties)
Note: The old capital account is now called the financial account. The
capital account in the new Balance of Payments system is now a tiny
part of the overall figure
The Financial Account
• Financial Account – includes transactions that result in a
change of ownership of financial assets and liabilities
between UK residents and non-residents
1. Net balance of foreign direct investment flows (FDI)
2. Net balance of portfolio investment flows (e.g.
inflows/outflows of debt and equity)
3. Balance of banking flows (e.g. hot money flowing
in/out of banking system)
4. Changes to the value of reserves of gold and foreign
currency
Balance of Payments Accounts in Summary
• Current Account
• (1) Balance of trade in goods
• (2) Balance of trade in services
• (3) Net primary income (interest, profits, dividends and migrant remittances)
• (4) Net secondary income (transfers i.e. contributions to EU, military aid, overseas aid)
• Capital account
• Sale/transfer of patents, copyrights, franchises, leases and other transferable
contracts (example would be international buying and selling of land by businesses)
• Debt forgiveness/cancellation (forgiving debt counted as a negative)
• Capital transfers of ownership of fixed assets (i.e. international death duties)
• Financial Account – includes transactions that result in a change of ownership of financial
assets and liabilities between UK residents and non-residents
• Net balance of foreign direct investment flows (FDI)
• Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity)
• Balance of banking flows (e.g. hot money flowing in/out of banking system)
• Changes to the value of reserves of gold and foreign currency
• Balancing item (estimated net errors & omissions)
• Overall balance of payments = zero
What is Foreign Direct Investment?
• FDI is investment from one country into another (normally
by companies rather than governments) that involves
establishing operations or acquiring tangible assets,
including stakes in other businesses
• Foreign direct investment flows:
1. Inward investment is a positive for the UK accounts
• E.g. an overseas business decides to build a manufacturing
factory in the UK
• A foreign retail firm invests to open new stores in the UK
2. Outward investment is a negative for the UK financial
account of the balance of payments
• Investment made overseas by UK businesses
The Geographical Pattern of UK Foreign Assets
UK foreign assets by continent, £ billion, 2005 to 2014
£ billion
Europe
2005
2742.1
2006
2926.1
2007
3632.7
2008
4078.7
2009
3581.6
2010
3740.3
2011
3756.4
2012
3802.0
2013
3526.7
2014
3451.8
Source: Office for National Statistics
Americas
Asia
1608.4
1841.6
2040.0
2272.3
2130.7
2265.9
2475.4
2308.8
2352.3
2605.4
540.9
521.3
630.3
675.6
633.6
862.5
975.0
990.6
1085.2
1030.2
Australasia &
Oceania
83.7
87.6
104.8
117.3
133.3
159.2
153.4
159.3
173.2
144.2
Africa
55.0
48.5
55.2
69.0
70.4
86.6
77.0
91.0
93.3
108.5
The amount of earnings from overseas investments is determined by the amount invested
and the associated rate of return. 45% of the UK’s investment abroad is in Europe with
around 35% of holdings in the Americas. Will this be affected by the 2016 Brexit vote?
What is Portfolio Investment?
• Portfolio investment happens when people / businesses
from one country buy shares or other securities such as
bonds in other nations.
• For example:
1. A UK investor might buy some shares in Google
(portfolio investment outflow for the UK)
2. A German investment bank might buy some of the
sovereign debt issued by the UK government (a portfolio
investment inflow for the UK)
• With share/equity investments , the standard definitions
of control use the internationally agreed 10% threshold of
voting shares although smaller % shares might be enough
to gain some ownership control/influence of bigger
companies
UK balance of payments in context
• The current account balance plus the capital account
balance measures the extent to which the UK is a net
lender (that is, in surplus) or net borrower (that is, in
deficit).
• Countries that run current account deficits have to be net
borrowers in the international financial system. This is the
case for the UK at present with a current account deficit in
2015 of more than 5% of UK GDP
• Countries that run current account surpluses can be net
lenders i.e. they can export surplus US $s etc. in overseas
investment – good example is China and their purchase of
US treasuries + investments made by Sovereign Wealth
Funds
UK Trade Balance in Goods and Services
Annual trade balance measured as a percentage of GDP
6
4
2
0
-2
-4
-6
-8
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Total trade balance
Trade in goods balance
Trade in services balance
UK Current Account Balance – 2000 to 2015
UK Current Account of the Balance of Payments (% of GDP)
3
2
1
0
-1
-2
-3
0,7
-1,9
-0,9
1
1,6
1,7
1,8
2,4
1,1
1,3
1,1
0,3
-2,3
-2,8
-2,4
-2,7
-2,6
-2,5
-2,6
1,2
0,4
-2,3
-3
-1,7
-2,7
-1,3
-0,6
-0,9
-0,8
-0,8
-0,9
-0,9
-1
-0,9
-0,9
-2,2
-2,3
-2
-0,6
-1,3
-2,1
-0,1
-1,3
-1,3
-4
-2
-1,5
-1,4
-1,3
-5
-6
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Trade balance
Primary balance
Secondary balance
UK Current Account Balance – The Long Run
BoP Current Account Balance – Annual - £ million
0
-20000
-40000
Financing the Current Account Deficit
-60000
-80000
-100000
The UK is running a historically high current account
deficit and this needs to be financed by net inflows on
the financial account of the balance of payments. In July
2016, the Bank of England noted that: “The financing of
the UK external deficit is reliant on continuing inflows of
portfolio and foreign direct investment, which have been
used to finance the fiscal deficit and corporate
investment, including in commercial real estate.”
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
-120000
Meaning of a deficit & a surplus on the current account
Current account deficit
Current account surplus
This is an external deficit
This is an external surplus
Net outflow of income from the economy’s
circular flow
Net inflow of income into the economy
Deficit countries need to run a financial
account surplus
Allows a country to run a financial account
deficit
Might be achieved by attracting inflows of
financial capital from other countries
External surplus countries may use
accumulated foreign currency reserves to
establish a sovereign wealth fun
Current account deficit nations are debtor
countries
Current account surplus nations are
creditor nations
Global Trade Imbalances and
Protectionism
A key feature of globalisation in recent years
has been rising trade imbalances which
threatens a resurgence of protectionism
Current account deficits and surpluses
Current Account Surplus Countries
Current Account Deficit Countries
Country
Surplus $bn
% of GDP
Country
Germany
274
7.5
United States -400
-2.4
China
183
1.9
UK
-114
-4.5
Saudi Arabia
133
17.7
Brazil
-81
-3.6
Switzerland
104
16.0
Turkey
-65
-7.9
Netherlands
83
10.4
Canada
-59
-3.2
South Korea
80
6.1
Australia
-49
-3.2
Kuwait
72
38.9
France
-37
-1.3
UAE
65
16.1
India
-32
-1.7
Qatar
63
30.9
Indonesia
-28
-3.3
Taiwan
58
11.8
Mexico
-26
-2.1
Deficit $bn
% of GDP
Source: International Monetary Fund, 2015
Key Causes of a Current Account Deficit
Poor price and non-price competitiveness
• Higher inflation than trading partners
• Low levels of capital investment and research
• Weaknesses in design, branding, product performance
Strong exchange rate affecting demand for exports and imports
• High currency value increases prices of exports
• Appreciating currency also makes imports cheaper
Recession in one or more major trade partner countries
• Recession cuts value of exports to these countries
• Might be barriers to switching to other markets e.g. UK businesses struggle to sell
to emerging markets such as India, Vietnam, Mexico
Volatile global prices (e.g. soft and hard commodities)
• Exporters of primary commodities might be hit by a fall in world prices
• Importing nations could be hit by higher prices for oil and gas, raw materials etc
Key Causes of a Current Account Surplus
Current Account Surplus Countries
Country
Surplus $bn
% of GDP
Germany
274
7.5
China
183
1.9
Saudi Arabia
133
17.7
Switzerland
104
16.0
Netherlands
83
10.4
South Korea
80
6.1
Kuwait
72
38.9
UAE
65
16.1
Qatar
63
30.9
Taiwan
58
11.8
Source: International Monetary Fund, 2015
• A large, persistent current account
surplus results from:
1.
A large and persistent surplus of
savings (S) over investment (I) for
households, firms and the
government. In these countries,
consumption could be higher and
this would help to rebalance trade
2.
A large gap between exports (X)
and imports (M), when net income
balance and net transfers are small
3.
An export surplus may be the result
of very high prices for exports of
commodities such as oil and gas.
• The surplus is not necessarily the
result of a country achieving a high
level of competitiveness.
Consequences of a Current Account Surplus
Current Account Surplus Countries
Country
Surplus $bn
% of GDP
Germany
274
7.5
China
183
1.9
Saudi Arabia
133
17.7
Switzerland
104
16.0
Netherlands
83
10.4
South Korea
80
6.1
Kuwait
72
38.9
UAE
65
16.1
Qatar
63
30.9
Taiwan
58
11.8
Source: International Monetary Fund, 2015
• If a country is running a current
account surplus, this means there is a
net inflow of foreign currency into
their economic system.
• A surplus on the current account
would allow a deficit to be run on the
capital account.
• For example, surplus foreign currency
can be used to fund investment in
assets located overseas
• For example some current account
surplus countries have large sovereign
wealth funds
• Current account surplus countries
nearly always have fairly strong
exchange rates as a result
Evaluating the effects of a current account surplus
Current Account Surplus Countries
Country
Surplus $bn
% of GDP
Germany
274
7.5
China
183
1.9
Saudi Arabia
133
17.7
Switzerland
104
16.0
Netherlands
83
10.4
South Korea
80
6.1
Kuwait
72
38.9
UAE
65
16.1
Qatar
63
30.9
Taiwan
58
11.8
Source: International Monetary Fund, 2015
• Trade imbalances have become a key
feature of the world economy
• Current account balances are neither
good nor bad in themselves.
• It is important to analyse how deficits
or surpluses are used
• For example – an evaluation of capital
investment projects funded from the
Chinese external surplus in SubSaharan Africa, and other regions and
their effects over time
• Persistent surpluses can lead to rising
protectionist sentiment within trade
deficit countries which in the long run
threatens the process of globalisation
Consequences from a current account deficit
Loss of aggregate demand if there is a trade deficit (M>X) which causes weaker real
GDP growth and reduced living standards and rising unemployment
Big current account deficits will cause the currency to depreciate, leading to
higher cost-push inflation and a deterioration in the terms of trade
Can lead to currency weakness and higher inflation and a country may run
short of vital foreign currency reserves
Trade deficit might be a reflection of lack of competitiveness / supply-side
weaknesses in the economy
Some countries running current account deficits may choose to borrow to
achieve a financial account surplus - increases risks
Unsustainable current account deficits can ultimately lead to a loss of investor
consequence, leading to capital flight and a currency / balance of payments crisis
The Export Multiplier Effect
A fall in exports will reduce AD and the final impact on GDP, jobs
and investment is amplified by multiplier and accelerator effects
The Export Multiplier Effect
GPL
AS
Many industries rely heavily on key
export industries remaining
competitive – these include:
GPL1
• Transportation / freight /
logistics businesses
GPL2
• Trade finance businesses e.g.
Insurance and trade credit
AD1
AD2
Y2 Y1
Real GDP
• Service businesses that operate
in ports and airports
Exports particularly important for
regional economic performance
Policies to reduce a trade (current account) deficit
• Demand management:
• A tightening of fiscal and/or monetary policy reduces real
spending power of consumers and leads to lower spending on
imports (fall in M improves trade balance)
• Lower exchange rate reduces the foreign price of exports and
makes imports more expensive – causes changes in demand
• Supply-side improvements:
• Policies to raise labour productivity and encourage start-ups
with export potential e.g. Life sciences, digital etc
• Investment in human capital to boost productive capacity and
competitiveness in high-value industries such as bio-technology,
engineering, medicine, tourism
• Protectionist measures such as import quotas and tariffs
(NB: But the is UK limited by global trade agreements
including WTO rules even though it is now exiting the EU)
Expenditure Switching and Expenditure Reduction
Expenditure Switching Policies
• These are policies designed to change the relative
prices of exports and imports
• For example - an exchange rate depreciation ought to
improve the price competitiveness of exports and also
make imports more expensive
Expenditure Reducing Policies
• Policies designed to lower real incomes and aggregate
demand and thereby cut demand for imports
• E.g. higher direct taxes and an increase in interest rates
Expenditure Switching and Expenditure Reduction
Expenditure Switching Policy
Instrument of Policy
Evaluative Comment
Depreciation of the exchange
rate
Reduces relative price of
exports & makes imports
more expensive
Risk of cost-push inflation –
which erodes competitive
boost + fall in real incomes
Import tariffs
Increases the price of imports Risk of retaliation from other
& makes domestic output
countries if import tariffs are
more price competitive
used as BoP policy
Low rate of inflation (perhaps Keeps general price level
deflation)
under control and makes
exports more competitive
Risks from deflation as a way
of achieving internal
devaluation – including lower
investment
Expenditure Switching and Expenditure Reduction
Expenditure Switching Policy
Instrument of Policy
Evaluative Comment
Depreciation of the exchange
rate
Reduces relative price of
exports & makes imports
more expensive
Risk of cost-push inflation –
which erodes competitive
boost + fall in real incomes
Import tariffs
Increases the price of imports Risk of retaliation from other
& makes domestic output
countries if import tariffs are
more price competitive
used as BoP policy
Low rate of inflation (perhaps Keeps general price level
deflation)
under control and makes
exports more competitive
Risks from deflation as a way
of achieving internal
devaluation – including lower
investment
Expenditure Reducing Policy
Instrument of Policy
Evaluative Comment
Increase in income taxes
Reduces real disposable
incomes causing falling
demand for imports
Cut in living standards and
risk of damage to work
incentives in labour market
Cuts in real level of
government spending
Lowers aggregate demand,
Damage to short term
firms may look to export their economic growth, risks that
spare capacity
austerity hits investment