The Balance of Payments, Exchange Rates Elasticity and Inflation - 031103

This Mind your Business article looks at The Balance of Payments, Exchange Rates, Elasticity and Inflation .

Mind your Business - 17 November 2003

The Balance of Payments, Exchange Rates, Elasticity and Inflation

The News

The Balance of Payments:
The UK balance of payments on current account stood at - £18,965 billion in 2002. Figures released this week suggest that this might get worse by the end of 2003 as the trade deficit widened to £4.8 billion during September. Factors contributing to the figures included increased imports of cars and oil coupled with reduced exports of North Sea oil, consumer, intermediate and semi-manufactured goods. The weaker export figures highlight the problems that manufacturers continue to face in competing with firms from other countries whilst the concern over the growing debt mountain in the UK helps to fuel the import figures.

As is normally expected, there was a surplus on the trade in services of £0.9 billion leaving the overall trade balance for the month at -£3.9 billion. The exchange rate is an important factor in trade; the value of sterling (GBP) against both the Euro and the $ ( US Dollar) rose during October - around $1.66 to the pound to nearly $1.70 and €1.41 to the pound to €1.46. The value against the dollar has dropped sharply in the first two weeks of November and is back down to the $1.67 mark. Such changes may not seem very much but for traders dealing in millions of pounds this can make a significant difference.

UK balance of trade figures

Monthly Balance of Trade figures.
Source:http://www.statistics.gov.uk/cci/nugget.asp?id=199 Reproduced under license from HMSO.

Does the balance of payments matter? Some would argue that what matters are what we are buying and selling as this can have an effect on our future productivity. If, for example, we are buying capital equipment, this could be used for future production and as such could be seen as investment and not be a cause for concern whereas if we are buying finished consumer goods this could present more of a problem.

Some point to the fact that the UK economy is like a household account - if you continually spend more than you earn eventually you are going to have to do something pretty drastic to solve the problem. Ultimately this means borrowing from abroad or running down gold and foreign currency reserves - and these are not exhaustive!

Other concerns relate to the link between the balance of payments and the exchange rate. If we continue to run a deficit then pressure on the pound to fall will continue and this could impact on inflation all of which may lead the Bank of England to be more likely to repeat the increase in interest rates that was witnessed during November. On the other hand, foreign exchange dealers might look at the fall in manufacturing and feel that the Bank of England are unlikely to make matters worse by pushing up rates too far and as a result decide to sell pounds to put funds in economies where interest rates are more attractive.

The links between all these economic concepts are extremely complex but understanding the main threads is vital to building an understanding of the economy as a whole for students of both economics and business studies.

Theories

The Balance of Payments: This is a measure of the extent of trade between the United Kingdom (UK) and the rest of the world. This trade is referred to as imports and exports, which in balance of payments accounting is looked at in terms of the change of ownership of resources linked to the payment for the change of ownership.

  • Imports represent the purchase of items from abroad that result in sterling being sold to acquire the foreign currency used to purchase the item. This is recorded as an outflow of funds.
  • Exports are the sale of items to other countries leading to sterling being purchased by foreign buyers to complete the transaction. This is recorded as an inflow of funds.

It is important to think of imports and exports in terms of the flow of funds as it helps to avoid the confusion that can arise when thinking of goods and services being traded. For example, a foreign tourist coming to visit Britain represents export earnings to the UK as they are changing their currency to spend sterling whilst on their visit. In summary, exports lead to a demand for sterling on the foreign exchange markets and imports lead to an increase in supply of sterling on the foreign exchange markets.

The trade is divided into different categories.

  • Trade in goods records the import and export of items such as cars, animals, timber, minerals, chemicals, food, textiles, glass, leather products, paper products, fuels, plastics, metal products, machinery, weapons, electrical goods, transport equipment, sports goods, watches and waste products amongst others! The difference between the value of imports and the value of exports is called the 'Balance of Trade' or the 'Trade in Goods'.
  • Trade in services records transactions in what used to be referred to as 'invisible trade' - the 'invisible' term aiming to describe the non-physical nature of the trade. Such transactions may include transportation - payments made to a haulage contractor to deliver goods abroad; the hire by a UK company of a freight ship to transport items; the payments made to use an aircraft for transporting items; payments to use pipelines or cables; travel by foreign visitors or by UK residents to other countries; the purchase and sale of communication services, insurance, financial and banking services; royalty payments; government services, license fees, payments for the use of TV programmes and so on.
  • Income flows measure the payments and receipts of dividends and interest and financial flows measure the payment and receipt of funds associated with investments in shares, loans and other securities.

Together all these inflows and outflows comprise the balance of payments on Current Account. It is this figure that comprises the major bulk of the balance of payments but often the trade figures highlighted will relate just to the trade in goods and services as this serves to illustrate the key trends in our trading patterns.

Balance of Payments on Current Account
Figures for the Balance of Payments on Current Account for the UK: 2001 - 2003.
Source: http://www.statistics.gov.uk/pdfdir/bop0903.pdf
Reproduced under license from HMSO

The final part of the balance of payments is the capital account. This records the transfers of funds. They might include foreign aid, funds brought by migrants to the UK, money received from the EU Regional Fund and funds from the purchase and sale of assets and liabilities including so called 'debt forgiveness'.

The Exchange Rate is the value of one currency expressed in terms of another - for example, £1 = $1.60. The exchange rate is determined by the demand for and supply of sterling on the foreign exchange markets. Note, it is NOT the same as the supply of money in circulation! The foreign exchange market exists to enable those who wish to buy foreign currency to 'meet' with those who wish to sell it. Currency exchange markets are truly global, in any one-day around $1.5 trillion worth of currencies are traded. A trillion is one thousand billion! So that is $1,500,000,000,000 or £900,000,000,000 traded every day world wide! This is almost as much as UK Gross Domestic Product (GDP) in a year. A large proportion - possibly as much as 70 - 80% of this trade is for speculative purposes rather than to finance trade; brokers simply moving funds from one financial centre to another in search of the best return on behalf of clients. Increases in the demand for GBP leads to an appreciation of sterling - each £1 will buy more of the foreign currency than previously whereas if the supply of GBP exceeds the demand, sterling will depreciate - each £1 will buy less of a foreign currency than before.

Changes in the exchange rate have an effect on the apparent prices of imports and exports. The term 'apparent' is used because the price in the originating country may not have changed but for the buyer or seller the fact that they may have to give up more of their own currency to acquire the same amount of pounds, or if they can get the same amount of the foreign currency by giving up less pounds, then prices will appear to change. An appreciation or strengthening of a currency will have the effect of reducing import prices, but increasing export prices, whereas a depreciation of the currency (a weakening) will lead to import prices rising but export prices appearing to fall. The impact on the economy as a whole and of individual businesses therefore depends on the amount of trade they carry out with the rest of the world and the proportion of that trade that is accounted for by exports and imports. A firm may, for example, buy in some component parts from China but sell the vast majority of its output in Europe. What is happening to the exchange rate between the Yuan and the Euro will have a significant effect on its overall position.

  • Appreciation of the £ - buys more of a foreign currency; Import prices fall; Export prices rise.
  • Depreciation of the £ - buys less of a foreign currency; Import prices rise; Export prices fall.

Exchange Rate of GBP (£) against US $
The value of the £ sterling (GBP) against the United States dollar ($) 2000 - 2003.
Source:http://www.statistics.gov.uk/

Because the UK is a relatively small island, we do tend to rely on importing raw materials and component parts for business. If the exchange rate weakens, this means that import prices rise and, other things being equal, could lead to an increase in business costs. This could have inflationary consequences if firms pass on the increased costs in the form of higher prices to customers. Alternatively, businesses may resist putting prices up but may have to accept lower profit margins or find ways of reducing costs elsewhere.

There is also a close link between the trade deficit and the state of the economy. In times of economic growth, there is a relatively high level of demand - some of which will be demand for goods from abroad. At the same time, exporters may recognise that there is a buoyant demand in the UK and switch sales from export markets to those in the domestic market. The net effect is for exports to fall and imports to rise thus contributing to the widening of the deficit. The issue is made all the more complex because the traditional theoretical explanation can be rendered inaccurate because of the impact of the price elasticity of demand for imports and exports.

In theory, if the exchange rate weakens, this would be a boost to UK exports whereas import prices rising would dampen demand for imports. As a result the trade deficit would narrow. But we need to distinguish between the amount traded (volume) and the payments or earnings from trade. If the price elasticity of demand for imports was inelastic, then an apparent rise in the price of imports of, say 10%, would lead to a fall in demand of less than 10%, total expenditure on imports would actually rise, and assuming other things remained equal, the trade deficit would get worse not better! The activity will try to help you make sense of some of these relationships.

Questions

Consider the following scenario and outline how you would categorise the various transactions that occur in terms of Balance of Payments accounting.

Sue works for a company of management consultants in Glasgow, Scotland. Her work involves offering advice and generating solutions for companies who have various problems. She is currently working with a salvage firm, A.P. McBride, who specialise in dismantling and recycling waste materials from ships, container vessels, oil platforms and so on. The company are currently dealing with a particularly tricky contract for a Norwegian oil company. Sue travels to Norway three times a month staying in an Oslo hotel for two nights at a time whilst she discusses issues with the Norwegian company. The company have purchased shares in McBride's and have close links with them.

Part of the problem has been ensuring sufficient insurance cover for the work. Sue has been in contact with a UK firm of insurance brokers based at Lloyds of London who have arranged an initial insurance deal with a US firm. In order to ensure fuller protection, the risk has been re-insured with a Greek company. McBride's work involves a variety of other businesses throughout the world; once the equipment has been broken up they sell some of the steel to a German manufacturer who recycles it. Some of the more toxic waste is shipped via a Panamanian vessel to Poland where it is re-processed. McBrides have been trying to expand and have managed to secure a loan from a merchant bank in Holland, in Euro, at very competitive rates. McBride's next big contract starts in the new year when they have negotiated an agreement to take storage vessels from a defunct chemical works in Finland for dismantling. Ships from Denmark will be landing with the cargo in February.

Storage vessels
Example of the type of vessels McBrides will be dismantling.

Sue's excellent work with McBride's has been recognised by a Russian salvage firm and she is going to spend 3 months at the beginning of next year living in St Petersburg offering advice to that company. She has arranged for a new bank account to be set up in Russia where she has deposited US $10,000. Her salary will be paid into her UK bank account by the Russian firm on completion of her contract. Her company has leased a flat for her opposite the Winter Palace and she has been to see the British Embassy on a recent pre-visit to St Petersburg who have explained a number of important points to her about living and working in Russia. Sue was very impressed with the building, owned by the UK government, in which the embassy staff worked and is looking forward to her new challenge.

Consider the data below - the figures have been simplified considerably! Use your knowledge of how the balance of payments is constructed to complete the table. For simplicity, assume that the UK only trades with the US, and that the exchange rate is £1 = $2. Note we have additionally ignored the value of income flows to maintain the simplicity.

  Quantity Price in originating country Value (£)
Import of Goods 10,000 $5  
Export of Goods 5,000 40p  
Balance of Trade  
Import of Services 10,000 $2  
Export of Services 12,000 60p  
Balance of Payments on Current Account  

Having completed the table above, now assess the impact on the current account given the following information and assuming that the exchange rate changes to £1 = $1.5

  • Price Elasticity of Demand for import of goods = -0.4
  • Price Elasticity of Demand for export of goods = -1.2
  • Price Elasticity of Demand for import of services = -1.4
  • Price Elasticity of Demand for import of services = -0.8

Study the tables showing the balance of payments on current account from 2001 to 2003 and the £/$ exchange rate.

  1. Given the movement of the exchange rate, what would you have expected to happen to the current account? Does the trend for the current account support or go against the theory?
  2. What other factors could have affected the pattern of the current account?
  3. If interest rates are raised in the UK but not in other major financial centres, what would you predict would happen to the current account? What influence would the degree of price elasticity of demand have on your answer?
  4. What impact does the fact that a high proportion of currency dealings each day, are to finance speculative dealings rather than trade, have on the theory of the benefits of a floating exchange rate?

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