copyright © 2007 pearson addison-wesley. all rights reserved. chapter 3 the balance of payments

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Chapter 3

The Balance of Payments

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 3-2


• International business transactions occur in many different forms over the course of a year

• The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP)



• BOP data is important for government policymakers and MNEs as it is a gauge of a nations competitiveness or health (domestic and/or foreign)

• For a MNE both home and host country BOP data is important as:

– An indication of pressure on a country’s foreign exchange rate

– A signal of the imposition or removal of controls in various sorts of payments (dividends, interest, license fees, royalties and other cash disbursements)

– A forecast of a country’s market potential (especially in the short run)


Typical BOP Transactions

• Each of the following represents an international economic transaction that is counted in and captured in the US BOP:– A US subsidiary of a foreign MNE acts as a

distributor for the MNEs products in the US market– A US based firm, manages the construction of a

major water treatment facility in a foreign country– The US subsidiary of a foreign firm pays profits

(dividends) back to a parent in its home (foreign) country

– The US government finances the purchase of military equipment for a foreign military ally


Fundamentals of BOP Accounting

• The BOP must balance

• It cannot be in disequilibrium unless something has not been counted or has been counted improperly

• Therefore it is incorrect to state that the BOP is in disequilibrium


Fundamentals of BOP Accounting

• There are three main elements of the actual process of measuring international economic activity:

– Identifying what is and is not an international economic transaction

– Understanding how the flow of goods, services, assets, and money create debits and credits to the overall BOP

– Understanding the bookkeeping procedures for BOP accounting

• It is a daunting task to measure all international transactions that take place in and out of a country over a year


The BOP as a Flow Statement

• The BOP is often misunderstood as many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement

• By recording all international transactions over a period of time such as a year, it tracks the continuing flows of purchases and payments between a country and all other countries

• It does not add up the value of all assets and liabilities of a country on a specific date (as an individual firm’s balance sheet would do)


The BOP as a Flow Statement

• Two types of business transactions dominate the balance of payments:– Exchange of Real Assets

– Exchange of Financial Assets

• Although assets can be identified as belonging to distinct groups, it is easier to think of all assets simply as goods that can be bought or sold (a clock versus a bond)


The Accounts of the BOP

• The BOP is composed of two primary sub accounts, the Current Account and the Capital/Financial Account

• In addition, the Official Reserves account tracks government currency transactions

• A fourth account, the Net Errors and Omissions account is produced to preserve the balance of the BOP


The Current Account

• The Current Account includes all international economic transactions with income or payment flows occurring within one year, the current period. It consists of the following four subcategories:– Goods trade and import of goods

– Services trade

– Income

– Current transfers

• The Current Account is typically dominated by the first component which is known as the Balance of Trade (BOT) even though it excludes service trade


Exhibit 3.3 U.S. Trade Balance and Balance on Services and Income, 1985-2003 (billions of US dollars)


The Current Account

• The deficits in the BOT of the past decade have been an area of considerable concern for the United States, in both the public and private sectors

• The goods trade deficit saw the decline of heavy traditional industries in the U.S. (steel, automobiles, automotive parts, textiles)


The Capital/Financial Account

• The Capital Account of the balance of payments measures all international economic transactions of financial assets. It is divided into two major components:– The Capital Account

– The Financial Account

• The Capital Account is minor (in magnitude), while the Financial Account is significant


The Financial Account

• Financial assets can be classified in a number of different ways including the length of the life of the asset (maturity) and the nature of the ownership (public or private)

• The Financial Account, however, uses a third method. This focuses on the degree of investor control over the assets or operations


The Financial Account

• The Financial Account consists of three components;– Direct Investment – in which the investor exerts

some explicit degree of control over the assets

– Portfolio Investment – in which the investor has no control over the assets

– Other Investment – consists of various short-term and long-term trade credits, cross-border loans, currency deposits, bank deposits and other A/R and A/P related to cross-border trade


Direct Investment

• This is the net balance of capital dispersed from and into the US for the purpose of exerting control over assets.

• Foreign direct investment arises from 10% ownership of voting shares in a domestic firm by foreign investors.

• The source of concern over foreign investment in any country focuses on two topics: control and profit.

• Some countries possess restrictions on foreigners may own in their country.

• The general rule or premise is that domestic land, assets and industry should be owned by residents of the country.

• Concerns over profit stem from the same argument.


Portfolio Investment

• This is the net balance of capital that flows in and out of the U.S. but does not reach the 10% threshold of direct investment.

• The purchase of debt securities across borders is classified as portfolio investment because debt securities by definition do not provide the buyer with ownership or control.

• Portfolio investment is motivated by a search for returns rather than to control or manage the investment.


Exhibit 3.6 Current and Financial/Capital Account Balances for the United States, 1992-2003 (billions of US dollars)


Net Errors & Omissions/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 within the country.

• These reserves are normally composed of the major currencies used in international trade and financial transactions (hard currencies).

• The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system.


The BOP in Total — Surplus

• A surplus in the BOP implies that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase – in value – or intervene and accumulate additional foreign currency reserves in the Official Reserves Account.


The BOP in Total — Deficit

• A deficit in the BOP implies an excess supply of the country’s currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value.


The BOP Interaction with Key Macroeconomic Variables

• A nation’s balance of payments interacts with nearly all of its key macroeconomic variables

• Interacts means that the BOP affects and is affected by such key macroeconomic factors as:– Gross Domestic Product (GDP)

– The exchange rate

– Interest rates

– Inflation rates


The BOP and GDP

• In a static (accounting) sense, a nation’s GDP can be represented by the following equation:

GDP = C + I + G + X – M


The BOP and GDP

• The variables from the formula on the previous page are defined as:C = consumption spending

I = capital investment spending

G = government spending

X = exports of goods and services

M = imports of goods and services

X – M = the current account balance


The BOP and Exchange Rates

• A country’s BOP can have a significant impact on the level of its exchange rate and vice versa

• The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP Data (see next slide)



(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:X = exports of goods and servicesM = imports of goods and servicesCI = capital inflowsCO = capital outflowsFI = financial inflowsFO = financial outflowsFXB = official monetary reserves

Current Account Balance

Capital Account Balance

Financial Account Balance



• Fixed Exchange Rate Countries– Under a fixed exchange rate system, the

government bears the responsibility to ensure that the BOP is near zero

• Floating Exchange Rate Countries– Under a floating exchange rate system, the

government has no responsibility to peg its foreign exchange rate

• Managed Floats– Countries operating with a managed float often find

it necessary to take action to maintain their desired exchange rate values


The BOP and Interest Rates

• Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries does have and impact on the financial account of the BOP

• Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere

• However, in the case of the U.S., the opposite has occurred due to perceived growth opportunities and political stability – allowing it to finance its large fiscal deficit

• However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the current account balance is worsening – making the U.S. a bigger debtor nation vis-à-vis the rest of the world


Trade Balances and Exchange Rates

• A country’s import and export of goods and services is affected by changes in exchange rates

• The transmission mechanism is in principle quite simple: changes in exchange rates change relative process of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand

• Theoretically, this is straightforward, in reality global business is more complex


Exhibit 3.8 – Trade Balance Adjustment to Exchange Rate Changes: The J-Curve


Capital Mobility

• The degree to which capital moves freely across borders is critically important to a country’s balance of payments

• The financial account surplus has probably been one of the major reasons that the U.S. dollar has been able to maintain its value over the past 20 years


Capital Mobility

• The authors argue that the post-1860 era can be subdivided into four distinct periods with regard to capital mobility.– 1860-1914 – continuously increasing capital mobility as the

gold standard was adopted and international trade relations were expanded

– 1914-1945 – global economic destruction, isolationist economic policies, negative effect on capital movement between countries

– 1945-1971 – Bretton Woods era say a great expansion of international trade

– 1971-2002 – floating exchange rates, economic volatility, rapidly expanding cross-border capital flows


Exhibit 3.10 A Stylized View of Capital Mobility in Modern History


Capital Flight

• Although no single definition of capital flight exists, it has been characterized as occurring when capital transfers by residents conflict with political objectives.

• Many heavily indebted countries have suffered capital flight, compounding their debt service problems.

• Capital can be moved via international transfers, with physical currency, collectables or precious metals, money laundering or false invoicing of international trade transactions.


Mini-Case Questions: Turkey’s Kriz (A)

• Where in the current account would the imported telecommunications equipment be listed? Would this location correspond to the increase in magnitude and timing of the financial account?

• Why do you think that net direct investment declined from $573 million in 1998 to $112 million in 2000?

• Why do you think that TelSim defaulted on its payments for equipment imports from Nokia and Motorola?

copyright © 2007 pearson addison-wesley. all rights reserved. chapter 3 the balance of payments

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