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					                      Balance of Payments
                           Chapter 1
   Balance of Payments (BOP)                 Examples of Credits (CR)
    measures all international                In a firm: firm sells goods and
    economic and financial                     services, firm borrows money
    transactions over a specified              from a bank or issues bonds.
    period of time, usually over a            In a household: you a week‟s
    calendar year.                             work, you sell some old furniture
   In theory, BOP uses double-entry           in a yard sale, you take out an
    bookkeeping. With double-                  auto loan or new mortgage or
    bookkeeping, each activity that            better still, you get a check
    results in a currency inflow (called       Grandma Sally for your birthday.
    Credits (CR)) is matched with an          In a nation: The US exports
    equal dollar amount of an activity         wheat, a U.S. insurance company
    that results in a dollar outflow           sells protection to a French
    (Debits (DR)).                             company, the Japanese buy U.S.
                                               Treasury bonds
    Balance of Payments Concepts
•   Examples of Debits (DR)             •   The DRs and CRs should match-
•   In a firm: firm buys new office         up.
    equipment, has workers work, firm   •   In a firm: firm buys new office
    pays interest or principal on a         equipment (DR), pays with a bank
    loan. A business donates to a           check (CR)
    local charity.                      •   In a household: you work (CR),
•   In a household: you buy                 your employer direct-deposits
    groceries, invest a savings bond,       your pay into your bank(DR)
    you make payments on your credit    •   In the US: US company imports
    card.                                   laptops from Taiwan (DR), Taiwan
•   In a nation: A U.S company              company paid from the US
    imports laptops from Taiwan, the        company‟s account in Taiwan
    government pays its assessment          (CR).
    to the UN, go to Europe on Air      •   In the US: European to Disney
    France                                  (CR), pays with traveler-checks
    Balance of Payments Concepts
•   For a nation, there are 3 Major       It indicates the net transfers
    accounts:                              between the home country and
•   1. Current Account: records net        foreign countries during a
    flow of goods, services, interest      specified period.
    payments, and unilateral
    transfers. Essentially measures       A net debit (DR) balance
    economic activity.                     (financial account deficit or net
•   2. Capital Account (KA): records       capital outflow) shows that
    public and private investment and      home country residents
    leading– investment activity.          increased their holdings of
•   Transactions that involve one-time     foreign assets relative to
    changes in the stock of assets.        foreigner‟s holding of home
•   Financial Account (FA)                 country assets.
•   Transactions that involve             A net credit (CR) balance
    international purchase or sale of      (financial account surplus or
    assets.                                net capital inflow) indicates the
            Balance of Payments Concepts

•   Capital outflow: domestic              3. Official Reserves Account:
    purchase of an asset from a                records changes in foreign
    foreigner (enters with a negative (-       reserves owned by the Central
    ) sign because it is an import of an       Bank
    asset.)                                 “Should” reflect any intervention
•   Capital inflow: domestic sale of an        activities.
    asset to a foreigner (enters with a     Official reserves include:
    positive sign (+) because it is an      1. Foreign currency in the form
    export of the asset.)                      of securities (usually in a foreign
•   FA deficit: more assets imported           government’s T-bills)
    that assets exported (increase in       2. to a much less extent, gold.
    net foreign wealth)                        This gold is often stored in Fort
•   FA surplus: more assets exported           Knox, at the NYC Fed, or at the
    than assets imported (decrease in          Bank for International Settlement
    net foreign wealth).                       in Basle. If the Fed intervenes to
                                               support the $, it sells reserves,
                                               and buys back $s. This is a CR in
                                               BOP (think of it as exporting
           Balance of Payments Concepts

3. Unilateral Transfers:
     pensions, gifts, foreign aid,      Capital Account – has two types of
     (free and paid for) military         classifications:
     aid. In deficit, except in 1991   1. Short-term debt: potentially the
     (Gulf War “gift”: $40 billion).      “hot money”, influenced by short-
                                          term rates, e.g., trade credit,
    Capital Account: We have had         Certificates of Deposit (CDs) of
     a surplus in recent years. This      one year or less.
     surplus means that foreigners
     have been investing more in the   2. Portfolio Investments: stocks and
     US than Americans have been          long-term debt. Affected by the
     investing overseas.                  country‟s economy, inflation
                                          outlook, and political climate.
    The BOJ buys our T-bills when
     it intervenes to hold down the    Direct investment: owner has control
     value of the Yen.                    of asset, e.g.: Honda‟s US auto
                                          factories, Pebble Peach, or 50%
    Thus, the US as a nation, has        control of a company‟s stock.
     been increasing it‟s net
     liabilities as the world’s
     biggest debtor.

                                      Balance of Payments
    Sources (CR)                                Uses(DR)                                  Balance Account (Sources-Uses or CR-DR)

                                                    Current Account Transactions (CA)
    •Exports of goods                           •Imports of goods                         Trade Balance
    •Exports of services                        •Imports of services                      „Invisibles‟ Balance
    •Inward unilaterals                         •Outward unilaterals                      Net inward Transfers
     private                                   Private
    public                                     public
                                                                                          Current Account Balance
                                                                                          =Net inflow from current transactions
                                                    Capital Account Transactions (KA)
    Inward portfolio investment                Outward portfolio investment             Net inward investment
    Short-term                                 Short-term
    Long-term                                  Long-term
    Inward direct investment                   Outward direct investment                Net inward investment
                                                                                          Capital Account Balance
                                                                                          =net inflow from capital transactions
                                           Central Bank Transactions and Errors and Omissions

    Decreases in reserves                      increases in reserves                    Net decreases in reserves
    Unrecorded inflows                         Unrecorded outflows                      =(-) changes in reserves
                                                                                          Net errors and omissions

    Grand Total of BOP = CA + KA –Changes in Reserves + Net Errors & Omissions =0
                     Balance of Payments

•   Official reserves include gold, govt holdings of foreign currency (commercial
    paper, T-bills, and bonds), money deposited at the IMF and SDRs with the
•   Increases of reserves when the entry is a use (DR), decreases of
    reserves is a source (DR).
Balance of Payments (2000)
   Current Account (CA)

   Exports   Millions             1,414,925
             Goods                  773,304
             Services               296,227
             Income Receipts        345,394
   Imports                       -1,797,061
               Goods             -1,222,772
               Services            -215,239
               Income Payments     -359,050
   Unilateral Transfers             -53,241
   Current Account Balance         -435,377
                Balance of Payments
                        The Financial Sector
•   In June 1999, US capital account definitions were modified to bring them
    more in line with definitions recommended by the International Monetary
•   Now there are two accounts: The Capital Accounts and Financial Accounts.
•   1. The new Capital Account includes items that were previously included in
    unilateral transfers, such as:
     – Debt forgiveness
     – Migrants‟ transfers (as they leave the country).
•   The new capital account is small for the US (< 0.1 percent of capital flows),
    but expected to grow.
• . The Financial Account               • Portfolio Investment:
     – Records international
        transactions in the financial     Individual or business
        sector                            purchase of stocks, bond,
     – Includes portfolio and foreign     or other financial assets
        direct investment
     – Includes changes in banks‟         or deposits. (An income
        and brokers‟ cash deposits        strategy)
        that arise from international
        transactions.                   • Foreign Direct
•   Foreign-Owned Assets in the US:       Investment: Purchase of
    Increase or decrease in foreign
    ownership of domestic assets.         financial assets that
•   Reserve Assets: Primarily the         results in a 10 percent or
    assets of central banks.              greater ownership share.
•   US-Owned Assets Abroad:
    Increase or decrease in US            (A financial control
    ownership of foreign financial        strategy)
Capital and Financial Account (2000)
          KA & FA Account
Capital Account, Net                                    680
Financial Account
US-Owned Assets                                     -553,349
                       US Official Reserve Assets       -290
                       US Government Assets             -715
                       US Private Assets            -552,344
Foreign-Owned Assets                                952,430
                       Foreign Official Assets       35,909
                       Other Foreign Assets         916,521
Net Financial Flows                                 399,761
The Balance of Payments
    The Statistical Discrepancy

 Balance on Current Account   -435,377

 Capital Account, net             680

 Net Financial Flows          399,081

 Statistical Discrepancy       35,616
             Example: Entries in the BOP

• Example: US firm $95 million worth computers to Brazil (entry 1a,
  below), and receives payment on its Swiss bank account (entry 1b).
  The firm imports $45 worth of chocolate from Belgium (entry 2a),
  and pays $ 5 million in insurance and freight to the Belgian shipping
  line (entry 3a); each time it pays from its Swiss bank account
  (entries 2b & 3b). It then donates $20 million to the International Red
  Cross (entries 4a & 4b). The remaining $25 million is transferred to a
  German bank account (entries 5a & 5b). After 2 days, the company
  invests the counterpart of US dollars in Euros (entries 6a & 6b) and
  sells $5 million worth of Euros to the Fed (entries 7a & 7b).
• Note: BOP– Sources and Uses of funds (FLOW) but Net In.
  Account – country’s assets and liabilities (STOCK).
• Example: CA =25 (net source) was used as: KA = -20 (private
  sector bought 20 worth of assets), and Change in Reserves = 5
  (Fed bought 5 worth of assets).
                                                  Current Account Transactions (CA)

EXPORTS (CR)                   IMPORTS (DR)                                                  BALANCE         Net

Goods exports (1a)     =95             Goods imports(2a) = 45                       +50
Services exports       =0              Services imports (3a) = 5                      -5
Inward Transfers       =0              Outward Transfers(4a)=20                      -20
                     -------                                --------                ------
                        95                                     70                   +25                +25
                                      Capital Transactions (KA)[ includes the Financial Accounts]

Short-term movements                   Swiss bank (1b)         =95
Swiss bank (2b)      =45
Swiss bank (3b)      = 5
Swiss bank (4b)      =20
Swiss bank (5a)      =25               German bank (5b)        =25
German bank (6a)     =10
German Bank (7a)    = 5
Long-term movements = 0                Euros (6b)              =10

                     =110                                      =130                                    -20

                                                         Changes in Reserves

Decreases            =0                       Increases (4a)           =5                                          -5

Grand Total          =205                                        =205                                              0
    Balance of Payment Concepts
•    We could view the Statistical       1. Dollars are leaving the US and
     Discrepancy (SD) as the result         not returning. Perhaps the
     of adding fairly accurate              currency is being held as store of
     Current Account numbers to             value by foreigners or as a
     inaccurate Capital Account             medium of exchange. The US
     numbers.                               collects “seigniorage.”
•    In the past there was a             2. Capital Account inflows may be
     tendency for this “Fudge               understated. “Flight Capital”, or
     Factor” to be routinely                funds coming into the US from
     positive (during the late 1970         unstable regions, often
     and through the 1980s).                undeclared.
     Reversed in 1991-2, 1997. A         • The “Twin Deficit:” The Federal
     positive (+) sign could mean           deficit rose sharply after 1981.
     that a Current Account deficit is      At about the same time, the
     not fully offset by a Capital          merchandise trade account
     Account surplus. Possibly              went into a large deficit.
     because of ---
        International Flow of Goods, Capital

•   What was the connection              •   Thus, we ran a large trade
    between the two deficits?                deficit.
    Simply put: the government cut       •   The trade deficit only began to
    taxes (T) but did not cut spending       shrink when economies overseas
    (G): Government began to live            began to recover and we could
    well beyond its means                    start exporting to them. Also we
•   Households received a tax cut            went into a recession in 1991 –
    which was the equivalent of a            and curtailed our household
    pay raise. Consumers saved               spending.
    some of the “raise” but logically    •   In the mid 1990s the Federal
    increased overall spending on            government started to run a
    goods and services.                      substantial surplus yet we had
•   Thus, the government spent the           a large trade deficit. Note:
    same, households spent more:             surplus was largely due to higher
    so, the nation as a whole                tax collections (SS tax went up
    increased spending. Some of              and govt collected taxes on large
    this new demand was met with             stock market gains).
    increased domestic output, but       •   Americans are now often referred
    the rest was met with increased          to as the “consumer of the last
    imports.                                 resort.”
        International Flow of Goods,
 The private sector is not saving       •   Note, in both cases, the only way
  (relative to income from wages,            the deficits could be financed
  interest and dividends).                   without “crowding out” private
 Possible demographic reason:               borrowing is to borrow abroad
  younger Baby Boomers are still             (resulting in capital inflows or a “
  accumulating goods like larger             capital account surplus.”)
  houses, etc. Older boomers are         •   Thus BOP =Zero!
  putting kids through college.          •   Japan is almost our mirror
 Thus this very large group is a net        image: (America in reverse).
  spender. Eventually kids will be       •   Largest international creditor –
  through college, big houses will be        BOJ has about $0.5 trillion in
  traded down for condos. When               foreign reserves (mostly US
  this happens, the boomer cohort            dollars)
  will start thinking about retirement   •   Huge level of private saving:
  and become major savers (like              possible reasons: age profile:
  their kind in Europe and Japan).           saving for retirement.
                                         •   However, the government is in
                                             deficit! (trying to stimulate the
                                             economy, low tax revenues)
International Flow of Goods, Capital/Trade deficits

•   Japanese save so much that          •   The US has a deficit yet has had
    they can cover private                  strong growth.
    investment needs, and the           •   Ignoring the contradictions above,
    Federal deficit, and still have         assume we wish to “cure” a
    plenty left over. So they need to       current account or trade deficit:
    move some savings overseas (to      •   Brazil, Mexico, and Thailand
    the U.S. mostly).                       devalued their currencies and
•   Thus Japan has a capital                eventually ran trade surpluses.
    account deficit.                    •   A falling currency should
•   A current account deficit is            reduce a trade deficit but this
    often considered a sign of poor         policy can backfire in the short-
    economic health. Brazil had a           term.
    deficit before its devaluation in   •   The idea of a lower US dollar is to
    1999. So did Mexico in 1995,            get U.S. consumers to substitute
    Thailand in 1997 etc….                  US goods for the now higher-
•   However, Japan has a surplus            priced Japanese goods.
    and has been in recession for a
     Coping with Trade Deficits and the J-Curve

• If US demand for the product
  is inelastic, total spending on
  Japanese exports may actually
  rise. This rise is what often                                   Trade
                                    Net                           Balance
  happens in the short-term.
                                    Change     Currency           Improves
• In the long-term, however,        In trade   depreciation       -elastic
  demand becomes more               Balance
  elastic and spending is more           0
  likely to drop.                                                 Time
• This pattern is said to form a
  J-shaped curve.
                                                    Trade Balance
                                                    Initially deteriorates
                                                    -inelastic demand
                Coping with Trade Deficits

•    A falling dollar would raise       •   Also, if it is more expensive to
     inflation, may cause financial         import investment goods
     panic. Falling dollar in 1985-87       (machine tools, parts),
     culminated in the Stock Market         protectionist policies may make
     crash of October 1987.                 whole economy less
•    Some potential government              competitive.
     policy solutions:                  2. Boosting the savings rates
1.   Protectionism:                         (austerity).
a.   tariffs: unit or value-based (ad    Savings can be boosted with a
     valorem) tax                           tight monetary or fiscal policy. The
b.   Quotas: limits the number of           underlying theory is that a trade
     imported units.                        deficit is caused by a country
                                            living beyond its means.
    Protectionist policies typically
     causes domestic inflation           However, demographics can
     through lack of competition.           play a large role.
        Coping with Trade Deficits
•   National differences: Social          •   This can be the result of excessive
    Security may reduce the                   purchases of foreign goods and
    perceived need to save for                services or excessive US
    retirement!                               investment overseas.
•   Easy to borrow in the U.S.: Low       •   In the short term, a balance of
    down payments on houses, autos,           payments deficit can be corrected
    and appliances.                           by:
•   Difficult to borrow in Japan:         •   continued borrowing of foreign
    cash for cars, 50% down on                currency;
    houses. Lenders are mostly loan       •   increasing interest rates to attract
    sharks.                                   overseas investors;
•   Correcting a Balance of Payments      •   imposing exchange controls;
•   Strictly speaking, the balance of     •   imposing tariffs and import quotas.
    payments always balances              •   In the long run, the government
    because of official financing.            can correct a balance of payments
    However, a balance of payments            deficit by reducing demand in the
    deficit means a persistent and            economy for all goods including
    large negative balance for official       imports. Reducing US inflation
    financing.                                rates or encouraging a dollar
                                              depreciation will also help.
     Correcting A BOP Surplus/ Debtor / Creditor
• Correcting a                            Net Debtor Nation
                                            – A nation whose total claims
  Balance of                                    abroad are less than the total
                                                foreign claims on the nation.
  Payments Surplus                    •   Net Creditor Nation
• An unwanted balance of                    – A nation whose stock of
  payments surplus can be the                   foreign financial assets is
  result of excessive foreign                   greater than the stock of
                                                foreign-held domestic financial
  investment in the USA. This                   assets.
  will place a future strain on the   •   It is neither necessarily good nor
  invisible balance. A reduction          bad to be a net debtor.
  in interest rates or restrictive    •   The US is the world‟s largest net
  exchange controls will correct          debtor, primarily because of
  the surplus.                            record FDI inflows.
                                      •   The US has been a net debtor in
                                          the past, and it spurred an
                                          industrial revolution.

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