International Finance FINA 342
Dr. Angela Ng HKUST
Class Notes 2 BALANCE OF PAYMENTS (BOP)
I. WHAT IS THE BALANCE OF PAYMENTS? An accounting statement that summarizes the economic transactions between residents of a home country and residents of all other countries. BOP is based on double-entry bookkeeping. Every transaction is recorded twice, once as a debit and once as a credit. According to accounting convention, a source of funds (either a decrease in assets or an increase in liabilities) is a credit and a use of funds (either an increase in assets or a decrease in liabilities) is a debit. Inflows are reported with a positive sign and are listed as a credit. Outflows are reported with a negative sign and are reported as a debit. Three major BOP categories: Current Account: records flows of goods, services, and transfers. Capital Account: shows public and private investment and lending activities. Official Reserves Account: measures changes in holdings of gold and foreign currencies by official monetary institutions.
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By definition, the overall BOP must balance. (Current account balance) + (Capital account balance) (Official reserves account) = BOP = 0 BOP is related to the foreign exchange market. All transactions that affect the inflows and outflows of foreign currency are recorded in the BOP.
Exhibit 2.1 Balance of Payments Categories Credits (+) a. Exports of goods Balance of Trade = a b c. Exports of services d. Imports of services e. Net transfers Debits (-) b. Imports of goods
Current Account Balance = (a b) + (c d) e f. Foreign investment – long-term – short-term h. Borrowing from overseas g. Investment overseas long-term short-term i. Lending to overseas
Capital Account Balance = (f g) + (h i) Increase in Official Reserve = Current account surplus + Capital account surplus
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BALANCE OF TRADE Merchandise trade represents exports and imports of tangible goods, such as oil, wheat, clothes, automobiles, computers, and so on. The trade balance measures whether a country is a net importer or exporter of goods (i.e., a net merchandise export). A trade surplus (deficit) indicates residents of a country are exporting more (less) than they are importing. CURRENT ACCOUNT The current account is a record of the trade of goods and services between a country and the rest of the world. Categories: Merchandise account or trade balance on goods Trade balance on services – The service account includes tourism, financial charges (banking and insurance), and transportation expenses. These trades in services are called invisible trade. Factor income – individual investment and interest income (returns on the risk-free or risk-bearing capital that has been exported or imported) Unilateral transfers – Examples: development aid, gifts, and grants. – Unilateral transfers are regarded as an act of buying goodwill from the recipients.
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CAPITAL ACCOUNT Capital account transactions affect a nation’s wealth and net creditor position. The sale of assets to foreigners and the borrowing of funds from abroad are transactions that are recorded with a positive sign because these transactions result in capital inflow. The purchase of foreign assets is recorded with a negative sign, as they lead to capital outflow. A surplus in the capital account implies a decrease in the net holding of foreign assets by domestic residents. Unlike trades in goods and services, trades in financial assets affect future payments and receipts of factor income. Categories: Direct investment – occurs when investors acquire a measure of control of foreign business. Portfolio investment – represents sales and purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of control. Other capital flows – Examples: short-term investment such as bank deposits, money market instruments, securities with a maturity of less than one year.
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OFFICIAL RESERVES ACCOUNT Under this account, foreign asset transactions of a country and foreign central banks are recorded. International or Official Reserves holdings of foreign currency denominated assets by central banks, including 1. gold, 2. government holdings of foreign exchanges, 3. special drawing rights (SDRs), and 4. reserve positions in the IMF. An increase in foreign assets held by the central bank is recorded with a negative sign because an increase in assets held by the central bank is a use of foreign currency. A decrease in the central bank’s stock of foreign assets is a source of foreign currency for the country. The change in official reserves measures a nation’s surplus or deficit on its current and capital account transactions by netting reserve liabilities from reserve assets. Example: Surplus An Increase in official holdings of foreign currencies or gold or both
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OVERALL BALANCE Statistical discrepancy Recordings, upon which the BOP statistics are constructed, are bound to be imperfect. Thus, the BOP includes a Net Errors and Omissions account to ensure that inflows equal outflows. A negative figure refects a mysterious outflow of funds while a positive amount reflects an inflow. Overall Balance or Official Settlement Balance = Current account balance + Capital account balance + Statistical discrepancy Balance of Payments Identity (BOPI): Current account + Capital account + Official settlements = 0 deficit/surplus deficit/surplus surplus/deficit The BOPI must necessarily hold. The BOPI equation indicates that a country can run a BOP surplus or deficit by increasing or decreasing its official reserves. The balance on the BOP account is often referred to as the sum of the current account and the capital account balances or equivalently, the negative of the official reserves balance. Current account deficit & Capital outflow, i.e. BOP deficit Decrease in official reserves
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Current account surplus & Capital inflow, i.e. BOP surplus Increase in official reserves Question: A country has a current account deficit, but an increase in its foreign reserves. Does this country have net capital inflow or outflow? What is the effect on the exchange rate if there is a current account deficit? Case 1: Fixed exchange rates
Case 2: Flexible exchange rates
Examples 1. U.S. exporter exports PC to a German importer. The German importer pays in $, which he obtained from Deutsche Bank. Export creates demand for $ and is recorded as a credit under the current account. The payment flow is booked under the capital account and is a debit.
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2. Japanese firm buys an office building in New York and pays in $ which it acquires from a New York based American bank. Again a demand for $ is created. A foreigner has acquired a U.S. asset. This is a capital import (foreign assets in the U.S. increase). Since the American bank has now increased its yen holdings, there is a corresponding debit entry (U.S. assets abroad increase, which is a capital export).
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II. RELATIONSHIP BETWEEN BOP AND NATIONAL ECONOMY NATIONAL ACCOUNT IDENTITIES A Simple Case: no government, no international trade, but international investment and borrowing are possible. (1) National Income or National Product (Y) = Consumption (C) + Savings (S) (2) National Spending/Expenditure (E) = Consumption (C) + Investment (I) I: Real investment refers to plant and equipment, research and development, and other expenditures designed to increase the nation’s productive capacity. (3) National Income (Y) National Spending (E) = Savings (S) Investment (I) Y > E S > I Surplus capital. Surplus capital must be invested overseas. Thus, S I = Net foreign investment A nation that produces more (less) than it spends will have a net capital outflow (inflow). A More General Case: national trades with foreign countries (4) National Income or National Product (Y) = National Spending (E) + [Exports (X) Imports (M)] (5) National Income (Y) National Spending (E) = Exports (X) Imports (M)
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(6) Savings (S) Investment (I) = Exports (X) Imports (M) (7) Exports (X) Imports (M) = Net Foreign Investment Question: How does this conceptually link with BOP?
Relation Between Government Deficit and Current Account Balance (8) E = C + I + Government Spending (G) = (Y S Tax) + I + G where Y = C + S + Tax (9) Y E = (S I) (G Tax) where G Tax = Government deficit (10) Current Account Balance = (S I) (G Tax) = Net savings Government budget deficit = Net savings + Government budget surplus Example from the 1980s: U.S.: Low savings rate, large government deficit, current account deficit. Japan: High savings rate, small government deficit, current account surplus.
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SUMMARY (a) Demand (C + I + X) creates supply (production) and income. (b) Income stays inside country as either consumption (C) or savings (S) or spending on foreign goods (imports M). Y (Income that stays in the country = national income) =C+S E = C + I (= national spending) (c) Demand (C + I) + X = E + X Gross Income created Y + M Y+M=C+I+X Y=C+I+XM (d) Y E = X M
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Exhibit 2.2 Linking National Income Identities with BOP Accounts National product (Y) National spending (E) minus Consumption (C) minus Consumption (C) = National savings (S) = Net foreign investment Investment (I)
National product (Y) National spending (E) minus Spending on domestic minus Spending on domestic goods and services goods and services Exports of goods and Imports of goods and services (X) services (M) = Balance on current account = Balance on capital and official reserves accounts = Y E = S I = X M = Net foreign investment
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