Download Balance of Payments - Pros Cons (Activity Answers) File

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Balance of Payments: Pros & Cons of Surpluses & Deficits
Most information from Matt McGee’s Economics: In Terms of The Good, The Bad and The
Economist 2nd ed. (2005) and notes from Ken Turner’s IB2 Econ classes (2013-14).
****Note: In the absence of a pegged currency, a current account surplus
should lead to an appreciation of that country’s currency while a current
account deficit should lead to a depreciation…both have their own
advantages and disadvantages****
For China, with a current account surplus and capital account deficit:
What are some advantages?
 Current account surplus indicated a positive gain for GDP as net exports are
 Foreign assets (such as US bonds) can be viewed as another form of saving for the
home country, which will enable future consumption.
 Increasing foreign holdings (such as US bonds) will in time generate income in the
form of profits, interest received, and dividends.
 Forex reserves (from the current account surplus) can be used for overseas FDI
and/or FPI.
o Related to this point, capital will flow to foreign markets with higher rates of
return than the domestic (Chinese) markets. This will lead to better resource
allocation and should increase profits for domestic (Chinese) firms.
What are some problems or disadvantages?
 Capital outflow means less investment in China.
 Domestic consumption suffers as Chinese goods go overseas instead of staying in
the country. Chinese citizens have fewer choices on what goods to consume.
 A current account surplus means there is a degree of diverting investment from the
domestic to the foreign market. This could lead to a loss of jobs (yet this is highly
contentious), skills, and technology gains.
 There will be a degree of tax loss, as a portion of tax bases--investment, output, and
wages--will be taxed outside the home country. (e.g. factory built overseas doesn’t
increase taxes for China)
 Politically, it can be problematic to maintain a continuous current account surplus.
China and the US has had a somewhat strained relationship in the 2000s.
 The US may be tempted to use protectionist measures to reverse its current
account deficit. This could lead to a loss of revenue in exports and a temptation to
incorporate protectionist measures of its own.
 There is pressure for the currency to appreciate. China has to spend much effort on
maintaining its pegged currency. If it allowed its currency to float, its exports may
decrease which could lead to a reduction in GDP and increase in unemployment.
For the US, with a current account deficit and capital account surplus:
What are some advantages?
 Even though it is on borrowed money, US citizens have the luxury of consuming
more than they produce. They also have more choices in what to consume (with
imports exceeding exports).
***It is OK to run a current account deficit as long as a country (e.g. the US) has the
ability to pay its loans back! Because the US is seen as a low risk investment, it is
able to attract more funds for a lower interest rate.
 The extra funds gained from borrowing and FDI/FPI can lower unemployment
and increase GDP/output in the short and long term.
 Increased imports can help producers create a wider variety of goods and
What are some problems or disadvantages?
 Borrowing from abroad means that loans have to be repaid w/interest.
 If the US continues to accrue massive debt in its current account, its ability to pay
off foreign debts might be questioned which would lead to fewer loans, creating a
decline in GDP and increase in unemployment. These would make paying back
loans much more difficult.
o International credit ratings agencies (such as “Moody’s”) assess a country’s
ability to pay back…calling bonds from different areas anything from AAA (great)
to junk (not great).
Also, because the US may eventually attract fewer loans (if its ability to pay back is
questioned), it would have to offer higher interest rates to attract lenders. This
would lead to them paying back an even higher % on new debt. The higher interest
rates would have a deflationary effect on the economy.
There is pressure for the currency to depreciate. If the currency depreciates, the
debtor nation (e.g. the US) could suffer severe shock as debt servicing (paying back
debt) becomes much more costly.
The US is consuming more imports than exports, which means there is a loss of
The sale of domestic assets to foreigners will cause outflows in the forms of
repatriated profits and dividends, which would intensify the current account deficit.
o “Large foreign investment may mean decreased profits.”
o “Money is flowing out of the current account.”
The more the US owes to China, the less power the US has in serious disputes
over a variety of issues. It could also lead to a loss of economic sovereignty if the
debt is so great that the US must adhere to demands China makes on how it should
run its economy.