2.6.3 The Balance of Payments

Structure of the Balance of Payments

The balance of payments (BoP) records all financial transactions between a country and the rest of the world.

It is made up of several accounts:

Current account: Records trade in goods and services, primary income, and secondary income.

Capital account: Records relatively minor capital transfers, such as debt forgiveness.

Financial account: Records flows of investment, such as FDI and portfolio investment, as well as changes in foreign exchange reserves.

Components of the Balance of Payments

Transactions that lead to a monetary inflow into the UK are recorded as credits, while transactions that lead to a monetary outflow are recorded as debits.

Current Account

• Trade in goods: Exports and imports of physical goods, such as cars, machinery, and food.
• Trade in services: Exports and imports of services, such as tourism, banking, and insurance.
• Primary income: Income flows from abroad, such as profits, interest, and dividends.
• Secondary income: Transfers of money, such as foreign aid, remittances, and gifts.

Capital Account

• Capital transfers: Transfers of ownership of fixed assets, such as land or buildings.
• Debt forgiveness: When a country cancels the debt owed by another country.

Financial Account

• Foreign direct investment (FDI): Investment in physical assets, such as factories or offices, in another country.
• Portfolio investment: Investment in financial assets, such as stocks and bonds, in another country.
• Reserve assets: Changes in a country's foreign exchange reserves, such as gold or foreign currency.

Current Account Deficits and Surpluses

• A current account deficit occurs when outflows, such as imports and income paid abroad, are greater than inflows from exports and income received i.e. X < M.
• A current account surplus occurs when inflows are greater than outflows i.e. X > M.
• Since the Balance of Payments must always balance, a current account deficit must be financed by a surplus in the capital and financial accounts, while a current account surplus must be offset by a deficit in the capital and financial accounts.

Causes of a Current Account Deficit

• Low competitiveness: If domestic goods are more expensive or of lower quality than foreign goods, imports will rise and exports will fall.
• Strong exchange rate: A strong currency makes imports cheaper and exports more expensive, leading to a deficit.
• High domestic demand: If domestic demand is high, consumers may buy more imports, leading to a deficit.
• Slow economic growth abroad: If other countries are growing more slowly than the domestic economy, demand for the country's exports weakens while its own demand for imports stays strong, leading to a deficit.
• Structural factors: Long-term changes in the economy, such as a decline in manufacturing or a shift towards services, can lead to a persistent deficit.

Policies to Reduce a Current Account Deficit

Expenditure-Switching Policies

Expenditure-switching policies: These aim to switch demand away from imports and towards domestically produced goods and services. Examples include tariffs, quotas, and devaluation of the currency.

Evaluation: These policies can be effective in the short term, but they may lead to retaliation from trading partners and higher prices for consumers.

Expenditure-Reducing Policies

Expenditure-reducing policies: These aim to reduce overall demand in the economy, which can reduce imports. Examples include contractionary fiscal policy and higher interest rates.

Evaluation: These policies can be effective in reducing a deficit, but they may lead to lower economic growth and higher unemployment.

Supply-Side Policies

Supply-side policies: These aim to increase the competitiveness of domestic industries and boost exports. Examples include investment in education and training, research and development, and infrastructure.

Evaluation: These policies can be effective in the long term, but they may take time to have an impact and may require significant government investment.

Significance of Global Imbalances

Persistent deficits: a persistent current account deficit can lead to a build-up of foreign debt, which may require higher taxes or spending cuts in the long term. It can also lead to a loss of confidence in the domestic currency resulting in depreciation and reduced Foreign Direct Investment (FDI) inflows.

Persistent surpluses: a persistent current account surplus can lead to inflationary pressures in the domestic economy due to increased aggregate demand. It can also lead to over-reliance on exports and vulnerability to external shocks, such as a global recession or changes in trading partners' demand.