21.

Balance of Payments on Current Account

What is the Balance of Payments? The balance of payments (BOP) records all of the many financial transactions that are made between consumers, businesses and the government in the UK with people across the rest of the World. The BOP figures tell us about how much is being spent by British consumers and firms on imported goods and services, and how successful UK firms have been in exporting to other countries and markets. It is an important measure of the relative performance of the UK in the global economy. At AS level, we focus on one part of the balance of payments accounts. This section is known as the current account. We will go through the make-up of this account in a later section. The importance of exports for the economy Why is the export sector of the economy vital for the UK? 1. Aggregate demand and the multiplier: An increasing share of Britains national output is exported overseas as the nation becomes ever more integrated into the global economy. Export earnings are an injection of AD into the circular flow. If British companies can successfully sell goods and services overseas, the rise in exports boosts national income and should have a positive multiplier effect on output and employment. 2. Manufacturing industry: Export sales are particularly important for manufacturing industry where exports are a high % of total production. Thousands of jobs depend directly on the performance of the export sector and even more are affected in supply industries. 3. Regional economic health: The relative success of failure of export industries is important for certain regions of the UK. When export sales dip, output, employment and living standards come under threat and threaten to widen the existing north-south divide. Measuring the current account The current account comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers. Net investment income comes from interest payments, profits and dividends from external assets located outside the UK. For example a UK firm may own a business overseas and decide to send back some of the operating profits from that asset to the UK. This would count as a credit item for our current account as it is a stream of profits flowing back into the UK. Similarly, an overseas investment in the UK might generate a good rate of return and the profits are remitted back to another country this would be a debit item in the balance of payments accounts.

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Transfers into and out of the UK include foreign aid payments and funds brought by migrants to the UK. For the UK the net transfers figure is negative each year, mainly on account of the UK being a net contributor to the budget of the European Union. As a relatively rich nation, the UK makes sizeable foreign aid payments to many other countries. The Current Account The current account balance is essentially a reflection of whether the British economy is paying its way with other countries. The annual balance is volatile from year to year, because each of the four component parts is subject to fluctuations. Trade in goods billion 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 -12.3 -21.8 -29.1 -33.0 -41.2 -47.7 -48.6 -60.9 -68.8 -77.6 -89.5 Trade in services billion 14.1 14.7 13.6 13.6 14.4 16.8 19.2 25.9 24.6 31.0 38.8 Total trade billion 1.8 -7.1 -15.5 -19.4 -26.8 -30.9 -29.4 -35.0 -44.2 -46.5 -51.2 Total Net Investment Income billion 3.3 12.3 1.3 4.5 11.7 23.4 24.6 26.6 25.2 7.8 5.3 Current transfers billion -5.9 -8.4 -7.5 -10.0 -6.8 -9.1 -10.1 -10.9 -12.0 -5.6 -13.8 Current balance billion -0.8 -3.2 -21.7 -24.8 -21.9 -16.5 -14.9 -19.3 -31.0 -50.7 -59.7 Current balance % of GDP -0.1 -0.4 -2.4 -2.6 -2.2 -1.6 -1.3 -1.6 -2.5 -3.9 -4.3

The current account balance saw its highest ever deficit in 2007 at just under 60 billion. Just ten years ago the current account was broadly in balance but ever since then the UK economy has been running a deficit with the rest of the world. Looking at the table above, please note that the data are presented in nominal terms and is not adjusted for the effects of inflation which can mean that a deficit of just under 90 billion for the year 2007 might give a slightly distorted view of the position. A better guide to the scale of the current account deficit is shown in the far right-hand column which expresses the current account balance as a share of UK GDP. What are the main questions that concern economists regarding these figures? i ii Causation: Why does the UK now run a large trade deficit in goods? Consequences: Does it really matter if the economy is running persistent current account deficits?

iii Correction: Which demand and supply-side economic policies are likely to be most effective in improving our trade balances in the years ahead? Trade in goods includes items such as: Manufactured goods Trade in services includes: Banking, insurance and consultancy

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Semi-finished goods and components Energy products Raw Materials Consumer goods (i) Durable goods (ii) Non-durable goods e.g. foods Capital goods (e.g. equipment)

Other financial services including foreign exchange and derivatives trading Tourism industry Transport and shipping Education and health services Research and development Cultural arts

Trade in goods includes exports and imports of oil and other energy products, manufactured goods, foodstuffs, raw materials and components. Until recently this was known as visible trade i.e. exporting and importing of tangible products. Since 1986 the net balance of trade in goods for the UK has been in deficit. And as the following chart shows, the trade deficit in goods has increased enormously in the last few years. In 2007 there was a record trade deficit of 89 billion, over four times the deficit seen in 1998. The biggest single cause of this was a near 60 billion trade gap in manufactured products such as DVD players, televisions, motor cars and oil.

UK Balance of Trade in Goods

Balance of exports minus imports of goods at current prices, billion
10 0 -10 -20 -30 -40 -50 -60 -70 -80 -90 80 82 84 86 88 90 92 94 96 98 00 02 04 06
10 0 -10 -20 -30 -40 -50 -60 -70 -80 -90
billions

GBP (billions)

Source: Reuters EcoWin

Trade in services Overseas trade in services includes the exporting and importing of intangible products for example, Banking and Finance, Insurance, Shipping, Air Travel, Tourism and Consultancy. Britain has a strong trade base in services with over thirty per cent of total export earnings come from services. Indeed the success of our service sector industries has been one of the strong points in the UKs economic performance during the current cycle.

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As the next chart illustrates, the UK balance of trade in services has been in surplus for many years. In 1999 the UK became the second largest exporters of services in the world and in 2007 a record surplus was achieved. Strong surpluses are especially common in financial and business services and hi-tech knowledge services.

UK Balance of Trade in Services

Balance of exports minus imports of services, current prices, billion
40
40

35

35

30

30

25
GBP (billions)

25
billions

20

20

15

15

10

10

0 80

82

84

86

88

90

92

94

96

98

00

02

04

06

Source: Reuters EcoWin

But the UK runs a deficit in international travel and transportation in part because of the growth of demand for overseas holidays as living standards have improved. Once again, rising incomes have caused a large rise in the demand for leisure and business travel and the strength of the exchange rate for example against the US dollar and the rapid expansion of low cost airlines offering short haul overseas breaks has also played its part. It will be interesting to see how this deficit in overseas travel is affected over the next couple of years by the economic downturn, big increases in airline fuel surcharges and also by the fall in the value of the pound against the Euro. Will there be a large drop in the number of British people travelling overseas for their holidays? If it does, this part of the balance of payments accounts will be affected. Britain has a comparative advantage in selling financial services to the rest of the world. London is one of the three main financial centres in the world and has the largest share of trading in many international financial markets. For example, around one third of all of the currency dealing takes place in Londons trading platforms and many overseas banks have established themselves in Londons money and capital markets. And numerous British financial businesses have world class status in their areas of expertise. Our UK based commercial banks, fund managers, securities dealers, futures and options traders, insurance companies and money market brokerage businesses are part of a complex network of

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financial and business services that represent a huge asset for the UK balance of payments accounts. The next chart provides a summary of the four components of the current account balance 1. 2. 3. 4. Trade in goods Trade in services Net investment income Net transfers of money

Note that the data is presented as an annual total and is measured in billion.

Components of the UK Balance of Payments

Annual balances for each component, billion
50
50

25

Trade in Services

25

0
Billion (billions)

Investment income Transfers

-25

Current account

-25

-50

Trade in Goods

-50

-75

-75

-100
97 98 99 00 01 02 03 04 05 06 07

-100

Source: Reuters EcoWin

The causes of the UK trade deficit Why do some countries including the UK and the United States run persistently large trade deficits? Whilst other nations including China, Germany and Japan achieve big trade surpluses each year? This is an example of the economics of causation i.e. looking at an issue and trying to unravel some of the main causes. It is good for your evaluation skills to group the explanations for the record trade deficit in goods into short-term, medium-term and long-term factors. In general, shorter-term explanations tend to focus on demand-side factors whereas longer-term causes are often the result of supply-side factors. Short-term factors

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billions

Strong consumer demand: One of the features of the British economy over the last decade has been a period of very strong consumer demand fuelled by rising incomes, low interest rates and rising property wealth. If household demand is greater than what homebased producers can supply, then the demand for imports tends to grow to meet this excess demand. Linked with this is the second point below about income elasticity. High income elasticity of demand for imports: Evidence suggests that UK consumers have a high income elasticity of demand for overseas-produced goods demand for imports grows quickly when consumer demand is robust. Economists Nicholas Fawcett and Michael Kitson in an article in the Guardian estimated that the income elasticity is around +2.3 (i.e. highly elastic) suggesting that a 2% increase in real incomes boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace with the surging demand for imported products, so the trade deficit widens when the economy enjoys a period of consumption-led growth.

ii

iii The strong exchange rate has helped to reduce the UK price of imports causing an expenditure-switching effect away from domestically produced output. In technical terms, the high pound has improved the terms of trade between the UK and other countries, allowing us to buy and consume more imports with each pound we earn. Consumers have taken advantage of the high pound and have been happy to buy lots of foreign produced goods and enjoy more travel overseas. Both have added to the current account deficit. iv Rising commodity prices: Another factor affecting our trade balance in the short term has been the rising cost of importing fuels, foods and other commodities used in production. The demand for many of these inputs is price inelastic so that as the global price rises, so total spending on them must also increase. Britain tends to be a net importer of many foodstuffs and beverages together with metals such as iron ore, copper and fuel such as coal, gas and now oil.

United Kingdom Import Penetration

Imports of goods and services as a percentage of GDP
25 24 23 22 21
Percent

25 24 23 22 21 20 19 18 17 16 15

20 19 18 17 16 15 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Reuters EcoWin

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The share of our national spending taken up by imports has grown steadily over the last fifteen years. Medium to long-term factors i UK trade balances have been affected by big shifts in comparative advantage in the world economy for example the growth of China as a source of exports of household goods and other emerging market countries in South-east Asia who have a labour cost advantage in exporting manufactured products. The availability of imports from other countries at a lower price inevitably causes a substitution effect from British consumers. Our trade performance has been hindered by supply-side deficiencies which impact on the price and non-price competitiveness of British products in global markets - non-price competitiveness factors such as design and product quality are now more important for trade than merely price alone. o o A relatively low rate of capital investment compared to other countries. The persistence of a productivity gap with our major competitors measured by differences in GDP per person employed or per hour worked this is linked to low investment and also to the existence of a skills-gap between UK workers and employees in many other countries. A relatively weak performance in terms of product innovation linked to a low rate of business sector spending on research and development.

ii

o ii

The UK manufacturing sector has been in long-term decline for more than twenty years. This is known as a process of deindustrialisation. Although we still have some world class manufacturing companies, the size of our manufacturing sector is not large enough both to meet consumer demand in the UK and also to export sufficient volumes of products to pay for a growing demand for imports.

iii The switch from being a net oil and gas exporter to being an importer: For nearly thirty years the UK economy enjoyed the bonanza of revenues from the oil and gas industry centred in the North Sea. Indeed there strong flow of oil export revenues tended to hide some of the deeper problems emerging in our trade statistics. In recent years, North Sea oil and gas production has peaked and is now declining at quite a rapid rate. A reduction in exploration and extracting investment has not helped and even the steep rise in world crude oil prices since 2006 has done little to arrest the decline in production. Britain has seen North Sea Oil production drop by around 40% since its peak of 4.5m barrels a day in 1999.

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UK Trade in Oil and Brent Crude Oil Price

Trade Balance bn and Brent Crude ($s per barrel)
7 6 5 4 3 2 1 0 -1 -2 -3 -4 7 6 5 4 3 2 1 0 -1 -2 -3 -4

GBP (billions)

Annual UK balance of trade in oil

100 90 80
USD/Barrel

100 90 80 70 60 50 40 Annual average price for Brent crude oil 30 20 10 97 98 99 00 01 02 03 04 05 06 07

70 60 50 40 30 20 10

Source: Reuters EcoWin

What does a current account deficit mean? Running a sizeable deficit on the current account basically means that the UK economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending. The current account does not have to balance because the balance of payments also includes the capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment. The Effects of Changes in the Balance of Payments on the UK Economy Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused by a rise in the value of sterling against other currencies that leads to a worsening of the balance of payments. This has further effects on the economy as a whole: o Reductions in demand in the circular flow: There will be a fall in AD because more money is leaving the circular flow of income (through imports) than is coming into the economy from exports. An inward shift of AD would lead to a contraction along the SRAS curve and a reduction in economic growth. Lost jobs: There will be a loss of employment if exporting industries require less labour and if UK businesses lose market share and output to cheaper imports from overseas. Dip in business confidence and investment: A fall in business confidence and a decline in planned capital investment spending by UK exporting firms whose order books are less full and whose profits take a hit from a fall in demand from overseas.

o o

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billions

Reductions in inflationary pressure: Lower inflation because imports coming into the UK are cheaper and a fall in AD takes the economy further away from full capacity national output. The exchange rate and the balance of payments o Changes in the exchange rate can have a big effect on the balance of payments although these effects are subject to uncertain time lags. When sterling is strong then UK exporters found it harder to sell their products overseas and it is cheaper for UK consumers to buy imported goods and services because the pound buys more foreign currency than it did before. The balance of payments and the standard of living A common misconception is that balance of payments deficits are always bad for the economy. This is not necessarily true. In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference. And in the short term, if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables. However, in the long term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living standards may decline. Economic policies to reduce a large trade deficit There are a number of policies that can be introduced to achieve an improvement in a countrys trade balance some of them focus on changing the growth of demand, others look to improve the supply-side competitiveness of an economy. As with any macroeconomic problem effective policies are those that target the underlying causes. 1. Demand management: Reductions in government spending, higher interest rates and higher taxes could all have the effect of dampening consumer demand and reducing the demand for import. 2. Natural effects of the economic cycle: If a countrys trade deficit worsens during a time of strong economic growth, one would expect to see the deficit fall during an economic slowdown or recession so some of the deficit is partially self-correcting as an economic cycle works itself through 3. A lower exchange rate: The central bank of a country might decide that a lower exchange rate provides a suitable way of improving competitiveness, reducing the overseas price of exports and making imports more expensive. To bring the exchange rate down it might opt to intervene in the currency markets although this strategy is by no means certain to work. Some economists argue that a large trade deficit will eventually cause an exchange rate depreciation anyway because a deficit means that there is an excess supply of a countrys currency being used to pay for imports. 4. Supply-side improvements: Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are all supply-side measures designed to boost a countrys export performance and perhaps build domestic industries that can compete better with imported products. The time-lags for supply-side policies to have an impact on the trade figures can be very long! 5. Protectionist measures such as import quotas and tariffs are rarely used by countries such as the UK because of our commitments to the World Trade Organisation and our membership of the European Union.

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UK, Exports to and Imports from China

billion per month, trade in goods and services
2.00
2.00

1.75

1.75

1.50

1.50

1.25
GBP (billions)

1.25
billions

1.00 Imports from China

1.00

0.75

0.75

0.50 Exports to China 0.25

0.50

0.25

0.00 96 97 98 99 00 01 02 03 04 05 06 07 08

0.00

Source: Reuters EcoWin

Key Concepts Current account International Monetary Fund (IMF) Investment income Overseas assets The overall balance of credits minus debits for trade in goods, trade in services, investment income and transfers. Monitors countries; economic and financial development, and provides lending for balance-of-payments difficulties. Interest, profits and dividends from assets owned and located overseas. Assets such as businesses, shares, property which are owned in overseas countries and which might generate a flow of investment income which is a credit item on the current account of the balance of payments. A trade deficit occurs when a country imports a greater value of goods and services than it exports.

Trade deficit

Suggestions for further reading on the balance of payments Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on the balance of payments. Chinas trade surplus jumps 48% in 2007 (BBC news, January2008) More UK firms re-locating production abroad (BBC news, July 2008) North Sea Oil an industry ebbing away (Economist, July 2008) Robust trade aids German economy (BBC news, June 2008) Toast to whisky industry as exports boom! (The Scotsman, June 2008)

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UK economy loses competitive edge to rival nations (Times, May 2007) UK Trade Deficit does it matter? (Money week, November 2007) US annual trade deficit narrows in 2007 (BBC news, February 2008)

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