BALANCE OF TRADE AND BALANCE OF PAYMENTS

By the end of the subtopic the learners should be able to:

1. Give a definition of international trade, factors that lead to international trade and the merits and demerits attached to international trade
2. Explain the balance of payments account and all the accounts in the balance of payment account
3. Explain the balance of trade account
4. Differentiate between trade deficit and trade surplus

Introduction

• Most countries around the world are becoming more interdependent on one another and that process of interdependence is called globalization.
• Due to this interdependency, countries exchange goods and services across  their international borders
• This exchange of goods and services between two or more countries is called international trade.
• However, a government can also put restrictions on the movement of goods and services.

Factors that lead to international trade

• Limited mobility of factors of production
  • Land is immobile
  • Mobility of labour is restricted by language and customs. There are also restrictions on immigration as well.
  • Capital is mobile, but usually crosses boundaries if the conditions are favourable, for example, if there is political stability and if there are no barriers of ploughing back profits.
  • Due to challenges in movement of factors of production like land and labour, countries with abundance of land compared to labour may specialize on commodities that are land intensive, for example, maize, tobacco and poultry.
  • Those goods may be exchanged for labour intensive products such as manufactured products that are produced in other countries.
• Climatic differences
• Differences of skills
• Technological differences

Balance Of Trade And Balance Of Payments

Balance of payments

• Balance of payments account records financial flows between a particular country and the world.
• When a country is involved in foreign trade it makes certain payments to other countries. In turn it also receives payments from its trading partners. These financial flows are captured in the balance of payments account.
• Financial flows that are also recorded in the balance of payments account, apart from foreign trade are international borrowing, international investments and loan repayments.
• Balance of payments account is usually divided into three main accounts which are current account, capital account and financial account.
• The accounts are presented in the form of a balance sheet account.

Sections of balance of payments account

Current account

• This section is concerned with income and expenditure that relate to foreign trade.
• It records a nation's performance in international trade of goods and services as well as other inflows or outflows of income and transfers.
• The current account records visible trade in goods and invisible trade in services.
• It also records incomes received from other countries and payments that are made to other countries.
  • Take for instance in Zimbabwe, payments that are recorded on the debit side include wages that are paid to foreigners working in Zimbabwe and interests, profits and dividends paid to people from other countries who have invested in Zimbabwe.
  • If Zimbabwean residents are working in other countries then their wages are recorded on the credit side of the current account.
  • Interest, profits and dividends that are earned by Zimbabweans who have invested in other countries are also recorded on the credit side.
• Current account also records current transfers.
  • These include payments between governments and other transactions that have no direct payments for productive activities.

Capital account

• This account records capital transfers and acquisition and disposal of non-financial assets.
• Capital transfers include grants from the government and debt forgiveness.
• Acquisition and disposal of non-financial assets is concerned with purchases and sales of assets, for example, purchases and sales of land, copyrights, trademarks and patents.

Financial account

• Financial account records transactions of changes in ownership of a country's foreign assets and liabilities.

Four main sub-accounts

1. Direct investments. These are investments in productive assets such as purchase of machinery, factories and equipment and setting up a new branch in a foreign country.
   These investments help in the process of wealth creation.
2. Portfolio investments. These are investments in paper assets for example, shares, treasury bills and government bonds.
3. Other financial flows. These include bank deposits from overseas residents and loans into a country from abroad.
4. Reserve assets. Involves changes in national reserves.

Causes of deficit in balance of payments account

• High income levels in the domestic economy results in a deficit.
  • This is because when people have high incomes they usually demand more goods and services from other countries.
  • When people demand more of domestic products there will be a reduction in exports and if they demand more of foreign products there will be an increase in imports.
  • Local firms may also increase their imports of raw materials in a bid to expand their output so as to meet increased demand.
  • However, the incomes from other countries should be low so that there will not increase the value of imports.
• An overvalued exchange rate can also lead to a deficit.
  • Overvalued exchange rate will make exports more expensive in terms of foreign currency and imports will be cheaper in terms of domestic currency.
  • If the demand for exports and imports is elastic then, revenue on exports will fall and expenditure on imports will rise.
• A country may be producing goods and services of low quality.
• A country may be producing goods and services that have low world demand.
• A deficit may also be caused by higher costs of production.

Effects of balance of payments deficit and surplus

The effects of a deficit or a surplus depend on the size, the cause and the duration of the deficit or surplus.

• In the short run a deficit will increase the standards of living because a country will be consuming more goods and services than what it is actually producing.
  • On the other hand, if the deficit is not financed by income from investments then it may be financed by either borrowing or reserves.
  • Borrowing may result in weakened investment account in the future due to an outflow of interest, dividends as well as profits.
• A deficit can also reduce money supply if it is not offset by monetary controls hence will lead to a reduction in inflationary pressure.
• A surplus would mean that there is increased opportunity cost since the country will be foregoing the opportunity to consume its goods and services.
• Surplus may also cause an inflationary pressure because it involves net inflow of money and a net outflow of goods and services.

Balance of Trade

• Balance of trade is the difference between a country's imports and its exports.
• It is the largest part of a country's balance of payments account.
• Balance of trade records flows of income from visible trade in and out of the country.
• When calculating balance of trade, the following formula is used;

visible balance=value of visible exports-value of visible imports

• Visible exports are goods that are sold to foreign countries in order to earn income. These goods include equipment, electrical gadgets and other manufactured products like food stuffs.
• Visible exports indicate an inflow of money from sale of goods into the country.
• Visible imports are goods bought from other countries. Therefore, visible imports indicate leakages of money out of a country.
• Visible balance of trade is the difference between the value of visible exports and visible imports.
• Balance of trade will be favourable if the exports of a country are more than the imports.
• A favourable balance of trade is known as trade surplus.
• If a country spends more than what it earns from selling its goods to other countries, then it is operating under a trade deficit.
• A trade deficit can also be referred to as an unfavourable balance of trade.
• In order to maintain a favourable balance of trade the government should put restrictions on international trade or create trade policies that boost trade surplus.
• This restriction of international trade is called protectionism.
• Balance of trade is the most important element of the current account.
  • A current account is a component of the balance of payments of a nation and it records exchange of goods and services the country has with trading partners.
  • It records three components and the sum of those three components is the net exchange.
  • The three components of a current account are;
    • Visible trade
    • Invisible trade
    • Net transfers
  • It is called the current account because only the values of goods and services traded within the current period are recorded in there.

Current account

Debit Credit Imports Exports Foreign aid Domestic spending abroad Foreign spending in the domestic markets Domestic investments abroad Foreign investments in the domestic economy

• If the debit side is greater than the credit side or if imports are greater than exports then it means that there is a net outflow or a trade deficit.
• If the credit side is greater than the debit side, it means that there is a positive balance of trade or a net inflow or a trade surplus.

Solutions to trade deficit

• The government should agree on a pegged exchange rate that keeps currency constant at a fixed rate, unlike a floating exchange rate where the exchange rate is determined by market forces.
• Government should also manage investments in foreign accounts so as to control volatility and the movement of currency.
  • Volatility of currency refers to the amount of risk that is involved with the size of changes in currency exchange rate.
  • Higher volatility means that the price of the currency can change drastically over a short period.
  • Lower volatility means that exchange is not fluctuating drastically but steadily changes in value over time.
  • Therefore, the higher the volatility, the higher the risk, hence volatility is to be controlled to solve trade deficit.