Balance of Payments

Overview:

Current Account:

• Net exports/ imports of goods and services (Balance of Trade)
• Net Income from abroad (Investment income from direct portfolio + employee’s compensation)
• Net current transfer (sums sent home by migrant and permanent workers abroad)

Capital Account:

• Capital transfers related to purchase and sale of fixed assets such as real estate

Financial Account:

• Net foreign direct investment
• Net portfolio investment
• Other financial items

Net Errors and Omission:

• Missing data such as illegal transfers

Reserves and Related Items:

• Changes in official monetary reserves including gold and foreign exchange reserves

Balance of Payments (BOP):

BOP indicates the demand and supply of a country’s currency.

Any transaction resulting in a payment to foreigners is entered as a debit and is negative sign (Cash Outflows)

Any transaction resulting in a receipt from foreigners is entered as a credit and is positive sign (Cash Inflows)

Current Account:        CA = Export (X) (inflow) – Imports (M) (outflow)

• Looking at the export and import of…

• Merchandise Trade: Physical goods like beef, cars (Trade Balance) – largest component
• Services: Interest Payment, Dividends, Consulting
• Unilateral transfer: foreign aid, wages repatriated (gift)

Y = C + I + G + CA (or Nex)

S = Y – C – G

S = I + CA

CA = S – I

CA Deficit: M>X (CA<0) – indicates a net borrower

Nation with largest CA-: U.S.

Factors lead to CA deficit:

• Import > Export
• -KA = Outflow > Inflow
• S-I = Low savings or high investment

Result of CA deficit:

• Currency Depreciation
• Protectionism
• Restrictions on Foreign Investors
• Boosting the savings rate
• NI – NS = (PS – PI) + (TA – GS)

• NI = National Income
• NS = National Spending
• PS = Private Saving
• PI = Private Investment
• TA = Taxes
• GS = Government Spending

Reduced deficit by increasing export (X) or decreasing import (M):

• Place restrictions on imports such as tariffs or quotas
• Emphasize policies that promote exports such as import substitution industrialization or policies that improve domestic companies’ global competitiveness.
• Use monetary policy to make a country’s currency depreciate, this makes exports less expensive.

Reduced by borrowing overseas, or drawing down its previously accumulated foreign wealth.

Sometimes is desirable because…

• If a country uses external debt to finance investments that have a higher return than the interest rate on the debt, it can remain solvent while running a CA deficit.

CA Surplus: X>M (CA>0) – indicates a net lender

A positive diff between a nation’s savings and investment

Nations with large CA+ are typically exporters of manufactured products or energy (because mass-market production or have a reputation for top quality)

E.g. China, Germany, Saudi Arabia, Japan and Switzerland

Acquires claims on foreign assets, or increases its net foreign wealth.

CA Balance = Change in Net Foreign Assets (NFA)

NFA position of a country = the value of the overseas assets that country owns – the domestic assets owned by foreigners.

        Positive – net lender

        Negative – net borrower

Capital Account:        KA = Capital Inflow (Cr) – Capital Outflow (Dr)

Looking at the inflow and outflow of…

• Portfolio Investment: Short term like investment in stocks and bonds
• Direct Investment: Long term, e.g. direct ownership in a foreign company, takeover or acquiring of a foreign company

• If goes invest overseas: capital outflow
• If foreign investment: capital inflow

CA = -KA        or         -CA = KA

Net Errors and Omissions: (Balancing items)

• Looking at statistical errors and untraceable monies within a country such as illegal transaction.

Official Settlement Account

• Total reserves held by official monetary authorities within a country including gold and foreign exchange reserves.
• Important account for fixed-rate regime countries. Why?

A country with a fixed ER uses 2 strategies:

1. BOP deficit (outflow>inflow): it has an excess supply of currency on the foreign exchange markets. Thus, a central bank buys its currency using official settlements reserves. As a country removes its currency from the international markets, BOP deficit falls. If the central bank has no reserve assets, then it must devalue its currency or a black market could form.
2. BOP surplus (inflow>outflow): has shortage of currency on the foreign exchange markets. Central bank can easily finance a surplus because it sells its currency to buy foreign currencies, accumulating official reserves.

J-Curve:

AUD ↓ - Import ↓ (expensive), Export ↑ (cheaper) – CA = (E-I) ↑

However, the change in spending patterns takes time while the volume of imports and exports adjust to new AUD. Take time for importers and exporters to find new products, deals already agreed will have to be fulfilled, manufactures of substitutes may take time to adjust their production.

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Accounting Principles: Example

1. Boeing (US company) sells $3 billion of its 747 airplanes to China, which pays with proceeds from a loan from a consortium of international banks (IB).

1. Eli Lily (US company) sends a dividend check for $25,255 to a Canadian investor. The Canadian investor deposits the check in a US bank a/c.

1. Mitsubishi (Japanese company) purchases $70 million of US Treasury bonds for its client. Mitsubishi down its dollar a/c to pay the bonds.

1. US authorizes NY Fed Reserve Bank to intervene in foreign exchange market. NYFRB purchases $5 billion with Yen and Euros that it holds as international reserves.

1. Japanese purchase of US T-bonds: (KA: Capital in)                CR
2. Japanese payment using an NY a/c (CA: CF out)                                DR

1. US citizen having a meal in Paris (CA: CF out)                                DR
2. Paying for the meal with American Express (CA: CF in)                CR

1. Gifts to parents in Bombay (CA: CF out)                                        DR
2. Receipt of goodwill (CA: CF in)                                        CR

1. Export of programming services (CA: CF in)                        CR
2. Being paid for the service by US bank a/c (CA: CF out)                        DR

1. Lufthansa buys $400m worth of Boeing jets in 1996 and is financed by the US Bank with a loan due until 1997.