1. 3.4.3 The International Economy The Balance of Payments AQA ECON4: T HE NATIONAL AND INTERNATIONAL ECONOMY Write down five things you know about the balance of payments. Compare your five points with a colleague in the class. Add all the points to a spider diagram on the board. How many different points can you make working as a class?

2. T HE B ALANCE OF P AYMENTS  You should know the difference between the current and capital and financial accounts on the UK balance of payments  Note: you will be aware of the composition of the current account from Unit 2; a detailed knowledge of the remainder of the accounts is not required, but the nature and significance of both short-term and long- term international capital flows should be understood  You should understand the importance of the City of London to the trade in financial services  You should understand the possible significance of deficits and surpluses for an individual economy  You should also understand the possible implications for the global economy of a major economy or economies with imbalances deciding to take corrective action  You should also be able to analyse and evaluate measures which may be taken to deal with balance of payments deficits or surpluses

3. T HE C URRENT, C APITAL AND F INANCIAL A CCOUNTS  The Current Account  Primarily records the trade in goods (visibles) and services (invisibles)  Also includes net income flows from interest, profit and dividends from UK assets owned overseas. It therefore includes payments made overseas from assets based in the UK, but owned by foreign MNCs  Includes overseas aid payments and payments to the European Union  The Capital Account  Primarily records international flows of capital such as inter- country loans or government investments overseas  The Financial Account  Primarily records net Foreign Direct Investment (FDI)  Also includes government owned assets such as gold, currency reserves and private assets held abroad  It will also include short-term capital flows, such as speculative movements on currency or share investments e.g. hot money What is meant by the term hot money? China’s hot money woes.

4. T HE C URRENT A CCOUNT The UK balance of payments on current account since 1997. The clear trend is the steady rise in the surplus on trade in services, and deficit on trade on goods. What are the implications of this trend on the UK economy? To what extent do you think it is likely to continue in future? Source: ONS NB: The overall current balance has also been included, which shows the added effect of investment income and current transfers

5. F INANCIAL S ERVICES AND T HE C ITY OF L ONDON  A significant part of the rise in the surplus in services has been the rise of the financial services industry  The City of London has become a highly specialised region of the UK, focussing on the provision of financial services, such as banking, insurance, brokerage, commodity and foreign currency exchange  This has made London one of the worlds leading global financial centres, with over 250 foreign banks located in London and employment of around 400,000 people  In addition, the US alone has nearly 500 financial services firms based in the City of London  The City of London alone through the provision of financial services contributed 9.7% total national income of the UK in 2013

6. F INANCIAL S ERVICES AND T HE C ITY OF L ONDON  However, the importance of the City of London does have criticism, which include:  Excessive concentration of wealth  High and rising property prices in London, distorting the housing market  The entrenchment of a north/south divide  Over-reliance on one sector of the economy Should the UK switch from banking to manufacturing?

7. F INANCIAL S ERVICES AND T HE C ITY OF L ONDON Source: ONS Financial services are the largest single item on the current account, and the vast majority of this is generated in the City of London. What do you think are the implications of such a significant contribution occurring in just one small geographical region of the UK?

8. S HORT AND L ONG T ERM C APITAL F LOWS You need to be able to distinguish between short and long term international capital flows  Short-Term Capital Flows  These are comprised mainly of speculative capital movements by wealthy individuals and companies  They can form “hot money” flows in currency markets or shifts in stock prices around the globe  Whilst it forms billions of dollars on a daily basis, it can be highly volatile in nature and create significant disturbance to the balance of payments as well as upsetting confidence and expectations in an economy  Long-Term Capital Flows  These are comprised mainly of FDI, long term investments or sources of finance for governments and MNCs  These can help enhance supply side improvements through making finance available on a global level and not just within a domestic economy  However, only large MNC’s can participate in this, which may distort competition at the expense of smaller firms  The global economy has become increasingly reliant on long-term capital flows for the expansion of globalisation, but as the credit crunch of 2008-12 demonstrated, the integration of capital investments across borders can create major problems in the event of weakness in one area of the market (in this case, mortgage debt)

9. W HY D OES THE UK H AVE A B ALANCE OF P AYMENTS D EFICIT ? It is important to note, why the UK has a deficit on the balance of payments before considering implications and measures that might be taken to deal with the problem  Economic growth  As an economy and disposable incomes grow, its citizens might significantly increase their consumption, which is likely to include a large number of imports  In the UK, we have a high marginal propensity to import  Weak product and price competitiveness  If a country isn’t competitive in terms of quality or the price of its goods, it is unlikely to be able to export high volumes  High exchange rate  A strong currency makes a country more likely to import and makes exports less price competitive  Weak productivity  If a country has limited productive capacity or uses its resources inefficiently, it is likely that imports will be demanded to close the gap between domestic demand and domestic consumption

10. P OLICES TO D EAL WITH A B ALANCE OF P AYMENTS D EFICIT These broadly fall into two categories:  Expenditure reducing  Polices, can be fiscal or monetary in nature, which aim to reduce the level of consumption and aggregate demand in an economy  This could be achieved through for example raising taxes (fiscal) to reduce disposable income, and therefore reduce the demand for imports  Expenditure switching  Policies which aim to encourage consumers to switch their demand away from imports towards domestically produced goods and services  This can be achieved if a country can increase the relative price of imports e.g. through tariffs and quotas  Or if a country is able to make its own output and exports more attractive. This may be achieved for example, through subsidies to domestic firms to cut production costs, general investment in the supply side of the economy or the depreciation/devaluation of the exchange rate Create a table to show all the implications of expenditure reducing versus expenditure switching policies to reduce a balance of payments deficit. Which policy or combination of policies do you consider to be most effective?

11. D EPRECIATION /D EVALUATION  A large number of countries have attempted at various times to depreciate their currency in an attempt to boost export competitiveness  Some countries have gone through a process of full devaluation, most recently Venezuela in 2013  However, whilst this may appear an attractive option, it has negative consequences  It makes imports more expensive, and if a country relies upon imports in a number of key areas, for example, primary raw materials, this will lead to cost-push inflationary pressures  If exports now become more price competitive, this will boost aggregate demand, and lead to demand-pull inflationary pressures  The effect of devaluation depends upon the Marshall-Lerner condition which states that the current account will only improve if the sum of elasticities of imports and exports is greater than 1. In other words, the demand for imports and exports is highly inelastic, they will not be sensitive to changes in the price, and thus the deficit may in fact worsen  The J – Curve (see next slide) Ukraine's failing economy: Who is to blame?

12. T HE J - C URVE  In the short run, it is likely that the demand for imports and exports will be inelastic  Primarily, this is because lengthy contracts often exist, which ties in firms to pre-agreed deals  Consequently, as outlined by the Marshall-Lerner condition, the balance of payments deficit may worsen in the short-term, and only recover once the adjustment has been fully factored into new contracts  Even then, additional currency movements will have occurred, so the benefits may not be as large as expected Time after devaluation Current account £+bn £ - bn

13. P OLICES TO D EAL WITH A B ALANCE OF P AYMENTS S URPLUS  A current account surplus is likely to indicate a strong exporting economy with effective economic management which creates jobs, employment and wealth  A number of countries with a single primary resource to export e.g. Saudi Arabia with oil, run current account surpluses, as has China in recent years  However, a high volume of exports can create inflation through the pressure on aggregate demand  It may also indicate the economy is too reliant on exports for growth, and its own domestic consumption is quite weak  A balance of payments surplus might be reduced by:  Encouraging free trade  If import constraints are removed e.g. tariffs/quotas, then this may boost the demand for imports as they become cheaper or more available  Appreciation/Revaluation of currency  If the currency is allowed to rise or is revalued upwards, then this will make exports less price competitive and imports more attractive  Reflation of domestic economy  If domestic demand is weak, then policies to encourage spending e.g. lower interest rates will increase the demand for imports

14. S UMMARY T ASK  Compare the balance of payments positions of the USA and China since 2005  What might have caused such a difference in BoP positions?  What might be the significance of these positions on the American and Chinese economies?  What corrective action might the US or China take? Source: World Bank