Balance of Payments (BOP)

• The Balance of Payments (BOP) measures all financial and economic transactions between a home country's residents and those of all other countries over a specified period.
• BOP statistics are published quarterly.
• BOP statistics show how nations measure their international economic activities and cross-border payments.
• Bankers, businessmen, economists, investors, currency traders, and policymakers closely monitor BOP statistics.
• Understanding trade and capital flow effects on macroeconomic variables and MNE management is emphasized, rather than record-keeping.

Learning Objectives

• Explore the fundamentals of balance of payments accounting and how nations measure their levels of international economic activity and cross-border payments.
• Examine the current and financial accounts which are the two fundamental accounts of the balance of payments.
• Describe how changes in the balance of payments impact key macroeconomic rates such as interest rates and exchange rates.
• Consider how international trade is altered by exchange rate changes.
• Explore the evolution of capital mobility, and the conditions that sometimes lead to crises.

Importance of BOP Data

• BOP data for home and host countries is an indication of pressure on a country's foreign exchange rate.
• It signals the imposition or removal of controls in various payments like dividends, interest, license fees, and royalties.
• It provides a forecast of a country's market potential, especially in the short run.

The Three Principal BOP Accounts

• Current account records exports and imports of goods and services.
• Capital account records transfers of financial assets and the acquisition/disposal of non-financial assets.
• The IMF recently introduced this account, merging it with the financial account.
• Financial account records public and private investment and lending activities.

BOP and Double-Entry Book Keeping

• The BOP statement relies on double-entry bookkeeping.
• Every credit entry corresponds to an equal and offsetting debit entry.
• Credit refers to a decrease in assets or an increase in liabilities.
• Exporting goods/services leads to foreign exchange earnings, which are inflows.
• Debit refers to an increase in assets or a decrease in liabilities.
• Import payments or service purchases lead to an outflow of foreign exchange.
• Because of double-entry book keeping, when supplemented with the errors and omissions account, the BOP is always in balance. -Current account balance + Capital account balance + Financial account balance = Balance of Payment = 0

Example of Double-Entry Book Keeping

• An Australian company exports machine tools to Malaysia for 300,000 ringgits (MR).
• The exchange rate is 1A$ = 3 MR, valuing the order at A$100,000.
• Debit: A$100,000 for the purchase of foreign assets (MR).
• Credit: A$100,000 for the export (reduction) of Australian goods.

U.S. Balance of Accounts Summary

• The U.S. Balance of Accounts is tracked, and the source data is extracted from the IMF Data Warehouse, International Monetary Fund.
• Includes current account balance, capital account balance, financial account balance, net errors/omissions, and reserves & related data.
• The sum or total of the accounts is always zero.

The Current Account

• The Current Account includes international economic transactions with income or payment flows occurring within one year/current period.
• Subcategories include:
• Goods trade: export and import of goods.
• Services trade.
• Income: current income generated from past investments.
• Current transfers: transfers between countries and financial settlements related to ownership changes.
• The Balance of Trade (BOT) typically dominates the Current Account, excluding service trade.
• The U.S. trade balance on goods and services is tracked.

The Capital and Financial Accounts

• The capital and financial accounts of the balance of payments measure all international economic transactions of financial assets.
• The capital account is transfers of financial assets and the acquisition and disposal of nonproduced/nonfinancial assets, which was recently introduced as a separate account.

The Financial Account

• Four key components: direct investment, portfolio investment, net financial derivatives, and other asset investment.
• Financial assets are classified by maturity and ownership (public/private).

Direct Investment

• This is the net balance of capital dispersed from and into a country for the purpose of exerting control over assets.
• Control threshold: a minimum of 10% ownership.
• Concerns over foreign investment relate to control and profit.
• Some countries have restrictions on foreign ownership.

Portfolio Investment

• This the net balance of capital flow in and out of a country that does not meet the 10% threshold to be classified as direct investment
• Debt securities purchased across borders are portfolio investments, not conferring ownership/control.
• Portfolio investment is motivated by a search for returns versus control/management.
• Portfolio investment is more volatile than net foreign direct investment over the past decade.

Inverse Relationship Between Current and Financial Accounts

• Exhibit 3.4 tracks current and financial account balances for the United States over recent years.
• There is an observed inverse relationship between the current and financial accounts.
• This is the usual case in advanced industrialized countries.
• Germany and Great Britain have similar patterns as the U.S.
• In Japan, a current account surplus is matched by a financial account deficit.

Net Errors and Omissions and Official Reserves Accounts

• The Net Errors and Omissions account ensures that the BOP actually balances.
• The Official Reserves Account is the total reserves held by official monetary authorities.
• These reserves are mostly major currencies used in international trade/finance (hard currencies).
• The significance of official reserves depends on whether a country uses a fixed or floating exchange rate.

China's Twin Surpluses

• Exhibit 3.5 shows China's unusual twin surplus in both current and financial accounts, where relationships are typically inverse.
• The financial account surplus fell sizably in 2012 but was again in surplus in 2016, partly due to reintroduced capital controls.
• The Chinese government uses reserves to manage the yuan's value and its impact on global competitiveness.

International Flow of Goods, Services, and Capital

• Basic macroeconomic identities (equations) link domestic spending, consumption, investment, and production to financial and current-account balances.
• Important concepts include National Income (NI) and National Spending (NS).

Domestic Savings, Investment, and Financial Account

• National Income Accounting: National Income (NI) is used for consumption (C) or savings (S).
• NI = C + S
• National spending (NS) is divided into consumption (C) and domestic investment (I).
• NS = C + I
• It can be derived that NI - NS = S - I.
• If NI > NS and S > I, it means surplus capital is spent overseas.
• A nation that produces more than it spends invests overseas.
• With positive Net Foreign Investment (NFI), there will be a net capital outflow which will appear in a financial account-deficit.

The Link Between the Current and Financial Accounts

• When consumption of domestic goods and services are deducted from national income, the remaining goods and services must equal to export (x).
• When spending on domestic goods and services are subtracted from total national spending, the remaining spending must be equal to imports (M).
• The equation NI - NS = X - M is where X = exports, M = imports and X-M=current account balance(CA).
• A CA surplus arises when national output exceeds domestic expenditures; a deficit arises when domestic expenditures exceed domestic output.
• It is indicated that NI-NS = S-I and NI-NS = X-M
• then S - I = X - M.
• If a nation's savings exceeds domestic investment, there is a current account surplus (CAS), such as Japan.
• If a nation saves less than invests, there is CA deficit (CAD), such as the US.
• S > I then X > M
• A nation with CAS is a net exporter of capital (positive NFI). A nation with CAD is a net importer of capital (negative NFI).

Limitations of Current Account Balances

• A current-account surplus is not always a sign of health, nor is a deficit always a sign of weakness.
• During 1992, Japan entered a recession. However, at the same time, its current-account surplus hit a record.
• A current-account surplus represents an excess of exports over imports which may appear as a good sign.
• A current-account surplus also represents an excess of domestic savings over domestic investment
• This excess savings could reflect a lack of domestic investment opportunities, which is not a good sign for the economy
• ex. Japan's current-account surplus has grown since 1990, reflecting a prolonged economic slump and relatively poor domestic growth opportunities.
• Reduction in Japanese investment, relative to Japanese saving, boosts Japan's current-account surplus even during a recession.

BOP Impacts on Key Macroeconomic Rates

• Macroeconomic rates of international finance include:
• Exchange rates
• Interest rates
• Inflation rates

The BOP and Exchange Rates

• The relationship between the BOP and exchange rates can be illustrated using the equation *(X-M) + (CI – CO) + (FI – FO) + FXB = BOP, where X = exports, M = imports, CI = capital inflows, CO = capital outflows, Fl = financial inflows, FO = financial outflows, FXB = official monetary reserves.
• Fixed exchange rate countries:
• The government is responsible to ensure that the BOP is near zero.
• If the sum of current and capital accounts is greater than zero, there is excess demand for domestic currency.
• The government has to sell domestic currency for foreign currency.
• If the sum of the current and capital accounts is negative, there is excess supply of domestic currency. The government has to buy domestic currency with foreign currency.
• Maintaining sufficient foreign currency reserves is important.
• Floating exchange rate countries:
• The government is hands-off when it comes to pegging its foreign exchange rate.
• If the sum of current and capital accounts is not close to zero-market forces will alter the exchange rate.
• Current account deficit with capital and financial accounts in balance can lead to: net BOP deficit, excess supply of domestic currency, and devaluation of domestic currency.
• Managed floats:
• Countries operating with a managed float often find it necessary to take action to maintain their desired exchange rate values
• Actions include no direct intervention and changing the domestic interest rate, which in a current account deficit, leads to increasing the domestic interest rate, a short term investment increases, and Capital flows into capital account balances.

The BOP and Interest Rates

• Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere
• In the U.S., the opposite has occurred due to perceived growth opportunities and political stability which has allowed the country to finance its large fiscal deficit
• The favorable inflow on the financial account is diminishing while the current account balance is worsening, leading to a bigger U.S. debtor nation compared to the rest of the world.

The BOP and Inflation

• Imports can lower a country's inflation rate.
• Foreign competition substitutes for domestic competition which maintains a lower rate of inflation.
• To some extent, lower-priced imports substitute for domestic production/employment. Gross domestic product will be lower and the current account balance will be more negative.

Trade Balances and Exchange Rates

• Imports and exports are affected by changes in exchange rates.
• Changes in exchange rates change relative prices of imports and exports, which means changing prices ultimately results in changes in quantities demanded.
• Trade balance adjustment occurs in three stages:
• Currency contract period
• Pass-through period
• Quantity adjustment period
• If export products are predominantly priced and invoiced in domestic currency, and imports are predominantly priced and invoiced in foreign currency, a sudden devaluation of the domestic currency can possibly result—initially—in a deterioration of the balance on trade. After exchange rate changes are passed through to product prices and markets have time to respond to price changes by altering market demands, the trade balance will improve.

Capital Mobility

• Capital mobility is the degree to which capital moves freely across borders.
• It's critically important to a country's balance of payments.
• The financial account surplus of the U.S. has offset current account deficits over the last 20+ years.
• China has run a surplus in both accounts in recent years.
• The free flow of capital in and out of an economy can destabilize economic activity and significantly contribute to an economy's development.
• The Bretton Woods Agreement promoted free movement of capital for current account transactions but had less regard for capital account transactions.
• The 1970s-1990s saw growth in capital openness, however the financial crisis of 1997/1998 stopped that because of destructive capital outflows and contagion.
• Economic history can be subdivided into five distinct periods with regard to capital mobility:
• 1860-1914: increased capital mobility due to the gold standard and expanded international trade relations.
• 1923-1938: global economic destruction and isolationist policies, negatively affecting capital movement.
• 1944-1973: Bretton Woods era had an expansion of international trade.
• 1973-1997: floating exchange rates, economic volatility, rapidly expanding cross-border capital flows.
• 1997-present: China and India attempt to open their markets.

Capital Controls

• A capital control is any restriction that limits or alters the rate or direction of capital movement into or out of a country.
• Free movement of capital is more the exception than the rule.
• Dutch Disease is the name given to the problem of a substantial currency appreciation due to the demand for a specific natural resource faced by several resource-rich smaller nations.
• Methods and examples of capital controls:

Capital Flight

• Capital flight refers to the rapid outflow of capital in fear of domestic political/economic conditions.
• It's one of the issues that capital controls aim to address.
• Rapid transfer of convertible currencies out of heavily indebted countries poses economic/political problems.

Globalization of Capital Flows

• Capital inflows are short-term in duration.
• Even mature markets can encounter crises.