Chapter 4

The Balance of
Payments
 LECTURE OUTLINE

• BOP definition and examples

• BOP components
• The interaction between BOP and key
macroeconomic variables

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 The Balance of Payments

• The measurement of all international

economic transactions between the
residents of a country and foreign residents
is called the balance of payments (BOP)
• Important for government policymakers and
MNEs as it is a measurement of a nation’s
competitiveness or health (domestic and/or
foreign)

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 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 (outflows) and
credits (inflows) to the overall BOP
– Understanding the book-keeping 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

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 The Accounts of the BOP

• The BOP is composed of:

– Current Account
– Capital/Financial Account
– Official Reserves Account: tracks government
currency transactions
– Net Errors and Omissions (a.k.a Statistical
Discrepancies) Account: produced to preserve
the balance of the BOP

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 Current Account

1. Net exports/imports of goods (balance of

trade)
2. Net exports/imports of services
3.Net income (investment income from direct and
portfolio investment plus employee
compensation)
4.Net transfers (sums sent home by migrants and
permanent workers abroad, gifts, grants, and
pensions)

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 Current account
Transactions Types Inflow/
outflow

J.C. Penney purchases stereos produced in

Indonesia that it will sell in its U.S. retail
stores.

The Mexican government pays a U.S.

consulting firm for consulting services
provided by the firm

A U.S. investor receives a dividend payment

from a French firm in which she purchased
stock.

The United States provides aid to Costa Rica in

response to a flood in Costa Rica.
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 Exhibit 4.2 The United States Current
Account, 2002-2010 (billions of U.S. dollars)

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 Exhibit 4.3 U.S. Trade Balances on Goods and
Services, 1985-2010 (billions of US dollars)

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 The Capital and Financial Account

• The Capital Account and financial accounts:

measures all international economic
transactions of financial assets.

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 The Capital Account

• Consist of:
– Capital Transfers:
The transfer of title to fixed assets & the transfer of funds
linked to the sale or acquisition of fixed assets, gifts and
inheritance taxes…
– Sale & Purchases Of Non-Produced, Non-
Financial Assets:
• The right to natural resources, and the sale & purchase
of intangible assets (patents, copyrights, trademarks,
franchises and leases).

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 The Financial Account

• Three components:
– Direct Investments: investor exerts some
explicit degree of control over the assets
– Portfolio Investments: investor has no control
over the assets
– Other Investments: 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

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 Direct Investment

• This is the net balance of capital dispersed from

and into the U.S. for the purpose of exerting
control over assets.
– When the capital flows out of the U.S., it enters the BOP as
a negative cash flow and vice versa

• Foreign direct investment arises from 10%

ownership of voting shares in a domestic firm by
foreign investors.
• Concern for FDI: control and profit.
– E.g: Restrictions on what foreigners may own in their country.

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 Portfolio Investment

• This is the net balance of capital that flows in and

out of the country but does not reach the 10%
threshold of direct investment.
– E.g: The purchase/sale of debt securities across borders

• Profit-motivated (return), rather than to control

or manage the investment.
• much more volatile than net foreign direct
investment over the past decade

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 Exhibit 4.4 The United States Financial Accounts
and Components, 2002-2010 (billions of U.S.
dollars)

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 Exhibit 4.5 The United States Financial Account,
1985-2010 (billions of U.S. dollars)

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 Exhibit 4.6 Current and Combined Financial/Capital
Account Balances for the United States, 1992-2010 (billions
of U.S. dollars)

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 Official Reserves Accounts

• 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.

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 Net Errors & Omissions

• The BOP must balance unless something

has not been counted or has been counted
improperly
• A subaccount of the BOP, may be
imbalanced, but the entire BOP of a single
country is always balanced.
• The Net Errors and Omissions account
ensures that the BOP actually balances.

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 Breaking the Rules: China’s Twin
Surpluses
• Exhibit 4.7 illustrates China’s highly unusual
twin surplus in both the current and
financial accounts (these relationships are
typically inverse)
• The rapid rise of the Chinese economy has
been accompanied by a 10 fold increase in
foreign exchange reserves (Exhibit 4.8)
• As a result, China’s foreign exchange
reserves are approximately 2.5 times larger
than the next largest (Exhibit 4.9)

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 Exhibit 4.7 China’s Twin Surplus, 1998-
2010 (billions of U.S. dollars)

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 Exhibit 4.8 China’s Foreign Exchange
Reserves (billions of U.S. dollars)

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 Exhibit 4.9 Largest Foreign Exchange Reserves
(billions of U.S. dollars)

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 Exhibit 4.1 Generic Balance of
Payments

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 The BOP in total

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

Where:
X = exports of goods and services
Current Account Balance
M = imports of goods and services
CI = capital inflows Capital Account Balance
CO = capital outflows
FI = financial inflows Financial Account Balance
FO = financial outflows
FXB = official monetary reserves

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 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

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 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

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

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

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 The BOP and Exchange Rates

• 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

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 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
prices of imports and exports, and changing prices
in turn result in changes in quantities demanded
through the price elasticity of demand

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 The BOP and Interest Rates

• Interest rates are used to intervene in the foreign

exchange market,
• The overall level of a country’s interest rates
compared to other countries does have an impact
on the financial account of the BOP
– Relatively low real interest rates should normally stimulate an
outflow of capital seeking higher rates elsewhere
– 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
– 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
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 Exhibit 4.11 Trade Balance Adjustment to
Exchange Rate Changes: The J-Curve

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 Capital Mobility

• The degree to which capital moves freely across

borders is critically important to a country’s balance
of payments
• The free flow of capital in and out of an economy
can potentially destabilize economic activity or can
contribute significantly to an economy’s
development
• Agreement was careful to promote free movement
of capital for current account transactions (e.g.,
foreign exchange or deposits) but less so for capital
account transactions (e.g., foreign direct
investment)

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 Capital Controls

• A capital control is any restriction that limits or

alters the rate or direction of capital movement
into or out of a country
• Free movement of capital is more the exception
than the rule

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 Capital Flight

• Capital flight occurs 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.

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