Balance of Payments

• The balance of payments is a summary of all economic transactions between a nation's residents and the rest of the world over a period.
• It serves as a statistical record of international transactions using double-entry bookkeeping.

Importance of Studying Balance of Payments

• Studying the balance of payments provides detailed information about the demand and supply of a country's currency.
• The balance of payments may indicate a country's potential as an international business partner.
• It helps in evaluating a country's performance in international economic competition.
• Examples of tracked international transactions include:
  • Import and export of goods/services
  • Cross-border investments in businesses, bank accounts, bonds, stocks, and real estate.

Credits and Debits

• Credit: any transaction resulting in a receipt from foreigners recorded with a positive sign
  • Increases the demand for dollars and the supply of foreign exchange from the U.S. perspective.
• Debit: any transaction that involves payment to foreigners recorded with a negative sign
  • Increases the dollar supply and the demand for foreign exchange from the U.S. perspective.

Components of the Balance of Payments

• The balance of payments is divided into the current account (CA), the capital and financial account (KA and FA), and the reserves account (RA).

Current Account (CA)

• Current account involves real transactions:
  • Includes import and export of goods and services
  • Includes transfers
  • This involves services, both that are non-financial, and financial
• Non-financial items for example: rent, freight, and insurance
• Financial items for example: dividends, interest, etc

Capital and Financial Account (KA and FA)

• Capital and financial account involves transactions with:
  • Purchase and sale of foreign assets or liabilities.

Reserves Account (RA)

• The reserves account involves:
  • Foreign assets held by a country’s central bank.

Types of International Transactions

• International transactions fall into four main categories:
  • Current account
  • Capital account
  • Financial account
  • Official reserve account
• Capital and financial accounts are sometimes merged into one.

Current Account Definition

• Current account includes the export and import of goods and services.

Capital Account Definition

• The capital account includes capital transfers, plus cross-border acquisition and disposal of nonproduced, nonfinancial assets.

Financial Account Definition

• The financial account includes the purchases and sales of financial assets like stocks, bonds, and bank accounts
• It excludes official reserves

Official Reserve Account Definition

• Official reserve account covers the purchases and sales of international reserve assets.

U.S. Balance of Payments for 2020 ($ billion)

• The summary (cont.) is as follows:
  • Exports: $2,134.4
  • Goods: $1,428.8
  • Services: $705.6
  • Imports: -$2,811.1
  • Goods: -$2,350.8
  • Services: -$460.3
  • Primary Income: $957.9 (-$769.4)
  • Secondary Income: $166.3 (-$294.2)
  • Balance on current account: −$616.1
  • Direct investment: $211.3 (-$311.7)
  • Portfolio investment: $715.9 (-$220.0)
    • Equity securities: $648.4 (-$241.8)
    • Debt securities: $61.7 ($21.8)
    • Derivatives, net: $5.8
  • Other Investment: $535.1 (-$268.6)
  • Balance on financial account: $662.0
  • Statistical discrepancies: −$31.4
  • Overall balance: $9.0
  • Official reserve account: −$9.0

Finer Breakdown of the Current Account

• The current account is divided into goods trade, services, primary income, and secondary income.

Goods Trade Category

• Goods trade represents exports and imports of tangible items
• Includes for example: oil, wheat, clothes, automobiles, computers, etc.

Services Category

• Services include payments and receipts for professional services like:
  • legal
  • consulting
  • financial
  • engineering, etc.
• Includes royalties for patents/intellectual property, shipping fees, and tourist expenditures.

Primary Income Category

• Primary income consists mainly of payments and receipts of interest, dividends, and other income on foreign investments.
• This is also referred to as investment income.

Secondary Income Category

• Secondary income covers unrequited payments known as current transfers
• Includes for example: foreign aid, remittances, etc.
• Also known as unrequited transfers.

Responsiveness to Exchange Rates

• The current account balance is sensitive to exchange rate changes, especially the trade balance (exports less imports in goods and nonfinancial services).
• Currency depreciation increases exports and reduces imports.
• Currency depreciation or devaluation improves (or worsens) the trade balance immediately if imports and exports are responsive (inelastic).

J-Curve Effect

• J-curve effect refers to the initial trade balance deterioration and eventual improvement following currency depreciation.

Capital Account Composition

• Capital account includes capital transfers, as well as acquisitions and disposals of nonproduced, nonfinancial assets.
• It flows between domestic residents and foreigners.
• Examples: land, mineral rights, airspace, brand names, domain names, contracts, leases, and licenses.
• These capital transfers differ from current transfers by way of:
  • Involving a change of ownership/acquisition/disposal of an asset
  • Being large and infrequent.
• The amount of the capital account is often considered negligible.

Financial Account Breakdown

• The financial account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets.
• Trading financial assets impacts future payments and receipts of primary income.
  • U.S. sales of assets: Credits, capital inflow, future liabilities.
  • U.S. purchases of assets: Debits, capital outflow, future payments from foreigners.
• Foreign direct investment (FDI) occurs when the investor gains control of the foreign business.
• Portfolio investment represents sales and purchases of foreign financial assets, such as stocks and bonds that do not transfer control.
• Other investment includes transactions in:
  • currency
  • bank deposits
  • trade credits, etc.

Statistical Discrepancy Explanation

• International payments and receipts are recorded at different times, places, and potentially using different methods
• These variances in collection causes records to be imperfect.
• Financial transactions are identified as being mainly responsible for the discrepancy.
• The overall balance is the cumulative balance of payments, including current, capital, and financial accounts, plus statistical discrepancies.
• A country’s international payment gap needing accommodation via official reserves.

Official Reserve Account Transactions

• Official reserve account transactions are undertaken by the country's central bank to finance the overall balance and intervene in the foreign exchange market.
• International reserve assets comprise: gold, foreign exchange, special drawing rights (SDRs), and reserve positions in the IMF.
• Foreign exchange composes about 96% of the total reserve assets held by IMF member countries.

Balance of Payments Identity (BOPI) Equation

• Formula: BCA + BKA + BFA + BRA = 0

Fixed Exchange Regime

• Under a fixed exchange rate regime, countries maintain official reserves to allow for balance of payments disequilibrium.

Flexible Exchange Regime

• Under a pure flexible exchange regime, balance must be achieved, and central banks do not maintain official reserves.
• Formula: BRA=0

Balance of Payments Accounting

• Transactions breakdown:
  • Real transactions: Exports/Imports of goods, services, and transfers
    • This all relates to the: CURRENT ACCOUNT
• Financial transactions purchasing/selling foreign assets/liabilities This relates to the: CAPITAL/FINANCIAL ACCOUNT

Double-Entry Bookkeeping

• Every international transaction is recorded twice of the balance of payments.
• Once as credit (+) and once as debit (-).
• This uses "T-accounts" for double entry bookkeeping

Fundamental Accounting Equation

• Current Account + Financial and Capital Account = 0
• Simplified version omitting the Reserve Account/Discrepancies

Transaction Recording

• Inflow of funds/source of funds recorded as credit
  • Which goes on the right-hand side of the T-account
• Outflow of funds/use of funds recorded as debit
  • Which goes on the left-hand side of the T-account

Recording Transactions, a Summary

• When recording items, consider these questions:
  • Question 1: Is it related to the CA, or is it related to the FA and KA
  • Question 2: Is it related to an account? If so, which one?
  • Question 3: Is it: a) a use of funds or an outflow? b) a source of funds or an inflow?

U.S. Perspective

• Examples for all accounting takes the U.S. perspective

BOP Accounting Examples

• Example 1:

  • A U.S. citizen purchase of $100 maple syrup from Canadian producer who deposits $100 into account at Citibank in New York.
  • The U.S. traded financial assets for real goods.
  • Two offsetting entries made on balance of payments
    • It enters the U.S. current account as a debit
      • The import of goods in the debit side is -$100
    • It shows up as a $100 credit in the U.S. financial account.
      • Short term capital in the U.S. dollar on the credit side for the producer

• Example 2:

  • U.S. citizen pays $200 for dinner at a Mexican restaurant in Mexico by charging his Visa credit card, which is credited in the restaurant’s bank account in US dollars.
  • The U.S. trades assets for all services
  • Creates the following two offsetting entries. -Enters U.S. current account $200 debit.
    • Shows up as a $200 credit in the U.S. financial account short-term capital liabilities for the restaurant.

• Example 3:

  • U.S. citizen buys $50 share of stock in the French oil company via check from his stockbroker account
  • French oil company (TOTAL) deposits $50 into its own U.S. bank (Wells Fargo) account
  • The U.S. trades assets for other assets
  • Two offsetting entries:
    • The U.S. financial account (portfolio investment) is -$50
    • This shows up as a $50 credit in U.S. financial account (short term capital liabilities).

• Total cost fo.b (free on board) = USD $265,000 Galeries Laffitte, The merchandise amount is $200,000 by check drawn from a New York citybank

Reserves Accounting

• Introducing the Reserve Account to the analysis.
• Increase in FX reserves is a result of the country's capability to either: 1) export more than it imports or 2) attract capital -OR- A combination of both.
• Reserves changes are additional transactions for the balance of payments.
• Balance of Payment formula for this circumstance is expressed as:
  • BCA + BFA + BKA +BRA=0, represents how current, financial, and capital accounts balance against changes in FX reserves (BRA).

Dollar Note Meaning

• American dollars have a certain economic quality
• It is a claim to the U.S. central bank, or rather on the U.S. economy as a whole
• Its owner is able to purchase real goods with it
• The dollars can be called a "short-term investment" in this case

Reserve Warning

• A potential warning on a key element of reserves is noted
• With the knowledge that an increase in a country’s reserves can seem potentially counter-intuitive it should be known
• This means that a debit can be (minus)
  • This is because it has more U.S. dollars for the other reserves
  • It causes an outflow
• Decrease is the opposite - This is because it has less U.S. dollars for the other reserves - It causes an inflow

California Inc, Example

• The entity "California Inc." is an actor in international trade
• Consider that is sells $USD 250,000 dollars worth of wine
• It receives payment from the Japanese retailer on 60 days credit
• It costs $USD 15,000 to ship it to Los Angeles

French Resident Example

• A French resident (owed U.S, dollars) buys a ticket to the United States using American Airline
• $7,000 dollars spent on headphones and other travel and plane accessories.
• The total cost of hotels, transportation, and other amenities of $14,900

Elepha Inc, Example

• Nigeria business acts as the key revenue generating entity
• Named "Elepha, Inc," has $100,000 dollars taxable and reports a dividend of $50,000
• From here it is used to purchase long-term bonds issued by the Nigerian government

Mohammed Hassan Example

• American resident named "A.Hassan" born in the country Algeria

• Has maintained contact with family there for five years

• Conducts a $5,000 dollars wire transfer to his aging father who receives funds via the Algerian National Bank

• The wire is is done in U.S. dollars

• An overview of major elements that drive economic performance is summarized for after the fifth transaction.

• A general summary from here is as follows" Reserves decreases, but in the balance of payment it is positive as Less reserves, dollar inflow=>+KA.

Current Account and Nation's Net Income Discussion

• How do they relate?
• Nation's net earnings are reflected from current account
• A surplus means money is flowing into the country

What happens after the Financial and Capital Account?

• This leads to net changes of inflows and outflows between nations
• A "national borrowing and sales" generates and shows where wealth is directed

Accounting "Balance of Payments"

It is "balanced" as follows:

1. Take current account
2. Add the capital account
3. Result against Reserves

Balance of Payment Relationships

• An increasing FX, or additional claims are represented with a: account surplus
• An account that is in deficit generates foreign liabilities by way of: decreasing FX

The Relationship of a Foreign Power and Net Wealth

• In terms of imports and exports we observe the following a) the country earns money through exports b) It needs to spend it in a proper fashion on imports

This makes for a situation of increasing net wealth A situation of losing reserve wealth, or the wealth must be compensated from a different source - such as a domestic source

Domestic Market and Current Accounts

• To create accurate analysis for the accounts one needs to look at competitiveness
• Foreign exchange and "Chinese rate" is also taken into account

"Chinese currency undervalues" result for lower prices abroad

Current Account Imbalance and Other Effects

Imbalances are problematic for this reason:

• The oversized expenditure (for production/economy)
• There has to be an undersized saving rate (in comparison to that of investment)
• According to analysts, all of this contributed to 2009 Financial crisis

From 1982 and onward the country has been having a hard time due to: a) continuous issues with accounts b) Surpluses exceptions

• *-The major creditor nation. Is from Japan All of the U.K., Germany, and China tend to use domestic outputs rather than foreign sources

This means that high saving countries may do well or can be at the expense of another