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 International Finance

Lecture 1
Balance of Payments Accounting
˜efinition: The balance of payments is a record of
transactions between residents of a country and
residents of the rest of the world.

The balance of payments is use to:

‡ project exchange rates
‡ assess the health of the economy
‡ assess the credit worthiness of an
economy
Balance of payments accounting is based on the
principles of double-entry bookkeeping : each
transaction is recorded twice, once as a debit and once as
a credit.

˜efinition. Assets are economic resources which are

expected to benefit future activities.
˜efinition. Liabilities are outsiders claims against
assets.
˜efinition. Credit : this means ´rightµ.
˜efinition. ˜ebit : this means ´leftµ.
 Kurrent Account
‡ The Kurrent Account is a record of
transactions affecting the left-hand side
of the budget constraint.
‡ It is a measure of the change in a
country·s net worth.
‡ It is a record of trade in goods in services
(including the services of capital and
labour) and gifts.
 Kurrent Account
‡ Merchandise Trade
‡ Services
‡ Income
‡ Kurrent Transfers
 Merchandise Trade
This is trade in physical goods such as
computers and automobiles.
It is often broken down into
Merchandise exports- free on board
Merchandise imports- cost insurance
freight.
 Services
‡ This is trade in invisible or intangible
goods.
‡ Examples are: shipping, travel,
communications, financial services,
insurance, tourism
‡ The sum of merchandise trade and
services is called the trade balance
 Kurrent Transfers
These are one-sided transactions such as
government grants, pension payments,
and private gifts.
 The Kapital Account
‡ A complication arose because debt forgiveness was
distorting balance of payments numbers.
‡ It was decided to include only gifts that would be
consumed within a year in the current account and to
make up a new account called the Kapital Account
that would include long-term gifts such as debt
forgiveness.
‡ Thus, the left-hand side of the budget constraint
should actually be the Kurrent Account plus the
Kapital Account.
‡ The Kapital Account is unimportant for the UK or the
US.
‡ Kurrent acc=exports-imports
‡ Kapital acc=change in foreign ownership
of domestic assets- change in domestic
ownership of foreign assets.
 Is it
Is this an entered as
increase or a positive
a decrease Is this a or a
in an debit or a negative
asset? credit? number
A country Increase (it
buys a has more ˜ebit Negative
good or a goods and
service services)

A country ˜ecrease
sells a (it has fewer Kredit Positive
good or a goods and
service services)
Thus we have:
Exports ² Kredits ² Positive Entry
Imports ² ˜ebits ² Negative Entry
A positive balance on the current account means
that a country sold more than it bought
A negative balance on the current account means
that a country bought more than it sold
The UK Kurrent Account 2006
350000

300000

250000

200000

50000 Kre it
De it
00000

50000

0
erch n i e er ice nco e Tr n er
Tr e

In millions, Pink Book

 Š-7 Kurrent Accounts as a
Share of Š˜P 2007



 
     

þ

þ

þ

Yource: IMF estimate

 Kurrent Account ˜eficit as a
Share of Š˜P

4
S
8

4
98

98

99

99

99

99

99
 The Financial Account
‡ This is the right-hand side of the
government·s budget constraint.
‡ The financial account is a record of
capital flows between residents of a
country and the rest of the world.
one way to break down capital flows is by the type of
transaction.
There are two main types of capital flows
1. ˜irect investment: When residents of a country acquire
shares in a foreign business with the intent of exercising
management control. This is typically defined as
purchasing 10 percent of a firm·s stock.
2. Portfolio investment: Investment without the intention
of exercising management control.
Portfolio investment used to be further broken down
between short- and long-term flows. But, secondary
markets exist for many long-term financial assets and
this has become increasingly meaningless. once can also
break it down between foreign claims on the home
country and home claims on foreigners.
´ome
purchase of
Increase
a foreign
Kapital in an Negative
asset outflow asset ˜ebit entry

Foreign sale
˜ecrease
of a home
Kapital in a Negative
asset outflow liability ˜ebit entry

´ome sale
˜ecrease
of a foreign
Kapital in an Positive
asset inflow asset Kredit entry
Foreign
purchase of
Increase
a home
Kapital in a Positive
asset inflow liability Kredit entry
 Ëeserve Account
‡ A special sub-account of the financial
account is the reserve account.
‡ The reserve account is a record of
changes in the home country·s official
(government) assets.
‡ When fixed exchange rates were more
prevalent this used to be separate from
the financial account.
 Foreign Ëeserves
‡ For most countries the most important
component is their foreign exchange
reserves. This is the foreign currency
held by the central bank.
‡ When a central bank intervenes in the
exchange market to influence the value
of its currency it uses its foreign
exchange reserves.
The
central
bank buys This is an
foreign increase in Negative
exchange an asset debt entry
The
central
bank sells This is a
foreign decrease in Positive
exchange an asset credit entry
 Ëeserve Account Balance
‡ Negative balance (debit, increase in an
asset): Ëeserves rose.
‡ Positive balance (credit, decrease in an
asset): Ëeserves fell.
‡ Another definition of the balance of
payments is minus one times the reserve
account balance.
‡ A positive (negative) balance of
payments: reserves rose (fell)
 Errors and omissions
‡ Each transaction is entered once as a
debit and once as a credit; that is, once
as a positive number and once as the
same negative number.
‡ So, all of the transactions should sum to
zero.
‡ In practice, it does not work out that
way.
 Errors and omissions
‡ ˜ata on merchandise trade comes from
customs declarations.
‡ Trade in services is typically estimated by
various sampling techniques; errors can be
substantial.
‡ Ëeporting of capital flows and investment
income is highly imperfect; people try to hide
these to evade taxes.
‡ The Statistical ˜iscrepancy or Errors and
omissions is the amount we need to add or
subtract to make things add up to zero.
Balance of Payments
Kurrent Account
Merchandise Trade
Exports
Imports
Services
Income
Kurrent Transfers
Kapital Account
Financial Account
˜irect Investment
Portfolio Investment
´ome claims on Foreigners
Foreign Klaims on the ´ome Kountry
Ëeserves
Errors and omissions
Examples for the Mythical
Kountry of Pongoland
Which account is credited?
Which account is debited?
 A European importer buys million pongos worth of
equipment from a Pongoland firm. Payment is made
with a cheque drawn on a Pongoland bank.

‡ The equipment is a Merchandise Export.

‡ It is a decrease in an asset, so credit
Merchandise Exports million.
‡ The cheque is a Foreign Klaim on
Pongoland. It is a decrease in a liability
so debit Foreign Klaims million.
 Pongoland imports 1.2 million pongos of food
from Latin America. Payment is made with
cheques drawn on Pongoland banks.
‡ The food is a Merchandise Import.
‡ It is an increase in an asset so debit
Merchandise Imports 1.2 million.
‡ The payment is a Foreign Klaim on
Pongoland.
‡ It is an increase in a liability so credit
Foreign Klaims 1.2 million.
Pongoland tourists spend 00,000 pongos while
travelling in Europe. They pay with Pongoland
travellers· cheques.
‡ The tourism is a Service.
‡ It is an increase in an asset so debit
Services . million.
‡ The travellers· cheques are a Foreign
Klaim on Pongoland.
‡ They are an increase in a liability, so
credit Foreign Klaims . million.
A Pongoland company purchases 20 percent of a
European Kompany for 00,000 pongos. It pays
with cheques drawn on Pongoland banks.
‡ ˜ebit ˜irect Investment . million.
‡ Kredit Foreign Klaims . million
 The government of Pongoland provides
foreign aid to a country in the form of
00,000 million of agricultural products.
‡ ˜ebit Kurrent Transfers . million
‡ Kredit Exports . million
 Pongoland investors receive 200,000 pongos
from their foreign investments. They are paid
with cheques drawn on foreign banks.
‡ The earnings are Income.
‡ They are no longer owed the income so
this is a decrease in an asset. or, view
this as an export of the services of
capital. Kredit Income .2 million.
‡ The cheques are Pongoland Klaims on
Foreigners.
‡ This is an increase in an asset; debit
Pongoland Klaims.
The Balance of Payments and the
National Accounts
‡ Y = K + I + Š + X where Y is output or income,
K is private domestic consumption, I is private
domestic investment, Š is government
spending (assumed to be consumption) and X
is exports minus imports, or net exports or the
current account.
‡ Y ² K ² Š = S = I + X, where S is income
minus total private and government
consumption, or savings.
‡ X = S ² I : the current account is domestic
investment minus saving