AS ECONOMICS: Unit 2 The National Economy SECTION B Part 1

The UK balance of payments on current account

Study Extracts A, B and C, and then answer all parts of part 1 which follow.

Extract A: UK current account balance (£bn) and the sterling exchange rate index, 2007 to 2013

AS Economics Unit 2 Section B Part 1 Image 1

Extract B: The largest current account deficit on record

Since the 2008-09 financial crisis, the government has focused on the need to reduce the budget deficit but the UK’s growing deficit on the current account of the balance of payments is rarely mentioned. Although the budget deficit as a percentage of GDP has fallen, the UK’s current account deficit has increased to record levels. The current account deficit for the third quarter of 2014, increased to £27 billion, or 6% of GDP, up from 5.5% of GDP in the second quarter of 2014. The size of the deficit has prompted some economists to express their concern about its impact on the future performance of the UK economy; they believe the current account deficit is worryingly large.

In the third quarter of 2014, the UK imported £31.9 billion more goods than it exported but this was offset by a surplus of £22.9 billion on its trade in services. The service sector is currently running a surplus equal to 5.1% of GDP, the largest surplus since records began in 1955.

Until recently, the UK received more income from its investments abroad than it paid to foreigners for their investments in the UK. This surplus has changed into a substantial deficit and is the main reason for the increase in the current account deficit that has taken place in the last few years.

In 2008, the value of the pound depreciated by almost 25%. This was expected to reduce the current account deficit and give a significant boost to UK manufacturers. However, there has been little, if any, improvement in the balance of trade in goods and the current account deficit is larger than ever.

Extract C: Dealing with the deficit

The current account deficit has been well above 5% of GDP for more than a year. The government was hoping that there would be a rebalancing of the economy towards manufacturing but, during the past 10 years, although the volume of manufactured exports rose by 21.7%, the volume of manufactured imports rose by 28.4%.

Recently, the UK economy has been growing more strongly but this has been accompanied by increased spending on imports. Low growth in Europe and some other parts of the world has made it hard for UK firms to increase exports. The World Bank has just downgraded its forecast for the growth of the world economy in 2015 from 3.4% to 3.0%.

If the UK continues to run a large current account deficit, there is a danger that the value of the pound could fall rapidly. A large fall in the sterling exchange rate could be inflationary and reduce living standards. However, some believe that this is necessary to reduce the deficit and sustain economic growth. Others maintain that, in the long run, the current account deficit will only be reduced if there are supply-side improvements that increase labour productivity and improve the competitiveness of UK manufacturers.

Q.1. Define the term ‘budget deficit’ (Extract B).

Answer: Budget deficit occurs when spending exceeds income. It occurs when the expenditures exceed revenues and this determines the financial health of a country. It is also known as the annual amount that the government borrows to meet the shortfall between current receipts and government spending.

Q.2. Using Extract A, identify two significant points of comparison between the UK balance of payments on current account and the sterling exchange rate index over the period shown.

Answer: The first point of comparison between UK balance of payments on current account and the sterling exchange rate index is in the year 2008 i.e. when the financial crisis took place around the world. UK budget deficit fell drastically and the value of pound depreciated by almost 25%. This fall in exchange rate creates devaluation of the currency and this makes exports more competitive and imports more expensive. Also, depreciation helps UK exporters and improves UK growth prospects.

The second point of comparison between the UK balance of payments on current account and the sterling exchange rate is around the year 2011-2012. Here, the budget deficit fell more rapidly than 2008 but the sterling exchange rate was rising. This is generally an unusual phenomenon. The budget deficit created record high levels for UK whereas the currency appreciated. This happened because of the good performance of the service sector and income from investments. If there is an appreciation due to speculation, then it can be harmful for exporters as they will not be able to compete.

Q.3. Extract C states: ‘the current account deficit will only be reduced if there are supply-side improvements that increase labor productivity’. Explain why an increase in labor productivity is likely to reduce the deficit on the current account of the balance of payments.

Answer: A current account deficit appears when the value of imports (of goods, services and investment incomes) is larger than the value of exports. It is rightly said that supply side improvements can reduce current account deficit because supply-side policies can be highly effective for long term progress in competitiveness and current account performance. And specially, supply side improvement that increases labor productivity is highly recommended for reducing current account deficit because these measures bring about more innovation and incentives to increase investment in industries with export potential and these are designed to enhance exports performance and compete more effectively with imports. However, the time-lags for supply-side policies are long.

Labor productivity is the output per worker and it plays an important role in a country’s competitiveness and trade performance. The productivity gap is the gap between the UK’s relatively poor productivity performance and that of the UK’s leading competitors and this need to be removed to achieve better results.

Increasing productivity means that the economy is becoming more competitive and will produce goods at a lower cost i.e. if UK firms can produce goods at a lower cost than UK exports will be more competitive which thus, raises exports. If there is an improvement in labor productivity subsequently with better education and training then firms will produce more for the same costs. This also increases exports which will help improve the current account.

Q.4. Extract C states: ‘there is a danger that the value of the pound could fall rapidly’. Using the data and your knowledge of economics, assess the consequences for the performance of the UK economy of a substantial reduction in the pound sterling exchange rate.

Answer: Between 2008 and 2013, the Pound experienced 25-30% devaluation in sterling, some cost push inflation and a shockingly large current account deficit but there was weak recovery of the economy too. This seems that the depreciation in the pound did little to help the UK economy. This happened because of many reasons:

  • Elasticity of demand and time lag: In the short run, demand for imports and exports are generally inelastic. Therefore, after devaluation, the current account worsens before it gets better.
  • Imported Inflation: Imports becomes more expensive and higher inflation can reduce the countries competitiveness. Therefore the improvement in the current account may only be temporary. There has been cost push inflation in UK in recent years.
  • State of Economy: If the economy is in a recession, depreciation may help to boost growth with slight effect on inflation. A fall in exchange rate will worsen the inflation if it is already high in the economy.
  • Poor productivity growth: Devaluation does not essentially do anything to promote investment and higher productivity. Some people believe that devaluation reduces the incentive to be efficient because firms become competitive without the effort of increasing productivity. Thus, poor productivity could be another feature for the growing current account deficit.
  • Profit motive of firms: Devaluation leads to a lower price of exports but firms can choose to keep the same foreign currency prices and increase their profit margins instead. In this way, rather than passing the devaluation onto foreign customers, UK exporters just make more profit. In 2008, UK export prices didn’t fall, but actually increased. Thus, devaluation may not cause lower export prices always, at least in the short run.

Thus, substantial reduction in exchange rate will have less impact on the economy than the expectations. Devaluation cannot solve all the problems of the economy. The effects of devaluation of a country also depend on the global economic environment.