3.3. The Balance of Payments

Definition of the Balance of Payments

The Balance of Payments is a statement that summarizes an economy’s transactions with the rest of the world for a specified time period. The balance of payments, also known as balance of international payments, encompasses all transactions between a country’s residents and its nonresidents involving goods, services and income; financial claims on and liabilities to the rest of the world; and transfers such as gifts. The balance of payments classifies these transactions in two accounts – the current account and the capital account. The current account includes transactions in goods, services, investment income and current transfers, while the capital account mainly includes transactions in financial instruments. An economy’s balance of payments transactions and international investment position (IIP) together constitute its set of international accounts.

Does the “balance of payments” actually balance? In theory, a current account deficit would have to be financed by a net inflow in the capital and financial account, while a current account surplus should correspond to an outflow in the capital and financial account for a net figure of zero. In actual practice, however, the fact that data are compiled from multiple sources gives rise to some degree of measurement error.

Source: Balance Of Payments (BOP) Definition | Investopedia http://www.investopedia.com/terms/b/bop.asp#ixzz3omyICw6S , accessed Saturday 17th October 2015

Debits and Credits The balance of payments (BOP) records all financial transactions made between consumers, businesses and the government in one country with others

• The BOP figures tell us about how much is being spent by consumers and firms on imported goods and services, and how successful firms have been in exporting to other countries.

• Inflows of foreign currency are counted as a positive entry (e.g. exports sold overseas) - credit

• Outflows of foreign currency are counted as a negative entry (e.g. imported goods and services) – debit

1

Consider the following and determine if it is a debit or credit into the BOP and how would it affect the relevant exchange rate

1. A U.S. household purchases a car from Japan.  2. A U.S. business sells a corporate bond to a British household.  3. The US gives wheat to Egypt.  4. A US citizen travels as a tourist to Germany. 

The Components of the Balance of Payments

The balance of payments is made up of these key partsi) The current accountii) The capital accountiii) Official financing account

In the IB syllabus the capital and official financing account are combined as the Capital and Financial Account

The current accountThe current account is made up of the following payments:

1. Trade in goodsThese items include the import and export of finished goods, such as cars, and computers; semi-finished goods, such as parts and components for assembly, and commodities, such as oil, tea and coffee.

2. Trade in servicesTrade services include financial services, tourism, and consultancy.Income from investment and employment

3. Investment income This refers to any income made from investing abroad, and includes profits, such as those from business activities of subsidiaries located abroad; interest received from UK financial investments and loans abroad, and dividends from owning shares in overseas firms.Payments to individuals who are residents of a country, and are employed in another, are also included in the current account. Investment and employment income are also known as 'primary income'.

2

4. TransfersThe final section of the current account includes transfer payments (transfers) arising from gifts between residents of different countries, donations to charities abroad, and overseas aid. Transfers are also known as 'secondary' income.

The Capital and Financial AccountThe Capital and Financial Account records the flows of capital and finance between the UK and the rest of the world. Types of flow include:

• Foreign direct investment (FDI), such as a UK firm establishing a manufacturing facility in China. Direct investment refers to investment in an enterprise where the owners or shareholders have some element of control of the business.

• Portfolio investment, such as a UK investor buying shares in an existing business abroad. With portfolio investment, the investor has no control over the enterprise. Financial derivatives are any financial instrument whose underlying value is based on another asset, such as a foreign currency, interest rates, commodities or indices.

• Reserve assets are foreign financial assets that are controlled by monetary authorities of the particular country. These assets are used to finance deficits and deal with imbalances. Reserve assets include gold, Special Drawing Rights, and foreign exchange held by the central bank of that country.

This process is often called official financing.

Net errors and omissionsIn theory, the Capital and Financial Account balance should be equal and ‘opposite’ to the Current Account balance so that the overall Account balances, but in practice this is only achieved by the use of a balancing item called net errors and omissions. This device compensates for various errors and omissions in the balance of payments data, and which brings the final balance of payments account to zero.

Source: http://www.economicsonline.co.uk/Managing_the_economy/Balance_of_payments.html, accessed Saturday 17th October 2015

3

Example of a Balance of Payments

Item Billions of US$ CommentCurrent AccountBalance of trade in goods

-25 A trade deficit

Balance of trade in services

+10 A trade surplus

Net investment income

-12 Net outflow of income i.e. due to profits of transnational corporations

Net overseas transfers

+8 Net inflow of transfers perhaps from remittance payments from migrants

Sum of 1+2+3+4 = Current account balance

-19 Overall – this country runs a current account deficit

Capital and Financial AccountNet balance of foreign direct investment flows

+5 Positive net inflow of FDI

Net balance of portfolio investment flows

+6 Positive net inflow into equity markets, property etc.

Changes to reserves of gold and foreign currency

+7.5 +8 means that this country's gold and foreign currency reserves have been reduced

Net errors and omissions

+0.5 Errors in data

Balance on capital +19 Capital and

4

& financial account

financial account surplus

Balance of Payments

0

Source: http://beta.tutor2u.net/economics/reference/balance-of-payments-1, accessed Saturday 17th October 2015-10-17

Difference between a current account deficit and surplus

The following variables go into the calculation of the current account balance (CAB):

X = Exports of goods and servicesM = Imports of goods and servicesNY = Net income abroadNCT = Net current transfersThe formula is:

CAB = X - M + NY + NCT

Current deficit Running a sizeable deficit on the current account basically means that the UK economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending.

Current surplus A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how much a country is saving as opposed to investing. What this means is that the country is providing an abundance of resources to other economies, and is owed money in return. By providing these resources abroad, a country with a CAB surplus gives other economies the chance to increase their productivity.

Source: http://www.investopedia.com/articles/03/061803.asp#ixzz3onCa6akD, accessed Saturday, October 17th 2015

5

Does a current account matter?

Positive aspects

1. Partial auto-correction: If some of the deficit is due to very strong consumer demand, the deficit will automatically partially-self correct when the economic cycle turns and there is a slowdown in spending

2. Investment and the supply-side: Some of the deficit may be due to increased imports of new capital and technology which will have a beneficial effect on productivity and competitiveness of producers in home and overseas markets

3. Capital inflows balance the books: Providing a country has a stable economy and credible economic policies, it should be possible for the current account deficit to be financed by inflows of capital without the need for a sharp jump in interest rates. The UK ran an average annual current account deficit of £10 billion from 1992-2004 and yet the economy has also enjoyed one of the longest sustained periods of growth and falling unemployment during that time.

Negative aspects

1. Structural weakness: The trade / current account deficit may be a symptom of a wider structural economic problem i.e. a loss of competitiveness in overseas markets, insufficient investment in new capital or a shift in comparative advantage towards other countries.

2. An unbalanced economy – too much consumption: A large deficit in trade is a sign of an ‘imbalanced economy’ typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these “macroeconomic imbalances” have to be addressed. Consumers cannot carry on spending beyond their means for the danger is that rising demand for imports will be accompanied by a surge in household debt.

3. Potential loss of output and employment: A widening trade deficit may result in lost output and employment because it

6

represents a net leakage from the circular flow of income and spending. Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import penetration, may find it difficult to find new employment.

4. Potential problems in financing a current account deficit: Countries cannot always rely on inflows of financial capital into an economy to finance a current account deficit. Foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. Higher interest rates then have the effect of depressing domestic consumption and investment. The current situation in the United States is very interesting in this respect. Such is the size of the current account deficit that the USA must rely on huge capital inflows each year and eventually investors in other countries may decide to put their money elsewhere – this would put severe downward pressure on the US dollar.

5. Downward pressure on the exchange rate: A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp fall in the exchange rate. This would then threaten an increase in imported inflation and might also cause a rise in interest rates from the central bank. A declining currency would help stimulate exports but the rise in inflation and interest rates would have a negative effect on demand, output and employment.

Policies to correct a current account deficit

Policies to reduce a current account deficit1. DevaluationThis involves reducing the value of the currency against others. (e.g. selling pounds would cause the value of the Pound to fall)

• If there is a devaluation in the currency, the price of importing goods increases and therefore the quantity demanded of imports falls.

• Exports will be become cheaper and there will be an increase in the quantity of exports.

• Therefore, assuming demand is relatively price elastic, we would expect a devaluation to lead to an improvement in (X-M) and therefore the current account on the balance of payments.

7

• However it does depend upon the elasticity of demand for exports and imports.

The Marshall Learner ConditionThis states that a devaluation will improve the balance on the current account, on the condition that the combined elasticity’s of demand for imports and exports is greater than one.

• If (PED x + PED m > 1) then a devaluation will improve the current account.

• If (PED x + PED m > 1) then an appreciation will worsen the current account.

This is because the effect on the current account depends on the total value and not just the quantity of exports.

Numerical example of Marshall-Lerner Condition

8

The J Curve effectIn the short term, demand for imports and exports tend to be inelastic. Therefore, after a devaluation, the current account tends to get worse before it gets better. However, over time, demand becomes more price elastic and the current account improves.

9

Another problem with devaluation is that it can lead to imported inflation. Basically imports will be more expensive. Higher inflation can reduce the countries competitiveness. Therefore the improvement in the current account might only be temporary.

2. Deflationary policiesIf an economy pursues a tightening of fiscal policy / monetary policy, this will reduce aggregate demand. Tight monetary policy involves increasing interest rates – this will leave people with less money to spend so they will reduce their consumption of imports. Also, a fall in AD and economic growth will reduce inflation and help to make UK exports more competitive.

• The UK has a high marginal propensity to import therefore a reduction in AD improves the current account significantly.

• Deflationary policies will also put pressure on manufacturers to reduce costs and this will lead to more competitive exports and so exports will increase.

• However this policy will conflict with other macroeconomic objectives – with lower aggregate demand (AD), growth is likely to fall causing higher unemployment. A government is unlikely to want to risk higher unemployment just to reduce a current account deficit.

10

3. Supply Side PoliciesSupply side policies can improve the competitiveness of the economy and help make exports more attractive. This can improve the current account position, but it may take considerable time to have effect.

To attain low inflation, supply side policies can help reduce costs and increase productivity. For example, privatization and deregulation can help reduce costs. However, in the control of inflation, the most significant factor is the use of monetary policy and controlling AD through interest rates. Supply side policies will take a long time to have any effect on reducing inflationary pressures.

Increased productivity can also help the balance of payments. If firms become more competitive, then UK goods will be in greater demand, increasing exports and improving the current account deficit

4. ProtectionismIncreased tariffs of quotas will reduce imports and improve the current account.However:1) Protectionism leads to retaliation so exports will decrease2) Domestic industries may become uncompetitive, because there is no incentive.

11

Consequences of a current account surplus

A current account surplus means an economy is exporting a greater value of goods and services than it is importing. A country with a current account surplus will have a deficit on the financial / capital account. i.e. a country with a current account surplus will have surplus foreign exchange it can use to invest in other countries.There is no hard and fast rule about what will happen if a country has a current account surplus. It depends on the size of the current account and the reasons for the current account surplus.In theory, you could expect a current account surplus (X-M) to boost employment because it is indicative of higher domestic demand.

• High exports (X) leads to increased employment in the export sector.

• Lower import spending may mean people are spending more on domestic goods rather than buying foreign goods. Greater demand for domestic goods helps domestic employment.

Current account surplus in fixed exchange rateOne reason for a current account surplus is when a country has a relatively undervalued exchange rate. This may be a country in a fixed exchange rate. For example, Germany is in the Euro, but due to better German competitiveness than its European neighbours, Germany has had more competitive exports. The German export sector has helped strengthen the German economy.

Ceteris paribus, this current account surplus is helping to boost domestic employment. Because German exports are competitive, Germany is selling a lot of exports and this is leading to higher domestic employment in the exporting sector. Without the strong export demand, the German economy would be weaker and we would be liable to have higher unemployment.

If you compare it to countries with a large current account deficits in the Euro, the German economy has done relatively better in terms of economic growth and employment.

12

For example, in the mid 2000s, Euro member countries like Greece, Spain and Portugal were uncompetitive in the Euro. This was one factor leading to lower economic growth and lower employment in these countries.Economists have often argued that Germany should boost consumer spending to help economic growth in other Euro countries.

Current account surplus and domestic demandA current account surplus is partly due to high exports, but the other side of the equation is imports and domestic demand.

A country may have a large current account surplus because of relatively weak domestic demand. This weak demand leads to lower consumer spending, and lower spending on imports. Therefore, in this case, domestic employment will suffer from the weak economy.The current account is often cyclical. In a boom, we see a rise in the current account deficit because consumer spending rises, leading to an increase in imports. During a boom unemployment falls and inflation rises.

But, in a recession, consumer-spending falls leading to lower imports, lower inflation, and an improvement in the current account. The deficit may convert to a surplus, but this is due to the recession, and therefore leads to higher unemployment

13

Examples of current account surplus – China, Japan

China had a record current account surplus in the mid 2000s; this was mainly due to greater competitiveness, helped by an undervalued Yuan. This was a factor in China’s record economic growth, and it led to higher employment.

Japan’s current account surplus was due to weak domestic demand, and a reluctance to buy imports. Japan’s export sector was still one of strongest sectors of the economy, but this period of a current account surplus was a period of low growth and weak employment growth.

A current account surplus will tend to boost domestic employment if:• It is due to an improvement in competitiveness, leading to

higher demand for exports.• If domestic demand is still relatively strong, but consumers are

buying domestic goods, rather than importing.

A current account surplus could lead to lower domestic employment if:

• The surplus is caused by a recession, which has hit domestic demand and led to a fall in import spending.

• In a global recession where a surplus is caused by falling exports and an even bigger fall in imports.

Source: http://www.economicshelp.org/blog/9996/trade/effect-current-account-surplus/, accessed Saturday, October 17, 2015

14

Questions

Components of the BOP

1: How would the following transactions affect US exports, imports and net exports?

(a) An American art professor spends the summer touring museums in Europe.

(b) Students in Paris flock to see the latest Hollywood movie starring Keano Reeves

(c ) Your American uncle buys a Volvo

(d) A Canadian citizen shops at a store in northern Vermont (USA) to avoid Canadian sales tax

2: Describe the difference between foreign direct investment and foreign portfolio investment. Who is more likely to engage in foreign direct investment – a corporation or an individual investor? Who is more likely to engage in foreign portfolio investment?

3: How would the following transactions affect US net foreign investment?

(a) An American cellular phone company establishes an office in the Czech Republic

(b) Harrod’s of London sells shares to the General Electric pension fund.

(c) Honda expands its factory in Ohio, USA

4: (a) How does a trade deficit affect the current-account balance?

(b) On which balance-of-payments account does tourism show up?

5: In order for Brazil to service its foreign debts without borrowing more money, what must be true of its trade balance?

6:Suppose Lufthansa buys $400 million worth of Boeing jets in 2000 and is financed by the U.S. Eximbank with a five-year loan that has no principal or interest payments due until 2001. What is the net impact of this sale on the U.S. current account, capital account, and overall balance of payments for 2000?

Current Account

15

7: Suppose the United States imposes import restrictions on Japanese steel. What is likely to happen to the U.S. current-account deficit? What else is likely to happen?

8: In the early 1990s, interest rates worldwide fell. As a net debtor nation, how should this affect the U.S. current-account balance?

9: During the 1990s, Mexico and Argentina went from economic pariahs with huge foreign debts to countries posting strong economic growth and welcoming foreign investment. What would you expect these changes to do to their current-account balances?

10: In the early 1990s, Japan underwent a recession that brought about a prolonged slump in consumer spending and capital investment (it was estimated that in 1994 only 65% of Japan's manufacturing was being used). At the same time, the U.S. economy emerged from its recession and began expanding rapidly. Under these circumstances, what would you predict would happen to the U.S. trade deficit with Japan?

11: What is likely to happen to the value of the dollar as the U.S. current-account deficit increases?

12: Suppose that Brazil starts welcoming foreign investment with open arms. How is this likely to affect the value of the Brazilian real? The Brazilian current-account balance?

13: In order for Brazil to service its foreign debts without borrowing more money, what must be true of its trade balance?

14:"The U.S. trade deficit is a consequence of the unwillingness of the current generation of American taxpayers to pay fully for the goods and services they want from government." Comment.

Connection between the current account and budget position

15: In 1990, Japan's Ministry of International Trade and Investment (MITI) proposed that firms be given a tax credit equal to 5% of the value of its increased imports. The purpose of this tax subsidy is to encourage Japanese imports of foreign products and thereby reduce Japan's persistent trade surplus. At the same time, the Japanese government announced that it will reduce its budget deficit during the coming year.

a. What are the likely consequences of the tax subsidy plan on Japan's trade balance, the value of the yen, and the competitiveness of Japanese firms?

b. What are the likely consequences of a lower Japanese budget deficit on Japan's trade balance?

16

16: During the Reagan era, 1981-1988, the U.S. current account moved from a tiny surplus to a large deficit. The following table provides U.S. macroeconomic data for that period.

YEAR 1980

1981 1982 1983 1984 1985 1986 1987

1988

PRIVATE SAVINGS 500 586 617 641 743 736 721 731 802

PRIVATE INVESTMENT 468 558 503 547 719 715 718 749 794

GOVERNMENT BUDGET DEFICIT -35 -30 -109 -140 -109 -125 -147 -112 -98

CURRENT-ACCOUNT BALANCE 2 5 -11 -45 -100 -125 -151 -167 -129

(a) Based on these data, to what extent would you attribute the changes in the U.S. current-account balance to a decline in the U.S. private savings-investment balance?

(b) To what extent would you attribute the changes in the U.S. current-account balance to an increase in the U.S. government budget deficit?

Current account surplus

17: Currently, social security is minimal in China. Suppose China institutes a comprehensive social security system. How is this policy switch likely to affect China's trade surplus?

18: During 1992, Japan entered a recession. However, at the same time, its current-account surplus hit a record. Is there a contradiction between Japan's large trade surplus and a weak national economy? Explain.

19: A current-account surplus is not always a sign of health; a current-account deficit is not always a sign of weakness. Comment on this statement.

Capital Account

20: What happens to Mexico's ability to repay its foreign loans if the United States restricts imports of Mexican agricultural produce?

21: In a freely floating exchange rate system, if the current account is running a deficit, what are the consequences for the nation's balance on capital account and its overall balance of payments?

17