Balance of Payments

Balance of Payments

The balance of payments records a country’s financial transactions with the rest of the world (see notes on 2.1.4). It comprises the current account which records trade in goods and services, together with income flows and the capital and financial account which records short and long term capital movements.

Causes of Current Account Surpluses and Deficits

As we discussed in section 2.1.4, some countries, such as the U.K. have a long term and persistent (or chronic) current account deficit, whilst others, such as Germany tend to run sizeable surpluses.

The main reasons for these imbalances are as follows:

Exchange rates _– A country may try to keep its currency undervalued __(ie below its free market or purchasing power parity rate of exchange (see notes on 4.1.8) This will make its imports expensive and its exports cheap, resulting in a current account surplus, provided that the __Marshall-Lerner condition is fulfilled (_see notes on 4.1.8).

A country with an over-valued currency is likely to have a current account deficit.

Endowment of natural resources – Countries with small populations but large reserves of valuable natural resources are likely to have chronic current account surpluses. Norway, with its reserves of oil and gas is a good example. But sometimes, a country that is heavily dependent on primary product exports can be plunged into a current account deficit if the price of the commodity falls. Primary products tend to have volatile prices because demand and supply are both inelastic.

Private and/or public sector deficit – The sum total of injections into the circular flow of income (government spending G + investment spending I, plus exports X) is equal to the sum total of withdrawals, or leakages (taxation T, plus saving S, plus imports__ M__).

Suppose a country has injections and withdrawals as follows:

_[ G $80bn + I $50bn + X $30bn ] = [ T $70bn + S $40bn + $50bn ] __(_both total $160bn)

In this case we can see that the economy is running both a private sector deficit, as investment spending exceeds saving, and also a public sector deficit, as government spending exceeds tax revenue. The consequence of this that the country runs an __external deficit __(ie a current account deficit).

A private or public sector deficit on its own could be big enough to spill over into a current account deficit, but where a country has both (the so called twin deficit problem), it will certainly have a current account deficit. This was certainly the case for Greece in the early years of this century.

In effect, a country running a current account deficit is living beyond its means, which has to be financed from an inflow of capital from abroad, either by borrowing or foreign direct investment.

Note that a current account deficit is not necessarily a sign of economic weakness: a high level of investment spending may result in a more productive and competitive economy and create more exports in due course. High government spending on education or infrastructure may also make the economy more competitive in the long run.

_Inflation _– If a country has higher inflation than its competitors it will find that the prices of its goods rise relative to those of other countries and it will therefore lose price competitiveness, resulting in falling exports and rising imports. However, it is possible that the rise in domestic prices could be offset by a fall in the exchange rate, which would restore international price competitiveness.

Correcting a Current Account Surplus and Global Trade Imbalances

Countries with current account surpluses do not generally face the same pressure to correct the imbalance. The surplus may be seen as sign of economic health and international competitiveness. But not all countries can run a surplus; one country’s surplus is another’s deficit. World exports and world imports are the same thing.

Countries with chronic surpluses will have a corresponding negative balance on their capital and financial accounts. In other words they are lending to deficit countries. These chronic current account surpluses and deficits can result in regional or global financial crises when countries can no longer service or repay the debts, resulting in defaults.

A debt default may have catastrophic effects for the debtor countries, which can be refused further loans and therefore have to drastically reduce their imports. A sudden and severe recession will result.

But the surplus countries will also suffer, as their banks will not be repaid. This can lead to a financial crisis as the banks then reduce their domestic lending to restore their finances. This is called a credit crunch and can result in a major recession.

It is therefore better if surplus countries, as well as deficit countries try to reduce current account imbalances. Surpluses can be reduced by the opposite kinds of policies to those used to correct a deficit:

  1. Fiscal and monetary expansion
  2. Removing protectionist measures
  3. Currency appreciation
  4. Removing exchange controls
Describe the measures that a government can take to correct a current account imbalance.
Your answer should include: demand switching policies / demand reduction policies / supply side policies / exchange rate / protectionist policies / foreign exchange controls / fiscal policy / monetary policy

Measures to Reduce a Current Account Deficit

We can distinguish three broad kinds of policies for dealing with a current account deficit. Demand switching policies aim to correct the deficit by making imports more expensive and/or exports cheaper. Demand reduction policies aim to correct the deficit by reducing the level of aggregate demand in the economy, which in turn results in lower imports. In the longer term, a deficit may be addressed by supply-side policies, which aim to increase productivity, reduce costs and improve non-price competitiveness.

Demand Switching Policies

Currency depreciation – A fall in a country’s exchange rate will make its exports cheaper abroad and imports more expensive in the domestic market.The exchange rate can be depreciated if the central bank lowers interest rates or sells its own currency on the foreign exchange market and buys foreign currency. This should correct a deficit in time, provided that the Marshall-Lerner condition is fulfilled (see notes on 4.1.8). The correction of a deficit may take some time because of the__ J curve effect__ (see notes on 4.1.8).

It should also be noted that currency depreciation can cause cost-push inflation, which could offset some of the competitive gain.

_Protectionist policies _– Tariffs and quotas will make imports more expensive, whilst subsidies to domestic producers may increase exports as well as reduce imports. While the U.K. remains in the European Union it cannot, on its own introduce protectionist polices. There is also the strong possibility that countries will retaliate if they are subjected to protectionist measures, so that reduced imports are matched by reduced exports.

Foreign exchange controls – A government can require the central to restrict access to foreign currency in order to reduce imports. This approach was used by the U.K in the early years after the second world war when the country needed to generate a current account surplus to repay the huge borrowing from the USA that had helped to finance the war effort and post-war reconstruction. Applications for foreign currency may be restricted to firms buying ‘essential imports’ such as food or for investment goods.

Foreign exchange controls are generally considered to result in inefficiency, as the government, rather than the market is allocating resources. It may result in corruption, where favoured firms get access to foreign currency in exchange for bribes.

A big attraction of demand switching policies is that they allow for a deficit to be corrected without reducing growth or causing a recession.

Demand Reduction Policies

As we have seen, a current account deficit can result from a private sector and/or public sector deficit. A private sector deficit can be addressed by a tightening of monetary policy. Higher interest rates will result in lower investment and higher savings (see notes on 2.6.2).

A public sector deficit can be addressed by tighter fiscal policy. This will involve reducing government spending and/or increasing taxes.

In addition to reducing imports, demand reduction may encourage domestic firms to try to export more as they can sell less at home.

Demand reduction policies will work best if the economy has a high marginal propensity to import (see notes on 2.4.4)

If the policy also helps to reduce inflation, it may help to improve price competitiveness of domestic goods and lead to higher exports and lower imports.

The main problem with demand reduction is that it will mean lower short run economic growth and possibly risks a recession.

__Supply Side Policies __

Supply side policies can make the economy more competitive and may lead to higher productive capacity, both of which should lead to higher exports and lower imports.

The main problem is that such policies can take many years to bear fruit.