Measuring trade

we distinguished between international merchandise trade and trade in

commercial services. The interplay between the two is the key element in
national trade and balance of payments accounting of which the main elements
are illustrated in Table 1.2.1. In the past it was common UK practice to
distinguish between ‘visible’ and ‘invisible’ trade, meaning effectively the
tangible items and the intangible items. The formal published trade figures now
have the two headings: ‘balance on goods’ and ‘balance on services’ as in Table
1.2.1. Other items of what used to be part of the invisibles account are now
treated under the new heading of ‘UK Assets and Liabilities’.

International balance of payments ratios

There are three yardsticks of international trade which are quotedcommonly by
economists and others seeking to compare trade performance between countries
relative to their economies:
• ratio of trade at market prices to gross domestic product (GDP). For example,
China now has a surprisingly open economy with a ratio of 44% in 2001, while
Japan’s ratio of trade to GDP was only 18%.
• ratio of current account balance to GDP. The ratios of the UK’s and USA’s
deficits to GDP are 1.7% and 5.1% currently while those of some of the EU
accession states exceed 40%.
• terms of trade. This more sophisticated measurement is the ratio of a country’s
prices of exports to those of its imports and is an indicator of competitiveness.
Imbalances in trading accounts
The surplus or deficit resulting from the sum of the balance on goods and the
balance on services is known as the ‘Balance of Trade’. The ultimate result of the
collection of UK trade figures is a net total known as ‘Balance of Payments’. This
figure represents formally the final surplus or debt resulting from all UK
transactions with the rest of the world in any given year.
It is customary to apply the term ‘current account balance’ to the reported net
surplus or deficit for a given period or the current year to date. The objective for
trade balances objective is to achieve ‘equilibrium’ or sufficient surpluses to pay
off a country’s debts but not over such a period as
to damage trade by affecting the exchange rate. A country whose balance of
payments shows consistent deficits is said to be in ‘disequilibrium’. Technically,
the term ‘disequilibrium’ applies equally where consistent surpluses are
experienced but this is a more desirable result and is rarely referred to under the
heading of disequilibrium.
Managing disequilibrium
A country with a surplus in its balance of payments is said to be a ‘creditor
nation’. It can add this surplus to its reserves or lend it to other nations to enable
them to improve their economies.
Conversely, if a country incurs a deficit in its balance of payments, it is said to be
a ‘debtor nation’ because it has spent more than it has earned. It must finance
this deficit either by drawing upon its reserves or borrowing externally.
Clearly, a country’s reserves of gold and foreign currencies are not inexhaustible
and, sooner or later, it would have to negotiate loans and eventually repay them.
We have already mentioned the role of the IMF as a provider of loans for this
purpose. IMF loans are generally granted with stringent conditions attached as to
the management of the borrowing country’s economy. In the 1970s the UK
negotiated significant loans from the IMF in order to cover accumulated deficits.
Changes in domestic economic policy, in agreement wit the IMF, enabled the
loans to be repaid quite soon.
A country with a persistent balance of payments deficit must take appropriate
measures to rectify the situation which would depend upon the causes of the
deficit. If it is due to its imports, measures must be taken to restrict imports
while stimulating exports. If it has been caused by an excessive outflow of
capital, then measures must be taken to control overseas investment. As we
shall discuss in Chapter 9.3 at the end of this book, both the UK and the USA are
in deficit at the end of 2003 and remedial action is likely to become necessary.
Some of the measures which a country may take are summarized as follows:
Import controls
In theory, there are two methods of controlling imports, the protection tools
described in:
• import quotas and
• import duties (tariffs)
Import quotas provide restrictions to the total number or value of goods which
may be imported into the country during a specified period. The imposition of
import duties is intended to reduce demand for the commodities in question by
increasing the price to the ultimate user.
As signatories to the GATT and its successor the WTO, the boundaries within
which the UK or the USA can impose import controls or tariffs, even to address
disequilibrium, are severely restricted. As a full member of the
EU the UK can depart from the common external tariff only in the most
exceptional circumstances.
Export incentives
A government might grant its exporters generally, or in specific industries,
subsidies or taxation reductions to enable them to reduce their prices and
undercut foreign competitors. Such incentives are also outlawed by theWTO ad
would certainly contravene EU agreements if applied to trade within Europe.
Monetary measures
Since the use of import controls and export incentives is constrained, the UK
usually resorts to monetary measures when there is a balance of payments
deficit. Recognising that the fundamental cause of current account deficits is
usually excessive home demand for imported goods and the absorption of home-
produced goods which may otherwise have been exported, the government may
adopt one or more of the following measures:
• increase interest rates - thereby discouraging borrowing and consequently
tightening and reducing spending power. Higher interest rates also attract
foreign short-term capital.
• open market operations - by selling securities in the open market the
government reduces the amount of money in circulation which diminishes
purchasing power.
• special deposits - in the form of directive to the banks to deposit a certain
proportion of their funds with the Bank of England where they are frozen. This
reduces the liquidity of the banks, which in turn restricts bank lending and
diminishes purchasing power.
Fiscal measures
A government can also reduce spending power more directly by means of higher
taxation, hire-purchase controls, etc.
Devaluation
The purpose of devaluing a currency is to make a country’s exports cheaper to
overseas buyers and, at the same time, its imports dearer. This method is
applicable when a system of fixed exchange rates is in place, but is usually the
measure of last resort.
Under a system of floating exchange rates, the exchange value of a currency will
gradually depreciate if it is overvalued, which will have the same effect as a
devaluation. The currencies of developing countries which
are ‘pegged’ by a fixed rate (or within a narrow fixed band) to a more stable
‘hard’ currency, such as the US dollar, are effectively insulated from the market
forces related to its own country’s economy.
Managing exchange rates
The history of exchange rates is complex. In the early days of trade exporters
would accept payment only in commodities which were considered to have
intrinsic value, such as gold, silver or jewels.
This approach continued until well into the nineteenth century when certain
currencies came into use for trade, notably the pound sterling, the Dutch guilder
and the French franc reflecting the growth of Empires during that century. The
British Empire’s wealth enabled the British Government to back every single
pound note with an equivalent amount of gold. The level of trust in paper
currency became so great that large areas of the world traded and maintained
reserves in sterling.
These territories became known collectively as ‘the Sterling Area’, a vast
expanse of British Government-backed paper which became a major
embarrassment to successive governments of the 1950s and 1960s when
countries began to convert their reserves to gold or US dollars. In about 1873,
the need to know the value of a trading currency led to the establishment of the
‘Gold Standard’ with currencies pegged in terms of their values in a specific
weight of gold and each other. The Gold Standard created the first system of
fixed exchange rates and provided the confidence required for a significant
expansion in world trade. The standard began to break down after 1918 and
disappeared during the 1930s. The lack of formal exchange rate mechanisms
contributed to the collapse in world trade during that inter-war period.
After World War II the IMF established a new system of fixed exchange rates
which was also fixed against gold but more remotely. Each country assigned a
value to its currency in terms of an ounce of gold (which was valued then at
$35). Nations were only allowed to adjust their exchange significantly in extreme
circumstances but could make minor adjustments (up to 10%) in circumstances
which were described as ‘fundamental disequilibrium’. Few countries used this
facility (only 6 between 1947 and 1971) and, by the 1960s, the system had
become highly unstable. By 1971 continuing US difficulties caused the Americans
to announce that the dollar would no longer be convertible into gold. Soon
afterwards the British and French Governments also came off the gold standard.
Since that date the main system of exchange rate ‘management’ has been to
allow currencies to float within reasonable limits against other currencies. In its
European Community phase the EU operated several fixed and semifixed
systems during the 1970s and 1980s, the last of which deteriorated into a
smaller ‘Deutsche Mark’ area. However, the establishment of the European
Monetary Union with the formation of the European Central Bank (ECB) and the
launch of the euro-currency from 1 January 1999 has put in place a single
currency throughout the Euro-zone which currently includes all members of the
EU15 except for Denmark, Sweden and the UK.
The UK retains the pound sterling which the British Government allows to float
whilst monitoring its position closely. The 10 members of the Eurozone have
foregone the ability to devalue or revalue a national currency individually.