EP Lecture 21 2012

7/31/2019 EP Lecture 21 2012

1/24

Economic Principles

Lecture 21:

The Balance of Payments

(See Chapter 25 in John Sloman Economics 7th Edition)

7/31/2019 EP Lecture 21 2012

2/24

The Balance of Trade and PaymentsAll states are involved in international trade, we saw theeconomic advantages of such activity in the last lecture. It

allows businesses and consumers to obtain products thatwould otherwise be unavailable (eg coffee or aluminium inthe UK) but ,more importantly, it enables absolute andcomparative advantages to be developed and, thus,

resources to be used more efficiently.

The record of the inflow of goods and services (imports)and outflow (exports) is known as the Balance of Trade.

Flows of money for other purposes such as income fromforeign property, investments, etc. will also bring moneyinto the country, or take it out, these flows are included in

the Balance of Payments Current Account.

7/31/2019 EP Lecture 21 2012

3/24

International Transactions (Money Flows)Besides the consumer trading in Goods & Services, money also flows around the world

1. UK nationals (labour) work in other countries and send home part of their income (Y).Likewise, foreign nationals work in the UK and send part of their incomes abroad.

2. UK companies invest (Capital = I ) in other countries, their income will be the return (oryield) from that investment. Foreign firms that invest in the UK may repatriate all or someof the profits they make on these investments.

FACTORY

UK

UK

HOUSEHOLDS

FOPsY CdO

WMTS

JG

E

Banks Fiscal Policy Trade

XI

FACTORY

UK

UK

HOUSEHOLDS

FOPsY CdO

WMTS

JG

E

Banks Fiscal Policy Trade

XI

3. UK nationals (eg fund managers) save abroad (S), likewise UK firms operating abroad willsave (S) some of their profits there in order to maintain foreign cash flows. In return forsaving abroad they receive a return (rate of interest).

4. Finally, the UK government (G) sends aid abroad (and receives revenue from the EU) , italso has to pay for embassies, as do other countries. The government also pays itsmembership fees to international/foreign institutions (e.g. NATO, UN, EU, IMF, WTO)

7/31/2019 EP Lecture 21 2012

4/24

The Balance of Payments accounts

The Balance of Payments Account keep a track of all these internationaltransactions. Treating inflows as a credit item,(+) and outflows as a debit item ()

1. The Current AccountExports (X) of Goods & Services +Imports (M) of Goods & Services

(a) Balance of Trade + / Incomes (Y) & current transfers from abroad +Incomes (Y) & current transfers to abroad

(b) Other Income Flows + / (c) Current Account Balance + /

2. Capital AccountTransfers of capital to UK from abroad +Transfers of capital abroad from UK

(d) Capital Account Balance + /

3. The Financial AccountNet investment in the UK from abroad +UK net investment abroad Short-term financial inflows to UK +Short-term financial outflows from UK Drawing on / Adding to official reserves + /

(e) The Financial Account Balance + /

4. The Balancing Item + /

Consumers

GovernmentBusiness

Labour (Y)

InvestorsBuying real assets(i.e. LAND & FDI)

InvestorsFinancial Assets

(i.e. Shares & Bonds)

Savers(bank deposits)

7/31/2019 EP Lecture 21 2012

5/24

The Balance of Payments Accounts

The relationship between the Current Account, the Capital Account and theFinancial Account

1. The Current AccountExports (X) of Goods & Services +Imports (M) of Goods & Services

(a) Balance of Trade + / Incomes (Y) & current transfers from abroad +Incomes (Y) & current transfers to abroad


2. Capital AccountTransfers of capital to UK from abroad +Transfers of capital abroad from UK

(d) Capital Account Balance + /

3. The Financial AccountNet investment in the UK from abroad +UK net investment abroad Short-term financial inflows to UK +Short-term financial outflows from UK Drawing on / Adding to official reserves + /

(e) The Financial Account Balance + /

4. The Balancing Item + /

Interest

Interest &Dividends

Profits &Rents

GovernmentBusinessLabour (Y)

7/31/2019 EP Lecture 21 2012

6/24

The Current Account(a) Balance of Trade (X - M) + / [CONSUMERS](b) Other Income Flows + /

(c) Current Account Balance + /

Capital Account(d) Capital Account Balance + / [INVESTORS]

The Financial AccountNet investment to & from abroad + / [INVESTORS]Short-term flows to & from abroad + / [SAVERS](e) The Financial Account Balance + /

The Balancing Item + /

Disequilibrium in Balance of Payments: Capital Flows = X MWhy they will always balance?

Fred buys a BMW fromGermany for 15,000

BMW now has15,000 they can;

Capital Flows

Thus X = M

Thus X < M (- 15,000)Capital a/c (+ 15,000)

Thus X < M (- 15,000)

Financial a/c (+15,000)

BUY 15,000 of UKgoods & services,

Or, INVEST15,000 in the UK

Or SAVE 15,000in a UK Bank

Or, BMW can sell s tosomeone who wants toBUY UK goods, INVEST inthe UK or, SAVE in the UK.Whatever happens the swill return to the UK; the

issue is who owns the s,(or assets )?

7/31/2019 EP Lecture 21 2012

7/24

Disequilibrium in the Balance of Payments

The Balance of Payments Current Account records flows ofincome into and out of the economy. In a large developed

economy there is almost no chance that the two sides willbalance (it would be coincidence if they did). Thus there willbe disequilibrium in the Balance of Payments:

If Inflows exceed Outflows (X>M) it is a SurplusIf Outflows exceed Inflows (M>X) it is in Deficit

Remember from the Circular Flow of Income:

X>M it is a net Injection and will increase National IncomeX

7/31/2019 EP Lecture 21 2012

8/24


Thus, there is an assumption that every country would like toachieve Balance of Payments surplus. If you remember from

the first lecture on macroeconomics, this is seen as one ofthe four main objectives of macroeconomic policy.

There is a fundamental problem with this however and it is

based on the simple (but sometimes forgotten) point that onecountrys exports are another countrys imports. Thus overthe world, trade must balance, which in turn means that ifone country has a surplus then at least one other must havea deficit. It is impossible for all to have a surplus.

It is possible that over time there could be balance: Country A may have deficits in years 1-3 and surpluses 4-6 Country B may have surpluses in years 1-3 and deficits 4-6

But in recent times that has often not happened.

7/31/2019 EP Lecture 21 2012

9/24


So what might turn a deficit into a surplus or vice versa?

A change in the exchange rate we will look at this indetail in the next lecture

Protectionism limiting the quantity in imports becoming

more open will increase the quantity of imports Increasing the competitiveness of exporting industries inthe economy, or subsidising exports

Inflation lower than in other countries reducing therelative price of traded goods on world markets (thoughexchange rate adjustment might cancel this out)

Internal deflation might reduce the demand for all goodsincluding imports

7/31/2019 EP Lecture 21 2012

10/24

Percentage change in GDP & the Current Account (as a % of GDP)

The UK 1970 to 2002

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

70 75 80 85 90 95 00

UK GDP% change

Current account (Bof P) as a % of GDP

Disequilibrium in Balance of PaymentsWhy does it happen?

Y => M

UK Inflation => relative

price M price X

=> Qd M => Qd X X< M

Other possible reasons?

UK products areuncompetitive (nobodywants them) or there arebetter goods & servicesfrom foreign suppliers

As the graph below shows, the UK has had aBalance of Payments Current Account deficit for

the past 25 years. We can also see that the deficitgets worse when growth is strong (eg 1986-89).

7/31/2019 EP Lecture 21 2012

11/24

The Current Account(a) Balance of Trade (X - M) + / [CONSUMERS]


Capital Account(d) Capital Account Balance + / [INVESTORS]

The Financial AccountNet investment to & from abroad + / [INVESTORS]

Short-term flows to & from abroad + / [SAVERS](e) The Financial Account Balance + /

The Balancing Item + /

The Relationship between the Balance of Payments &Exchange Rates

As consumers,

investors & savers ,UK nationals supply(sell) s in exchangefor a foreign currency

As consumers,investors & savers

foreign nationals:demand (buy) susing their currency

Thus, if UK Nationals demand more imports, seek better investment opportunitiesabroad or, choose to save abroad (attracted by higher interest rates) the supply of s on

the foreign exchanges will increase.

Likewise, if foreign nationals demand more UK goods & services, seek what they see asbetter investment opportunities in the UK ,or choose to deposit their savings in a UK bank,the demand for s on the foreign exchanges will increase.

These different choices by UK & foreign nationals will all be recorded in the

Balance of Payments Accounts (eventually)

7/31/2019 EP Lecture 21 2012

12/24

Foreign ExchangesFred exchanges for

Exchange Rates & the Balance of PaymentsExchange Rates & financial sectorhow it all works

Fred wants to buy a BMW

for 15,000

BMW now has 15,000worth of Euros (), which itwill deposit in a bank

The Forex dealerwill now Sell

these s to anyone who wants to

Buy UK goods,

Invest in the UK

or, Save in the UK.

The question is: wheredoes the foreign exchangedealer store these s, & s

while waiting for buyers?

A UK Bank

Hans wishes tobuy a UK made

JCB costing 50,000

A German Bank

JCB sells to Hans for50,000 and deposits

the cash in a UK bank

A UK Bank

A German Bank

The majority of currency never leaves the country

7/31/2019 EP Lecture 21 2012

13/24

Exchange Rates & the Balance of PaymentsInternational Transactions and Money Supply (liquidity)

Freds UK Bank A/c

100,000(BMW) - 15,000

85,000

Assume1.00 =1.00BMWs German Bank

A/c100,000

(BMW) +15,000115,000

UK Forex DealerStock of100,000

-15,000

+50,000

German Forex DealerStock of 100,000

+15,000

- 50,000

JCBs UK Bank A/c

100,000(JCB) + 50,000150,000

Hans German Bank A/c

100,000(JCB) -50,000

50,000

UK Forex DealerGerman a/c balance

135,000

German Forex DealerUK a/c balance

65,000

An Inflow of fundsfrom abroad

(net supply 35000)

An Outflow of fundsAbroad

(net demand 35000)

7/31/2019 EP Lecture 21 2012

14/24


In practice, exchange rates will adjust in most cases tochange the relative price of traded goods and services, as

we will investigate in the next lecture.

However, we should remember that trade is only part of thefull Balance of Payments Account, so it is possible tomaintain a Current Account Balance of Payments deficit if:

There is a Capital Account Surplus There is a Financial Account Surplus

The deficit can be financed by issuing our currency to therest of the world providing surplus countries are preparedto accept it and either hold it in reserve or use it for tradewith third countries (this is an explanation for the consistency

of the American Current Account deficit in recent times).

7/31/2019 EP Lecture 21 2012

15/24


State TradeBalance($bn)

Current AccountBalance($bn)

Current AccountBalance

(% of GDP)

USA -592.4 -391.9 -3.2

UK -138.1 -33.7 -1.6

Germany +207.9 +179.0 +5.2

France -65.1 -49.4 -2.0

Japan +87.5 +180.3 +3.4

Brazil +17.1 -43.8 -2.7China +174.7 +286.8 +4.9

Hong Kong -42.9 +17.0 +8.1

Sample Countries Trade and Current Account Balances: mid 2010

Source: The Economist, 11th - 17th September 2010

7/31/2019 EP Lecture 21 2012

16/24


Although the above figures cover only one year, they aretypical of the recent past; China, Germany and Japan have

had trade surpluses continuously for at least 15 years, theUSA and UK deficits. Note that:

Some states have trade deficits but smaller CurrentAccount deficits (USA, UK, France) or even a surplus(HK). They therefore have a net inflow of income fromabroad.

Conversely there are states with trade surpluses but

smaller Current Account surpluses (Germany) or deficits(Brazil), indicating a net outflow of income.

China and Japan have trade surpluses and a net inflow of

income which leads to a larger Current Account surplus.

7/31/2019 EP Lecture 21 2012

17/24


State Stock of Inward

FDI (US$m)

Global

Ranking

Stock of FDI

Abroad (US$m)

Global

Ranking

USA 2398000 1 3259000 1

UK 1025000 3 1643000 3

Germany 1021000 4 1403000 4France 1202000 2 1759000 2

Japan 205400 19 726500 7

Brazil 318500 12 124300 22

China 576100 8 227300 13Hong Kong 873800 5 808000 6

Sample Countries Stocks of Foreign Direct Investment 2008/2009

Source: CIA Factbook

Note that other agencies (eg IMF) produce figures that vary with these,though the rank order tends to be more or less the same in all cases.

B

7/31/2019 EP Lecture 21 2012

18/24


The amount of Foreign Direct Investment (FDI) that acountry has is a function of its openness to international

capital and attitude to globalisation.

Note that the top four states (USA, France, UK, Germany)ranked are the same for the amount of FDI stock withintheir economy and the amount invested abroad. HongKong too is almost equally ranked in both lists.

Some states are more open to inward investment thanoutward (Brazil, China) and others vice versa(Japan).

The chief reason is that both China and Brazil are amongthe BRIC states (Brazil, Russia, India, China); NewlyIndustrialising Countries (NICs) or Emerging Economies

with large potential markets, yet comparatively low costs.

Di ilib i i h B l f P

7/31/2019 EP Lecture 21 2012

19/24


Comparing Hong Kong and China shows the importance ofopenness to FDI. Hong Kong was governed by Britain until

1997 and developed a very open attitude to foreign anddomestic business which has generally continued to thepresent day. Technically HK is part of China since 1997, butits economy is still run separately from the mainland undera two systems, one country policy which gives it a highdegree of economic autonomy, for example its own currency.

Source: World Bank

Despite being many times larger than HK, China has much

less FDI invested at home and abroad.

China Hong Kong

Area 9600000m km2 1100km2

Population 1336m 7m

GDP $5745000m $1336m

Ease of Doing Business (Rank) 86 2

Di ilib i i h B l f P

7/31/2019 EP Lecture 21 2012

20/24


Countries with short term Balance of Payments deficits canfinance them using reserves of foreign currency or gold. In

the past, this was how trade was balanced, hence theimportance for countries to balance the external economicrelations; if they did not it was a drain on the reserves.

As we have noted, not all countries can have a balance orsurplus, so the emphasis to solve a Balance of Paymentsimbalance was on deficit countriesthey had the problem.

The simplest way to solve it was with protectionist measures

(eg tariffs) but the effect of this was to shift the problem toother countries which had been in surplus. They now had adeficit and would retaliate, and so on. The result of all thiswas that the overall level of world trade reduced, but

inevitably, some states still had deficits.

Di ilib i i th B l f P t

7/31/2019 EP Lecture 21 2012

21/24


The above situation can be avoided if we have a currency, orcurrencies, that are internationally acceptable and surplus

countries are willing to hold them.

This would mean that we could have 100 countries with a$1m surplus and one country with a $100m deficit (note thatworld trade balances).

Thus, as long as the 100 countries are happy to accept andhold $ and exchange them between themselves for trade thesystem works without any need for protectionism. In simple

terms this is the system that developed after World War 2.

However, the key point is that everyone must haveconfidence in the value of the reserve currency ($ in this

case), otherwise they will not be prepared to use it.


7/31/2019 EP Lecture 21 2012

22/24


State Foreign

ExchangeReserves ($m)

Global

Ranking

Gold reserves

(tonnes)*

Global

Ranking

USA 132933 16 8133.5 1

UK 107853 18 310.3 17

Germany 208704 11 3401.8 2France 166319 13 2435.4 5

Japan 1096185 2 765.2 9

Brazil 297696 6 33.6 48

China 2622000 1 1054.1 6

Hong Kong 268731 10 2.1 86

Sample Countries Foreign Exchange and Gold Reserves 2009

Source: IMF* Note that these figures have not been audited in most cases


7/31/2019 EP Lecture 21 2012

23/24


The table above shows that China and Japan have thelargest foreign exchange reserves in 2009. This is mainly

due to the large trade surpluses they have accumulated overmany years. Note that reserves will not only be in US$, othercurrencies, particularly the, are becoming more popular.

In order to be a reserve currency there must be confidencethat it is going to hold its value and be acceptable throughoutmost of the world. This will depend on a number of politicaland economic factors such as stability, global power, recordon growth and inflation, etc. If confidence in a reserve

currency is lost the potential effects for the global economyare disastrous (large scale devaluation at least).

Major countries still hold gold reserves to retain confidence

(at the time of writing a tonne of gold is worth about $50m).

7/31/2019 EP Lecture 21 2012

24/24

Economic Principles

Lecture 21:

The Balance of Payments

Documents

EP Lecture 21 2012