A Level Economics. International Issues. Correcting Disequilibrium in Balance of Payments

Introductory Task

Section 1: Components of the Balance of Payments

As we say in the AS level, the Balance of Payments records all economic transactions between a country’s residents and non-residents during a specific time period, and is composed of:

  • Current account;
  • Capital account;
  • Financial account; and
  • Net errors and omissions (or balancing amount).

Remember, a credit to any account moves it towards a surplus (and will be matched by a debit in another account).

Financial Account

This records movements of funds in and out of the country and can form a large part of the Balance of Payments. It is composed of:

  • Direct investments
    • Example debits: A new factory built in a foreign country, the takeover of an existing firm in another country;
    • Example credits: A foreign country building a new domestic factory or taking over a domestic firm.
  • Portfolio investments
    • Purchase and sale of government bonds. Equity purchase that does not lead to legal control of company.
  • Other investments
    • Bank deposits, bank loans and intergovernmental loans between countries.
  • Reserve assets
    • Government’s holding of gold, FX, Special Drawing rights (this is is special form of international money created by the IMF).
    • Additions to reserves are shown as debits and reductions as credits, because, for example, if the central bank sells some foreign currency, then they will gain some of their domestic currency in exchange, so there will be a flow of currency into the country.

Note: The income from the investments specified above would appear in the primary income section of the current account.

Financial Account Deficit

A deficit is not necessarily a problem – particularly because it can lead to an inflow of profits, interest and dividends in future years. It may also be short term, such as hot money flowing out of the country seeking higher interest rates in other countries.

A financial account deficit is a cause for concern if it is due to a long-term lack of confidence in the domestic country’s prospects. This can lead to capital flight, where residents transfer their money from domestic to foreign banks and firms move production overseas. This can reduce tax revenue, employment, and economic growth. It can also cause a depreciation in the exchange rate.

Financial Account Surplus

This can occur when more direct and portfolio investments enter a country than leave it. This could be due to foreigners viewing the country’s economic prospects as positive.

A financial account surplus can have advantages. It can be used to finance a deficit on the current account. It can create employment and raise economic growth.

In the long run, a financial account surplus will result in money flowing out of the country in the form of profit, interest and dividends, which could lead to a deficit on the primary income balance of the current account.

Capital Account

This is typically a small part of the Balance of Payments consisting of non-produced non-financial assets, such as government debt forgiveness, money brought into and taken out of the country by migrants, sales an purchases of copyrights, patents, trademarks and mineral rights.

Net errors and omissions

To ensure the Balance of Payments balances, this account is always necessary. It occurs due to the quantity of transactions involved meaning that 100% accuracy is hard to achieve. Over time, as quality of information improves, countries generally are able to reduce the size of this account. In theory, the net errors and omissions accounts of all countries should net out, but due to errors, this is often not the case.


Effect of Fiscal, Monetary, Supply-side, Protectionist and Exchange Rate Policies on the Balance of Payments

A government can use:

  • Contractionary fiscal or monetary policy to reduce demand for imports and encourage firms to move some of their products into the export market;
  • Supply side policies to promote greater international competitiveness;
  • Protectionist policy to replace demand for imports with demand for domestic products (e.g. introducing or increasing a tariff on foreign goods – most effective when high quality domestic substitute goods are available);
  • Exchange rate changes to influence price of exports and imports, effecting the trade balance.

Fiscal policy, monetary policy and exchange rate policy can be used either to reduce a deficit or a surplus on the current account. Supply-side policy is only used to reduce a deficit. Protectionist policy would also probably only be used to reduce a deficit.

Of course, a government pursuing a different macroeconomic policy objective, such as reducing unemployment, may use a measure such as reducing income tax that can inadvertently increase a current account deficit by increasing spending on imports.

A country trying to increase its economic development, or finance a current account deficit, may aim for a financial account surplus. This could be by attracting a foreign country to start doing business in the domestic country, which would increase employment and income growth. It could also be by selling shares in domestic firms to foreigners, allowing domestic firms to expand. Borrowing from overseas can also help cover costs of imported materials and capital goods, which can in the long-run reduce a current account deficit.

Macroeconomic stability will encourage each of the above things, and can be helped using supply-side policy (although this can take time to be effective).

  • Improving the quantity and quality of education, training, infrastructure and technology in the country will be attractive to foreign investors.
  • Trade union reform to reduce the risk of industrial action can also attract foreign companies into the country.
  • Privatisation can increase opportunities for foreign direct investment.

Task 1 – Migrant workers in South Africa

South Africa usually has a current account deficit despite having a trade in goods surplus. Its primary income balance is negative. Large inflows of portfolio investment in the past have resulted in large outflows of interest and dividends. These payments now account for over half of the current account deficit. South Africa also often has a relatively large deficit on its secondary income balance due to a large net outflow of workers’ remittances.

South Africa’s current account deficit has often led to a fall in the value of the country’s currency, the rand.

In pairs, discuss:

1.) Apart from large outflows of interest and dividend payments, two other possible causes of South Africa’s current account deficit; and

2.) Why a current account deficit might be self-correcting.

Task 2 – India’s current account deficit

India has had a deficit on the current account of its balance of payments for some time. The country spends a relatively high amount on imported oil and this contributes to a deficit on trade in goods and services. The country usually has a surplus on its trade in services, with software services exports accounting for nearly 40% of its total service exports. The country sells 90% of its software services to the USA, UK and EU. Due to workers’ remittances, the country usually has a surplus on its secondary income account. The main contributor to the current account deficit is the deficit that occurs on primary income. The country pays out large sums in profit interest and dividends arising from inflows of foreign direct investment and portfolio investment and loans.

Decide whether:

1.) India is likely to have a deficit or a surplus on its financial account; and

2.) You would recommend that India should diversify the service sector.

Section 2: Expenditure-switching and Expenditure-reducing Policies

Remember from AS level, that an expenditure switching policy is a policy tool aiming to encourage consumers to switch from purchasing foreign produced products, to purchasing domestic produced products, and an expenditure reducing policy is a policy tool aiming to reduce domestic demand, thus reducing imports and increasing exports.

Expenditure-switching policy

Most common used policies are supply-side, protectionist and exchange rate. For instance, a government could increase spending on infrastructure to reduce the cost and therefore price of domestic products, could impose import tariffs to increase the cost and therefore price of foreign products, or could instruct their central bank to lower the exchange rate, effectively reducing export prices and increasing import prices.

Expenditure-reducing policy

Both fiscal and monetary policies can be used as expenditure-reducing policy. For instance, a government could raise taxes and cut spending. A central bank could reduce the amount of money available and increase the interest rate.

Task 3

In March 2018, the Sri Lankan government announced new legislation to protect the country’s industries against unfair competition from industries in other countries, such as dumping and foreign governments subsidising their exports. The Sri Lankan government said they would investigate whether unfair practices were happening and damaging the country’s industries. They stated that if they found that the country’s industries were being harmed by unfair competition, then they would impose tariffs on the imports from the foreign industries involved.

Write a speech which explains why foreign industries might engage in dumping, including a section detailing whether it is ever justifiable for a government to subsidise its firms. We will then listen to some of these speeches to see if they are convincing.

Task 4

In small groups, prepare a presentation on what you think would be the most effective combination of policy tools to improve Georgia’s balance of payments.

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