Chapter Three

The Balance
of Payments INTERNATIONAL 3
FINANCIAL
MANAGEMENT
Chapter Objective:

This chapter serves to introduce the student to the

balance of payments. How it is constructed and how
balance of payments data may be interpreted.
EUN / RESNICK
Second Edition
 Chapter Three Outline
 Balance of Payments Accounting
 Balance of Payments Accounts
 The Current Account
 The Capital Account
 Statistical Discrepancy
 Official Reserves Account
 The Balance of Payments Identity
 Balance of Payments Trends in Major
Countries
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 Balance of Payments Accounting
 The Balance of Payments is the statistical record
of a country’s international transactions over a
certain period of time presented in the form of
double-entry bookkeeping.
 Credit balance shows receipts of foreign exchange
from abroad and debit balance shows payments in
foreign exchange.
N.B. when we say “a country’s balance of payments” we are referring
to the transactions of its citizens and government.
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 Balance of Payments Example
 Suppose that Maplewood Bicycle in
Maplewood Missouri, USA imports
$100,000 worth of bicycle frames from
Mercian Bicycles in Darby England.
 There will exist a $100,000 credit recorded
by Mercian that offsets a $100,000 debit at
Maplewood’s bank account.
 This will lead to a rise in the supply of
dollars and the demand for British pounds.

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 Balance of Payments Accounts
 The balance of payments accounts are those that
record all transactions between the residents of a
country and residents of all foreign nations.
 They are composed of the following:
 The Current Account
 The Capital Account
 Statistical Discrepancy
 The Official Reserves Account

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 The Current Account
 Includes all imports and exports of goods and
services. (Balance Of Trade)
 Includes unilateral transfers of foreign aid.
 Invisibles includes on account of trade in services
like travel, tourism, investment income and
unilateral transfer .
 Non monetary movement of golds.
 If the debits exceed the credits, then a country is
running a trade deficit.
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 Assignment
 Find out the balance of trade and balance of
current account from the following details.
Item Amount in $
Inflow on account of services 1000
Outflow on account of services 800
Outflow of dividend 1100
Inflow of dividend 560
Export of goods and services 10000
Import of goods and services 12000
Remittances (Net Receipts) 1200

3-7
 The Capital Account
 The capital account measures the difference between U.S.
sales of assets to foreigners and U.S. purchases of foreign
assets.
 The capital account is composed of Foreign Direct
Investment (FDI), Foreign Loans , Banking Transaction ,
Portfolio investments and other capital flows.
 Credit side – Borrowing from countries abroad, FDI and FPI and short
term investment.
 Debit side – Country’s investment and loans abroad and bank
balances held abroad. If the Credit side and debit side difference is
known as Basic Balance.which may be +/-.
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 Assignment
 Find out the Balance of Capital Account if inflow of loan
$2000, Repayment of loan $ 2150 FDI inflow $7000 FDI
outflow $1500 FII’s Investment in India $500 Short term
movement of funds $-200.

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 Statistical Discrepancy
 There’s going to be some omissions and mis
recorded transactions—so we use a “plug” figure
to get things to balance.
 This may arise due to different source of data.
 Or difference due to transaction recording now
and actual payment in next year.

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 The Official Reserves Account
 Official reserves assets include gold, foreign currencies,
SDRs, reserve positions in the IMF.
 Beginning from 2nd April, 2004 in order to conform to the
international practice the amount deposited with IMF
under reserve tranche at IMF is also treated as a
component of ORA.
 The basic purpose of ORA is to maintain the foreign
exchange incomings and
 To meet Balance of Payments Deficit by withdrawing
from ORA.
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 Summing up we get
 BOT= E-I
 BCA=BOT+ Net Earning on Invisibles
 BKA = FE Inflow – FE Outflow on account of
foreign investment and loan.
 Overall BOP = BCA+BKT+SD

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  Find out the foreign account reserve from the
following data:
 Opening Foreign exch reserve - $70000
 Balance of current account - $(5500)
 Balance of Capital Account $ 2000
 Statistical Discrepancy during the year - $(500)

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 The Balance of Payments Identity
BCA + BKA + BRA = 0
This situation is called accounting equilibrium
where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account
Under a pure flexible exchange rate regime,
BCA + BKA = 0

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 U.S. Balance of Payments Data
  Credits Debits
Current Account    
1 Exports $1,167.61  
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)

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 U.S. Balance of Payments Data
  Credits Debits
Current Account     In 1997, the
1 Exports $1,167.61  
U.S. imported
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
more than it
  Balance on Current Account ($166.80) exported, thus
Capital Account     running a
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28) current account
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) deficit of
  $264.58  
7 Statistical Discrepancies   ($96.76) $166.8 billion.
  Overall Balance $1.02  
Official Reserve Account ($1.02)

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 U.S. Balance of Payments Data
  Credits Debits During the same
Current Account     year, the U.S.
1 Exports $1,167.61  
2 Imports   ($1,295.53)
attracted net
3 Unilateral Transfers $6.13 ($45.01) investment of
  Balance on Current Account ($166.80) $264.58 billion
Capital Account    
4 Direct Investment $107.93 ($119.44)
—clearly the
5 Portfolio Investment $387.62 ($79.28) rest of the world
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
found the U.S.
7 Statistical Discrepancies   ($96.76) to be a good
Overall Balance
 
Official Reserve Account
$1.02  
($1.02)
place to invest.

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 U.S. Balance of Payments Data
  Credits Debits
Current Account
1 Exports
 
$1,167.61
 
 
Under a pure
2 Imports   ($1,295.53)
flexible
3 Unilateral Transfers $6.13 ($45.01) exchange rate
  Balance on Current Account ($166.80) regime, these
Capital Account    
4 Direct Investment $107.93 ($119.44) numbers would
5 Portfolio Investment $387.62 ($79.28) balance each
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
other out.
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)

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 U.S. Balance of Payments Data
  Credits Debits
Current Account
1 Exports
 
$1,167.61
 
 
In the real
2 Imports   ($1,295.53)
world, there
3 Unilateral Transfers $6.13 ($45.01) is a statistical
  Balance on Current Account ($166.80) discrepancy.
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)

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 U.S. Balance of Payments Data
  Credits Debits
Current Account
1 Exports
 
$1,167.61
 
 
Including that,
2 Imports   ($1,295.53)
the balance of
3 Unilateral Transfers $6.13 ($45.01) payments identity
  Balance on Current Account ($166.80) should hold:
Capital Account    
4 Direct Investment $107.93 ($119.44) BCA + BKA + BRA=0
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Capital Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)
($166.80) + $264.58 + ($96.76) = $1.02= –($1.02)
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 Balance of Payments and the
Exchange Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P S
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
  $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02   Q
Official Reserve Account ($1.02) Exchange rate $
McGraw-Hill/Irwin 3-21 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
 Balance of Payments and the
Exchange Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P S
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
  $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02   Q
Official Reserve Account ($1.02) Exchange rate $
As U.S. citizens import, they are supply dollars to the FOREX market.
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 Balance of Payments and the
Exchange Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P S
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
  $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02   Q
Official Reserve Account ($1.02) Exchange rate $
As U.S. citizens export, others demand dollars at the FOREX market.
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 Balance of Payments and the
Exchange Rate
  Credits Debits
Current Account    
1 Exports $1,167.61   P SS
2 Imports   ($1,295.53) 1

3 Unilateral Transfers $6.13 ($45.01)

  Balance on Current Account ($166.80)
Capital Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
  $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02   Q
Official Reserve Account ($1.02) Exchange rate $
As the U.S. government sells dollars, the supply of dollars increases.
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 Balance of Payments Trends
U.S. Balance of Payments Trends

200
Balance of Payments ($b)

150
100
50
Current Account
0
Capital Account
-50
-100
-150
-200
Year

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 Balance of Payments Trends
Japan's Balance of Payments Trend

150
Balance of Payments ($b)

100

50
Current Account
0
Capital Account
-50

-100

-150
Year

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 Balance of Payments Trends
Germany's Balance of Payments Trend

80
Balance of Payments ($b)

60
40
20
Current Account
0
Capital Account
-20
-40
-60
-80
Year

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 Accounting Equilibrium
 If debit on current account is greater than the
credit, funds flow into the country that are
recorded on the credit side of the capital account.
 The excess debit is wiped out.
 So concept of Balance of payment is based on the
concept of accounting equilibrium.
 The accounting balance is an ex-post concept
which has actually happened over a specific
period.
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 Disequilibrium
 Normally such equilibrium are not found and
disequilibrium is a common phenomenon.
 If national income exceeds national spending the excess
amount will be invested abroad resulting in capital account
deficit and vice versa.
 If national output exceeds national spending the
difference manifests itself in export causing a current
account surplus.
 The surplus is invested abroad which means a capital
account deficit.
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 Disequilibrium
 If deficit on current account continues to persist
ORA will be eroded. And more borrowing will be
required
 Persisting current account deficit means more
spending on imports and saving ratio will fall and
more capital flows will lead to disequilibrium.
 This will make the country in vicious debt trap.
 So adjustment measures have to be taken to
correct disequilibrium.
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 Approaches to adjustment
 Classical View (David Hume) :
 Self adjusting process (Specie Flow Mechanism)
 Trade Deficit will lead to outflow of Gold
 Money supply is decreased (Spending power less)
 Decrease in price makes export price more
competitive
 So export will again rise to remove the deficit.

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 Elasticity Approach (Marshall and
Lerner)
 Trade deficit will be followed by devaluation of
currency.
 Exports become cheaper in international market.
 Will lead to higher export earning
 Import will be costlier so import bills will be
squeezed so less Import amount.
 Elimination of trade deficit.

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 Mundell-Flemming Approach
 Rise in interest rate will lead to lower income
 Lower income means lower import
 Elimination of trade deficit
 Again if there is rise in interest rate may attract
more capital flows
 So improvement in capital account will absorb
trade deficit.

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 New Cambridge School approach
 It advocates for greater taxes plus lower
governmental expenditure
 Leads to lower income
 Lower income means lower import
 Elimination of trade deficit.

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 Capital Account Convertility
 It means relaxing controls on capital account
transactions.
 It can be a quantitative restrictions on capital
movement or imposition of tax on the outflow of
the funds.
 So CAC is the freedom to convert local financial
assets into foreign financial assets and vice versa
at market determined rates of exchange.

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