Understanding Balance of Payments (BOP)

• Balance of Payments (BOP) is a summary statement of all economic transactions between a nation's residents and the outside world over a period of time.
• The balance of payments is the statistical record of a country's international transactions over time, presented using double-entry bookkeeping.

Importance of Balance of Payments

• Provides information on the demand and supply of a country's currency.
• Signals a country's potential as a business partner.
• Evaluates a country's performance in international economic competition.
• International transactions include import and export of goods/services, and cross-border investments in businesses, bank accounts, stocks, bonds, and real estate.

Recording Transactions

• Transactions resulting in receipts from foreigners are recorded as credits (positive sign).
• Transactions resulting in payments to foreigners are recorded as debits (negative sign).
• From a U.S. perspective, credits increase the demand for dollars/supply of foreign fx, while debits increase the supply of dollars/demand for foreign exchange.

Balance of Payments Components

• The balance of payments comprises of the current account (CA), the capital account (KA), and the financial account (FA), and the reserves account (RA).
• The Current Account involves real transactions, including import/export of goods and services plus non-financial (rent/freight/insurance) and financial (dividends/interest) transfers
• The Capital and Financial Accounts involve financial transactions and the purchase/sale of foreign assets or liabilities.
• The Reserves Account includes foreign assets held by the country's central bank

Balance of Payments Accounts

• Transactions are grouped into four main accounts: current, capital, financial, and official reserve.
• The Current account includes the export and import of goods and services.
• The Capital account consists of capital transfers and the cross-border acquisition and disposal of nonproduced, nonfinancial assets.
• The Financial account (excluding official reserves) includes purchases and sales of stocks, bonds, bank accounts, and other financial assets.
• The Official Reserve Account covers purchases and sales of international reserve assets.

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

• Current Account: Exports totaled $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: $166.3.
• Current Account Balance for 2020: -$616.1
• Capital Account: Credits totaled $0.4, Debits: -$5.9, Capital Account Balance: -$5.5
• Financial Account: Direct investment: $211.3, Portfolio investment: $715.9 (Equity: $648.4, Debt: $61.7, Derivatives: $5.8), Other investment: $535.1
• Financial Account Balance: $662.0
• Statistical discrepancies: -$31.4
• Overall balance: $9.0
• The Official Reserve Account: -$9.0
• The U.S. Bureau of Economic Analysis is the source for the data.

Current Account Categories

• Goods trade: Exports and imports of tangible goods (oil, wheat, clothes, automobiles, computers, etc.)
• Services: Payments and receipts for legal, consulting, financial, engineering, other services, royalties for patents/intellectual property, shipping fees, and tourist expenditures.
• Primary income: Payments and receipts of interest, dividends, and other income on foreign investments (investment income).
• Secondary income: "Unrequited" payments called current transfers (foreign aid, remittances).

Current Account Balance Sensitivities

• The current account balance, especially the trade balance (exports minus imports), is sensitive to exchange rate changes.
• Currency depreciation tends to increase exports and decrease imports.
• The trade balance can improve or worsen immediately after currency depreciation/devaluation, if imports and exports are responsive or inelastic
• The J-curve effect is the initial deterioration and eventual trade balance improvement after a country's currency depreciates.

Capital Account

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

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 credits, creating capital inflow but future liabilities.
• U.S. purchases of foreign assets are debits, leading to capital outflow but future payments from foreigners.

Financial Account Categories

• Foreign direct investment occurs when investors get a measure of control on the foreign business.
• Portfolio investment represents sales and purchases of foreign financial such as stock/bonds that do not involve transfer of control.
• Other investment includes bank deposits, transactions in currency, trade credits, etc.

Statistical Discrepancy

• Payments and receipts from international transactions are recorded at different times and places, by differing methods, making recordings imperfect.
• Financial transactions may contribute significantly to the discrepancy.
• The cumulative balance of payments including the current, capital, and financial accounts, and statistical discrepancies, result in the overall balance.
• A country's international payment gap must be accommodated with official reserves.

Official Reserves Account

• Includes transactions by the central bank to finance the overall balance and intervene in the foreign exchange market.
• Reserve assets comprise gold, foreign exchange, special drawing rights (SDRs), and reserve positions in the IMF.
• Foreign exchange accounts for approximately 96% of reserve assets held by IMF member countries.

Balance of Payments Identity (BOPI)

• The Balance of Payments Identity (BOPI): BCA + BKA + BFA + BRA = 0
• Where BCA = balance on the current account, BKA = balance on the capital account, BFA = balance on the financial account, BRA = balance on the reserves account.
• Under a fixed exchange regime, countries maintain reserves to allow for BOP disequilibrium.
• Under a pure flexible exchange regime, the overall balance must balance, and central banks need not maintain official reserves (BRA=0).

Balance of Payments Accounting

• Transactions split into real transactions (export/import of goods and services) in the CURRENT ACCOUNT.
• Financial transactions which is purchasing/selling of assets/liabilities in the CAPITAL/FINANCIAL ACCOUNT.
• In double-entry bookkeeping, every international transaction enters the balance of payments twice, once as a credit (+) and once as a debit (-).

Balance of Payments Accounting Principles

• Cash inflows/source of funds are recorded as credit on right-hand side of T-account
• Cash outflows/use of funds are recorded as debit on left-hand side of T-account
• A transaction recording assessment should address if the transaction qualifies under the Current, Financial, or Capital account
• Assessment should be made of which account does it qualify under

Balance of Payments Accounting (U.S. Perspective)

• Example 1: A U.S. citizen buys $100 of maple syrup from a Canadian producer.
  • The Canadian producer deposits the $100 in its Citibank account in New York; the U.S. trades financial assets for real goods.
  • Enters the U.S. current account as -$100 (Imports of Goods, debit side).
  • Shows up as a $100 credit in the short term capital (Liabilities) in U.S. dollars within the U.S. financial account.
• Example 2: A U.S. citizen pays $200 for dinner at a Mexican restaurant by charging it to a Visa credit card
  • The transaction creates the following two offsetting entries in the U.S. balance of payments:
  • It enters the U.S. CA with a negative sign (i.e. on the debit side) for $200.
  • It shows up as a $200 credit in the U.S. financial account (financial account) as short-term capital (liabilities) for the restaurant
• Example 3 : A U. S. citizen buys a $50 newly issued stock in teh French oil company TOTAL by drawing check on their stockbroker account
  • It enters the U.S. financial account (portfolio investment) with a negative sign -$50
  • It shows up as a $50 credit in the U.S. financial account (short term capital liabilities)
• Increase in FX reserves stems from the country's ability to export more than imported items, or attracting capital
• Reserves changes, even when associated with another balance of payment transaction, is another transaction in the balance of payments
• The current account balance is not affected.

Impact of Central Bank Intervention

• A U.S. citizen imports $100 of maple syrup (CA: -$100). A Canadian producer deposits payment in a U.S. bank (US KA: +$100).
• No change occurs in FX reserves of the U.S.A. as CA + KA = 0 occurs
• The U.S. central bank (Federal Reserve) then exchanges CAD100 for US$100 (assuming FX rate is 1). FX reserves decrease by $100 (-CAD100), compensated by $100 (+USD100) inflow.
• As a result of short-term capital dropping 100USD, the country has less foreign currency
• An opposite change is seen Reserves =-100 versus KA is -100 and CA and CA + KA is a change in reserves amounting to +100
• A dollar note represents a claim on the US central bank and the US economy.
• The Federal Reserve Note owner can exchange it for real US goods, it is a short term investment
• The U.S. dollars in circulation for the reserves is a debit increase in US reserves but a credit increase of U.S. dollars, leading to an inflow of U.S. dollars
• Decrease in a country's reserve assets is a credit; an inflow of U.S. dollars means there are less U.S. dollars in circulation with the reserves
• Additional Examples*:
• California Inc sells USD 250,000 worth of wine to Japanese retailer on 60 days credit and Los Angeles shipping cost amount is $15.000 for freight on board totalling US $265,000.
• Galeries Laffitte imports 200.000 worth of textiles from a Soouth Korean company with merchandise to be paid from it's New York CIty branch in Citicorp after payment of check
• For a $7,000 round trip by air with the French resident purchasing a $100 headphone, and spending $14,900 for hotels, meals etc, the US realizes $22,00 export income from the non-financial services sector
• Elepha, a wholly owned Nigerian company, gains $100,000 in after tax profits and dividends , and declares $50,000 dividend which is reinvested into the company
• Muhammed Hassan is a U.S. resident who transfers US $5,000 from New York Citibank to his aging father's bank

Summary of Balance of Payments

Reserves decrease due to a positive inflow of +KA funds.

• National Westminster Bank in London buys £62,500 sterling from the Fed in exchange for US $100,000
• A Citicorp Branch sells 75,000 CHF for $50,000
• The current account reflects a nation’s Net Income from inflows and outflows
• Financial surplus money is flowing into an economy
• The current account consists of debit spendings and credit revenues
• Account surpluses consists of money flowing into other countries due
• Current account and surplus accounts are balanced together
• Exports from US greater than imports results in net foreign wealth
• More exports means greater capital inflows
• Current account surplus: additional claims or increasing FX reserves