The balance of payments (BoP) is a record of all external financial transactions between one economy and the rest of the world. The two main components of the BoP are the current account and financial account. The BoP must sum up to zero.
Current Account The current account includes: – Trade in goods/visibles (raw materials, manufacture goods, cars etc.). – Trade in services/invisibles (banking, insurance, transport etc.). – Investment income (profits, dividends and interest on assets abroad). Money from the use of capital abroad. – Transfers including aid, remittances (money sent to relatives abroad) and EU contributions.
Financial Account The financial account includes: – Multinational companies or foreign direct investment (foreign owned factories and plants). – Portfolio investment (shares and bonds).
Reasons for Foreign Capital Flows Foreign capital flows affect the financial account. Reasons for foreign capital flows include:
1) Multinational Companies.
Multinational companies (MNCs) looking to enter a new foreign market will need to invest in that country to set up a factory to produce, this causes an inflow of foreign direct investment (FDI) into that country.
2) Foreign Trade.
Consumers may take out loans from foreign banks to buy foreign goods.
3) Private Transfers.
Agents may transfer funds abroad to avoid or evade domestic taxes and fund holiday homes.
4) Bank Loans.
Banks in one country may lend money to, or take the savings of, agents in another country.
Speculators may buy/sell foreign debt and shares to make a quick profit.
6) Government Bonds.
A government may sell bonds to foreign agents to raise funds for government spending.
Current Account Surplus and Deficit A current account surplus means the exports of goods and services is greater than the imports of goods and services and money flows into the domestic economy. This is matched by a financial account deficit. A financial account deficit means domestic residents invest more overseas than foreign residents invest in the domestic economy.
A current account deficit means the imports of goods and services is greater than the exports of goods and services and money flows out of the domestic economy. This is funded by a financial account surplus. A financial account surplus means foreign residents invest more in the domestic economy than domestic residents invest overseas.
Causes of A Current Account Deficit Many factors could cause a current account deficit:
1) Exchange Rate Appreciation.
An appreciation/rise in the domestic country’s exchange rate means the domestic economy becomes less internationally price competitive, exports become dearer and fall, imports become cheaper and rise so the current account moves towards a deficit.
2) Global Recession.
A global recession means foreign consumers have a lower income so they buy less UK exports, UK exports fall and the current account moves towards a deficit.
3) Poor Quality Goods.
If the quality of the domestic economy’s goods falls, foreign consumers will demand less of the domestic economy’s goods so exports fall, domestic consumers buy more foreign goods so imports rise and the current account moves towards a deficit.
A rise in country A’s inflation makes A’s goods less internationally price competitive, exports are dearer and fall, imports are cheaper and rise so the current account moves towards a deficit.
5) Domestic Income.
A rise in the domestic country’s income means consumers buy more domestic and foreign goods so imports rise, domestic firms sell more to domestic consumers so exports fall, and the current account moves towards a deficit.
Significance of A Current Account Deficit A current account deficit may or may not be a problem, it depends on the size of the deficit and what caused the deficit.
If the current account deficit is small and sustainable then it is not a problem, the domestic economy can easily fund it. A large sustainable current account deficit is not a problem because the domestic economy can fund it. Moreover, a current account deficit may not be a problem if the domestic economy imports a lot of capital goods. Machinery may be imported so the domestic economy’s productive capacity rises, LRAS shifts right and in the future the domestic economy can produce
more consumer goods for its domestic consumers so its imports fall and the domestic economy can sell more consumer goods to foreign consumers so the domestic economy’s exports rise.
A current account deficit could be a sign that the economy is growing because economic growth means incomes rise and consumers buy more imports. Although, a current account deficit could be a sign that the economy is in a recession (so it is not producing enough exports).
Additionally, a current account deficit may be a problem because it indicates that the domestic economy’s goods are not internationally competitive. Maybe the domestic economy’s goods are poor quality relative to the rest of the world.
A current account deficit may also be a problem because if an economy is producing too little exports then there may not be enough jobs and unemployment may be too high.
A large and unsustainable current account deficit is a problem because money is leaving the economy. An economy could fund the current account deficit by borrowing international money from foreign banks. But, if there is a large and persistent current account deficit, creditors may soon deem the economy more risky as there is a higher chance of default. Credit worthiness falls, interest rates rise so the cost of borrowing international money rises, it becomes more difficult for the economy to repay its foreign debt, the risk of default rises further, credit worthiness falls further and the loop spirals out of control. Eventually the economy must reduce its imports.
A current account surplus may even be a problem because it may mean that the domestic economy is producing goods for foreign consumers rather than domestic consumers. Also, a large current account surplus for the domestic economy means other countries have a current account deficit, this could cause trade frictions and disputes.
Remedies to Cure A Current Account Deficit Many remedies could be used to cure a current account deficit:
1) Exchange Rate Adjustment.
An exchange rate devaluation makes the domestic currency cheaper, the domestic economy is more internationally price competitive, exports are cheaper and rise, imports are dearer and fall, so the current account moves towards a surplus.
But this depends on the Marshall-Lerner condition: A devaluation will only lead to an improvement in the current account if the sum of the elasticities of demand for exports and imports is greater than one. Moreover, as shown by the J-curve: After an exchange rate devaluation, the current account moves into a deficit in the short-run because of fixed contracts for exports and imports. Exports are cheaper and imports are dearer yet their volumes remain the same, so the current account initially moves towards a deficit. After contracts are renegotiated in the long-run, exports rise, imports fall and the current account moves towards a surplus.
2) AD Management.
A fall in AD means income falls, at a lower income the marginal propensity to import is lower, so imports fall and the current account moves towards a surplus. The initial decrease in AD could be caused by a rise in interest rates or a rise in taxation.
But in the short-run, a higher domestic interest rate attracts foreign savings, so the value of the domestic currency rises, exports become dearer and fall, imports become cheaper and rise, so the current account moves towards a deficit. The domestic economy could raise taxes to decrease AD instead, but taxes take time to come into effect.
3) Supply-Side Policies.
Supply-side polices could be used to increase LRAS and increase the productive capacity of the domestic economy so that it is able to meet its own consumption needs.
But this costs money and a large investment so in the short-run AD will rise, inflation will rise, the domestic economy loses international price competitiveness, exports become dearer and fall, imports become cheaper and rise, so the current account moves towards a deficit. Moreover, supply-side policies only come into effect in the long-run.