BALANCE OF PAYMENT PROBLEMS

Current Account Deficit  Two broad ways in which a current account is covered – loans from abroad and investments from abroad.  There are several possible negative effects of current account deficits — capital account surpluses — in the long run for a net debtor nation:

 Borrowing from abroad means that the loans will ultimately have to be repaid with interest.  Continuous current account deficits will be looked upon harshly by the international business and financial community, and ultimately the ability to pay off foreign debts might be questioned.  If the investors choose to avoid the weak economy then it will force the currency to depreciate, which in turn will force the country to pay more to service the debt.

 The domestic economy might be forced into raising interest rates in order to attract continued foreign (portfolio) investment and keep a desired exchange rate. In essence, the domestic economy is letting foreign firms fund domestic investment.  Ultimately, the sales of domestic assets to foreigners will cause outflows in the form of repatriated profits and dividends — which could in fact intensify the current account deficit. Also, the increase in interest rates will have a deflationary effect on the domestic economy.

 Finally, there is always the risk that foreign capital starts to exit.  If inflows of FDI and portfolio investment seek other markets, then the home country can find itself in the situation where domestic unemployment rises as capital leaves.  There might also be a significant reduction in imports.

 On the other hand, a current account deficit allows a country to enjoy greater consumption than production — even though it might be on borrowed money.  If the deficit is relatively short-lived, a few years or so, then there would be little economic damage — quite the opposite if the inflows in capital account are partially used for investment.  Also as long as the debt is fairly small compared to the GDP of the country (people still want to invest in the USA)

CURRENT ACCOUNT SURPLUS  A current account surplus means that there is a net outflow in capital account, i.e. the home country’s net foreign assets have increased. There will be a number of gains for such a net creditor nation:  The foreign assets can be viewed as another form of saving for the home country which will enable increased future consumption. Capital will flow to countries with a higher rate of return than the home country. This enhances resource allocation and increases profits for domestic firms. The increase in foreign holdings will in time generate income in the form of profits, interest received, and dividends.

Disadvantages  Current consumption possibilities for the home country decrease as resources are diverted abroad.  A current account surplus means that there is a degree of diverting investment from the domestic to the foreign market. This could lead to a loss of jobs (yet this is highly contentious), skills and technology gains.  There will be a degree of tax loss, as a portion of tax bases — investment, output and wages — will be taxed outside the home country.  There is also a political element in running continuous current account surpluses for many years. This was a main ingredient in trade friction between the US and Japan during the 1980s — and between the US and China during the 2000s.

Methods of Correction  MANAGED CHANGES IN EXCHANGE RATES  A country operating under a managed currency regime, e.g. a pegged exchange rate system, can devalue its currency in order to alleviate a persistent current account deficit.  By pegging the home currency at a lower exchange rate, the relative price of domestic goods falls. However a lower price does not necessarily mean more revenue!  A fall in export prices might actually mean that while export volume increases, export revenue does not.

REDUCTION IN AGGREGATE DEMAND/EXPENDITURE- REDUCING POLICIES  Household spending is greatly influenced by income, which of course means that a degree of income will be spent on imports.  An overall reduction in aggregate demand will reduce imports. Therefore, deflationary fiscal and monetary policies can be implemented in order to adjust a current account deficit by reducing imports — this is an expenditure-reducing policy.

CHANGE IN SUPPLY-SIDE POLICIES TO INCREASE COMPETITIVENESS  There are a number of policies which will increase long run aggregate supply by increasing the ability and propensity of firms to produce and laborers to supply.  By reducing labor costs, adding to labor skills (human capital), creating incentives for investment in technology and generally increasing productivity, a country can increase its international competitiveness.  This would ultimately increase imports and also divert some spending towards domestic goods rather than imports.  The problem is that such supply- side policies commonly take several years to implement and even longer before the effects are visible in the balance of payments.

PROTECTIONISMIEXPENDITURE- SWITCHING POLICIES  Recall that protectionism can be broadly defined as any policy where the ratio of the price of domestic goods to imported goods falls, i.e. imports become relatively more expensive.  Devaluation and interventionist depreciation both serve to decrease the home country’s demand for imports, which means that demand for goods is diverted from imports towards domestic goods.  This substitution effect is known as expenditure switching. Another method — now illegal for WTO members to use — is the use of tariffs and quotas to limit imports and force home citizens to consume domestic goods.

CONSEQUENCES OF A CAPITAL ACCOUNT DEFICIT OR SURPLUS  CAPITAL ACCOUNT DEFICIT A capital account deficit in effect means that the country has increased its net holdings of property, capital and financial assets abroad.  These outflows of money will ultimately create profits and returns which will flow into the current account. One disadvantage of this increased foreign wealth is the possibility of a currency appreciation in the long run due to a current account surplus.  It is also possible that outflows in capital account deprive the home economy of investment funds and negate growth and employment opportunities.

CAPITAL ACCOUNT SURPLUS  When the capital account shows a surplus, the economy is receiving net money inflows — which are matched by outflows for imports in current account. In effect, other countries are funding the home economy’s imports to a certain extent.  There is little need for a country to worry about these net capital account inflows if it is short term or if most of the funds are being used for investment rather than consumption.

 It is when sizeable sums of money are being borrowed from abroad to fuel consumption for longer periods that a capital account surplus can become a threat to the home economy.  Debts have to be repaid; the exchange rate might fall due to negative expectations from foreign investors; interest rates might rise to keep speculative flows coming; and foreign capital might start to leave the country causing lower growth and increased unemployment.

4.8 – Terms of Trade  The amount of export goods needed to purchase a given amount of import goods is the term of trade.  3 elements make up the terms of trade(ToT) for a country – the exchange rate, the price of exports, and the price of imports.  A change in any of the variables (ceteris paribus) will effect the terms of trade.

 A depreciation on one countries currency (USD changes from Thai Baht to 30) means that the USA will have to sell more Hershey bars in order to the get the required amount of Baht in order to buy pineapples. This will cause USA’s terms of trade to deteriorate.  An appreciation of the Baht will also be an improvement in the ToT for Thailand.  If the market price for pineapples falls then Thailand’s Tot will deteriorate.

Improvement in terms of trade.  One of the misconceptions is that a improvement in the terms of trade is always a good thing.  The reason for this being wrong is that the ToT is simply a ratio between the price of exports and imports, and does not deal with the effects to the change.

Positive  A country that has improved its ToT will be able to consume more imports and this should raise their standard of living.  It will be easier for companies to pay of their interest and loans  They will also be able to import raw materials cheaper.

 Improved ToT can also improve the current account. If the exports are inelastic improvement in the ToT’s can increase export revenue. Also if the imports and demand inelastic the import spending would decrease.

Negative  If exports are demand elastic then an improvement in the ToT will cause export revenue to fall.  This can cause a loss in revenue and possible job losses.

Deterioration of the terms of trade.  Positive  A decrease in the price of exports relative to the price of imports will lead to an improvement in the current account. This will possibly create more jobs.  Negative  Higher price of foreign goods will only lower consumption possibilities.

Impact for developing countries.  Developing countries tend to be must more dependant on a few and in some cases one commodity which makes up a large percentage of their GDP.  If this price drops it can cause economic problems for the country.