Chapter 3 The Balance of Payments

Management 3460 Institutions and Practices in

International Finance

Fall 2003Greg Flanagan

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Chapter Objectives:

The student will be able to:Explain the balance of payments accounts; interpret the accounts;

explain the BP effect on floating exchange rates;

Explain the effect of government intervention on the FE market;

Be aware of the trends in international BP.

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Outline Balance of Payments Accounts

The Current Account The Capital Account Statistical Discrepancy Official Reserves Account

The Balance of Payments Identity Canadian Balance of Payments Data The effect of BP on exchange rates Balance of Payments Trends in Major Countries

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Balance of Payments Accounting

The Balance of Payments is the statistical record of a specific country’s international transactions over a certain period of time (annual) using double-entry bookkeeping.

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Balance of Payments Accounts

records all transactions between the residents of a country and residents of all foreign nations.

composed of the following:The Current Account

The Capital Account

The Official Reserves Account

Statistical Discrepancy

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The Current Account iMports and eXports of goods

“balance of merchandise trade”mercantalism

and imports and exports of services including:investment income;unilateral transfers (foreign aid).

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The Current Account

Current account balanceIf balance < 0 (debits exceed

credits), then a country is running a trade deficit.

If balance > 0 (credits exceed debits), then a country is running a trade surplus.

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The Capital Account

The capital account measures the difference between sales of assets to foreigners and purchases of foreign assets.

The capital account is composed ofdirect investment (FDI); portfolio investments and; other investments.

Reported as Canadian Assets Abroad and Canadian Liabilities to non-residents

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Difference between Capital and Current account balance

The balance of payments (BP) must balance!

Official reserves can rise and fall assets include gold, foreign currencies,

SDRs, reserve positions in the IMF. Statistical discrepancy

some omissions and errors therefore a estimate makes the accounts balance.

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The Balance of Payments Identity

BCA + BKA + BRA = 0 Where:

BCA = balance on current account

BKA = balance on capital account

BRA = balance on the reserves account

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Cdn Balance of Payments 2002

Goods & services

-1,853 of which: travel

-8,330 Balance

66,653 Payments

58,323 Receipts

Services

57,846 Balance

356,459 Payments

414,305 Receipts

Goods

49,516 Balance

423,112 Imports

472,628 Exports

1,361 Balance

Current transfers

-27,511 Balance

29,643 of which: interest

59,149 Payments

31,638 Receipts

Investment income

1

3

2

$'000,000

4 23,366 Balance

487,902 Payments

511,268 Receipts

Total

1+2+3=4

Current Account

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62,864 Total Canadian liabilities to non-residents

9,464 Other investments

3,782 Money market

18,712 Bonds

-1,436 Stocks

Portfolio liabilities

32,342 Direct investment in Canada

-80,825 Total Canadian assets abroad

-10,657 Other investment assets

-6,243 Bonds

-18,707 Stocks

Portfolio assets

-45,217 Direct investment abroad

-17,961 Financial account

-13,145 Total

3

4

1

2

5

1+2 = 3

3+4 = 5

$'000,000

Capital and Financial Account

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Effect of Balance of Payments on the Foreign Exchange Market

Reciprocal markets

Demand for foreign goods (imports) = demand for FE

Demand for Cdn goods (exports) = supply of Cdn$

Debits = demand for foreign exchange/ supply of Cdn$.

Credits = supply of foreign exchange/ demand for Cdn$.

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Floating Foreign Exchange Market

If the current account + capital account > 0

i.e. Trade surplus Qs > Qd Cdn$

If the current account + capital account < 0

i.e. Trade deficit Qd > Qs Cdn$

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Foreign Exchange Market

BP < 0 (Trade deficit)Cdn$

QUS$

S

D

Cdn$

QUS$

BP > 0 (Trade surplus)

S

Qd

D

A floating exchange rate adjusts automatically

QsQdQs

Cdn$ depreciates Cdn$ appreciates

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Intervention in the Foreign Exchange Market

the current account + capital account < 0 Qs < Qd Cdn$

Bank of Canada sells foreign exchange = increase in supply of FE Cdn$

If the current account + capital account > 0 If Qd < Qs Cdn$

Bank of Canada buys foreign exchange = increase in demand of FE Cdn$

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Foreign Exchange Market

B of C sells FECdn$

QUS$US$

S

D

B of C buys FE

S

US$

D

D*

S*

The Bank of Canada can intervene in the FE market

Cdn$ appreciates

Cdn$ depreciates

QUS$

Cdn$

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Balance of Payments Trends

Canada has usually experienced surpluses on the current account and deficits on the capital account.

Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account.

During the same period, Japan has experienced the opposite of the U.S., similar to Canada.

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Balances on the Current (BCA) and Capital (BKA) Accounts of the United States

-500

-400

-300

-200

-100

0

100

200

300

400

500

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

U.S. BCA

U.S. BKA

Source: IMF International Financial Statistics Yearbook, 2000

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

-50

-40

-30

-20

-10

0

10

20

30

40

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

UK BCA

UK BKA

Source: IMF International Financial Statistics Yearbook, 2000

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Balances on the Current (BCA) and Capital (BKA) Accounts of Japan

-150

-100

-50

0

50

100

150

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Japan BCA

Japan BKA

Source: IMF International Financial Statistics Yearbook, 2000

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Balances on the Current (BCA) and Capital (BKA) Accounts of Germany

-80

-60

-40

-20

0

20

40

60

80

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Germany BCA

Germany BKA

Source: IMF International Financial Statistics Yearbook, 2000

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Balances on the Current (BCA) and Capital (BKA) Accounts of China

-15

-10

-5

0

5

10

15

20

25

30

35

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

China BCA

China BKA

Source: IMF International Financial Statistics Yearbook, 2000

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Balance of Payments Trends

Germany traditionally had current account surpluses, since 1991 Germany has been experiencing current account deficits.

This is largely due to German reunification and the resultant need to absorb more output domestically to rebuild the former East Germany.

What matters is the nature and causes of the disequilibrium.

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Balances on the Current (BCA) and Capital (BKA) Accounts of Five Major Countries

-500

-400

-300

-200

-100

0

100

200

300

400

500

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

China BCA

China BKA

Japan BCA

Japan BKA

Germany BCA

Germany BKA

UK BCA

UK BKA

U.S. BCA

U.S. BKA

Source: IMF International Financial Statistics Yearbook, 2000