Balance of Payments 2023-24 PDF

2.5 The Balance of Payments 1 YEAR 12 MACROECONOMICS 2023-24 There has been a huge increase in the amount of international trade, especially since WW2. The value of global exports is now more than 30 times what it was in 1950. World trade has grown more than proportionately with GDP – in some countr...

2.5 The Balance of Payments 1 YEAR 12 MACROECONOMICS 2023-24 There has been a huge increase in the amount of international trade, especially since WW2. The value of global exports is now more than 30 times what it was in 1950. World trade has grown more than proportionately with GDP – in some countries, the value of exports to GDP ratio is significantly higher than the world average. Why countries trade (4.1) Balance of Payments (2.5) Exchange Rates (4.2) International Globalisation (4.3) TRADE Protectionism or Integration (4.1, 4.4) Definitions and Measurements Definition The balance of payments (BoP) records all economic transactions between residents of an economy and the rest of the world. The Balance of Payments is a system of accounts in which many ‘balances’ can be derived, such as the balance of trade in goods and services, the current account balance, and the capital and financial account balance. The BoP should balance overall, with the current account balance being offset by the financial and capital account balance. There is also a ‘balancing item’ called ‘net errors and omissions’ which ensures that the BoP is indeed balanced. Components of the Balance of Payments Current Account: covers trade in goods and services, as well as net primary (stream of income from existing foreign assets, such as rent, interest, dividends) and net secondary income (transfers, which are one-way flows). Financial Account: covers transactions that result in a change in ownership of financial assets and liabilities between UK residents and foreign residents. This includes net FDI, net portfolio investment (debt and equity), banking flows (‘hot money’), and changes in gold and foreign currency reserves. Capital Account (we will not study this): covers sale/purchase of non-produced, nonfinancial assets such as patents, copyrights, leases, franchises. https://www.tutor2u.net/economics/reference/balance-of-payments-the-financialaccount Current Account or Financial Account for the UK? Tesco buys green beans from Zambia I go on holiday to Chicago Jack gets monthly rent from a property he owns in Chicago I earn interest from my savings account in India Hearing that the Reserve Bank of India will lower interest rates, I decide to move my money back to the UK Toyota opens a new factory in the UK Alex sends money from the UK to South Africa to help her sister go to university Components of the Current Account The BoP Current Account records all income flows from international trade in goods and services, primary income (investment income) and secondary income (transfers). 1. Trade balance: a measure of net international trade in goods and services. The trade balance records the total value of exports minus the total value of imports. Exports: credit item on the current account (money flowing in) Imports: debit item on the current account (money flowing out) If value of exports > value of imports, there is a trade surplus. If value of exports < value of imports, there is a trade deficit. Components of the Current Account 2. Primary Income (investment income) balance: this is the difference between total earnings received by domestic residents from assets located outside the domestic economy and the total income paid out to foreign owners of assets located in the domestic economy. Examples: rent on foreign property, interest payments from foreign bank accounts, dividend payments from foreign financial assets. 3. Secondary Income (transfers) balance: net balance on one-way transfers into and out of the domestic economy. Examples: foreign aid, membership dues to international organisations, remittances sent by individuals to relatives overseas, social security payments abroad. The Current Account balance Money earned by domestic residents and flowing into the country counts as a credit item, while money flowing out to foreigners counts as a debit item. There is a current account (CA) surplus if: Trade Balance + Net primary and secondary income balance > 0 This means that more money is flowing into the country from trade in goods and services, as well as primary income and secondary income, than is flowing out. Similarly, there is a current account (CA) deficit if: Trade Balance + Net primary and secondary income balance < 0 Note that it is not enough to simply look at exports and imports in order to determine the CA balance. Source: ONS Note that the UK current account is normally in deficit. Between 1999 Q1 and 2019 Q4, there was only one quarter where the current account was in surplus. UK Current Account Balance of payments, UK Office for National Statistics (ons.gov.uk) UK Trade Balance (part of the Current Account) UK Primary Income (part of the Current Account) The Financial Account The financial account looks at the domestic ownership of foreign assets (e.g. UK residents holding foreign bank accounts or shares in foreign companies), as well as foreign ownership of domestic assets (e.g. foreigners owning UK government bonds or holding UK bank accounts). A current account deficit places the UK as a net borrower with the rest of the world, indicating that overall expenditure in the UK exceeds national income. The UK is consuming more than is producing. The UK must attract net financial inflows to finance its current account deficit. This can be achieved through either selling some of UK’s foreign assets or accruing liabilities with (borrowing from) the rest of the world. UK Financial Account Can’t balance your balance of payments? Chalk it up to net errors and omissions! Factors influencing the current account 1. Economic activity in the domestic economy Increasing economic activity in the domestic economy is likely to increase the demand for imports, reducing net exports (X-M). This is because higher income for domestic households, firms and government, is likely to increase aggregate demand, some of which will be satisfied through the purchase of imports. This will worsen the trade balance and is also expected to lead to an increase in a current account (CA) deficit (or a fall in a CA surplus, or turn a CA surplus to CA deficit). Similarly, Falling economic activity in the domestic economy is likely to ______________. This is because ___________________________________________________. This will improve the trade balance and _______________________________. Current account deficits – Chains of Reasoning | tutor2u 2. Economic activity in other countries Increasing economic activity in other countries is likely to increase the demand for exports, increasing net exports (X-M). This is because a higher income for foreign households, firms and government, is likely to increase external demand, increasing the total value of exports. This will improve the trade balance and is expected to lead to a fall in the CA deficit (or increase a CA surplus; or turn a CA deficit to CA surplus). Similarly, Falling economic activity in other countries is likely to ____________________. This is because ____________________________________________________. This will worsen the trade balance and _________________________________. 3. Inflation rate in the domestic economy A relatively low domestic rate of inflation is likely to increase the relative pricecompetitiveness of domestically-produced goods and services. If prices of domestically-produced goods and services rise slower than prices of goods and services produced in other economies, there should be an increase in demand for exports and a fall in demand for imports. The total value of exports should increase, and the total value of imports should fall; thus, the balance of trade should improve. A low rate of domestic inflation should lead to a fall in a current account deficit (or increase a CA surplus; or turn a CA deficit to CA surplus). Can you write a similar chain of reasoning for how a relatively high domestic rate of inflation affects the CA balance? 4. Productivity growth in the domestic economy Higher productivity growth in the domestic economy is likely to increase the relative price-competitiveness of domestically produced goods over time. As average costs of domestic production fall relative to foreign production, domestic goods should become more price-competitive. There should be an increase in demand for exports and a fall in demand for imports. The total value of exports should increase and the total value of imports should fall. Thus, the balance of trade should improve. Therefore, rising productivity growth in the domestic economy should lead to a fall in a current account deficit (or increase a CA surplus, or turn a CA deficit to CA surplus). How does low productivity growth in the domestic economy affect the CA? Current account deficits – Chains of Reasoning | tutor2u 5. The exchange rate The exchange rate is the price of one currency in terms of another currency (or currencies). In this case, we can think of it as the price of domestic currency in terms of foreign currency; for example, what is the price of £1 in US dollars or euros? We will talk about this in Section 4.2. A fall (depreciation) in the exchange rate is likely to increase the relative pricecompetitiveness of domestically produced goods for foreign buyers, as less foreign currency is required to buy goods priced in domestic currency. This should lead to an increase in demand for exports and fall in demand for imports (as prices of imports also rise for domestic buyers). There should be an increase in net exports (X-M)1, leading to a fall in a current account deficit or increase a CA surplus (or turn a CA deficit to CA surplus). 1Whether or not this happens depends on the price elasticity of demand for exports and imports and whether or not the Marshall-Lerner condition holds (Section 4.2) Current account deficits – Chains of Reasoning | tutor2u 2.5 The Balance of Payments 2 YEAR 12 MACROECONOMICS 2023-24 Consequences of a current account imbalance Persistent current account imbalances A persistent CA deficit means that there is a sustained short-fall of foreign exchange income from trade (net exports), primary income (investment income) and secondary income (current transfers). The UK and USA have persistent CA deficits. Similarly, a persistent CA surplus means that there is a sustained excess of foreign exchange income from trade, primary income and secondary income. China and Germany have experienced persistent CA surpluses. Current account balance (BoP, current US$) | Data (worldbank.org) Current Account Deficits: Is There a Problem? - Back to Basics: Finance & Development (imf.org) Possible consequences of a CA deficit 1) Downward pressure on the exchange rate: a persistent CA deficit can lead to a depreciation of the domestic currency. This is caused by a fall in the demand for domestic currency (because foreigners demand fewer pounds) and an increase in the supply of domestic currency (because we are exchanging pounds for foreign currency in order to buy imports) (Section 4.2). 2) Reduced foreign exchange reserves: this is a problem because foreign reserves held by the central bank are used to maintain the exchange rate, to meet foreign financial obligations, and to provide liquidity in the economy in case of a crisis (the central bank can exchange their foreign reserves for domestic currency). Why do countries keep foreign currency reserves? | World Economic Forum (weforum.org) 3) Increased foreign ownership of domestic assets: a CA deficit needs to be offset by a Financial Account surplus. This means the sale of domestic assets (shares, bonds, other property) to foreign buyers to acquire foreign exchange. This may lead to further (future) outflows of income, as outflows of primary income (profits, rent and dividends). This could lead to reduced domestic income in future. Possible consequences of a CA deficit 4) Loss of domestic sovereignty, if there is increasing foreign influence on decisions affecting the domestic economy. 5) Possible increase in indebtedness (liabilities), due to increased foreign borrowing. This could lead to increasing costs of external debt servicing (as interest payments on external debt are required in foreign exchange). 6) Possible increase in domestic borrowing costs, especially if the central bank base rate is increased to prevent the currency from depreciating Section 4.2 (or to address rising inflation). 7) Negative impact on international credit ratings, due to a possible increase in perceived risks and uncertainty for creditors. 8) Possible lack of funds to support domestic demand management, restricting the extent to which fiscal policy could be used to stimulate aggregate demand (AD). Possible consequences of a CA surplus Based on what you know about the consequences of CA deficits, you should be able to work out the consequences of a CA surplus. Make sure you can expand on the points below: 1) A sustained rise in the exchange rate 2) Increased foreign exchange reserves 3) Purchase of foreign assets (shares, bonds, property) by domestic buyers, which could lead to increased domestic income in future. 4) Greater wealth and influence of domestic companies in foreign economies. 5) Increased lending in foreign exchange, which could lead to greater interest payments in future. 6) Possible target for protectionist measures (retaliation) by other countries, if the persistent surplus is believed to be as a result of protectionist policies. 7) Positive impact on international credit ratings 8) Possible increasing funds to support domestic demand management in future Current Account Surplus (CAS): Summary Possible Advantages Possible Disadvantages CAS means that most likely NX > 0. Thus there is higher domestic production and real GDP and employment Higher AD due to higher exports might be inflationary Useful for developing countries – growth can be export-led even if domestic consumption is low due to low incomes Domestic economy reliant on foreign economies; this might be a source of volatility CAS means a deficit on the financial and capital accounts. These capital outflows (foreign investment) are likely to increase primary income in the future Financial outflows means that there is not much investment in the domestic economy – could lead to lower long run economic growth Current Account Deficit (CAD): Summary Possible Advantages Possible Disadvantages CAD means that there is a surplus on the financial and capital accounts. Thus, it might be an indication that the economy is an attractive destination for FDI, and this provides an important source of finance CAD means that NX is likely to be negative, which means that AD is lower. Lower AD for domestic goods and services can lead to higher unemployment Inflation may be lower because of the If CAD is very high, it might reduce lower AD (if, however, the CAD causes the business confidence and investment in the exchange rate to depreciate, this might be economy inflationary) If the capital flows are suddenly reversed (capital flight), then there will be a BOP crisis Evaluating the consequences of current account imbalances The significance of a current account imbalance (deficit or surplus) will depend on 1) The size of the CA deficit (or surplus) The larger the deficit, the larger the outflow of income from the domestic economy that could have been spent on products produced domestically. The larger a CA deficit, the more international borrowing may be required to finance the CA deficit; this could lead to greater costs associated with debt repayments. 2) The duration – how long the CA deficit (or surplus) persists for In the short term, a CA deficit can boost living standards, as households buy more consumer durables etc. In the long term, it may be a symptom of a weak economy, reflecting the lack of international competitiveness. The longer a CA deficit is sustained, the greater the loss of ownership and control of assets located in the domestic economy. A CA deficit also has implications for the exchange rate (depends on whether the exchange rate is fixed or floating – more on this in Section 4.2) The significance of a current account imbalance (deficit or surplus) will depend on 3) Cause of the CA deficit (or surplus) Structural weaknesses and a lack of international price-competitiveness (possibly due to low productivity growth) are likely to be far more damaging to an economy, because there are likely to be larger outflows of income and greater inflationary pressure over time. If the country is importing significant amounts of capital goods, this can increase productive capacity, which raises international competitiveness and could correct the CA deficit over time; not considered a problem if it facilitates long-run growth. Note that fluctuations in the exchange rate could also be the cause of CA imbalances. Structural weaknesses that might affect international competitiveness and the CA Lack of adequate financial markets, meaning a lack of investment Lack of human capital due to poor education, inadequate R&D Low (growth of ) productivity Persistently high relative prices and rate of inflation High production costs (e.g., wages, utilities, rents) Corruption and lack of strong institutions Poor quality / lack of infrastructure Weak environment for business (e.g., high levels of regulation and ‘red tape’) Can the economy afford a CA imbalance? If a country continues to attract portfolio and direct investment from abroad, it will be more able to finance its CA deficit and afford imports. This is far more likely if an economy, and the value of its assets, is growing. If a country has a large existing stock of domestic-resident-owned assets, it is far more likely to afford to sustain a CA deficit over time, by selling a proportion of these assets to non-residents. If a CA deficit is caused by a commitment to fix (peg) the domestic currency, the currency may be fundamentally overvalued. Though this may be sustainable in the short-run, in the long-run it is far more likely to be harmful and may cause a currency/debt crisis. If a CA surplus is an indication that a currency is fundamentally undervalued, due to manipulation by monetary authorities (China?), this may lead to significant trade disputes and retaliation – could lead to a trade war. Current Account Balance: policy options Policies to correct a persistent CA deficit Policies to correct a persistent CA surplus Deflationary policies (reducing AD) Devaluation (applies to fixed exchange rates) Reflationary policies (increasing AD) Revaluation (applies to fixed exchange rates) Direct controls (protectionism) Remove controls (protectionism) Supply-side policies (to address structural weaknesses) Reducing a CAD: Deflationary or Expenditure reducing policies Policies that reduce aggregate demand are known as ‘expenditure reducing’. For example: Contractionary fiscal policy (reduce government spending or increase taxes) Contractionary monetary policy (reduce the money supply or raise interest rate) Write a chain of reasoning explaining how an increase in direct taxes could help reduce a CA deficit. 1. An increase in direct taxes will lead to a reduction in spending by households (lower consumption due to lower disposable income) and firms (lower investment due to lower retained profits). 2. This will lead to a reduction in aggregate demand; this is shown by a shift from AD1 to AD2 (previous slide). There is a contraction along the SRAS curve. Equilibrium real GDP falls from Y1 and Y2, and the price level falls from PL1 to PL2. 3. The fall in income leads to a fall in the demand for imports by households and firms. As the value of imports falls, there will likely be an increase in the trade balance and help reduce the CA deficit. 4. In addition, the fall in the price level will make domestic goods more internationally competitive. This may increase the value of exports purchased by foreigners, which will lead to a further improvement in the trade balance and a reduction in the CA deficit. Reducing a CAD: Expenditure switching policies Switching expenditure away from foreign goods to domestic goods and services, through a) Devaluation of a fixed exchange rate (reduction in the value of the domestic currency in terms of a foreign currency) b) Direct controls such as protectionist policies to encourage buying domestic goods and services Write a chain of reasoning explaining how a currency devaluation (in a fixed exchange rate regime) could help reduce a CA deficit. 1. A devaluation of the domestic currency will make imports more expensive for domestic buyers and exports cheaper for foreigners. 2. This should lead to an increase in the demand for, and hence value of, exports. Assuming that the demand for imports is price elastic, the value of foreign goods and services imported should also fall. This will lead to an increase in the trade balance. 3. Thus, this should correct a CA deficit. This can be shown by a shift in the AD curve from AD1 to AD2 (previous slide). This leads to an increase in real GDP and an increase in the price level. 4. If there is plenty of spare capacity in the economy, this increase in AD will not lead to demand-pull inflation. However, if the economy is operating at close to full capacity, then the rise in the domestic price level will make exports relatively more expensive, thus reducing the initial effect of the devaluation. How do protectionist policies help reduce a CA deficit? 1. The use of protectionist policies, such as, tariffs, quotas, export subsidies, exchange controls and administrative measures, are intended to encourage increased spending on domestically produced goods and services instead of imports. 2. The fall in the value of imports should improve the trade balance and should reduce a current account deficit. 3. However, the extent to which expenditure switching policies, using protectionist measures, are likely to be effective will be heavily dependent on whether foreign governments retaliate and the extent to which domestic producers are able to supply products that have previously been imported (import substitution). Supply-side policies (Section 3.3) can help to improve the price and quality competitiveness of the domestic economy and reduce a CA deficit Increasing labour market flexibility: increased education and training to improve occupational mobility, reducing trade union power, reducing the minimum wage Improving incentives to work: reducing unemployment benefits, lowering income tax rates, raising the minimum wage Improving incentives for entrepreneurs (lower corporation tax rates and/or lower tax incentives for investment) Deregulation to reduce administrative costs and unnecessary burden of regulation Using subsidies for R&D in new technologies and promoting innovation. Investment in transport infrastructure You should now be able to discuss policies to reduce a CA surplus 1. Reflationary policies (expenditure increasing) ◦ a) Expansionary fiscal policy (increase G, lower T) ◦ b) Expansionary monetary policy (increase money supply, lower interest rate) 2. Revaluation (in the case of a fixed exchange rate) – expenditure switching 3. Reducing controls on foreign trade and foreign exchange – trade liberalisation policies (expenditure switching towards imports of goods and services)