International FinanceFINA 5331

Lecture 5: Balance of Payments

Read: Chapters 3

Aaron Smallwood Ph.D.

Balance of Payments Example

• Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle frames from Mercian Bicycles in Darby England.

• There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood’s bank account.

• This will lead to a rise in the supply of dollars and the demand for British pounds.

• The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations.

• They are composed of the following:– The Current Account– The Financial Account

• The Official Reserves Account

– The Capital Account– Statistical Discrepancy

Balance of Payments Accounts

The Current Account

• Includes all imports and exports of goods and services, including financial services (invisible trade or investment income).

• Includes unilateral transfers of foreign aid.

• If the debits exceed the credits, then a country is running a trade deficit.

• If the credits exceed the debits, then a country is running a trade surplus.

• It is thought that the current responds to changes in income and the exchange rate.

The current account

• Consists of four categories– Merchandise trade (tangible goods)– Services (trade in factors of production)– Investment income (credit if we receive

payment on previous investment, debit if we make payments on previous investments).

– Unilateral transfers (gifts and aid).

The Current Account

• A credit on the current account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).

• A debit on the current account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Current Account

• When a domestic company sells goods or services to a foreign resident, there will be a credit recorded on the current account.

• When a domestic resident buys goods or services from a foreign firm, there will be a debit recorded on the current account.

• When a foreign asset pays interest to a domestic resident, or a domestic resident earns income in the foreign economy, there will be a credit recorded on the current account.

• When a domestic asset pays interest to a foreign resident, or a foreign resident earns income in the domestic economy, there will be a debit recorded on the current account.

J-curve Effect

What conditions are necessary for J-curve effect?

εIM is the import demand elasticity = %Δimports divided by %ΔSt.

When εIM is greater than one (in absolute value), a domestic depreciation will lead to a fall in the RMB value of imports. Import demand is said to be elastic.

When εIM is equal to one (in absolute value), a domestic depreciation will not change the RMB value of imports.

When εIM is less than one (in absolute value), a domestic depreciation will lead to a rise in the RMB value of imports. Import demand is inelastic.

The J-curve can only occur when import demand elasticities are inelastic.

Algebra of Import Demand Elasticities

J-curve

• The point is your company’s expenditures on imports may increase following a domestic currency depreciation.

• While export volumes are expected to increase, if small, the generated revenue may not fully cover the increase in costs. Profits could be reduced.

• For an economy, if imports rise by a larger amount than exports, the trade balance could move into deficit.

The Financial Account

• The financial account for China measures the difference between Chinese sales of assets to foreigners and Chinese purchases of foreign assets.

• The financial account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments, and technically official reserves.

• Because of their importance, official reserves are sometimes treated separately.

The Financial Account

• A credit on the financial account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).

• A debit on the financial account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Financial Account

• When a domestic entity (firm or individual) sells an asset to a foreign resident, there will be a credit recorded on the financial account.

• When a domestic resident buys an asset from a foreign entity, there will be a debit recorded on the financial account.

• Note – income earned on these assets is recorded on the current account, NOT the financial account!!!

The Balance of Payments Identity

BCA + BFA + BRA = 0BCA = balance on current accountBFA = balance on financial accountBRA = balance on the reserves account

(which assumes no capital account balance and no statistical discrepancy)

• Note: When a country experiences a currency crisis, we typically see BRA>0 (and HUGE)

Under a pure flexible exchange rate regime, BCA + BFA = 0

Because BRA = 0

Official settlements

• The official settlements balance, sometimes referred to as the overall balance, is the balance on the current account plus capital account plus non-official reserve component of the financial account.

• If a country has a balance of -$5 billion in their official reserves, the official settlements balance is +$5billion.

Balance of Payments Trends

• Since 1982, the U.S. has experienced continuous deficits on the current account and continuous surpluses on the non-official reserve component of the financial account.

• During the same period, China has experienced surpluses in both and deficit in official reserves.

China BOP

Japan BOP

USA BOP

Balances on the Current (BCA) and Financial (BKA) Accounts of United Kingdom

1981 1986 1991 1996 2001 2006 2011-100

-80

-60

-40

-20

0

20

40

60

80United Kingdom

Bala

nces

in B

illion

s of

US

dolla

rs

Current Account Balance

Financial Account Balance

Official reserves

• In the US official reserve assets include gold, foreign currency, and special drawing rights (issued by the IMF).

• The official settlements balance is BCA+BFA

• When BCA+BFA≠0, the central bank must acquire or deplete holdings of official reserves.