Balance of Payments (Deficit)

BOP deficit caused by

- current account deficit OR - capital financial account deficit

Capital and Financial account

- direct investments - portfolio investments

Current account

- goods balance - services balance - income balance - unilateral transfers balance (govt and private)

1. expenditure reducing policy, contractionary fiscal policy effect on imports

...leads to fall in AD and fall in national income. This induces a fall in demand for imports, leading to a fall in total import expenditure. Balance of trade and current account deficit would thus be reduced. Assuming that bop is in deficit initially and there is no impact on other components of bop, this leads to a reduction in bop deficit and thus an improvement in overall bop position in the long run

1. expenditure reducing policy, contractionary fiscal policy effect on exports

...reduction in AD, reduces general price level especially if the country is near full employment level of income and thus improves the price comptitiveness of exports this makes exports cheaper and imports relatively more expensive compared to domestic goods. Assuming demand for exports and imports is price elastic, a rise in export earnings and a fall in import expenditure will reduce the balance of trade and current account deficit assuming bop is in deficit initially and there is no impact on other components of bop, this results in a reduction in bop deficit and an improvement in overall bop position in the long run

Causes of Current Account Deficit

1. Changes in global demand conditions 2. Changes in international competitiveness 3. Changes in terms of trade 4. Changes in exchange rates

POLICIES TO CORRECT BOP DEFICIT

1. Expenditure reducing policies (contractionary fiscal policy and contractionary monetary policy) 2. Expenditure switching policies (exchange rate policy, import controls) 3. Supply side policies (lower cost of production, boost productivity)

Causes of Capital and Financial Account deficit

1. changes in interest rate 2. changes in exchange rate 3. changes in international competitiveness 4. changes in global demand conditions

Limitation on economy - external debt

2. worsen external debt servicing problem the country may have borrowed in foreign currencies. When its currency depreciates, the size of its external debt in foreign currency remains the same but the amount of domestic currency needed to service the same debt will increase

Limitation on economy - redistribution of incomes

3. redistribution of incomes depreciation benefits those in export and import-competing sectors but imposes losses on non-trading sector (domestic consumption sector) this is due to increased prices that must be paid for the traded goods with no compensating increase in income in the non-trading sector

Limitation on economy - speculation

4. speculation speculators may take advantage of the situation by selling large sums of depreciated currency in anticipation of further depreciation. this can increase the bop deficit (outflow of hot money from KFA)

Balance of Payments Deficit

A bop deficit occurs when the total international receipts of a nation from abroad are less than its total international payments to abroad over a period of time

Impact on government 1. impact on other macroeconomic aims

A fall in investment level and production level will lead to rising unemployment in the economy as firms reduce their demand for factors of production including labour. This further triggers contraction in both consumption and investment expenditure, further slowing down economic growth as consumer and investor confidence deteriorates

Favourable balance of payments position

A favourable bop position indicates avoidance of large or persistent bop deficit/surplus - prevents foreign reserves from depleting - ensures a more stable exchange rate of the country's currency to promote higher volume of trade and FDI in country

Changes to exchange rates - depreciation

A persistent balance of payments deficit results in a depreciation of the country's currency due to a fall in demand for and increase in supply of the domestic currency in forex market With this depreciation, imported inflation may result if economy is heavily dependent on imports, leading to higher cost of living and higher cost of production. Detrimental to both actual and potential economic growth

Effect of a contractionary monetary policy on imports

A rise in interest rate makes it more costly to borrow money for consumption and investment. This reduces the level of consumption and investment and consequently the level of national income, inducing a fall in demand for imports hence there is a fall in total import expenditure, balance of trade and current account deficit would thus be reduced assuming balance of payment is in deficit initially and there is no impact on other components of bop, this reduces bop deficit and improves overall bop position in the long run

Balance of Payments

A summary record of all the international transactions between residents of a country and the rest of the world over a period of time, usually one year

deficit

Assuming balance of trade and current account are in equilibrium initially, a fall in export earnings and a rise in import expenditure will bring about a balance of trade and current account deficit. Assuming no impact on the other components of balance of payments, this results in balance of payments deficit

deficit

Assuming balance of trade and current account are in equilibrium initially, a fall in export earnings will bring about a balance of trade and current account deficit Assuming there is no impact on other components of balance of payments, this results in a balance of payments deficit Global Recession - US sub-prime mortgage crisis that led to financial crisis and subsequent recession in 2008

deficit

Assuming both balance of trade and current account are in equilibrium initially, a rise in import expenditure will bring about a balance of trade deficit and current account deficit Assuming no impact on other components of balance of payments, this results in balance of payments deficit.

deficit

Assuming both balance of trade and current account is in equilibrium initially, a fall in export earnings and a rise in import expenditure will bring about a balance of trade and current account deficit. Assuming there is no impact on the other components of balance of payments, this results in a bop deficit

outflow of hot money -> deficit

Assuming capital and financial account is initially in equilibrium, such outflow of "hot money" will bring about a capital and financial account deficit Assuming there is no impact on the other components of balance of payments, this results in a bop deficit

deficit improvement

Assuming no impact on other components of balance of payments, this results in reduction of bop deficit and improvement in overall bop position in the long run

deficit

Assuming that a country's balance of trade and current account was initially in equilibrium and Assuming demand for imports and exports is price elastic, an improvement in terms of trade could cause a balance of trade and current account deficit. Assuming no impact on other components of BOP, this results in BOP deficit

deficit

Assuming that demand for exports is price elastic, this leads to a more than proportionate fall in quantity demanded of exports, leading to fall in export revenue Assuming that demand for imports is price elastic, this leads to a more than proportionate increase in quantity demanded for imports and a rise in import expenditure Assuming that balance of trade and current account was initially in equilibrium, the fall in export revenue and rise in import expenditure will result in balance of trade and current account deficit Assuming no other impact on other components of bop, this results in balance of payments deficit

outflow of hot money -> deficit

Assuming the capital and financial account is in equilibrium initially, such outflow of "hot" money brings about a capital and financial account deficit. Assuming there is no impact on the other components of bop, this results in a bop deficit.

outflow of FDI -> deficit

Assuming the capital and financial account is in equilibrium initially, such outflow of capital brings about a capital and financial account deficit Assuming there is no impact on other components of bop, this results in a bop deficit

outflow of capital -> deficit

Assuming the capital and financial account is initially in equilibrium, such outflow of capital brings about a capital and financial account deficit. Assuming no impact on other components of balance of payments account, this results in bop deficit

deficit improvement

Assuming there is no impact on other components of balance of payments, this results in reduction of bop deficit and thus improvement in overall bop position in the long run

Short term flows 1. Changes in interest rates (fall)

Ceteris paribus, a fall in interest rates in a country relative to those in other countries will result in short-term capital outflow as financial institutions/individuals choose to place their funds in countries that can offer higher interest rates

2. Changes in international competitiveness

Consumers in a country with higher domestic inflation relative to its trading partners will find its domestic goods relatively more expensive compared to imported goods and its exports relatively more expensive than its trading rivals This causes consumers to switch from domestic goods to imports, as demand for import rises, import expenditure rises. Assuming that the demand for exports is price elastic, a rise in export prices leads to a more than proportionate fall in quantity demanded of exports, resulting in a fall in export revenue.

Rising income of domestic economy

Conversely, rising national income of domestic economy due to strong economic performance (eg. rapid economic growth in China) increases household's purchasing power and consumption expenditure. Demand for imports and hence import expenditure will rise.

Limitation on economy - inflation

Depreciation may bring about undesirable effects on the economy 1. inflation rise in import prices can lead to cost-push inflation, rise in demand for exports can ead to demand-pull inflation. Especially so when country is highly dependent on imports and near full employment level of income. Inflation reduces the real incomes of citizens, leading to lower material sol

Limitations

Depreciation will increase the country's volume of exports and prompt foreign countries to retaliate by depreciating their currencies or imposing trade barriers to discourage consumption of exports of the country that depreciated its currency

Affected by changes in supply conditions

Eg. The aftermath of earthquake and tsunami that struck Japan in 2011 caused the productive capacity of the Japanese economy to be reduced due to damages This reduction in availability of factors of production would drive up costs of production and lead to higher prices of exports. Assuming no change in import prices, this leads to an improvement in Japan's terms of trade

Long term 1. Changes in international competitiveness

Factors such as higher labour cost, rising rentals, higher energy prices of slow gains in productivity could result in rising average cost of production. This can result due to a change in government policy or rising import prices of raw materials or energy and lead to a fall in export competitiveness. Foreign investors take into account COP, govt subsidies, political stability and tax policies of the country before deciding on the best investment destination. The level of investment depends on the expected rate of return to investment. If expected rate of return falls relative to that in other countries, this may result in an increase in net FDI outflow

Limitation

Firms may not be willing to send workers for training as there is loss of output during training. Firms may also underestimate true benefits of education and training hence amount of training undertaken may be less than socially optimal. Workers may face difficulties in learning new skills, especially the older ones

1. changes in global demand conditions

Global recession causes national income of trading partners to fall, this leads to a fall in purchasing power and demand for imports from trading partners. This decreases export revenue of a country.

Export incentives

Govt can give export incenties like tax exemption on exporting industries and investment grants to help export sector to modernise and increase efficency, increasing volume of exports. This will increase export revenue and reduce balance of trade and current account deficit. Assuming no impact on other components of balance of payments, this results in reduction in balance of payments deficit and thus an improvement in overall balance of payments position in the long run

Process innovation

Govt can provide subsidies for R&D. Firm can be encouraged to undertake R&D in areas of process innovation or product development. Process innovation is the implementation of a new or slightly improved production or delivery method. Includes significant changes in techniques, equipment, etc. Leads to more efficient ways of producing existing products or delivering existing services -> reduced COP -> makes exports more price competitive -> increase in QD of exports -> increase export revenue and reduce balance of trade and current account deficit Assuming no impact on other components of bop, results in reduction in balance of payments deficit and thus an improvement in overall bop position in the long run

Contractionary monetary policy effect on hot money

Higher interest rates will lead to short term capital inflows as foreign residents will want to earn the higher interest income from their funds, this leads to a reduction in capital and financial account deficit assuming balance of payments is initially in deficit and there is no impact on the other components of balance of payments, this results in a reduction in bop deficit and thus improvement in overall bop position in the long run

Exchange rate policy

If the currency is under managed float exchange rate system, central bank can choose to depreciate currency This will make exports cheaper in terms of foreign currency and imports more expensive in terms of domestic currency. Assuming demand for imports and exports are price sensitive, this leads to increase in QD of exports and decrease in QD of imports. Balance of trade deficit and current account deficit will be reduced. Assuming there is no impact on other components of bop, this leads to a reduction in bop deficit and an improvement in overall bop position in the long run

Official reserves

If there is net currency inflow - lend to IMF/other central banks - repayment of past loans - adding to official foreign reserves If there is net currency outflow - borrow from IMF/other central banks - drawing on foreign exchange assets

2. Quotas

Import quotas limit the volume or supply of imports by specifying the max amt of a foreign produced good that is permitted into the country over a specified period of time. This reduces the supply of imported good in the country, causing its price to rise and leading to a fall in consumption of imported good. On the other hand, the demand for domestically produced import substitute will rise, reducing import expenditure and reducing balance of trade and current account deficit. Assuming no impact on the other components of bop, this results in reduction in bop deficit and thus improvement in overall bop position in the long run

4. Changes in exchange rates

In flexible exchange rate or managed float regime, when currency appreciates, price of exports in terms of foreign currency becomes relatively higher and price of imports in terms of domestic currency becomes relatively lower.

Limitation of Import controls policy

Leads to distortion in resource allocation which leads to inefficiency, breeds inefficient domestic producers because of reduced competition from abroad. There will be little incentive for domestic producers to seek more efficient methods of productions to reduce price of goods. In addition, welfare of citizen is reduced because import controls distort market forces, resulting in higher domestic prices and prevents consumers from benefiting for all the advantages of international specialization and trade (better quality and lower prices)

Limitation

May result in retaliation and trade wars as other countries whose exports were affected by given country's policies may similarly impose restriction on the country's exports of goods or services. This could lead to a decline in opportunities for export led growth for countries involved in dispute

Is bop deficit always a cause for concern?

Not likely. Depends on - size - duration (persistent vs short term) - causes (due to loss of competitiveness of country's exports -> bad. due to large amounts of investments from abroad or purchase of capital equipment-> it ok)

Product development

Product development involves the launching of new/improved goods or services to the market which will improve a country's export non-price competitiveness Eg. Singapore's MILO B-Smart and Maggie Low Fat Noodles -> leads to her exports being more competitive -> QD of export increase -> increase export revenue -> reduce balance of trade and current account deficit in addition, demand for imports will fall as domestically produced goods are more attractive relative to foreign goods. With reduction in import expenditure, balance of trade and current account deficit will be reduced

productivity

Productivity is an economic measure of output per unit of input. Lower gains in productivity in a country relative to other countries leads to relatively higher costs of production and higher export prices. Assuming demand for exports is price elastic, quantity demanded of exports will fall more than proportionately when export prices rise, causing export earnings to fall. At the same time, imports are relatively cheaper compared to domestic goods. Leading to an increase in quantity demanded of imports and rise in import expenditure

budget

Spending on subsidies on training and incentives for R&D may drain govt resources, diverting resources away from other areas of competing needs

Import controls (protectionist measures) 1. Tarriffs

Tarrifs or import duties discourage expenditure on imports by increasing the price of imports. This causes the QD for imported good to be reduced and makes domestically produced goods that are substitutes for imported good relatively cheaper. This reduces import expenditure and reduce bop and current account deficit Assuming no impact on other components of bop, this results in reduction in bop deficit and improvement in overall bop position

3. Changes in terms of trade

Terms of trade refers to the ammount of domestically produced goods that must be given up in exchange for one unit of foreign good. Average price of exports/Average price of imports x 100% An improvement in terms of trade means that the country is able to obtain more foreign goods for the same quantity of domestically produced goods exported

Impact on producers

The fall in consumption by households causes firms to decrease production further. Producers will expect lower demand for their goods and services and lose confidence and reduce investment expenditure.

Impact on conumers

The fall in national income induces a fall in consumption by households because households have lower purchasing power. A lower level of consumption could lead to a fall in household's material standard of living With lower household income, the level of household savings would fall. Since households have to spend a larger proportion of their disposable income to maintain their existing level of consumption of necessities, the level of savings falls. Alternatively, should households feel pessimistic about the economic outlook, they may decide to save more in anticipation of the possibility of a further reduction in income in the future

Limitations

The policy for currency depreciation assumes that demand for imports and exports are price elastic. In reality, demand for exports and imports tend to be price inelastic in the short run due to contractual obligations as well as the need for time to source for substitutes and change consumption patterns. Thus, this depreciation may actually increase the balance of trade and current account deficit in the short run.

Time lag

Time lag in implementation of supply side policies which may compromise its effectiveness as economic conditions are very dynamic. Even so, such policies must still be undertaken to ensure long term improvement in country's BOP

SUPPLY SIDE POLICIES

To reduce the bop deficit, government can introduce measures to lower COP and boost productivity of factors of production.

3. Embargoes

Total government bans on certain imports. Causes the demand for domestically produced import substitute to rise. This reduces import expenditure and reduces balance of trade and current account deficit. Assuming there is no impact on other components of bop, this reduces bop deficit and thus an improves overall bop position in the long run

2. depletion of foreign exchange reserves

When a country has a balance of payments deficit it has to use its gold and foreign currency reserves to finance the deficit. Eg. 1996/7 Thailand, Asian Financial Crisis

3. rise in external debt

When a country runs out of means to finance its deficit it will have to borrow from international organisations such as International Monetary Fund or other countries. Thus they incur external debt. Rising external debt indicates that an increasing share of future domestic incomes must be paid out to foreigners to service the debt and leads to huge opportunity cost. Money could have otherwise been used to improve productive capacity or promote economic growth

2. Changes in exchange rates

When domestic currency depreciates or is expected to depreciate, capital flight may take place because investors do not want to hold on to a currency whose value is falling or likely to fall. This results in short-term capital outflow.

4. Changes in global demand conditions

With global recession and consequent reduction in consumption by households in both foreign and domestic sectors, producers and exporters face lower demand for their goods and hence the level of investment from abroad will be reduced. lower demand -> less profitable to invest as lower expected rate of return

Consequences of balance of payments deficit

has a contractionary effect on economy eg. a bop deficit due to fall in export earnings and rise in import expenditure reduces the level of AD assuming the economy is at or near full employment, this fall in AD causes a fall in national output, fall in gpl and increase in unemployment. Initial fall due to fall in net exports leads to a greater decrease in national income via the multiplier process and negative economic growth

Expenditure switching policy

implemented to switch expenditure of domestic consumers away from imports towards domestically produced goods

Skillsfuture

improves the quality of labour force -> raise labour productivity -> leads to rise in LRAS additionally, assuming increase in labour productivity leads to fall in per unit labour cost -> cop decreases -> rise in SRAS this leads to a fall in gpl -> rise in price competitiveness of exports -> increase export revenue and reduce balance of trade and current account deficit

Evaluation of expenditure reducing policies

the use of expenditure reducing policy to reduce bop deficit is most appropriate when inflation is the cause of deficit because such a policy has a dampening effect on the general price level can improve the bop position but tends to increase unemployment and cause a fall in national income due to its contractionary effect hence it may conflict with the macroeconomic objectives of economic growth and full employment, especially if the country is already experiencing recession an expenditure reducing policy to reduce gpl and export prices may not necessarily increase revenue from exports if the demand for exports is price inelastic the effectiveness of expenditure reducing policy is also largely dependent on the nature of imports