Balance of Payments: Understanding Accounts & Trends

Overview of Topics

• Balance of Payments Accounting.
• Balance of Payments Accounts.
• The Current Account.
• The Capital Account.
• The Financial Account.
• Statistical Discrepancy.
• Official Reserves Account.
• The Balance of Payments Identity.
• Balance of Payments Accounting.
• Balance of Payments and Net Foreign Wealth
• Balance of Payments Trends in Major Countries.

Understanding the Balance of Payments (BoP)

• The balance of payments summarizes all economic transactions between a country's residents and the rest of the world over a period of time.
• It is a statistical record of a country’s international transactions, using double-entry bookkeeping.

Importance of Studying the BoP

• Provides insights into the demand and supply of a country’s currency.
• Can indicate a country's potential as a business partner.
• Assesses a country's performance in international economic competition.
• International transactions include: imports, exports, cross-border investments in businesses, bank accounts, bonds, stocks, and real estate.

Recording Transactions

• Receipts from foreigners are recorded as credits (positive sign). From a U.S. perspective, this boosts demand for the U.S. dollar and increases the supply of foreign exchange.
• Payments to foreigners are recorded as debits (negative sign). From the U.S. perspective, this increases the supply of dollars and the demand for foreign exchange.

Components of the Balance of Payments

• The BoP consists of: the Current Account (CA), Capital Account (KA), Financial Account (FA), and Reserves Account (RA)
• The Current Account (CA) involves real transactions like the import and export of goods and services plus transfers
• Types of services under Current Account include: Non-financial (rent, freight, insurance) and financial (dividends, interest)
• The Capital Account (KA) and Financial Account (FA) involve financial transactions like the purchase and sale of foreign assets or liabilities
• The Reserves Account (RA) involves foreign assets held by the country’s central bank

Balance of Payments Accounts: Key Types

• Current account includes export and import of goods and services.
• Capital account consists of capital transfers and the cross-border acquisition and disposal of non-produced, nonfinancial assets.
• Financial account (excluding official reserves) includes purchases and sales of financial assets, such as stocks, bonds, bank accounts, etc.
• Official reserve account covers purchases and sales of international reserve assets.
• Capital and financial accounts are sometimes merged into a single capital account.

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

• The U.S. Current Account for 2020 shows:
  • 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, Secondary income: -$294.2
• Balance on current account [[1] + [2] + [3] +[4]] in the US was $-616.1
• U.S. Capital Account shows Credits of 0.4 and Debits of -5.9
• Balance on the capital account in the US was -5.5

Financial Account Summary for 2020

• Direct investment: Credits of $211.3 billion, Debits of -$311.7 billion
• Portfolio investment: Credits of $715.9 billion, Debits of -$220.0 billion
  • Equity securities show credits of $648.4 billion and debits of -$241.8 billion
  • Debt securities show Credits of $61.7 billion and Debits of $21.8 billion.
• Other investment: Credits of $535.1 billion, Debits of -$268.6 billion
• Balance on financial account [[5] + [6] + [7]] in the US was $662.0 billion.
• Statistical discrepancies: -$31.4 billion
• Overall balance: $9.0 billion
• Official Reserve Account: -$9.0 billion
• Source: U.S. Bureau of Economic Analysis

Dissecting the Current Account

• Categorized into goods trade, services, primary income, and secondary income
• Goods trade involves tangible goods exports and imports, such as oil, wheat, clothes, automobiles, computers
• Services include payments and receipts for legal, consulting, financial, engineering, and other services, royalties for patents, shipping fees, tourist expenditures.
• Primary income is largely payments and receipts of interest, dividends, and other income on foreign investments previously made (investment income)
• Secondary income consists of "unrequited" payments called current transfers (foreign aid, remittances)

Sensitivity in the Current Account

• Current account balance and trade balance are sensitive to exchange rate changes
• Currency depreciation tends to increase exports and decrease imports
• The trade balance can improve immediately if imports and exports are responsive (elastic) to currency depreciation or devaluation.
• The J-curve effect describes the initial decline and eventual improvement of the trade balance after a country’s currency depreciates.

Understanding the Capital Account

• Includes capital transfers acquisitions and disposals of nonproduced, nonfinancial assets between domestic residents and foreigners
• Examples include land, mineral rights, air space, brand and domain names, contracts, leases, licenses.
• Capital transfers, unlike current transfers, change ownership, or involve acquisition/, disposal of an asset.
• Capital transfers tend to be large and infrequent
• The amount of the capital account is often negligible

Key Aspects of the Financial Account

• Measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets.
• Trades in financial assets affect future payments and receipts of primary income.
• U.S. sales of assets to foreigners are recorded as credits, result in capital inflow, and create future liabilities
• U.S. purchases of foreign assets are recorded as debits, lead to capital outflow, and result in future payments from foreigners.

Components of the Financial Account

• Foreign Direct Investment (FDI): investor gains control of the foreing business
• Portfolio Investment: sales and purchases of foreign financial assess, such as stocks and bonds, that do not involve a transfer of control
• Other Investment: transactions in currency, bank deposits, trade credits

Insights into Statistical Discrepancy

• International transaction recordings happen at different times and places, using different methods, which leads to imperfect results.
• Financial transactions are mainly responsible for the discrepancy.
• Overall balance is the cumulative balance of payments including the current, capital, and financial accounts, and any statistical discrepancies.
• A country's payment gap must be accommodated with official reserves.

Understanding the Official Reserves Account

• Encompasses transactions done by the central bank to finance the overall balance and influence the foreign exchange market.
• International reserve assets include gold, foreign exchange, special drawing rights (SDRs), reserve positions in the IMF.
• Foreign exchange accounts make up approximately 96% of the total reserve assets held by IMF member countries.

The Balance of Payments Identity (BOPI) Formula

• BCA + BKA + BFA + BRA = 0
  • BCA = balance on current account
  • BKA = balance on capital account
  • BFA = balance on financial account
  • BRA = balance on the reserves account
• With a fixed rate, countries use official reserves to correct the imbalance.
• Under a purely flexible regime, overall balance is equal, and central banks don't have to hold reserves (BRA=0).

Practical Accounting for Balance of Payments

• Transactions are divided to real transactions or financial transactions
• Real transactions involving export, imports of services and goods, and transfers goes to Current Account
• Financial transaction involving purchasing or selling of foreign assets or liabilities goes to Capital or Financial Account
• The value of entries are calculated using double-entry bookkeeping where Debit - Credit +
• Current Account + Financial and Capital Account = 0, assuming there are no discrepancies in the accounts or reserve accounts

Understanding Inflows vs Outflows

• When recording inflows (i.e. source of funds), it is recorded as credit, and thus assigned to the right-hand side in a T-account
• When recording outflows (i.e. using of funds), it is recorded as a debit, and thus assigned to the left-hand side in a T-account

Steps for Accounting

• Identify if the transaction is a CA, FA, or KA
• Then identify which account it belongs to
• Next determine whether it involved using or sourcing funds

Considerations for Balance of Payments Accounting Examples

• Examples assume that US perspective is being referenced in a transaction
• The work assumes that is the economic activities being referenced occurred in the USA

Example 1 of BoP Accounting: Trade of goods and services

• A U.S. citizen purchases $100 of maple syrup from a Canadian producer, who deposits the $100 into their Citibank account in New York.
• The U.S. trades financial assets for real goods.
• The transaction inputs two offsetting entries in the U.S. BoP and is recorded in the debit side on the current account at -$100
• In the U.S financial account it shows up as a $100 credit on the short-term capital (Liabilities) side

Example 2 of BoP Accounting: Payment

• A U.S. citizen spends $200 on dinner at a restaurant in Mexico, using a Visa credit card; the restaurant credits the bank in US dollars
• Here, the U.S. trades assets for services
• This transaction creates two offsetting entries in the U.S. balance of payments.
• Inputs the U.S. CA with a negative sign (i.e. on the debit side) for $200.
• Records $200 credit in the U.S. financial account and is treated as short-term capital liabilities for the restaurant

Example 3 of BoP Accounting: Stock Purchase

• A U.S. citizen buys $50 of stock issued in TOTAL of France, by using a check on his stockbroker money
• TOTAL deposits $50 in a U.S. bank in Charlotte, NC
• Here, the U.S. trades assets for assets
• This transaction creates two offsetting entries in the U.S. balance of payments.
• Enters the financial account for -$50
• The U.S. financial account shows a $50 credit, where it is recorded as the short-term capital liabilities

The role of Reserves

• Reserves Account is related to country's increase in ability to: Export more then it imports, plus ability to raise capital

What impacts Reserve amounts

• Reserves is changed when there is change in the current account and financial account
• Current account and financial account determines the FX reserve value
• Current account + financial + capital account balance =-change in FX reserves (BRA), using the formula: BCA + BFA + BKA +BRA=0

BoP Account Example 1 Revisited

• A U.S. citizen purchases $100 of maple syrup from a Canadian producer, who deposits the $100 into their Citibank account in New York, where U.S. citizen imports syrup for CA: -$100
• Then, the Canadian receives $100 and the finances the U.S. economy via US KA: +$100
• This leads to CA + KA = 0 => No change in FX reserves of the U.S.A.

What if Maple Syrup producer exchanges US dollar for Canadian

• Now imagine the producer asks to use New Your Citibank to exchange to Canadian dollars
• Then central bank has federal reserved to exchange CAD100 for US$100 (assuming FX rate is 1)
• Foreign exchange reserves decrease by $100 (- CAD100) and are compensated by an inflow of $100 (+ USD100).
• This results in reducing short-term capital of non-residents drops by 100 USD.
• This also leads to the fact that drop in FX reserves means less foreign currencies using this values: KA = -100 and CA + KA =-changes in reserves and changes in reserves =+100

The Power of a Dollar

• A dollar indicates a claim on the US economy
• Someone holding a Federal Reserve Note is entitled to exchange it for US real goods and indicates short-term investments in cash

Caveat about Reverse Asset Amounts

• Increase in a country's reserve assets is recognized as a debit (minus), i.e. More U.S. dollars for reserves and Outflow of U.S. dollars
• Decrease in a country's reserve assets is recognized as a credit (plus), i.e. Less U.S. dollars for reserves and Inflow of U.S. dollars

Example Transaction 4: California Inc

• California Inc sells USD 250,000 worth of wine to Japanese retailer with 60 days credit due, the total cost for shipping amounts to USD 15,000
• The total cost f.o.b. (free on board)= USD 265,000

Example Transaction 5: Galeries Laffitte

• Galeries Laffitte based in New York buys textiles from a South Korean company for $200,000,billed in US dollars
• The company Galeries Laffitte pays with a check drawn on a New York branch of Citicorp.

Example Transaction 6: French Resident

• A resident in France, buying U.S. dollars worth of services
• Buys airline tickers costing $7000 and spends $100 on the plane
• Cost of hotels, food and transportation in US = $14,900

Example Transaction 7: Elepha Inc

• Elpha a Nigerian subsidiary of Phil based in NY, has after tax profits of $100,000 ad issues dividend payments of $50,000
• Re-invests the remaining profit amount
• Phil uses the dividend to buy long-term debt issues by Nigeria

Example Transaction 8: Mohammed Hassan

• Is a citizen of Algeria, living in the US who lives in New York transfers $5000 from his branch at NY branch of Citicorp to his ageing father at Algiers branch of the Algeria National Bank.

Example Transaction 9 National Westminster Example

• A bank based in London pays $100,000 to buy £62,500 sterling from the Fed, also known as the US central bank

Example Transaction 10: Citicorp

• The branch of CIticorp based in New New sells 75,000 CHF and receives $50,000

Understanding Surpluses and Income

• The current account demonstrates a nation's net income
• A surplus indicates more financial activity, a higher income is recorded, and more money is flowing into the country.
• In contrast Financial and Capital account demonstrate inflow and outflow of international investment
• The surplus in financial capital account means money is flowing into a country because of an increase in borrowing and sale in assets, and a higher liability

Further considerations for the Bop

• The balance reflects: Current account + Financial and Capital account = Reserves Account
• A current account surplus indicates increasing claim for foreign funds
• A deficit in current account means additional foreign liabilities and decreasing FX reserves

Impact of Exports Compared to Imports

• Exports are higher which will also be related to higher foreign wealth as it reflects ability to retain more income
• The rise in foreign assets will purchase other claims abroad
• Lower amount of exports implies less income that is earned and thus resulting in less income
• The loss in earnings reflects as sell abroad leading to debt

Analyzing competitiveness and imbalance with Current Account Surpluses/Deficits

• Can be analyzed to see how competitive a country is
• An example is manufacturers of America calling out the Chinese to undervalue it's currency and exchange rates, making them less competitive given currency devaluation.
• Imbalances also can be looked at to see how the domestic economy is doing.
• Oversized expenditure/ undersized saving leads to a domestic imbalance

Past BoP Trends in Respected Countries

• U.S. has had continuous deficits since 1982 The US has had surpluses in the 1991 financial account
• The US has a large current account deficits compared to other countries since 1982
• The UK has had similar trends in deficits, but financial surpluses
• The UK demonstrates lower magnitude for financial debt
• German tends to have low current account surpluses
• Germany has not had current account surpluses since it's re-unification
• Japan has had financial deficits
• China as an overall has had surpluses in general so far at the date of recording