What Is Balance of Payment?

1. Introduction:

In the context of globalisation and integrated economies, protecting balance of payment has become one of the central issues that policy makers should draw attention to. Indeed, past evidence showed that balance of payment problem could lead to severe crisis and deep economic downturn. The essay will examine how balance of payment issues could arise and attempt to distinguish the nature of problems under different exchange rate systems.

2. What is balance of payment?

Balance of payment (BOP) can be defined as a measurement of the net transactions between domestic residents and the rest of the world over a specific period (lipsey). Governments use BOP to keep track of the international transactions and payments between countries; and it is an important economic indicator showing the country's level of borrowing or lending abroad. There are 2 main components in BOP: current account and capital and financial account. Current account records transactions from trade in goods and services - visible account and from net income plus transfers of residents between countries - invisible account. This is a key component of BOP because when considering BOP deficit or surplus, government usually refers to the balance on current account. The other major part of BOP is capital and financial accounts, which records transactions related to international movements of ownership of financial assets, such as company shares, bank loans or government securities.

Overall, BOP must be balanced, which means any deficit on the current account must be matched by a surplus on the capital account or vice versa. The reason is that if we are spending more abroad than the foreign residents are spending here, we must be incurring a debt. As a result, a current account deficit involves borrowing from abroad thus reflects net national dissaving (investing more than domestic saving) and a surplus reflects net national saving which is then lent to overseas.

2. Does balance of payment deficit matter?

Fairly speaking, the current account deficit does not necessarily mean an unhealthy sign for an economy as long as the deficit arises from a large purchase of capital goods, such as technology, machinery or management techniques. Such long-term investment will accumulate domestic capital stocks, which benefits the economy in forms of high productivity and economic growth as well as improving the international competitiveness of the economy. As a result, the net return generated from investment will mean no problem for the country with debt repayment in the long term. Moreover, some countries, like the UK, possess a large number of dynamic growing industries, which implies an abundance of good investment opportunities for foreign investors seeking for high rate of return. Hence, we might expect a large inflow of capital or high level of FDI into these economies. This would result in a surplus in financial capital account, and automatically make the current account become deficit.

On the other hand, the persistent deficit in current account may act as a warning for the economies operating in an unsustainable manner. The deficit could be interpreted as the excessive domestic consumption over domestic output. Regarding to the demand side, it may be resulted from the high marginal propensity to consume of residents in those countries. The UK households, for instance, may prefer consuming foreign products to domestic ones, thus spending a large amount of money on imported goods and services. On the supply side, the deficit may arise from the inefficiency and uncompetitiveness of domestic industries. In addition, some nations seemed to waste a large portion of national income on status projects or military purposes that offer no returns at all. Eventually, the government may find it difficult to finance its substantial debt repayment, and in the extreme case, this could lead to sovereign debt crisis and seriously deteriorating the economic performance.

In recent years, there have been growing concerns about the explosion of global macro-imbalance. As shown in figure i below, while such countries like China or Japan have shown themselves as the gatherers of world savings and enjoyed a large surplus on their current account, there was a mirror image of Western economies that became huge borrowers. It is argued that the core of the recent financial crisis was initiated by the widening global imbalances. According to Turner Review 2009, 'these saving from surplus countries are typically invested not in a wide array of equity, property or fixed income assets - but almost exclusively in apparently risk-free or close to risk-free government bonds or government guaranteed bonds'. In other words, the world saving gluts will effectively drive down the real risk-free rates of interests, therefore, encouraging investors to move into more risky assets that offer high yield. This also fuelled the housing bubble and credit extension in some developed countries, which subsequently triggered a series of unexpected events as we have seen during the period of 2007-2009.

3. Floating exchange rate - how a currency crisis can occur:

So far, we have looked at the underlying causes and some possible consequences of balance of payment problems. It is important to emphasize that the deficit in balance of payment may differ in nature between floating and fixed exchange rate.

What does it mean by 'floating exchange rate'? Lipsey and Chrystal defined this as 'a regime in which there is no official intervention in the exchange rate system from the authority'. In other words, the equilibrium 'price' is determined by market forces or the interaction of supply and demand for foreign currency.

Advocates of floating exchange rate regimes suggest that the self-correction mechanism of the regime will eliminate problems arising from the fundamental disequilibrium of balance of payment. In other words, when there is a large trade deficit, which means excessive supply of domestic currency, it will put a downward pressure on exchange rates, and hence making the price of export lower and price of import higher. This can help export sector and control demand for import, thus gradually moving the exchange rate back to equilibrium state. The implication is that each element of balance of payment does not necessarily have to be balanced, as long as current account deficit can be offset by a surplus in capital account and vice versa. As a result, it is likely that adopting floating exchange rate may be a long-term solution to the balance of payment issue.

However, critics of floating exchange rate regimes argue that the auto-correction of balance