3.3. The Balance of Payments

• Most important trading relationship in the world between China and the United States

China's trade balance (Aug 2018-Jan 2019) and The value of the US trade deficit with China in 2017

Task 4: Analyse the following 6 graphics. What conclusions can you come to for each situation?

Task 5: Consider the trade flows between China and the 15 countries in which it has a trade deficit with. What conclusions can you come to about the Chinese economy?

Difference between a current account deficit and surplus

The following variables go into the calculation of the current account balance (CAB):

X = Exports of goods and services

M = Imports of goods and services

NY = Net income abroad

NCT = Net current transfers

The formula is:

CAB = X - M + NY + NCT

Current deficit

Running a sizeable deficit on the current account basically means that the UK 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.

Current surplus

A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how much a country is saving as opposed to investing. What this means is that the country is providing an abundance of resources to other economies, and is owed money in return. By providing these resources abroad, a country with a CAB surplus gives other economies the chance to increase their productivity.

Source: http://www.investopedia.com/articles/03/061803.asp#ixzz3onCa6akD, accessed Saturday, October 17^th 2015

Task 8:

• What is the effect of a change in a currency's value in relation to portfolio investment flows?
• The Chinese Yuan was devalued by approximately 2% in August 2015. How did the net portfolio inflows respond to this change in the currency's value?

Task 9: In 2015, the US Federal Reserve started to raise interest rates. The US Dollar Index went from 98.69 to 102.21 between 2015 and 2016. How did the net portfolio flows respond to this change in the currency's value?

Questions - Components of the BOP

1: How would the following transactions affect US exports, imports and net exports?

(a) An American art professor spends the summer touring museums in Europe.

(b) Students in Paris flock to see the latest Hollywood movie starring Keano Reeves

(c ) Your American uncle buys a Volvo

(d) A Canadian citizen shops at a store in northern Vermont (USA) to avoid Canadian sales tax

2: Describe the difference between foreign direct investment and foreign portfolio investment. Who is more likely to engage in foreign direct investment – a corporation or an individual investor? Who is more likely to engage in foreign portfolio investment?

3: How would the following transactions affect US net foreign investment?

(a) An American cellular phone company establishes an office in the Czech Republic

(b) Harrod’s of London sells shares to the General Electric pension fund.

(c) Honda expands its factory in Ohio, USA

4: (a) How does a trade deficit affect the current‑account balance?

(b) On which balance‑of‑payments account does tourism show up?

5: In order for Brazil to service its foreign debts without borrowing more money, what must be true of its trade balance?

6: Suppose Lufthansa buys $400 million worth of Boeing jets in 2000 and is financed by the U.S. Eximbank with a five‑year loan that has no principal or interest payments due until 2001. What is the net impact of this sale on the U.S. current account, capital account, and overall balance of payments for 2000?

7: Jobson plc is a UK based multinational business. It has plants in Singapore, the USA, the UK and Australia. It specialises in the manufacture and distribution of a wide variety of food and drink products. Below are some of its transactions over the past 12 months.

Profits from plants in Singapore, Malaysia and Ireland taken back to the UK

Buying shares in a French drinks producing firm

Exporting £30 million of soft drinks to EU nations from its UK plant.

Holding a conference for senior managers from all of its plants in Bermuda.

Paying for a team of Japanese management consultants to help with the restructuring of its London headquarters

Buying new production machinery from Germany for its UK plant

Investing £50 million on upgrading production facilities in its USA, Singapore and Australian factories.

In The UK Balance of Payments, explain which of the above would be shown as:

(a)Export of services

(b)Imports of services

(c) Exports of goods

(d) Imports of goods

(e)Net investment income

(f) The purchase or sale of assets on the capital account

Does a current account deficit matter?

Positive aspects

1. Partial auto-correction: If some of the deficit is due to very strong consumer demand, the deficit will automatically partially-self correct when the economic cycle turns and there is a slowdown in spending

2. Investment and the supply-side: Some of the deficit may be due to increased imports of new capital and technology which will have a beneficial effect on productivity and competitiveness of producers in home and overseas markets

3. Capital inflows balance the books: Providing a country has a stable economy and credible economic 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. The UK ran an average annual current account deficit of £10 billion from 1992-2004 and yet the economy has also enjoyed one of the longest sustained periods of growth and falling unemployment during that time.

Negative aspects

1. Structural weakness: The trade / current account deficit may be a symptom of a wider structural economic problem i.e. a loss of competitiveness in overseas markets, insufficient investment in new capital or a shift in comparative advantage towards other countries.

2. An unbalanced economy – too much consumption: A large deficit in trade is a sign of an ‘imbalanced economy’ typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these “macroeconomic imbalances” have to be addressed. Consumers cannot carry on spending beyond their means for the danger is that rising demand for imports will be accompanied by a surge in household debt.

3. Potential loss of output and employment: A widening trade deficit may result in lost output and employment because it represents a net 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.

4. Potential problems in financing a current account deficit: Countries cannot always rely on inflows of financial capital into an economy 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. Higher interest rates then have the effect of depressing domestic consumption and investment. The current situation in the United States is very interesting in this respect. Such is the size of the current account deficit that the USA must rely on huge capital inflows each year and eventually investors in other countries may decide to put their money elsewhere – this would put severe downward pressure on the US dollar.

5. Downward pressure on the exchange rate: A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp 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.

Policies to correct a current account deficit

Policies to reduce a current account deficit

1. Devaluation

This involves reducing the value of the currency against others. (e.g. selling pounds would cause the value of the Pound to fall)

• If there is a devaluation in the currency, the price of importing goods increases and therefore the quantity demanded of imports falls.

• Exports will be become cheaper and there will be an increase in the quantity of exports.

• Therefore, assuming demand is relatively price elastic, we would expect a devaluation to lead to an improvement in (X-M) and therefore the current account on the balance of payments.

• However, it does depend upon the elasticity of demand for exports and imports.

The Marshall Learner Condition

This states that a devaluation will improve the balance on the current account, on the condition that the combined elasticity’s of demand for imports and exports is greater than one.

• If (PED x + PED m > 1) then a devaluation will improve the current account.

• If (PED x + PED m > 1) then an appreciation will worsen the current account.

This is because the effect on the current account depends on the total value and not just the quantity of exports.

The J Curve effect

In the short term, demand for imports and exports tend to be inelastic. Therefore, after a devaluation, the current account tends to get worse before it gets better. However, over time, demand becomes more price elastic and the current account improves.

• J-Curve Effect and Japan's experience - Japanese Yen depreciated on a trade weighted basis late 2012

2. Deflationary policies

If an economy pursues a tightening of fiscal policy / monetary policy, this will reduce aggregate demand. Tight monetary policy involves increasing interest rates – this will leave people with less money to spend so they will reduce their consumption of imports. Also, a fall in AD and economic growth will reduce inflation and help to make UK exports more competitive.

• The UK has a high marginal propensity to import therefore a reduction in AD improves the current account significantly.

• Deflationary policies will also put pressure on manufacturers to reduce costs and this will lead to more competitive exports and so exports will increase.

• However this policy will conflict with other macroeconomic objectives – with lower aggregate demand (AD), growth is likely to fall causing higher unemployment. A government is unlikely to want to risk higher unemployment just to reduce a current account deficit.

3. Supply Side Policies

Supply side policies can improve the competitiveness of the economy and help make exports more attractive. This can improve the current account position, but it may take considerable time to have effect.

To attain low inflation, supply side policies can help reduce costs and increase productivity. For example, privatization and deregulation can help reduce costs. However, in the control of inflation, the most significant factor is the use of monetary policy and controlling AD through interest rates. Supply side policies will take a long time to have any effect on reducing inflationary pressures.

Increased productivity can also help the balance of payments. If firms become more competitive, then UK goods will be in greater demand, increasing exports and improving the current account deficit

4. Protectionism

Increased tariffs of quotas will reduce imports and improve the current account.

However:

1) Protectionism leads to retaliation so exports will decrease

2) Domestic industries may become uncompetitive, because there is no incentive.

Consequences of a current account surplus

1. Appreciation of the currency – may lead to a loss in export competitiveness

2. If the country is using a managed or fixed exchange rate system, then the appreciation could/will lead to the need for the monetary authorities for intervention in the FOREX market.

3. Employment – a current account surplus will tend to boost domestic employment if:

a) It is due to an improvement in competitiveness

b) If domestic demand is strong and consumers are buying domestically-produced goods instead of importing

A current account surplus could lead to lower domestic employment if:

a) The surplus is caused by a recession which leads to a fall in import spending

b) Global recession – surplus caused by falling exports but larger decline in imports

4. It could put pressure on its trading partners to take action to reduce its own current account deficit with the country particularly if these imbalances are long-term

5. Less imported inflation due to strong currency – this makes imported imports relatively cheaper (increase in SRAS) but could have a negative effect on AD (lower net exports)

6: Interest rates could be lowered to reduce pressure on currency – positive implications for AD. In addition, the excess of domestic savings could allow a country to fund its own public/private borrowing requirements – this should also lead to a fall in interest rates.

7. Part of the Current account surplus could have been because of an inflow of investment income. Increasing Investment income for domestic firms may be valuable to the economy as it increases the I component of AD in the future.