3.3 Balance of Payments
Balance of payments: records financial transactions made between consumers, businesses and the government in one country with others
The BOP figures tell us about how much is being spent by consumers and firms on imported goods and services, and how successful firms have been in exporting to other countries
Debit items: payments
Credit items: receipts
Components of the Balance of Payments
Current transfers are transfers of money where nothing is received in return, such as workers remittances, pensions, aids and donations
Non financial asset transfers include the purchase or use of natural resources that have not been produced.
Capital transfers include things like debt forgiveness, non- life insurance claims and investment grants
Reserve assets are foreign currencies purchased to be used by the central bank in its monetary policy
Portfolio investment is the purchase of shares and bonds
Direct investment includes investment in physical capital usually undertaken by multinational corporations
Current account balance: equal to the sum of the capital account and financial account balances
Current account surplus: this indicates that the country is a net leader to the rest of the world as it usually implies that the current account is large and therefore the country is a major exporter. Overall it means that more income is flowing into the country than outwards.
Current account deficit: this indicates that the country is a net borrower to the rest of the world as it usually implies that the current account is small and therefore the country mainly imports products. Overall it means that less income is flowing into the country than outwards.
Current Account Surplus
If there is a current account surplus, then exports tend to exceed imports, this means that the demand for the currency has risen as people have bought products in that country’s currency. This then causes an upward pressure on the exchange rate and the relative value of the currency to rise, appreciation.
The increase in relative exports causing appreciation is shown in the adjacent diagram.
Implications of a persistent current account surplus
Appreciation: as exports increase, the demand for the currency increases and therefore the value of the currency increases.
Reduced export competitiveness: as the currency appreciates, in a floating exchange rate, exports become comparatively more expensive so demand for exports fall.
Lower domestic consumption and investment: as the currency appreciates, imports will become more affordable compared to domestic products so consumption of domestic products falls. The appreciation can also deter foreign investment from abroad as it becomes more expensive.
Current Account Deficit
If there is a current account deficit, then imports tend to exceed exports, this means that the supply of the currency has risen as people have bought fewer products in that country’s currency. This then causes a downward pressure on the exchange rate and the relative value of the currency to fall, depreciation.
The relative increase in imports causing depreciation is shown in the adjacent diagram.
Implications of a persistent current account deficit
Exchange rates: the currency should automatically depreciate, which will then help to rectify the deficit as exports become cheaper relative to imports.
Interest rates: the central bank may decide to increase these in order to encourage foreign direct investment, however, this may reduce domestic investment and consumption as there is a greater incentive to save than spend which could lead to lower levels of growth.
Indebtedness: if the country is having to borrow in order to finance the current account deficit then they may accumulate so much debt that they are unable to pay it back and so default. This undermines confidence in the economy, so they may be unable to get any future loans.
International credit ratings: a persistent current account deficit may cause the international credit rating agencies to lower their rating which may lead to even lower expectations about the economy’s future.
Demand management: in order to rebalance the account deficit they make take measure to reduce demand which can be very painful for the economy as a whole.
Methods to resolve a current account deficit
Expenditure switching policies: these may include devaluing the exchange rate, tariffs and polices to reduce inflation. The aim is to reduce the demand and supply of imports, rather than reducing overall consumption.
Expenditure reducing policies: these policies aim to reduce the real spending of consumers. Such policies include fiscal and monetary polices. For instance, the government may increase taxes and reduce spending, whilst the central bank may increase interest rates to incentivise saving.
Supply-side policies: policies may be needed in order to improve the country’s productivity in order to improve its exports competitiveness in the international markets. These policies including lowering production costs by reducing the minimum wage, trade union power, business taxes and implementing deregulation.
Marshall Lerner Condition
This condition states that currency devaluation will only lead to an improvement in the balance of payments if the sum of demand elasticity for imports and exports is greater than one. This can be explained by using a J curve diagram.
Initially following depreciation, at point A, the current account deficit will worsen because prexisting trade contracts mean that the demand for imports and exports will remain fairly inelastic. Therefore, the volume of imports and exports may remain largely unchanged. In the long term, from point B, demand for imports and exports becomes more elastic as consumers tastes and preferences adapt and firms' contracts change. Therefore, the desired affect of increased exports following depreciation will gradually come into fruition.