The balance of payments and exchange rates

The components of the balance of payments

The balance of payments is a record of all financial transactions between one country and other countries. When there is an inflow of foreign currency into the UK, this is recorded as a positive item, whereas when there is an outflow of foreign currency this is recorded as a negative item.

The main components of the balance of payments are the current account and the capital and financial account.

The current account is composed of the following:

  • The trade in goods balance: this is the value of goods exported minus the value of goods imported
  • The trade in services balance: this is the value of services exported minus the value of services imported
  • The income balance: this is income flows into the country from non-residents minus income flow out of the country from residents to non-residents. e.g. income refers to compensation to employees and investment income
  • Current transfers: refers to items such as food aid and the EU’s Common Agricultural Policy. i.e. items that do not generate a direct return

The capital and financial account

This comprises transactions associated with changes of ownership of the UK’s foreign financial assets and liabilities. A key factor influencing the financial account is foreign direct investment. Also included are portfolio investment of shares and bonds, changes in foreign currency reserves, and short-term capital flows, sometimes termed as ‘hot money’ flows, associated with speculation

The balance on this account should exactly offset the current account balance. However, in practice, there is a significant component comprising errors and omissions.

Current account deficits and surpluses

For many years, the UK has had a deficit on the current account. In particular, the trade in goods balance has deteriorated over a number of years.

The main reasons for the UK’s deficit in its trade in gods balance are:

  • the high value of sterling 1996-2008
  • continuous economic growth 1992-2008 – the UK has a high marginal propensity to import so rising real incomes have led to a significant increase in imports
  • relatively low productivity of the UK’s workers resulting in higher average costs
  • the relocation of manufacturing to countries with lower labour costs
  • the ‘Chindia’ effect: the industrialisation and economic opening of China and Indian has led to a flood of cheap imports into the UK

Surpluses on the trade in services have been insufficient to offset the deficits on the trade in goods balance

The implications of global imbalances

Like the UK, the USA has experienced large current account deficits, while in contrast, China has experienced huge current account surpluses. Whether such a global imbalance can be sustained in the long run is a major question. In the one hand, if the deficits are easily financed by inflows on the current account, there may be no cause for concern. Further, under a system of floating exchange rates over time, there should be an automatic adjustment (i.e. deficit would cause exchange rate to fall). On the other hand, continuous deficits by the USA have, in effect, been financed by the Chinese, which may not be a sustainable option in the long run. Further, exchange rate adjustments might occur suddenly, as when the value of the pound fell by 27% between July 2008 and March 2009.

The influence of exchange rates

The exchange rate is the rate at which one currency exchanges for another; in other words it is the price of one currency in terms of another. e.g. £1 = $1.61.

Causes of changes in the exchange rate

A variety of factors can influence the value of a country’s currency (under a system of floating exchange rate), including the following:

  • Relative inflation rates: if the country’s inflation rate is higher than that of its major competitors, according to purchasing power parity (PPP) analysis, it would be expected that the value of the currency would fall. The PPP rate is the rate at which a particular product would be sold at the same price in the UK and abroad when expressed in a common currency
  • Relative interest rates: if the UK has higher interest rates than that of other countries, then foreigners with surplus balances are likely to place them in UK banks, so increasing the demand for sterling and causing the value of the pound to increase.
  • The state of the economy: for example, of the UK economy is performing well, then this will increase the confidence of speculators and foreign investors, who will buy sterling, so causing its value to rise.
  • The balance of payments on current account: if there is a persistent deficit on the current account, then the supply of the currency would be high relative to the demand for it, and the value of the currency would be expected to fall. In practice, this factor is not significant because the flows of money associated with trade are small compared to ‘hot money’ flows and other transactions recorded in the current account.
  • Political stability: in developing countries, instability may cause a loss of confidence in the country’s currency
  • Speculation: the exchange rate might be affected by speculation concerning a range of possible events, including factors such as the future state of the economy, a change in government or impending strikes. For example, if it is expected that the economy will recover from a recession much more quickly than originally thought then speculators may buy sterling, so pushing up its value

Effects of a change in the exchange rate of a currency

Suppose that the value of the pound against the dollar falls, e.g. from £1 = $2 to £1 = $1.50. There are two effects:

  • It will make the price of goods exported from the UK decrease in the country of sale. For example, a bottle of UK whisky costing £20 would have sold for $40 in the USA but will now sell for $30.
  • It will make the price for goods imported into the UK increase. For example, a $10 bottle of Californian wine would have been price at £5 in the UK but will now cost £6.67.

The Marshall-Lerner condition

For there to be a fall in the current account, the Marshall-Lerner condition needs to be met. This is that the sum of all the price elasticities of demand for imports and exports be greater than 1.

The J curve effect 

It is possible that there could be a time lag before the full effects of the depreciation of the currency work through the economy, such that in the short run, the sum of the price elasticities of demand be less than 1, but greater than 1 in the long run. The gives rise to the J-curve effect

Initially, the current account deteriorates, since demand for imports is price inelastic because of contracts or stocks. Also,the demand for exports may be inelastic because it takes time for consumers to adjust to price changes. In the longer term, demand for both imports and exports may become more elastic and, if the Marshall-Lerner condition is fulfilled, the current account will improve.

European Monetary Union

The euro was launched on 1 January 1999. Initially, there were 11 members of the Euro Zone; a further five countries had joined by 2009. Denmark and the UK agreed an opt-out clause. Furthermore, many of the newer members and Sweden, do not meet the convergence criteria, set out below:

  • The fiscal deficit has be be below 3% of GDP
  • The public sector net debt must be less than 60% of GDP
  • Countries must have an inflation rate within 1.5%  of the three EU countries with the lowest inflation rate
  • Long-term interest rates must be within 2% of the three lowest interest rates in the EU.
  • Exchange rates must be kept within ‘normal’ fluctuation margins of Europe’s exchange rate mechanism.

In addition, 1997 the Blair government, with a Brown-controlled Treasury, formulated 5 economic tests that would justify Britain’s entry into the European Monetary Union. These were:

  1. Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
  2. If problems emerge, is there sufficient flexibility to deal with them?
  3. Would joining the EMU create better conditions for firms making long-term decisions to invest in Britain?
  4. What impact would entry to the EMU have on the competitiveness of the UK’s financial services industry, particularly the City’s wholesale markets?
  5. In summary, would joining EMU promote higher growth, stability and a lasting increase in jobs?

They came to the conclusion that these tests were not met in 1997, nor in reanalysis in 2003. In 1997 it was decided that UK economy was neither sufficiently converged with that of the rest of the EU, nor sufficiently flexible, to justify a recommendation of membership at that time. Under reanalysis, the conclusions in 2003 were:

  1. There has been significant convergence since 1997, but there remained some structural differences, particularly in the housing market.
  2. While UK flexibility had improved, they could not be confident that it is sufficient.
  3. Euro membership would increase investment, but only if convergence and flexibility were sufficient.
  4. The City would benefit from Eurozone membership.
  5. Growth, stability and employment would increase as a result of euro membership, but only if convergence and flexibility were sufficient.

The sterling-euro exchange rate was also an important issue in 2003, if the pound was over-valued against the Euro then clearly the UK would have to interest in joining. Furthermore, due to the recent sovereign debt (PSND) crisis within the EU, in countries such as Greece, Ireland and Portugal, the UK is probably in a better position as it has been able to control its interest rates separately. However, during the uncertainty of the global credit crisis that cause PSND issues, euro membership was looking attractive.

The main advantages of monetary union

  • Elimination of transaction costs i.e commission charged on the exchange of currencies. However, these represent a very small proportion of GDP.
  • Price transparency: it is easy to compare price of goods across countries which have adopted the Euro. Competition within the Eurozone should therefore increase and the likelihood of price discrimination should diminish. However, there is still evidence of price differences in the Eurozone.
  • Easier trading conditions for firms inside the eurozone, which might enable them to further economies of scale
  • Encouragement to transnational companies to invest in euro zone countries as opposed to the countries of non-members. However, the evidence that this has happened is weak.

The main disadvantages of monetary union

  • Loss of independent monetary policy, i.e. countries no longer have the ability to set their own interest rates. The interest rate is set by the European Central Bank (ECB). This means that the needs of individual countries are placed second to the needs of the euro zone as a whole
  • The ECB’s inflation target of below 2% is more stringent than that of the Bank of England. A criticism is that this policy is less flexible and more deflationary than that of the UK
  • Loss of exchange rate flexibility against other countries that have adopted the Euro
  • Transition costs – menu costs.
  • Meeting the requirements of the growth and stability pact might result in a slower rate of economic of economic growth, which could in turn result in a higher level of unemployment. For example, countries are no supposed to run fiscal deficits higher than 3% of GDP. In practice, this rule has not been adhered to, however.
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