The Balance of Payments: Linking the Domestic Economy to the International Economy

Open economy An economy that has interactions in trade or finance with other countries. Closed economy An economy that has no interactions in trade or finance with other countries. Balance of payments The record of a countrys trade with other countries in goods, services, and assets.

Financing International Trade

When we buy something from another country, we use the currency of that country to make the transaction.

We record international transactions in the balance of payments accounts.

Balance of Payments Accounts

A countrys balance of payments accounts records its international trading, borrowing and lending.

Balance of Payments (BOP)

A record of international transactions between residents of one country and the rest of the world. International transactions include exchanges of goods, services or assets.

Residents means businesses, individuals and government agencies, including citizens temporarily living abroad, but excluding local subsidiaries of foreign corporations.

Balance of Payments (BOP)

The Balance of Payments (BOP) is also the record of a countrys sources (supply) and uses (demand) of foreign exchange.

Foreign exchange is simply all currencies other

than the domestic currency of a given country.

The Balance of Payments

Monetary and fiscal policy must take the BOP into account at the national level BOP data may be important

Indicates pressure on exchange rate May signal imposition/ removal of controls over payments, dividends, interest. Helps forecast countrys market potential

For example

BOP transactions (US side)

Daimler-Chrysler purchases manufacturer in Chicago. GM China pays dividends to parent in US. An American tourist purchases a necklace in India. A Mexican lawyer purchases US bond via investment broker in New York.

Rule of thumb: follow the cash flow

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Balance of Payments Accounts (cont.)

The balance of payment accounts are separated into 3 broad accounts:

current account: accounts for flows of goods and services (imports and exports). financial account: accounts for flows of financial assets (financial capital). capital account: flows of special categories of assets (capital), typically non-market, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks.

B of P
A. Current Account A. Net exports/imports goods&services (Balance of Trade)

B.
C.
B.

Net Income (investment income from direct portfolio investment plus employee compensation)
Net transfers (sums sent home by migrant abroad)

Capital Account Capital transfers related to purchase and sale of fixed assets such as real estate

C.

Financial Account A. B. C. Net foreign direct investment Net portfolio investment Other financial items

Basic Balance = A+B+C

D.

Net Errors and Omissions

Missing data such as illegal transfers

Overall Balance = A+B+C+D

E.

Reserves and Related Items Changes in official monetary reserves including gold and foreign exchange reserves

(A:E) = Overall Balance

BOP Accounting

The BOP must balance How to measure international economic activity?

Is it an international economic transaction? How do flow of goods/services/assets/money translate in debits & credits? Bookkeeping procedures for BOP?

Main transactions in BOP:

Exchange of real assets. Exchange of financial assets.

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Double-entry Accounting in the BOP

All transactions are either debit or credit transactions Credit transactions result in receipt of payment from foreigners

Merchandise exports Transportation and travel receipts Income received from investments abroad Gifts received from foreign residents Aid received from foreign governments

Double-entry Accounting (Contd)

Debit transactions involve to payments to foreigners

Merchandise imports Transportation and travel expenditures Income paid on investments of foreigners Gifts to foreign residents Aid given by home government Overseas investments by home country residents

Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance.

The Current Account

A countrys current account is the sum of its:

net exports (exports minus imports) net income received from investments abroad, and net transfer payments from abroad.

Exports earn foreign exchange and are a credit (+) item on the current account. Imports use up foreign exchange and are a debit () item.

The Current Account

The balance of trade is the difference between a countrys exports of goods and services and its imports of goods and services. A trade deficit occurs when a countrys exports are less than its imports.

Net exports of goods and services (EX IM), is the difference between a countrys
total exports and total imports.

The Current Account

Investment income consists of holdings of

foreign assets that yield dividends, interest, rent, and profits paid to Indian asset holders (a source of foreign exchange).

The Current Account

Net transfer payments are the difference

between payments from India to foreigners and payments from foreigners to India.

The Current Account

The balance on current account consists of net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments. It shows how much a nation has spent relative to how much it has earned.

The Current Account

Goods Trade or Balance of Trade (BOT) export/import of goods. Services Trade export/import of services (financial, construction, and tourism).

Income predominately current income associated with investments made in previous periods, + wages & salaries paid to non-resident workers.
Current Transfers financial settlements due to change in ownership of real resources or financial items. Any transfer b/n countries which is oneway, a gift or a grant. CA typically dominated by export/import of goods, for this reason Balance of Trade (BOT) is widely quoted.

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For example
Trade balance Debit: Sun Microsystems buys LCDs from Hong Kong. Credit: Singapore Airlines buys Boeing jet. Trade in services Debit: American rents an apartment in Singapore. Credit: TUI - Germany places an ad in the NYT. Income payments Debit: Honda US pays dividend to Honda Japan. Credit: Bank Austria pays salary to rep in NY office. Unilateral Current Transactions Debit: Peace Corps pays US volunteer teachers in Bosnia. Credit: TotalFina pays tuition of employee for Stern MBA.

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The Balance of Payments: Linking the United States to the International Economy
The Current Account
Trade Flows for the United States and Japan, 2009

The Balance of Payments: Linking the United States to the International Economy

The Current Account

CURRENT ACCOUNT
The Balance of Payments of the United States, 2009 (billions of dollars)

Exports of goods Imports of goods Balance of trade Exports of services Imports of services Balance of services

$1,149 1,965 816 479 372 107

Income received on investments

Income payments on investments Net income on investments Net transfers Balance on current account

782
708 74 104 739

Net Exports Equals the Sum of the Balance of Trade and the Balance of Services

The Capital Account

For each transaction recorded in the current account, there is an offsetting transaction recorded in the capital account.

The capital account records the changes in assets and liabilities.

The Capital/Financial Account

Capital account: transfers of fixed assets, real estate, acquisitions/disposal of non-produced/nonfinancial assets Financial account: three components; classified by degree of control,

Direct Investment Net balance of capital which is dispersed from and into US for the purpose of exerting control over assets.

E.g. US company acquires foreign company stake (-) Foreign company acquires US company stake (+) foreign direct investment (FDI): 10%+ of voting shares acquired.

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The Capital/Financial Account

Portfolio Investment Net balance of capital which flows in/out of US but does not reach 10% ownership.

No voting or control rights over the asset. Purchase/sale of equity securities. Purchase/sale of debt securities. Far more volatile than FDI.

Other Investment Assets/Liabilities Short & long-term trade credits, cross-border loans, currency & bank deposits, & other accounts receivable and payable in cross-border trade.

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The Capital Account

The balance on capital account in India is the sum of the following (measured in a given period):

the change in private Indian assets abroad the change in foreign private assets in India the change in Indian government assets abroad, and the change in foreign government assets in the India

The Capital Account

In the absence of errors, the balance on capital account would equal the negative of the balance on current account. If the capital account is positive, the change in foreign assets in the country is greater than the change in the countrys assets abroad, which is a decrease in the net wealth of the country.

The Balance of Payments: Linking the United States to the International Economy

The Current Account

CURRENT ACCOUNT
The Balance of Payments of the United States, 2009 (billions of dollars)

Exports of goods Imports of goods Balance of trade Exports of services Imports of services Balance of services

$1,149 1,965 816 479 372 107

Income received on investments

Income payments on investments Net income on investments Net transfers Balance on current account

782
708 74 104 739

Net Exports Equals the Sum of the Balance of Trade and the Balance of Services

The Balance of Payments: Linking the United States to the International Economy

The Current Account

The Balance of Payments of the United States, 2009 (billions of dollars) (continued)

FINANCIAL ACCOUNT
Increase in foreign holdings of assets in the United States Increase in U.S. holdings of assets in foreign countries Balance on financial account 1,864 1,206 658 -2

BALANCE ON CAPITAL ACCOUNT

Statistical discrepancy
Balance of payments

83
0

Why Is the Balance of Payments Always Zero?

The sum of the current account balance, the financial account balance, and the capital account balance equals the balance of payments. To make the balance on the current account equal the balance on the financial account, the balance of payments includes an entry called the statistical discrepancy.

Dont Let This Happen to YOU!

Dont Confuse the Balance of Trade, the Current Account Balance, and the Balance of Payments

Statistical Discrepancy?

It is the net result of errors and omissions on both the credit and debit sides.

Where do these errors come from?

Under-reporting merchandise imports Under-reporting investment incomes Under-reporting capital exports Basically, people succeed in hiding their imports, foreign investment incomes, capital flight from their governments for tax and other purposes.

Account Overview (Level 2)

Current Account
Merchandise trade exports imports Trade Balance Services military trans. (net) other services, net Service Balance Balance on goods & services Investment income, net Unilateral transfers US government grants US govt pensions, and other transfers Private remittances and other transfers All transfers, net Balance on current account

Capital Account
Changes in US assets abroad, net other US govt assets US private assets All changes, net Changes in foreign assets in the US, net foreign private assets All changes, net

Changes in holdings of official international reserves, net

Statistical discrepancy
Balance on capital account

Current Account Surplus and Deficit: Implications

A current account surplus means exports of goods and services, investment income and transfers exceed imports and outflows. A current account deficit means imports of goods and services, and outflows are greater than exports and inflows; must be financed by borrowing (capital account inflows).

BOP Surplus and Deficit

In terms of the supply and demand of a nations currency, there is:

A balance of payments surplus if quantity demanded for a currency exceeds quantity supplied, putting upward pressure on the value of the nations currency.

A balance of payments deficit if quantity supplied of a currency exceeds quantity demanded, putting downward pressure on the value of the nations currency.

Balance of Payments Accounting

Consider three transactions:
1) Wal-Mart buys $100M worth of clothing from a Chinese Manufacturer. Wal-Mart pays for the clothing by writing a check drawn off its account at Bank of America. 2) Warren Buffet collects $50M in interest payments from his financial investments overseas. The Payment is made by crediting Warrens bank account in London. 3) Microsoft sells $20M worth of software to the French government. They pay in cash.

Balance of Payments Accounts

Current Account Exports Goods: $20M (3) Services: Imports Goods: -$100M (1) Services: Net Factor Income: $50 (2) Net Unilateral Transfers:
CA Balance: -$30M

Capital & Financial Account Foreign acquisition of US assets: US Treasuries: Private Securities: $100M (1) FDI: Currency: -$20M (3) US acquisition of foreign assets: FDI: Foreign Securities: -$50 (2) Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: KFA Balance: $30M

Tsunami Relief Aid

President Bush authorized $350M in aid for the Asian countries affected by the Tsunami.
This will appear in the BOP accounts under unilateral transfers. Assume this transfer is paid in cash

Balance of Payments Accounts

Current Account Exports Goods: Services: Imports Goods: Services: Net Factor Income: Net Unilateral Transfers: -$350M
CA Balance: -$350M

Capital & Financial Account Foreign acquisition of US assets: US Treasuries: Private Securities: FDI: Currency: $350M US acquisition of foreign assets: FDI: Portfolio Investment: Official Reserve Assets Foreign acquisition of US ORA: US acquisition of foreign ORA: KFA Balance: $350

National Income Identities and the Current Account Balance

Recall the aggregate expenditure equation in our study of macroeconomics:
AE (=AD) = C + I + G + X - M

Leakages are:
S+T+M

Injections are:
I+G+X

=> In equilibrium: injections = leakages

S+T+M=I+G+X

The balance of payments on Current Account could be rewritten as:

(X - M) = (T - G) + (S - I)

or
(M - X) trade deficit = (G - T) + (I - S) = government + private sector balance balance

Trade deficit = government deficit + priv. sector deficit

An increase in govt. expenditure (G), or a reduction in private saving (S) worsens the trade balance (i.e. raises trade deficit)

Are trade deficits a problem?

A trade deficit is not necessarily a bad thing (e.g. when growing domestic industries attract foreign investments)

if borrowing is financing investment (which generates economic growth and income in future) then it is not a problem

However, if a country persistently runs a trade deficit this is something to worry about (e.g. vulnerability to loss of foreign investors confidence)

excessive borrowing on capital account to finance consumption on current account will incur higher interest payments and eventually lead to reduction in consumption

The Effect of a Government Budget Deficit on Investment

The Twin Deficits, 19782008

During the early 1980s, large federal budget deficits occurred at the same time as large current account deficits, but twin deficits did not occur in the 1990s.