Currently, the UK is in the midst of what some are calling a BoP crisis. Europe may also be in the beginning of such a crisis. While the Yen is falling as rapidly against the USD Japan is not likely to be as exposed to such a crisis.
This is a complicated topic and equally complicated to simplify but I will try.
Put simply a country and all countries that export and import goods and services and invest in foreign assets of have foreigners invest in their assets have accounting ledgers that track these flows
Those accounting ledgers are the current account and the capital account. When domestic spending exceeds the national income the current account is in deficit. Because domestic spending and domestic income in a closed economy must be zero the implications of a current account
The deficit must be imports exceeding exports. alternatively, domestic savings must fall short of investment. Given those identities, the rest of the world (ROW) must provide local investment in order to finance the current account deficit. That ledger is the capital account.
The balance of payments is the equation that states that a current account deficit must have an equal and opposite capital account surplus. In other words, if imports exceed exports. The ROW must finance that gap.
Emerging markets typically get funding from the ROW by
Issuing bonds or borrowing from ROW banks in USD or other foreign currency. This makes the BOP particularly vulnerable to crisis because the EM is unable to print USD. But the forces are the same for DM. Specifically, a BoP crisis happens when ROW either stops providing capital
To a country or worse reverses investment pulling prior investment from the country. That places tremendous pressure on the capital account and because the capital account and current account must balance places pressure on the current account to reduce domestic spending in
Excess of domestic income.
Pausing here. Often the current account is thought of as the net of exports vs imports. This IMHO clouds the macro because it just appears that the current account can be fixed by reducing imports. That may be difficult as some countries don’t own
Certain goods like energy must be imported but again that is clouding the issue.
The current account is in deficit if domestic spending is higher than domestic income. It helps to look at the gross
Let’s look at what the UK is doing
While central bankers are hiking rates to reduce domestic demand, fiscal policymakers are planning aggressive domestic spending. Because government spending is part of domestic spending and domestic income is not necessarily improving these policies are likely out of balance
Domestic spending is being hit by hikes and stimulated by government spending. It seems that domestic spending vs domestic income is going to go into a greater deficit. Meaning the current account is going to go into a greater deficit and the capital account will need to go
Into greater surplus. But what if ROW is also either stopped their domestic investment into the UK or is fleeing UK investment? That means something must break. High policy pressure to expand the current account deficit and high pressure to contract the capital account surplus
This is the very definition of a currency crisis. This is the UK at the moment
If the opposing policy actions for the BoE and Fiscal policymakers result in higher domestic spending relative to domestic income and the pricing of domestic assets in local currency is not attractive
enough for ROW to shift from capital flight to investment the prices of both domestic assets and the exchange rate must adjust to where that investment flow returns or domestic spending must contract.
A couple of things. Clearly the size of the desired current account deficit
The increase must be measured by its relationship to the country’s GDP to see if this matters much in the repricing of the currency.
Secondly, I ignored domestic investment in ROW. This differentiates Japan from the UK. If faced with similar pressures Japanese savings abroad can
Return home and that process will offset the capital account pressure by financing the domestic current account deficit instead of someone else’s current account deficit.
At the moment the UK is planning aggressive fiscal spending while ROW is not interested in funding the
resulting capital account pressure and domestic foreign investment is either unwilling or simply too small to matter to offset by returning home. The sharp move up in the yield of UK long-term bonds and the sharp move down in the GBP are the signs of a BoP crisis. They are likely
To continue until domestic spending experiences a significant reduction and the pain is felt.
Is Europe on the brink of the same? Well its scale is much larger, its domestic foreign investment is substantial, and the pressure on the current account deficit to expand is due more to
energy needs vs domestic sources and the EU haven’t embarked on as many dangerous fiscal policy actions as the UK but the conditions indicate the potential for such actions and need to be carefully watched.