Chapter 4

The Balance of Payments

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The Balance of Payments: Learning Objectives

Learn how nations measure their own levels of international economic activity, and how that is measured by the Balance of Payments Examine the economic relationships underlying the two basic sub-components of the balance of payments the Current and Capital Accounts Consider the financial dimensions of international economic activity and how they differ between merchandise & services trade

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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The Balance of Payments Learning Objectives (Cont.)

Identify balance of payment activities by nations in pursuit of macroeconomic policies Examine how exchange rate changes and volatility influence trade balances over time Evaluate the history of capital mobility, and conditions that lead to capital flight in times of crisis

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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The Balance of Payments

Chapter Objective:
This chapter serves to introduce the student to the balance of payments, how it is constructed and how balance of payments data may be interpreted.

Chapter Outline
Balance of Payments Accounts
The Current Account The Capital Account

External Balance and the Exchange Rate Balance of Payments Trends in Major Countries
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The Balance of Payments

The measurement of all international economic transactions between the residents of a country and foreign residents (an accounting record of all monetary transactions between a country and the rest of the world) is called the Balance of Payments (BOP). The Balance of Payments is the statistical record of a countrys international transactions over a certain period of time presented in the form of double-entry bookkeeping. Why is it useful to examine a countrys BOP? The BOP provides detailed information about the supply and demand of the countrys currency.

The IMF is the primary source of similar statistics worldwide Multinational businesses use various BOP measures to gauge the growth and health of specific types of trade or financial transactions by country and regions of the world against the 4-5 home country

The Balance of Payments

Home country and host country BOP data are important to business managers, investors, consumers and government officials because the data ere influenced by key macroeconomic variables such as gross domestic product (GDP), employment, price levels and exchange rates. Government officials need such measures of economic activity in order to evaluate the general competitiveness of domestic industry, to set exchange rate policies or goals. BOP is a cash flow statement.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Exhibit 4.1 Generic Balance of Payments

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Debit & Credit

A summary of transactions between domestic and foreign residents for a specific country over a specified period of time. It accounts for transactions by businesses, individuals, and the government All international transactions can either be classified as debit or credit entry. Transactions that reflect fund inflows generate positive numbers (credits) for the balance * Credit involves receipts of payments from foreigners Transactions that reflect fund outflows generate negative numbers (debits) * Debit involves payments to foreigners 4-8

DEBIT & CREDIT

CURRENT ACCOUNT Exports (+) Imports (-) FINANCIAL ACCOUNT Exports (+) Imports (-)

BOP
A surplus in the BOP implied that the demand for the countrys currency exceeded the supply and that the government should allow the currency value to increase or intervene and accumulate additional foreign currency reserves in the Official Reserves Account. A deficit in the BOP implied an excess supply of the countrys currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value.

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The Current Account

International transactions involving goods and/or services, income and current transfers. Main items: Goods (credits, debits) Services (credits, debits) Income (credits, debits)
Investment income and compensation of employees

Current transfers (credits, debits)

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The Current Account

Goods Trade export/import of goods. Services Trade export/import of services; common services are financial services provided by banks to foreign investors, construction services and tourism services Income predominately current income associated with investments which were made in previous periods. Additionally the wages & salaries paid to non-resident workers Current Transfers financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries which is one-way, a gift or a grant, is termed a current transfer

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Balance of Payments
1. Current Account: a. Payments for merchandise and services
Import export = balance of trade

b. Factor income payments

Interest and dividend payment

c. Transfer payments
Aid, grants, gifts

A large current account deficit indicates sending more cash abroad to buy goods and services or to pay income than receiving for those same reasons

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Balance of Payments
2. Capital Accounts
a. Value of financial assets transferred across country borders by people who move to a different country. b. Value of nonproduced nonfinancial assets that are transferred across country borders (patents and trademark)

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Balance of Payments
3. Financial Accounts a. Direct foreign investment (DFI) b. Portfolio investment
transaction of long-term financial assets such as stocks and bonds between countries that do not affect the transfer of control

c. Other capital investment

transaction of short-term financial assets such as money market securities between countries

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Capital and Financial Account (cont.)

2. Financial account
(a) Direct investment (abroad or in Australia) (b) Portfolio investment (transactions in equity and debt securities) (c) Other investment (e.g. trade credits, loans, currency and deposits, other) (d) Reserve assets (e.g. monetary gold, foreign exchange, reserve position in the IMF)

3. Net errors and omissions

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The Capital and Financial Accounts

Capital account is made up of transfers of fixed assets such as real estate and acquisitions/disposal of nonproduced/non-financial assets Financial account consists of three components and is classified either by maturity of asset or nature of ownership. The three components are
Direct Investment Net balance of capital which is dispersed from and into a country for the purpose of exerting control over assets. This category includes foreign direct investment
If a U.S. firm builds a new automotive parts facility in another country or actually purchases a company in another country.
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Defining International Economic Transactions

Current Account Transactions
The export of merchandise, goods such as trucks, machinery, computers is an international transaction Imports such as French wine, Japanese cameras and German automobiles are international transactions The purchase of a glass figure in Venice by an American tourist is a US merchandise import

Financial Account Transactions

The purchase of a US Treasury bill by a foreign resident

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The Capital and Financial Accounts

Portfolio Investment Net balance of capital which flows in and out of the country but does not reach the 10% ownership threshold of direct investment. The purchase and sale of debt or equity securities is included in this category
This capital is purely return motivated The purchase or sale of debt securities, like U.S. Treasury bills, across borders. They are purely profit motivated (return).

Other Investment Assets/Liabilities Consists of various short and long-term trade credits, cross-border loans, currency and bank deposits and other accounts receivable and payable related to cross-border trade

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The Other Accounts

Net Errors and Omissions Account is used to account for statistical errors and/or untraceable monies within a country Official Reserves total reserves held by official monetary authorities within a country.
These reserves are typically comprised of major currencies that are used in international trade and financial transactions and reserve accounts (SDRs an international reserve asset, defined by the IMF as the value of a weighted basket of five currencies) held at the IMF Under a fixed rate regime official reserves are more important as the government assumes the responsibility to maintain parity among currencies by buying or selling its currency on the open market Under a floating rate regime the government does not assume such a responsibility and the importance of official reserves is reduced

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THE BALANCE
The Balance on Goods (Balance on Trade) measures the balance on imports and exports of merchandise.
The Balance on Current Account expands the balance on goods to include receipts and expenses for services, income flows and unilateral transfers.

The Basic Balance measures all of the international transactions (current, capital and financial) that come about because of market forces. The Overall Balance (also called the Official Settlements Balance) is the total change in a countrys foreign exchange reserves caused by the basic balance plus any governmental action to influence foreign exchange reserves.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Exhibit 2.2 Summary of U.S. Current Account in the Year 2006 (in billions of $)

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2006 Distribution of U.S. Exports and Imports

Insert Exhibit 2.4 from page 28

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Do monetary and fiscal policies affect the exchange rates and BOP components?
Monetary Policy: An unanticipated shift to expansionary monetary policy will lead to more rapid economic growth, accelerated inflation and lower real interest rates BOP effects: Higher income and higher domestic prices stimulate imports and discourage exports. Lower real rates discourage foreign and domestic investment at home. Increase demand will encourage imports & discourage exports, which moves the current account towards deficit. Exchange rate effects: The adverse impact of the countrys current account will increase the supply of currency in the FX markets; causing the currency to depreciate.
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Exhibit 4.2 The United States Current Account, 1998-2005 (billions of U.S. dollars)

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Exhibit 4.3 U.S. Trade Balance and Balance on Services and Income, 1985-2005 (billions of U.S. dollars)

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Exhibit 4.4 The United States Financial Account and Components, 1998-2005 (billions of U.S. dollars)

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Exhibit 4.5 The United States Financial Account, 1985-2005 (billions of U.S. dollars)

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Exhibit 4.6 Current and Combined Financial/Capital Account Balances for the United Sates, 1992-2005 (billions of U.S. dollars)

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Exhibit 4.7 The United States Balance of Payments, Analytic Presentation, 1995-2005 (billions of U.S. dollars)

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Exhibit 4.7 The United States Balance of Payments, Analytic Presentation, 19952005 (billions of U.S. dollars) (cont.)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Balance of Payments Interaction with Key Macroeconomic Variables In a static (accounting) sense, a nations GDP can be represented by the following equation:
GDP = C + I + G + X M
C I G X M = consumption spending = capital investment spending = government spending = exports of goods and services = imports of goods and services

XM= Current account balance

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The Balance of Payments and Exchange Rates

The relationship between BOP and exchange rates can be illustrated by use of a simplified equation:
Current Account Balance + Capital Account Balance + Financial Account Balance + Reserve Balance = Balance of Payments

(X-M)

(CI - CO)

(FI - FO)

(FXB)

BOP

CI = capital inflows CO = capital outflows FI = financial inflows FO = financial outflows FXB = official monetary reserves
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Exhibit 4.8 Trade Balance Adjustment to Exchange Rate Changes: The J-Curve

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Capital Mobility
The degree to which capital moves freely cross-border is critically important to a countrys balance of payments Historical patterns of capital mobility
1860-1914 period characterized by continuously increasing capital openness as more countries adopted the gold standard and expanded international trade relations 1914-1945 period of global economic destruction due to two world wars and a global depression 1945-1971 Bretton Woods era, saw great expansion of international trade in goods and services 1971-2002 period characterized by floating exchange rates, economic volatility, but rapidly expanding cross-border capital flows

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Exhibit 4.9 A stylized View of Capital Mobility in Modern History

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Capital Flight
Five primary mechanisms exist by which capital may be moved from one country to another:
Transfers via the usual international payments mechanisms, regular bank transfers are easiest, cheapest and legal Transfer of physical currency by bearer (smuggling) is more costly, and for many countries illegal Transfer of cash into collectibles or precious metals, which are then transferred across borders Money laundering, the cross-border purchase of assets which are then managed in a way that hide the movement of money and its owners False invoicing on international trade transactions
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Summary of Learning Objectives

The Balance of Payments is the summary statement of all international transactions between one country and all other countries The Balance of Payments is a flow statement, summarizing all the international transactions that occur across the geographic boundaries of the nation over a period of time, typically a year Although the BOP must always balance in theory, in practice there are substantial imbalances as a result of statistical errors and misreporting of current account and financial/capital account flows
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Summary of Learning Objectives

The two major sub-accounts of the balance of payments, the current account and the financial/capital account, summarize the current trade and international capital flows of the country respectively The current account and financial/capital account are typically inverse on balance, one in surplus while the other experiences deficit Although most nations strive for current account surpluses, it is not clear that a balance on current or capital account, or a surplus on current account, is either sustainable or desirable
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Summary of Learning Objectives

Although merchandise trade is more easily observed, the growth of services trade is more significant to the BOP for many of the worlds largest industrialized countries today Monitoring of the various sub-accounts of a countrys BOP activity is helpful to decision-makers and policymakers on all levels of government and industry in detecting the underlying trends and movement of fundamental economic forces driving a countrys international economic activity
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Summary of Learning Objectives

Changes in exchange rates change relative prices of imports and exports which in turn result in changes in quantities of demanded through the elasticity of demand A devaluation results initially in a further deterioration in the trade balance before an eventual improvement the path of adjustment takes on the shape of a flattened j The ability of capital to move instantaneously and massively cross-border has been one of the major factors in the severity of recent currency crises Although not limited to heavily indebted countries, the rapid and sometimes illegal transfer of convertible currencies out of a country poses significant economic and political problems
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Current Account
Trade in goods: Debit: U.S. firm purchases German machine tools. Credit: Singapore Air Lines buys a Boeing jet. Trade in services: Debit: An American takes a cruise on a Dutch cruise line. Credit: The Brazilian tourist agency places an ad in The New York Times. Income payments and receipts: Debit: The U.S. subsidiary of a Taiwan computer manufacturer pays dividends to its parent. Credit: A British company pays the salary of its executive stationed in New York. Unilateral current transactions: Debit: The U.S.-based International Rescue Committee pays for an American working on the Afghan border. Credit: A Spanish company pays tuition for an employee to study for an MBA in the United States. 4-42

Examples:
Direct investment: Debit: Ford Motor Company builds a factory in Australia. Credit: Ford Motor Company sells its factory in Britain to British investors. Portfolio investment: Debit: An American buys shares of stock of a European food chain on the Frankfurt Stock Exchange. Credit: The government of Korea buys United States treasury bills to hold as part of its foreign exchange reserves. Other investment: Debit: A U.S. firm deposits $1 million in a bank balance in London. Credit: A U.S. firm generates an account receivable for exports to Canada.
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QUESTIONS ? ? ? ? ?
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