The Link between the Current Account and Changes in a Countrys Net Foreign Wealth - Term Paper Example

Discuss the Link between the Current Account and Changes in a Country’s Net Foreign Wealth Essentially the traditional balance of payment is Change in Net Foreign Asset = Current Account Net Foreign wealth or Net Foreign Asset is the exposure of a country in terms of its liability. Simply put, Net Foreign Asset is the total current value of its offshore asset less the current value of other countries’ asset within its borders. And, Current Account is the sum of Balance of Trade, net Factor Income and net Transfer Payments. Balance of Trade, in the meantime, is the total current value of exported goods and service less the total value of imported goods and services. Factor Income is the return or income of a particular asset an example of which are the income derived from land or the rent paid by its occupant. Net Transfer Payment is the liability of the government in financing its operation or the difference between the required payments needed to finance social services or other similar government function and the availability of funds coming from the income of the government. Before giving illustrations and meaning to each of the economic phrases, it is imperative to state that the link between the two sides of the equation reflects the Balance of Payments of a country. The Balance of Payment is the record of all the fiscal transaction of a nation with the rest of the world. Balance of Payments ideally should always be zero to ensure that nations are not spending beyond their means or on the opposite side, not hoarding its fiscal resources that could lead to a regional or global financial crisis. Spending beyond a country’s means could result to increasing its local or external debts which would counter-act or zero out its Balance of Payments. An unchecked increase in external and local loans could result to an economic collapse starting with its monetary system after a short duration spiral. The domino-effect would then ensue, affecting inflation for consumer items, interest rates for banks, closure of manufacturing plants dependent on imported raw materials that lead to the loss of jobs. Hoarding, on the other hand, results to the shortage of the amount of money being circulated in the global or regional economy. Since the US dollar is considered as the de facto international currency, the absence of the dollar in international circulation could lead to the collapse of some economy due to the spiralling devaluation of its monetary system against the dollar. The absence of available money for institutional short term loans from international sources could prompt government to look inward to finance its US dollar requirements. The absence of money in circulation on a regional or global economy would result to government controlled banks to lower their interest rates. Rational Expectation Theory would then dictate the momentum. Lower interest rates from government controlled banks translate to lower income for money in the bank which will lead to the exodus of money from the banks to high yield instruments such as bonds and government loans. On the other hand, a Balance of Payment from all countries is indicative of a progressive and healthy world economy. In essence, the amount of goods produced is equal to the goods required by the market, the amount of money in circulation needed to purchase the goods are in the hands of the population transacting for the goods. Net Foreign Asset – as articulated earlier—is the net asset of a country abroad. This would include the assets of its industries offshore or overseas that earn revenues that will redound to the benefit of the country in general and the country’s citizen in particular. To illustrate: The United States although has a much publicized deficit that runs into billions of dollars has a substantial holding in other countries that earns for it some revenue to maintain its Balance of Payment. Resolving the value of these investments abroad to current valuation enables it to achieve Balance of Payment. This scheme contributes to the continued resiliency of the American economy. Nevertheless, “the change in the net foreign asset position was due to a sharp fall in the national saving rate relative to investment undertaken. The shortfall in saving was covered by foreign capital inflows, a necessary counterpart to the current account deficit. As the United States turned into a net foreign debtor other industrialised countries became net foreign creditors.” (Hoffman, 2003) Net Foreign Asset build up is normally undertaken by the private industry of the country and not by the state itself in an open economy. The build-up includes the purchase or the installation of several manufacturing facilities in other countries that has a large population. The general logic is to lower or eliminate transport cost. By manufacturing the goods within the country, tariff and taxes usually collected at the gates of the said country will then be reduced to the taxes as a consequence of its operation. The additional benefit for the country where the manufacturing facilities were installed or built is the decrease in the prices of the goods being manufactured. For consumer goods such as food products and pharmaceutical products the effect will be the pressure for the local producers to improve the quality of their product while matching the prices of the goods manufactured from the facilities owned by offshore companies. Current Account – Is the current value of all the net foreign asset of a country. This would include the foreign aid it receives and the net revenue of all its exporting activities that would include export of goods and services. The advent of globalisation has put into the fore the resurgence of adventurism amongst the captains of the industry. To illustrate: During the sixteenth hundred much of Europe’s countries that are ruled by monarch engaged its entire war chest in exploring the Far East. The primary purpose of which is to expand the influence of the country or the monarchy. The influence would include trade and commerce with the settlements found in the Far East. The main consideration then was to find fresh sources of raw materials, new trading partners and to establish a foothold on new assets that can be used to expand the realm. Globalisation resurrected this impetus by letting companies explore new ways to streamline or economize their operation. Capitalising on the technological advances made over the last decade of the century, communication with offshore or remote facilities by companies thereby management can make decision base on real time data. With all the resources accessible to properly manage any offshore office or facility, companies expanded their base of operation in other countries. These innovations in operation resulted in savings for the company while increasing its asset base that redounded to the benefit of the country as well. Balance of Trade – as oppose to balance of payment is the balance of country’s exports as against a country’s import. Export and Import includes non-tangible service provisioning. Service provisioning includes back-office operation of some companies that cater to other offshore company’s requiring such service. Balance of Trade however is not prospective, it does not include future service and earnings but rather it only include services or goods already delivered, consumed and finished. Simply put, Balance of Trade is the difference between exports and imports. A positive Balance translates to trade surplus while the opposite is termed as trade deficit. A continuing trade deficit will result to a depletion of foreign exchange and eventually, this will lead to further devaluation of the currency of the country since its foreign reserve will be severely depleted. A domino effect that will cascade to other economic indicators can also exacerbate the situation. To illustrate: devaluation will lead to an increase in the cost of raw materials that is coming from other countries. This will translate to inflation due to the increase in manufacturing cost. Corrective measures can be done to curb inflation however such effort will not have lasting effect if the root cause of the problem such as trade deficit is not resolved. Thus, any remediation effort will only have a palliative or temporary effect. Depletion of foreign exchange reserves due to trade deficit can be corrected either by borrowing or by asking for aid which would nonetheless prove to be a disaster for the country as the inflation remains high and economic activity is hindered due to the high cost of production but low income returns. Factor Income – These are the revenues derived from assets in an economic cycle. This would include earnings from the assets. That would include interests from deposits or rental from real estate assets. This will also include earnings from bearer bonds and other instruments that can be traded for cash. Revenue earnings from land or vehicle rentals are also considered Factor Income. Transfer Payments – Refers to a government mechanism that aims to re-distribute wealth. This would include payments to social security that would end-up to welfare. This would similarly involve government dole outs and health care subsidy. To sum it up, no actual returns are expected from transfer payments since the principle merely entails to re-distribute wealth for the purpose of spending. As oppose to Factor Income, wherein returns are expected from an asset, transfer payments do not create assets that will be a source of income later. Bibliography Hoffman, M. (2003, June 26th). Saving Investment and the Net Foreign Asset Position. Retrieved January 14, 2011, from repec.org: http://repec.org/mmfc03/Hoffmann.pdf Read More