Saturday, November 29, 2008

Balance of Payments Statistics - Should We Worry?

UK Current account deficit. Source: ONS

With unemployment rising and national debt heading towards the £1 trillion mark, very little attention is being given to the UK's current account deficit. Many people struggle to understand what the current account deficit actually is. (My economic students often erroneously assume a current account deficit means the government is borrowing from abroad) A current account deficit means the value of imports of goods and services is greater than our exports.

A current account deficit means more foreign currency is leaving the economy than coming in. Therefore, we need to finance this current account deficit by having a surplus on the capital and financial accounts. This involves savings in UK banks, hot money flows and long term investment.

To give a simple example, if we have a trade deficit and are importing Chinese toys. The Chinese may use their export revenue to buy British government securities or save in British banks. Therefore, we gain the foreign currency to be able to afford the Chinese imports.
  • Therefore, some argue that in an era of global capital flows, a current account deficit is nothing to worry about. A country like the UK can easily attract capital flows and investment and this will finance the deficit. If we can't attract the necessary capital flows, the Pound will devalue and this devaluation will change the terms of trade to improve the current account.
  • Furthermore, you could argue that these capital flows are beneficial. For example, Japanese investment in building new factories in the UK provides a boost not only on the Balance of Payments but also in increasing productive capacity.
  • A current account deficit also helps to improve living standards because consumption levels are higher.
  • The Credit crunch shows that the hope of free flowing capital can soon coming crashing to an end. - Just look at Iceland. Iceland were running a current account deficit of over 7% of GDP. This was fine whilst international investors were willing to save in Icelandic banks. But, the credit crunch caused people to withdraw their money away from Iceland. As people withdrew their capital the Icelandic Krona collapsed causing a loss of confidence in economy and reducing living standards.
  • A current account deficit can lead to higher interest rates. To attract hot money flows and keep money in the country, Iceland and Hungary have had to keep interest rates high. This leads to lower growth and higher borrowing.
  • With a large current account deficit, the country always faces the possibility of a large devaluation. Devaluation in the currency can be damaging because it will:
  1. lead to inflation
  2. higher price of imports and cost of living
  3. loss of confidence in the economy.
Of course, devaluations can help boost exports, growth and they will reduce the size of the deficit. But, if the devaluation is too sharp it generates a negative momentum and loss of confidence in the economy.

Current account deficits are not necessarily a bad thing. Similarly a current account surplus is not the sign of a strong economy. Japan had a huge current account surplus during its lost decades of deflation and recession. However, current account deficits are a problem if they became 'unmanageable'. This is anything over 5% of GDP, but, of course varies from one country to another. The real problem comes if the balance of payments also involves external debt and the country can't repay.

There is also a danger of relying on hot money flows and a fluid money markets.

Should the UK worry about current account deficit of 3% of GDP?

The recession and devaluing pound should improve the deficit. But, the persistent deficit suggest the UK economy is unbalanced and the economy would benefit from diversifying and encouraging exports and manufacturing.

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