THE BALANCE OF PAYMENTS (part 2)

The balance of payments current account was discussed in the AS macroeconomic pages. This page concentrates on the capital and financial accounts. The balance of payments are published by the Office for National Statistics in The Pink Book and are available online. I have summarised the accounts into a more accessible format and one in which A level exams are likely to present the information.

UK Balance of Payments Summary 2010 (£millions)

It is an over-simplification to say that credits are inflows of pounds and debits are outflows, but for A level students there is no need to delve into the exact accounting methods. Perhaps the most important concept for the A level student is the principle of double-entry accounting. This principle means that the Balance of Payments must balance because an entry on the debit side must be balanced on the credit side. If the debits and credits are not equal on line n, then the difference must have been an error hence the figure of -£8,499 on line o. It may seem that -£8,499 million is a a big error but it is less than 0.8% of the credits £960,777.

If a good or service is imported ( a debit on line a or b) it has to be paid for. Where did the money to pay for this come from? The most obvious answer is that a good or service must also have been sold abroad to earn the money to pay for the import (a credit on line a or b). However there is an overall deficit on the balance of goods and services of -£39,684m (line c). Income from investments made abroad of £23,039 is not enough to make up the difference and the UK also transferred a balance of £20,081m abroad in the form of charity, government grants and EU membership fees (line e).


Notice then that that in 2010 the UK current account was in deficit by £36,726 million (line f). Where did the money come from to balance the deficit? There are a number of possibilities:

1. Immigrants into the UK might have brought some money into the country when they arrived and deposited it in a British bank, this would show up in the capital account (line h). and indeed in 2010 there is a surplus (credits are bigger than debits) so this might be part of the answer.

2. Foreign companies have invested in the UK, for example when a Japanese firm builds another car factory in the UK or an oil sheik buys a British football club. This would show up on the Foreign Direct Investment (FDI) section of the financial account (line i). Any foreign investment that involves buying over 10% of the shares in a British company would also show up here. Line j shows that FDI into Britain of £28,936m was greater than UK investment abroad of £7,132m.

3. Foreigners might have bought more shares in British companies the UK citizens bought in foreign companies. Where a firm or individual buys less than 10% of the value of the company it appears in the portfolio investment section (line j)

4. Other (line k), includes movements of cash into and out of British banks, loans, and government bonds Much of this is short-term movement (hot money), often being transferred for a few hours only as it seeks out the highest interest rate in world markets. Notice how large these movements of hot money are compared to FDI or imports and exports of goods and services. These short-term movements of money have a significant effect on the demand and supply of pounds and hence on short-term interest rates.

5. When Britain was operating a policy of fixed exchange rates the Bank of England held large amounts of gold and foreign currency (line l). If imports exceed exports this meant British firms and their banks were continually selling pounds to the Bank of England in exchange for foreign currencies. Therefore the reserves at the Bank of England would change. The £6,070m figure in the debit column in the first table means that in the second table (showing the net balances) is a minus. Therefore gold or foreign reserves are building up in the bank because a minus number means pounds are leaving the BOP accounts in order to purchase foreign currencies or gold.

Note that the change in reserves are a relatively small amount and this is because the UK now operates a floating exchange rate, and there is far less need for the Bank of England to be buying and selling gold or foreign currencies to support the value of the pound. Changes in gold reserves were only £18 million in 2010, the majority of the changes were in foreign currency reserves and Special Drawing Rights (SDRs), which are a form of international currency used by the International Monetary Fund and national governments.