Question

A country has a current account surplus of \(£ 6\) billion but a financial account deficit of \(£ 4\) billion. (a) Is its balance of payments in deficit or surplus? (b) Are its foreign exchange reserves rising or falling? (c) If the country has a fixed exchange rate, is the central bank buying or selling domestic currency? Explain.

Short answer

(a) Surplus; (b) Reserves are rising; (c) Central bank is buying domestic currency.

Step-by-step solution

Understanding the Balance of Payments

The Balance of Payments (BOP) consists of the current account and the financial account. The current account represents exports and imports of goods and services, income, and current transfers. The financial account captures changes in ownership of international assets. The BOP should balance if the sum of these accounts plus any errors and omissions is zero.

Calculate the Balance of Payments

To determine the BOP condition, we sum the current account surplus and the financial account deficit. Here: \[ \text{BOP} = \text{Current Account Surplus} + \text{Financial Account Deficit} = £6\, \text{billion} + (-£4\, \text{billion}) = £2\, \text{billion} \] This means the BOP is in surplus.

Determine Impact on Foreign Exchange Reserves

A surplus in the balance of payments indicates that the country is earning more from its international trade and financial transactions than it is spending. Consequently, the foreign exchange reserves are likely to rise.

Implications for a Fixed Exchange Rate System

If the country maintains a fixed exchange rate, the central bank manages currency fluctuations to maintain the peg. With a balance of payments surplus, the central bank accumulates foreign currency and buys domestic currency to maintain the exchange rate, resulting in rising foreign exchange reserves.

Key concepts

Current Account

The Current Account is a fundamental concept in understanding a country's international economic position. It consists of the balance of trade, which includes the import and export of goods and services. Additionally, it counts net income from abroad, such as dividends and interest, and net current transfers, like foreign aid.
Understanding the Current Account is crucial because it reflects the nation's net earnings on international transactions over a period. A surplus, as seen in this case with the £6 billion, means the country is exporting more than it is importing and receiving more in payments than it is sending out.

• Balance of Trade: Exports vs. Imports
• Net Income: Earnings on Investments
• Current Transfers: Aids and Gifts

A surplus is generally a positive indicator of a country's economic health, suggesting it is competitive in the global market.

Financial Account

The Financial Account plays a vital role in the Balance of Payments, reporting changes in international ownership of financial assets. This includes investments such as stocks, bonds, and real estate between countries, as well as reserve assets held by the central bank.
A deficit in the financial account, like the £4 billion deficit noted here, indicates that a country is investing more in foreign assets than it is receiving from foreign investors. This can happen through a variety of channels:

• Foreign Direct Investment (FDI): Investing in businesses abroad
• Portfolio Investment: Buying foreign stocks and bonds
• Other Investments: Loans and banking flows

While a financial account deficit might seem negative, it could mean the country is actively acquiring valuable foreign assets for future gains.

Foreign Exchange Reserves

Foreign Exchange Reserves are critical for a country's financial stability and ability to manage its currency. These reserves consist of foreign currencies and other assets like gold, held by a nation's central bank and used to back liabilities such as the national currency.
In our scenario, with a balance of payments surplus of £2 billion, foreign exchange reserves are expected to rise. This surplus indicates the country is accumulating more foreign currency than it is spending.

• Balances international trade differences
• Stabilizes currency during economic fluctuations
• Enhances creditworthiness and investor confidence

Rising reserves suggest a robust financial state, enabling the country to maintain economic stability and meet foreign obligations.

Fixed Exchange Rate

A Fixed Exchange Rate, or pegged exchange rate, is a system where a country's currency value is tied to another major currency or basket of currencies. This is managed by the central bank, and in a surplus scenario, such as this, specific actions are required.
Here, with a surplus in the balance of payments, the central bank typically buys domestic currency and sells foreign currency to maintain the pegged rate. This action prevents the domestic currency from appreciating beyond the desired level.

• Stabilizes currency for international trade
• Controls inflation and interest rates
• Provides predictability in foreign transactions

These interventions require careful management, as they can deplete reserves if prolonged but boost confidence and trade with fixed expectations.