Chapter 4 - Balance of Payment
Chapter 4 - Balance of Payment
Chapter 4 - Balance of Payment
FOUR
BALANCE OF PAYMENT
CHAPTER FOUR OVERVIEW
4-4
TYPICAL BOP TRANSACTIONS
• Each of the following represents an international
economic transaction that is counted in and captured in
the U.S. BOP:
– A U.S. subsidiary of a foreign MNE acts as a distributor for
the MNE’s products in the U.S. market
– A U.S.-based firm manages the construction of a major water
treatment facility in a foreign country
– The U.S. subsidiary of a foreign firm pays profits (usually by
distributing dividends to shareholders) back to the parent firm
in its home (foreign) country
– A Mexican lawyer purchases a U.S. corporate bond through
an investment broker in the U.S.
4-5
THE ACCOUNTS OF BOP
※ The classification of accounts of the BOP in this chapter follows the definition
of the International Monetary Fund (IMF)
※ Because the IMF is the primary sources of statistics for BOPs, its terminologies
are more wildly accepted
※ In fact, this system is also used by the Organization for Economic Cooperation
and Development (OECD) and United Nations System of National Accounts
(UNSNA)
4-6
THE ACCOUNTS OF BOP
• The BOP is composed of three primary accounts, the Current
Account, the Capital Account, and the Financial Account
• In addition, the Official Reserves Account tracks
government currency transactions
• The fourth account, the Net Errors and Omissions Account,
is produced to preserve the balance of the BOP
– Later, I will introduce the theoretical double-entry bookkeeping rule of
the BOP, and you will understand that BOP should balance
– However, it is impossible to record all international transactions
associated with a nation, so in practice the organizations to produce
BOP reports collect national data for different accounts separately,
which could result in the imbalances of the BOP
4-7
THE CURRENT ACCOUNT
• The Current Account includes all international economic
transactions with income or payment flows occurring within
the current year. It consists of the following four
subcategories:
– Goods trade
• The export and import of goods
• The most traditional international economic activities
• The current account is typically dominated by this component, which is
known as the Balance of Trade (BOT)
– Services trade
• The export and import of services
• Including financial services provided by banks to foreign importers and
exporters, travel services of airlines, and construction services of
domestic firms in other countries
• For the major industrial countries, like the U.S., this subaccount grows
fast in the past decade
4-8
THE CURRENT ACCOUNT
– Income
• The dividend income from subsidiaries is the income receipts
• The wages and salaries paid to nonresident workers are income
payments
– Current transfers
• The change in ownership of real resources or financial items is
called a transfer
• Any transfer between countries that is one-way–a gift or grant–
is termed a current transfer
• For example, funds provided by the U.S. government to aid a
less-developed nation, or money sent home by migrants and
permanent workers abroad
※Although the information of balance of trade (BOT) is so
widely quoted in the business press in most countries, this
number is somewhat misleading for large industrialized
countries because the service trade is not taken into account
4-9
U.S. Trade Balance & Balance on Services & Income, 1985-
2007 (billions of US$)
※ The U.S. goods trade balance has been consistently negative, but has been
slightly offset by the continuous surplus in the balance of services trade
4-10
THE CURRENT ACCOUNT
• The deficits in the BOT of the U.S. in the past two
decades have been wildly debated since merchandise
trade is the original core of international trade
• Reasons for the deficits in the BOT of the U.S.
– Relatively high income in the U.S. creates the import demand
– The price of the imported products after passing the exchange
rate is cheaper, which may be caused by that many trading
partners of the U.S. adopt the policy of depreciating their
currency against US$ to maintain the competitive power in
the U.S. market
– The biggest bilateral deficits are with China and Japan, which
maintain relative weakness of their currencies by buying
massive amounts of U.S. dollars (usually investing in
Treasury bonds) while selling corresponding amounts of their
own currencies 4-11
THE CURRENT ACCOUNT
– FYI, at the end of 2009, Japan and China held the largest
amount of Treasury bonds in the world, each of which owns
768.8 billion and 755.4 billion US$, respectively
– Later, you will see the above actions will increase the cash
inflow for the financial account and thus cause the surplus of
the financial account of the U.S.
• The deficit in the BOT results in the decline of heavy
traditional industries in the U.S. (steel, automobiles,
automotive parts, textiles)
• The consistent surplus in the services trade account
may be from travel and passenger fares, transportation
services, expenditures by foreign students pursuing
studies in the U.S., telecommunications services,
financial services, etc.
4-12
THE CAPITAL AND FINANCIAL ACCOUNT
4-13
THE FINANCIAL ACCOUNT
• The financial account in the balance of payments
measures all international economic transactions of
financial assets
• The financial account is classified into three
components, depending on the degree of investor
control over the assets or operations
– Direct Investment – in which the invested financial assets
exerts some explicit degree of control over the real assets
– Portfolio Investment – in which the invested financial
assets has no control over the real assets
– Other Financial Investment – consists of bank deposits,
various short-term and long-term trade credits, cross-
border loans, currency deposits,, and other A/R and A/P
related to cross-border trade
4-14
DIRECT INVESTMENT
4-15
DIRECT INVESTMENT
• Some countries possess restrictions on foreigners to own
assets in their country, e.g., domestic land, assets, and
industry should be owned only by residents of the
country
• However, the U.S. has few restrictions on what foreign
residents or firms can own or control assets in the U.S.
• As for profit, the concern of possible profit outflow may
limit the foreign investment in some countries
– There are evidences indicating that foreign firms in the U.S.
reinvest most of their profits in their U.S. business (at a higher
rate than domestic firms in the U.S.)
• The capital inflow in the form of direct investment is
generally welcomed in the U.S. due to the possible
increase of jobs, production, services, technology, etc.
4-16
PORTFOLIO INVESTMENT
• This is the net balance of capital that flows in and out
of the U.S. but does not reach the 10% threshold of
direct investment
• The purchase of debt securities across borders is also
classified as portfolio investment because debt
securities by definition do not provide the buyer with
ownership or control
• Portfolio investment is motivated by a search for
returns rather than to control or manage the asset
• The motivating forces for portfolio investment flows
are only return and risk, so the series of the flow of
portfolio investment is less predictable (Exhibit 3.5)
4-17
Financial Account Balances for the United
States, 1985-2007 (billions of US$)
4-18
TRANSACTION BOOKKEEPING IN BOP
• Before introducing the net errors and omissions and
reserves accounts in the BOP, the theoretical
bookkeeping process for BOP is introduced first
• There are three main elements of the actual process of
recording international economic activities:
– Identifying what is and is not an international economic
transaction
– Understanding how the flows of goods, services, assets, and
money create debits and credits to the overall BOP
– Understanding the bookkeeping procedures for BOP
accounting
• The rule of thumb aids the understand of BOP
accounting: “Follow the cash flow.”
– Credits (+): cash inflow
– Debits (–): cash outflow 4-19
TRANSACTION BOOKKEEPING IN BOP
4-22
TRANSACTION BOOKKEEPING IN BOP
4-23
THE BOP AS A FLOW STATEMENT #
• The BOP is often misunderstood as many people infer
from its name that it is a balance sheet, whereas in
fact it is a cash flow statement
– It does not add up the value of all assets and liabilities of a
country on a specific date (as an individual firm’s balance
sheet would do)
• By recording all international transactions over a
period of time such as a year, it tracks the continuing
flows of purchases and payments between a country
and all other countries
• According to the above double-entry bookkeeping
rule, the BOP must balance theoretically
4-24
NET ERRORS & OMISSIONS/OFFICIAL RESERVES ACCOUNTS
The following transactions (expressed in U.S. $ billions) take place during a year.
Calculate the U.S. merchandise-trade, current-account, capital-account, and
financial-account balances.
a. The United States exports $300 of goods and receives payment in the form of
foreign demand deposits abroad.
b. The United States imports $225 of goods and pays for them by drawing down its
foreign demand deposits.
c. The United States pays $15 to foreigners in dividends drawn on U.S. demand
deposits here.
d. American tourists spend $30 overseas using traveler's checks drawn on U.S.
banks here.
e. Americans buy foreign stocks with $60, using foreign demand deposits held
abroad.
f. The U.S. government sells $45 in gold for foreign demand deposits abroad.
g. In a currency support operation, the U.S. government uses its foreign demand
deposits to purchase $8 from private foreigners in the United States.
26
SUGGESTED ANSWERS
4-27
THE U.S. BOP FROM 1998-2007
There is a surplus on the
basic balance, which
+ : cash inflow means a net cash inflow of
(demand) 45 billion US$ to the U.S.
– : cash outflow
(supply)
The U.S. government uses
its official reserves to buy
2 billion US$, i.e., it
creates a net demand of 2
billion US$ by purchasing
US$ with its official
reserves in the exchange
rate markets
4-28
THE ANALYSIS OF BOP
4-29
FIXED AND FLOAT EXCHANGE RATE
REGIMES
• Fixed exchange rate regime
– The domestic currency, guaranteed by the government, is
convertible into a fixed amount of a foreign currency, a basket
of currencies, or another measure of value, such as gold
– Devaluation (revaluation): A deliberate downward (upward)
adjustment to a country’s official exchange rate, also called
the parity rate, relative to other currencies
– In a fixed exchange rate regime, only a decision by a
country’s government (i.e., the central bank) can alter the
official value of the currency
• Float exchange rate regime
– A currency’s value is allowed to fluctuate according to the
demand and supply in the foreign exchange market
– Depreciation (appreciation): refers to a drop (increase) in the
foreign exchange value of a floating currency 4-30
THE BOP IN TOTAL — SURPLUS
• A surplus in the BOP ⇒ net cash inflow for the
domestic country ⇒ foreign residents demand the
domestic currency to pay the cash to the domestic
residents ⇒ the demand of the domestic currency
exceed the supply of the domestic currency
• The domestic currency has the pressure to appreciate
• If the government wants to maintain the fixed
exchange rate, it can intervene the market by selling
its own currency in exchange for other currencies and
thus building up its stores of hard currencies, i.e., its
foreign exchange reserves
– Selling its own currency causes a cash outflow (supply)
which diminishes the surplus in the BOP
4-31
THE BOP IN TOTAL — DEFICIT
• A deficit in the BOP ⇒ net cash outflow for the
domestic country ⇒ domestic residents demand the
foreign currency to pay bills to foreign residents ⇒
an excess supply of the country’s currency in foreign
exchange markets worldwide
• The domestic currency has the pressure to depreciate
• To maintain the fixed exchange rate, a government
can intervene the market by purchasing it own
currency at the expense of its foreign exchange
reserves to support the domestic currency value
– Buying its own currency causes a cash inflow (demand)
which offsets the deficit in the BOP
4-32
OFFICIAL RESERVES ACCOUNTS
• The significance of official reserves depends generally
on whether the country is operating under a fixed
exchange rate regime or a floating exchange rate
system
– In a fixed-rate system, the government decides the fixed
exchange rate, also called the parity rate, to exchange for
other foreign currencies
– For excess supply (demand) of the domestic currency, to
prevent the value of the domestic currency from falling
(rising), the government should spend its official reserves
(domestic currency) to purchase the domestic currency
(official reserves) to support (calm down) the value of the
domestic currency
– Under a floating-rate system, governments have no such
responsibility and the role of official reserves is diminished
4-33
CURRENT AND FINANCIAL ACCOUNT
BALANCE RELATIONSHIPS
• Since the BOP should balance, it is possible to infer the
inverse relation between the current account and the
financial account, which are the two major accounts in
the BOP
• In the examples on Slides 4-21 and 4-22, it is found that
the double-entry bookkeeping in theory requires that the
current and financial accounts offset for each other
• Intuitively, countries experiencing current account
deficits “finance” these purchases through equally large
surpluses in the financial account (like the U.S.)
– For the U.S., both real and financial assets possessed by
foreigners increases, the country become a “net debtor”
– On the other hand, for Japan, the current account surplus is
matched against a financial account deficit 4-34
CURRENT AND FINANCIAL/CAPITAL ACCOUNT BALANCES
FOR THE U.S., 1992-2007 (BILLIONS OF US$)
※ The above figure shows the inverse relationship between the balances
of the current account and the capital/financial account in the U.S.
4-35
CURRENT AND FINANCIAL ACCOUNT
BALANCE RELATIONSHIPS
4-39
THE BOP INTERACTION WITH
MACROECONOMIC VARIABLES
4-40
THE BOP INTERACTION WITH KEY
MACROECONOMIC VARIABLES
4-41
THE BOP AND GDP
• In a static (accounting) sense, a nation’s GDP can be
represented by the following macroeconomic
accounting identity:
GDP = C + I + G + X – M
where
C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
X – M = the sum of balances of the first two subaccounts in
the current account, which is close to the total balance on the
current account and thus used to “approximate” the balance
on the current account 4-42
THE BOP AND GDP
• In the same period, a positive current account balance
(surplus) contributes directly to increasing the measure
of GDP, but a negative current account balance (deficit)
decreases GDP
• Taking multiple periods into account
– GDP ↑ ⇒ disposable income ↑ ⇒ consumption ↑ ⇒ import ↑
⇒ balance of current account ↓
– GDP ↑ ⇒ capital investment ↑ ⇒ export ↑ ⇒ balance of
current account ↑
※Thus, in a dynamic sense, the relationship between GDP and
balance of the current account is uncertain
※BTW, GDP↑ ⇒ capital investment ↑ ⇒ employment rate ↑
(could be offset by the foreign sourcing, i.e., the import of
cheaper goods and services from foreign countries), so the
BOP also influences the employment rate 4-43
THE BOP AND EXCHANGE RATES
4-57
EXHIBIT 4.8 – THE J-CURVE EFFECT
※ There are three stages to adjust the deficit of the balance of trade
※ The adjustment path of the trade balance is like the shape of a flattened “J”
※ In the pass-through period, import prices ↑ and export prices ↓ due to the currency
depreciation (explained on the next slide)
※ In the quantity adjustment period, import demand ↓ and export demand ↑, so the
balance of trade–exports less imports–improves eventually
4-58
TRADE BALANCES AND EXCHANGE RATES
J-CURVE ADJUSTMENT
4-59
THE BOP AND INTEREST RATES
• Apart from the use of interest rates to intervene the foreign
exchange market, the overall level of a country’s interest rates
compared to other countries have impact on the financial
account of the BOP
• Relatively low real interest rates should normally stimulate an
outflow of capital seeking higher rates elsewhere
• In the case of the U.S., even with low real interest rates, the
opposite has occurred due to perceived growth opportunities
and political stability, which allows it to finance its large
fiscal deficit
• However, it is beginning to appear that the favorable inflow
on the financial account is diminishing while the current
account balance is worsening
4-60
THE BOP AND INFLATION RATES
4-61