4.1The Balance of Payments

8/12/2019 4.1The Balance of Payments

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The Balance of Payments

Ch 4


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International business transactions occur in

many different forms over the course of a year

The measurement of all internationaleconomic transactions between the residents

of a country and foreign countries is called the

balance of payments (BOP)


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BOP data is important for government policymakers and MNEs as it is agauge of a nations competitiveness or health (domestic and/or foreign)

For a MNE, both home and host country BOP data is important as:

An indication of pressure on a countrys foreign exchange rate

A signal of the imposition or removal of controls in various sorts ofpayments (dividends, interest, license fees, royalties and other cashdisbursements)

A forecast of a countrys market potential (especially in the short run)


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Typical BOP Transactions

Each of the following represents an international economictransaction that is counted in and captured in the U.S. BOP:

A U.S. subsidiary of a foreign Company acts as a distributor for theCompany s products in the U.S. market

A U.S. based firm, manages the construction of a major watertreatment facility in a foreign country

The U.S. subsidiary of a foreign firm pays profits (dividends) back to aparent in its home (foreign) country

The U.S. government finances the purchase of military equipment fora foreign military ally


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Fundamentals of BOP Accounting

The BOP mustbalance

It cannot be in disequilibrium unless

something has not been counted or has beencounted improperly

Therefore it is incorrect to state that the BOP

is ever in disequilibrium


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Fundamentals of BOP Accounting

There are three main elements of the actual process of measuring

international economic activity:

Identifying what is and is not an international economic transaction

Understanding how the flow of goods, services, assets, and money

create debits and credits to the overall BOP Understanding the bookkeeping procedures for BOP accounting

It is a daunting task to measure all international transactions that take

place in and out of a country over a year

Exhibit 4.1 presents a sample generic BOP


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Exhibit 4.1 Generic Balance of

Payments


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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

By recording all international transactions over a period oftime such as a year, it tracks the continuing flows of purchases

and payments between a country and all other countries

It does not add up the value of all assets and liabilities of a

country on a specific date (as an individual firms balancesheet would do)


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The BOP as a Flow Statement

Two types of business transactions dominate

the balance of payments:

Exchange of Real Assets

Exchange of Financial Assets

Although assets can be identified as belonging

to distinct groups, it is easier to think of allassets simply as goods that can be bought or

sold (a clock versus a bond)


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The Accounts of the BOP

The BOP is composed of twoprimary sub

accounts, the Current Account and the

Capital/Financial Account

In addition, the Official Reserves account

tracks government currency transactions

A fourth account, the Net Errors andOmissions account is produced to preserve

the balanceof the BOP


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The Current Account

The Current Accountincludes all international economic transactions with incomeor payment flows occurring within one year, the current period. It consists of thefollowing four subcategories:

Goods trade and import of goods

Services trade

Income Current transfers

The Current Account is typically dominated by the first component which is knownas the Balance of Trade (BOT) even though it excludes service trade

Exhibit 4.2 documents the U.S. current account from 20022010; Exhibit 4.3

follows with U.S. trade balance on goods and services


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Exhibit 4.2 The United States Current Account, 2002-

2010 (billions of U.S. dollars)

IMF WEO Data

http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx
http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspxhttp://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx


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Exhibit 4.3 U.S. Trade Balances on Goods and Services, 1985-

2010 (billions of US dollars)


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The Current Account

The deficits in the BOT of the past decade have been an area ofconsiderable concern for the United States, in both the public

and private sectors

The goods trade deficit saw the decline of heavy traditional

industries in the U.S. (steel, automobiles, automotive parts,textiles)

Recent developments against this trend?


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The Capital/Financial Account

The Capital Account of the balance of

payments measures all international economic

transactions of financial assets. It is divided

into two major components:

The Capital Account

The Financial Account

The Capital Account is minor (in magnitude),

while the Financial Accountis significant


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Financial assets can be classified in a number

of different ways including the length of the

life of the asset (maturity) and the nature of

the ownership (public or private)

The Financial Account, however, uses a third

method. This focuses on the degree of

investor control over the assets or operations


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The Financial Account consists of threecomponents;

Direct Investmentin which the investor exerts

some explicit degree of control over the assets Portfolio Investmentin which the investor has

no control over the assets

Other Investmentconsists of various short-termand long-term trade credits, cross-border loans,currency deposits, bank deposits and other A/Rand A/P related to cross-border trade


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Direct Investment

This is the net balance of capital dispersed from and into a country for the

purpose of exerting control over assets.

Foreign direct investment arises from 10% ownership of voting shares in a

domestic firm by foreign investors.

The source of concern over foreign investment in any country focuses ontwo topics: control and profit.

Some countries possess restrictions on what foreigners may own in their

country.

The general rule or premise is that domestic land, assets and industryshould be owned by residents of the country.

Concerns over profit stem from the same argument.


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Portfolio Investment

This is the net balance of capital that flows in and out of a country but doesnot reach the 10% threshold of direct investment.

The purchase of debt securities across borders is 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 investment.

As illustrated in Exhibit 4.4, portfolio investment has shown much more

volatile behavior than net foreign direct investment over the past decade


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The BOP in Total Deficit

A deficitin the BOP implies an excess supply

of the countrys currency on world markets,

and the government should then either

devalue the currency or expend its officialreserves to support its value.


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The BOP in Total Surplus

Exhibit 4.10 provides a comprehensive overview of how theindividual accounts are combined to create some of the most

useful summary measures for multinational business

managers

Total of groups A, B, and C form the basic balance; this is one

of the most frequently used summary measures of the BOP

A surplusin the BOP implies that the demand for the countrys

currency exceeded the supply and that the government should

allow the currency value to increasein valueor intervene

and accumulate additional foreign currency reserves in theOfficial Reserves Account


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Exhibit 4.4 The United States Financial Accounts and

Components, 2002-2010 (billions of U.S. dollars)


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Other Investment Assets and Liabilities, Current and

Financial Account Balance Relationships

Exhibit 4.5 shows the major subcategories of the U.S. financial

account balance from 1985 to 2009: direct investment,

portfolio investment, and other long-term and short-term

capital investment

Exhibit 4.6 illustrates the current and financial account

balances for the United States over recent years


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Exhibit 4.5 The United States Financial Account, 1985-2010 (billions

of U.S. dollars)


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Net Errors & Omissions/Official

Reserves Accounts The Net Errors and Omissions account ensures that the BOP

actually balances. (See economist article on BB)

The Official Reserves Account is the total reserves held byofficial monetary authorities within the country.

These reserves are normally composed of the majorcurrencies used in international trade and financialtransactions (hard currencies).

The significance of official reserves depends generally on

whether the country is operating under a fixed exchange rateregime or a floating exchange rate system.


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Exhibit 4.6 Current and Combined Financial/Capital Account Balances for

the United States, 1992-2010 (billions of U.S. dollars)


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Breaking the Rules: Chinas Twin

Surpluses

Exhibit 4.7 illustrates Chinas highly unusual twinsurplus in both the current and financial accounts(these relationships are typically inverse)

The rapid rise of the Chinese economy has beenaccompanied by a 10 fold increase in foreignexchange reserves (Exhibit 4.8)

As a result, Chinas foreign exchange reserveswere approximately 2.5 times larger than the

next largest in 2010(Exhibit 4.9) $3.549 trillion for 31 December 2012 (CIA

Worldfactbook)


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Exhibit 4.7 Chinas Twin Surplus, 1998-2010 (billions of

U.S. dollars)


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Exhibit 4.8 Chinas Foreign Exchange Reserves

(billions of U.S. dollars)


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Exhibit 4.9 Largest Foreign Exchange Reserves (billions of U.S.

dollars)

E hibi


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Exhibit

4.10 The

United

States

Balance

of

Payments

, Analytic

Presentation, 2000-

2010

(billions

of U.S.

dollars)


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The BOP Interaction with Key Macroeconomic Variables

A nations balance of payments interacts withnearly all of its key macroeconomic variables

Interacts means that the BOP affects and is

affected by such key macroeconomic factorsas:

Gross Domestic Product (GDP)

The exchange rate

Interest rates

Inflation rates


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The BOP and GDP

In a static (accounting) sense, a nations GDP can berepresented by the following equation:

GDP = C + I + G + X M

C = consumption spendingI = capital investment spending

G = government spending

X = exports of goods and services

M = imports of goods and services

XM = the current account balance


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The BOP and Exchange Rates

A countrys BOP can have a significant impact

on the level of its exchange rate and vice versa

The relationship between the BOP and

exchange rates can be illustrated by use of a

simplified equation that summarizes BOP Data

(see next slide)


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(XM) + (CICO) + (FIFO) + FXB = BOP

Where:

X = exports of goods and services

M = imports of goods and servicesCI = capital inflows

CO = capital outflows

FI = financial inflows

FO = financial outflows

FXB = official monetary reserves

Current Account Balance

Capital Account Balance

Financial Account Balance


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Fixed Exchange Rate Countries Under a fixed exchange rate system, the government bears the

responsibility to ensure that the BOP is near zero

Floating Exchange Rate Countries Under a floating exchange rate system, the government has no

responsibility to peg its foreign exchange rate

Managed Floats Countries operating with a managed float often find it necessary to

take action to maintain their desired exchange rate values


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The BOP and Interest Rates

Apart from the use of interest rates to intervene in the foreignexchange market, the overall level of a countrys interest ratescompared to other countries does have and impact on the financialaccount of the BOP

Relatively low real interest rates should normally stimulate an outflow

of capital seeking higher rates elsewhere However, in the case of the U.S., the opposite has occurred due to

perceived growth opportunities and political stabilityallowing it tofinance its large fiscal deficit

However, it is beginning to appear that the favorable inflow on thefinancial account is diminishing while the current account balance isworseningmaking the U.S. a bigger debtor nation vis--vis the rest ofthe world


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Trade Balances and Exchange Rates

A countrys import and export of goods and services isaffected by changes in exchange rates

The transmission mechanism is in principle quite simple:

changes in exchange rates change relative prices of imports

and exports, and changing prices in turn result in changesin quantities demanded through the price elasticity of

demand

Theoretically, this is straightforward; in reality global

business is more complex


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Exhibit 4.11 Trade Balance Adjustment to Exchange Rate

Changes: The J-Curve


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Capital Mobility

The degree to which capital moves freely

across borders is critically important to a

countrys balance of payments

The United States financial account surplus

has at least partially offset the current account

deficits over the last 20 or more years

China has run a surplus in each of these

accounts in recent years


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Capital Mobility

The free flow of capital in and out of an economy can

potentially destabilize economic activity or can contribute

significantly to an economys development

Thus, Bretton Woods Agreement was careful to promote free

movement of capital for current account transactions (e.g.,

foreign exchange or deposits) but less so for capital account

transactions (e.g., foreign direct investment)

1970s - 1990s saw growth in capital openness, the financial

crisis of 1997/1998 stopped that due to destructive capital

outflows and contagion


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Exhibit 4.12 The Evolution of Capital

Mobility


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Capital Controls

A capital control is any restriction that limits or alters the rateor direction of capital movement into or out of a country

Free movement of capital is more the exception than the rule

Exhibit 4.13 outlines several methods of and purposes for

capital controls Dutch Diseaseis the name given to the problem of a

substantial currency appreciation due to the demand for a

specific natural resourcefaced by several resource-rich

smaller nations


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Capital Flight

Although no single definition of capital flightexists, it hasbeen characterized as occurring when capital transfers byresidents conflict with political objectives.

Many heavily indebted countries have suffered capital flight,compounding their debt service problems.

Capital can be moved via international transfers, with physicalcurrency, collectables or precious metals, money launderingor false invoicing of international trade transactions.

4.1The Balance of Payments

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