Balance of Payments

The Balance of Payments
The balance of payments (BOP) is an accounting system for the external sector of the economy. The BOP keeps track of all transactions between home residents and the rest of the world. Receipts of money from abroad are regarded as credits and are entered in the accounts with a positive sign (+). Outflows of money from the country are regarded as debits and are entered with a negative sign (-). 3 main parts of the BOP: The current account, the capital account, the financial account, each part subdivided.
Balance of Payments and Exchange Rates

Components of the BOP Assessing the BOP figures
The Balance of Payments Accounts

A countrys balance of payments accounts keep track of both its payments to and its receipts from foreigners. Is a summary (net) record of flows, not stocks Every international transaction automatically enters the balance of payments twice: once as a credit (+) and once as a debit (-) (Double-entry bookkeeping system).
THE BALANCE OF PAYMENTS: The Current Account The current account keeps track of the export and import of goods and services, and the international movement of income. Current Account Visible Balance Invisible Balance
When exports exceed imports of goods and services, there is a surplus in the Balance of Trade.
Current Account (CA)

Payments for Goods, Services, Resources, etc. Sub-accounts:
Merchandise Trade ~ trade in tangibles: X (+), M(-) Services Trade ~ banking, travel, shipping, royalties, etc. Net Investment Income ~ payment for service of capital. Includes interest payments, dividends. Payment to home = X (+) Unilateral Transfers ~ gifts, workers remittances, retirement payments to persons abroad. out = (-)
UK balance of payments: 2004 ( millions)

CURRENT ACCOUNT 1. Trade in goods a) Exports b) Imports Balance on trade in goods 2. Trade in services a) Exports b) Imports Balance on trade in services Balance on trade in goods and services 3. Net income flows (wages and investment income) 4. Net current transfers (government and private) Current account balance +190 688 48 632 57 944 +95 872 76 754 +19 118 38 826 +24 004 10 860 25 682
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THE BALANCE OF PAYMENTS

Meaning of the balance of payments The current account
trade in goods trade in services
balance of trade in goods and services

current transfers and income flows

CURRENT ACCOUNT 1. Trade in goods a) Exports b) Imports Balance on trade in goods 2. Trade in services a) Exports b) Imports Balance on trade in services Balance on trade in goods and services 3. Net income flows (wages and investment income) 4. Net current transfers (government and private) Current account balance

Meaning of the balance of payments The current account
trade in goods trade in services
+190 688 48 632 57 944 +95 872 76 754 +19 118 38 826 +24 004 10 860 25 682
balance of trade in goods and services
current transfers and income flows

balance on current account
UK balance of payments: 2004 ( millions) (

5
Current account balance as % of GDP in selected countries: 19702006

Current account balance:% of GDP
4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 1970 1975 1980 1985 1990 1995 2000 2005

5 5

4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 1970 1975 1980 1985 1990 1995 2000 2005
4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 1970 1975 1980 1985 1990 1995 2000 2005
UK
UK
USA

5
THE BALANCE OF PAYMENTS: The Capital Account

Japan
4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 1970 1975 1980 1985 1990 1995 2000
The Capital Account and Financial Account measures flows relating to external assets and liabilities. The current account deficit is financed in the capital account. Thus the use of the term transactions is restricted to exchanges involving changes of ownership including the creation and liquidation of claims. Flows in the Capital and Financial Account can broadly be categorized into Portfolio, Direct Investment and Other investments.
UK
USA
2005
The Portfolio investment covers transactions with the nature of investing through non equity securities like bonds, bills, negotiable certificate of deposits, shares, etc. Portfolio investors are primarily concerned with the safety of their investment, the likelihood of an appreciation in the value of that investment and the return they will obtain from their investment. The Direct investment item covers assets and liabilities of investors that have effective voice in the management of an enterprise.
Capital/Financial Account (KA)

Purchase or Sale of Assets
U.S. resident purchases asset from foreign
debit ~ (-) capital outflow (K-out); lending to rest of world increase in U.S. claims on foreign country decrease in foreign claims on U.S.
Foreign purchases asset from U.S. resident

credit ~ (+) capital inflow (K-in); borrowing from rest of world decrease in net U.S. claims on foreign

CAPITAL ACCOUNT 5. Net capital transfers Capital account balance FINANCIAL ACCOUNT 6. Investment (direct and portfolio) a) Net investment in UK from abroad b) Net UK investment abroad Balance of direct and portfolio 7. Other financial flows (mainly short-term) a) Net deposits in UK from abroad and borrowing by UK residents b) Net deposits abroad by UK residents and UK lending to overseas residents Balance of other financial flows 8. Reserves (drawing on +, adding to ) Financial account balance +2 073 +2 073

The capital account The financial account
+126 599 183 078
56 479
+407 526
323 826
+83 700 +193 +27 028

investment

investment
direct

investment
direct portfolio

+126 599 183 078
56 479
+407 526
323 826
+83 700 +193 +27 028

investment
direct portfolio

+126 599 183 078
56 479
+407 526
other financial flows (mainly short-term)
323 826
+83 700 +193 +27 028

investment
direct portfolio

+126 599 183 078
56 479
+407 526
other financial flows (mainly short-term) flows to and from reserves
323 826
+83 700 +193 +27 028

CAPITAL ACCOUNT 5. Net capital transfers Capital account balance FINANCIAL ACCOUNT 6. Investment (direct and portfolio) a) Net investment in UK from abroad b) Net UK investment abroad Balance of direct and portfolio 7. Other financial flows (mainly short-term) a) Net deposits in UK from abroad and borrowing by UK residents b) Net deposits abroad by UK residents and UK lending to overseas residents Balance of other financial flows 8. Reserves (drawing on +, adding to ) Financial account balance +2 073

TOTAL CURRENT + CAPITAL + FINANCIAL ACCOUNTS
+2 073
Total current account

+126 599 183 078
25 682 +2 073 +27 028 +3 419 3 419 0
Total capital account 56 479 Total financial account Total current + capital + financial accounts
+407 526
9. Net errors and omissions Overall balance of payments

+83 700 +193 +27 028
323 826

TOTAL CURRENT + CAPITAL + FINANCIAL ACCOUNTS Total current account Total capital account Total financial account Total current + capital + financial accounts 9. Net errors and omissions Overall balance of payments 25 682 +2 073 +27 028 +3 419 3 419 0

TOTAL CURRENT + CAPITAL + FINANCIAL ACCOUNTS Total current account Total capital account Total financial account Total current + capital + financial accounts 9. Net errors and omissions Overall balance of payments 25 682 +2 073 +27 028 +3 419 3 419 0

investment
direct portfolio
The Balance of Payments Account Export of goods and services A Import of goods and services B Investment income receipts C Investment income payments D Transfers receipts E Transfers payments F Current Account (A-B+C-D+E-F) G Portfolio Investment assets H Portfolio Investment liabilities I Direct Investment assets J Direct Investment liabilities K Other investment assets L Other investment liabilities M Capital/Financial Account(H+I+J+K+L+M) = N Errors and omissions = Reserves- (G+N)
other financial flows (mainly short-term) flows to and from reserves
Assessing the balance of payments figures
Statistical Discrepancy
CA + KA + Stat.Dis. = 0 Why Statistical Discrepancy?
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The Fundamental Balance of Payments
Identity
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Sampling Error
financial, services trades data inaccuracies
Unrecorded interest/dividends
Global BOP Deficit correlated with interest rates.
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Timing Discrepancies Black Markets
Any international transaction automatically gives rise to two offsetting entries in the balance of payments resulting in a fundamental identity:
Current account + financial account + capital account = 0 (12-3)
Transactions Example
Record transactions in the following accounts:
CA: A = goods; B = services; C = income; D = Unilateral Transfers KA: E = Change in MRU claims on foreign assets; F = Change in foreign claims on assets in MRU
Mauritian citizen receives 3000 interest payment from German bonds, deposits in German bank.
C (+), E(-)
Mauritian citizen converts to MRU Rs at UK Bank.

E (+), F(-)
debit = K-out = decrease foreign claims on MRU. (they gave up Rs) credit = K-in = decrease in MRU claims on foreign assets (we gave up , more Rs in)
MRU firm sells Rs $1 sugar to the UK, paid for out of UK-owned deposit account in MRU.
A (+), F(-):
merchandise export is credit decrease in foreign-owned MRU Rs deposits = K-out = decreased foreign claims on MRU assets.
Mauritian Bank loans Mauritian rupee to Indian Bank

F(+), E(-)
debit = K-out = increase in Mauritian claims on foreign assets (future debt payments) credit = K-in = increase in foreign claims on MRU Rs. (acquire rupees)
German resident sells MRU Government Bond to French resident

does not show on U.S. Balance of Payments!
Mauritian tourist spends $10,000 deposit in US bank while traveling in the U.S.
B(-), E(+)
tourist spending abroad is service import ~ a debit decrease in MRU claims on foreign assets ~ K-in
Mauritian charity donates medicine to Haiti

A (+), D(-): goods export, paid for by gift (unilateral transfer)

Examples of Paired Transactions
w

w
A U.S. citizen buys a $1000 typewriter from an Italian company, and the Italian company deposits the $1000 in its account at Citibank in New York.
That is, the U.S. trades assets for goods. This transaction creates the following two offsetting entries in the U.S. balance of payments:
It enters the U.S. CA with a negative sign (-$1000). It shows up as a $1000 credit in the U.S. financial account.
A U.S. citizen pays $200 for dinner at a French restaurant in France by charging his Visa credit card.
That is, the U.S. trades assets for services. This transaction creates the following two offsetting entries in the U.S. balance of payments:
It enters the U.S. CA with a negative sign (-$200). It shows up as a $200 credit in the U.S. financial account.
Slide 12-42
Copyright 2003 Pearson Education, Inc.

w

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A U.S. citizen buys a $95 newly issued share of stock in the United Kingdom oil giant British Petroleum (BP) by using a check drawn on his stockbroker money market account. BP deposits the $95 in its own U.S. bank account at Second Bank of Chicago.
That is, the U.S. trades assets for assets. This transaction creates the following two offsetting entries in the U.S. balance of payments:
It enters the U.S. financial account with a negative sign (-$95). It shows up as a $95 credit in the U.S. financial account.
A U.S. bank forgives $5000 in debt owed to it by the government of Bygonia.

This transaction creates the following two offsetting entries in the U.S. balance of payments:
It enters the U.S. capital account with a negative sign (-$5000). It shows up as a $5000 credit in the U.S. financial account.

Table 12-2: U.S. Balance of Payments Accounts for 2000 (billions of dollars)

Table 12-2: Continued

The Current Account, Once Again
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The Capital Account
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The balance of payments accounts divide exports and imports into three categories:
Merchandise/Goods trade
Exports or imports of goods
It records asset transfers and tends to be small for the United States. It measures the difference between sales of assets to foreigners and purchases of assets located abroad.
Financial inflow (capital inflow)
A loan from the foreigners with a promise that they will be repaid
The Financial Account

w
Services
Payments for legal assistance, tourists expenditures, and shipping fees
Income
International interest and dividend payments and the earnings of domestically owned firms operating abroad
Financial outflow (capital outflow)

A transaction involving the purchase of an asset from foreigners

The Statistical Discrepancy
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Official Reserve Transactions
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Central bank
The institution responsible for managing the supply of money
Data associated with a given transaction may come from different sources that differ in coverage, accuracy, and timing.
This makes the balance of payments accounts seldom balance in practice. Account keepers force the two sides to balance by adding to the accounts a statistical discrepancy. It is very difficult to allocate this discrepancy among the current, capital, and financial accounts.
Official international reserves

Foreign assets held by central banks as a cushion against national economic misfortune
Official foreign exchange intervention

Central banks often buy or sell international reserves in private asset markets to affect macroeconomic conditions in their economies.

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Table 12-3: Calculating the U.S. Official Settlements Balance for 2000 (billions of dollars)
Official settlements balance (balance of payments)

The book-keeping offset to the balance of official reserve transactions It is the sum of the current account balance, the capital account balance, the nonreserve portion of the financial account balance, and the statistical discrepancy.
Example: The U.S. balance of payments in 2000 was -$35.6 billion, that is, the balance of official reserve transactions with its sign reversed.
A country with a negative balance of payments may signal that it is running down its international reserve assets or incurring debts to foreign monetary authorities.

Table 12-3: Continued
CASE STUDY OF VANUATU
Vanuatu is usually faced with a large current account deficit which reflects the savingsinvestment gap in the economy. This raises a crucial policy question as to how the country should finance this deficit in a manner that does not destabilize macroeconomic stability. As an import dependent economy imports far exceeds exports and the trade deficit in Vanuatu is usually large . This deficit is partly financed by the export of services, mainly though tourism earnings. The Income account on the other hand is usually in the deficits. To improve the current account the country needs to promote exports, limit imports, or undertake a combination of both, and promote tourism or the services sector generally. However, persistent deficits in the Current Account, or a deterioration in its level will require that this be financed in the Capital Account. Financing in the Capital Account can take the following forms (i) the encouragement of foreign direct investment, (ii) the undertaking of an external borrowing (loan) or (iii) seeking of more foreign assistance to finance the deficit. Obviously, the different ways to finance the current deficit has different policy implications. Borrowing implies the necessity of future repayments of principal and interest. Direct productive foreign investments in say, building factories and stores entail the potential repatriation of profits of these foreign owned enterprises. But it is important to note that the promotion of foreign direct investment in Vanuatu has broader development applications than the mere transfer of capital resources.
Consequences of current and capital account imbalances

Consequences of a current account deficit: Foreign ownership of domestic assets: such as property, businesses, stocks and bonds. Threatens economic sovereignty, national security. If foreigners lose faith in economy and sell off assets, will lead to massive depreciation of country's currency, destabilizing economy further. Foreign indebtedness: Current account deficits must be offset by capital account surpluses. To attract financial investment in the economy central banks must keep interest rates high, discouraging domestic investment, which threatens to further increase current account deficits in the future. Example: China uses some of its US$ reserves to buy US government bonds, financing US budget deficits. Since it can borrow from China, the US government can keep taxes low, meaning higher levels of disposable income and consumption for Americans. Since much of US consumption is made up of imports from China, low taxes mean strong demand for Chinese output. Indirectly, China's purchase of US government bonds is financing America's trade deficit with China.
Consequences of a current account surplus: Increased ownership of assets abroad: A surplus in the current account leads to a build-up of foreign exchange reserves and/or deficit in the capital account. As Country A acquires more of Country B's assets, the threat of protectionism by Country B grows.

Balance of Payments

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Balance of Payments

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The Balance of Payments

Balance of Payments and Exchange Rates

The Balance of Payments Accounts

Current Account (CA)

UK balance of payments: 2004 ( millions)

PDF created with pdfFactory Pro trial version www.pdffactory.com

UK balance of payments: 2004 ( millions)

UK balance of payments: 2004 ( millions)

THE BALANCE OF PAYMENTS

UK balance of payments: 2004 ( millions)

current transfers and income flows

UK balance of payments: 2004 ( millions)

THE BALANCE OF PAYMENTS

balance of trade in goods and services

current transfers and income flows

PDF created with pdfFactory Pro trial version www.pdffactory.com

UK balance of payments: 2004 ( millions) (

Current account balance as % of GDP in selected countries: 19702006

Current account balance as % of GDP in selected countries: 19702006

Current account balance as % of GDP in selected countries: 19702006

Current account balance:% of GDP

4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 1970 1975 1980 1985 1990 1995 2000 2005

Current account balance as % of GDP in selected countries: 19702006

THE BALANCE OF PAYMENTS: The Capital Account

Current account balance:% of GDP

4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 1970 1975 1980 1985 1990 1995 2000

PDF created with pdfFactory Pro trial version www.pdffactory.com

Capital/Financial Account (KA)

Foreign purchases asset from U.S. resident

UK balance of payments: 2004 ( millions)

THE BALANCE OF PAYMENTS

+126 599 183 078

THE BALANCE OF PAYMENTS

THE BALANCE OF PAYMENTS

PDF created with pdfFactory Pro trial version www.pdffactory.com

THE BALANCE OF PAYMENTS

UK balance of payments: 2004 ( millions)

+126 599 183 078

THE BALANCE OF PAYMENTS

UK balance of payments: 2004 ( millions) (

+126 599 183 078

other financial flows (mainly short-term)

THE BALANCE OF PAYMENTS

UK balance of payments: 2004 ( millions) (

+126 599 183 078

other financial flows (mainly short-term) flows to and from reserves

PDF created with pdfFactory Pro trial version www.pdffactory.com

UK balance of payments: 2004 ( millions) (

UK balance of payments: 2004 ( millions) (

Total current account

25 682 +2 073 +27 028 +3 419 3 419 0

9. Net errors and omissions Overall balance of payments

UK balance of payments: 2004 ( millions) (

UK balance of payments: 2004 ( millions) (

THE BALANCE OF PAYMENTS

other financial flows (mainly short-term) flows to and from reserves

Assessing the balance of payments figures

PDF created with pdfFactory Pro trial version www.pdffactory.com

The Balance of Payments Accounts

Timing Discrepancies Black Markets

Current account + financial account + capital account = 0 (12-3)

Mauritian citizen converts to MRU Rs at UK Bank.

Mauritian Bank loans Mauritian rupee to Indian Bank