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30 years on, Hong Kong's dollar peg is still a star performer

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John Tsang says given the important role that the linked exchange rate system has played - and continues to play - in Hong Kong's rise to international economic and financial prominence, there is no reason to change it.

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65A2 Balance of Payments - components (1)

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66A2 Balance of payments - Probs and Sols (1)

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67A2 Correcting a Current Account Deficit (1)

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62A2 Exchange rates - fixed exchange rates (1)

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61A2 Exchange rates - floating exchange rates (1)

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60A2 Exchange rates - an introduction (1)

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Current Account Deficit - Problems - Data Response from Anderton

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Bring the data in this article up to date - application & analysis

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Bring the data in this article up to date - application & analysis

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www.tradingeconomics.com

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Britain's balance of payments has never been more deeply in the red. There have been some monster external deficits down the years but the one notched up in 2014 trumped them all.

Little is said in official circles about the nation's current account. George Osborne talks about boosting exports and rebalancing the economy, but, the chancellor is not nearly as worried about the trade deficit as he is about the budget deficit. And not nearly as worried as he should be.

The trend is clear. The UK ran a current account deficit of 3.5% of national income in 2012. The next year it rose to 4.7% of gross domestic product. Last year, it hit 5.9% of GDP.

There are two reasons for this deterioration. Firstly, the UK runs a sizeable deficit on visible trade - manufactured goods, raw materials, oil and food. This is a chronic problem; there has not been a surplus on manufacturing since the early 1990s, while the days when Britain was a net oil exporter are over.

In the years leading up to the financial crisis, the profits generated by the City helped mask the size of the trade deficit. In essence, the UK was making more money on its investments abroad than foreign citizens were making on their investments in the UK, in part because UK investors were making riskier but more lucrative bets.

Since the crash, however, the position has switched. The deficit on investment income in 2014 was £45bn, bigger than the £35bn deficit on trade in goods and services combined.

In the past, news of a deficit this big would have alarmed foreign holders of sterling. They would have pulled their money out of the UK, prompting a fall in the value of the pound, which would have helped boost exports and trim imports, leading to an improvement in the balance of payments.

But seen from abroad, the UK looks a haven of stability. Growth was stronger in the first quarter at 0.4% than previously believed. Consumers are spending and businesses are investing.

But warning bells are clanging. Consumers are running down their savings to fund their spending. That will suck in imports. The pound is rising on the foreign exchanges. That will make imports cheaper. The current account deficit is set to get bigger. Sooner or later, the markets will notice and get alarmed. A good old-fashioned sterling crisis will follow.
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UK's current account deficit is the forgotten deficit

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Britain's balance of payments has never been more deeply in the red. There have been some monster external deficits down the years but the one notched up in 2014 trumped them all. Little is said in official circles about the nation's current account.

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Pointless

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A record balance of payments deficit of £96.2bn (5.2% of GDP) for 2015, and £32.7bn (7% of GDP) for the fourth quarter alone - both higher in percentage terms than in any year since the second world war - and the first, instinctive reaction of the government is to let what is left of our steel industry go hang, so that imports can be boosted even further.

These latest figures are horrifying in both cash terms and as a percentage of GDP. During the war, when this country was, economically, on its uppers, the balance of payments deficit reached some 10%, financed by the Lend Lease arrangements with Washington and by running down our overseas assets.

Every schoolchild should know what happened after that: years of austerity, because our war-oriented productive capacity had slowly to be adapted to peacetime conditions and the expectations of the public for a recovery and improvement in living standards. This involved a succession of export drives so that we could, once again, "pay our way" in the world.

It was Ed Balls, much maligned at the time but now increasingly highly regarded, who pointed out that the 2008-09 financial crisis had economic effects that were the peacetime equivalent of war. But, unlike the situation in 1945, we did not have a war-ravaged economy. We had an economy that had been plunged into recession by a banking crisis. As Balls argued in his seminal Bloomberg speech of August 2010, the last thing we needed, after the economy had begun to recover in response to the fiscal stimulus of 2009, was a policy of austerity. We needed to foster economic growth, and adopt policies that would alleviate a burgeoning balance of payments problem.

The crunch has now come with the impact austerity has had on business investment and the export sector

When the Conservatives resumed what they regarded as their ancestral right - the keys to Nos 10 and 11 Downing Street - people like George Osborne would say that "you can't spend your way out of a recession". They would quote James Callaghan, who, in order to please the US administration and the IMF, said something similar when seeking an IMF loan in 1976. But Callaghan subsequently retracted that assertion in his memoirs, and was strongly critical of the deflationary monetarist policies of the early 1980s.

When Cameron and Osborne arrived in office, they were obsessed with the wrong deficit. "Paying our way in the world" has precious little to do with the balance between public and private sector spending and everything to do with the balance of our overseas trade and payments.

The parallel made by Balls with the impact of war should have alerted policymakers to the fact that it took decades for European nations to recover from the war. There was no need for the UK and others to rush to bring down their budget deficits after 2009. As it happens, many commentators are making great play with the fact that Osborne, while inflicting untold misery on vulnerable citizens with his mean-minded cuts, keeps missing those self-inflicted targets anyway.

The crunch has now come with the impact the policy of austerity has had on business investment and the export sector, and hence on the balance of payments. Now, I am not saying for one moment that the blame for what is now manifestly a balance of payments crisis lies solely at the chancellor's door. The problems have been piling up ever since the Thatcher government's monetarist experiment with a sensationally overvalued exchange rate that inflicted serious damage on manufacturing.

The damaging effects of an overvalued exchange rate continued, intermittently, under successive Conservative and Labour governments. Back in November 2002 Mervyn King said, at an Inflation Report press conference: "What we've seen is a weak net trade sector, offsetting a strong sector producing to meet domestic demand. I think in large part it is the consequence of a sharp rise in the real exchange rate, and what flowed from that."

But this government's obsession with the wrong deficit has exacerbated a long-term problem, and brought things to a head. And the very idea of allowing such a strategic industry as steel to go down - quite apart from the social implications in south Wales - beggars belief.

Here we come to some interesting parallels with the circumstances surrounding the June 1975 referendum. Then, as now, there was nervousness in the foreign exchange market as R-Day approached. But then it was less to do with the possibility of exit ("Brexit" had yet to be coined) as with a rise in inflation of 3.9% in one month, bringing the year-on-year figure to 21.7%. These days the monetary policy committee struggles to meet an inflation target of 2% for the whole year.

Then, as now, there was growing concern about the balance of payments and the pound. Then came the 1976 IMF crisis, and an attempt to stem a fall in the pound that had first, in the words of Sir Douglas Wass, Treasury permanent secretary at the time, "declined to fall" and then fallen too much.

The paradox now is that, patently absurd though the whole idea of Brexit is, fears about it have been unsettling the pound. Now we have the balance of payments crisis. I did not get where I am today forecasting exchange rates, but it is not inconceivable that circumstances are combining to bring the pound down to a more competitive level, and that, as in 1975-76, things could get completely out of hand.
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Steel shrivels while Britain's balance of payments crisis grows

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A record balance of payments deficit of £96.2bn (5.2% of GDP) for 2015, and £32.7bn (7% of GDP) for the fourth quarter alone - both higher in percentage terms than in any year since the second world war - and the first, instinctive reaction of the government is to let what is left of our steel industry go hang, so that imports can be boosted even further.

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A current account deficit means the value of imports of goods/services / investment incomes is greater than the value of exports. It is sometimes referred to as a trade deficit. Though a trade deficit (goods) is only part of the current account.

If there is a current account deficit, it means there is a surplus on the financial/capital account. See: Balance of payments for an explanation of the different components.

Why a current account is considered harmful to the economy

1. If a current account deficit is financed through borrowing it is said to be more unsustainable. This is because borrowing is unsustainable in the long term and countries will be burdened with high-interest payments. E.g. Russia was unable to pay its foreign debt back in 1998. Other developing countries such as Brazil, African countries have experienced similar repayment problems. Countries with large interest payments have little left over to spend on investment.

2. A factor behind the Asian crisis of 1997 was that countries had run up large current account deficits by attracting capital flows (hot money) to finance the deficit. But, when confidence fell, these hot money flows dried up, leading to a rapid devaluation and crisis of confidence.

If you run a current account deficit, it means you need to run a surplus on the financial/capital account. This means foreigners have an increasing claim on your assets, which they could desire to be returned at any time. For example, if you run a current account deficit, it could be financed by foreign multinationals investing in your country or the purchase of assets. There is a risk that your best assets could be bought by foreigners, reducing long term income.

A current account deficit may imply that you are relying on consumer spending, and are becoming uncompetitive. This leads to a lower growth of the export sector. This is particularly a problem for countries in the Euro - who cannot devalue to restore competitiveness. It caused very large current account deficits and was a factor behind the EU recession of 2008-13

A Balance of payments deficit may cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of your currency (devaluation). This can lead to a decline in living standards and lower confidence for investment.

UK current account since 1955

UK current account deficit as a % of GDP since 1955. The large current account deficit (5% of GDP) in 1988 was indicative of an unbalanced economy - with

The large current account deficit (5% of GDP) in 1988 was indicative of an unbalanced economy - with economic boom, high inflation and demand greater than supply. This economic boom, led to the recesion of 1991/92 where the UK deficit declined.

1. A current account deficit could occur during a period of inward investment (surplus on financial account). This inward investment can create jobs and investment. E.g. the US ran a current account deficit for a long time as it borrowed to invest in its economy. This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US money. Japanese investment has been good for UK economy - not only did the economy benefit from increased investment but the Japanese firms also helped bring new working practices in which increased labour productivity.

2. With a floating exchange rate a large current account deficit should cause a devaluation which will help automatically reduce the level of the deficit.

3. A current account deficit may just indicate a strong economy, which is growing rapidly. For example, the rise in deficit on UK primary incomes (2015-16) is a reflection that investment in the UK was giving a good return to foreign investors.

Evaluation

It depend on the size of the current account deficit as a % of GDP. For example, a deficit of over 5% would be cause for greater concern.

It depends on how you are financing the current account deficit. If a country is borrowing from abroad to finance consumption, this is damaging in the long-term. If it is financing the current account deficit through attracting long-term capital investment, this could have positive benefits.

It depends on the country in question. For example, the US probably has less reason to be concerned about a current account deficit. The US can attract a lot of capital flows to buy dollar securities. However, a developing economy may be more vulnerable to a current account deficit. This is because investors may be quicker to fear an economic downturn and remove their capital.

Related
In 2016, we see the UK current account deficit rise to nearly 7% of GDP - caused by deficit in goods, but also deficit on primary incomes (net investment incomes, wages) and secondary incomes (transfers) The size of this deficit was a factor behind the depreciation in the value of Sterling (exacerbated by Brexit)

However a current account deficit is not necessarily harmful

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Problems of a current account deficit - Economics Help

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A current account deficit means the value of imports of goods/services / investment incomes is greater than the value of exports. It is sometimes referred to as a trade deficit. Though a trade deficit (goods) is only part of the current account.

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Understand the formula
Calculate and verify the BoP position
Apply the condition to the J-curve phenomenon

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Exchange Rates - Marshall Lerner Condition | tutor2u Economics

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Given that in short run X and M are inelastic and that in the medium to long run X and M become more elastic - Draw the J-Curve to show how the Balance of Payments reacts to a depreciation of the currency over time

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Powerpoint

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Notes

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Finacial & Capital Account

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Calculations
Exam technique
Application
Analysis
Evaluation