Balance of Payments – UK Economy Under Labour

The Balance of Payments concerns levels of international trade in goods, services, money and foreign direct investment (FDI). These fall into one of two groups, either the Current Account which covers goods, services and money transfers or the Capital Account which covers direct and financial investment and currency trading.

In any one year there can be a surplus or deficit in the accounts. If the Current Account was in deficit, that would be that the UK had imported more goods and services from abroad than we had exported – we should have a net loss, or deficit. The two accounts need to balance, and so, in this situation, the Capital Account would need to be in surplus, in that excess capital flowed into the UK rather than left it.

If the Capital Account cannot make up the deficit of the Current Account then the government must attract capital by investment or banking with a high rate of interest. If there is not sufficient then the government must use its own foreign currency reserves to finance the deficit.

This is obviously undesirable for the government, but other problems come with a deficit situation. A fall in exports will affect aggregate demand (see below), and this could cause associated problems such as the multiplier effect from less money in the circular flow, higher unemployment and less investment. This, combined with an increase in import penetration, may mean the closure of large sectors, especially manufacturing, as demand falls for UK goods.

Make-up of Aggregate Demand in the economy from all sources according to the Keynesian formula

Make-up of Aggregate Demand in the economy from all sources according to the Keynesian formula

The Balance of Payments can also affect the exchange rate, with a deficit having a weakening effect, making imports more expensive and possibly contributing to cost push inflation. However, the exchange rate can itself affect the Balance of Payments. When sterling is strong, it makes imports cheaper for us to buy, and our exported goods more expensive to buy, or less profitable to sell, abroad.

All of these problems mean the government’s aim is to have a positive Balance of Payments, showing a surplus on the Current Account – exporting more goods and services than we import.

It is worth noting, however, that there are some benefits of a deficit. These include a rise in living standards, albeit short term, and if imports are capital goods, for use in production, then this will have the effect of increasing the productive potential of the economy in the long term.

Successfulness

The government has not managed to achieve a Current Account surplus, with an increasing deficit every year since the small surplus in their election year.

UK Current Account to 2006

Source: Originally from http://www.tutor2u.net/economics/presentations/ukbofp2006/default.html
GRAPH 22: UK Current Account to 2006

As shown by the colours on Graph 22, for every full year that this government has been in power, the Current Account has been in deficit, with a sustained increase in that deficit every year but 2003.

Clearly, the government have failed to meet their objective. The trend before their election appeared to be positive, with decreasing deficits and a small surplus in 1997; however deficits have quickly formed again to levels which are up to nearly -£45 billion in 2006.

But this data masks the real changes that have occurred during the last decade. As mentioned with unemployment, a distinct two-speed economy has formed as manufacturing industries have shrunk and the tertiary sector has grown.

UK Balance of Services and Goods

Source: Adapted from http://www.tutor2u.net/economics/presentations/ukbofp2006/default.html
GRAPH 23: UK Balance of Services and Goods

As is clear from Graph 23, many more services, such as insurance, have been exported than imported, while imports over exports of goods, such as consumer durables, has risen very rapidly. However, the negative balance on goods has increased roughly seven-fold, but the balance of services has only doubled.

To put this into context, the value of the surplus from services was around £29bn compared with a net goods deficit of about £84bn. This clearly shows how while the surplus for services is growing, it is not accelerating fast enough or is large enough to cover the rising deficit we are experiencing from the goods balance.

International Comparisons

The state of Balance of Payments affairs varies greatly between nations. In the USA, the country has developed a trade deficit even greater than our own.

USA and UK Current Account as a percentage of GDP

Source: http://www.tutor2u.net/economics/presentations/useconomy2007/default.html
GRAPH 24: USA and UK Current Account as a percentage of GDP

Their trade deficit has, like ours, been caused by a falling level of exported goods combined with increased imports and import penetration. Our overall Current Account has been held up by increasing export of services, America’s has not; meaning the balance has slipped further into deficit.

However, America as the world’s largest economy struggles with their Balance of Payments, Europe’s biggest economy, Germany, has a strong position with their balance.

Germany Balance of Goods

Source: http://www.tutor2u.net/economics/presentations/europegermany/default.html
GRAPH 25: Germany Balance of Goods

Their trade surplus on goods is increasing (Graph 25) and their, relatively small, deficit on services is falling. Their economy is a strong producer and has high export levels, which help to balance any imports they need to create an economy that has a strong inflow of money.

Comparisons should perhaps also be drawn to those developing nations, where outsourcing from western countries is moving to – countries such as China where manufacturing is a huge industry, producing many of the goods we own and use.


Chinese Current Account

Source: http://www.tutor2u.net/economics/presentations/europegermany/default.html
GRAPH 26: Chinese Current Account

This very strong position, at a surplus of over US$ 150 billion in 2005, is primarily based upon their goods exports.

Over Time

Looking back over time at the UK’s goods balance, there has been a long-term trend in our deficit.

UK Trend in balance of trade in goods

Source: Originally from http://www.tutor2u.net/economics/presentations/ukbofp2006/default.html
GRAPH 27: UK Trend in balance of trade in goods

Since 1983 our goods have been incurring a trade deficit, and the position achieved by the government through the past decade has only worsened the problem. While there were small surpluses in the early 1980s, the trend for a deficit appears to have only deepened since.

In respect to historical data, the government has not performed well on this economic indicator.

Recent Changes

There have been slight movements against the above trend in recent quarters.

UK Current Account Balance

Source: http://www.statistics.gov.uk/cci/nugget.asp?id=194
GRAPH 28: UK Current Account Balance

While the annual figures have continued to increase the deficit every year since 1997, with the exception of 2003, as Graph 28 shows, the value of deficit has fallen for the most recent two consecutive quarters, with the negative balance of the first quarter of 2008 roughly half that of the third quarter of 2007. The trade deficit on goods fell £1.4bn, however the surplus on services also fell, but only by £0.4bn.

This may be a temporary feature, such as in 2003, however it could be the beginning of a more long-term decline in the UK’s trade deficit.

The reasons behind the deficit fall are down to a rise in the surplus on the Capital Account, with increasing investment to the UK, and fewer deficits incurred upon that account. It may also be likely that, if not now but in the future, the UK’s demand for imports will slow as spending decreases with the gloomy economic conditions currently being experienced.

Evaluation

The government has not successfully achieved a trade surplus. While the two-speed economy has continued to increase exports of services, the Current Account has fell further and further into deficit as goods imports significantly outweigh exports.

Internationally, the situation varies greatly, and while our position is not desirable it is better than some countries, if still far worse than others.

The government has not fulfilled its economic objective, in fact going against it with a growing deficit when they perhaps could and should have done more to prevent it.

Please note that this was written during Summer 2008, before the worst of the economic problems of the following months