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The Balance of Payments

The balance of payments records financial transactions between countries. The accounts are split into two sections with the current account measuring trade in goods and services and net investment incomes and transfers whilst the capital account tracks capital flows. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment.

UK Balance of Trade in Goods


Balance of exports minus imports of goods at current prices, billion

0 -10 -20 -30 -40


(billions)

0 -10 -20 -30 -40 -50 -60 -70 -80 -90 -100

-50 -60 -70 -80 -90 -100 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Reuters EcoWin

The UK trade balance in goods is shown in the chart below and the following chart tracks the balance of trade in services. The trade deficit in goods has increased in every year since 2000 and reached a record in 2008 of over 90bn. The surplus in trade in services has also grown each year although the overall gap in exports and imports for trade in goods and services remains very wide. The UK enjoys a strong net inflow of interest, profits and dividends from her stock of overseas investment and this helps to rebalance the current account of the balance of payments. Reasons for the UKs trade deficit in goods High income elasticity of demand for imports the income elasticity for imports is high so when consumer demand is strong, the volume of imported products grows quickly Long-term decline in the capacity of manufacturing industry because of de-industrialisation There has been a shift of manufacturing production to lower-cost emerging market countries and then export products back into the UK. Many UK businesses have out-sources assembly of goods to other countries whilst retaining other aspects of the supply chain such as marketing and research within the UK. The UK is a net importer of foodstuffs and beverages and has also seen a sharp rise in imports of oil and gas as our North Sea oil and gas production is long past its peak levels The trade balance is vulnerable to shifts in world commodity prices and exchange rates. We import a large volume of raw materials, component parts and pieces of capital equipment.

billions

When considering causation of a trade deficit it is important to consider (i) Cyclical causes e.g. the impact of the downturn in world trade in 2009 (ii) Structural causes e.g. the effects of globalisation and the supply-side performance of the UKs manufacturing export businesses (iii) External shocks e.g. volatility in commodity prices Trade in Services

UK Balance of Trade in Services


Balance of exports minus imports of services, current prices, billion

60 55 50 45 40
(billions)

60 55 50 45 40

30 25 20 15 10 5 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

30 25 20 15 10 5

Source: Reuters EcoWin

Britain is the second largest exporter of services in the world economy and the structural surplus in services represents an important long-term change in our balance of payments. Much of the surplus comes from exporting business and financial services, for example insurance, currency trading, banking, management consulting and legal services. But it is important to be aware of other industries where there are some world-class British businesses exporting overseas. The UK is the biggest exporter of creative services ranging from architecture to television programmes, from film and theatre to books, live and recorded music and design businesses.

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35

35

UK Trade Balance in Goods & Services with China


Annual balance of trade, billion
0.0
0.0

-2.5

-2.5

-5.0

-5.0

-7.5
(billions)

-7.5

-10.0

-10.0

-12.5

-12.5

-15.0

-15.0

-17.5

-17.5

-20.0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

-20.0

Source: UK Statistics Agency

The chart above indicates the growing divergence in the value of trade of trade between the UK and China. Exports have grown relatively slowly has the UK missed an opportunity here?

United Kingdom - Percentage of World Exports and Imports


Per cent, quarterly figure
6.0 6.0

5.5

5.5

5.0

5.0

Per cent of world trade

4.5

4.5

4.0

4.0

3.5

3.5

3.0

3.0

2.5 97 98 99 00 01 02 03 04 05 06 07 08 09

2.5

UK: percentage of world exports

UK: percentage of world imports


Source: Reuters EcoWin

billions

Our share of world trade in goods and services has been in decline for many decades, although the pace of decline has slowed down we now account for around 4% of global trade. Note the trend rise in the share of trade achieved by emerging market countries in Asia including China. They now take one fifth of global trade. Measuring the current account The current account of the balance of payments is the sum of 1. 2. 3. 4. Net Trade in Goods Net Trade in Services Net Income from overseas assets Net Transfers

The UK ran a current account deficit of 25bn in 2008 or 1.7% of GDP. So too does the USA. Other countries have surpluses. Indeed 4/5ths of the trade surpluses in the world economy can be found in China, Japan, Germany and the oil-exporting nations of the gulf. Chinas surplus in 2008 was 9.5 per cent, Germany 7.3%.

Components of the UK Balance of Payments


Annual balances for each component, billion

0.0
Billion

0.0 -1.0 -2.0 Forecast Current account balance as a % of GDP -3.0 -4.0 75 50

-1.0 -2.0 -3.0 -4.0 75 50

Billion (billions)

25 0 -25 -50 -75 -100

Trade in Services Investment income Transfers

25

-25

Current account Trade in Goods

-50 -75 -100

97

98

99

00

01

02

03

04

05

06

07

08

09

10

11

Source: Reuters EcoWin

What does a current account deficit mean? Running a sizeable deficit on the current account basically means that an economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending. The current account does not have to balance because the balance of payments also includes the capital account. The capital account tracks capital flows in and out of a country. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment. Does a current account deficit matter?

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Should we be concerned if, as an economy, we are running a large current account deficit? The UK has run large current account deficits in recent years with barely any effect on the overall performance of the economy. The United States economy is also experiencing a huge trade deficit at the moment. What are the implications of this? In the 1950s, 60s and 70s, small balance of payments deficits in the UK caused economic crises with periods of speculative selling of sterling on the foreign exchange markets and much political instability. The devaluation of the pound in 1967 led directly to the resignation of the then Chancellor, James Callaghan. These days, trade deficits seem to have little effect from day to day in global currency markets. Some economists believe the balance of payments no longer matters because of globalisation and financial liberalisation because globally integrated capital markets can finance trade and current account deficits. The free movement of capital has allowed countries, in principle, to increase their domestic investment beyond what could be financed by a countrys own savings. Increasingly what we want to consume is produced abroad and if a country wants to operate with a current account deficit, then provided there is a capital account surplus, there is no fundamental constraint. The main arguments for being relaxed about a current account deficit are as follows: i ii Partial auto-correction: If some of the deficit is due to strong consumer demand, the deficit will partially correct when the cycle turns and there is a slowdown in spending or a recession. Investment and the supply-side: Some of the deficit may be due to increased imports of new capital and technology that will improve productivity and competitiveness of producers.

iii Capital inflows balance the books: Providing a country has a stable economy and credible policies, it should be possible for the current account deficit to be financed by inflows of capital without the need for a sharp jump in interest rates. But i Structural weaknesses: The current account deficit may be a symptom of a wider structural problem i.e. a loss of competitiveness, insufficient investment in new capital or a shift in comparative advantage towards other countries. An unbalanced economy too much consumption: A large trade gap can reflect an unbalanced economy typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these trade imbalances have to be addressed.

ii

iii Loss of output and employment: A widening trade deficit may result in lower output and employment because it represents a leakage from the circular flow of income and spending. Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import penetration, may find it difficult to find new employment. iv Potential problems in financing a current account deficit: Countries cannot always rely on inflows of capital to finance a current account deficit. Foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. The collapse of the Icelandic economy in 2008-09 is a good example of a country that was running a completely unsustainable current account deficit. Similar problems have been experienced by nations inside the Euro Zone for example Spain and Ireland. However in their case, they cannot rely on a depreciation of the exchange rate to improve competitiveness. v Downward pressure on the exchange rate: A large deficit in trade can lead to a fall in the exchange rate. This would then threaten an increase in imported inflation and might also cause a rise in interest rates from the central bank. A declining currency would help stimulate exports but the rise in inflation and interest rates would have a negative effect on demand, output and employment.

The view that a current account deficit is bad and that a current account surplus is good is nave as we shall see when we discuss briefly the economics of countries that run persistent surpluses in their overseas trade accounts. Economics of trade and current account surpluses

Current Account Deficits and Surpluses


Current account balance as a percentage of GDP 10.0 7.5 5.0 2.5
Per cent of GDP

10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 -12.5 98 99 00
Germany Japan

0.0 -2.5 -5.0 -7.5 -10.0 -12.5 01 02 03 04 05 06 07 08 09 10

Quarterly data Spain United Kingdom

United States West Germany Source: OECD

Many countries operate with a current account surplus. There are several causes and each country will have a unique set of circumstances: Export-oriented growth: Some countries have set out to increase the capacity of their export industries as a growth strategy. Investment in new capital provides the means by which economies of scale can be exploited, unit costs driven down and comparative advantage can be developed. Germany, Japan and China are countries that are net exporters of goods. However export-dependent countries have all suffered from the global economic downturn. 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 nations central bank, i.e. selling their own currency and accumulating reserves of foreign currency. One of the persistent disputes between the USA and China has revolved around allegations that the Chinese have manipulated the Yuan so that export industries can continue to sell huge volumes into North American markets. High domestic savings rates: Some economists attribute current account surpluses to high levels of domestic savings and low rates of domestic consumption of goods and services. China is an economy with a high household saving ratio and a huge trade surplus; in contrast the savings ratio in the United States has collapsed and their trade deficit has got bigger and bigger. Critics of countries with persistent trade surpluses argue that they should do more to expand domestic demand and provide a boost to 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.

Policies to control / reduce a balance of payments deficit If the root cause of a trade deficit is an excessive level of aggregate demand, the deficit may improve in a recession, when real incomes and spending fall. If the deficit reflects supply-side weakness, then policies need to improve cost and non-price competitiveness. Expenditure Reducing Policies These are policies that aim to reduce the real spending of consumers Fiscal policy can be used (e.g. a rise income tax that reduces disposable income) Higher interest rates would dampen consumer spending and reduce economic growth

Expenditure Switching Policies

UK Trade in Goods and Services & the Exchange Rate


Quarterly trade balance, billion (bottom pane) and exchange rate index (top pane)

110 105
Sterling index

110 105 100 95 90 85 80 75 70 0 -2 -4 -6 -8 -10 -12 -14

100 95 90 85 80 75 70

Quarterly balance (billions)

0 -2 -4 -6 -8 -10 -12 -14 Q1 Q3 05 Q1 Q3 06 Q1 Q3 07 Q1 Q3 08 Q1 Q3 09 Q1 10

Effective Exchange Rate Index

Balance of Trade in Goods and Services


Source: Reuters EcoWin

These are policies that encourage consumers to switch their spending away from imports toward the output of domestic firms. Expenditure-switching occurs if the relative price of imports can be raised, or if the relative price of UK exports can be lowered. Measures include: o A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of exported goods and services. A lower exchange rate also increases the profitability of exporting.

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o o

Tariffs or other import controls can occasionally be used but the UK is bound by its commitments to the World Trade Organisation. Policies that reduce the rate of inflation in the economy below that other international competitors leading to a gradual improvement in price competitiveness

The J-Curve effect In the short term depreciation may not improve the current account. This is due to the low price elasticity of demand for imports and exports in the short term. Initially the volume of imports will remain steady because contracts for imported goods will have been signed. Export demand will also be inelastic in response to the exchange rate change in the short term. Therefore the earnings from exports may be insufficient to compensate for higher spending on imports. The balance of trade may worsen and this is known as the J-Curve effect.

Surplus on the current account Time

Net improvement in the current account balance Deficit on the current account Point in time at which currency depreciation depreciates

Providing that the elasticity of demand for imports and exports are greater than one, then the trade balance will improve over time. This is known as the Marshall-Lerner condition.
Export and Import Volumes - the importance of Elasticity of Demand Original exchange rate Exports of Pocket PCs from the UK UK price () US price ($) Demand Export revenue () New exchange rate Ped for UK exports = 1.4 UK price () US price ($) Demand Export revenue () % change in ex rate % change in demand Net trade balance Original exchange rate New exchange rate 1 = $1.80 1 = $1.60 -1,000,000 +238,562.5 Deficit Surplus 350 560 46,220 16,177,000 11.1 15.55 350 630 40,000 14,000,000 1 = $1.60 Ped for US imports = 0.5 USA price ($) UK price () Demand Import spending () % change in ex rate % change in demand 450 281.25 56670 15,938,438 11.1 5.55 1 = $1.80 Imports of US DVD players USA price ($) UK price () Demand Import spending () 450 250 60000 15,000,000

Combined elasticity of demand for X and M + 1.4 + 0.5 = 1.9

The Economics of the China Yuan-US Dollar Peg Throughout Chinas rise to prominence, Chinese authorities have faced accusations that they have controlled the currency keeping it artificially low to gain a competitive advantage and promote export-oriented growth (by 2007 the value of Chinas exports amounted to about 36% of its GDP).
USD (billions)

United States - Current Account Deficit with China


Quarterly current account balance in $ billions
0 0

-10

-10

-20

-20

-30

-30

-40 Critics in the U.S claim that this is exacerbating global trade -50 imbalances. The argument is that an undervalued currency is making U.S -60 goods and services more expensive to -70 Chinese consumers, whilst simultaneously making Chinese goods -80 much cheaper relatively for Americans. 90 91 92 93 This beggar-thy-neighbour policy, argues the US administration, is key to the huge trade deficit run between China and the U.S.

-40

-50

-60

-70

-80 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Source: Reuters EcoWin

China's "managed float" regime has effectively had three periods: for more than a decade, China pegged its currency to the dollar at a rate of 8.28 yuan for every dollar; then from July 2005 to July 2008, the yuan was allowed to gradually appreciate almost 20 per cent in a crawling peg; and then from July 2008 to the present, the Chinese have effectively re-pegged at about 6.83 yuan to the dollar. The move to allow a brief revaluation came after significant political pressure from the U.S and the E.U (in some cases, in the form of the threat of trade sanctions). But as export growth has slowed, the Chinese seem to have reverted back to their old ways, prompting the IMF to reiterate that the yuan (despite the 20 per cent revaluation since 2005), was still significantly undervalued, and Ben Bernanke, the Federal Reserve chairman, calling a shift in exchange rates an extraordinarily urgent part of rebalancing the world economy. On Nov 11, 2009, the Peoples Bank of China acknowledged the case for a stronger yuan in its quarterly report on monetary policy, stating that it will improve the setting of the yuan exchange rate in a proactive, controlled and gradual manner based on international capital flows and movements in major currencies. This seems to heed some of the growing global pressure to allow the free market to set the rate, particularly from the U.S, E.U, and more recently from within Asia and APEC. The growth of China over the last 30 years, with goods produced at a lower relative unit labour cost than in the US, as well as other factors that have contributed to price and non-price competitiveness, has meant a rapid increase in demand for Chinese manufactured goods in the US. As US imports rose faster than exports, a trade deficit emerged. However, in a free floating currency market, such a deficit would self-correct. The U.S trade deficit means that Americans are supplying more of their dollars on the FX market, whilst demanding more Chinese yuan. Supply and demand would thus interact such that the yuan would appreciate (and the dollar concomitantly depreciates). The weak dollar would then make U.S goods on the international market more price competitive relative to Chinese imports, making Chinese goods less attractive to Americans, whilst simultaneously Americans import less from China. This assumes that trade flows are significant enough to influence the exchange rate, but estimates suggest that only when the trade deficit gets to c.5% of GDP does it start to have sufficient impact to change exchange rates. In any case, Chinas intervention in the currency market to peg the value of yuan against a basket of currencies (of which the dollar carries most weight) prevents this self-correcting mechanism to occur. To stop the yuan from automatically appreciating, the Chinese intervene and sell yuan for dollars. Thus they create a demand for dollars which keeps the dollar stronger against the yuan than it would otherwise be. However, crucially, rather than spending their dollars to buy American goods and services, the Chinese buy financial assets, thus transferring ownership of U.S debt abroad. Thus in effect, in terms of the balance of payments, China is financing Americas current account deficit by providing its financial account surplus. As for the Europeans, as the euro rises against the dollar, the yuan peg means that the single currency is also rising against the yuan. Thus Eurozone exporters are also suffering from a damaging exchange rate that is hindering its economic recovery.

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To quote an EU official, The Americans get the toys, the Chinese get the Treasuries and we get screwed. China, on the other hand, posits that a stable exchange rate is a key aid for its exporters and that it also promotes stability in the global economy. From Chinas perspective, in previous economic cycles, there appears to be a strong correlation between exports and business confidence in Asia, and thus its reluctance to allow an appreciation and put its exports at a competitive disadvantage. So what would be the effect of a revaluation of the Chinese exchange rate? Ceteris paribus, the cost of Chinese goods would increase for foreign consumers, whilst the cost to Chinese consumers of foreign (namely U.S and European) goods and services would fall. If the revaluation was significant enough, some believe it would cause a change in the value of imports and exports so as to reduce the trade deficit in the U.S and E.U (which would in turn increase aggregate demand and real GDP). In terms of the theory, this requires that the MarshallLerner condition holds, namely that the sum of the price elasticities of demand for exports and for imports is greater than 1. That is to say, the change in the relative price of exports and imports for the U.S needs to ensure the quantity response is overall elastic, so that the value changes accordingly. This is more likely to hold in the long-term rather than the short-term due to the inelastic nature of import and export contracts and agreements (in which case the trade position could be exacerbated before it improved, as per the reverse J curve). Whilst there is debate over the exact figures for the elasticities, Thorbecke (2006) finds that the sum of the absolute values of the price elasticities (for U.S-China) is about 2.56, which does indeed satisfy the Marshall-Lerner conditions so the move should work. However, this does not mean a revaluation of the yuan is a panacea for the U.S. trade deficit. As Justin Lin Yifu, the World Bank's chief economist pointed out, China is not the sole reason for the U.S plight, with only about one-third of the US trade deficit for the years 1990-2007 being with China (however, more recently Chinas share of the U.S trade deficit has surged from 69% in 2008 to 83% in May 2009). Also, many Chinese goods are raw materials, used as inputs into producing final goods in the U.S, a fact which seems to have been overlooked. Furthermore, given the size of the deficit ($143 bn), a revaluation would have to be quite large for it to have any noticeable effect on U.S-China trade. The yuan's 20 percent rise from 2005-2008 barely registered on the price tags of Chinese goods abroad, as buyers - often foreign firms like Wal-Mart used their monopsony power to demand that costs be kept down and their suppliers were able to oblige, thanks in part to productivity gains. And even if prices rose sufficiently, other countries' goods might simply displace those that China makes. The US-China deficit issue depends on if Chinese imports compete directly with U.S-made goods, or if they are a substitute for other imports (if the latter, a yuan revaluation will simply change the geography of the deficit). Finally, it is important to remember that a revaluation in the yuan simply changes the relative prices of the U.SChinese imports and exports, and has very little effect on non-price competitiveness. The higher Chinese productivity and lower relative unit labour costs, as a result of its comparative advantage in certain goods, means that even if consumers could buy American, they may not necessarily want to. The effect of the Chinese undervalued exchange rate is also being felt amongst developing economies which are facing harsh price competition from low-cost Chinese exports. Given the dollar-yuan peg, if the developing economies currencies appreciate against the dollar, they appreciate against the yuan too. Arguably, the credit crunch and slowing domestic incomes and demand may have served to correct some of the trade imbalances. Chinas trade surplus with the rest of the world has plummeted from 11% to less than 6% of its GDP and, in the same month the U.S trade deficit shrank to $30.7 billion, with the trade deficit with China down by about 14 percent or $20 billion, compared with one year ago. Source: Mo Tanweer, EconoMax, Spring 2010

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