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Strong exchange rate – The gradual appreciation of the sterling over other currencies including the US Dollar makes exports less competitive and imports cheaper. This higher value of the exchange rates has induced reduction in the total value of exports.

Despite having huge amounts of current account deficits, UK has balanced its BOP by ensuring surpluses in the Capital/Financial account. The internationalisation of the financial markets, liberalisation of trade in financial instruments and globalisation, has made it easier to finance the current account deficit. Economists believe that there are no economic constraints if a country depends on its capital account surpluses as compared to its current account. The Capital account has recorded surpluses in the last 20 years (Pink book, 2010). One of the main reasons for this surplus has been UK’s ability to attract cash flow into the country. Below is a summary that has contributed to these surpluses over the last few years:

Lower interest rates – The short term interest rates are quite higher in the UK compared to the countries in the euro zone and the US. This has attracted large amounts of inflows into the UK banking sector in return for a favourable interest rate.

Foreign direct investment – UK’s economic structure and favourable standards regulating the financial markets have made UK a favourite FDI venue. Huge acquisitions such as the $16bn purchase of Abbey National by Santander Central Hispano, Spain's largest bank; the acquisition of UK-based Amersham by General Electric of the US for $9.6bn (Frances Williams, 2005) and the much talked about acquisition of Cadbury by US Kraft foods are some in a series of FDI that have contributed to UK’s current position (Geoffrey Owen, 2010).

RELATION BETWEEN UK BALANCE OF PAYMENT AND ITS EXCHANGE RATE

As explained above the UK balance of payment for last 10 years has been in deficit and its exchange rate index has been fluctuating. By this statement we can conclude that there is not a simple relation between balance of payment and exchange rate. So we need to look at the theoretical explanation of this relation. The elasticity model of the balance of trade (Krueger, 1983) has shown the existence of a theoretical relationship between exchange rate and the trade balance. To begin with we know that a weak currency would improve the export and would reduce the import thereby reducing the deficit in the case of UK and vice versa. If we look from the balance of payment view, a deficit in UK would mean more supply of currency for the import and less demand of currency for the exports thereby depreciating the currency. But this doesn’t always hold true. Also in the short term there are factors which don’t let this simple relation hold. The factors that have been found in studies are:

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