Unit 4: The Global Economy

The structure of the BOP account

The balance of payments (BOP) account is the record of all monetary transactions of a country with the rest of the world over a period of time, usually a year.

Inflow of capital or sources of funds such as exports of goods and services are recorded as positive items or credit items. The outflow of capital or uses of funds such as imports of goods and services are recorded as negative items or debit items.

Components of the balance of payments accounts

Current account measures the flow of funds from trade in goods and services of a country with the rest of the world. The sum of net exports of goods and services, net income and net current transfers in a given year is the current account balance.

Current account deficit usually refers to the sum of net exports of goods and services, net income and net current transfers in a given year is negative.

Current account surplus usually refers to the sum of net exports of goods and services, net income and net current transfers in a given year is positive.

Individual elements of BOP can be in deficit or surplus. The overall BOP accounts will always balance, as it is impossible for a country to have more currency flowing out than flowing in unless the imbalance is financed by drawing additional foreign exchange.

The sum of the current, capital and financial accounts is equal to zero. For example, if a country is importing more than exporting, its trade balance will be in deficit, the shortfall will have to be balanced in other ways, such as by income earned from its foreign investments or by depleting central bank reserves. Therefore, when the current account is in deficit, the sum of the capital and financial accounts must be in surplus and vice versa. Similarly, any debits must be matched by credits.

In practice, however, the balance of payments rarely actually balances; there are too many transactions for them to all be recorded accurately. We can therefore write the relationship between the accounts as follows:

Calculations of BOP elements

Suppose the Balance of Payments Account of country Y (in millions of US dollars) is given as the table below.

i) What is the trade balance?

Trade Balance = X – M = [12000 + 8000 – (9000+10000)]= US $1000 million

ii) What is the current account balance?

The current account is in deficit of US $1000 million.

iii) What is the capital account balance?

The capital account is in surplus of US $80 million.

iv) What is the financial account balance?

Current Account + Capital Account + Financial Account = 0

-1000 + 80 + Financial Account = 0

The financial account is in surplus of US $920 million.

v) What is the change in reserve assets?

The Financial Account = Foreign direct investment + portfolio investment + reserve assets

920 = - 300 – 60 + Y

Y = 920 + 300 + 60

   = US $1280 million

The reserve transaction is a credit of US$1,280 million under the net-inflow convention used here. It finances the remaining deficit by selling reserves, so reserve holdings fall by US$1,280 million: the change in the stock is −US$1,280 million, not +US$1,280 million. This calculation assumes zero errors and omissions, no other omitted financial flows, and no valuation changes.

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Relationship between the current account and the exchange rate

Current account deficit and the exchange rate

A current account deficit means that the combined balance of trade in goods and services, primary income and current transfers is negative. A widening trade deficit can put downward pressure on the exchange rate, other things equal. However, the current account is not the trade balance alone, and offsetting financial flows can prevent depreciation.

This can be seen in Figure 4.6.1. The combination of an increased supply of the currency and decreased demand for the currency leads to depreciation from e1 to e2. The quantity of currency is uncertain, and it depends on the respective change in the demand and supply of the currency.

Current account surplus and the exchange rate

A current account surplus means that the combined balance of trade in goods and services, primary income and current transfers is positive. A rising trade surplus can put upward pressure on the exchange rate, other things equal, but financial outflows and other transactions may offset this pressure. Appreciation is not inevitable.

This can be seen in Figure 4.6.2. The combination of a decreased supply of the currency and increased demand for the currency leads to appreciation from e1 to e2. The quantity of currency is uncertain, and it depends on the respective change in the demand and supply of the currency.

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Relationship between the financial account and the exchange rate

When there is a surplus on the financial account, more funds are flowing into the country than are flowing out. This increases the demand for the domestic currency, and leads to an appreciation of the exchange rate.

When there is a deficit on the financial account, there is a net outflow of investment funds from the economy. This means that the demand for the domestic currency is going down, and supply of the domestic currency is going up, as investors are selling the domestic currency in order to buy foreign currencies. This leads to the domestic exchange rate depreciating.

Implications of a persistent current account deficit (HL)

1) Indebtedness

A current account deficit is financed by net financial inflows, asset sales or a reduction in reserve assets, allowing also for the capital account. Financing may involve private borrowing, portfolio investment or FDI; it does not necessarily require government borrowing or reserve depletion. Sustainability depends on the size, duration and terms of financing and on whether the funds support future income and repayment capacity.

2) International credit ratings

As the economy needs to borrow to finance the debts, the country has to bear heavy interest rates and loan repayments. The risk of a country going bankrupt increases, and causes a downgrading in the international credit ratings.

3) Foreign ownership of domestic assets

Allowing for the capital account and errors and omissions, a current account deficit has an offsetting financial-account balance. Under the net-inflow convention used in this chapter, this is a financial-account surplus. FDI is one possible source of financing: it can support productive capacity, although profits may later be remitted abroad. Financing need not take the form of foreign ownership of domestic firms.

4) Exchange rate and interest rate

A persistent current account deficit will generate a depreciation or devaluation pressure on the exchange rate. If the government wants to release the pressure, it can raise the interest rate to encourage capital inflow. However, a higher interest rate has a contractionary effect on the economy.

5) A need for demand management

One reason for a persistent current account deficit is the high economic growth that triggers an increase in demand for imports. The government may have to adjust the current account deficit by a contractionary demand management policy. However, this may hinder economic growth.

6) Economic growth

A current account deficit is not necessarily a trade deficit or evidence of weak growth. Falling net exports can reduce aggregate demand, other things equal, but rapid domestic growth may itself raise imports and widen the current account deficit. Imports of productive capital can also support future growth. The cause and financing of the deficit must therefore be examined before judging its effects.

Methods to correct a persistent current account deficit (CAD)

1) Expenditure switching policies

Expenditure switching policies aim at switching expenditure away from imported goods and services to domestically produced goods and services. Trade protection such as tariffs and quotas are implemented to reduce the demand for imports. However, we have studied that trade protection incurs a cost to society as well as a misallocation of resources. Devaluation of the exchange rate may cause imported inflation. These policies have to be carefully monitored.

2) Expenditure reducing policies

Expenditure reducing policies aim at lowering the aggregate demand and lowering the level of national income and decreasing imports. Governments may reduce AD by implementing a contractionary fiscal and monetary policy. A lower AD will lower the pressure of inflation and export sectors may benefit from lower prices compared with its trading partners. Lower imports and higher exports improve the CAD. However, the degree of contractionary demand-side policies has to be carefully examined to avoid an over contraction of the economy that can cause serious unemployment.

3) Supply-side policies

Supply-side policies aim to increase the competitiveness of the import and export-competing sectors. Governments may implement policies like improving market efficiency and labour productivity so that production costs are lowered. Exports become more attractive while imports become less attractive; this improves the CAD. However, the implementation of supply-side policies take a long time and can be costly to implement. It may also worsen income inequality when the market efficiency is improved.

4) Exchange rate policies

Exchange rate policies aim to lower the price of exports by devaluating the domestic currency. When the domestic currency is devaluated, the price of exports is lowered and the quantity transacted is higher. At the same time, the price of imports increases and the quantity transacted is lowered. Given that the Marshall-Lerner condition is satisfied, a devaluation of the domestic currency will improve the CAD. The Marshall-Lerner condition is discussed in detail below.

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The Marshall-Lerner condition and the J-curve effect

The Marshall-Lerner condition

Depreciation or devaluation does not automatically improve the current account. It changes relative prices, but the effect on export receipts and import expenditure depends on demand elasticities, the currency in which values are measured, price pass-through and adjustment lags. The Marshall–Lerner condition below explains when depreciation improves the trade balance under the model’s assumptions; the J-curve explains why the short-run outcome may differ.

The Marshall-Lerner condition states that for a currency devaluation or depreciation to improve the CAD, the sum of the PED for exports and the PED for imports (the absolute value) must be greater than one.

1) PED (X) + PED (M) > 1, devaluation/depreciation of domestic currency helps improve the CAD.

2) PED (X) + PED (M) = 1, devaluation/depreciation of domestic currency causes no change in the CAD.

3) PED (X) + PED (M) < 1, devaluation/depreciation of domestic currency deteriorates the CAD.

The J-curve effect

The J-curve effect states that if the PED for exports and the PED for imports are low in the short run, the Marshall Lerner condition is not satisfied. A depreciation or devaluation in the currency may not help improve the CAD in the short run.

Figure 4.6.3 shows that a trade deficit exists in the country in time \(t_1\). In the short run, the PED for exports and imports is low, as consumers need time to realise the change in the exchange rate and prices. In addition, the exporting and importing retailers usually make contracts with the manufacturing firms where the exchange rate is kept constant within the contract period to avoid risk from fluctuating exchange rates. Thus, retailers will not lower the prices immediately after the depreciation of the exchange rate. The deficit in the short run becomes bigger since the Marshall Lerner condition is not satisfied. After time \(t_2\), the PED for exports and imports increases and the Marshall Lerner condition is satisfied. The trade deficit becomes smaller and gradually the trade balance can be improved.

Implications of a persistent current account surplus

1) Lower domestic consumption and investment

A current account surplus is a positive combined balance of trade in goods and services, primary income and current transfers. It may reflect strong export competitiveness or domestic saving exceeding investment. Weak domestic demand can also contribute to a surplus, but a surplus alone does not establish low consumption, low income or a low standard of living. Its causes must be assessed.

2) Pressure for appreciation of the domestic currency and lower export competitiveness

A persistent current account surplus may put pressure on the domestic currency to appreciate, as the demand for the domestic currency is higher than the supply. The appreciation may lower the export competitiveness and export sectors may suffer. However, the appreciation may force the exporting industries to be more efficient to maintain competitiveness in the international market.

3) Inflation and employment

A current account surplus means that net exports (X - M) are increasing, shifting AD to the right. This might increase inflation and employment.