In this note we consider the numbers which tell us something about how well Britain is doing in paying her way in the international economy.

The balance of payments records financial transactions between Britain and the international economy. The accounts are split into two sections with the current account measuring trade in goods and services and net investment incomes and transfers whilst the capital account tracks capital flows in and out of the UK. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment.

Components of the UK current account of the balance of payments

	Balance of trade in goods	Balance of trade in services	Net Investment Income	Current transfers	Current account balance
	£ billion	£ billion	£ billion	£ billion	£ billion
1997	-12.3	14.1	3.3	-5.9	-0.8
1998	-21.8	14.7	12.3	-8.4	-3.2
1999	-29.1	13.6	1.3	-7.5	-21.7
2000	-33.0	13.6	4.5	-10.0	-24.8
2001	-41.2	14.4	11.7	-6.8	-21.9
2002	-47.7	16.8	23.4	-9.1	-16.5
2003	-48.6	19.2	24.6	-10.1	-14.9
2004	-60.9	25.9	26.6	-10.9	-19.3
2005	-67.3	17.9	29.9	-12.2	-26.6

 

 
The causes of a trade deficit

It is useful to group the explanations for a trade deficit in goods into short-term, medium-term and long-term factors. Some relate to the demand-side of the economy, others to supply-side economic influences

Short-term factors

• Strong consumer demand – real household spending has grown more quickly than the supply-side of the economy can deliver, leading to a high level of demand for imported goods and services. Research evidence suggests that UK consumers have a high income elasticity of demand for overseas-produced goods – demand for imports grows quickly when consumer demand is robust.  Nicholas Fawcett and Professor Mike Kitson estimated that the income elasticity is around +2.3 suggesting that a 2% increase in real incomes boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace with the surging demand for imported products, so the trade deficit widens when the economy enjoys a period of consumption-led growth.
• The strong sterling exchange rate has helped to reduce the UK price of imports causing an expenditure-switching effect away from domestically produced output. In technical terms, the high pound has improved the terms of trade between the UK and other countries, allowing us to buy and consume more imports with each pound we earn. Consumers have taken advantage of the high pound!
• The weakness of the global economy and in particular the slow growth in the Euro Zone has damaged UK export growth. Nearly 60% of UK manufactured goods exports and over 50% of our exports of services are to fellow members of the European Union. The Euro Zone economy grew by only 0.3% in 2003 and real GDP growth for the Euro Zone has been below 1% pa in each of the last three years.

Medium-term factors

• UK trade balances have been affected by important shifts in comparative advantage in the international economy – for example the rapid growth of China as a source of exports of household goods and other countries in South-east Asia who have a cost advantage in exporting manufactured products
• The availability of imports from other countries at a relatively lower price inevitably causes a substitution effect from British consumers.

Longer-term factors

• Much of our trade deficit is due to structural rather than cyclical factors
• Our trade performance has been hindered by supply-side deficiencies which impact on the price and non-price competitiveness of British products in global markets
• A relatively low rate of capital investment
• The persistence of a productivity gap with our major competitors – measured by differences in GDP per person employed or per hour worked – this is linked to low investment and also to the existence of a skills-gap between UK workers and employees in many other countries
•  A relatively weak performance in terms of product innovation – linked to a low rate of business sector spending on research and development
• The UK manufacturing sector has been in long-term decline for more than twenty years. Although we still have some world class manufacturing companies, the size of our manufacturing sector is not large enough both to meet consumer demand in the UK and also to export sufficient volumes of products to pay for a growing demand for imports