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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 Balances - Deficits and Surpluses
Current account deficit as a percentage of GDP
10.0 7.5 5.0 2.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 -12.5 98 99 Germany Ireland Japan 00 01 02 03 04 05 06 07 08

PERCENT

0.0 -2.5 -5.0 -7.5 -10.0 -12.5

Why might the deficit as a share of GDP be a better guide to the size of a trade imbalance?

Spain United Kingdom United States

West Germany

Source: OECD

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


United States Balance of Trade in Goods
$ billion per month
8 6 4 8 6 4 2 0 -2 -4 -25 -30 -35 -40 -45 -50 -55 -60 -65 -70 01 02 03 04 05 06 07 08
Source: Reuters EcoWin

Percent

2 0 -2 -4

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?

-25 -30 -35

USD (billions)

-40 -45 -50 -55 -60 -65 -70

Annual growth of real GDP

Trade balance in goods and services $bn

billions

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?


US Trade Deficit and the US Dollar
trade balance $ billion per month, dollar exchange rate index
130 125 120 130 125 120 Dollar depreciating 115 110 105 100 95 -25 -30 -35 -40 -45 -50 -55 -60 -65 -70 00 01 02 03 04 05 06 07 08 09

Index USD (billions)

115 110 105 100 95 -25 -30 -35 -40 -45 -50 -55 -60 -65 -70

Federal Reserve, Nominal Trade Weighted Exchange Index Broad Trade Balance, Total, Goods and services, SA Source: Reuters EcoWin

billions

Any evidence for the UK?


UK Trade & the Sterling Exchange Rate
Quarterly trade balance, billion (bottom pane) and exchange rate index
105 100
Sterling index
105 100 95 90 85 80 75 70

95 90 85 80 75 70

Quarterly balance (billions)

0.0 -2.5 -5.0 -7.5 -10.0 -12.5 -15.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08


Effective Exchange Rate Index Balance of Trade in Goods and Services

0.0 -2.5

-7.5 -10.0 -12.5 -15.0

Source: Reuters EcoWin

billions

-5.0

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
Ped X + Ped M > 1 for the trade balance to improve

Time

C A

Trade deficit

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


GDP per hour worked
Comparison, 1996-2007 Index, UK = 100
140 135 130 125 120 115 110 105 100 95
1992
Source: ONS

France Germany UK US

1994

1996

1998

2000

2002

2004

2006

Source: UK competitiveness indicators, Feb 2009

Investment Gap?
Business investment
Comparison, 1992-2007
Per cent of GDP in current prices

14

12

Germany France

10

UK US

8 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: OECD

Source: UK competitiveness indicators, Feb 2009

Research Gap?
Gross domestic expenditure on R&D
Comparison, 1992-2006
Per cent of GDP 3.0
France

2.5

Germany UK US

2.0

1.5

Source: OECD

Source: UK competitiveness indicators, Feb 2009

19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07

UK Exports and Imports


UK Exports and Imports of Goods and Services
Annual value of trade - billion at current prices
450 Balance of Payments: Exports: Total Trade in Goods & Services 368.337G
Balance of Payments: Imports: Total Trade in Goods & Services 415.817G

450

400

400

350 Imports

350

GBP (billions)

300

300

250

Exports

250

200

200

150

150

100 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

100

Source: Reuters EcoWin

billions

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