Balance of Payments & Trade Blocs: Economics Guide

Posted on Sep 6, 2024 in Economy

Balance of Payments (BOP)

BOP records economic transactions between residents of one country and all other countries.

Current Account

Relates to income and payment flows.

• Trade in goods (X-M): X (credit) represents exports, M (debit) represents imports.
• Trade in services (X-M)
• Income from investment
• Current transfers: No exchange of goods and services.

Current Account Surplus (abcd > 0)

Inflow of money from export revenue, trade in services, investment income, and incoming transfers is larger than the outflow of money from import expenditure, trade in services, income sent abroad, and outgoing transfers.

Current Account Deficit (abcd < 0)

Inflow < outflow

Capital Account

Relates to transactions of capital assets.

• Capital transfers: Transactions involving transfers of ownership of fixed assets.
• Transactions of non-produced and non-financial assets: Transactions of branding value/patents.

Financial Account

Relates to transactions of financial assets.

• FDI: Long-term investment made by MNCs/foreign investors in overseas countries.
• Portfolio investment: Short-term investment (stocks, savings).
• Reserve assets

Assume no change in the capital account. Current account deficit implies a financial account surplus. Current account surplus implies a financial account deficit.

Consequences of Current Account Deficit

1. Downward pressure on domestic currency: Demand for the country’s exports decreases, demand for domestic currency decreases, depreciation pressure, the price of imports (in domestic currency) increases, the cost of imported raw materials increases, the cost of production increases, inflationary pressure.
2. Upward pressure on interest rates: The government may need to maintain high-interest rates to reduce inflation. Higher interest rates reduce aggregate demand (AD) and reduce economic growth (EG).
3. Increased foreign ownership of domestic assets: The current account deficit is financed with a financial account surplus, implying increased incoming FDI and increased foreigners’ purchases of domestic assets. Many income-generating assets are owned by foreigners, and the income generated may be sent overseas instead of being invested domestically.
4. Indebtedness: The current account deficit is financed with a financial account surplus. If there is not enough incoming FDI/portfolio investment, the government may need to finance the current account deficit by depleting reserve assets or borrowing from other countries/the IMF, leading to indebtedness.
5. Reduction in international credit rating: Indebtedness reflects the lower ability of the government to repay its debt. International credit rating agencies would lower the rating of the government bond, reducing the government’s ability to generate funds through selling bonds.

Evaluation of Current Account Deficit

1. Current account deficit may be automatically corrected: The price of exports (in foreign currency) decreases, demand for exports increases, export revenue increases, imports decrease (given that the Marshall-Lerner condition is satisfied), and the trade balance (X-M) increases, correcting the current account deficit.
2. Higher interest rates may prevent the domestic currency from dropping to a damaging level.
3. Incoming FDI can fuel economic growth: FDI is a type of investment that increases AD and creates job opportunities. It may not bring as much harm as expected.
4. Whether the current account deficit is problematic depends on how the country finances it: Some countries can attract enough incoming FDI/portfolio investment, causing a financial account surplus without depleting reserve assets.

Monetary Policy

The use of adjusting interest rates and money supply by the Central Bank to affect AD and achieve macroeconomic objectives.

Since the demand for commodities is inelastic, a decrease in commodity prices causes a proportionately smaller increase in quantity demanded. The reduction in revenue due to lower prices is larger than the gain in total revenue due to higher quantity demanded. The export revenue would decrease from P1 x Q1 to P2 x Q2.

Direct/portfolio investment: Involves the purchase of foreign assets in another country, e.g., property, stock, which are components of the financial account.

Income from investment: Involves income generated from investment in another country, e.g., rent gained from property, dividends gained from stock, which is a component of the current account.

Contractionary Monetary Policy

Implemented by raising interest rates or reducing the money supply. Higher interest rates increase the cost of borrowing, leading households and firms to borrow less to consume and invest, reducing consumption expenditure and investment expenditure. Since consumption and investment are components of AD, it causes AD to decrease. The aggregate price level decreases, slowing down inflation. Real GDP decreases, slowing down economic growth.

Methods to Correct Current Account Deficit

Increase export revenue and decrease import expenditure.

1) Expenditure Switching Policies

Aim: Switch expenditure from imported goods to domestic goods.

Way: Protectionist measures (e.g., tariffs).

Tariff: Increases import price, reduces demand for imports, and reduces import expenditure.

Cons: Risk of retaliation – trading partners may impose similar measures on the country’s exports, reducing export revenue. The cost of imported raw materials would increase, and some exporters rely on cheap imported raw materials. Imposing tariffs may increase the cost of production, reducing export competitiveness and harming export revenue.

2) Expenditure Reducing Policies

Aim: Reduce expenditure on imports.

Way: Reduce spending by reducing AD through contractionary demand-side policies.

Fiscal policy: Increase income tax/corporation tax, reduce consumption and investment, reduce government spending, and reduce AD.

Monetary policy: Increase interest rates/reduce money supply, leading to a higher cost of borrowing, reducing consumption and investment, and reducing AD.

Cons: Lower real GDP and lower economic growth, conflicting with another macroeconomic objective (maintain economic growth).

Limitation: Time lag – it takes time for people to adjust to changes in taxation/interest rates; they may not reduce their spending immediately. There is a time lag between the implementation of the policy and the effects being seen. It only works in the long run.

3) Supply-Side Policy

Aim: Improve export revenue by increasing export competitiveness.

Way: Supply-side policies to increase efficiency.

Market-oriented policy: Competition-based, reduce regulation, make it easier for firms to start up, increase competition in the market, give firms a higher incentive to increase their efficiency, reduce the cost of production, and improve the quality of exports.

Interventionist policy: Investment in education and technology increases productivity.

Con: Competition may lead to less competitive firms shutting down. Interventionist policies have an opportunity cost of government spending.

Limitation: Time lag.

4) Exchange Rate Policy (Expenditure Switching)

Devaluation: The price of exports (in foreign currency) decreases, demand for exports increases, and export revenue increases. The price of imports (in domestic currency) increases, demand for imports decreases, and import expenditure decreases.

Limitation: Whether devaluation can improve the current account deficit depends on the size of the price elasticity of demand (PED) for exports and imports. It only works when the Marshall-Lerner condition is satisfied, that PED (X) + PED (M) > 1.

In the short run, the Marshall-Lerner condition may not be satisfied, as there is a time lag for people to adjust to the change in the exchange rate. When the government starts to devalue the currency, devaluation could worsen the current account deficit. The policy would only work in the long run when the Marshall-Lerner condition is satisfied (J-curve).

Trade Blocs

Member countries form a trade agreement to promote trade by eliminating trade barriers.

Level 0: Preferential Trade Agreement

Gives preferential access to certain products by certain countries by eliminating trade barriers.

• Bilateral: Between two countries, e.g., CEPA between Hong Kong and China.
• Multilateral: Among more than two countries, e.g., WTO.

Level 1: Free Trade Area

A trade bloc where members eliminate tariffs on most goods (if not all) while individual members can retain their own external policies.

Level 2: Customs Union

Level 1 + members follow a common external policy (set higher tariffs on imports from non-members).

Level 3: Common Market

Level 2 + allows the free movement of factors of production among member countries.

Level 4: Monetary Union

Level 3 + common central bank + common currency, e.g., Eurozone.

Pros of Trading Agreements

1. Increased competition from foreign imports: Increasing efficiency.
2. Trade creation: When members form trading blocs, they eliminate tariffs placed on imports, increasing the quantity of imports and the amount of trade. More trade is created between members. More efficient member countries replace less efficient domestic producers, leading to economies of scale (lower average costs and increased quantity).

Cons of Trading Agreements

1. Import-competing sectors may suffer from intense competition.
2. Unemployment.
3. Imports may increase, potentially worsening the current account balance.
4. Trade diversion (for customs unions and above): A member country may switch from trading with a more efficient non-member country to a less efficient member country due to the common external tariff. This can lead to a loss of overall economic efficiency.