Chapter 2

The Balance of Payments

and International Flow of Funds
 Chapter Content

1. Balance of Payments (BoP)

✓ The role of BoP
✓ Key components of BoP
✓ Links between components of BoP
2. International Trade Flows
✓ Factors Affecting International Trade Flows
3. International Capital Flows
✓ Factors Affecting International Capital Flows
 Balance of Payments
✓ International business transactions occur in many
different forms over the course of a year.
✓ BoP is an accounting and a summary of all
international economic transactions between the
residents of a country and foreign residents.
✓ It shows the country’s trading position, net position as
foreign lender or borrower, and changes in its official
reserve holding.
✓ Composed of the three main accounts: current
account, capital account and financial account.
 Balance of Payments
Why is BoP important?

✓ BoP gives info on demand and supply of currencies =>

help determine whether the country’s currency is
appreciating/depreciating
✓ It reveals financial & economic status => implications
for policymakers & managers.
✓ For an MNE, both home and host country BoP data are
important:
– They indicate pressure on a country’s exchange rate
– An adverse BoP position => exchange control to
restrict non-essential imports, control capital outflow
– A forecast of a country’s market potential (especially
in the short run)
 Fundamentals of BOP Accounting
Debits and credits in double-entry accounting
✓ Accounts normally containing a debit balance will
increase in amount when a debit is added to them, and
vice versa (expenses, assets).
✓ Accounts normally containing a credit balance will
increase in amount when a credit is added to them, and
vice versa (liabilities, revenues, and equity).
Use of money Source of money
Debit Credit
Asset Accounts Increase Decrease
Expense Accounts Increase Decrease
Liability Accounts Decrease Increase
Equity Accounts Decrease Increase
Revenue/Income
Decrease Increase
Accounts
 Fundamentals of BoP Accounting
✓ Every txn should be recorded with both debit and
credit sides => BoP account balances should be
summed up to zero
✓ Transactions resulting in payments from residents
to nonresidents are recorded as debits.
✓ Mainly comprise:
+ decreases in liabilities
+ increases in assets/goods
✓ Typically, this is when residents receive
goods/services/financial assets from nonresidents
 Fundamentals of BoP Accounting
✓ Every txn should be recorded with both debit and
credit sides => BoP account balances should be
summed up to zero
✓ Transactions resulting in payments to residents
from nonresidents are recorded as credits.
✓ Mainly comprise:
+ increases in liabilities
+ decreases in assets/goods
✓ Typically, this is when residents sell
goods/services/financial assets to nonresidents
 Fundamentals of BoP Accounting
✓ In compiling the BoP account, like in the
compilation of other national accounts statistics, it
is necessary to distinguish residents of an economy
from non-residents.
✓ For individuals, residents refer to those who
normally stay in the economic territory of the
economy, irrespective of their nationality.
✓ For organizations, residents refer to those which
ordinarily operate in the economic territory.
 Residents
Sống ở VN Sống ở nước ngoài
Tổ chức kinh tế thành lập, kinh doanh Văn phòng đại diện ở nước ngoài
tại VN
CQNN, lực lượng vũ trang, tổ chức Văn phòng đại diện ở nước ngoài
chính trị xã hội, quỹ XH, quỹ từ thiện
của VN hoạt động tại VN
Công dân VN làm việc tại các tổ chức
là văn phòng đại diện của các tổ chức
VN, cơ quan ngoại giao, lãnh sự của
VN ở nước ngoài
Công dân VN tại VN
Công dân VN cư trú ở nước ngoài < 12
tháng
Công dân VN đi du lịch, học tập, chữa
bệnh, thăm viếng ở nước ngoài
Người nước ngoài cư trú ở VN >12
tháng, trừ mục đích học tập, chữa
bệnh, du lịch, làm việc cho CQĐDNG,
lãnh sự, văn phòng các tổ chức nước
ngoài tại VN
 Fundamentals of BoP Accounting
Classification Rules

Debits Credits
Reflect use of funds Reflect source of funds

- Increase in overseas assets - Decrease in overseas assets

(e.g., buy financial assets (sell financial assets)
(stock, bond)

- Decrease in overseas - Increase in overseas

liabilities liabilities
- Increase in Official reserves - Decrease in Official reserves
(gold, foreign exchange) (gold, foreign exchanges)
Fundamentals of BoP Accounting
Examples
Debits
Imports
Income payments to
nonresidents from investing in
home country (interest &
dividend)
Unilateral transfers to
nonresidents (aids, gifts)
Capital outflows (make deposits
in banks abroad, buy foreign
stocks, bonds)
Increase in Official reserves
(gold, foreign exchange)
Credits
Exports
Income from investing abroad
Unilateral transfers from
nonresidents
Capital inflows (foreign deposits
in domestic banks, sell domestic
stocks, bonds to nonresidents)
Decrease in Official reserves
(gold, foreign exchanges)
Fundamentals of BoP Accounting
BoP is often misunderstood as a balance sheet, whereas
in fact it is a cash flow statement
✓ It does not add up the value of all assets and
liabilities of a country on a specific date (as a firm’s
balance sheet would do)
✓ By recording all international transactions over a
period, it tracks the continuing flows of purchases
and payments between a country and all other
countries
 Accounts of BOP
✓ BOP is composed of three primary sub accounts:
Current Account, Capital Account and Financial
Account
✓ The Official Reserves account tracks government
currency transactions. This is also known as Official
Financing Balance.
✓ The Net Errors and Omissions account, is produced to
preserve the balance of the BoP.
 Current Account
• Current Account includes all international economic
transactions with income or payment flows occurring
within one year. It consists of the following 4
subcategories:
– Goods trade
– Services trade
– Primary Income
– Secondary income/Current transfers
• Current Account is typically dominated by the first
component which is known as the Balance of Trade
(BOT) even though it excludes services trade
 Current Account
• Primary income/factor income:
– Mostly composed of income earned by MNCs on their
DFI (investment in fixed assets), and income earned by
investors on portfolio investment (investments in
foreign securities).
– Labor income
– Primary income received reflects an inflow of funds.
Primary income paid reflects an outflow of funds.
– Net primary income = receipts - payments.
• Secondary income/current transfers:
– Aid/grants/gifts from another country; remittances
– A cash transfer is classified as current transfer except
when linked to the acquisition or disposal of a fixed
asset.
– Net secondary income = receipts - payments
 Current Account
• Payment entries:
– Transactions generating a cash inflow (exports
and income receipts) represent a credit.
– Transactions generating a cash outflow (imports
and income payments) represent a debit.
– So, a large current account deficit indicates that
the United States is sending more cash abroad.
United States, BOP (billions of U.S.
Dollars) – Current Account
Current Account Transactions - Examples
 Questions
Classify the following as a transaction reported in a
subcomponent of the current account of the two
countries involved:
a. A US food chain imports wine from Chile.
b. Vietnamese parents pay for their son who is studying
at Tokyo University.
c. A Vietnamese university gives a scholarship to a
Laotian student.
d. FPT – Vietnam buys insurance from Prudential – the
US.
 Questions
e. The Vietnamese government hires a Japanese
company to build metro in Ho Chi Minh City.
f. A Thai drug gang smuggles heroine into Vietnam,
receives cash in USD and comes back to Thailand with
the cash.
g. The Vietnamese government pays the salary of
ambassador working in the Vietnamese Embassy in the
Netherlands.
h. A Vietnamese employee working at the International
Committee of the Red Cross in Cambodia and is paid in
Swiss francs.
i. A Vietnamese tourist pays for a lunch in Kuala
Lumpur with her HSBC credit card.
 Capital Account
Capital Account records:
✓ Capital transfers: debt forgiveness and value of financial
assets transferred across country borders by people who
move to a different country.
✓ Acquisition/disposal of non-produced, non-financial
assets:
+ intangible: brand name, copyrights, trademarks
+ tangible: rights to use land/water (for mining, fishing)
✓ Non-financial non-produced assets consist of assets
that have not been produced within the production
boundary, and that may be used in the production of goods
and services.
 Financial Account
Financial Account records:
– Direct Investment – in which the investor exerts
some explicit degree of control over the assets
– Portfolio Investment – in which the investor has
no control over the assets
– Other Investment – Other investment is a residual
category that includes all financial transactions not
considered direct investment, portfolio investment.
– DI measures the expansion of firms’ foreign
operations, whereas PI and OI measure the net flow
of funds due to financial asset transactions.
 Financial Account
✓ Transactions that lead to increase in foreign
assets/decrease in foreign liabilities are recorded as
debit (use of funds)
✓ Transactions that lead to decrease in foreign
assets/increase in foreign liabilities are recorded as
credit (source of funds)
 Direct Investment
✓ This is the net balance of capital that flows from
and into a country to exert control over assets.
✓ Foreign direct investment arises from 10%
ownership of voting shares in a domestic firm by
foreign investors.
✓ The source of concern over foreign investment in
any country focuses on two topics: control and
profit.
✓ Some countries impose restrictions on the assets
(profits) foreigners may own (repatriate) in their
country.
 Portfolio Investment
✓ This is the net balance of capital that flows in and
out of the U.S. but does not reach the 10%
threshold of ownership as of direct investment.
✓ The purchase of debt securities across borders is
also classified as portfolio investment because
debt securities do not provide the buyer with
ownership or control.
✓ Portfolio investment is motivated by a search for
returns rather than to control or manage the
investment.
 Official reserves
✓ Convertible foreign currency (“hard” currency)
✓ Gold
✓ Special drawing rights (SDR)
✓ Foreign bond denominated in a hard currency
 Questions
Classify the following as a transaction reported in a
subcomponent of the capital account/ financial account
of the two countries involved:
a. A Vietnamese resident purchases a Japanese yen-
denominated bond from a Japanese company.
b. Samsung builds a factory of $ 20 million in Thu
Duc.
c. A Vietnamese company buys a patent from Toyota –
Japan.
 Questions

Double-entry bookkeeping
a. Boeing sells a 747 airplane of $750 million to Vietnam
Airlines. VNA pays with a syndicate loan underwritten
by two US banks.
b. Agribank buys $100 million of 10-year US Treasury
bonds for Trung Nguyen Coffee and pays for it by using
its deposit on dollar account with Citibank in the US.
c. Apple pays dividend of $50,000 to a Japanese investor
in Tokyo. The Japanese investor deposits the dividend in
his dollar account at the Bank of Mizuho in the US.
 Balance of Payments

Relationships
✓ CA = current account
✓ KA = financial & capital accounts
✓ OB = CA + KA (Overall Balance)
✓ FR = foreign reserves.
Generally, CA and KA have opposite signs.
There are usually omissions & errors in compiling
CA and KA, so:
OB = CA + KA + OM
 Balance of Payments
OB >0: foreign exchange inflows > outflows
✓ FR is likely to increase to absorb the surplus
✓ ΔFR <0
OB <0: foreign exchange inflows < outflows
✓ FR is likely to decrease to fund the deficit
✓ ΔFR >0
Theoretically:
CA + KA + ΔFR = 0 (if no error/omission, or OM=0)
Realistically:
CA + KA + OM + ΔFR = 0
 Balance of Payments
✓ OFB = ΔFR (Official Financing Balance)
✓ OB + OFB = 0 (because BoP has to balance)
✓ OB = - OFB = - ΔFR
✓ CA + KA + OM = - OFB
Or:
✓ OM = -(OFB + CA + KA)
This is the formula to determine the errors in the
compilation of BOP.
 Balance of Payments
✓ OFB reflects the change in official reserves
✓ OB tends to be not in balance (OB is not 0), and this
imbalance is offset by OFB
In other words:
✓ when OB < 0 (deficit), central banks will provide the
foreign exchange/reduce reserves, or OFB>0
✓ when OB > 0 (surplus), central banks will absorb the
excess foreign exchange/increase reserves, or OFB<0
✓ Once again, recall that OB = - OFB or OFB = - OB
 Current & Financial accounts

✓ national income = domestic goods & services + exports

✓ national spending = domestic goods & services + imports
✓ national income – national spending = exports – imports

Therefore:
✓ national income > domestic expenditures => Current
Account surplus
✓ national income < domestic expenditures => Current
Account deficit
 Current & Financial accounts
✓ national income = consumption + saving
✓ national spending = consumption + domestic investment
✓ national income – national spending = saving – domestic
investment = net foreign investment

Therefore:
✓ nation’s income > spending => saving > domestic
investment => financial-account deficit
✓ nation’s income < spending => saving < domestic
investment=> financial account surplus
 Current & Financial accounts

✓ national income – national spending = saving – domestic

investment
✓ national income – national spending = exports – imports
✓ saving – domestic investment = exports - imports

Therefore:
✓ nation’s saving > domestic investment => Current
Account surplus.
✓ nation’s saving < domestic investment => Current
Account deficit.
 Current & Financial accounts

✓ saving – domestic investment = exports – imports

✓ saving – domestic investment = net foreign investment
✓ net foreign investment (net capital outflow) = exports -
imports

Therefore:
✓ Balance on current account = net capital outflow
✓ CA surplus => net capital exporter
✓ CA deficit => net capital importer
 Current & Financial accounts

✓ Balance on current account = net capital outflow

✓ CA surplus => net capital exporter
✓ CA deficit => net capital importer

Implications
✓ Excess of goods & services bought must be financed by
an equal amount of borrowing from abroad (FA
surplus)
✓ Theoretically, CA balance and FA balance must
exactly offset one another.
 Question
Suppose Vietnam has a national government saving
surplus of $10 billion.
At the same time, investment in Vietnam exceeds private
savings by $15 billion.
What can you conclude about Vietnam's balance on current
account?
 Question

In December 1994, a major earthquake rocked Kobe, Japan,

destroying the housing stock of more than 300,000 people
and ruining bridges, highways, and railroad tracks.
What impact, if any, do you think this event had on the
Japanese current account deficit? Why?
Question
Question
International Trade Flows
 International Trade Flows
✓ Different countries rely on trade to different extents.
✓ The trade volume of European countries is typically
between 30 – 40% of their respective GDP.
✓ Meanwhile, the trade volume of U.S. and Japan is
typically between 10 – 20% of their respective GDP.
✓ Nevertheless, the volume of trade has grown over time
for most countries.
Vietnam Trade (2010 – 2021)
 Factors Affecting International
Trade Flows
• Cost of labor
- Countries where labor costs are low typically have an
advantage, especially in labor-intensive industries.
• Inflation
- A relative increase in a country’s inflation rate will
decrease its current account, as imports increase and
exports decrease.
 Factors Affecting International
Trade Flows
• Credit conditions
- When credit conditions become more restrictive,
MNCs receive little funding, thus reducing their
corporate spending => reduce their demand for
imported supplies
• National Income
- A relative increase in a country’s income level will
decrease its current account, as imports increase.
 Factors Affecting International
Trade Flows
• Government Restrictions/Policies
– A government may reduce its country’s imports by
imposing tariffs on imported goods, or by enforcing a
quota.
– Other countries may retaliate by imposing their own
trade restrictions for economic reasons.
– Sometimes though, trade restrictions may be
imposed on certain products for health and safety
reasons.
– Subsidies for exporters
– Restrictions on piracy
 Factors Affecting International
Trade Flows
• Government Restrictions/Policies
– Tax breaks
– Labor laws
– Business laws
– Country trade requirements
– Country security law
 Factors Affecting International
Trade Flows
• Exchange Rates
– If a country’s currency begins to rise in value, its
current account balance will decrease as imports
increase and exports decrease.
• Note that the factors are interactive, such that their
simultaneous influence on the balance of trade is a
complex one
 Questions
✓ Accel Co. produces tennis rackets in the Netherlands
and sells them online to consumers in the U.S. at €100.
✓ Malibu Co. is a U.S. producer and Accel’s competitor,
selling the same kind of racket of the same quality at
$140. It also sells some of rackets to European
countries.
✓ Eleven months ago, the exchange rate was €/$ = 1.60;
the exchange rate now is €/$ = 1.20.
✓ Calculate the price of Accel racket in the US market
before and after the change of exchange rate.
✓ What can you say about the demand for Accel racket in
the US market before and after the change?
 Correcting A Balance of Trade Deficit
✓ By reconsidering the factors that affect the balance of
trade, some common correction methods can be
developed.
✓ For example, a floating exchange rate system may
correct a trade imbalance automatically since the trade
imbalance will affect the demand and supply of the
currencies involved.
 Correcting A Balance of Trade
Deficit
• However, a weak home currency may not necessarily
improve a trade deficit.
– Foreign firms may lower their prices to maintain
their competitiveness.
– Some other currencies may weaken too.
– Many trade transactions are prearranged and cannot
be adjusted immediately. Higher cost of imports will
more than offset the reduced imports. This is known
as the J-curve effect.
– The impact of exchange rate movements on
intracompany trade is limited.
J-Curve Effect
 Correcting A Balance of Trade
Deficit
Measures thought to improve CA deficits might backfire:
– Protectionism: this could lead to lower exports due to
possible appreciation of home currency (due to less
demand for imports), or higher input costs for producing
exports. Also, residents may look for imports elsewhere.
– Ending foreign ownership of domestic assets: If foreigners
cannot hold claims on the nation, they will export = what
they are willing to import, ending net capital inflows. But
this will raise real domestic interest rates => more
savings & less investment => slow growth.
International Capital Flows
 International Capital Flows
✓ Capital flows usually represent portfolio investment or
direct foreign investment.
✓ The DFI positions inside and outside the U.S. have
risen substantially over time, indicating increasing
globalization.
✓ Both DFI positions increased during periods of strong
economic growth.
Vietnam’s Investment (2010 – 2021)
 Factors Affecting DFI
• Changes in Restrictions
– New opportunities may arise from the removal of
government barriers.
• Privatization
– DFI has also been stimulated by the selling of
government operations.
• Potential Economic Growth
– Countries with higher potential economic growth are
more likely to attract DFI.
 Factors Affecting DFI
• Tax Rates
– Countries that impose relatively low tax rates on
corporate earnings are more likely to attract DFI.
• Exchange Rates
– Firms will typically prefer to invest their funds in a
country when that country’s currency is expected to
strengthen.
• Change in restrictions
 Factors Affecting DFI
1. What are the advantages and disadvantages of DFI,
compared to other funding sources?
2. How could governments encourage DFI?
 Factors Affecting International
Portfolio Investment
• Tax Rates on Interest or Dividends
– Investors will normally prefer countries where the
tax rates are relatively low.
• Interest Rates
– Money tends to flow to countries with high interest
rates.
• Exchange Rates
– Foreign investors may be attracted if the local
currency is expected to strengthen
Vietnam’s Investment (2010 – 2021)
Impact of International capital flows

• Tax Rates on Interest or Dividends

– Investors will normally prefer countries where the
tax rates are relatively low.
• Interest Rates
– Money tends to flow to countries with high interest
rates.
• Exchange Rates
– Foreign investors may be attracted if the local
currency is expected to strengthen
Agencies that Facilitate International Flows
International Monetary Fund (IMF)
• The IMF is an organization of 183 member countries.
Established in 1946, it aims
– to promote international monetary cooperation and
exchange stability;
– to foster economic growth and high levels of
employment; and
– to provide temporary financial assistance to help
ease imbalances of payments.
Agencies that Facilitate International Flows
International Monetary Fund (IMF)
• Its operations involve surveillance, and financial
and technical assistance.
• Its compensatory financing facility attempts to
reduce the impact of export instability on country
economies.
• The IMF uses a quota system, and its unit of
account is the SDR (special drawing right).
 Agencies that Facilitate International Flows
World Bank Group
• Established in 1944, the Group assists development
with the primary focus of helping the poorest people
and the poorest countries.
• It has 183 member countries, and is composed of five
organizations - IBRD, IDA, IFC, MIGA and ICSID.
 Review
Factors Affecting Exchange Rates.
If Asian countries experience a decline in economic
growth (and experience a decline in inflation and interest
rates as a result), how will their currency values (relative
to the U.S. dollar) be affected?
 Review
Impact of Crises
✓ Why do you think most crises in countries (such as the
Asian crisis) cause the local currency to weaken
abruptly?
✓ Is it because of trade or capital flows?
 Review
✓ Is a current account deficit something to worry about?
✓ If a government wants to correct a current account
deficit, why can’t it simply enforce restrictions on
imports?
✓ Why might different tax laws on corporate income
across countries allow firms from some countries to
have a competitive advantage in the international trade
arena?
 Review
✓ Assume that the dollar is presently weak and is
expected to strengthen over time. How will these
expectations affect the tendency of U.S. investors to
invest in foreign securities?
✓ It is sometimes suggested that a floating exchange rate
will adjust to reduce or eliminate any current account
deficit. Explain why this adjustment would occur.
 Review
✓ Why does the exchange rate not always adjust to a
current account deficit?
✓ If a country imposes lower corporate income tax rates,
does that provide an unfair advantage?