Wednesday, July 23, 2008

Reasons for current account deficit in UK (Unit 3/ 6)

Reasons for current account deficit in UK

Price uncompetitiveness

1. Inflation rate. Countries with high inflation rate generally have more pricey goods as firms need to factor in increase in costs of production such as wages, oil price, raw materials, capital goods, rental etc. This can erode its international competitiveness, as the demand for the exported goods will likely fall. This has adverse effect onto the Balance of Payments, particularly the current account. However, this may not be that applicable to UK, since it generally has low & stable inflation even within the EU

2. Exchange rate. Pound has risen sharply against many other major currencies ever since 1996. As a result, UK exports have become less price-competitive, while its imports have become more price-competitive. This is true especially for manufactured goods. Assuming the sum of elasticity of demand for both exports & imports is greater than 1, the appreciation of pound will worsen the existing trade deficit

3. Costs of labour. In UK, unit labour costs have also risen relative to its major competitors like France & Germany, partly due to sluggish productivity growth. Besides, workers there often demand for higher pay which is not compensated by an equal increase in productivity

4. Loss of comparative advantage. UK used to be famous for its visible exports & was previously known as ‘workshop of the world’. However, UK loss its comparative advantage with respect to production costs to NICs like China. The latter has risen & dominates the global export market due to factors like EOS, weak Yuan & cheap labour

Non-price uncompetitiveness

5. Income elasticity of demand. YED for imported goods in UK is reckoned to be between 1.6 to 2.0 (very elastic) while the YED for exports is lower at between 1.0 to 1.5. This means that when world incomes rise, UK imports will grow quicker than exports. This also helps to explain, why the UK’s current account has been in persistent deficit

6. Other non-price factors include unattractive design, relatively poor quality control, difficulty to obtain spare parts, poor after sales service especially outside Europe & low spending onto fixed capital

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