Chapter 3

The Balance of
Payments

Learning Objectives
Learn how government and multinational
enterprise management uses balance of
payments accounts and accounting in
decision-making
Examine how the primary accounts of the
balance of payments reflects fundamental
economic and financial activities across
borders
Explore how changes in the balance of
payments affect key macroeconomic rates
like exchange rates and interest rates
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Learning Objectives
Analyze how exchange rate changes affect
the prices and competitiveness of
international trade
Evaluate how governments have responded
to the globalization of capital markets in
their use of capital restrictions in an effort to
hinder capital mobility

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The Balance of Payments

To sever natural interrelations is not to make oneself
independent, but to isolate oneself completely.
Frederic Bastiat

The measurement of all international

economic transactions between the
residents of a country and foreign residents
is called the balance of payments (BOP)

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The Balance of Payments

BOP data is important for government policymakers and MNEs
as it is a gauge of a nations competitiveness or health
(domestic and/or foreign)
For a MNE, both home and host country BOP data is important
as:
An indication of pressure on a countrys foreign exchange
rate
A signal of the imposition or removal of controls in various
sorts of payments (dividends, interest, license fees,
royalties and other cash disbursements)
A forecast of a countrys market potential (especially in the
short run)

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Fundamentals of BOP Accounting

A BOP statement is a statement of cash
flows over an interval of time.
A credit is an event, such as the export of a
good or service, that records foreign
exchange earnedan inflow of foreign
exchange to the country.
A debit records foreign exchange spent,
such as payments for imports or purchases
of servicesan outflow of foreign exchange.

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Fundamentals of BOP Accounting

The BOP must balance.
It cannot be in disequilibrium unless
something has not been counted or has
been counted improperly.
Therefore, it is incorrect to state that the
BOP is in disequilibrium.

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Exhibit 3.1 The U.S. Balance of

Accounts, Summary

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The Accounts of the BOP

The BOP has three major sub-accounts
the current account, the capital account,
and the financial account.
In addition, the official reserves account
tracks government currency transactions.
A fifth account, the net errors and
omissions account is produced to preserve
the balance of the BOP.

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The Current Account

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The Current Account includes all international economic

transactions with income or payment flows occurring within one
year, the current period. It consists of the following four
subcategories:
Goods trade and import of goods
Services trade
Income
Current transfers
The Current Account is typically dominated by the first component
which is known as the Balance of Trade (BOT) even though it
excludes service trade
Exhibit 3.2 follows with U.S. trade balance on goods and services

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Exhibit 3.2 U.S. Trade Balances on Goods

and Services

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The Current Account

Merchandise trade is the original core of
international trade.
The manufacturing of goods was the basis of the
industrial revolution and the focus of the theory of
comparative advantage in international trade.
Declines in steel, automobiles, automotive parts,
textiles, and shoe manufacturing have caused
massive economic and social disruption

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The Capital and Financial

Accounts
The capital and financial accounts of the
balance of payments measure all
international economic transactions of
financial assets.
The capital account is made up of transfers
of financial assets and the acquisition and
disposal of nonproduced/nonfinancial assets.
Has only been introduced recently as a separate
account

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The Financial Account

The financial account consists of four components
direct investment, portfolio investment, net
financial derivatives, and other asset investment.
Financial assets can be classified in a number of
different ways including the length of the life of the
asset (maturity) and the nature of the ownership
(public or private).
The financial account, however, uses degree of
control over assets or operations to classify financial
assets.

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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.
The source of concern over foreign investment in
any country focuses on two topics: control and
profit.
Some countries possess restrictions on what
foreigners may own in their country.
Concerns over profit stem from the same argument.

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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 direct
investment.
The purchase of debt securities across borders is classified as
portfolio investment because debt securities by definition 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.
As illustrated in Exhibit 3.3, portfolio investment has shown
much more volatile behavior than net foreign direct
investment over the past decade.

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Exhibit 3.3 The U.S. Financial

Accounts, 1985-2013

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Net Errors and Omissions and

Official Reserves Accounts
Exhibit 3.4 illustrates the current and
financial account balances for the United
States over recent years.
Note the inverse relation between the
current and financial accounts.

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Exhibit 3.4 Current and Financial/Capital

Account Balances for the United States

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Net Errors & Omissions/Official

Reserves Accounts
The Net Errors and Omissions account ensures that
the BOP actually balances.
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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Breaking the Rules: Chinas Twin

Surpluses
Exhibit 3.5 illustrates Chinas highly unusual twin
surplus in both the current and financial accounts
(these relationships are typically inverse).
Note that the financial account surplus fell sizably in
2012, only to rise to a record level in 2013as a
result of continuing deregulation of capital inflows
into the countrys economy.
The reserves allow the Chinese government to
manage the value of the Chinese yuan and its
impact on Chinese competitiveness in the world
economy.

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Exhibit 3.5 Chinas Twin Surplus,

1998-2013

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BOP Impacts on Key Macroeconomic

Rates
A countrys balance of payments both
impacts and is impacted by the three
macroeconomic rates of international
finance:
exchange rates;
interest rates; and
inflation rates

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The BOP and Exchange Rates

The relationship between the BOP and
exchange rates can be illustrated by use of a
simplified equation:

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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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The BOP and Interest Rates

Relatively low real interest rates should
normally stimulate an outflow of capital seeking
higher rates elsewhere
The opposite has occurred in the U.S. due to
perceived growth opportunities and political
stabilityallowing it to finance its large fiscal
deficit
The favorable inflow on the financial account is
diminishing while the current account balance is
worseningmaking the U.S. a bigger debtor
nation vis--vis the rest of the world
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The BOP and Inflation

Imports have the potential to lower a countrys
inflation rate.
Foreign competition substitutes for domestic
competition to maintain a lower rate of inflation
than might have been the case without imports.
On the other hand, to the extent that lowerpriced imports substitute for domestic
production and employment, gross domestic
product will be lower and the balance on the
current account will be more negative.

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Trade Balances and Exchange

Rates
A countrys 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
Theoretically, this is straightforward; in
reality global business is more complex
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Exhibit 3.6 Trade Adjustment to

Exchange Rates: The J-Curve

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Trade Balance Adjustment Path:

The Equation
A countrys trade balance is essentially the
net of import and export revenues.
The U.S. trade balance, expressed in U.S.
dollars, is then expressed as follows:

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Capital Mobility
The degree to which capital moves freely
across borders is critically important to a
countrys balance of payments
The United States financial account surplus
has at least partially offset the current
account deficits over the last 20 or more
years
China has run a surplus in each of these
accounts in recent years

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Capital Mobility
The free flow of capital in and out of an economy
can potentially destabilize economic activity or can
contribute significantly to an economys
development
Thus, Bretton Woods 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)
1970s-1990s saw growth in capital openness, the
financial crisis of 1997/1998 stopped that due to
destructive capital outflows and contagion
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Capital Mobility
The authors argue that the post-1860 era can be
subdivided into four distinct periods with regard to
capital mobility.
1860-1914: continuously increasing capital mobility as the
gold standard was adopted and international trade
relations were expanded
1914-1945: global economic destruction, isolationist
economic policies, negative effect on capital movement
between countries
1945-1971: Bretton Woods era say a great expansion of
international trade
1971-2097: floating exchange rates, economic volatility,
rapidly expanding cross-border capital flows
China and India attempt to open their markets

These points are laid out in Exhibit 3.7.

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Exhibit 3.7 The Evolution of the

Global Monetary System

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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
Exhibit 3.8 outlines several methods of and
purposes for capital controls
Dutch Disease is the name given to the problem of
a substantial currency appreciation due to the
demand for a specific natural resource faced by
several resource-rich smaller nations

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Exhibit 3.8
Purposes of
Capital
Controls

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Capital Flight
Capital flightthe rapid outflow of capital in
opposition to or in fear of domestic political and
economic conditions and policiesis one of the
problems that capital controls are designed to
control.
Although it is not limited to heavily indebted
countries, the rapid and sometimes illegal transfer
of convertible currencies out of a country poses
significant economic and political problems.
Many heavily indebted countries have suffered
significant capital flight.

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Globalization of Capital Flows

Capital inflows are short-term in duration
Even mature markets can encounter crisis

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Global
Finance in
Practice
3.2

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