International Finance

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International Finance
Academy of Economic Studies Faculty of
International Business and Economics

• Lecture IV
• Balance of Payments

Lect. Cristian PAUN Email cpaun_at_ase.ro URL
http//www.finint.ase.ro
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Definition of BoP

• The balance of payments is a statistical record
  of all the economic transactions between
  residents of the reporting country and residents
  of the rest of the world during a given time
  period.
• The usual reporting period for all the statistics
  included in the accounts is a year.
• The balance of payments is one of the most
  important statistical statements for any country.
• BoP reveals how many goods and services the
  country has been exporting and importing, and
  whether the country has been borrowing from or
  lending money to the rest of the world.
• Basic concepts regarding the elaboration of the
  BPs
• Residents
• Economic territory
• Real flows / Financial flows

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Domestic and foreign residents

• A key definition that needs to be resolved at the
  outset is that of a domestic and foreign
  resident.
• . It is important to note that citizenship and
  residency are not necessarily the same thing from
  the viewpoint of the balance-of-payments
  statistics.
• The term residents comprises individuals,
  households, firms and the public authorities, and
  there are some problems that arise with respect
  to the definition of a resident.
• Multinational corporations are by definition
  resident in more than one country. For the
  purposes of balance-of-payments reporting, the
  subsidiaries of a multinational are treated as
  being resident in the country in which they are
  located even if their shares are actually owned
  by foreign residents.
• International Financial Institutions are treated
  as being foreign residents even though they may
  actually be located in the reporting country.

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The role of Balance of Payments

• Allows a quantitative and qualitative comparative
  analysis of the real and financial transactions
  of a country with the rest of the world
• Permits an evaluation of the advantages and
  disadvantages that each nation has in its
  commercial exchanges with third countries
• Could be used as a good measure for the external
  competitiveness of the national economy
• Using the BPs we can determine the degree of
  attractiveness of the internal business
  environment for the resident and non-resident
  investors
• Could be used for the estimation of financing
  need of an open economy
• The BPs represents the base for some
  macroeconomic policies such as fiscal, monetary,
  foreign exchange, commercial (tariff and
  non-tariff barriers) policies

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Balance of Payments accounting principles

• An important point about a country's
  balance-of-payments statistics is that in an
  accounting sense they always balance.
• Balance of Payments respects the double-entry
  book-keeping accounting principle
• Each transaction between a domestic and foreign
  resident has two sides to it, a receipt and a
  payment, and both these sides are recorded in the
  balance-of-payments statistics.
• Each receipt of currency from residents of the
  rest of the world is recorded as a credit item (a
  plus in the accounts) while each payment to
  residents of the rest of the world is recorded as
  a debit item (a minus in the accounts).

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Inflows and Outflows registered in Balance of
Payments
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Types of transactions registered in BoP

• (1) An exchange of goods/services in return for a
  financial asset.
• (2) An exchange of goods/services in return for
  other goods/services. Such trade is known as
  barter or countertrade.
• (3) An exchange of a financial item in return for
  a financial item.
• (4) A transfer of goods or services with no
  corresponding quid pro quo
• (for example military and food aid).
• (5) A transfer of financial assets with no
  corresponding quid pro quo (for
• example, migrant workers' remittances to their
  families abroad, a
• money gift).

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The structure of the Balance of Payments
I. Current account A. Goods and
services Services Goods B. Income From
direct or portfolio investments From other
investments (interests) C. Current
transfers Official sector Other sectors II.
Capital account Capital transfers Purchased /
sold assets III. Financial account Direct
investment Portfolio investment Other
instruments (external loans, IMF loans) Transit
account Clearing / Barter account Reserve
assets ( gold, SDR, foreign currency) IV. Errors
and omissions
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The International Investment position

• 1. Reserve assets of the bank system
• Monetary gold
• SDRs holdings
• Convertible foreign currencies
• 2. International debt depending on the type of
  lenders
• Multicultural IMF, EU, IBDR, EBRD
• Bilateral detailing on the main lenders
• Private Banks detailing on countries
• Foreign bonds / Euro bonds
• Supplier credits detailing on countries
• Other private lenders
• 3. International debt depending on the type of
  debtors
• Public debt
• Guaranteed public debt
• Commercial debt without guarantee
• 4. Claims and short-term engagements
• Claims incasso, letter of credit, bank
  guarantees received
• Engagements incasso, letter of credit, issued
  guarantees, financing lines, other engagements
• 5. Foreign investment

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The Trade Account balance

• The trade balance is sometimes referred to as the
  visible balance because it represents the
  difference between receipts for exports of goods
  and expenditure on imports of goods which can be
  visibly seen crossing frontiers.
• The receipts for exports are recorded as a credit
  in the balance of payments, while the payment for
  imports is recorded as a debit.
• When the trade balance is in surplus this means
  that a country has earned more from its exports
  of goods than it has paid for its imports of
  goods.
• Current account balance is very sensitive to
  domestic versus foreign prices, exchange rate
  movements, foreign income, domestic income and
  market barriers.

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The Current Account balance

• The current account balance is the sum of visible
  trade balance and the invisible balance.
• The invisible balance shows the difference
  between revenue received for exports of services
  and payments made for imports of services such as
  shipping, tourism, insurance and banking.
• In addition, receipts and payments of interest,
  dividends and profits are recorded in the
  invisible balance because they represent the
  rewards for investment in overseas companies,
  bonds and equity while payments reflect the
  rewards to foreign residents for their investment
  in the domestic economy.
• They are receipts and payments for the services
  of capital that earn and cost the country income
  just as do exports and imports.

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The Capital Account balance

• 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.
• Capital inflows are, in effect, a decrease in the
  country's holding of foreign assets or increase
  in liabilities to foreigners.
• Capital outflows are, in effect, an increase in
  the country's holding of foreign assets or
  decrease in liabilities to foreigners.
• All purchases or sales of assets, including
• Direct investment
• Securities (debt)
• Bank claims and liabilities
• Official reserves transactions
• When U.S. citizens buy foreign securities or when
  foreigners buy U.S. securities, they are listed
  here as outflows and inflows, respectively.

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Official Settlements Balance

• Given the huge statistical problems involved in
  compiling the balance-of-payments statistics
  there will usually be a discrepancy between the
  sum of all the items recorded in the current
  account, capital account and the balance of
  official financing (see below) which in theory
  should sum to zero.
• The summation of the current balance, capital
  account balance and the statistical discrepancy
  gives the official settlements balance
• The balance on this account is important because
  it shows the money available for adding to the
  country's official reserves or paying off the
  country's official borrowing.
• A central bank normally holds a stock of reserves
  made up of foreign currency assets - principally
  US treasury bills (the US authorities hold mainly
  deutschmark and yen treasury bills).
• Such reserves are held primarily to enable the
  central bank to purchase its currency should it
  wish to prevent it depreciating.

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Official Settlements Balance

• Note 1 the countries whose currency is used as a
  reserve asset can have a combined current and
  capital account deficit and yet maintain fixed
  parity for their currency without running down
  their reserves or borrowing from the IMF. This
  can be the case if foreign authorities eliminate
  the excess supply of the domestic currency by
  purchasing it and adding it to their reserves.
• Note 2 The official settlements concept of a
  surplus or deficit is not as relevant to
  countries that have floating exchange rates as it
  is to those with fixed exchange rates. This is
  because if exchange rates are left to float
  freely the official settlements balance will tend
  to zero because the central authorities neither
  purchase nor sell their currency, and so there
  will be no changes in their reserves. If the
  sales of a currency exceed the purchases then the
  currency will depreciate, and if sales are less
  than purchases the currency appreciates.

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Official Settlements Balance

• Note 3 The settlements concept is, however, very
  important under fixed exchange rates because it
  shows the amount of pressure on the authorities
  to devalue or revalue the currency.
• Under a fixed exchange-rate system a country that
  is running an official settlements deficit will
  find that sales of its currency exceed purchases,
  and to avert a devaluation of the currency
  authorities have to sell reserves of foreign
  currency to purchase the home currency.
• In a fixed exchange-rate regime the settlements
  concept ignores the fact that the authorities
  have other instruments available with which to
  defend the exchange rate, such as prices, capital
  controls and interest rates.

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The automatic adjustment of the BPs

• Automatic adjustment through the price mechanism

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The automatic adjustment of the BPs (second part)

• Automatic adjustment through compensatory finance

Exports lt Imports
Rise in the foreign currency demand
Diminution of the quantity of money in
circulation
Foreign investments
Rise in the interest rate
Deflation
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Internal factors of disturbing the BPs

• The significant decrease of exports caused by
  natural calamities or political events
  (revolution, civil wars)
• The imports increase versus the exports decrease
  on the background of the intensification of the
  internal demand for goods and services
• The diminution in the manufacturing degree of
  exports
• The deterioration of the internal environment
  business
• The insufficient promotion / encouragement of
  exports
• The inefficient commercial policy for domestic
  products and services (tariff, non-tariff
  barriers)
• Inadequate structure for internal economic system

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External factors of disturbing of the BPs

• The disturbance of the world prices concerning
  the products with an important weight in the
  structure of external trade
• The proliferation of trade barriers and the
  commercial policy of other countries
• The lack of real comparative or competitive
  advantages
• The disturbance of zonal commercial flows as a
  result of some international commercial dispute

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BoP in selectedcountries
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BoP in selectedcountries
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Open economy identities based on BoP

• In an open economy gross domestic product (GDP)
  differs from that of a closed economy because
  there is an additional injection - export
  expenditure which represents foreign expenditure
  on domestically-produced goods.
• YC IG X-M
• If we deduct taxation from the right-hand side we
  obtain disposable income for an open economy
• Yd C I G X-M-T
• Rearranging the equation we obtain
• (X M) (S - I) (T -
  G)

Net saving / dissaving of private sector
Current account deficit
Government fiscal deficit or surplus
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The equilibrium level of national income

• The equilibrium level of national income is
  determined where injections (the variables on the
  left hand side) are equal to leakages (the
  variables on the right hand side)
• I G X S T M
• Injections are all those factors that work to
  raise national income, while leakages are those
  factors that work to lower it.

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Open economy multipliers

• We know that Y C J G X - M
• Keynes proceeded to make assumptions concerning
  the determinants of the various components of
  national income.
• Government expenditure and exports are assumed
  to be exogenous government expenditure being
  determined independently by political decisions,
  and exports by foreign expenditure decisions and
  foreign income.
• Domestic consumption is partly autonomous and
  partly determined by the level of national
  income
• C Ca c x Y
• where Ca is autonomous consumption and c is the
  marginal propensity to consume, that is the
  fraction of any increase in income that is spent
  on consumption.
• In this simple model consumption is assumed to
  be a linear function of income. An increase in
  consumers' income induces an increase in their
  consumption.

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Open Economy Multipliers

• Import expenditure is assumed to be partly
  autonomous and partly a positive function of the
  level of domestic income
• M Ma m x Y
• Where Ma is autonomous import expenditure and m
  is the marginal propensity to import, that is the
  fraction of any increase in income that is spent
  on imports.
• From the initial equation we obtain that
• Y Ca c x Y I G X Ma m x Y
• Equivalent with
• (1 - c m) x Y Ca l G X Ma
• but (1 c) s (marginal propensity to save)
• Y 1/(sm) x Ca l G X Ma

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Open Economy Multipliers

• Equation can be transformed into difference form
  to yield

dY 1/(sm) x (dCa dl dG dX - dMa)
Government Expenditure Multiplier
dY/dG l/(s w) gt0

• This equation says that an increase in government
  expenditure will have an expansionary effect on
  national income, the size of which depends upon
  the marginal propensity to save and the marginal
  propensity to import.
• Since the sum of these is less than unity, an
  increase in government expenditure will result in
  an even greater increase in national income.
• the value of the open-economy multiplier is less
  than the closed-economy multiplier which is given
  by 1/s.

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Foreign Trade or Export Multiplier

• From the initial equation we obtain that
• dY/dG l/(s w) gt0
• In practice it is often the case that government
  expenditure tends to be somewhat more biased to
  domestic output than private consumption
  expenditure, implying that the value of m is
  smaller in the case of the government expenditure
  multiplier than in the case of the export
  multiplier.
• Any increase in government expenditure will have
  a more expansionary effect on domestic output
  than an equivalent increase in exports.

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Government Expenditure and Export Multipliers
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The Current Account Multipliers

• Y C I - G M - X 0
• Y- c x Y m x Y-Ca Ma-I-G-X 0
• Since Y(1- c m) Y(s m) we have
• Y(s m) - Ca Ma - 1 - G - X 0
• Multiplying both sides by m/(s m) yields
• m Y m/(ms) x (Ca - Ma I G X) 0
• But CA X M X Ma m
  x Y
• CA X Ma -
  m/(ms) x (Ca - Ma I G X)

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Current Account Multipliers Government
Multiplier

• CA X Ma - m/(ms) x (Ca - Ma I G X)
• dCA dX DMa m/(ms) x (dCa dMa dI dG
  dX)
• From equation written above we can derive the
  effects of an increase in government expenditure
  on the current account balance which is given by
  dCA/dG m/s m lt 0.
• That is, an increase in government spending leads
  to a deterioration of the current account balance
  which is some fraction of the initial increase in
  government expenditure.

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Current Account Multipliers Export Multiplier

• The other multiplier of interest is the effect of
  an increase in exports on the current balance.
  This is given by the expression
• dCA/dX 1 (m/s m) (s m/s m) (m/s
  m) s/s m gt0.
• Since s/s m is less than unity, an increase in
  exports leads to an improvement in the current
  balance that is less than the original increase
  in exports.
• The explanation for this is that part of the
  increase in income resulting from the additional
  exports is offset to some extent by increased
  expenditure on imports.