Balance of payments

We have seen how essential it is for most countries to trade Internationally, especially in
the UK as most of our ……………………………………………………….is imported. All
countries have different reserves of resources such as natural resource eg. minerals, skilled labour
force, fertile land etc. Thus, International Trade arises because countries
a) differ in their ability to produce goods, b) differ in their demand for these goods.
Thus nations specialise in the production of certain goods and services and exchange the
resulting surpluses with other countries, depending on the how much of one good or service will
exchange for another; the proportions in which these are exchanged is called the Terms of
Many Economists and Politicians believe that International Trade has increased the standard of
livings of most people in most countries due to GLOBAL SPECIALISATION (Div of Lab) and
INTERNATIONAL ECONOMIES OF SCALE. However, there are also many who feel that
International Trade does not help many poor and 'under-classes' in many Economic Systems.
This has resulted in riots and demonstrations in cities, which have hosted WTO meetings and G7
meetings, such as Seattle, Genoa etc (see Economics Collection Video - section 2 Global Trade).
BALANCE OF PAYMENTSis a Statement of Account of a country’s transactions with the
rest of the world
. The B o P (which had its structure changed in 1999) traces the flows of funds
(INFLOWS and OUTFLOWS) and must, of course, always balance.
The Balance of Payments is published monthly and is split into different parts –
PART 1 – The Current Account - shows the UK's deficit or surplus on its day-to-day trading
with the rest of the world. The following make up the Current A/c;
Trade in Goods (Visible Imports/Exports) – the purchase and sale of goods. The
export and import of goods was referred to as visible trade; if you think for 8 seconds you
will come up with 5000 examples!! The difference between the visible exports and
imports is known as the BALANCE OF TRADE.
Trade in Services (Invisible Trade) – the purchase and sale of services. The imports
and export of services is referred to as Invisible Trade. Invisible Trade takes the
following forms –
Financial and other services e.g. banking, insurance, and advertising. If an
American Insurance Corp insures a UK firm then this is an outflow of currency
from UK (invisible import)
Shipping Services – at one time almost the entire world trade was carried by British
Ships e.g. if a British Shipping Company shipped goods for a firm in Spain, then
the payment for this would be an inflow of currency into Britain (invisible export)
Travel and Tourism – some countries have a very large tourist industry. e.g. if a UK resident went on holiday to France this would be an outflow of funds (invisible import) IRA BSE HIGHER ECONOMICS - 1 - Balance of Payments March 23, 2011
Civil Aviation and Merchant Shipping – air and sea transport has reduced the time factor drastically and such services are in demand. Government Services – this includes military and civil expenditure in foreign countries and is an outflow of funds e.g. British embassies, the British Army in Germany. Private Transfers – e.g. immigrants (apart from illegal ones!!) bring funds with them into the country which benefits the balance of payments, emigrants take funds out to the detriment of the Balance of Payments. Income Section - 2 parts to this;
1) Compensation of the earnings of our employees abroad (usually seasonal workers - so forget it for the UK!!) and 2) Income from Investments (the biggest part), which includes; A) Direct Commercial/Business Overseas Investment eg UK firms buying a foreign company - or vice versa! B) Investment in Stocks, Shares and Bonds C) Loans/borrowings and, D) Reserve Assets is all the interest which the UK gets from its 'Official Reserves'. 3) SDR's at the IMF; (Special Drawing Rights at the International Monetary Fund). Current Transfers - a) Government Transfers - This is where money
flows outwith the Economy but NOT for goods and services. It includes 1) all the funds which flow from the UK to the EU as part of our 'annual subscription' for membership, 2) Overseas Aid eg to many African countries, and 3) Transfer Payments to UK citizens/pensioners etc who live abroad.
b) Other Transfers eg, other movements of funds from UK to other countries
such as the EU or gifts abroad or taxes paid by UK firms to foreign governments
and vice versa.

PART 2 - CAPITAL ACCOUNT - includes Government grants, writing
off foreign debts and the purchase or sale of foreign lands, buildings etc and
other assets such as Patents, Copyrights, Franchises, Logos, Trademarks etc. It is
almost always in surplus.

Other Capital Flows – movement of funds or 'Hot Money' into or out of the country by
individuals, Banks, International Companies and Governments. These monetary
movements are attracted by high interest rates – if the investor can obtain better interest
rates in another country then the funds will be moved abroad; in micro-seconds by
computer transfer. If the UK offers better rates then there will be an inflow of funds,
thus an increase in the demand for Sterling - which will increase (appreciate) the value of
Sterling on the FOREX market

PART 3 - FINANCIAL ACCOUNT - (This is similar to the old 'Capital Account'). It is
basically transactions in 'capital' items ie Assets and Liabilities.
So, it is investment overseas by UK firms (Outward Investment) and vice versa
by foreign firms ie (Inward Investment). Like the "Income Section" of the
Current Account; the Financial Account has Direct Investment, Stocks and
Shares, Other Investments - such as the British opening foreign bank accounts and
vice versa and the Government having funds (deposits) in foreign banks, in both
currencies, SDR's and Gold etc.
IRA BSE HIGHER ECONOMICS - 2 - Balance of Payments March 23, 2011
PART 4 NET ERRORS AND ANY OMISSIONS - this represents the sum of all errors and
omissions, caused for example by the smallest of errors in calculations, or if something is missed
out or if there is a time delay in getting some information.
When dealing with such large numbers it is obvious that there will be some errors. This figure is the amount needed to make sure that the B of P 'Balance Sheet' actually balances. See Stanlake page 482 for an example of the UK's 1997 B of P statement.
The sum of the current balance, capital balance, financial account and the Net Errors, gives the
total overall net balance or Total Currency Flow. If this balance is negative there has been a
net outflow of foreign currency (in the Red); if it is positive there has been a net inflow of funds
(in the Black). A positive balance, however, can be misleading; it does not necessarily indicate
that a country has been earning a surplus on its trading transactions.
It could just be lots of dosh in-flowing into the UK as Inward Investment, which will have, of
course, future outflows - as profits are sent back to the home country. Or, net borrowing
(inflows) on the capital account (Loans and Borrowings) may more than offset a deficit on the
current account (Goods and Services) so that the overall balance is positive.

If a deficit has been made then this is cleared (repaired!!) in the following way –
borrow reserves from the INTERNATIONAL MONETARY FUND (IMF) and use these reserves to clear the debt borrow from any other Monetary Authorities – foreign banks or ECB, or foreign governments – but unfavourable interest rates may be enforced pay the outstanding balances out of gold and foreign currency reserves in the Central Bank. This is a direct, physical monetary movement of gold and currency, and runs our balances down to lower levels sell overseas investments acquired in earlier times – and so obtain foreign currency in this way.

If a surplus has been made then this is cleared (repaired!!) in the following way –
build up our reserves of gold and foreign currency at the Central Bank repay loans from the INTERNATIONAL MONETARY FUND repay loans to other monetary authorities purchase assets overseas. The Total to be financed reflects the change in holdings of financial assets.

Current Expenditure – as some of you would have already seen in Std Grade, is expenditure by
Businesses or Government, which is necessary for the normal, ordinary, day-to-day running of
the firm or Government department, or even school. It is on things like wages, electricity,
stationery, petrol, repairs, food – ie consumables.
IRA BSE HIGHER ECONOMICS - 3 - Balance of Payments March 23, 2011

Within INTERNATIONAL TRADE, Current Expenditure is the difference between today’s
visible and invisible exports and today’s visible and invisible imports i.e. – what we are, as a
nation, currently trading.
Capital Expenditure – in Business and Government, is a form of Investment, i.e. – we will
probable get no benefits today - but lots more benefits in the future. Thus, as a firm buying a
new computer system, vehicles, premises, fixed capital etc., - these are all examples of capital
expenditure i.e. – we will see little benefit immediately but you will see more long term benefits
in the future.
Within INTERNATIONAL TRADE, capital expenditure is also a form of investment, only
outwith our domestic economy e.g. – a UK firm, BP Amoco, investing in a refinery in Canada or
a foreign firm’s inward investment in the UK, e.g.
All the above represent CAPITAL FLOWS – the difference between Capital Flows from the UK
and to the UK is called the UK’s annual CAPITAL BALANCE.
Remember when a foreign firm invests in the UK (Such as …………………………….
then they must convert their currency to £ sterling (sell their currency and buy pounds) either at
the ‘spot’ rate, i.e. today’s rate or at some different rate some time in the future, whenever it is
that they will need the funding in Sterling.
Since the FOREX rate may go up or down in the interim period - and, if it is a 'Global Currency'
which is subject to frequent trading, the 'rate' may be very volatile and move very often each
hour, then firms (or individuals) can negotiate or 'haggle' and fix an exchange rate contract with
their bank today for some future date, when they will actually need the foreign currency.
This is obviously a bit of a chance, a gamble; but at least they will know exactly how much of
their own currency
will be due at the end of the time period; so, the 'future' rate at least gives
the business 'certainty'.
They will know exactly how much they will need to set aside in their own currency in order to
finance the transaction; however, the firm may gain if the currency has risen in the time period;
or, the bank may gain if the currency has fallen over the same time period.
This is equally true for a UK firm investing abroad e.g. ……………………………….

If the balance of payments account shows a deficit on total currency flow then more money is
owed to foreigners, than they owed to us in any financial year; this deficit has to be paid back. In
the short run the gold and foreign currency reserves can be use for small debts but in the long run
the deficit has to be corrected or the reserves will dry up.
Curing a deficit - the most obvious way to do this is either reduce our . . . . . . . . . . . . or increase
our . . . . . . . . . . or both!! However, we can also pursue the following measures;
1 Deflationary Policies - Deflation involves dampening down demand for all goods and
services. The most direct way to do this, is by reducing SPENDING . The amounts of money
people have to spend on Goods and Services, including IMPORTED goods and services, can be
reduced by either increasing taxes (especially ………………………) or raising interest rates to
reduce borrowing and so, spending.
IRA BSE HIGHER ECONOMICS - 4 - Balance of Payments March 23, 2011
Raising interest rates also helps to make a country more attractive for foreigners to invest their
surplus cash. However, before they can invest in the UK they must sell their surplus currencies
on the FOREX market and then buy £s Sterling with the proceeds and then pay that Sterling into
a UK bank account. These currency-flows into the UK will further help to reduce the Balance of
Payments deficit.
Deflationary policies, however, also have the effect of dampening down demand in the home
market - since taxes or interest rates or both, are now higher; thus creating unwanted goods and
services, which may cause a reduction in Revenues for firms and so a 'down-sizing' … possibly
leading to a contraction in the Economy.
However, watch out here because, since we are taxed more and paying higher interest rates for
borrowing, then we will probably buy LESS imports. BUT, what if the higher interest rates cause
more demand for Sterling and so Sterling APPRECIATES (Strengthens) on the FOREX market
(we know this already in that when the demand for anything, cet par, goes up, then the price will
go up also).
Now this Strong pound makes it CHEAPER for us to Import foreign goods eg Cars, Cameras,
Clothes, Camels etc - so, there could possibly be an adverse (bad) effect on our Bof P too!!
2 Floating Exchange Rates - A balance of payments deficit (ie we are importing far more than
we are exporting) will be accompanied by an increased SUPPLY of sterling abroad (as we sell £'s
to get foreign dosh!) - and, of course, an increase in the DEMAND for the currency of the country
we are buying from. Since the value of the pound is determined by the market mechanism, the
fall in demand will lead to it being worth less in terms of other currencies.
This fall in value or DEPRECIATION will now mean cheaper UK goods for foreigners, dearer
imports to the UK for us, and thus the balance of payments deficit can be automatically cured;
this system is known as an 'AUTOMATIC STABILISER'.
3 Trade Restrictions - Applying some or all of the range of trade restrictions (ie quotas, tariffs
etc) can help to reduce imports, although the danger of retaliation means their long term
effectiveness is in doubt. Also the WTO will not be very chuffed!
4 Devaluation - If a country experienced a serious payments deficit, it could devalue its
currency rate of exchange against others currencies, having the effect of making its exports
cheaper and its imports dearer, so reducing the deficit. This will only work on FIXED rates
5 Exchange Controls - By restricting the amount of foreign currency available to importers, the
quantity of imported goods can be (crudely) controlled. The Government through the Bank of
England has the authority to impose exchange control limits that could also be applied to the
amount of foreign currency taken abroad by British tourists.
It might appear that a Balance of Payments deficit is more serious than a surplus but having a big,
persistent trading surplus could still pose major Economic problems (as the Japanese suffered
throughout the most of the 1990's and still are!!). North Sea oil has helped to us move towards a
Balance Of Payments surplus for the UK; which in turn has increased the value of the pound
This has made UK's manufacturing exports more expensive to foreigners, causing demand for
them to fall and leading to a certain amount of downsizing and de-industrialisation in the British
economy especially in …………………………… Finally, it is obvious that curing a balance of
payments surplus is essentially a reversal of the policies designed to cure a deficit.
IRA BSE HIGHER ECONOMICS - 5 - Balance of Payments March 23, 2011


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