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Balance of Payments Adjustment Policies
Policies to correct a BoP imbalance
• Most discussions focus on countries running a current account deficit
• But persistent surpluses can also be a problem!
• Both deficit and surplus can be described as a disequilibrium
• Evaluation might consider:– Automatic partial correction of a deficit
– Demand-side policies
– Supply-side policies
– The consequences of policies for other macroeconomic objectives such as growth, inflation and jobs
Deficits and Surpluses as a share of GDP
Current account deficit as a percentage of GDP
Current Account Balances - Deficits and Surpluses
Germany Ireland Japan
Spain United Kingdom United States
West Germany
Source: OECD
98 99 00 01 02 03 04 05 06 07 08
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
PE
RC
EN
T
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
Why might the deficit as a share of GDP be a better guide to the size of a trade imbalance?
Are deficits self-correcting?
• Some partial self-correction
• Economic slowdown and recession – Squeeze on real incomes and output
– Fall in import demand
– Releases capacity for exporting
• Deficit might lead to depreciation in the exchange rate– Change in relative prices of exports and
imports
– Expenditure-switching towards exports and away from imports
– Depends on price elasticity of demand for X and M and also elasticity of supply
The US trade deficit and their recession
$ billion per month
United States Balance of Trade in Goods
Annual growth of real GDP Trade balance in goods and services $bnSource: Reuters EcoWin
01 02 03 04 05 06 07 08b
illio
ns
-70
-65
-60
-55
-50
-45
-40
-35
-30
-25
US
D (
bill
ion
s)
-70
-65
-60
-55
-50
-45
-40
-35
-30
-25
-4
-2
0
2
4
6
8
Pe
rce
nt
-4
-2
0
2
4
6
8
Note the steep fall in the trade deficit as the economy hit recession.
Why is income elasticity of demand important in this chart?
But what are the wider economic effects?
Expenditure switching
• Expenditure switching:
– Change in relative prices of X and M
– Changes incentives for consumers
– Changes profitability of exporting
– Can be caused by
• Movement in the exchange rate
• Introduction of import tariffs and other forms of protectionism
• Period of high or low relative inflation
– Key point is whether trade volumes respond to changing prices
– I.e. price elasticity of demand for X and M
Does a depreciation cut the trade deficit?
trade balance $ billion per month, dollar exchange rate index
US Trade Deficit and the US Dollar
Federal Reserve, Nominal Trade Weighted Exchange Index Broad Trade Balance, Total, Goods and services, SA
Source: Reuters EcoWin
00 01 02 03 04 05 06 07 08 09
bill
ion
s
-70
-65
-60
-55
-50
-45
-40
-35
-30
-25
US
D (
bill
ion
s)
-70
-65
-60
-55
-50
-45
-40
-35
-30
-25
95
100
105
110
115
120
125
130
Ind
ex
95
100
105
110
115
120
125
130
Dollar depreciating
Any evidence for the UK?
Quarterly trade balance, £ billion (bottom pane) and exchange rate index
UK Trade & the Sterling Exchange Rate
Effective Exchange Rate Index Balance of Trade in Goods and ServicesSource: Reuters EcoWin
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
bill
ion
s
-15.0
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
Qu
art
erly
ba
lan
ce £
(b
illio
ns)
-15.0
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
70
75
80
85
90
95
100
105
Ste
rlin
g in
de
x
70
75
80
85
90
95
100
105
The J Curve
• Effect of a depreciation on the trade deficit depends on price elasticity of demand.
• In the short term, demand is often inelastic – limits extra revenue from exports
• Demand for M is inelastic – higher prices cause a rise in total spending on imports
• The J Curve effect says a trade deficit can worsen after a depreciation, but get better in the long term provided that the elasticity of demand is high enough
• Marshall-Lerner condition: Trade balance will improve if Ped X + Ped M . 1
• Elasticity of supply of domestic producers is also important (often forgotten)
The J Curve effect
Trade surplus
Trade deficit
A
Time
B
C
Ped X + Ped M > 1 for the trade balance to improve
Expenditure Reduction
• Expenditure reduction– Cutting aggregate demand
– Direct effect on consumption and therefore demand for imports:
– Possible routes:
• Higher direct taxes – lower disposable income
• Low taxes on saving
• Increased interest rates – to dampen consumption
• Cut in government spending
– Focus here is on income elasticity of demand for imports
Supply-side policies
• To rebalance trade over the medium term
• Focus on
– Improving competitiveness in global markets:• Innovation
• Research and development
• Product quality / design
• Infrastructure to support trade sectors
– Attracting inward investment – producing output domestically and then exporting
– Raising productivity / lowering unit costs
– Developing areas of new competitive advantage
– Raising foreign income elasticity of demand for exports
– Reducing foreign price elasticity of demand for exports
Weaknesses on supply-side and UK trade
• Persistent productivity gap
• Low business investment as a share of GDP
• Low levels of research and development
• Loss of capacity in manufacturing industry
• Evidence that UK exports have lower income elasticity of demand than our income elasticity of demand for imports
The Productivity Gap
95
100
105
110
115
120
125
130
135
140
1992 1994 1996 1998 2000 2002 2004 2006
Source: ONS
France
Germany
UK
US
GDP per hour workedComparison, 1996-2007Index, UK = 100
Source: UK competitiveness indicators, Feb 2009
Investment Gap?
Business investment Comparison, 1992-2007Per cent of GDP in current prices
8
10
12
14
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Germany
France
UK
US
Source: OECD
Source: UK competitiveness indicators, Feb 2009
Research Gap?
1.5
2.0
2.5
3.0
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Source: OECD
France
Germany
UK
US
Gross domestic expenditure on R&DComparison, 1992-2006Per cent of GDP
Source: UK competitiveness indicators, Feb 2009
UK Exports and Imports
Annual value of trade - £billion at current prices
UK Exports and Imports of Goods and Services
Source: Reuters EcoWin
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07b
illio
ns
100
150
200
250
300
350
400
450
GB
P (
bill
ion
s)
100
150
200
250
300
350
400
450
Imports
Exports
Balance of Payments: Exports: Total Trade in Goods & Services 368.337GBalance of Payments: Imports: Total Trade in Goods & Services 415.817G
Summary points
• Some trade deficits are partially self correcting
• But recession and a depreciation are not enough if the root causes lie on the supply-side of the economy
• Ultimately BoP adjustment requires:– Period of below trend growth
– Improvement in investment in traded goods industries
– Control of price and cost inflation relative to that of our competitors
– Open trade to drive better export performance
– Protectionism is not the answer
