BSc Financial Economics International Finance Professor Anne Sibert

International Finance

Lecture 1 Balance of Payments Accounting

Definition: The balance of payments is a record of transactions between residents of a country and residents of the rest of the world.

The balance of payments is use to: ‡ project exchange rates ‡ assess the health of the economy ‡ assess the credit worthiness of an economy

Credit : this means ´rightµ. Definition. once as a debit and once as a credit. Definition. Definition. Liabilities are outsiders claims against assets. Debit : this means ´leftµ. Assets are economic resources which are expected to benefit future activities. Definition. .Balance of payments accounting is based on the principles of double-entry bookkeeping : each transaction is recorded twice.

. ‡ It is a measure of the change in a country·s net worth.Current Account ‡ The Current Account is a record of transactions affecting the left-hand side of the budget constraint. ‡ It is a record of trade in goods in services (including the services of capital and labour) and gifts.

Current Account ‡ Merchandise Trade ‡ Services ‡ Income ‡ Current Transfers .

Merchandise Trade This is trade in physical goods such as computers and automobiles. .free on board Merchandise imports. It is often broken down into Merchandise exports.cost insurance freight.

travel. financial services. tourism ‡ The sum of merchandise trade and services is called the trade balance .Services ‡ This is trade in invisible or intangible goods. insurance. communications. ‡ Examples are: shipping.

pension payments.Current Transfers These are one-sided transactions such as government grants. . and private gifts.

The Capital Account ‡ A complication arose because debt forgiveness was distorting balance of payments numbers. ‡ It was decided to include only gifts that would be consumed within a year in the current account and to make up a new account called the Capital Account that would include long-term gifts such as debt forgiveness. . the left-hand side of the budget constraint should actually be the Current Account plus the Capital Account. ‡ Thus. ‡ The Capital Account is unimportant for the UK or the US.

.change in domestic ownership of foreign assets.‡ Current acc=exports-imports ‡ Capital acc=change in foreign ownership of domestic assets.

Is this an increase or a decrease Is this a in an debit or a asset? credit? A country buys a good or a service A country sells a good or a service Increase (it has more goods and services) Is it entered as a positive or a negative number Negative Debit Decrease (it has fewer Credit goods and services) Positive .

Thus we have: Exports ² Credits ² Positive Entry Imports ² Debits ² Negative Entry A positive balance on the current account means that a country sold more than it bought A negative balance on the current account means that a country bought more than it sold .

Pink Book .The UK Current Account 2006 350000 300000 250000 200000 50000 00000 50000 0 erch n i e Tr e er ice nco e Tr n er Cre it De it In millions.

G-7 Current Accounts as a Share of GDP 2007 6 4 2 0 Canada -2 France Germany I aly   Japan UK US -4 -6 -8 Source: IMF estimate .

Current Account Deficit as a Share of GDP 4 S 4 8 8 98 98 99 99 99 99 99 4 .

The Financial Account ‡ This is the right-hand side of the government·s budget constraint. . ‡ The financial account is a record of capital flows between residents of a country and the rest of the world.

Once can also break it down between foreign claims on the home country and home claims on foreigners. This is typically defined as purchasing 10 percent of a firm·s stock. Portfolio investment: Investment without the intention of exercising management control. secondary markets exist for many long-term financial assets and this has become increasingly meaningless. Portfolio investment used to be further broken down between short.One way to break down capital flows is by the type of transaction. But. Direct investment: When residents of a country acquire shares in a foreign business with the intent of exercising management control. 2. There are two main types of capital flows 1.and long-term flows. .

Home purchase of a foreign asset Foreign sale of a home asset Home sale of a foreign asset Foreign purchase of a home asset Capital outflow Capital outflow Capital inflow Capital inflow Increase in an asset Decrease in a liability Decrease in an asset Increase in a liability Debit Negative entry Debit Negative entry Credit Positive entry Credit Positive entry .

‡ When fixed exchange rates were more prevalent this used to be separate from the financial account.Reserve Account ‡ A special sub-account of the financial account is the reserve account. ‡ The reserve account is a record of changes in the home country·s official (government) assets. .

This is the foreign currency held by the central bank. .Foreign Reserves ‡ For most countries the most important component is their foreign exchange reserves. ‡ When a central bank intervenes in the exchange market to influence the value of its currency it uses its foreign exchange reserves.

The central bank buys foreign exchange The central bank sells foreign exchange This is an increase in an asset debt Negative entry This is a decrease in an asset credit Positive entry .

‡ Another definition of the balance of payments is minus one times the reserve account balance. increase in an asset): Reserves rose. decrease in an asset): Reserves fell. ‡ A positive (negative) balance of payments: reserves rose (fell) . ‡ Positive balance (credit.Reserve Account Balance ‡ Negative balance (debit.

that is. all of the transactions should sum to zero. ‡ In practice. ‡ So. it does not work out that way. . once as a positive number and once as the same negative number.Errors and Omissions ‡ Each transaction is entered once as a debit and once as a credit.

errors can be substantial.Errors and Omissions ‡ Data on merchandise trade comes from customs declarations. people try to hide these to evade taxes. ‡ Trade in services is typically estimated by various sampling techniques. ‡ Reporting of capital flows and investment income is highly imperfect. . ‡ The Statistical Discrepancy or Errors and Omissions is the amount we need to add or subtract to make things add up to zero.

Balance of Payments Current Account Merchandise Trade Exports Imports Services Income Current Transfers Capital Account Financial Account Direct Investment Portfolio Investment Home claims on Foreigners Foreign Claims on the Home Country Reserves Errors and Omissions .

Examples for the Mythical Country of Pongoland Which account is credited? Which account is debited? .

It is a decrease in a liability so debit Foreign Claims million. ‡ The equipment is a Merchandise Export. so credit Merchandise Exports million. ‡ The cheque is a Foreign Claim on Pongoland.A European importer buys million pongos worth of equipment from a Pongoland firm. ‡ It is a decrease in an asset. . Payment is made with a cheque drawn on a Pongoland bank.

Payment is made with cheques drawn on Pongoland banks.2 million.2 million. ‡ It is an increase in an asset so debit Merchandise Imports 1. .Pongoland imports 1. ‡ The food is a Merchandise Import. ‡ The payment is a Foreign Claim on Pongoland.2 million pongos of food from Latin America. ‡ It is an increase in a liability so credit Foreign Claims 1.

‡ They are an increase in a liability. They pay with Pongoland travellers· cheques.Pongoland tourists spend 00.000 pongos while travelling in Europe. million. million. ‡ It is an increase in an asset so debit Services . ‡ The tourism is a Service. so credit Foreign Claims . ‡ The travellers· cheques are a Foreign Claim on Pongoland. .

It pays with cheques drawn on Pongoland banks.A Pongoland company purchases 20 percent of a European Company for 00. ‡ Credit Foreign Claims . million .000 pongos. million. ‡ Debit Direct Investment .

‡ Debit Current Transfers . million .000 million of agricultural products.The government of Pongoland provides foreign aid to a country in the form of 00. million ‡ Credit Exports .

debit Pongoland Claims. ‡ The cheques are Pongoland Claims on Foreigners. Or.2 million. They are paid with cheques drawn on foreign banks. ‡ This is an increase in an asset. . ‡ They are no longer owed the income so this is a decrease in an asset. Credit Income .000 pongos from their foreign investments. view this as an export of the services of capital. ‡ The earnings are Income.Pongoland investors receive 200.

where S is income minus total private and government consumption.The Balance of Payments and the National Accounts ‡ Y = C + I + G + X where Y is output or income. ‡ Y ² C ² G = S = I + X. G is government spending (assumed to be consumption) and X is exports minus imports. or net exports or the current account. ‡ X = S ² I : the current account is domestic investment minus saving . I is private domestic investment. or savings. C is private domestic consumption.