essential economics: The UK Balance of Payments
Topic: The UK Balance of Payments
Download a printable version of this revision note
Students should know the difference between the current and capital account of the balance of payments. The nature and significance of both short term and long term international capital flows should be understood
What does a current account deficit tell us about the performance of an economy? And does it matter if a nation operates with a high current account deficit? We will consider these two questions in this revision focus.
Quick recap on the current account
The current account balance is the sum of four separate balances
- The balance of trade in goods
- The balance of trade in services
- Net investment income from overseas assets
- Net transfers of money between people and between governments
The USA and UK current account balances are shown in the chart below.
Note that we are measuring the deficit as a percentage of GDP – a better guide to the scale of the deficit given the different size of each economy.
The UK last had a small current account surplus in 1998 – our deficit in the six years since has hovered around 2.0 – 2.5% of GDP.
In contrast the United States deficit has grown each year from 2% in 1997 to a huge 6% in 2004.
What does a current account deficit tell us about the performance of an economy?
A current account deficit is not necessarily or automatically a bad thing!
- The UK has run a deficit since 1998 but its overall macroeconomic achievements have been good
- Germany has run a sizeable and growing surplus in recent years but has suffered from slow growth and high unemployment
- Japan has enormous current account surpluses but has had three recessions in the last twelve years
Much depends on
- The causes of a current account deficit
- Whether or not the deficit is likely to correct itself as an economy moves through a normal cycle
- Whether or not the deficit can be easily financed through attracting sufficient capital inflows
What of the UK ?
Here are the figures for 2004 as released by the Office for National Statistics
- There was a record surplus on trade in services of £18.3 billion
- But the highest ever recorded deficit of £57.6 billion on trade in goods.
- Exports of goods and services were up by two per cent while imports rose by five and a half per cent to reach a record annual level
- We ran a large net investment income surplus (of nearly £20 billion) partly offset by a negative transfers balance approaching £8 billion
- Taken as a whole, the current account deficit was over £26 billion – just over 2.5% of national income
What does the current account deficit tell us about the UK ?
- Consumption: Partly the deficit is the result of a period of sustained economic growth and strong consumer demand for goods and services – our manufacturing sector is not large enough to meet all of the demand for consumer goods and durables, so we must import to satisfy this excess demand
- UK consumers have a high marginal propensity to import as income rises
- Many imported manufacturing goods are relatively cheaper than UK substitutes - this causes a substitution effect towards overseas output
- The long run decline of manufacturing limits the choice of domestic supplier for us to choose
- Sterling : The trade deficit in goods has been affected by the strength of the UK exchange rate e.g. the appreciation in the value of sterling against the US dollar and against the Chinese Yuan (we are running an £8 billion trade deficit with the Chinese)
- Other economies: Two major export markets (the USA and the Euro Zone) have both experienced technical recessions at points in the last four years. The slow growth in the Euro Zone which account for over half of our merchandise exports is a problem for UK firms exporting to Western Europe
- In contrast China accounts for only 1.2% of our exports, and eastern Europe only 2%
- Services: Our trade surplus in services is improving – good news – reflecting our comparative advantage in many service industries
- The UK is the second largest exporter of services in the world with an 8% world market share
- Surpluses include: Architecture (£4 bn); legal services (£1.5 bn);
- Investment Income: This is quite volatile from year to year – but our surplus reflects a large amount of overseas investment by UK businesses over recent years (including investing in new plant, retail outlets and acquisitions of foreign owned businesses). This helps to stabilise our balance of payments, without it the current account deficit would be much more of a problem
Day to day the current account deficit is not a major problem for the UK – the next paragraph explains why
It is now easier to finance a current account deficit because of globalisation and international financial market liberalisation. Even if a country is running a current account surplus, provided there is a capital account surplus, there is no fundamental economic constraint.
The UK has found it fairly easy to attract these capital flows
Why?
- Interest rates: Short term interest rates are higher than in for example the Euro Zone and the United States . This attracts inflows of money into our banking system seeking a favourable rate of interest
- FDI: Britain’s economy remains a favoured venue for inflows of foreign direct investment – supply side reasons including a more flexible labour market and low cost and wage inflation help explain this
- Investment in markets: Foreign investors are keen to buy into competitive UK product markets including communication industries, transport, and financial services
The current account deficit is not afundamental problemfor Britain – not when it is only 2 – 2.5% of our GDP.
And
- Slower growth: At some point the British economy will experience a phase of slower growth and weaker consumer spending – this will dampen down the demand for imported goods and services. For example there is already widespread evidence of a slowdown in the housing market following the recent series of small increases in official interest rates by the Bank of England
- A lower pound: The exchange rate may start to depreciate in the coming years providing a boost those UK industries exposed to competition in international markets
But ………. there are grounds for worrying about the current account deficit
- The deficit reflects an unbalanced economy with consumers spending beyond their means
- The deficit reflects a loss of cost and price competitiveness in export sectors – some of which is the result of a poor supply side performance in terms of low productivity, insufficient research and development and a lack of innovation and other forms of non-price competitiveness
- A rising current account deficit may lead to increasing import penetration in domestic markets, which threatens jobs and living standards in the medium term
- There is no guarantee that the free flow of capital into a country will continue – this will then create a “financing problem” for the UK . It is a bit like the bank deciding to stop lending you money when you keep going back to them to ask them to give you another extension to your overdraft or loan!
The economic history of Britain has been heavily influenced by its balance of payments position. Nowadays, it's quite possible to run current account deficits for a long time, reflecting a country's ability to attract the world's increasingly mobile capital. The problem, though, is that the same capital can swiftly head for the exit at the first sign of trouble.
Stephen King, Independent, December 2004
Now things are different for the United States – where the current account is much larger. Alan Greenspan recently commented that he wasn’t worried too much about it because US interest rates are heading upwards and the declining dollar will boost US exports. But there is not much that the USA can do about its trade deficit with China because of the current fixed exchange rate with the Yuan. But Greenspan may be too optimistic. America is financing its current account deficit by getting foreign investors to buy US government debt (and real estate in Manhattan !).
Within the next ten years, foreign owned assets in the USA may account for nearly 100% of their GDP. And the US government may be paying up to 3% of her GDP each year just in interest payments on foreign-owned government debt. That is a pretty hefty bill to pay for US consumers spending more on imports than the nation can afford.
Sooner or later, all governments have to do something to correct a large current account deficit. They cannot simply sit back and expect a lower exchange rate and the different phases of the economic cycle to do the job for them!
| Business Objectives |
| Causes of Unemployment |
| Current Account Deficits |
| Economies of Scale & Scope |
| Globilisation & the UK |
| Manufacturing Industry in the UK |
| Phillips Curve |
tutor2u is the leading global publisher of e-learning resources for Economics, Business, Politics, Enterprise, Law, Sociology, Religious Studies and related subjects. Our materials are used by over 3,500 schools and colleges in the UK and in educational institutions in over 85 other countries. tutor2u offers a range of free and subscription-based materials - designed to support teachers and inspire students. The business also runs a popular series of student revision workshops and teacher conferences. tutor2u was named Online Learning Resource of the Year at the prestigious BETT Show - the World's leading educational show.
|
Privacy & terms of Use |
Contact us |
Teacher Newsletters & Subject Blogs |
