The second possible solution to overcome current account deficit is deflation (Machuraji, 2009). Deflation is the policy by which a government diminishes spending power in the economy and can be effectuated through a rise in interest rates or a rise in taxes (Book, 2011). The expected effect of this policy is the reduction of spending power which in turn would reduce imports as imports represent a fundamental proportion of consumer expenditure (Book, 2011). Moreover, deflationary policies would force manufacturers to lessen their costs leading to more competitive exports and thus rising exports (EconomicsHelp, 2012). Nevertheless, this policy might lead to lower growth and subsequently lead to higher unemployment, thus reducing the benefit of it on the current account deficit (EconomicsHelp, 2012).
The third possible solution to current account deficit is protectionism, which is achieved by the government taking direct control over imported goods, comprising taxes on imports and restrictions on import volumes and values (Book, 2011). Retaliation and the rules of international treaties such as the EU and GATT can represent threats to the success of this policy by diminishing the possible area of actions a government could tackle (Book, 2011).
- Analyse the UK’s balance of payments for the period of 10 years.
The UK balance of payments is a statistical statement designed to provide an orderly record of the UK’s economic transactions with the rest of the world. It “draws a series of balances between inward and outward transactions, provides a net flow of transactions between UK residents and the rest of the world and report how that flow is funded” (The Pink Book, 2011).
Hence, in the balance of payments, money coming into the UK economy as a result of goods and services being exported is recorded as a positive figure, while money going out of the UK economy as a result of goods and services being imported is recorded as a negative figure. If both imports and exports are summed up to be equal, there is no overall surplus or deficit in a country’s balance of payments. If a country is exporting more than it is importing, then the country’s trade balance should be a surplus and if a country is importing more than it is exporting, then the country’s trade balance should be a deficit. This is what the UK is experiencing now.
For many years, with strict rules and regulations, the cost of producing goods in the UK has been very expensive and this disadvantages businesses wanting to compete either nationally or internationally. The shortfall the UK is experiencing can be counter balanced in other ways, such as foreign investment in the UK.
Current Account
The last time the UK current account recorded a surplus was in 1983. Since then, the current account has run in a deficit getting deeper and deeper.
Figure C1: The UK Current Account between 1997 and 2009
Over the last few decades, the UK has moved towards a service economy resulting in the deficit in the current account (The ERA Foundation, 2009). As the manufacturing industry has been declining, the UK is moving towards a post-industrial era; more goods are being imported into the country. In 1997, the UK recorded its lowest current account deficit (The Pink Book, 2011) due to a significant fall in the value of the pound between 1996 and 1997. Since then the current account deficit seems to have deepened as shown in figure 3.1. Choi and Mark (2009) seem to think there is no obvious trend in the current account.
Looking at figure 1, the UK current account seems to have no specific trend patterns. There is a constant relationship between the current account deficit and exchange rates. If the value of the pound increases, then the current account deficit increases and vice versa. So during 2000 and 2003, the value of the pound slowly declined leading to the smaller current account deficit. After 2003, the deficit grew meaning the pound’s value rose, causing the deficit to peak in 2006. This peak resulted from a large increase in the amount of income flowing out of the UK compared to only a portion of income coming into its economy. After the peak in 2006, the UK economy started to fall into trouble. The sub-prime market crisis that started in the U.S. late in 2007 led to a fall in the value of the pound compared to other countries, reducing the UK current account deficit. As UK residents and other residents started to feel the pinch of the financial crisis, both imports and exports started to slow down. The significant decrease in the trade of goods and services between 2007 and 2009 broadly matched the fall in the current account deficit.
Goods and Services
Trade in services for the UK has always been in a surplus, as the level of professionally skilled labour force is higher than in other countries. The UK is able to offer a skilled labour force thanks to the economy moving towards a service industry. However, this is different for trade in goods. The UK is concentrating on being a move service industry and as a result UK residents have always had to import the goods they needed. This has left the UK current account in a bigger deficit as the UK has no manufacturing industry due to high labour costs. The last time the UK trade of goods traded in a surplus was between 1980 and 1982. The growth in exports of North Sea Oil was the reason behind the surplus in the early 1980s. Since 1997, trade in goods and services has remained analogous.
Figure C2: Balance of Goods and Services
Looking at figure 2, the balance of goods and services has been increasing steadily in two different directions. As the trade in goods has continually increased its deficit, trade in services has continually increased its surplus. The only trend that occurred in the balance of goods and services was between 2007 and 2009. Events in the financial sector affected business sentiments and investment decisions. It can be seen that when the financial crisis occurred in late 2007, trade started to slow down and may be due to the impact of the mirroring of the financial meltdown hence the decrease in the surplus of services during the period of 2007 and 2009 was largely dominated by a decrease in the financial services surplus, reflecting a fall in exports of financial intermediation services indirectly measured (FISIM) by monetary financial institutions and a decrease in other business surpluses.
Income
Normally, when domestic income rises; we expect to see an increase in the demand for imports.
Figure C3: National Income Figure C4: Comparing income to imports
The national income for the UK current account has constantly been growing a surplus between 2000 and 2005. The fluctuations in the national income have been largely due to movements in the net earnings on direct investment. Until 2001, earnings on both investment abroad and investment in the UK approximately doubled, but in 2002 both fell sharply largely due to cuts in official interest rates and subsequent falls in interest receipts and payments on loans and deposits. From 2003 to 2007 income increased significantly, and by 2007 both investment income credits and debits were approximately two and a half times the earnings seen in 2002. This reflected stronger profits on direct investment and a higher rate of return on both portfolio and other investment, together with significant levels of investment over the period (The Pink Book, 2009). In 2008 and 2009 income credits and debits both fell especially because of lower earnings on direct investment while in 2009 the fall was mainly due to lower earnings on other investment as internationally interest rates continued to fall and the stock of other investment assets and liabilities fell by over 15 per cent (ONS, 2009; The Pink Book 2011).
Figure 4 illustrates the relationship between income and imports. Over the decade, the amount of income earned has constantly increased; however, this is not truly represented in imports. While income has increased in tenths over the decade, imports have increased in hundredths over the same period. This can result in the UK economy looking bad as its own residents are willing to pay for goods abroad.
Current Transfers
“Current transfers comprise transfers of income between residents of the reporting country and the rest of the world that carry no provision for repayments” (The World Bank, 2012).
Figure C5: Current Transfers
The graph clearly shows that the UK is in a deficit with their current transfers. Between 1997 and 2001, the transfers fluctuated between 9 and 15 billion US dollars where it peaked in 2001. The deficit increased again in each of the 6 subsequent years until 2007, where it was its highest on record. The deficit on general government transfers widened in 2008 and continued steadily until in 2009 and over the same period the deficit for other sectors decreased drastically in 2008 but regained in 2009 (The Pink Book, 2009).
Financial Account
It is said that if the current account is in a deficit then the financial account should be in a surplus.
Figure C6: The UK Financial Account between 1997 and 2009
The impact of globalisation of the world economy explains why investment both abroad and in the UK increased all other times except when the financial crisis occurred in 2008. The crises resulted in disinvestment not only in the UK but around the world leading to a reduction in loans internationally and a repatriation of deposits. In 1997, the UK financial account was shown as a negative figure just like the current account. After 1997, the financial account grew, staying in a surplus. Between 2005 and 2006, direct investment in the UK exceeded direct investment abroad; however, between 2007 and 2008, this was vice-versa. During the two-year period, net outward direct investment had narrowed each year driven by a net outflow of reinvested earnings and other capital transactions and partially been offset by a net inflow of equity capital (The Pink Book, 2009).
In 2006 and 2007, due to the UK’s relatively high interest rate, the attractiveness of UK debt securities to foreign investors led to net inward portfolio investment in the UK and this position was maintained as the acceleration of the global financial crisis drove up demand for less risky long- term debt securities, even though interest rates had dropped considerably in the UK, while UK equity offered greater value for money to international investors as sterling depreciated (The Pink Book, 2009) but in 2009 investors also returned to short-term debt issued by monetary financial institutions as confidence improved in the UK banking sector.
Direct Investment
Direct investment refers to external investment in which an investor of an economy acquires a lasting interest and a degree of influence or control over the management of an enterprise located in another economy.
Figure C7: Direct Investment abroad and in the UK
Figure C8: Balance of Direct Investment
As seem in figure C7, all investment made to the UK has been in a surplus while all investment made abroad has been a deficit. When combining both graphs together we get figure C8. Now the balance of direct investment fluctuates over the decade peaking at its highest in 2005 and lowest in 2007. From the graph it is noticeable that more investment was made abroad in both 2000 and 2007 reflecting a rise in mergers and acquisitions. The largest outward acquisitions were the investment in Mannesmann AG by Vodafone Airtouch for a reported £100 billion and the purchase of Atlantic Richfield Company by BP Amoco Plc for a reported £18 billion (The Pink Book, 2009). Direct investment declined abroad between 2001 and 2006 and then recovered in 2007. As a result of the global recession, since 2007, direct investment abroad has decreased each year, reaching its lowest in 2009 due to lower investment in equity capital, lower reinvested earnings, and a switch from net outflows to net inflows of other capital.
Direct investments in the UK were similar as abroad but did not reach the heights of investment. When the recession occurred in 2008, investment in the UK and abroad slowed down.
Portfolio investment
Portfolio investment refers to investment in non-resident equities and debt securities. Compared with direct investors, portfolio investors in equity and debt securities of non-resident enterprises have no lasting interest or influence in the management of the companies they invest in. A holding of less than 10% equity in an enterprise is regarded as portfolio investment (A brief Guide to Concepts of Balance of Payments (BoP) Account, 2001).
Figure C9: Portfolio Investment Assets Figure C10: Portfolio Investment Liabilities
Figure C11: Portfolio Investment Assets and Liabilities Figure C12: Balance of Portfolio Investments
Looking at graphs C9, C10, C11 and C12, we can see that there has been a net inflow of portfolio investment into the UK due to investment into the UK exceeding investment abroad with investments in debt generally exceeding investment in equities. In 2008 however, portfolio investment abroad showed net disinvestment as the global financial crisis deepened. The disinvestment was almost equally shared between equities and debt securities but 2009 portfolio investment abroad recovered strongly. The switch from net disinvestment to net investment for debt securities was mainly due to a reduction in disinvestment by UK monetary financial institutions and an increase in investment by UK securities dealers (The Pink Book, 2009).
Unemployment Rate, Treasury Bill Rate and Effective Exchange Rate
Figure C13: Unemployment Rate, Treasury Bill Rate and Effective Exchange Rate
Both the unemployment rate and Treasury bill rate have stayed constant throughout the decade until the last two years. The financial crisis was the biggest crisis since the great depression in the 1930’s. There was no surprise about the outcome of the recession but the large drop in the effect exchange rate is another matter. Looking at the graph, a positive change in the exchange rate shows an increase in value of the pound against other currencies while a negative change in the exchange rate shows a decrease in the value of the pound against other currencies. Again over the decade, the rate has fluctuated near enough around the same figure, however, when the recession occurred there was a large fall in the value of the pound.
- From the data provided is there any observable relationship between the UK balance of payments accounts and the exchange rate?
The current financial crisis has led to many economists questioning the relationship between the balance of payments and exchange rates. For the UK, the trade of goods and services in the balance of payments is of huge concern as the UK imports many goods. The pound has had a lot of limelight in the news over the last few years since the start of the financial crisis in 2008. Many opinions were discussed of whether the UK should adopt the Euro or keep the pound since it became weaker against other currencies.
The high value of the pound compared to other foreign currencies can lead to UK residents spending money abroad as it is cheaper and not in their own country and thus worsening the state of the balance of payments becoming. If the value of the pound were to be cheaper, it would encourage UK residents to spend more on domestic goods and would most probably improve the state of the UK balance of payments.
In reality, for many years the value of the pound has always been stronger than other currencies and year on year the UK current account has gone from bad to worse. The exchange rate has experienced tremendous growth. The elasticity model of the balance of trade (Krueger, 1983) has shown the existence of a theoretical relationship between the balance of payments and the exchange rate.
Figure D1: UK Imports and Exports
Figure D2: Balance on Goods
As the following chart shows, the trade deficit in goods has increased enormously in the last few years. After the UK had experienced a relative sterling devaluation from 1997 to 2008, the deficit rate of imports and exports had been increasing steadily and stable until the end of 2005 when the sterling’s value rose and finally fell drastically in 2008 following the financial crisis. This, therefore, saw an improvement in the UK exports. However, imports were increasing at a tremendous rate because of the weakening of the UK economy especially in the financial services sector. Consequently, changes in the exchange rate can have a big effect on the balance of payments although these effects are subject to uncertain time lags. When the sterling is strong UK exporters found it harder to sell their products overseas and it is cheaper for UK consumers to buy imported goods and services.
It is noticeable that the UK has a current account deficit. If the value of the pound were to devalue, then the deficit would most probably be reduced. This devaluation would depend on foreigners’ elasticity of demand for British exports and UK consumer’s elasticity of demand for foreign imports. The Marshall Lerner condition states that for a devaluation to be successful in terms of reducing the current account deficit, the sum of two elasticities must be greater than one. Export and import elasticity are looked at separately.
UK exporters cannot go wrong if the pound falls in value. However the small the depreciation in the pound is, and however low the elasticity for their exports is, the revenue they will receive will have to rise. So if the value of the pound is reduced, UK firms will still receive the same amount of money for each sale. This exchange will only effect foreigners as to whether they will pay more or less for the goods they purchase. “In summary, for export revenue to rise following a devaluation of the pound, the elasticity of demand for these exports simply has to be greater than zero. Obviously, the higher the elasticity the bigger the increase in export revenue, but anything over zero will help reduce the current account deficit” (S-Cool, 2011).
Import elasticity works a little differently. If the value of the pound devalues, then imports become less favourable because the price of imports into the UK will rise. This is what the UK government would look to achieve as it would mean that the current account would trade in a surplus rather than a deficit. In import elasticity, you can either be elastic or inelastic.
The more elastic the demand for UK imports, the more successful devaluation will be in terms of reducing the import revenues and the bigger the reduction in the current account deficit: The more inelastic the demand for UK imports, devaluation will result in increasing import revenues which will contribute to a larger current account deficit.
References
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