Measurement and Meaning of the Balance of Payments
The balance of payments (BoP) records transactions between firms, consumers, and governments of different countries.
UK BoP accounts specifically track transactions between UK residents and the rest of the world.
Transactions demanding foreign exchange are recorded as debits; transactions that produce foreign exchange are recorded as credits.
If recorded correctly, total credits equal total debits; the foreign exchange bought must equal the foreign exchange sold.
Components of the Balance of Payments
BoP accounts consist of two main components:
Current Account:
Measures purchases of goods, services, net income & transfers.
Capital and Financial Account:
Records transactions in financial assets and liabilities.
The two accounts must sum to zero:
Balance of Trade = $X - IM = Y - (C + I + G)$
Where $X$ = exports, $IM$ = imports, $Y$ = national income, $C$ = consumption, $I$ = investment, $G$ = government spending
The current account balance = $X - IM + ext{(net income from overseas assets)}$
Note: BoP focuses on current flows, not changes in net wealth or capital gains.
Understanding the 2017 UK Balance of Payments Accounts
Credits and Debits Overview:
Current Account Credits: £808,356 million
Current Account Debits: £887,315 million
Balance: -£78,959 million
Breakdown of Goods and Services:
Goods:
Credits: £338,871 million | Debits: £476,319 million | Balance: -£137,448 million
Services:
Credits: £277,039 million | Debits: £165,477 million
Primary Income & Secondary Income:
Credits and debits in both categories contribute to the overall account balance.
Capital Account:
Total of both accounts reflects international investments and transactions.
Importance of the Balance of Payments
Overall BoP accounts must balance; however, some discrepancies (problems) may arise:
Trade Deficit Implications:
Indicates domestic spending exceeds domestic production ($C + I + G > Y$).
A current account deficit suggests borrowing from abroad.
Effects of Borrowing:
Net borrowing can be beneficial if linked with investment.
Conversely, it may be detrimental if increasing debt without repayment capacity.
Current Account vs. Capital and Financial Account Adjustments
Market determined exchange rates need equal demand and supply for currency to clear.
When Exchange Rate Imbalances Occur:
Excess demand raises exchange rates; excess supply lowers it.
Authorities Pegging Exchange Rate:
Authorities may intervene by using foreign currency reserves if supply exceeds demand.
Devaluation of currency could be necessary if reserves dwindle.
Drivers of Exchange Rate Changes
An increase in demand for UK currency can result from:
Increased demand for UK goods/assets.
A decrease in demand for UK currency may arise from:
Decreased demand for UK goods/assets.
Over the long term, exchange rate changes reflect inflation differentials.
Purchasing Power Parity (PPP):
Suggests goods should have similar prices when adjusted by current exchange rates.
News Impact on Exchange Rates
FX market flows are influenced by professional investors assessing potential returns.
Exchange rate adjustments are based on unexpected and unpredictable news rather than just historical data.
The role of news is intrinsic and random, driving market perceptions and reactions.
Conclusion
Understanding the balance of payments and exchange rates is crucial for interpreting national economic health and international financial interactions.
Both accounts have direct implications on economic policies and status in global markets.