2. LECTURE OUTLINE
BOP definition and examples
BOP components
The interaction between BOP and key
macroeconomic variables
3. The Balance of Payments
The measurement of all international economic
transactions between the residents of a country and
foreign residents is called the balance of payments (BOP)
Important for government policymakers and MNEs as it is a
measurement of a nation’s competitiveness or health
(domestic and/or foreign)
4. 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 (outflows) and credits
(inflows) to the overall BOP
Understanding the book-keeping procedures for BOP
accounting
A BOP statement is a statement of cash flows over an
interval of time.
5. The Accounts of the BOP
The BOP is composed of:
Current Account
Capital and Financial Account
Official Reserves Account: tracks government
currency transactions
Net Errors and Omissions (a.k.a Statistical
Discrepancies) Account: produced to preserve the
balance of the BOP
6. Current Account
1. Goods trade: Net exports/imports of goods (balance of
trade)
2. Service trade: Net exports/imports of services
3. (Factor) income: Net income (investment income from
direct and portfolio investment plus employee compensation)
4.Current transfer: Net transfers (sums sent home by migrants
and permanent workers abroad, gifts, grants, and pensions)
9. Current account
Transactions Types Inflow/
outflow
J.C. Penney purchases stereos produced in Indonesia
that it will sell in its U.S. retail stores.
The Mexican government pays a U.S. consulting firm
for consulting services provided by the firm
A U.S. investor receives a dividend payment from a
French firm in which she purchased stock.
The United States provides aid to Costa Rica in
response to a flood in Costa Rica.
10. Exhibit 4.2 The United States Current Account,
2002-2010 (billions of U.S. dollars)
11. U.S. Trade Balances on Goods and Services, 1985-2016
(billions of US dollars)
12. The Capital and Financial Account
The Capital Account and financial accounts:
measures all international economic
transactions of financial assets.
13. The Capital Account
Consist of:
Capital Transfers:
The transfer of title to fixed assets & the transfer of funds
linked to the sale or acquisition of fixed assets, gifts and
inheritance taxes…
Sale & Purchases Of Non-Produced, Non-Financial
Assets:
The right to natural resources, and the sale & purchase of
intangible assets (patents, copyrights, trademarks, franchises
and leases).
14. The Financial Account
Three components:
Direct Investments: investor exerts some explicit
degree of control over the assets
Portfolio Investments: investor has no control over the
assets
Other Investments: 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
15. Direct Investment
This is the net balance of capital dispersed from and into
the country for the purpose of exerting control over
assets.
When the capital flows out of the U.S., it enters the BOP as a
negative cash flow and vice versa
Foreign direct investment arises from 10% ownership of
voting shares in a domestic firm by foreign investors.
Concern for FDI: control and profit.
E.g: Restrictions on what foreigners may own in their country.
16. Portfolio Investment
This is the net balance of capital that flows in and out
of the country but does not reach the 10% threshold of
direct investment.
E.g: The purchase/sale of debt securities across borders
Profit-motivated (return), rather than to control or
manage the investment.
much more volatile than net foreign direct investment
over the past decade
17. The United States Financial Accounts and Components,
2002-2010 (billions of U.S. dollars)
18. The United States Financial Account, 1985-2016 (billions of
U.S. dollars)
19. Current and Combined Financial/Capital Account Balances for the
United States, 1992-2010 (billions of U.S. dollars)
20. Official Reserves Accounts
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.
21. Net Errors & Omissions
The BOP must balance unless something has not been counted or has been
counted improperly
A subaccount of the BOP
, may be imbalanced, but the entire BOP of a single
country is always balanced.
The Net Errors and Omissions account ensures that the BOP actually balances.
23. Breaking the Rules: China’s Twin
Surpluses
Exhibit 4.7 illustrates China’s 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, China’s foreign exchange reserves are approximately 2.5 times
larger than the next largest (Exhibit 4.9)
28. The BOP in total
(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
29. The BOP Interaction with Key Macroeconomic
Variables
A nation’s 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
30. The BOP and GDP
In a static (accounting) sense, a nation’s 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
31. The BOP and Exchange Rates
A country’s 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:
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
32. 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
33. Trade Balances and Exchange Rates
A country’s 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
34. The BOP and Interest Rates
Interest rates are used to intervene in the foreign exchange
market,
The overall level of a country’s interest rates compared to
other countries does have an impact on the financial account
of the BOP
Relatively low real interest rates should normally stimulate an outflow of
capital seeking higher rates elsewhere
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
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-à-vis the rest of the world
35. BOP and inflation rates
Imports have the potential to lower a country’s inflation
rate.
On the other hand, to the extent that lower-priced
imports substitute for domestic production and
employment, gross domestic product will be lower as the
balance on the current account falls with rising imports.
36. Capital Mobility
The degree to which capital moves freely across borders is
critically important to a country’s balance of payments
The free flow of capital in and out of an economy can
potentially destabilize economic activity or can contribute
significantly to an economy’s development
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)
37. 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
38. Capital Flight
Capital flight occurs 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.
#4:A BOP credit is an event, such as the export of a good or service, that records foreign exchange earned—an inflow of foreign exchange to the country. A debit records foreign exchange spent, such as payments for imports or purchases of services—an outflow of foreign exchange.
By recording all international transactions over a period of time such as a year, the BOP 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 like a balance sheet does for an individual firm
#5:The supply and demand for a country’s currency may be imbalanced, but that is not the same as the entire BOP. A sub-account of the BOP, such as the balance on goods and services (a sub-account of any country’s current account), may be imbalanced (in surplus or deficit), but the entire BOP of a single country is always balanced.
In addition, the official reserves account tracks government currency transactions, and a fifth statistical subaccount, the net errors and omissions account, is produced to preserve the balance in the BOP.
#6:
Services trade. Common international services are financial services provided by banks to foreign importers and exporters, travel services of airlines, and construction services of domestic firms in other countries.
Income. This is predominantly current income associated with investments made in previous periods. If a U.S. firm created a subsidiary in South Korea to produce metal parts in a previous year, the proportion of net income that is paid back to the parent company in the current year (the dividend) constitutes current investment income. Composed of income earned/paid by MNCs on their direct foreign investment (investment in fixed assets in foreign countries that can be used to conduct business operations) as well as income earned by investors on their portfolio investments (investments in foreign securities). Additionally, wages and salaries paid to nonresident workers are also included in this category.
These are generally rent on property, interest on capital, and profits on investments.
Employee compensation: Vietnamese working for a US company in the US salaries: debit to US BOP
Current transfer: Unilateral transfers to and from abroad – Financial settlements associated with the change in ownership of real resources or financial items: gifts or donations sent to the resident of a country by a non-resident relative; Transfer payments made by migrant or guest workers back to their home countries, global remittances, are an example of current transfers.
Other name: Factor income – primary income, current transfer: secondary income
#9:The major categories of services include travel and passenger fares; transportation services; expenditures by U.S. students abroad and foreign students pursuing studies in the United States; telecommunications services; and financial services.
Good Import – debit
Service export – credit
Factor income – debit
Current transfer - debit
#20:If the exchange rate is fixed, the government of the country officially declares that the currency is convertible into a fixed amount of some other currency. For example, the Chinese yuan was fixed to the U.S. dollar for many years. It was the Chinese government’s responsibility to maintain this fixed rate, also called parity rate. If for some reason there was an excess supply of yuan on the currency market, to prevent the value of the yuan from falling, the Chinese government would have to support the yuan’s value by purchasing yuan on the open market (by spending its
hard currency reserves) until the excess supply was eliminated. Under a floating rate system, the Chinese government possesses no such responsibility and the role of official reserves is diminished.
#21:To record errors or statistical discrepancies.
#24:Although current account surpluses of this magnitude would ordinarily create a financial account deficit, the positive prospects of the Chinese economy have drawn such massive capital inflows into China that the financial account, too, is in surplus. It has also been perpetuated by rigid capital outflow restrictions, limiting the capital that may leave the country.
Note that beginning in 2012, the net financial/capital account balance did indeed go negative, more in-line with traditional theoretical expectations. This was partly a result of the continued deregulation of the Chinese financial sector combined with slowing economic growth. Although the balance on the financial/capital account was again in surplus in 2016, partly the result of the
reintroduction of limited capital controls, those data are still considered preliminary and revisions are always expected
#25:hese reserves allow the Chinese government to manage the value of the Chinese yuan and its impact on Chinese competitiveness in the world economy. The magnitude of these reserves will allow the Chinese government to maintain a relatively stable managed fixed rate of the yuan against other major currencies like the U.S. dollar as long as it chooses
#32:Fixed exchange rate: If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and sell domestic currency for foreign currencies or gold in order to bring back the BOP to near zero.
Floating exchange rate: The fact that the current and capital account balances do not sum to zero will automatically—in theory—alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit and a capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. Like all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero.
Managed float: day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take action to maintain their desired exchange rate values. They often seek to alter the market’s valuation of their currency by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets.
The primary action taken by these governments is to change relative interest rates,
a change in domestic interest rates is an attempt to alter the capital account balance, CI - CO, especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in the current account.
#34:Relatively low real interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country currencies. However, in the case of the United States, the opposite effect has occurred. Despite relatively low real interest rates and large BOP deficits on the current account, the U.S. BOP financial account has experienced offsetting financial inflows due to relatively attractive U.S. growth rate prospects, high levels of productive innovation, and perceived political safety
#35:In particular, imports of lower-priced goods and services place a limit on what domestic competitors can charge for comparable goods and services. Thus, foreign competition substitutes for domestic competition to maintain a lower rate of inflation than might have been the case without imports.
