Balance of payments

The balance of payments

Maintaining a balance of payments with the rest of the world is a macro-economic objective. In simple terms, if the balance of payments balances, then the combined receipts from selling goods and services abroad, and from the return on investments abroad, equals the combined expenditure on imports of goods and services, and investment income going abroad.

The balance of payments is also an official account of international payments, published in a document called the Pink Book. Statistics on UK imports and exports have been gathered in the UK since 1687.

As an official record, the balance of payments is broken down into two basic accounts – the current account, and the capital and financial account.

The current account

The current account is made up of the following payments:

Trade in goods

These items include the import and export of finished goods, such as cars, and computers; semi-finished goods, such as parts and components for assembly, and commodities, such as oil, tea and coffee.

Trade in services

Trade services include financial services, tourism, and consultancy.

Income from investment and employment

Investment income refers to any income made from investing abroad, and includes profits, such as those from business activities of subsidiaries located abroad; interest received from UK financial investments and loans abroad, and dividends from owning shares in overseas firms.

Payments to individuals who are residents of a country, and are employed in another, are also included in the current account. Investment and employment income are also known as ‘primary income’.

Transfers

The final section of the current account includes transfer payments (transfers) arising from gifts between residents of different countries, donations to charities abroad, and overseas aid. Transfers are also known as ‘secondary’ income.

Any deficit on the Current Account will be balanced by actions on the Financial and Capital Accounts.

The Capital and Financial Account

The Capital and Financial Account records the flows of capital and finance between the UK and the rest of the world. Types of flow include:

1. Real foreign direct investment (FDI), such as a UK firm establishing a manufacturing facility in China. Direct investment refers to investment in an enterprise where the owners or shareholders have some element of control of the business.
2. Portfolio investment, such as a UK investor buying shares in an existing business abroad. With portfolio investment, the investor has no control over the enterprise.
3. Financial derivatives are any financial instrument whose underlying value is based on another asset, such as a foreign currency, interest rates, commodities or indices.
4. Reserve assets are foreign financial assets that are controlled by monetary authorities – namely the Bank of England. These assets are used to finance deficits and deal with imbalances. Reserve assets include gold, Special Drawing Rights, and foreign exchange held by the Bank of England.

This process is often called official financing.

Net errors and omissions

In theory, the Capital and Financial Account balance should be equal and ‘opposite’ to the Current Account balance so that the overall Account balances, but in practice this is only achieved by the use of a balancing item called net errors and omissions. This device compensates for various errors and omissions in the balance of payments data, and which brings the final balance of payments account to zero.

Financing deficits and surpluses

The financing of a deficit is achieved by:

1. Selling gold or holdings of foreign exchange, such as US dollars, yen or euros, or:
2. Borrowing from other Central Banks or the International Monetary Fund (IMF).

A surplus will be disposed of by:

1. Buying gold or currencies.
2. Paying off debts.

UK trade performance

Apart from 1997, every year since 1987 has seen a deficit on the UK Current Account. This deficit reached a peak at 6% of GDP in the fourth quarter of 2013.  The deficit tends to follow a cyclical pattern, as shown in the chart below.

UK Current Account 2008  – 2015 (Quarterly – % of GDP).

Is a current account deficit a problem?

A deficit can be a problem if:

1. It is persistent.
2. It forms a large share of GDP.
3. There are no compensating inflows of investment income or inward capital account flows.
4. The Central Bank has low reserves.
5. The economy has a poor record of repaying debt.

Economic growth and trade

In the UK, there is a strong connection between a growing economy and trade deficits. Soon after the economy went into recession in 1990, the trade deficit began to fall quickly. However, as the economy came out of recession and into a period of strong growth from 1993, the trade deficit began to rise quickly, and continued to rise through the next 15 years.  It is likely that the recession that started in late 2008 will cause the deficit to fall back, as indeed the above table indicates.

Causes of a current account deficit

There are several possible causes of a persistent current account deficit, including the following:

Excessive growth

If the economy grows too quickly, and rises above its own trend rate, which in the UK is around 2.5%,  then domestic output (AS) may not be able to cope with domestic aggregate demand.

High export prices

High export prices will occur if a country’s inflation is higher than that of its competitors, or if its currency is over-valued which will reduce its price competitiveness.

Non-price factors

Non-price factors can discourage exports, such as poorly designed products, poor marketing or a worsening reputation for reliability.

Poor productivity

An economy might not be producing enough from its scarce factors of production. Labour productivity, which is defined as output per worker, plays an important role in a country’s competitiveness and trade performance, and the UK has suffered from poor productivity. The productivity gap is the gap between the UK’s relatively poor productivity performance and that of the UK’s leading competitors.

Low levels of investment in real capital

This could be caused by excessive long-term interest rates, or low levels of research and development.

Low levels of investment in human capital

This involves a lack of investment in education and training, which reduce skill levels relative to competitor countries and force countries to produce low value exports.