The Balance of Payments

Ch 4
The Balance of Payments
International business transactions occur in
many different forms over the course of a year
The measurement of all international
economic transactions between the residents
of a country and foreign countries is called the
balance of payments (BOP)
The Balance of Payments
BOP data is important for government policymakers and MNEs as it is a
gauge 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 of
payments (dividends, interest, license fees, royalties and other cash
disbursements)
A forecast of a countrys market potential (especially in the short run)
Typical BOP Transactions
Each of the following represents an international economic
transaction that is counted in and captured in the U.S. BOP:
A U.S. subsidiary of a foreign Company acts as a distributor for the
Company s products in the U.S. market
A U.S. based firm, manages the construction of a major water
treatment facility in a foreign country
The U.S. subsidiary of a foreign firm pays profits (dividends) back to a
parent in its home (foreign) country
The U.S. government finances the purchase of military equipment for
a foreign military ally
Fundamentals of BOP Accounting
The BOP must balance
It cannot be in disequilibrium unless
something has not been counted or has been
counted improperly
Therefore it is incorrect to state that the BOP
is ever in disequilibrium
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
Exhibit 4.1 Generic Balance of
Payments
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 of
time 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 balance
sheet would do)
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 all
assets simply as goods that can be bought or
sold (a clock versus a bond)
The Accounts of the BOP
The BOP is composed of two primary 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 and
Omissions account is produced to preserve
the balance of the BOP
The Current Account
The Current Account includes all international economic transactions with income
or payment flows occurring within one year, the current period. It consists of the
following 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 known
as 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
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
Exhibit 4.3 U.S. Trade Balances on Goods and Services, 1985-
2010 (billions of US dollars)
The Current Account
The deficits in the BOT of the past decade have been an area of
considerable 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?
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 Account is significant
The Financial Account
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
The Financial Account
The Financial Account consists of three
components;
Direct Investment in which the investor exerts
some explicit degree of control over the assets
Portfolio Investment in which the investor has
no control over the assets
Other Investment consists of various short-term
and long-term trade credits, cross-border loans,
currency deposits, bank deposits and other A/R
and A/P related to cross-border trade
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 on
two 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 industry
should be owned by residents of the country.
Concerns over profit stem from the same argument.
Portfolio Investment
This is the net balance of capital that flows in and out of a country but does
not 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

The BOP in Total Deficit
A deficit in 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 official
reserves to support its value.
The BOP in Total Surplus
Exhibit 4.10 provides a comprehensive overview of how the
individual 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 surplus in the BOP implies that the demand for the countrys
currency exceeded the supply and that the government should
allow the currency value to increase in value or intervene
and accumulate additional foreign currency reserves in the
Official Reserves Account
Exhibit 4.4 The United States Financial Accounts and
Components, 2002-2010 (billions of U.S. dollars)
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


Exhibit 4.5 The United States Financial Account, 1985-2010 (billions
of U.S. dollars)
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 by
official monetary authorities within the country.
These reserves are normally composed of the major
currencies used in international trade and financial
transactions (hard currencies).
The significance of official reserves depends generally on
whether the country is operating under a fixed exchange rate
regime or a floating exchange rate system.
Exhibit 4.6 Current and Combined Financial/Capital Account Balances for
the United States, 1992-2010 (billions of U.S. dollars)
Breaking the Rules: Chinas Twin
Surpluses
Exhibit 4.7 illustrates Chinas highly unusual twin
surplus in both the current and financial accounts
(these relationships are typically inverse)
The rapid rise of the Chinese economy has been
accompanied by a 10 fold increase in foreign
exchange reserves (Exhibit 4.8)
As a result, Chinas foreign exchange reserves
were approximately 2.5 times larger than the
next largest in 2010(Exhibit 4.9)
$3.549 trillion for 31 December 2012 (CIA
Worldfactbook)

Exhibit 4.7 Chinas Twin Surplus, 1998-2010 (billions of
U.S. dollars)
Exhibit 4.8 Chinas Foreign Exchange Reserves
(billions of U.S. dollars)
Exhibit 4.9 Largest Foreign Exchange Reserves (billions of U.S.
dollars)
Exhibit
4.10 The
United
States
Balance
of
Payments
, Analytic
Presentati
on, 2000-
2010
(billions
of U.S.
dollars)
The BOP Interaction with Key Macroeconomic Variables
A nations balance of payments interacts with
nearly all of its key macroeconomic variables
Interacts means that the BOP affects and is
affected by such key macroeconomic factors
as:
Gross Domestic Product (GDP)
The exchange rate
Interest rates
Inflation rates
The BOP and GDP
In a static (accounting) sense, a nations GDP can be
represented by the following equation:
GDP = C + I + G + X M

C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
X M = the current account balance


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)
The BOP and Exchange Rates
(X M) + (CI CO) + (FI FO) + FXB = BOP

Where:
X = exports of goods and services
M = imports of goods and services
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
FXB = official monetary reserves

Current Account Balance
Capital Account Balance
Financial Account Balance
The BOP and Exchange Rates
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
The BOP and Interest Rates
Apart from the use of interest rates to intervene in the foreign
exchange market, the overall level of a countrys interest rates
compared to other countries does have and impact on the financial
account 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 stability allowing it to
finance its large fiscal deficit
However, it is beginning to appear that the favorable inflow on the
financial account is diminishing while the current account balance is
worsening making the U.S. a bigger debtor nation vis--vis the rest of
the world
Trade Balances and Exchange Rates
A countrys import and export of goods and services is
affected 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 changes
in quantities demanded through the price elasticity of
demand
Theoretically, this is straightforward; in reality global
business is more complex
Exhibit 4.11 Trade Balance Adjustment to Exchange Rate
Changes: The J-Curve
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
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


Capital Mobility
The authors argue that the post-1860 era can be subdivided
into four distinct periods with regard to capital mobility.
1860-1914 continuously increasing capital mobility as the gold
standard was adopted and international trade relations were expanded
1914-1945 global economic destruction, isolationist economic
policies, negative effect on capital movement between countries
1945-1971 Bretton Woods era say a great expansion of international
trade
1971-2097 floating exchange rates, economic volatility, rapidly
expanding cross-border capital flows
China and India attempt to open their markets
These points are laid out in Exhibit 4.12

Exhibit 4.12 The Evolution of Capital
Mobility
Capital Controls
A capital control is any restriction that limits or alters the rate
or 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 Disease is the name given to the problem of a
substantial currency appreciation due to the demand for a
specific natural resource faced by several resource-rich
smaller nations
Capital Flight
Although no single definition of capital flight exists, it has
been characterized as occurring when capital transfers by
residents 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 physical
currency, collectables or precious metals, money laundering
or false invoicing of international trade transactions.