The balance of payments - Business Environment

The balance of payments is a record of the United Kingdom’s international trade with other countries over a period of time, usually a year. It records the flows of money rather than goods, so that an import will be recorded as a negative amount since the money is flowing out of the country to pay for the good, and an export is recorded as a positive amount. Money flows into and out of the United Kingdom for two basic reasons: first, in exchange for goods and services (current transactions), and second, for investment purposes (capital transactions). These two flows are recorded separately in the UK balance of payments accounts which are produced by the government. Since 1992, when customs posts were abolished, balance of payment figures have been collected through Intra stat and are based on VAT returns.
Current transactions
The current account records the flows of money received and paid out in exchange for goods and services. It is subdivided into visible trade (the import and export of goods) and invisible trade (the import and export of services). Invisible trade includes:

  1. Services like banking, insurance, tourism.
  2. Interest, profits and dividends.
  3. Transfers, which include grants to developing countries, payments to international bodies like the EU and private transfers such as gifts.

The balance of these flows on visible trade is called the balance of trade and the balance on the current account overall is called the current balance. It is to one of these balances that journalists and politicians are usually referring when they talk about the balance of payments. Table shows the balance of payments for the United Kingdom in 2004. It can be seen that the balance of trade was –£57 944 million, the invisible balance was +£32 262 million and the current balance was £25 682 million. More will be said later about the history of the balance of payments in the United Kingdom.
Capital transactions
As well as these current transactions there are flows of money for investment purposes.
These include funds from both the public and private sectors and long-term and short-term monetary movements.
Long-term capital transactions include:

  • Overseas investment in the United Kingdom (e.g. purchase of shares, acquisition of real assets, purchase of government securities by non-residents).
  • UK private investment overseas, where UK residents buy shares, acquire real assets, and so on, in overseas countries. The capital account does not include interest, dividends or profits but only flows of money for investment purposes. A capital transaction can give rise to a current flow in the future. If a non-resident bought shares in a UK company the initial amount would appear on the capital account. The resulting flow of dividends paid in the future would be recorded as a flow on the invisible account.
  • Official long-term capital (i.e. loans from the UK government to other governments).
    Short-term transactions include:
  • Trade credit as goods are often not paid for as they are received the physical export and import of goods is not matched with an inflow or outflow of money.
    In order that the balance of payments balances, these amounts would be included here as trade credit.
  • Foreign currency borrowing and lending abroad by UK banks.
  • Exchange reserves held by other countries and other organisations in sterling.
  • Other external banking and money market liabilities in sterling.

These capital transactions are recorded in the UK balance of payments as changes from the previous year; they are not a record of all the transactions that have taken place over time. If money is flowing into the United Kingdom for investment purposes there is an increase in the UK liabilities and these are shown as positive amounts on the balance of payments. If money is flowing out of the country there is an increase in the UK assets and these are shown as negative amounts in the balance of payments.
Until 1986, capital flows to/from the private sector and capital flows to/from the public sector were shown in two separate accounts. In 1986 the format of the balance of payments was changed to show all capital transactions in one account under the heading of ‘UK transactions in external assets and liabilities’. In 1998 the format of the balance of payments was changed once more to bring it into line with the standards published in the fifth edition of the IMF Balance of Payments Manual. The UK balance of payments now comprises three sections:

  • the current account, as before;
  • the capital account, which records capital transfers and transfers of non-financial assets into and out of the UK. As Table shows, the balance on this account was £2073 million in 2004;
  • the financial account, which gives the balance of trade in financial assets. This section of the balance of payments is itself subdivided between direct investment, portfolio investment, other investments and reserve assets. The balance on the financial account for 2004 was +£27 028 million.

Speculative flows of currencies would appear in the financial account of the balance of payments. Portfolio investment is the purchasing of shares in companies while direct investment is the setting up of subsidiaries. Reserve assets shows the change in official reserves an increase in official reserves is shown as a negative amount and a decrease is shown as a positive amount.
The balance of payments overall should balance as negative flows will be balanced by positive flows. As this is often hard to understand two examples will be given.
Example 1
If a UK resident buys foreign goods there will be a negative entry in the current account equal to the value of those goods. That individual has to pay for those goods in foreign currency and could do this by using money from a foreign currency bank account if he or she has one, or by borrowing the foreign currency from a bank in that country. Either way there is an increase in the amount of liabilities and the same amount would be shown as a positive amount in the capital account.
Example 2
If a foreign investor purchased shares in a UK company, there would be a positive amount recorded in the capital account. The investor might pay for these shares by using sterling from a sterling bank account and so there would be an equal negative amount shown in the capital account.

The balance of payments should therefore always balance but invariably fails to do so, owing to errors and omissions in the recording process, and so a balancing item is included to ensure that it does. As can be seen from Tables, the balancing item can be very large, and this calls into question the accuracy of the figures.

Equilibrium in the balance of payments
If the balance of payments always balances how can there be a deficit on the balance of payments? The answer is that the media and politicians are referring to the current balance or the balance of trade rather than the overall balance of payments position. A balance of payments surplus on the current account is where the value of exports exceeds the value of imports. A deficit is where the value of imports exceeds the value of exports. As explained above, if there is a surplus on the current account, this will be matched by an outflow in the capital account, for example a reduction in the size of sterling bank balances, or an increase in official reserves. The opposite is true for a deficit. This implies that there cannot be a balance of payments problem; however, persistent surpluses or deficits on the current account are considered to be problematic. A persistent deficit has to be financed in some way, either through borrowing, to increase the external liabilities, or by selling more of its assets. A deficit will also lead to pressure on the exchange rate, as will be shown later. A continued surplus is also a problem, since one country’s surplus must mean that other countries are experiencing a deficit, and they will be faced with the problem of financing the deficit. Political pressure will be brought to bear, and there is the possibility of the introduction of tariffs or other import controls in order to reduce a deficit.
Methods of correcting balance of payments deficits
Since surpluses are not regarded as being such a problem as deficits, this section will concentrate on action needed to overcome a deficit, although the actions would be reversed for a surplus. When there is a current account deficit, the outflow of funds is greater than the inflow of funds from international trade. The authorities need to increase exports and/or reduce imports. Thus:

  1. A fall in the exchange rate will have the double effect of making exports cheaper abroad and imports dearer at home, thus encouraging exports and discouraging imports. This will be explained fully later.
  2. To increase exports British companies that produce for the export market could be subsidized. This would have the effect of reducing the price of UK goods abroad, making them more competitive.
  3. Import controls could be imposed to restrict the level of imports coming in to the country.
  4. A rise in the rate of interest would make Britain more attractive to investors and therefore increase capital flows into Britain and help offset the current account deficit.

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