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Study notes

Balance of Payments - Trade Imbalances

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

The global economy will always have some deficit countries and some surplus countries

Balance of Payments - Revision Video
  • The balance of trade is the difference between the value of country’s exports and imports of goods and services combined.
  • The scale of global trade imbalances has increased over the years and this has created tensions between nations and poses a threat to globalisation
  • More countries are using managed exchange rates as a way of dealing with growing trade deficits.

Balance of payments and the standard of living

  • In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference
  • In the short term, if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables
  • The deficit might also be the result of importing much needed capital equipment that will boost a country's productive capacity in the long run

Especially for a developing country, a trade deficit can bring benefits. Economists might justify a trade deficit by arguing that poorer nations should be importing capital by running a current-account deficit. Providing productive investments are made, this gives a country the extra capital to drive future GDP growth so it can pay the foreigners back.

Current account imbalances in the world economy (Source: Asian Development Bank)

Balance of Payments and Aggregate Demand

  • 1.When there is a current account deficit – this means that there is a net outflow of demand and income from a country's circular flow. In other words, trade in goods and services and net flows from transfers and investment income are taking more money out of the economy than is flowing in. Aggregate demand will fall.
  • 2.When there is a current account surplus there is a net inflow of money into the circular flow and aggregate demand will rise.

A Balance of Payments Crisis

A BoP crisis occurs when a country cannot pay for essential imports or service its debt (i.e. pay interest), often as a result of currency devaluation; usually preceded by large capital inflows in order to boost growth but then investors get worried about their debt and remove their capital.

Key Dangers from running Persistent Trade Deficits

  1. A deficit leads to lower aggregate demand and therefore slower growth
  2. In the long run, persistent trade deficits undermine the standard of living
  3. Trade deficit can lead to loss of jobs in home-based industries
  4. Deficit countries need to import financial capital to achieve balance
  5. A trade deficit can lead to currency weakness and higher imported inflation
  6. Countries may run short of vital foreign currency reserves
  7. A trade deficit is a reflection of lack of price / non-price competitiveness
  8. Currency weakness can lead to capital flight / loss of investor confidence

Many countries operate with a trade and current account surplus – good examples are China, Germany, Japan, Norway and several emerging market countries with strong export sectors.

A country with a surplus on the current account sees capital outflows of the same amount. This capital is either deposited in banks overseas or used to purchase foreign assets, from government bonds to companies, leading to an increase in the surplus nation's ownership of foreign assets.

Main Causes of Structural Trade Surpluses

There are several causes of a trade surplus and each country will have a unique set of circumstances:

  1. Export-oriented growth: Some countries have set out to increase the capacity of their export industries as a growth strategy. Investment in new capital provides the means by which economies of scale can be exploited, unit costs driven down and comparative advantage can be developed.
  2. Foreign direct investment: Strong export growth can be the result of a high level of foreign direct investment where foreign affiliates establish production plants and then export from this base
  3. Undervalued exchange rate: A trade surplus might result from a country attempting to depreciate its exchange rate to boost competitiveness. Keeping the exchange rate down might be achieved by currency intervention by a nation's central bank, i.e. selling their own currency and accumulating reserves of foreign currency. One of the persistent disputes between the USA and China has revolved around allegations that the Chinese have manipulated the Yuan so that Chinese export industries can continue to sell huge volumes into North American markets.
  4. High domestic savings rates: Some economists attribute current account surpluses to high levels of domestic savings and low domestic consumption of goods and services. China has a high household saving ratio and a huge trade surplus; in contrast the savings ratio in the United States has collapsed and their trade deficit has got bigger. Critics of countries with persistent trade surpluses argue they should do more to expand domestic demand to boost world trade.
  5. Closed economy – some countries have a low share of national income taken up by imports – perhaps because of a range of tariff and non-tariff barriers.
  6. Strong investment income from overseas investments: A part of the current account that is often overlooked is the return that investors get from purchasing assets overseas – it might be the profits coming home from the foreign subsidiaries of multinational businesses, or the interest from money held on overseas accounts, or the dividends from taking equity stakes in foreign companies.

Significance of Current Account Surpluses

  • Contributor to GDP i.e. net external demand is positive
  • Might cause demand-pull inflationary pressure
  • Accumulation of foreign exchange reserves
  • Pressure on the currency to appreciate
  • Allows a country to be a net exporter of capital
  • Huge surpluses could trigger protectionist responses

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