Balance of Payments (Edexcel A Level Economics A)

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

• 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

1. 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 (-)

2. 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 (-)

3. 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 (-)

4. 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

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

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