Balance of Payments

Balance of Payments

The __balance of payments __is a record of a country’s financial transactions with the rest of the world. Trade and investment create inflows and outflows of money between countries. Inflows are recorded as positive or credit items (+) and outflows as negative or debit items (-).

The current account __records the trade in goods and services, together with income flows, and comprises the following __four elements:

  1. The trade (or visible) balance – refers to the trade in physical goods. It comprises exports (+) and imports(-) of raw materials, semi-processed and finished manufactured goods. The U.K. has had a persistent __deficit __on visible trade since the 1970s. In other words visible imports exceed in value visible exports
  2. The invisible trade balance – refers to the trade in services, such as financial services (banking and insurance), tourism, business services (i.e. legal advice, management consultancy, accountancy, advertising & marketing). The U.K. has a strong and persistent surplus on invisible trade, reflecting the economy’s internationally competitive service industries
  3. __The balance of primary income __– refers to income earned by U.K. owned assets (profits, interest & rent) and workers abroad (wages & salaries) and the income earned by foreign owned assets and workers in the U.K. Profits, interest rent and wages earned abroad are credit items (+), and those earned by foreign owned assets and workers in the U.K. are debit items. The U.K. has built up a very large portfolio of assets abroad over a long period of time. In most years the U.K. has a positive (surplus) balance on primary income, but it tends to fluctuate a lot. For instance, if the U.K. economy is in recession, the profits of foreign owned businesses in the U.K. are likely to go down, but profits from U.K. owned businesses abroad might go up if those countries have booming economies
  4. The balance of secondary income – refers mainly to transfers between governments and inter-governmental organisations. For instance, the U.K. contribution to the E.U. budget is a debit item, but payment to the U.K. government by the E.U. for subsidies for British farmers is a credit item. The U.K. has an overall deficit on secondary income. This reflects the fact that it is a rich country and contributes to various aid and development programmes which mainly benefit poorer countries. Also, as one of the richer members of the E.U., the U.K. is a net contributor to the E.U. budget

The UK Current Account Balance

Since the 1980s the U.K. current account has been in deficit. This has been mainly due to a widening deficit on visible trade, as U.K. manufacturing has been in long term decline. Although the U.K. has a healthy surplus on invisible trade, this is considerably smaller than the trade deficit. The negative balance on secondary income also contributes to an overall current account deficit.

Does a Current Account Deficit Matter?

The overall value of exports in the world is the same as that of imports (when one country exports something, another imports it). The global current account therefore sums to zero. If some countries are running current account surpluses, others must be in deficit. Large and persistent current account imbalances between countries can cause problems. Deficit countries must borrow to cover the difference between their exports and imports, so a chronic deficit can lead to a build up of international indebtedness. In the worst cases, if not corrected, a current account deficit may lead to a country defaulting on its debts and then being unable to borrow any more.

Although the U.K. has a chronic current account deficit, it is not widely seen as a problem because:

  1. The deficit is a small % of GDP. Just as an individual can manage higher borrowing and debt as income rises, (rich people can afford bigger mortgages, for instance) the same is true of a country. Provided the deficit does not grow faster than the economy, it should not be a problem to finance it
  2. The current account is not the main determinant of the U.K. net overseas debt. The value of UK net assets abroad (the value of UK owned assets abroad minus the value of foreign owned assets in the U.K) is many times greater than the current account deficit
  3. The U.K. has been very successful in attracting foreign direct investment. This results in credit items on the __capital and financial account __of the balance of payments, and so helps to finance the current account deficit.

The Current Account and Macro-Economic Objectives

The four main macro-economic objectives for governments are:

  1. Full employment (low unemployment)
  2. Steady economic growth
  3. Stable prices (low inflation)
  4. Long term current account equilibrium on the balance of payments

The problem here is that these objectives are not always compatible_._

Balance of Payments, figure 1

Policies that boost the level of aggregate demand (AD) will generally lead to faster growth and lower unemployment, at least in the short run. But increased demand will tend to create inflationary pressure and some of the extra demand will be spent on imports, worsening the current account.

Equally, policies to reduce AD will tend to improve the current account and bring down inflation, but at the expense of higher unemployment and lower growth.

This conflict of objectives can be solved to some extent by focusing on export-led growth rather than consumption-led growth. In recent decades, growth in the UK has been heavily dependent on consumption, financed by cheap credit. Recent governments have not been successful in rebalancing the economy towards export-led growth. This requires higher levels of investment, including training and re-skilling of workers to make businesses more internationally competitive_._

Increased Interconnectedness of National Economies

In recent decades the process called ‘globalisation’ has resulted in much more economic interdependence between countries_. _The main aspects of this important change in the world economy are:

  1. International trade has been growing much faster than world GDP, so that for most countries, exports and imports represent a growing share of their output. In the U.K. for instance, roughly a quarter of GDP is exported. This makes the U.K. economy more dependent on the rest of the world
  2. Increasingly capital and people are internationally mobile. U.K. businesses own lots of companies overseas, and vice versa. Some U.K. companies earn more profits abroad than they do in the U.K. Some countries are increasingly reliant on migrant workers. The U.K. for instance employs large numbers of workers from abroad in the NHS, hospitality and agriculture
  3. Technology transfers between countries has resulted in some industries relocating to newly industrialising countries, such as China and India

The Capital and Financial Account

This is the section of the balance of payments where flows of money arising from movements of capital between countries are recorded. __Long term capital flows __include foreign direct investment (businesses from one country setting up businesses abroad) and long term lending or borrowing abroad by banks. __Short term capital flows __mainly arise from speculative buying or selling of currencies whose value is thought likely to rise or fall. For instance, if speculators think the Bank of England is likely to raise interest rates, holders of dollars or euros might sell them and buy pounds, leading to an inflow of short term capital that can be quickly reversed if interest rates are expected to fall.

Capital inflows are credit items (+) and capital outflows are debit items (+).