Exchange Rate - Competitiveness and Balance of Payment Performance

Question: Discuss about the Exchange Rate, Competitiveness and Balance of Payment Performance. Answer: Introduction The main focus of the report is to analyze the balance of payments of different countries. The method of balance of payments is used by the countries to examine all the international financial transactions in a period of time. The method is calculated quarter of each year and at the end of each year. The account includes all the trade items conducted by both the public and private sectors in order to determine the amount of money is going out and in the country (Alawattage, 2009). The transaction is recorded as debit if the country has given or paid an amount of money. On the other hand, the transaction is recorded as credit if the country has received an amount of money. The balance of payment should be zero which means liabilities and assets should be balanced but in practically it rarely happens. Therefore, it helps to provide information regarding if the country has a surplus or deficit. It is divided into the following categories capital account, current account, and financial a ccount. The three categories are the sub divisions in which the accounts are recorded of different international financial transaction (Arestis, Hein and Le Heron, 2007). Main body Current account balance The balance of payment of a country includes three accounts of transactions: capital account, current account and financial account. The current account includes imports and exports of products and services and also transfers and income. It is composed of four different categories: services, merchandise trade, unilateral transfers and factor income. Therefore, if the current accounts are deficit which means the country had used more production than produced (Balance of payments and the relationship to national accounts, 2011). The trade balance and current account balance is very much sensitive to the exchange rates. `The approach of elasticity to the theory of balance of payments states that changes in the rate of exchange influence the price and consumption/resources expenditures between consumption and production of non tradables items and tradables items. However, if the currency of a country depreciates against the currency of its trading partners then the exports of that countr y would rise and the imports will fall which affects the trade balance. The prices of the products and services which decrease in the foreign current terms results in the rise in the demand of foreign product and imports become most costlier in the terms of domestic currency (Bayne and Woolcock, 2011). It subsequently diminishes the domestic demand which return creates swing in current account. According to the theories, swings of the current account balance on global prospective has developed different threads on the causes. Different approaches argued that swings are generally caused by the events such as differentials in the productivity growth, volatility in business cycle, demographic dynamics and valuation effects (Blanchflower, 2009). The optimistic view explains the swings in the current account balance as the equilibrium phenomenon which results from responses of firms and household to the world of financial and economic integration that links the countries ever closer. The situation is not so alarming because swings in the current account will self correct themselves through the interaction between political, market forces and technological over time. Inability or unwillingness of surplus nations to stimulate deficit and country having domestic demand to control overspendings, increase the probability of the hard landing with the catastrophic impacts (Clarida, 200 7). However, it is believed that if appropriate measures are taken then orderly resolution of the swings would be achievable but it is important for the government to remove the distortions that ruin the market forces. According the literatures and theories on swings in the current account balance, models of general equilibrium are used to explain the structure of current account. The important factor that leads to swings in the current account is the concept of consumer spending or economic growth which causes deterioration in current accounts because higher spending by the consumer will lead to increase in spending on imports (Cottle, 2009). The economy of UK was booming in 1980s with the rise in spending by the consumers and inflation which led to deficit on current account. However, in 2009 recession led to the temporary improvement in deficits because consumers reduced their spending which causes huge swing in the current account balances. The fluctuations in rate of exchange are one of the causes of swings in the current account balance. The depreciation in the exchange rates makes the currencies more competitive by making the exports competitive and imports expensive (Data.worldbank.org, 201 6). This will improve the position of current account and led to positive swing. However, swing would be negative or positive depends on the factors such as the price elasticity. Marshall Lerner explained the price elasticity which shows J curve effect reflecting on how the depreciation affects current account in the short terms and causes negative swings in the case of inelastic demand. The swings in the current account will be improved over time if the demand becomes elastic and led to the swing in the current balance back (Dunn and Mutti, 2004). Current account deficit A deficit in the current account happens when the value of the imports of services, investment and products is more than the values of exports. The liabilities of a country increases and the liability need to be paid back (Erratum, 2013). If the deficit amount increases then it become difficult for a country to pay back and hence it is important for the country to generate sufficient surplus current account to repay the borrowed amount. There are policies that can be adopted by the government to reduce the current account deficit. Devaluation refers to fall in the currency value against others. Devaluation in the value of currency increases the price of the importing products and demand of the imported products falls. The exports of the product become cheaper and export quantity increases (Fidrmuc and Siddiqui, 2015). Therefore, assuming that the demand is price elastic, it would be expected that devaluation lead to the improvement in exports and imports. It depends on the demand elasticity for imports and exports. According to Marshall learner, devaluation can improve the current account balance depending on the condition that demand elasticity for imports and exports is greater than 1 (Further information on UK balance of payments, 2009). Devaluation would improve the current account = PED x + PED m 1 An appreciation would ruin the current account = PED x + PED m 1 The effect on the current account generally depends on total value and not on the quantity of the exports. The demand for exports and imports remains to be inelastic in short term. Therefore, the current account ruins after the devaluation. The demand become price elastic over time and improves the current account (Further information on UK balance of payments, 2011). Deflationary policies Deflationary policies aim at decreasing the inflation rate and aggregate demand. It includes tightening of the monetary policy or fiscal policy that will decrease the aggregate demand. Monetary Policies Monetary policy with tight control includes increase in the rates of interest. High rate of interest will increase the mortgage repayments and debt cost and leaving the people with less spending. This will reduce the consumption of imported products and hence improving the current account (Holton, 2012). Therefore, higher rate of interest led to the fall in the aggregate demand and reducing the growth of economy. The issue with the monetary policy to decrease the deficit in the current account is that it increases in the rate of interest will increase the flow of cash and therefore an appreciation in the rate of exchange (Lschner et al., 2015). The appreciation increases imports and exports become less competitive. However, higher rate of interest reduce spending on the imports which improves current account. Deflationary fiscal policy The monetary policy can also be used as fiscal policy such as government can increase the income tax and this will reduce spending on the imports and consumer flexible income. The main advantage of using fiscal policy is that it does not affect the rate of exchange adversely. High income tax will improve the government finances (Medina, Prat and Thomas, 2010). Supply side policies The competitiveness of an economy can be improved with supply side polices which helps to increase the export items. Analyzing the balance of payments of UK Balance of payments is used by the countries to estimate all the international financial transactions in a period of time. According to the report, the economy of UK shows a disappointing performance. The balance from current and capital account shows negative balance. The exports and imports to first quarter of 2008 marks the start of global recession. During the global recession both imports and exports fell. However, volumes of import become higher and it also impact export volumes (Parsley and Popper, n.d.). However, the volume of import and export increased by 6.3% from 2008 to 2013, the performance was much worse than Germany and United States but better than G 7 countries. The prices of the shares falls and export volume fallen by four percent. However, the imports and exports of the product and services increases after 2009 and there is a growth in the value of the service exports. Traditionally, fall in the rate of exchange was assumed to make the exports cheaper in the fore ign markets and more imports in the domestic markets. Country Name United Kingdom Country Code LBY Indicator Name Current account balance (BoP, current US$) Indicator Code BN.CAB.XOKA.CD 2008 35701700000 2009 9380600000 2010 16800700000 2011 3192400000 2012 23836300000 2013 -108100000 The current account of balance of payments shows a modest improvement in the net trade volumes. The current account payment takes place for two reasons. The country invests heavily and a payment of the property income takes place in both the directions. The government and individuals pay transfers to different countries and to their residents. The deficit on the transfer payments has steadily increased from 0.7% to 1.5 % of GDP while the investment balance has been at the worse position after the global crisis. The deficit in balance of payment is no smaller and the country should have adopted adequate steps to make progress (Priestley and degaard, 2004). The figures given in the current balance are the difference between inaccurately and large measured inflow and inaccurately and large measured outflow. The shrinkage of import and growth of export would together be the helpful source for the demand of the UK output. The current account of balance of payments is expected to improve i n future. The financial account of balance sheet also shows negative which means foreign investment falls. The asset decreases and liabilities increases in the balance of payment in the given year. The overall deficit of BOP has increased around 4 percent in the given year which higher than the depreciation. It is clear that substantial gain in the competitiveness results from fall of the rate of exchange. However, between the year 2011 and 2013 considerable amount of profit was eroded. From the year 2008 to 2011 competiveness was lost because of the poor productivity performance of the country (Pugel, 2009). The account shows that imports and exports have flowed from depreciation. According to the research, conventional analysis depreciation has been the root of deficit. The companies produced products that can be differentiated and increase in the price of the product. The companies also chooses maximum profit strategy and profit maximizing price was set at the mark up cost. The depreciation led to fall in the costs in the foreign currency and as a result export sales increases and export prices reduced (Von Broembsen, 2012). The current account balance shows more imports and less export and there was increase in the prices of industrial and agriculture raw materials. However, despite of depreciation, deficit in the balance of payments is not small from the year 2008 to 2013. The total returns earned from composition effects the assets of United Kingdom exceeded than that of liabilities by 0.9% per annum in the period from 2008 to 2013. High capital gains are generally associated with the liabilities and assets from 2008 to 2013 that is derived by comparing the assets transactions with the reported balances (Summary of balance of payments, 2009). The external liabilities and assets of the country states that excess returns comes from the return effects rather composition effect. The return effects in 2007 amounts up to 0.3% while the composition effect was up to 0.1 percent while the composition effect is around -0.2 percentage points. The United Kingdom enjoys the favorable return on the investment that they made. Small movements in the returns on external liabilities and assets turn the surplus on the investment account into deficit. Comparison of United Kingdom, Australia and France Country Name United Kingdom Australia India Country Code LBY AUS IND Indicator Name Current account balance (BoP, current US$) Current account balance (BoP, current US$) Current account balance (BoP, current US$) Indicator Code BN.CAB.XOKA.CD BN.CAB.XOKA.CD BN.CAB.XOKA.CD 2005 14945000000 -43342943310 -10283543308 2006 22170000000 -45318593060 -9299060317 2007 28510300000 -64163007802 -8075694484 2008 35701700000 -52121667002 -30971987181 2009 9380600000 -48898407699 -26186435957 2010 16800700000 -44714246092 -54515877624 2011 3192400000 -44524758685 -62517637222 2012 23836300000 -68007540501 -91471245846 2013 -108100000 -49954786532 -49225968929 Graphical Representation Comparison of United Kingdom, Australia and India Country Name Australia United Kingdom India Country Code AUS GBR IND Indicator Name Official exchange rate (LCU per US$, period average) Official exchange rate (LCU per US$, period average) Official exchange rate (LCU per US$, period average) Indicator Code PA.NUS.FCRF PA.NUS.FCRF PA.NUS.FCRF 2005 1.309473333 0.549998333 44.099975 2006 1.327973441 0.543486667 45.30700833 2007 1.1950725 0.499771667 41.34853333 2008 1.192178333 0.54396625 43.50518333 2009 1.28218881 0.641919263 48.40526667 2010 1.090159486 0.647179346 45.72581212 2011 0.969463201 0.624140836 46.67046667 2012 0.965801031 0.633046989 53.43723333 2013 1.035843097 0.639660578 58.59784542 2014 1.109363293 0.607729627 61.02951446 Graphical Representation Analysis of BoP Balance of payment is considered to be one of the primary aspects to identify and determine the financial position of the country. The balance of payment theory of exchanges rate currently determined and identify that the price of the foreign exchange market is related to the term of the domestic money and is current identified and analyze by the free force of the demand and supply on the foreign exchange market. From the analysis of the data of the three countries Australia, United Kingdom and India it is clear and evident that the United Kingdom is at the better position, following the country is Australia which holds a much better balance of payment when compared with India (Summary of balance of payments, 2009). The balance of payment is considered to be one of the major aspects of the economic condition of the company. The theory related to the balance of payment and foreign exchange is interrelated with each other. It generally follows the exterior value of the nation currency which will rely o the demand and supply of the currency. The theory related to this topic is primarily refers to the overall key force of the demand and supply which are determined by several key item in the balance of payment in the country. According to the key theory, a decrease in the balance of payment leads to the overall decrease n the exchange rate. On the other hand the increase in the overall increase in the balance of payment increase the overall strength of the country regarding exchange rate value which will result in the overall increase in the price of the home currency in term of foreign current. Therefore, the cost of foreign money as far as domestic currency should ascent, i.e., the swapping scale of the domestic currency should fall. Then again, a surplus in a critical position of BOP infers a more prominent demand for home currency in a foreign nation than the accessible supply. Therefore, the cost of domestic currency as far as foreign currency increases, i.e., the rate of exchange moves forward (Stamatopoulos and Harissis, 2010). To put it plainly, the BoP hypothesis essentially holds that the exchange rates are dictated by the Balance of payment hinting demand and supply positions of foreign exchange in the nation concerned. All things considered, the hypothesis is additionally assigned as "Demand Supply Theory." The hypothesis attests that, the rate of exchange is the capacity of the supply of and demand for foreign money and not solely the capacity of costs getting between two nations as declared by the Purchasing Power Parity Theory which does not consider undetectable things. As per the Balance of payment hypothesis, the demand for foreign exchange emerges from the "debit" things to be determined of Balance of payment, while, the supply of foreign exchange emerges from the "credit" things. Since the hypothesis expect that the demand for and supply of foreign money are controlled by the position of the Balance of payment, it infers that supply and request are resolved predominantly by components that are autonomous of varieties in the rate of exchange or the fiscal strategy (Savona, Kirton and Oldani, 2011). As per the hypothesis, given demand supply plans, their convergence decides the balance exchange scale of cash. It ought to be noticed that the lower the cost of a money, the more noteworthy will be the demand for it, and in this way, the demand bend inclines descending. Then again, the supply bend slants upward from left to right demonstrating that a bringing down of the estimation of cost of the money tends to get its supply. Conclusion The report focuses on the balance of payments of different countries. Balance of payments is used by the countries to evaluate all the international financial transactions in a period of time. The current account balance and financial account balance of UK shows negative balance during the year 2008 to 2013. The balance of payment shows the current account, financial account and capital account. The balance of payment of UK shows good performance in comparison to Australia and India. The balance of payment of India shows the least performance in comparison to UK and Australia. Therefore, BOP helps to provide detailed information regarding the economic condition of the countries. References Alawattage, U. (2009). Exchange Rate, Competitiveness and Balance of Payment Performance.Staff Studies, 35(1). Arestis, P., Hein, E. and Le Heron, E. (2007).Aspects of modern monetary and macroeconomic policies. Basingstoke: Palgrave Macmillan. Balance of payments and the relationship to national accounts. (2011).United Kingdom Balance of Payments: The Pink Book, 2011(1), pp.139-141. Bayne, N. and Woolcock, S. (2011).The new economic diplomacy. Farnham, England: Ashgate Pub. 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