The Balance of Payments

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Balance of Payments account
 Records financial transactions between the
UK and all other countries
 At AS you learned about the current
account of which there are 4 main parts
1. The balance of trade in goods (visible
trade)
 The UK imports more than it exports
- it runs a trade deficit
2. The balance of trade in services
 UK comparative advantage in
financial, insurance and ICT services
has led to an overall balance of trade
surplus
 This trade surplus is not large
enough to cover the trade deficit
 Now many more services are
imported because British firms are
outsourcing services e.g. call centres
to India
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Balance of Payments
account
3. Net income flows
 Not all flows of money are from trade
in goods and services
 Income flow from use of factors of
production overseas
 Interest, profits and dividends on UK
assets abroad
 These also flow out of the country to
overseas owners
 Net income flows are the difference
between inward and outward flows
 These tend to be positive in the UK
4. Current transfers
 Net current transfers consist mainly
of government transfers to and from
overseas organisations e.g. the EU
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The capital and financial accounts
 At A2 you are expected to have some knowledge
of the other two accounts
 Capital account
 Financial account
 These record flows of financial capital arising
from saving, investment and currency
speculation
 Capital account is relatively unimportant
 Consists largely of
 repatriation of financial capital from
people entering or leaving the UK
 Government transfers including some
type of foreign aid
 Financial account records the vast majority of
flows of financial capital into and out of the UK
and has 3 main components
 Net FDI – difference between UK
acquisitions abroad and Foreign
acquisitions in the UK
 Net portfolio investment – purchase of
financial assets e.g. shares
 Other capital flows – hot money
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Capital flows
 International Capital flows have grown very rapidly
in recent decades reflecting the process of
globalisation
 This growth brings the following benefits
 Promotes growth of world trade
 Source of finance for firms which is particularly
important in less developed countries
 FDI facilitates the transfer of technology,
information and best practice between firms
and countries bringing about supply side
improvements
 This growth in capital flows can bring the following
disadvantages
 Difficulties in one sector of the financial
systems can affect the whole global financial
system
 Sub prime mortgage crisis in the USA in
2007 led to a UK ‘credit crunch’ where
banks tightened lending criteria
 FDI may lead to global dominance by
multinational firms
 Large scale hot money flow can destabilise
exchange rates
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Financial Services and the City
of London
 Financial services industry one
of the UK’s largest industries
 Mostly based in the City of
London
 Over a million people employed
 Nearly a quarter of London’s
contribution to GDP is financial
services
 See graph opposite to see
growth of services in terms of
their share of UK exports
 Read ‘the golden gateway’ on
P200

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Causes of a trade (goods) deficit
 It is useful to group the explanations for a trade deficit in goods into short-term, medium-term
and long-term factors
 Some relate to the demand-side of the economy and others to supply-side economic
influences
 Short-term factors
1. Strong consumer demand
 real household spending has grown more quickly than the supply-side of the economy can
deliver, leading to a high level of demand for imported goods and services
 Research evidence suggests that UK consumers have a high income elasticity of demand
for overseas-produced goods
 demand for imports grows quickly when consumer demand is robust
 Nicholas Fawcett and Professor Mike Kitson estimated that the income elasticity is
around +2.3 suggesting that a 2% increase in real incomes boosts demand for imports
by 4.6%
 Because the overseas demand for UK exports rarely keeps pace with the surging
demand for imported products, so the trade deficit widens when the economy enjoys a
period of consumption-led growth.

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Causes of a trade (goods)
deficit
2. The strong sterling exchange
rate has helped to reduce the
UK price of imports causing an
expenditure-switching effect
away from domestically
produced output
 Consumers have taken
advantage of the high
pound!
 In technical terms, the
high pound has improved
the terms of trade
between the UK and
other countries, allowing
the British people to buy
and consume more
imports with each pound
they earn
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Causes of a trade (goods)
deficit
 Medium-term factors
 UK trade balances have been
affected by important shifts in
comparative advantage in the
international economy
 for example the rapid growth of
China as a source of exports of
household goods and other
countries in South-east Asia
who have a cost advantage in
exporting manufactured
products.
 The availability of imports from
other countries at a relatively
lower price inevitably causes a
substitution effect from British
consumers.
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Causes of a trade (goods) deficit
 Medium-term factors
 Much of the UK’s trade deficit is due to
structural rather than cyclical factors
 Trade performance has been hindered by
supply-side deficiencies which impact on the
price and non-price competitiveness in global
markets
 non-price competitiveness factors such as
design and product quality are now more
important for trade than merely price alone.
 A relatively low rate of capital investment
compared to other industrialised countries
 The persistence of a productivity gap with
major competitors
 linked to low investment and also to the
existence of a skills-gap between UK
workers and employees in many other
countries
 A relatively weak performance in terms of
product innovation – linked to a low rate of
business sector spending on research and
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development
Causes of a trade (goods) deficit
 Long-term factors
 The UK manufacturing sector
has been in long-term decline
for more than twenty years.
 Although there are some world
class manufacturing
companies, the size of the
manufacturing sector is not
large enough both to meet
consumer demand in the UK
and also to export sufficient
volumes of products to pay for
a growing demand for imports
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