Ans for week 6 essay (a)

Qn: Explain the potential causes of a balance of payments deficit in the current account. [10]

Interpretation of Qn:
Explain - Make clear and give reasons for
Potential - Possible
Current account - Visible and invisible trade

Comment from Cambridge:
- Deficit in current account could be due to deficit in visible trade account (low export earning and high import expenditure) and invisible trade account (service, income flow, transfer of money)
- Must group possible factors under more general themes rather than mere listing of every possible causes.
- Need to explain possible factors and provide analytical explanation based on elasticities (price, income and cross) of demand.

Ans:
- Define Balance of payments
- Define current account of BOP
- Explain current account deficit: If receipts are less than payments, there is a current account deficit.

Deficit in visible trade - Low export earning
(I) Structural changes
> Change in pattern of demand for export
(i) Presence of substitute of greater use and better quality.
E.g Switch from analogue watch by Swiss to digital watch by Japanese
(ii) Economic downturn in major export market
- Demand for export falls.
- If demand for export is income elastic, total revenue for export decrease.
> Loss in comparative advantage
- New producers (more price competitive/efficient/productive) emerge.
E.g. China, India
- technology changes
- pattern of production change as cost of production change due to inefficiency/ low productivity in domestic production.
- Decrease in demand for export
> Changes in terms of trade
- Impact depend on elasticity of demand
- Unfavourable movement in terms of trade, export earning falls, import expenditure increases if demand for export and import are price elastic.
- Current account worsen
E.g Primary produce - coffee and impact on Brazil
> Overvaluation of home currency
- Export less competitive
- Current account deficit
E.g Argentina currency crisis in 1999
(II) Barriers in form of unfair trade
> Imposition of trade barrier in foreign countries
> Price of export more expensive in foreign markets.
> Quantity demanded for export decreases
> If demand for export is price elastic, total export earning decreases.
> Current account deficit
E.g. imposition of tariff on imported steel by US, lasted for a few months and imposition of tariff on Japanese printer by European community.

Deficit in Visible trade - Higher import expenditure
(I) Stuructural changes
> Change in pattern of demand for import
(i) increase in population/ income at home (boom/ expansionary demand management policies)/ change in taste and preference in favour of import
(ii) investment in capital goods (import from abroad)

Deficit in Invisible trade - lower level of invisible earning
(I) Under-development or inefficient service sector
> lack of demand for service provided to foreign countries.
(II) Little investment income flow for developing countries as few sources of investment abroad by residents.
(III) Indulgence in overseas aid/grants (unilateral transfers)
> huge outflow of transfer
> current account deficit E.g US

Conclusion:
There are many potential causes for deficit in current account.