Balance of Payments:

Chapter 5

Chapter Objectives
& Lecture Notes
FINA 5500

Chapter Objectives: FINA 5500

Chapter 5 / Balance of Payments
1.

To be able to post a given Balance of Payment (BOP) transaction as a debit or a credit

account

2.

To be able to identify whether a given BOP transaction is a component of the Current

Account, Capital Account, or Official Reserve Account

3.

To be able to construct the Balance of Trade, Current Account, Capital Account, or

Official Reserve Account from given set of BOP transactions

4.

To be able to compare and contrast the Current and Capital Accounts

5.

To be able to explain in your own words the effects of the changes in a countrys
inflation rate on its Balance of Trade (BOT)

6.

To be able to explain in your own words the effects of the changes in a countrys GNP on
its BOT

7.

To be able to explain in your own words the relationship between the value of a countrys
currency and its BOT

8.

To be able to explain the J-Curve effect and how it affects the relationship between the
value of a countrys currency and its BOT

9.

To be able to explain in your own words how a countrys spending, savings and
investment patterns affect its BOP

10.

To be able to explain in your own words how a countrys current account and capital
account flows are interrelated

11.

To be able to evaluate the effectiveness of the following government policies to change

its BOT : (a) devaluing / revaluing its currency; (b) protectionism; (c) regulating flow of
international capital; (d) changing spending and saving patterns.

OVERVIEW : CHAPTER 5
Components of the Balance of
Payments (BOP)
z Composition of each component
z How are the BOP components affected
z Policy implications for managing BOP
z

BALANCE OF PAYMENTS
ACCOUNTING PRINCIPLES (1)
Economic transactions between
domestic and foreign residents.
z Viewpoint of one country (i.e. USA).
z Domestic assets and domestic liabilities
are
a
e cchanged
a ged us
using
g deb
debits
sa
and
d ccredits.
ed s
z

1
1

BALANCE OF PAYMENTS
ACCOUNTING PRINCIPLES (2)
z

Double-entry accounting system.

If a transaction creates supply of the nation's
nation s currency in the
foreign exchange market it is recorded as a Debits (eg
Imports)
Debits are used to increase assets and decrease
liabilities.
If a transaction creates demand for the nation's currency in
g exchange
g market it is recorded as a Credit ((eg
g
the foreign
Exports)
Credits are used to increase liabilities and decrease
assets.
Since the foreign exchange market clears (i.e. supply =
demand): DEBIT = CREDIT
3

BALANCE OF PAYMENTS
ACCOUNT COMPONENTS
z

Current Account
Merchandise
Services
Net income from investments
Unilateral transfers (Gifts and grants)

C it l A
Capital
Accountt
Short term capital flows
Long term capital flows

Official Reserves Account

4

2
2

BALANCE OF PAYMENTS
ACCOUNTING IDENTITY
z

Current Account Balance plus Capital

Account Balance plus Official Reserves
Balance equals zero

MERCHANDISE TRANSACTIONS
Largest component of the Current Account,
It consists of:
z Exports: When US producers sell their products abroad,
buyers (foreigners) supply their own currencies and
create a demand for dollars in the FX market
It is recorded as a credit transaction (+)
z Imports: When US residents buy products from abroad,
they supply dollars (and create a demand for foreign
currencies) in the FX market.
It is recorded as a debit transaction (-)
z Merchandise Export - Merchandise Import: Largely
Negative (for US)
z Examine US Merchandise Trade Balance Data
z

3
3

SERVICE TRANSACTIONS
Export and Import of Services
z Travel / Transportation / Financial / Insurance
/ Computer & Information / Construction /
Communication
z The net difference (export - import) for US is:
z

Service Exports - Service Imports: Generally positive

Smaller then Merchandise Export - Imports
Has grown over the past years

OTHER CURRENT ACCOUNTS

z

Net Investment Income

Income (interest, dividend, etc) received from US
investment abroad minus income paid to
foreigners investing in the US
Mostly increasing in recent years

Unilateral Transfers
Net of gift received from and given to foreign
countries
Mostly negative

Examine US Current Account Statistics

8

4
4

CAPITAL ACCOUNTS (1)

z

Records changes in asset ownership of a

country
Real asset (factories, building, land, etc)
Financial assets (securities: stocks, bonds,
etc)
Short
Sh t tterm
Long term

CAPITAL ACCOUNTS (2)

z

Capital account transactions:

Reflects the flow of capital in and out of the US
Affects the FX market:

Debit:

Increase in US investments overseas

Decrease in overseas investments in the US
Capital Outflow from the US
It creates a supply of $ in FX market

Credit:

Decrease in US investments overseas

Increase in overseas investments in the USI
Capital Inflow into the US
It creates a demand for $ in FX market
10

5
5

OFFICIAL RESERVE ACCOUNT

Credit: Decrease in US Governments
holding of FX and gold: transactions by Fed
or US Treasury
z Debit: Increase in US Governments
holding of FX and gold: transactions by Fed
or US Treasury
z Current Account Balance + Capital Account
Balance + Official Reserve Account = 0
z Used to offset the net effects of the Current
and Capital Account balances.
z

11

Balance of Payments Accounting

Entries: A Summary (1)
ACCOUNT

CREDITS

DEBITS

Merchandise:

A. Export of Goods

B. Import of Goods

Service:

C. Export of Service

D. Import of Service

Net Investment
Income:
Unilateral
Transfers:
Capital Flows:

E. Income from Foreign

Investments
G. Transfers to US from
Overseas
I. Increase in Foreign
Investments in US /
Decrease in US
investments overseas
Official Reserve: K. Decrease in Official
Holding of FX & Gold

F. Income paid to
Foreign Investors
H. Transfers to
Overseas from US
J. Decrease in Foreign
Investments in US /
Increase in US
investments overseas
L. Increase in Official
Holding of FX & Gold
12

6
6

Balance of Payments Accounting

Entries: A Summary (2)
Balance of Trade (BOT) = (A - B) + (C-D)
Current Account Balance = (A-B) + (C-D) + (E-F) + (G-H)
Capital Account Balance = (I-J)
Official Reserve Balance = (K-L)
Current Account + Capital Account + Official Reserve = 0

13

INFLATION & BOT

z

If domestic inflation / price levels increase:

Export will decrease
Imports will increase
BOT will decrease

If domestic inflation / price levels decrease:

Export will increase
Imports will decrease
BOT will increase

14

7
7

NATIONAL INCOME (GNP) &

BOT
z

If national income / prosperity increases:

Imports will increase more than exports:
BOT will decrease:

If national income / prosperity decreases:

Imports will decrease more than exports:
BOT will increase:

15

PRICE OF DOLLAR & BOT

z

If the price of $ increases:

Export will decrease:
Imports will increase:
BOT will decrease

If the price of $ decreases:

Export will increase:
Imports will decrease:
BOT will increase
16

8
8

GOVERNMENT POLICY & BOT

z

Methods used by governments to reduce

BOT deficit:
Currency depreciation
Protectionism
quotas
tariffs

Regulating flow of international capital

17

BOT & THE PRICE OF DOLLAR

z

If Export > Import: BOT surplus

Excess Demand for $ in the FX market
Price of $ may increase

If Export < Import: BOT deficit

Excess supply for $ in the FX market
Price
P i off $ may d
decrease

18

9
9

FEEDBACK LOOP IN THE BOT

z

BOT deficit (decreases) in the US : Imports > Exports

Excess supply of $ in the FX market

Price of $ will decline
Export will increase and Imports will decrease
BOT will increase

BOT surplus (increases) in the US : Imports < Exports

Excess demand for $ in the FX market

Price of $ will increase
Export will decrease and Imports will increase
BOT will decrease
19

PRICE OF DOLLAR & BOT :

ANOTHER LOOK
Reasons why
y decline in $ p
prices will not always
y
correct the BOT deficit:
(1) Capital flows into the US.
(2) The producer of the import may respond by lowering
price of their product.
(3) The price of a currency does not change uniformly
with
ith allll currencies
i
(4) The J - Curve effect

20

10
10

BOP and Economic

Fundamentals (1)
National Income = Consumption + Savings (1)
National Spending = Consumption + Investment (2)
National Income - National Spending
=
Savings - Investment (3)

21

BOP and Economic

Fundamentals (2)
National Income - Domestic Spending = Export (1)
National Spending - Domestic Spending = Import (2)
National Income - National Spending
=
Export - Import (3)

22

11
11

BOP and Economic

Fundamentals (3)
Savings - Investment = Export - Import
Capital Account Flows = Current Account Flows

23

12
12

BOP Practice Problems Set #1

1. Please enter the alphabets associated with each transaction listed below in the
proper cells in the following table.
Credit

Debit

Goods / Merchandise
Service
Net Investment Income
Unilateral Transfers
Capital Account
Official Reserve
2. Based on the transaction amounts, please calculate the following Balance of
Payment accounts:
Balance of Trade
Current Account Balance
Capital Account Balance
List of transactions
a. Payment of $20 million in Social Security to US citizens living in Costa Rica
b. Sale overseas of Elvis Presley CDs valued at $15 million.
c. Tuition receipts of $30 million by American universities from foreign students.
d. Payment of $8 million consulting fees to Arthur Andersen by a Mexican firm
e. Sale of a $100 million Eurobond issue in London by IBM.
f. Payment of $10 million in interest by IBM to its Eurobond investors in London
g. Purchase by TI of memory chips valued at $60 million from Toshiba, in Japan.
h. Purchase of $25 million in East European stocks by Fidelity Investments (USA).
i. Fidelity receives $5 million in dividends from its East European stock investment
j. US Federal Reserve sells $20 million of Japanese bonds
k. US Federal Reserve buys $30 million of Japanese yen

BOP Practice Problems Set #2

1. Please enter the numbers associated with each transaction listed below in the
proper cells in the following table.
Credit

Debit

Goods / Merchandise
Service
Net Investments
Unilateral Transfers
Capital Account
Official Reserve
2. Based on the transaction amounts, please calculate the following Balance of
Payment accounts:
Balance of Trade
Current Account
Balance
Capital Account
Balance
List of transactions
1.Purchase of $35 million in Japanese bonds by Vangaurd (USA).
2. A $25 million US aid to Bosnia
3.$45 million sales by All State Insurance in France
4.Purchase by HP of components valued at $65 million from Hyndai, in Korea.
5. Payment of $10 million in dividends by GE to its investors in Frankfurt
6. A $120 million stock issue in Frankfurt by GE.
7. Purchase of $50 million French Francs by the US Federal Reserve
8. Purchase of $60 million in Japanese Govt Bonds by the US Federal Reserve
9. Foreign tourists spending $15 million in New Orleans
10. Sale of Star Wars DVD, valued at $55 million, in China.

BOP Practice Problem Set #3

1. Please enter the alphabets associated with each transaction listed below in the
proper cells in the following table.
Credit

Debit

Goods / Merchandise
Service
Investment Income
Unilateral Transfers
Capital Account
Official Reserve
2. Based on the transaction amounts, please calculate the following BOP accounts:
Balance of Trade
Current Account Balance
Capital Account Balance
List of transactions
A. Payment of $20 million in Social Security to US citizens living in Costa Rica
B. Sale overseas of Elvis Presley CDs valued at $15 million.
C. Tuition receipts of $30 million received by US universities from foreign students.
D. Payment of $8 million consulting fees to Arthur Andersen by a Mexican firm
E. Purchase of $ 32 million of British Pounds by the US Federal Reserve
F. Purchase of $ 6 million of British government bonds by the US Federal Reserve
G. Sale of a $100 million Eurobond issue in London by IBM.
H. Payment of $10 million in interest by IBM to its Eurobond investors in London
I. Sale of $8 in gold by the US Federal Reserve
J. Purchase by TI of memory chips valued at $60 million from Toshiba, in Japan.
K. Purchase of $25 million in East European stocks by Fidelity Investments (USA).

BOP Practice Problems Set #4

Transactions
1. Licensing fees earned by IBM
2. Spending by Japanese at Disneyland
3. Investments in Plant expansion in Ohio by Honda
4. Sales of wheat to GB
5. Sales of Phantom jets to Canada
6. Purchase of oil from Saudi Arabia
7. Profits on sales by Nestles US affiliate
8. Purchase of Japanese automobiles
9. Hotel bills of US tourists in Paris
10. Remittances by Mexican Americans to relatives in Mexico
11. Social Security Payments to Americans living in Italy
12. Purchase by the French of IBM stocks
13. Interest earnings on loans to Argentina
14. Payments to Filipino workers at US bases in Phillippines
15. Increase in New York bank deposits by Saudi Arabia Govt
16. Deposits of funds by the US Treasury in British banks
17. Profits on US-owned auto plants abroad
18. Sales of computer to Germany
19. New investment in a German Chemical plant by Dupont
20. Increase in US bank loans to Mexico
21. Deposits in Swiss banks by Americans
22. Purchases of Japanese stocks and bonds by Americans
23. Economic aid to Pakistan
24. Purchase by Japanese of US real estate
25. Increase in Arab bank deposits in New York
26. Purchase of US Treasury Bonds by Bank of Japan
27. Purchase of Swiss-franc bonds by the Federal Reserve
28. Purchase of gold by US Treasury
29. Increase in holding of Japanese yen by Federal Reserve

Debit /
Credit

Account: Merchandise / Service / Net Investment Income

/ Unilateral Transfer / Capital / Official Reserve

Economic Effects of Balance of Payment Changes: A Summary

US
exports to
foreign
country

Foreign
imports
from US

US export

US import

US imports
from foreign
country

Foreign
exports
to US

US BOT with
foreign
country

US trade deficit
with foreign
country

US inflation is higher than foreign inflation

US inflation is lower than foreign inflation
US GNP increasing, foreign GNP constant
US GNP decreasing, foreign GNP constant
US dollar appreciates / foreign currency depreciates
US dollar depreciates / foreign currency appreciates
US Govt increases tariffs on foreign goods
US Govt decreases tariffs on foreign goods
Foreign Govt increases tariffs on US
Foreign Govt decreases tariffs on US
US Govt increases quotas on foreign goods
US Govt decreases quotas on foreign goods
Foreign Govt increases quotas on US
Foreign Govt decreases quotas on US

US BOT increases = US trade deficit decreases

US BOT decreases = US trade deficit increases

US dollar

Foreign currency

US CURRENT ACCOUNT BALANCE: 1990 - 2007 (in billions of US $)

Year
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

Merchandise
Balance
-111
-77
-97
-132
-166
-174
-191
-198
-248
-348
-455
-429
-485
-550
-669
-787
-838
-819

Service
Balance
30
46
58
62
67
78
87
90
82
83
75
64
61
54
62
76
85
119

Net
Net
Current
Investment Unilateral Account
Income
Transfers Balance
29
-27
-77
24
10
3
24
-35
-50
25
-40
-85
17
-40
-121
21
-38
-114
22
-43
-124
13
-45
-141
4
-53
-215
14
-50
-302
21
-59
-417
32
-51
-385
27
-65
-461
45
-71
-523
67
-84
-624
72
-90
-729
57
-92
-788
82
-113
-731

USBalancesofPaymentsStatistics:20052007(inMillionsofDollars)
2005

2006

2007

1,283,753
894,631
389,122
1,995,320
1,681,780
313,540
72,358
535,263
462,905
89,784

1,457,015
1,023,109
433,905
2,210,298
1,861,380
348,918
57,194
685,150
627,956
92,027

1,645,726
1,148,481
497,245
2,345,984
1,967,853
378,130
81,749
817,779
736,030
112,705

546,631
14,096
5,539
566,266
1,247,347
259,268
988,079
n.a.
32,313

1,251,749
2,374
5,346
1,259,469
2,061,113
487,939
1,573,174
29,710
47,078

1,289,854
122
22,273
1,267,459
2,057,703
411,058
1,646,645
6,496
41,287

Currentaccount
Exportsofgoodsandservices
Goods
Services
Importsofgoodsandservices
Goods
Services
NetInvestmentIncome
Incomereceipts
Incomepayments
NetUnilateralTransfers

Capitalaccount
U.S.ownedassetsabroad
U.S.officialreserveassets
U.S.governmentassets
U.S.privateassets
ForeignownedassetsintheUS
ForeignofficialassetsintheUS
OtherforeignassetsintheUS
NetFinancialderivatives
Statisticaldiscrepancy

KeyBalances
Balanceongoods
787,149
838,270
819,373
Balanceonservices
75,582
84,987
119,115
Balanceongoodsandservices
711,567
753,283
700,258
728,993
788,116
731,214
Balanceoncurrentaccount
Source:U.S.DepartmentofCommerce,BureauofEconomicAnalysiswebpage(http://www.bea.gov)

Recent US Merchandise Trade Balance: By Countries & Product Lines (in Millions of $)
2003
2004
2005
2006
2007
US Exports of goods
683965
807516
894631 1023109
1148481
US Imports of goods
1031784 1477094 1681780 1861380
1967853
US Trade Balance On Goods
-347819 -669578 -787149 -838270
-819373
Export of goods: By areas and countries
Europe
Latin America & Western Hemisphere
Asia and Pacific
Middle East
Africa
Members of OPEC

168298
141492
179847
18122
9493
18315

189416
171887
221860
21594
12778
21579

207895
192382
237511
29765
14886
31305

241274
222298
274532
35795
18228
39108

280845
243063
308248
43646
22966
48659

166713
86758
13047
56073
26359

189981
110697
34638
52288
30842

212192
120264
41800
53265
33585

230983
133892
55038
57593
40743

249712
135962
65073
60898
49025

227204
169043
391435
25365
16985
41978

321486
256746
542072
51283
45636
94109

355404
295914
608703
62467
65211
124942

383812
334876
684298
71907
80420
145367

411179
348378
718562
77405
92005
174340

81840
201752
110574
131039
55271

196973
259871
158096
130094
77349

243886
294080
173034
138375
84967

288126
306066
201195
148560
89237

321685
320323
213552
146037
94280

-58906
-27551
-211588
-7243
-7492
-23663

-132070
-84859
-320212
-29689
-32858
-72530

-147509
-103532
-371192
-32702
-50325
-93637

-142538
-112579
-409766
-36112
-62192
-106259

-130334
-105316
-410314
-33759
-69039
-125681

-68793
-74966
-23816
-35039
-28912

-162335
-77806
-47399
-69890
-46507

-202085
-85110
-52770
-81888
-51382

-233087
-90967
-67302
-75083
-48494

-256611
-85139
-77589
-70611
-45255

Exports of goods: By Product Category

Agricultural products
Nonagricultural products
Foods, feeds, and beverages
Industrial supplies and materials
Capital goods, except automotive
Automotive
Consumer goods

49657
634308
45977
147636
311249
75256
80923

62943
744573
56568
203917
331441
89213
103239

64887
829744
58955
233057
363321
98406
115286

72869
950240
65963
276080
414987
106977
129074

92115
1056366
84264
316361
447433
121045
146102

Imports of goods: By Product Category

Petroleum and products
Nonpetroleum products
Foods, feeds, and beverages
Industrial supplies and materials
Capital goods, except automotive
Automotive
Consumer goods

67807
963977
43602
224117
295717
178966
243534

180459
1296635
62144
412934
343582
228162
377146

251856
1429924
68095
524527
379331
239449
411533

302430
1558950
74938
602537
418258
256629
446146

330978
1636875
81683
639352
444488
258920
478541

Canada
Mexico
China
Japan
Germany
Import of goods: By areas and countries
Europe
Latin America & Western Hemisphere
Asia and Pacific
Middle East
Africa
Members of OPEC
China
Canada
Mexico
Japan
Germany
Trade Balance: By areas and countries
Europe
Latin America & Western Hemisphere
Asia and Pacific
Middle East
Africa
Members of OPEC
China
Japan
Mexico
Canada
Germany

TopTenCountrieswithwhichtheU.S.hasaTradeDeficit:
Overa10yearperiod

June2008:

Country Name
China
Canada
Japan
Mexico
Venezuela
Federal Republic of Germany
Saudi Arabia
Nigeria
Russia
Angola

Deficit in
Millions
of US$
-21,429.60
-7,163.15
-6,126.89
-5,689.46
-4,620.40
-3,898.89
-3,688.51
-3,339.81
-2,710.33
-1,939.87

Year-To-Date
Deficit in
Millions
of US$
-117,462.93
-39,014.04
-39,694.25
-35,701.70
-20,237.73
-22,692.17
-21,477.62
-19,456.43
-8,672.37
-8,750.23

Deficit in
Millions
of US$
-5,249.77
-4,707.49
-1,754.84
-1,604.54
-1,452.96
-1,239.68
-1,075.63
-943.84
-900.04
-858.85

Year-To-Date
Deficit in
Millions
of US$
-31,018.24
-25,119.73
-10,798.21
-7,138.59
-6,628.92
-8,245.93
-5,659.12
-4,176.92
-2,463.38
-3,748.75

June1998

Country Name
Japan
China
Federal Republic Of Germany
Mexico
Taiwan
Canada
Italy
Korea, Republic Of
France
Malaysia