The Balance of Payments

1
The Balance of Payments
3Chapter 3

• Chapter Objective
• This chapter serves to introduce the student to
  the balance of payments, how it is constructed
  and how balance of payments data may be
  interpreted.
• Chapter Outline
• Balance of Payments Accounts
• The Current Account
• The Capital Account
• External Balance and the Exchange Rate
• Balance of Payments Trends in Major Countries

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Balance of Payments

• The Balance of Payments is the statistical record
  of a countrys international transactions over a
  certain period of time presented in the form of
  double-entry bookkeeping.
• Why is it useful to examine a countrys BOP?
• The BOP provides detailed information about the
  supply and demand of the countrys currency.
• The trade statistics in the Current Account, for
  example, show the composition of trade what a
  country imports and what it exports.
• The Capital Account shows inflows and outflows of
  capital in various categories.
• Viewed over time, BOP data can shed light on
  important developments in a countrys comparative
  advantage and international competitiveness.

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Balance of Payments Accounts

• They are composed of the following
• The Current Account
• The Capital Account
• The Official Reserve Account

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Balance of Payments Accounts

• Current Account
• Records flows of exports, imports, investment
  income, and international financial transfers.
• Merchandise trade export and import of tangible
  goods
• Services payments and receipts for legal and
  consulting fees, royalties, tourist expenditures
• Investment income payments and receipts of
  interest, dividends, and other income on foreign
  investments
• Unilateral Transfers unrequited payments
  (e.g. Foreign aid).
• If the debits exceed the credits, then a country
  is running a trade deficit.
• If the credits exceed the debits, then a country
  is running a trade surplus.

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Balance of Payments Accounts

• The capital account
• Records sales to foreigners of Canadian financial
  assets and Canadian purchases of foreign
  financial assets.
• The capital account is composed of Foreign Direct
  Investment (FDI), portfolio investments, and
  other investment.
• Direct investment involves acquisitions of
  controlling interests in foreign businesses.
• Portfolio investment represents investment in
  foreign shares and bonds that do not involve
  acquisitions of control.
• Other investment includes bank deposits, currency
  investment, trade credit and the like.

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Balance of Payments Accounts

• The Reserve Account
• The Reserve Account of BOP records changes in the
  amount of official reserve assets held by the
  Bank of Canada.
• Official reserves assets include gold, foreign
  currencies, SDRs, reserve positions in the IMF.
• If a country must make net payment to foreigners
  because of BOP deficit, the country could either
  run down its official reserve assets or borrow
  anew from foreigners.

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Balance of Payments Accounts

• Statistical Discrepancy
• Theres going to be some omissions and
  misrecorded transactionsso we use a plug
  figure to get things to balance.
• Exhibit 3.4 shows a discrepancy of 0.8 billion
  in 2002.
• How to calculate?
• BP 0 when all known transactions are accounted
  for, so the SD is the "residual" value that will
  balance the books.

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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
• Under a pure flexible exchange rate regime, where
  the CB does not maintain any official reserves, a
  CA surplus or deficit must be matched by KA
  deficit or surplus
• BCA BKA 0
• Under the fixed exchange rate regime, the
  combined balance on the current and capital
  accounts will be equal in size, but opposite in
  sign, to the change in the official reserves
• BCA BKA -BRA

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Balance of Payments

• Fixed Exchange Rate
• BOP determines necessity of government
  intervention
• Can help forecast devaluation/revaluation of
  currencies
• Floating Exchange Rate
• Government has no responsibility as FX rates are
  determined by market forces
• Managed Floats
• Focus of government is on interest rates

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Balance of Payments Trends in Major Countries

• From 1982-2000, U.S. has had continual annual
  trade deficits (-CA) with the rest of the world
  (ROW), along with annual capital surpluses (KA),
  in roughly equal annual amounts.  U.S. has been a
  "net debtor" nation over this period.
• Over the same period, Japan has had annual trade
  surpluses with ROW, along with annual capital
  outflows, also in roughly equal amounts.  Japan
  is a "net creditor" nation, investing its trade
  surplus in foreign stocks, bonds, real estate,
  government debt (T-bonds, etc.), businesses
  (FDI), art, etc.  Japan has been accused of
  "mercantilism," i.e. erecting trade barriers, or
  protectionist trade policies to restrict or limit
  imports.

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Balances on the Current (BCA) and Capital (BKA)
Accounts of the U.S.
Source IMF International Financial Statistics
Yearbook, 2000
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Balances on the Current (BCA) and Capital (BKA)
Accounts of Japan
Source IMF International Financial Statistics
Yearbook, 2000
13
Balances on the Current (BCA) and Capital (BKA)
Accounts of United Kingdom
Source IMF International Financial Statistics
Yearbook, 2000
14
Balances on the Current (BCA) and Capital (BKA)
Accounts of China
Source IMF International Financial Statistics
Yearbook, 2000
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Balance of Payments Trends in Major Countries

• Like the U.S., the United Kingdom recently
  experienced continuous current account deficits,
  coupled with capital account surpluses. The
  magnitude, however, is far less that that of the
  United States.
• 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. This has left
  less output available for exports.
• China has been running trade surpluses AND
  capital account surpluses.  For example, in 2002
  China had a 35.4B trade surpluses and a 6.4B
  capital inflow.  Reason Official reserve
  holdings of dollars has increased.  Chinese govt.
  buys up dollars with Yuan, to keep the dollar
  strong and the Yuan low, and the Yuan/ rate
  stable.   

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Impact on Currency

• CA All the other factors constant, a deficit
  balance on a countrys current account implies
  that there is excess supply of its currency in
  the foreign markets. Hence, its currency should
  depreciate.
• KA All other factors constant, a surplus balance
  in a countrys financial account implies that
  there is excess demand for assets denominated in
  its currency. Hence, its currency should
  appreciate.

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Affects on the Economy

• Is a nations current account balance, by itself,
  a good measure of its economic health?
• NO there is no law, economic or political, which
  states that the current account balance must be
  positive. Unlike running a budget deficit in
  which a person or institution spends more than it
  makes, running a deficit in the current account,
  simply means a country imports more than it
  exports.
• Is a current account surplus and financial
  account deficit by itself an indication of
  economic strength?
• NO, particularly not if the exodus of the
  financial capital occurs because there are a few
  good investment opportunities in the country.
• Is the net inflow of capital bad?
• NO, if the capital is being invested in such a
  way as to enhance the productive capacity of the
  country.

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Do monetary and fiscal policies affect the
exchange rates and BOP components?

• Monetary Policy An unanticipated shift to
  expansionary monetary policy will lead to more
  rapid economic growth, accelerated inflation and
  lower real interest rates
• BOP effects Higher income and higher domestic
  prices stimulate imports and discourage exports.
  Lower real rates discourage foreign and domestic
  investment at home.
• Exchange rate effects The adverse impact of the
  countrys current account will increase the
  supply of currency in the fx markets causing the
  currency to depreciate. The adverse impact of the
  countrys financial account will decrease demand
  for the countrys currency, causing it to
  depreciate.

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Do monetary and fiscal policies affect the
exchange rates and BOP components?

• Fiscal Policy An unanticipated shift to more
  expansive fiscal policy will result in budget
  deficits, increase in aggregate demand, inflation
  and an increase in real interest rates.
• BOP effectIncrease demand will encourage imports
  discourage exports, which moves the current
  account towards deficit.
• Meanwhile, the higher interest rates attract
  foreign investment and discourage domestic
  investment from leaving the country, moving the
  financial account surplus.
• Exchange rate effects The adverse impact of the
  current account will increase the SUPPLY of the
  countrys currency, causing the currency to
  depreciate.
• The positive impact of the KA will increase
  demand causing the currency to appreciate.

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What about monetary and fiscal policies?

• So what do you think is the net effect?
• The overall effect is mixed, but the interest
  rate effect will likely dominate in the short
  term leading the exchange rate appreciation.