Why is the balance of payments more important than a dollar exchange rate?

A researcher of Foreign Trade Research Center at Kyiv School of Economics Trade + Olga Nikolaieva answers the questions about the balance of payments.

What is a balance of payments and why is it important?

 

A balance of payments counts all of the transactions between individuals, companies and public authorities within Ukraine. It sums up the results of international trade and financial transactions for some period of time, for example, for one year. That is how a balance of payments describes the input and output of foreign currencies in Ukraine. 

 

 What are the parts of the balance of payments?

 

A balance of payments is divided by a current account and an account of capital. 

A current account sums up the results of goods and services trade, net investment income (dividends) and direct payments (for example, transfers of workers abroad). An account of capital shows direct foreign investments, portfolio investments, external loans.

 

What is typical for a current account in Ukraine?

 

A shortage of goods trade (import is higher than the export of goods) is quite typical in Ukraine. In 2018 a shortage of the current account was $4,7 billions of 3,4% of GDP. Earlier a deficit of current account was almost 9% as, for example, in 2013. Situation changes with crisis, when import decreases rapidly. As to the trade of services, it usually has a trade surplus – export is higher than the import of services due to the gas transportations. In general, a balance of goods trade is higher than a balance of services trade and other current accounts, that is why a balance of the current account is formed with shortage and shows an outflow of currency from the country. 

 

Why is the trade deficit bad in Ukraine?

 

When the deficit of the current account is constantly high, it is formed with the help of consumption account and usually associated with an increase in loans and fiscal deficit (country spends more than it has). This situation isn`t stable in the long-term and in case of macroeconomic instability, it leads to destructive consequences while equaling the balance. Ukrainians had a similar experience in 2008-2009 and 2014-2015. 

 

What does a deficit of trade balance equal in Ukraine?

 

Besides a current account, the balance of payment also has an account of capital. Moreover, it contains direct foreign investments, portfolio investments, debt (both long- and short-term) of the private and public sector, trade loans.

In 2018 a surplus of financial account was $7.5 billion, which was higher than a deficit of a current account ($4.7 billion). So in total in 2018 there was a surplus of a balance of payments, which allowed to increase foreign exchange reserves in Ukraine.

 

Short-term loans and direct foreign investments – what are the differences?

 

Direct foreign investments mean investment in economic growth and they are long-term. It is difficult to sell assets such as factories or banks in a time of crisis. That is why they are considered to be a more stable source of income. Short-term loans are highly dependent on external conditions and, in case of an unfavorable situation, an inflow can become an outflow, which will deepen the crisis. Consequently, a situation can be dangerous, when a considerable deficit of trade balance is covered by short-term loans. An inflow of direct foreign investment and long-term loans are more favorable.

 

What happens when earnings are not enough?

 

If the earnings are not enough, the difference is covered by spending foreign exchange reserves of the country. This provides stability for national currency with a fixed exchange rate in Ukraine (prior to 2014). Nevertheless, this option creates a false feeling of stability and, in case of a considerable crisis, reserves run out quickly as they are finite. That is why usually exchange rate collapses (depreciation of hryvnya).

The other option is a flexible exchange rate that allows for the macroeconomic disbalances not piling up. In the case of hryvnya weakening, import increases and consequently, its demand decreases and Ukrainian export becomes cheaper for foreign buyers, which eventually leads to balance adjustment.

 

Translated by KSE student Yana Tkachenko