The Balance of Payments and Exchange Rate

General
1. The balance of payments is a record of all financial dealings over a period of time between economic agents of one country and all other countries
2. The Balance of Trade is the difference between the total value of visible exports and the total value of visible imports
3. The current account is where the payments for the purchase and sale of goods and services are recorded
  1. Visibles and Invisibles
    1. Visibles are trade good such as cars
      1. Visible exports include manufactured goods and sale of coal
      2. Visible imports include imports of food and purchase of oil
    2. Invisibles are financial transactions associated with trade e.g. shipping, tourism, financial services, income from workers working abroad
      1. Invisible exports include foreign tourists and earnings from nationals overseas
      2. Invisible imports include interest profits and payments by foreigners
  2. The difference between X and M is the current account position on the balance of payments
    1. Current Account Deficit - when the total value of imports of all 4 components is greater than the total value of exports of all 4 components
      1. A CAD might be desirable in certain circumstances
        If a developing country is importing new technologies to boost the long run productive potential of the economy
        If a natural disaster has wiped out domestic harvests and infrastructure & both consumer and capital goods are being imported to restore the standard of living
        High oil prices can cause C.A. imbalances as the high price benefits OPEC nations but worsens the C.A. for oil importing nations
        Oil importing is a sign of growth and industrialisation etc so importing oil to fuel further economic growth is good
      2. Sustainability
        Providing an economy has sufficient foreign currency to fund the shortfall, it could be argued that the deficit is not a problem. However, a sustained CAD may become worrying if foreign currency reserves begin to run low. In addition, the deficit may be funded by foreign demand for domestic currency, shares and property, because foreigners pay for these goods, the money from which the government uses to pay the deficit off. Once these finish, the governments still need money so they sell bonds, but to maintain the global demand for their currency they need high interest rates on the bonds and this results in higher debt. The longer the CAD, the greater the debt.
        Policies to Reduce the CAD
        Demand management: Reductions in government spending, higher interest rates and higher taxes could all have the effect of dampening consumer demand reducing the demand for imports. This leads to an increase in spare productive capacity which can then be allocated towards exporting.
        Natural effects of the economic cycle: One would expect to see a trade deficit fall during a recession – so some of the deficit is partially self-correcting – but this does little to address the problems of a structural balance of payments problem.
        A lower exchange rate provides a suitable way of improving competitiveness, reducing the overseas price of exports and making imports more expensive
        Protectionist measures such as import quotas and tariffs are rarely used because of our commitments to the World Trade Organisation and our membership of the European Union.
        Supply-side improvements
        Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are supply-side measures designed to boost exports performance and compete more effectively with imports. The time-lags for supply-side policies to have an impact are long.
        Policies to encourage business start-ups – successful small businesses with export potential
        Investment in education and health-care to boost human capital and increase competitiveness in fast-growing and high value industries such as bio-technology, engineering, finance, medicine
        Investment in modern critical infrastructure to support businesses and industries involved in international markets
        Increasing Interest rates
        Reduces consumer spending – (more attractive to save, less incentive to borrow, lower disposable income after paying increased mortgage costs). Lower consumers spending will lead to lower import spending and therefore improve the current account
        Higher interest rates lead to hot money flows and an appreciation in the exchange rate. This makes exports more expensive and imports cheaper. This tends to worsen the current account (assuming demand is relatively price elastic)
        In the UK, a rise in interest rates may often improve the current account because the UK has a high propensity to spend on imports. A reduction in consumer spending could have a big impact on reducing import spending. Demand for exports is relatively price inelastic. Movements in the exchange rate don’t have a big impact on demand for exports.
      3. Running a deficit on the current account means that there is a net withdrawal from the circular flow of income and spending. Spending on imported goods and services exceeds the income from exports.
        In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference
        In the short term, if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables. It means that the economy is expanding.
        Aggregate demand will fall since X-M is negative.
    2. Current Account Surplus - when the total value of exports is greater than the total value of imports
      1. Exporting more than importing means increased net foreign wealth, which can be used to buy more foreign goods and services
      2. A large sustained CAS reduces what is available for consumption - imports could be increased (more for consumption) or resources used for exports could be diverted to produce goods for domestic consumption
        Lack of consumption
        Capital Account Deficit
      3. Sustained CAS causes friction between countries
        If one country has a CAS, another (or more) must have a CAD
        If one country is a net lender, building up wealth overseas, another must be a net borrower building up debt overseas
        If a country with a CAS reduced its trade surplus by reducing exports to another country, that country might be able to fill the gap created by expanding their output. Thus countries with a CAD accuse countries with a CAS of "poaching jobs"
        However, the benefits to that country will be small because another country is likely to fill the market gap. When a country with a CAS reduces its surplus, it will improve the CA positions of many countries. The benefit of a large reduction in surplus to any single country will be relatively small
        Causes of a CAS
        Export-oriented growth: Increased capacity of export industries by investment in new capital so that economies of scale can be exploited, unit costs driven down and comparative advantage can be developed.
        Foreign direct investment: Strong export growth can be the result of a high level of foreign direct investment where foreign affiliates establish production plants and or exporting.
        Undervalued exchange rate: A trade surplus might result from a country attempting to depreciate its exchange rate to boost competitiveness. Keeping the exchange rate down might be achieved by currency intervention by a nation’s central bank, i.e. selling their own currency and accumulating reserves of foreign currency.
        High domestic savings rates: High levels of domestic savings and low domestic consumption of goods and services can cause surpluses. They should do more to expand domestic demand to boost world trade.
        Closed economy – some countries have a low share of national income taken up by imports – perhaps because of a range of tariff and non-tariff barriers.
        Strong investment income from overseas investments: A part of the current account that is often overlooked is the return that investors get from purchasing assets overseas – it might be the profits coming home from the foreign subsidiaries of multinational businesses, or the interest from money held on overseas bank accounts, or the dividends from taking equity stakes in foreign companies.
        Countries which attempt to reduce their CAD can only be successful if other countries reduce their CAS
        A large CAS will cause currency value to rise
        A strong currency keeps inflation down but makes exports less competitive
    3. The C.A. Deficit/Surplus is significant if it is large in relation to national income and is sustained over a long period of time
      1. If a country runs a CAD year after year, but it is small in relation to national income over time, then it is insignificant
      2. If a country runs a large CAD over a short period of time but then follows this with a large surplus over the next period, it is insignificant
    4. Shifts in demand and trade will cause temporary deficits and surpluses.
  3. There are 4 components of the current account - trade in goods, trade in services, investment income and transfers
    1. Transfers generally arise from the repatriation of earnings - migrant workers send home earnings contributing to the deficit of transfers
      1. Investment income comes from interest, profit and dividends
        Each component covers both outflows and inflows
        Exports = Money In and Imports = Money Out
        It is like we export the worker and so the money he sends back is an export
4. The Financial Account is where flows of money associated with saving, investment, speculation and currency stabilisation are recorded. Flows in are given a positive sign and flows out have a negative sign
  1. Financial Account Deficit - When the flow of money out of a country is greater than the flow of money coming in
  2. Financial Account Surplus - When the flow of money into a country is greater than the flow of money going out
5. Net Invisibles is the difference between Invisible Exports and Invisible Imports
  1. Balance on invisible trade
6. The Current Balance is the difference between the total value of exports and the total value of imports
  1. Sum of both above
7. Trade Gap - A deficit on the balance of trade in goods
  1. Trade deficits lead to a fall in the exchange rate, while trade surpluses lead to a rise in the exchange rate
8. Default - not paying loans back
9. Credit Crunch - the point at which foreign lenders stop lending
10. The UK has had a CAD for a long time (since 1990s for sure)
  1. Spain, UK and USA were the countries with the biggest deficits in the world totaling over $1 trillion in 2006
  2. The UK has had strong economic growth since 1990s and as AD has grown, imports have risen
    1. We have a trade of goods deficit but a trade of services surplus - we are a service-sector economy
      1. The large finance sector has contributed to the investment income surplus resulting from returns on UK business activity abroad
    2. Unemployment has fallen and the UK has approached full capacity, so the ability of domestic suppliers to meet demand has reduced, thus imports have risen to meet the higher level of demand
      1. Firms have had to import higher levels of raw materials from abroad as production has risen, deepening the deficit further
  3. Greater openness to trade by countries like China has resulted in low wage economies becoming large exporters of manufactured goods, leaving high wage-cost economies losing market share both domestially and abroad
  4. The Sterling has been strong in recent years, making UK exports less competitive and imports cheaper
The Exchange Rate
1. The price of one currency expressed in terms of another currency
2. The exchange rate has a direct impact on the price of imports and exports
3. If the exchange rate is floating, then exchange price of currencies is free to change according to demand and supply
4. An increase in the price of a currency is called appreciation or strengthening
  1. If caused by active policy it is a revaluation
5. A decrease in the price of a currency is called weakening or devaluation
  1. If caused by active policy it is a devaluation
6. when the sterling is strong, UK exports become more expensive abroad, so they become less competitive. Foreign goods are cheaper compared to domestic goods, so imports are more competitive and we import more. This worsens the C.A position
7. A weakening of the sterling should make UK exports more competitive, therefore X should rise and imports should fall as foreign goods become more expensive relative to UK goods
The FOREX (foreign exchange) market
1. An exchange rate of E2 is unsustainable in the long run. The FOREX market should make the exchange rate fall until the market clears. However there are 3 factors preventing this from happening
  1. Speculation plays a large role in currency movements. Speculators gamble on short-run movements in shares or currencies. If the majority of speculators think that a currency will fall, they will sell the currency and this increase in supply will put downward pressure on the price. A collective belief that a currency will strengthen will cause demand to rise with a consequent increase in price. Speculation can lead to a "self-fulfilling prophecy".
  2. Hot money inflows help to keep the Sterling strong
    1. Hot money is funds held by international investors who seek the highest real return. Each country has a different interest rate and inflation rate and it is the real rate of interest which attracts hot money.
    2. In the UK inflation has been low and stable while interest rates have been higher than those in other European countries so we have attracted lots of hot money
  3. Strong growth and a flexible commercial sector have attracted FDI. This business spending in the UK has helped sustain the demand for sterling
2. Changes in the exchange rate result in shifts in the FOREX
3. The equilibrium is the exchange rate. However in reality the supply of sterling is higher than the demand and this difference represents the current account deficit
  1. Excess supply of sterling is needed to buy the foreign currencies needed to fund imports
4. This is where currencies are traded and the main determinant of demand and supply is trade in goods and services
Government policies
1. Expenditure-reducing Policies
  1. The aim is to slow economic growth, reducing demand for imported goods. It can also reduce domestic inflation which should increase the competitiveness of exports. By lowering domestic growth below world growth, the value of imports is likely to fall relative to the value of exports
2. Expenditure-switching policies
  1. The aim is to reduce the demand for imports and increase the demand for exports. This is done by devaluing or allowing the depreciation of the domestic currency so that the exchange rate returns to its initial level and there are no long term effects on exports relative to imports. This can be done by lowering interest rates to cut hot money inflows, but this might encourage consumption rather than deter it.
3. Protectionism
  1. This is the attempt by a national government or trading group to reduce imports by increasing their price (through import taxes or tariffs), restricting their quantity (through quotas) or by using bureaucracy to deter foreign sellers (trade restrictions, slow customs practices or high safety standards). The main problem with protectionism is retaliation. Most countries will respond by imposing similar policies on exports from protectors. Although imports will fall, if exports also fall then the overall impact on the C.A. is unclear

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	Created by Kati Christova about 10 years ago