bop session 14

8/3/2019 BOP Session 14

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The Balance of Payments: Linking theDomestic Economy to the InternationalEconomy

Open economy An economy that

has interactions in trade or finance

with other countries.

Closed economy An economy that has

no interactions in trade or finance with

other countries.

Balance of payments The record of

a countrys trade with other countries

in goods, services, and assets.


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Balance of Payments (BOP)

A record of international transactions betweenresidents of one country and the rest of the world.

International transactions include exchanges ofgoods, services or assets.

Residents means businesses, individuals and

government agencies, including citizens temporarilyliving abroad, but excluding local subsidiaries offoreign corporations.


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Balance of Payments (BOP)

The Balance of Payments (BOP) is also the

record of a countrys sources (supply) and uses

(demand) of foreign exchange.

Foreign exchangeis simply all currencies other

than the domestic currency of a given country.


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For example

BOP transactions (US side)

Daimler-Chrysler purchases manufacturer in

Chicago.

GM China pays dividends to parent in US.

An American tourist purchases a necklace in

India.

A Mexican lawyer purchases US bond viainvestment broker in New York.

Rule of thumb: follow the cash flow


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Balance of Payments Accounts(cont.)

The balance of payment accounts are separated into 3

broad accounts:

current account: accounts for flows of goods and

services (imports and exports).

financial account: accounts for flows of financial

assets (financial capital).

capital account: flows of special categories of assets

(capital), typically non-market, non-produced, orintangible assets like debt forgiveness, copyrights and

trademarks.


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B of PA. Current Account

A. Net exports/imports goods&services (Balance of Trade)

B. Net Income (investment income from direct portfolio investment plus employeecompensation)

C. Net transfers (sums sent home by migrant abroad)

B. Capital Account

Capital transfers related to purchase and sale of fixed assets such as real estate

C. Financial Account

A. Net foreign direct investment

B. Net portfolio investment

C. Other financial items

D. Net Errors and Omissions

Missing data such as illegal transfers

E. Reserves and Related Items

Changes in official monetary reserves including gold and foreign exchange reserves

(A:E) = Overall Balance

Basic Balance = A+B+C

Overall Balance = A+B+C+D


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BOP Accounting

The BOP must balance

How to measure international economic activity?

Is it an international economic transaction?

How do flow of goods/services/assets/money translate indebits & credits?

Bookkeeping procedures for BOP?

Main transactions in BOP:

Exchange of real assets.

Exchange of financial assets.


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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

Transportation and travel receipts

Income received from investments abroad

Gifts received from foreign residents

Aid received from foreign governments


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Double-entry Accounting(Contd)

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, andvice versa, so the overall balance of payments is always in

balance.


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The Current Account

A countrys current accountis the sum

of its:

net exports (exports minus imports)

net income received from investmentsabroad, and

net transfer payments from abroad.

Exports earnforeign exchange and area credit (+) item on the current account.

Imports use upforeign exchange and

are a debit () item.


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The Current Account

The balance of tradeis the differencebetween a countrys exports of goods andservices and its imports of goods and services.

A trade deficitoccurs when a countrysexports are less than its imports.

Net exports of goods and services (EX

IM),is the difference between a countrystotal exports and total imports.


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The Current Account

Investment incomeconsists of holdings of

foreign assets that yield dividends, interest,

rent, and profits paid to Indian asset holders

(a source of foreign exchange).


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The Current Account

Net transfer paymentsare the difference

between payments from India to foreigners

and payments from foreigners to India.


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The Current Account

The balance on current accountconsists ofnet exports of goods, plus net exports of

services, plus net investment income, plus net

transfer payments. It shows how much anation has spent relative to how much it has

earned.


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The Current Account

Goods Trade or Balance of Trade (BOT) export/import of goods.

Services Trade export/import of services (financial, construction, andtourism).

Income predominately current incomeassociated with investmentsmade in previous periods, + wages & salaries paid to non-resident workers.

Current Transfers financial settlements due to change in ownership ofreal 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 reasonBalance of Trade (BOT)is widely quoted.


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For example

Trade balance

Debit: Sun Microsystems buys LCDs from Hong Kong.

Credit: Singapore Airlines buys Boeing jet.

Trade in services

Debit: American rents an apartment in Singapore.Credit: TUI - Germany places an ad in the NYT.

Income paymentsDebit: Honda US pays dividend to Honda Japan.

Credit: Bank Austria pays salary to rep in NY office.Unilateral Current Transactions

Debit: Peace Corps pays US volunteer teachers in Bosnia.

Credit: TotalFina pays tuition of employee for Stern MBA.


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The Balance of Payments: Linking theUnited States to the International Economy

The Current AccountTrade Flows for the United

States and Japan, 2009


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Net Exports Equals the Sum of the Balance of Trade and the

Balance of Services

The Balance of

Payments of the United

States, 2009 (billions of

dollars)

CURRENT ACCOUNT

Exports of goods $1,149

Imports of goods 1,965

Balance of trade 816

Exports of services 479Imports of services 372

Balance of services 107

Income received on investments 782

Income payments on investments 708

Net income on investments 74

Net transfers 104

Balance on current account 739

The Current Account


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The Capital Account

For each transaction recorded inthe current account, there is anoffsetting transaction recorded inthe capital account.

The capital accountrecords the

changes in assets and liabilities.


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The Capital/Financial Account

Capital account: transfers of fixed assets, realestate, acquisitions/disposal of non-produced/non-

financial assets

Financial account: three components; classified bydegree of control,

Direct Investment Net balance of capital which is

dispersed from and into US for the purpose of exerting

control over assets. E.g. US company acquires foreign company stake (-)

Foreign company acquires US company stake (+)

foreign direct investment (FDI): 10%+ of voting shares acquired.


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The Capital/Financial Account

Portfolio Investment Net balance of capital which flowsin/out of US but does not reach 10% ownership.

No voting or control rights over the asset.

Purchase/sale of equity securities.

Purchase/sale of debt securities. Far more volatile than FDI.

Other Investment Assets/Liabilities Short & long-termtrade credits, cross-border loans, currency & bank

deposits, & other accounts receivable and payable incross-border trade.


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The Capital Account

The balance on capital accountin India is

the sum of the following (measured in a given

period):

the change in private Indian assets abroad

the change in foreign private assets in India

the change in Indian government assets abroad,

and

the change in foreign government assets in the India


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The Capital Account

In the absence of errors, the balance on

capital account would equal the negative of

the balance on current account.

If the capital account is positive, the change

in foreign assets in the country is greater

than the change in the countrys assetsabroad, which is a decrease in the net

wealth of the country.


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Net Exports Equals the Sum of the Balance of Trade and the

Balance of Services

The Balance of

Payments of the United

States, 2009 (billions of

dollars)

CURRENT ACCOUNT

Exports of goods $1,149

Imports of goods 1,965

Balance of trade 816

Exports of services 479Imports of services 372

Balance of services 107

Income received on investments 782

Income payments on investments 708

Net income on investments 74

Net transfers 104

Balance on current account 739

The Current Account


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FINANCIAL ACCOUNT

Increase in foreign holdings of assets in the United States 1,864

Increase in U.S. holdings of assets in foreign countries 1,206

Balance on financial account 658

BALANCE ON CAPITAL ACCOUNT -2

Statistical discrepancy 83

Balance of payments 0

The Current Account

The Balance of Payments of the

United States, 2009 (billions of

dollars) (continued)


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Statistical Discrepancy?

It is the net result of errors and omissions on both thecredit 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, foreigninvestment incomes, capital flight from their governments

for tax and other purposes.


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Account Overview (Level 2)

Current AccountMerchandise trade

exportsimportsTrade Balance

Servicesmilitary trans. (net)other services, netService Balance

Balance on goods & services

Investment income, net

Unilateral transfersUS government grants

US govt pensions, andother transfers

Private remittances andother transfers

All transfers, net

Balance on current account

Capital AccountChanges in US assets abroad, net

other US govt assetsUS private assetsAll changes, net

Changes in foreign assets in the US,

net foreign private assetsAll changes, net

Changes in holdings of officialinternational reserves, net

Statistical discrepancy

Balance on capital account


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Current Account Surplus and Deficit:Implications

A current account surplus means exports of goodsand 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).


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BOP Surplus and Deficit

In terms of the supply and demand of anations currency, there is:

A balance of payments surplus if quantity demanded

for a currency exceeds quantity supplied, putting

upwardpressure on the value of the nations currency.

A balance of paymentsdeficitif quantity supplied of a

currency exceeds quantity demanded, putting

downwardpressure on the value of the nations

currency.

B l f P t


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Balance of PaymentsAccounting

Consider three transactions:1) Wal-Mart buys $100M worth of clothing from a Chinese

Manufacturer. Wal-Mart pays for the clothing by writing a

check drawn off its account at Bank of America.

2) Warren Buffet collects $50M in interest payments from his

financial investments overseas. The Payment is made by

crediting Warrens bank account in London.

3) Microsoft sells $20M worth of software to the French

government. They pay in cash.


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Balance of Payments Accounts

Current Account

Exports

Goods:

Services:

ImportsGoods:

Services:

Net Factor Income:

Net Unilateral Transfers:

CA Balance:

Capital & Financial Account

Foreign acquisition of US assets:

US Treasuries:

Private Securities:

FDI:Currency:

US acquisition of foreign assets:

FDI:

Foreign Securities:

Official Reserve AssetsForeign acquisition of US ORA:

US acquisition of foreign ORA:KFA Balance:

-$100M (1)

$100M (1)

$50 (2)

-$50 (2)

$20M (3)

-$20M (3)

-$30M

$30M


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Tsunami Relief Aid

President Bush authorized $350M in aid for the Asiancountries affected by the Tsunami.

This will appear in the BOP accounts under unilateral

transfers.

Assume this transfer is paid in cash


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Balance of Payments Accounts

Current Account

Exports

Goods:

Services:

ImportsGoods:

Services:

Net Factor Income:

Net Unilateral Transfers: -$350M

CA Balance: -$350M

Capital & Financial Account

Foreign acquisition of US assets:

US Treasuries:

Private Securities:

FDI:Currency: $350M

US acquisition of foreign assets:

FDI:

Portfolio Investment:

Official Reserve AssetsForeign acquisition of US ORA:

US acquisition of foreign ORA:KFA Balance: $350


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National Income Identitiesand the Current Account Balance

Recall the aggregate expenditure equation in

our study of macroeconomics:

AE (=AD) = C + I + G + X - M

Leakages are:S + T + M

Injections are:

I + G + X

=> In equilibrium:injections= leakages

S + T + M=I + G + X


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The balance of payments on Current Account could be re-

written as:

(X - M) = (T - G) + (S - I)

or

(M - X) = (G - T) + (I - S)

trade = government + private sectordeficit balance balance


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Trade deficit = government deficit + priv. sector

deficit

An increase in govt. expenditure (G), or a

reduction in private saving (S) worsens the

trade balance (i.e. raises trade deficit)


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Are trade deficits a problem?

A trade deficit is not necessarily a bad thing (e.g. when growingdomestic industries attract foreign investments)

if borrowing is financing investment (which generates economic growth

and income in future) then it is not a problem

However, if a country persistently runs a trade deficit this is

something to worry about (e.g. vulnerability to loss of foreign

investors confidence)

excessive borrowing on capital account to finance consumption on

current account will incur higher interest payments and eventually leadto reduction in consumption


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The Effect of a GovernmentBudget Deficit on Investment

The Twin Deficits,

19782008

During the early 1980s, large federal budget deficits occurred at the same time as large current account deficits, but twin

deficits did not occur in the 1990s.

bop session 14

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