Economic Principles

Lecture 21: The Balance of Payments

(See Chapter 25 in John Sloman Economics 7th Edition)

The Balance of Trade and Payments

All states are involved in international trade, we saw the economic advantages of such activity in the last lecture. It allows businesses and consumers to obtain products that would otherwise be unavailable (eg coffee or aluminium in the UK) but ,more importantly, it enables absolute and comparative advantages to be developed and, thus, resources to be used more efficiently. The record of the inflow of goods and services (imports) and outflow (exports) is known as the Balance of Trade.
Flows of money for other purposes such as income from foreign property, investments, etc. will also bring money into the country, or take it out, these flows are included in the Balance of Payments Current Account.

International Transactions (Money Flows) Besides the consumer trading in Goods & Services, money also flows around the world
FACTORY UK

E I G
Fiscal Policy

X
Trade

FOPs
UK

Cd

Banks

S
HOUSEHOLDS

1. UK nationals (labour) work in other countries and send home part of their income (Y). Likewise, foreign nationals work in the UK and send part of their incomes abroad. 2. UK companies invest (Capital = I ) in other countries, their income will be the return (or yield) from that investment. Foreign firms that invest in the UK may repatriate all or some of the profits they make on these investments.

3. UK nationals (eg fund managers) save abroad (S), likewise UK firms operating abroad will save (S) some of their profits there in order to maintain foreign cash flows. In return for saving abroad they receive a return (rate of interest). 4. Finally, the UK government (G) sends aid abroad (and receives revenue from the EU) , it also has to pay for embassies, as do other countries. The government also pays its membership fees to international/foreign institutions (e.g. NATO, UN, EU, IMF, WTO)

The Balance of Payments accounts The Balance of Payments Account keep a track of all these international transactions. Treating inflows as a credit item,(+) and outflows as a debit item ()

1. The Current Account Exports (X) of Goods & Services Imports (M) of Goods & Services (a) Balance of Trade Incomes (Y) & current transfers from abroad Incomes (Y) & current transfers to abroad (b) Other Income Flows (c) Current Account Balance

+ +/ + +/ +/ + +/ + + +/ +/

Consumers

Government Business Labour (Y)

2. Capital Account Transfers of capital to UK from abroad Transfers of capital abroad from UK (d) Capital Account Balance
3. The Financial Account Net investment in the UK from abroad UK net investment abroad Short-term financial inflows to UK Short-term financial outflows from UK Drawing on / Adding to official reserves (e) The Financial Account Balance

Investors Buying real assets (i.e. LAND & FDI)

Investors Financial Assets (i.e. Shares & Bonds) Savers (bank deposits)

4. The Balancing Item

+/

The Balance of Payments Accounts The relationship between the Current Account, the Capital Account and the Financial Account
1. The Current Account Exports (X) of Goods & Services Imports (M) of Goods & Services (a) Balance of Trade Incomes (Y) & current transfers from abroad Incomes (Y) & current transfers to abroad (b) Other Income Flows +/ (c) Current Account Balance

+ +/ + +/

Government Business Labour (Y)

2. Capital Account Transfers of capital to UK from abroad Transfers of capital abroad from UK (d) Capital Account Balance

+ +/

Profits & Rents

3. The Financial Account Net investment in the UK from abroad + UK net investment abroad Short-term financial inflows to UK Short-term financial outflows from UK Drawing on / Adding to official reserves + / (e) The Financial Account Balance

+ +/

Interest & Dividends Interest

4. The Balancing Item

+/

Disequilibrium in Balance of Payments: Why they will always balance? The Current Account (a) Balance of Trade (X - M) (b) Other Income Flows (c) Current Account Balance Capital Account (d) Capital Account Balance

Capital Flows = X M

+ / [CONSUMERS] +/ +/
+ / [INVESTORS] + / [INVESTORS] + / [SAVERS] +/ +/

Capital Flows

The Financial Account Net investment to & from abroad Short-term flows to & from abroad (e) The Financial Account Balance
The Balancing Item Fred buys a BMW from Germany for 15,000 Thus X = M Thus X < M (- 15,000) Capital a/c (+ 15,000) Thus X < M (- 15,000) Financial a/c (+15,000)

Or, BMW can sell s to someone who wants to BUY UK goods, INVEST in the UK or, SAVE in the UK. Whatever happens the s will return to the UK; the issue is who owns the s, (or assets )?

BMW now has 15,000 they can; BUY 15,000 of UK goods & services,
Or, INVEST 15,000 in the UK Or SAVE 15,000 in a UK Bank

Disequilibrium in the Balance of Payments

The Balance of Payments Current Account records flows of income into and out of the economy. In a large developed economy there is almost no chance that the two sides will balance (it would be coincidence if they did). Thus there will be disequilibrium in the Balance of Payments:

If Inflows exceed Outflows (X>M) it is a Surplus If Outflows exceed Inflows (M>X) it is in Deficit
Remember from the Circular Flow of Income: X>M it is a net Injection and will increase National Income X<M it is a net Withdrawal and will reduce National Income Thus a surplus is generally seen as being better for a country than a deficit, which is taking income out of the Circular Flow and lead to less income and employment.

Disequilibrium in the Balance of Payments

Thus, there is an assumption that every country would like to achieve Balance of Payments surplus. If you remember from the first lecture on macroeconomics, this is seen as one of the four main objectives of macroeconomic policy. There is a fundamental problem with this however and it is based on the simple (but sometimes forgotten) point that one countrys exports are another countrys imports. Thus over the world, trade must balance, which in turn means that if one country has a surplus then at least one other must have a deficit. It is impossible for all to have a surplus. It is possible that over time there could be balance: Country A may have deficits in years 1-3 and surpluses 4-6 Country B may have surpluses in years 1-3 and deficits 4-6 But in recent times that has often not happened.

Disequilibrium in the Balance of Payments

So what might turn a deficit into a surplus or vice versa?

A change in the exchange rate we will look at this in detail in the next lecture Protectionism limiting the quantity in imports becoming more open will increase the quantity of imports Increasing the competitiveness of exporting industries in the economy, or subsidising exports Inflation lower than in other countries reducing the relative price of traded goods on world markets (though exchange rate adjustment might cancel this out) Internal deflation might reduce the demand for all goods including imports

Disequilibrium in Balance of Payments

As the graph below shows, the UK has had a Balance of Payments Current Account deficit for the past 25 years. We can also see that the deficit gets worse when growth is strong (eg 1986-89).
Percentage change in GDP & the Current Account (as a % of GDP) The UK 1970 to 2002
10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 70 75 80 85 90 95 00

Why does it happen?

Y => M
UK Inflation => relative price M price X => Qd M => Qd X X< M

UK GDP% change Current account (Bof P) as a % of GDP

Other possible reasons? UK products are uncompetitive (nobody wants them) or there are better goods & services from foreign suppliers

The Relationship between the Balance of Payments & Exchange Rates

The Current Account (a) Balance of Trade (X - M) (b) Other Income Flows (c) Current Account Balance Capital Account (d) Capital Account Balance The Financial Account Net investment to & from abroad Short-term flows to & from abroad (e) The Financial Account Balance The Balancing Item + / [CONSUMERS] +/ +/ + / [INVESTORS] + / [INVESTORS] + / [SAVERS] +/ +/ As consumers, investors & savers , UK nationals supply (sell) s in exchange for a foreign currency As consumers, investors & savers foreign nationals: demand (buy) s using their currency

Thus, if UK Nationals demand more imports, seek better investment opportunities abroad or, choose to save abroad (attracted by higher interest rates) the supply of s on the foreign exchanges will increase. Likewise, if foreign nationals demand more UK goods & services, seek what they see as better investment opportunities in the UK ,or choose to deposit their savings in a UK bank, the demand for s on the foreign exchanges will increase. These different choices by UK & foreign nationals will all be recorded in the Balance of Payments Accounts (eventually)

Exchange Rates & the Balance of Payments Exchange Rates & financial sector how it all works
Fred wants to buy a BMW for 15,000 BMW now has 15,000 worth of Euros (), which it will deposit in a bank

Foreign Exchanges Fred exchanges for

A UK Bank

The Forex dealer will now Sell these s to anyone who wants to Buy UK goods, Invest in the UK or, Save in the UK.

A German Bank

JCB sells to Hans for 50,000 and deposits the cash in a UK bank

Hans wishes to buy a UK made JCB costing 50,000

A UK Bank

The question is: where does the foreign exchange dealer store these s, & s while waiting for buyers?

A German Bank

The majority of currency never leaves the country

Exchange Rates & the Balance of Payments International Transactions and Money Supply (liquidity)
Freds UK Bank A/c 100,000 (BMW) - 15,000 85,000
JCBs UK Bank A/c 100,000 + 50,000 150,000

Assume 1.00 = 1.00

UK Forex Dealer Stock of 100,000 - 15,000 German Forex Dealer Stock of 100,000 +15,000

BMWs German Bank A/c 100,000 (BMW) + 15,000 115,000 Hans German Bank A/c 100,000 (JCB) - 50,000 50,000 UK Forex Dealer German a/c balance 135,000 An Inflow of funds from abroad (net supply 35000)

(JCB)

+50,000

- 50,000

German Forex Dealer UK a/c balance 65,000 An Outflow of funds Abroad (net demand 35000)

Disequilibrium in the Balance of Payments

In practice, exchange rates will adjust in most cases to change the relative price of traded goods and services, as we will investigate in the next lecture. However, we should remember that trade is only part of the full Balance of Payments Account, so it is possible to maintain a Current Account Balance of Payments deficit if: There is a Capital Account Surplus There is a Financial Account Surplus The deficit can be financed by issuing our currency to the rest of the world providing surplus countries are prepared to accept it and either hold it in reserve or use it for trade with third countries (this is an explanation for the consistency of the American Current Account deficit in recent times).

Disequilibrium in the Balance of Payments

Sample Countries Trade and Current Account Balances: mid 2010
State Trade Balance ($bn) -592.4
-138.1

Current Account Balance ($bn) -391.9

-33.7

Current Account Balance (% of GDP) -3.2

-1.6

USA
UK

Germany
France Japan Brazil China Hong Kong

+207.9
-65.1 +87.5 +17.1 +174.7 -42.9

+179.0
-49.4 +180.3 -43.8 +286.8 +17.0

+5.2
-2.0 +3.4 -2.7 +4.9 +8.1

Source: The Economist, 11th - 17th September 2010

Disequilibrium in the Balance of Payments

Although the above figures cover only one year, they are typical of the recent past; China, Germany and Japan have had trade surpluses continuously for at least 15 years, the USA and UK deficits. Note that: Some states have trade deficits but smaller Current Account deficits (USA, UK, France) or even a surplus (HK). They therefore have a net inflow of income from abroad.

Conversely there are states with trade surpluses but smaller Current Account surpluses (Germany) or deficits (Brazil), indicating a net outflow of income. China and Japan have trade surpluses and a net inflow of income which leads to a larger Current Account surplus.

Disequilibrium in the Balance of Payments

Sample Countries Stocks of Foreign Direct Investment 2008/2009 State Stock of Inward Global Stock of FDI Global FDI (US$m) Ranking Abroad (US$m) Ranking
USA 2398000 1 3259000 1

UK
Germany France Japan Brazil

1025000
1021000 1202000 205400 318500

3
4 2 19 12

1643000
1403000 1759000 726500 124300

3
4 2 7 22

China
Hong Kong

576100
873800

8
5

227300
808000

13
6

Source: CIA Factbook Note that other agencies (eg IMF) produce figures that vary with these, though the rank order tends to be more or less the same in all cases.

Disequilibrium in the Balance of Payments

The amount of Foreign Direct Investment (FDI) that a country has is a function of its openness to international capital and attitude to globalisation. Note that the top four states (USA, France, UK, Germany) ranked are the same for the amount of FDI stock within their economy and the amount invested abroad. Hong Kong too is almost equally ranked in both lists. Some states are more open to inward investment than outward (Brazil, China) and others vice versa (Japan). The chief reason is that both China and Brazil are among the BRIC states (Brazil, Russia, India, China); Newly Industrialising Countries (NICs) or Emerging Economies with large potential markets, yet comparatively low costs.

Disequilibrium in the Balance of Payments

Comparing Hong Kong and China shows the importance of openness to FDI. Hong Kong was governed by Britain until 1997 and developed a very open attitude to foreign and domestic business which has generally continued to the present day. Technically HK is part of China since 1997, but its economy is still run separately from the mainland under a two systems, one country policy which gives it a high degree of economic autonomy, for example its own currency.
China Area
Population GDP Ease of Doing Business (Rank)

Hong Kong 1100km2

7m $1336m 2

9600000m km2
1336m $5745000m 86

Source: World Bank

Despite being many times larger than HK, China has much less FDI invested at home and abroad.

Disequilibrium in the Balance of Payments

Countries with short term Balance of Payments deficits can finance them using reserves of foreign currency or gold. In the past, this was how trade was balanced, hence the importance for countries to balance the external economic relations; if they did not it was a drain on the reserves.

As we have noted, not all countries can have a balance or surplus, so the emphasis to solve a Balance of Payments imbalance was on deficit countries they had the problem. The simplest way to solve it was with protectionist measures (eg tariffs) but the effect of this was to shift the problem to other countries which had been in surplus. They now had a deficit and would retaliate, and so on. The result of all this was that the overall level of world trade reduced, but inevitably, some states still had deficits.

Disequilibrium in the Balance of Payments

The above situation can be avoided if we have a currency, or currencies, that are internationally acceptable and surplus countries are willing to hold them. This would mean that we could have 100 countries with a $1m surplus and one country with a $100m deficit (note that world trade balances). Thus, as long as the 100 countries are happy to accept and hold $ and exchange them between themselves for trade the system works without any need for protectionism. In simple terms this is the system that developed after World War 2. However, the key point is that everyone must have confidence in the value of the reserve currency ($ in this case), otherwise they will not be prepared to use it.

Disequilibrium in the Balance of Payments

Sample Countries Foreign Exchange and Gold Reserves 2009 State Foreign Global Gold reserves Global Exchange Ranking (tonnes)* Ranking Reserves ($m)
USA UK Germany France Japan 132933 107853 208704 166319 1096185 16 18 11 13 2 8133.5 310.3 3401.8 2435.4 765.2 1 17 2 5 9

Brazil
China Hong Kong

297696
2622000 268731

6
1 10

33.6
1054.1 2.1

48
6 86

Source: IMF * Note that these figures have not been audited in most cases

Disequilibrium in the Balance of Payments

The table above shows that China and Japan have the largest foreign exchange reserves in 2009. This is mainly due to the large trade surpluses they have accumulated over many years. Note that reserves will not only be in US$, other currencies, particularly the , are becoming more popular.

In order to be a reserve currency there must be confidence that it is going to hold its value and be acceptable throughout most of the world. This will depend on a number of political and economic factors such as stability, global power, record on growth and inflation, etc. If confidence in a reserve currency is lost the potential effects for the global economy are disastrous (large scale devaluation at least). Major countries still hold gold reserves to retain confidence (at the time of writing a tonne of gold is worth about $50m).

Economic Principles
Lecture 21: The Balance of Payments