Does the balance of payments matter?

In the last four years, the deficit on the current account has averaged between 4% and 5%, but during that period  we had a six month period when the deficit on goods and services (a key part of the current account) averaged 7% of UK GDP while predictions are that there was a surplus for the last six months of 2019. The last time this happened was over 20 years ago. For 2019 as a whole we might be talking about a deficit averaging 1.5% of GDP. However, there has been a major change in the composition of our balance of payments;  our manufacturing sector has declined significantly and its contribution to the balance of payments has been negative. Despite falls in the value of sterling particularly in 2008 and after the Brexit vote, manufacturing failed to thrive as predicted, even after the “J curve effect” which suggests a time-lag between a fall in the value of the currency and an improvement in the balance of payments. Possibly this was because of low UK productivity, poor growth among our main trading partners, limiting their demand for our goods, or  because UK producers opted to keep prices the same in foreign currency, therefore increasing their profits. Fortunately, the manufacturing deficit has been partially offset by our service industries where we have a comparative advantage.

Both The Times and Financial Times have printed articles about the decline in the importance of the balance of payments. Their articles refer to the time when newspapers published the balance of payments figures on the front page and the data would be prominent on the television news. Economics students would rank the balance of payments as one of the country’s main economic objectives while today, they struggle to remember what comes after low inflation, low unemployment and high GDP growth. One reason for the decline in the attention given to the balance of payments is that the figures are recognised as sometimes being inaccurate and also likely to be influenced by special factors, such as the way the deficit increased in the run-up to Brexit because businesses built up stocks in case of disruption while, more recently, a partial cause of the improvement in the balance of payments has been the run down in these stocks.

So does a persistent deficit matter? A sustained deficit implies a leakage from the circular flow of income, has implications for living standards and might be a sign that the economy is underperforming since it is selling few exports and buying too many imports.  It might also lower the exchange rate with implications for inflation and living standards since imports will become more expensive.

If a deficit is driven by over-consumption, possibly financed by high levels of debt and inadequate savings, then a persistent balance of payments gap is evidence of serious distortions within the economy. (A deficit can be good if a developing country is importing capital and new technology). According to the IMF “When a country runs a current account deficit, it is building up liabilities to the rest of the world that are financed by flows in the financial account. Eventually, these need to be paid back.”  Their view comes from the way a current account deficit must be financed which involves a surplus on the financial account. This means  that overseas individuals, banks and businesses will be carrying out activities which bring money into the UK. These would include foreign millionaires buying property in London, either to rent or live in, foreigners buying UK company shares or putting money into UK banks or foreign companies building new factories in the UK.  The UK is fortunate that it is an attractive place for such transactions. We have a sound legal and financial system, clear property rights and, currently,  membership of the EU single market, making us attractive to non-EU businesses so we have been able to finance the deficit without difficulty.

If our attractiveness falls, then the situation could change, with depreciating sterling, since the demand for it from foreigners buying UK exports or depositing money in the UK will be smaller than its supply on the foreign exchange market as we try to buy imports or higher interest rates to attract money from overseas with undesirable consequences for the domestic economy.







Heading for a crash?

The last week has not been kind to the British motor industry. Production fell to 1.52m cars in 2018, a five year low, with a 22% fall in December making the drop the largest yearly drop since the Financial Crisis.  At the start of the week, Nissan confirmed stories circulating over the weekend that it would not be building its new X-Trail SUV in Sunderland. This is despite a government announcement two years ago that it had reached a deal with Nissan to ensure, among other things that the new model would be built in Sunderland. Last month, Jaguar Land Rover (JLR) announced that they are planning to cut 4,500 jobs and this was followed by figures they published last week announcing a £3.4bn loss in the last three months of 2018 as a result both of falling diesel sales and falling demand from China which previously accounted for almost 1/3 of their sales. This loss compares with profits of £190m over the same period in 2017. In addition, their new electric vehicle is being developed and built in Austria and they have announced that the Land Rover Defender will be built in Slovakia.

The industry has suffered from two major factors. Firstly, sales of diesel vehicles have slumped following the VW emission scandal in 2015 and tighter emission controls on cars. As a result, British sales of diesel cars slumped by 30% in 2018. This means that rather than have one factory in Japan and another in Europe for the X-Trail, the Japanese factory will be large enough to meet the expected demand.

Secondly the lack of progress over Brexit, combined with a trade deal between Japan and the EU, which the UK will not be a part of if we leave with “no deal” has impacted on Nissan’s decision. The Japan-EU deal will create the largest free-trade area in the world with virtually all customs duties being abolished between the participants. Over the next seven years tariffs will be phased out and, equally as important, the EU and Japan will agree to accept international product specifications, thereby making it easy for them to compete in the other’s market. If we do not reach a deal with the EU, car exports to the EU will face a 10% tariff.

Why is the motor industry so important? We are the 11th largest car manufacturer in the world and the 4th largest in the EU behind Germany, France and Spain, with JLR, Ford, Nissan and BMW Mini being the four largest UK producers, employing 54,000 workers between them, almost 75% of total direct employment in the industry. There are many more who are employed in producing components and transporting finished vehicles and parts. The industry accounts for almost 4% of GDP and is  a major exporter, particularly to the EU and the USA, producing 10% of our exports. Last year 1.24 million of the 1.52 million cars produced were exported. It attracts significant foreign investment; in the year before Brexit, there was £5bn of inward investment into the industry from overseas. Last year this fell to £½bn.

However not all in the industry is gloomy. High value manufacturers, such as Aston Martin, McLaren and Rolls Royce, are doing well. The problem is that they are dwarfed by the larger producers who are suffering.

The impact of a fall in sterling.

Since the referendum in 2016, sterling has fallen from £1 = 1.27 euros to 1.16 euros today and from $1.45 to $1.32, having dropped to 1.1 euros and $1.25 earlier in the month, and there is talk about further falls depending on whether we do or do not reach an agreement with the EU. For those looking for a longer perspective, £1 was worth $4 after the Second World War, dropped to $2.8 when sterling was devalued in 1949, then $2.4 when it was devalued again in 1967 and it fell once flexible exchange rates were introduced during the 1970s.

Economic theory predicts that the fall in sterling would lead to an improvement on the current account of our balance of payments as exports of goods and services increased because of their fall in price while imports, now more expensive, dropped as UK consumers and businesses sought cheaper alternatives. The size of the changes in imports and exports are determined by the price elasticity of demand, summed up by the Marshall Lerner condition which states that a devaluation or depreciation of the exchange rate will improve a country’s balance of payments if the sum of the price elasticities of demand for imports and exports are greater than one. The improvement is not immediate because demand for imports and exports is inelastic in the short term, giving rise to the J Curve effect where, following devaluation, a country’s balance of payments first deteriorates and then improves. Even if UK firms do not cut prices in overseas markets, the higher profits they are now receiving from exports should encourage them to devote more resources to their export markets.

Therefore, we should, by now, be experiencing a significant improvement in the balance of payments but this has not happened. In the time following the fall in sterling, the quarterly deficit in goods increased from £31.2bn (March – May 2016) to £34.7 (September – November 2018).  So why has the balance of payments not improved? Firstly, there is recent evidence that some companies are stockpiling imports (both components and finished products) in case of a disorderly Brexit. Another current issue has been the relatively slow GDP growth in UK export markets which has reduced the demand for our products.

There are two more significant reasons for the failure of our trade balance to improve and these cast doubt on the validity of using devaluation to improve one’s balance of payments. Firstly, because of globalisation, supply chains are highly integrated, with UK firms needing to import far more components to manufacture products than twenty years ago. Therefore, exporters will find that, rather than being able to cut their prices by the full extent of the drop in the value of the currency, they will have to take account of the higher costs of their imported components and raw materials, thus reducing the beneficial impact of devaluation. Secondly, the validity of devaluation depends on the price elasticity of demand and, increasingly, non-price factors, such as marketing and reliability, are becoming more important. Unfortunately, as Brexit nears, short-term doubts over its impact on such things as delivery dates and the ease of obtaining spare parts, will not help boost our exports, irrespective of the exchange rate.

Trade Wars

In an attempt to escape from the latest Brexit news, this week’s blog examines the trade war between the USA and China. Until recently, economics textbooks glossed over tariffs, quotas and protectionism; they were mentioned as possible approaches to improving a country’s balance of payments but it was accepted that although there were customs unions in existence, such as the EU, with a common external tariff (i.e. all products entering the union paid the same tariff, irrespective of where the goods entered the customs union, tariffs were not changed frequently as an economic weapon. This was because the accepted view among economists and (most) politicians was that world free trade was beneficial, allowing goods and services to be made  in the countries most suited to their production (lowest opportunity cost in economic terms) and then traded for products made overseas, thereby allowing consumers to benefit from lower prices and an increased standard of living.

However all of that has changed with the imposition of tariffs by the USA on Chinese goods and retaliation by China, followed by retaliation for the retaliation by the USA! The crisis began in July, after months of negotiations, when the USA imposed 25% tariffs on an initial $34 billion of Chinese goods, including machinery, electronics, cars and computer components such as hard drives.  China then retaliated and the following month the USA placed 25% tariffs on a further $16bn of Chinese goods which were matched by reciprocal Chinese tariffs on American goods such as cars. Then in September, President Trump imposed further 10% tariffs on $200 billion of Chinese goods and has threatened to increase this to 25% next year. China has retaliated with tariffs on $60 billion of US goods. The rationale for the American tariffs was two-fold – firstly that, according to President Trump, China had an “unfair” trade surplus in goods of $376 billion with the USA, thereby hitting American jobs, and secondly that China engaged in unfair trading practices, frequently involving foreign firms being forced to share their technology with Chinese ones.

The effects of the tariffs will depend on many factors. It is possible that businesses might find a way round the tariffs. For example, US soya producers have complained about the tariffs on their products but there is already evidence that they have been able to increase their exports to Brazil and Brazilian firms have exported to China. However many US businesses have expressed concern over the rise in costs of components imported from China and the effect they will have on consumer prices in the US. On the other hand, President Trump has argued that the tariffs will persuade US firms to produce more in the US to avoid the tariffs but others suggest that US firms will still produce overseas, where manufacturing costs are cheaper, but in countries other than China. A key factor will be the price elasticity of demand for the goods affected. This will determine whether producers can pass on the tariff,  whether they will have to absorb some or all of it and whether they will need to cut output with subsequent effects on output and employment.


It is rare to see two successive blog posts on the same topic but it is also rare for an economic issue to receive the attention which President Trump’s proposed tariffs on steel and aluminium have attracted. Since the last post, Gary Cohn, his chief economic adviser, has resigned in protest at the decision, swaying the political balance in the White House from supporters of free trade towards protectionists, the EU has added to its list of potential targets for retaliation to include peanut butter, Bourbon, Florida orange juice and Harley Davidson motorcycles, and President Trump has continued to threaten retaliation against the retaliation, talking of tariffs against EU car exports. There have also been comments in the newspapers looking back to the 1930s and the protectionist measures imposed by the USA as a way of helping them escape the Great Depression, which served only to make the world situation worse.

The language of the debate (if that is what it can be called) continues to be confused. On the one hand President Trump argues that the tariffs are justified by WTO rules on the grounds of national security, a legitimate reason for imposing tariffs; the argument being that steel is an important product for the defence industries. However the main exporters of steel to the USA are the EU (the largest), Canada, Mexico and South Korea – hardly countries which are likely to go to war with the USA. China does not feature among the list of the major steel exporters to the USA. Furthermore some of the steel exported is highly specialised and not even manufactured in the USA.

While talking of national security as a justification, President Trump simultaneously continues to refer to the need to reduce the US balance of payments deficit, arguing that the deficit is “BAD” and the fault of foreign countries. Not only has the deficit occurred in part because foreign producers can produce more cheaply than US ones, it has also allowed the US to consume more than it produces and, subsequently, living standards have risen. Foreign trade is not a zero-sum game – both deficit and surplus countries benefit from greater trade.

So how has a country like the USA (and the UK) been able to run such a large and persistent deficit? This is because foreign governments, banks and individuals have been willing to hold dollars and US assets rather than change them back into their own currency. In the same way that a generous parent’s continual lending allows their children to spend more than they earn, the UK current account deficit might be partially financed by a financial account surplus caused by rich foreigners and businesses placing money earned from selling to the UK in UK banks or buying property in London, UK shares or government bonds. The same applies to the US, but is reinforced by the additional benefit the USA has which is that the dollar is so widely used for international trade and as a reserve currency.

The exchange rate and the economy.

The traditional view of a fall in the value of a developed country’s currency was that it would lead to an increase in the value of their exports and a fall in the value of their imports, hence improving the balance of payments and, via the resultant increase in aggregate demand, cause an increase in employment and growth.

However the above analysis needs considerable qualification. Although a fall in the value of a currency will almost always increase the VOLUME of exports and reduce the VOLUME of imports, whether the values change in the same way will depend on the elasticities of demand for exports and imports. For a developing country whose exports are commodities with an inelastic demand, a fall in the value of the currency might worsen its balance of payments. Over time the UK’s exports have moved up-market and therefore it can be argued that they have become less price sensitive since factors such as design and quality become more important.

Secondly, the analysis assumes that firms can increase their production of exports to meet higher demand and this will depend on the state of the domestic economy, the availability of labour, raw materials and components. This is unlikely to be easy in the short term and economists talk of the “J Curve effect” whereby a devaluation initially leads to a worsening balance of payments as quantities of exports and imports do not change much, possibly because of long-term contracts or the difficulties in increasing output of export and import-substitutes and, only over time, will the balance of payments improve. While this might not apply to tourism, where people can switch their holiday destinations relatively quickly, high tech exports and imports of manufactured exports will be much slower to adjust. Firms need to take a view as to the permanence of any change in the exchange rate. In my last post, I wrote that the £:$ exchange rate fluctuated from $1.71 in July 2014, $1.32 after the Brexit vote, then to $1.21 in January, 2017, and was at $1.38 (20th January 2018) but at the time of writing (27th January 2018) it had risen to $1.42. Firms planning long-term contracts will need to take a view as to the likely long-term exchange rate and largely ignore short-term fluctuations.

We should also not forget the downside of a devaluation which is that imports become more expensive and therefore living standards fall. Not only does one’s foreign holiday cost more, but imported finished products and anything using imported components or raw materials becomes more expensive, with the increase in price depending upon how easily the supplier can pass on the increased cost to the buyer. As products become more complex and firms take advantage of globalisation, the supply chain becomes longer and there is a greater likelihood of imports being involved in some in the final product. Thus an increase in UK exports of goods is very likely to require an increase in imports needed to make our exports and some of the increased competitiveness will be lost by the higher cost of imported components and raw materials.

Recent examination of the exchange rate and UK trade in goods might suggest that the exchange rate  has a significant impact. In the last year the volume of UK goods exported rose almost 9% which would imply that the fall in sterling post Brexit has had a positive impact until one reflects that UK imports have increased by 7% during the same period, despite their increase in price. What this shows is that the exchange rate is simply one of many factors affecting the demand for imports and exports and we cannot ignore factors such as quality, income, interest rates or anything else which changes the desire to consume goods and services.

China-UK investment: key questions following Hinkley Point C delay | Business | The Guardian

Theresa May’s decision to put off approval for nuclear power station has put Chinese-British business relationship under strain

Source: China-UK investment: key questions following Hinkley Point C delay | Business | The Guardian

Essential reading for all economics students. China is an increasingly important provider of finance for the UK economy – helping to offset our rather hefty current account deficit. The article explores the diverse nature of Chinese investment, why the UK is attractive opportunity, and why money from China is still treated with caution.

Nigeria’s dollar crunch adds to fuel crisis —


Refinery woes, currency controls and militant attacks combine to prolong acute shortage

Source: Nigeria’s dollar crunch adds to fuel crisis —

Inadequate infrastructure means that, despite being Africa’s top oil exporter, Nigeria has to import fuel putting downward pressure on the value of it’s currency, the Naira (see Chart 2 below). Value-added increases when oil is refined to become something more useful, in this case fuel, so the $’s received for each barrel of oil Nigeria exports is worth less than the $’s Nigeria has to pay for the same volume of refined oil, leading to a reduction in foreign exchange reserves (see Chart 1 below).

It is difficult to see how this cycle will end. If the value of the Naira continues to fall, the price of refined oil in Naira terms will continue to rise, further depleting foreign exchange reserves and accelerating the Naira’s depreciation.

There are several solutions, central bank intervention to revalue the Naira, but they need, already dwindling, foreign exchange reserves in order to manipulate the market price for the Naira. Investment in infrastructure, a fiscal supply-side policy, to reduce the reliance on refined oil imports is an alternative, but oil accounts for 90% of Nigeria’s export revenue and, subsequently, a significant proportion of government revenue. The price of oil has collapsed and with it government revenue, a classic example of the dangers of over-reliance on a primary commodity, prone to price volatility. The fall in foreign exchange reserves, the value of the Naira and an increasing budget deficit will make lenders nervous and will lead to an increase in the yield on government borrowing, put simply, the interest rate on government bonds will have to rise to offset the greater risk, increasing government expenditure on debt repayments.

Clearly, these options are not presently viable, but the second should have been enacted when the oil price was high and export earnings plentiful, however, corruption, some $16bn in government oil receipts is unaccounted for in the last year alone, has meant that infrastructure remains undeveloped.

A further consequence of the falling value of the Naira is that despite global oil prices falling, Nigerians have to pay more for petrol at the pump. To combat rising petrol prices the Nigerian government have imposed price controls, however, this has resulted in several-hour long queues and a rise in hidden market activity. Subsequently, Nigerians either face having to pay extortionate prices or waste valuable time queueing. Ultimately, output is lost and Nigeria’s economy suffers.

Nigeria’s relatively new president has a tough task on his hands.

Chart 1

Chart 2