Balance of Payments (Edexcel A Level Economics A)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Components of the Balance of Payments
The Balance of Payments (BoP) for a country is a record of all the financial transactions that occur between it and the rest of the world
The BoP has two main sections:
The current account: all transactions related to goods/services along with payments related to the transfer of income
The financial and capital account: all transactions related to savings, investment and currency stabilisation
Money flowing into the country is recorded in the relevant account as a credit (+) and money flowing out as a debit (-)
The current account of the balance of payments
The Current Account is often considered to be the most important account in the BoP
It records the net income that an economy gains from international transactions
An Example of the UK Current Account Balance For 2017
Component | 2017 |
|---|---|
Net trade in goods (exports - imports) | £-32.9bn |
Net trade in services (exports - imports) | £27.9bn |
Sub-total trade in goods/services | £-5bn |
Net income (interest, profits and dividends) | £-2.1bn |
Current transfers | £-3.6bn |
Total Current Account Balance | £-10.7bn |
Current Account as a % of GDP | 3.7% |
Goods are also referred to as visible exports/imports
Services are also referred to as invisible exports/imports
Net income consists of income transfers by citizens and corporations
Credits are received from UK citizens who are abroad and send remittances home
Debits are sent by foreigners working in the UK back to their countries
Current transfers are typically payments at government level between countries e.g. contributions to the World Bank
The capital account
The Capital Account records small capital flows between countries and is relatively inconsequential
E.g. debt forgiveness by the government towards developing countries
E.g. capital transfers by migrants as they emigrate and immigrate
The financial account
The Financial Account records the flow of all transactions associated with changes of ownership of the UK’s foreign financial assets and liabilities
It includes the following sub-sections
Foreign Direct Investment (FDI): flows of money to purchase a controlling interest (10% or more) in a foreign firm. Money flowing in is recorded as a credit (+) and money flowing out is a debit (-)
Portfolio Investment: flows of money to purchase foreign company shares and debt securities (government and corporate bonds). Money flowing in is recorded as a credit (+) and money flowing out is a debit (-)
Financial derivatives: are sophisticated financial instruments which investors use to speculate and return a profit. Money flowing in is recorded as a credit (+) and money flowing out is a debit (-)
Reserve Assets: are assets controlled by the Central Bank and available for use in achieving the goals of monetary policy. They include gold, foreign currency positions at the International Monetary Fund (IMF) and foreign exchange held by the Central Bank (USD, Euros etc.)
Causes of Deficits & Surpluses on the Current Account
It is called the BoP as the current account should balance with the capital and financial account and be equal to zero
If the current account balance is positive, then the capital/financial account balance is negative (and vice versa)
In reality, it never balances perfectly and the difference is called 'net error and omissions'
If there is a current account deficit, there must be a surplus in the capital and financial account
The excess spending on imports (current account deficit) has to be financed from money flowing into the country from the sale of assets (financial account surplus)
If there is a current account surplus, there must be a deficit in the capital and financial account
The excess income from exports (current account surplus) is financing the purchase of assets (financial account deficit) in other countries
Causes of Current Account Deficits
Relatively low productivity | Relatively high value of the country’s currency | Relatively high rate of inflation |
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Rapid economic growth resulting in increased imports | Non-price factors such as poor quality and design |
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Measures to Reduce Imbalances on the Current Account
The Government has several options available to them in order to tackle a current account deficit
They could do nothing, leaving it to market forces in the foreign exchange market to self-correct the deficit
They could use expenditure switching policies
They could use expenditure reducing policies
They could use supply-side policies
The choice of any policy - or any combination of policies generates both costs and benefits
Costs and Benefits of Policies Used to Tackle Current Account Deficit
Policy Option | Benefit | Cost |
|---|---|---|
Do nothing | Floating exchange rates act as a self-correcting mechanism. Over time a higher level of imports will end up depreciating the currency causing imports to decrease (they are now more expensive) and exports to increase (they are now cheaper). This improves the deficit | There may be other external factors that prevent the currency from depreciating. It may take a long time for self-correction to happen and many domestic industries may go out of business in the interim. The longer it takes to self-correct, the more firms will delay investment in the economy |
Expenditure Switching | This is often successful in changing the buying habits of consumers, switching consumption on imports to consumption on domestically produced goods/services. This helps improve a deficit | Any protectionist policy often leads to retaliation by trading partners. This may consist of reverse tariffs/quotas which will decrease the level of exports. This may offset any improvement to the deficit caused by the policy |
Expenditure Reducing | Deflationary fiscal policy invariably reduces discretionary income which leads to a fall in the demand for imported goods and improves a deficit | Deflationary fiscal policy also dampens domestic demand which can cause output to fall. When output falls, GDP growth slows and unemployment may increase |
Supply-side | Improves the quality of products and lowers the costs of production. Both of these factors help the level of exports to increase thus reducing the deficit | These policies tend to be long term policies so the benefits may not be seen for some time. They usually involve government spending in the form of subsidies and this always carries an opportunity cost |
Significance of Global Trade Imbalances
As global trade is a net sum game where the value of global exports = global imports, it follows that if one country is running a current account surplus then another country is running a deficit
Persistent deficits can be problematic as it means that finance from abroad (in the form of loans or foreign direct investment) is required in order to fund continued imports
This may mean that a country is gradually selling its assets
Owning money to a foreign entity creates vulnerabilities
The 2008 Global Financial Crisis demonstrated the impact of fast changing conditions in which creditors were insisting on being repaid quickly e.g. Greece owed creditors (including Germany) significant sums and was required to pay these back creating numerous problems in their economy
Persistent surpluses can be problematic as it means that the focus of the allocation of a nation's resources is on meeting foreign demand as opposed to meeting domestic demand
This can limit availability of goods/services in the local economy which can possibly decrease the standard of living for some households
It can also create instability in the foreign exchange market if there is a floating exchange rate mechanism in operation
E.g. China ran a surplus for years but did not allow its currency to float freely. In recent years they have switched their focus to increasing domestic demand
This surplus has resulted in significant foreign direct investment by Chinese firms and the level of foreign asset ownership is high
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