CHAPTER 9 The Balance of Payments The Balance

CHAPTER 9 The Balance of Payments

The Balance of Payments § Balance of Payments (BOP): measures all international economic transactions between residents & foreign residents. • Monetary and fiscal policy must take the BOP into account • at the national level BOP data may be important – Indicates pressure on exchange rate – May signal burden/ removal of controls over payments, dividends, interest. – Helps forecast country’s market potential 2

Balance of Payments § § § A record of international transactions between residents of one country and the rest of the world International transactions include exchanges of goods, services or assets “Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations.

The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. Why is it useful to examine a country’s BOP? § The BOP provides detailed information about the supply and demand of the country’s currency. • The trade statistics in the Current Account, for example, show the composition of trade – what a country imports and what it exports. • The Capital Account shows inflows and outflows of capital in various categories. § Viewed over time, BOP data can explain important developments in a country’s comparative advantage and international competitiveness. 4

Double-entry Accounting in the BOP § § All transactions are either debit or credit transactions Credit transactions result in receipt of payment from foreigners: • Merchandise exports (valued f. o. b. ) • Transportation and travel receipts • Income received from investments abroad • Gifts received from foreign residents • Aid received from foreign governments

§ § Debit transactions involve to payments to foreigners • Merchandise imports • Transportation and travel expenditures • Income paid on investments of foreigners • Gifts to foreign residents • Aid given by home government • Overseas investments by home country residents Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance.

BOP A. B. Current Account A. Net exports/imports goods&services (Balance of Trade) B. Net Income (investment income from direct portfolio investment plus employee compensation C. Net transfers (sums sent home by migrant abroad) Capital Account Capital transfers related to purchase and sale of fixed assets such as real estate C. D. Financial Account A. Net foreign direct investment B. Net portfolio investment C. Other financial items Net Errors and Omissions Basic Balance = A+B+C Overall Balance = A+B+C+D Missing data such as illegal transfers E. Reserves and Related Items Changes in official monetary reserves including gold and foreign exchange reserves Σ (A: E) = Overall Balance 7

BOP Accounting § The BOP must balance § BOP is a flow statement, not a stock statement. • Main transactions in BOP: – Exchange of real assets. – Exchange of financial assets. 8

The Current Account § § § Goods Trade or Balance of Trade (BOT) – export/import of goods. Services Trade – export/import of services (financial, construction, and tourism). Income – predominately current income associated with investments made in previous periods, + wages & salaries paid to non-resident workers. Current Transfers – financial settlements due to change in ownership of real resources or financial items. Any transfer b/n countries which is one-way, a gift or a grant. CA typically dominated by export/import of goods, for this reason Balance of Trade (BOT) is widely quoted. 9

Current Account § The current account is that balance of payments account in which all short-term flows of payments are listed: • Goods and services balance (exports – imports) – Merchandise trade balance (exports – imports) – Services balance (exports – imports) • Net Investment income • Unilateral transfers – Private transfer payments – Governmental transfers

What are Services? § Travel and tourism § Trade transportation § Insurance § Education § Financial, technical, and marketing services § Telecommunication § Use of property rights (royalties) § Other professional and consulting services

What is Investment Income? § Payment to holders of foreign financial assets, including: • Interest on bonds and loans • Dividends and other claims on profits by owners of • foreign businesses Payments made to temporary (nonresident) workers

Unilateral Transfers § Official government grants in aid to foreign § § governments Openhanded giving (e. g. , scarcity aid) Migrant workers transfers to families in their home countries

The difference between the import and export of goods is sometimes called the balance of merchandise trade. Although the popular press often uses this measure, the merchandise trade balance is not a good summary because services are an important component of trade. The balance on goods and services includes trade in services. This includes visible and invisible trade. 14

The Current Account 15

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The Capital/Financial Account § Capital account: transfers of fixed assets, real estate, § gaining/disposal of non-produced/non-financial assets Financial account: three components; classified by degree of control, • Direct Investment • Portfolio Investment • Other Investment Assets/Liabilities –Short & longterm trade credits, cross-border loans, currency & bank deposits, & other accounts receivable and payable in cross-border trade. 17

Capital Account § The capital and financial account is that balance of payments account in which all cross-border transactions involving financial assets are listed. This includes transactions between foreign and domestic residents, and foreign and domestic governments. • All purchases or sales of assets, including: – – – Direct investment Securities (debt) Bank claims and liabilities Official reserves transactions When Turkish citizens buy foreign securities or when foreigners buy Turkish securities, they are listed here as outflows and inflows, respectively.

Foreign Direct Investment (FDI) § § § Any flow of lending to, or purchases of ownership in, a foreign enterprise that is largely owned by residents of the investing country. • Securities (stocks and bonds) • Loans • Bank deposits • Minority ownership positions FDI is the purchase of assets to establish financial control of a foreign entity. Generally ownership of 10% or more of a company’s outstanding stock is considered FDI. Portfolio investment involves little management control or interest, and is solely for financial gain.

The Capital/Financial Account, 2007 -2009 (billions of US$) 20

For example… • Direct Investment • Debit: Ford builds factory in Australia. • Credit: Ford sells its factory in UK. • Portfolio Investment • Debit: US investor buys BASF stock @ Frankfurt Stock Exchange • Credit: Korean gov’t buys US T-bills to hold as forex reserves. • Other investment • Debit: HP deposits $10 m in a bank account in London. • Credit: HP generates accounts receivable in Canada. 21

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The Other Accounts § Net Errors and Omissions – Account is used to § account for statistical errors and/or untraceable monies within a country Official Reserves (ORA) – total reserves held by official monetary authorities within a country. • Comprised of major currencies used in international trade and financial transactions, & reserve accounts. 23

Official Reserve Assets § Early on in this century, this was primarily gold § Now primarily financial assets denominated in a foreign currency that is widely accepted in international transactions: • • • Euro assets (heavily used by U. S. ) Yen assets (heavily used by U. S. ) U. S. dollar assets (key currency worldwide) Reserve positions in IMF SDRs (created by IMF)

Official Reserves Transactions § Governments can influence exchange rates by buying § and selling official reserves. The buying and selling of official reserves is recorded in the “official transactions” account. • Also referred to as “changes in holdings of official international reserves” or “official settlements balance”. § It is the part of the balance of payments accounts that records the amount of its own currency or foreign currencies that a nation buys or sells.

Statistical Discrepancy? § It is the net result of errors and omissions on both the § credit and debit sides. Where do these errors come from? • • Under-reporting merchandise imports Under-reporting investment incomes Under-reporting capital exports Basically, people succeed in hiding their imports, foreign investment incomes, capital flight from their governments for tax and other purposes.

Account Overview Current Account Merchandise trade exports imports Trade Balance Services military trans. (net) other services, net Service Balance on goods & services Investment income, net Unilateral transfers government grants govt pensions, and other transfers Private remittances and other transfers All transfers, net Balance on current account Capital Account Changes in US assets abroad, net other US govt assets US private assets All changes, net Changes in foreign assets in the US, net foreign private assets All changes, net Changes in holdings of official international reserves, net Statistical discrepancy Balance on capital account

Current Account Surplus and Deficit § A current account surplus means exports of goods and services, investment income and transfers exceed imports and outflows. § A current account deficit means imports of goods and services, and outflows are greater than exports and inflows; must be financed by borrowing (capital account inflows).

Meaning of Overall Balance § The current account and the capital account measure § § the private and non-government supply of and demand for dollars. Official Settlements Balance: B = CA + KA Because the balance of payments must sum to zero, any imbalance in the official settlements balance must be financed (paid for) by official reserves flows: B + OR = 0

BOP Surplus and Deficit § The Official Settlements Balance (B ) is sometimes § referred to as the net sum of the items above the line or autonomous transactions, and The Official Reserves Transactions (OR ) are referred to as the sum of the items below the line, also called nonautonomous or accommodating transactions. • When B = 0, there is said to be a BOP equilibrium, and if • • B 0, a BOP disequilibrium. When B > 0, there is said to be a BOP surplus. When B < 0, there is said to be a BOP deficit.

Official Transactions Account § Most of the Official Reserves flows are official § interventions by the country’s monetary authorities in the foreign exchange markets. When a government buys its own currency to hold up the currency’s price, we say that the government has supported its currency. • It is holding the exchange rate higher than that rate otherwise would have been. § When it sells its currency, it is attempting to depress the value of its currency. • It is forcing the exchange rate to be lower than that rate would otherwise have been.

Official Transactions Account § Because § they are an accounting identity, the current, capital, and official transactions accounts must sum to zero—in total, the balance of payments balances. The supply of currency, including government’s, must equal the demand for currency, including government’s.

2010 Balance of Payments Accounts

2010 Balance of Payments Accounts

The Balance of Payments in Total Balance of Payments, Analytic Presentation, 1997 -1999 35

What if…? § BOP shows surplus: • D > S for that currency. • Allow currency value to increase, • Or accumulate foreign reserves. § BOP shows deficit: • S > D for that currency. • Devalue currency, • Or use official reserves to support currency. 36

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