The Balance of Payments and International Economic Linkages CHAPTER 5 The Balance of Payments and International Economic Linkages

Balance of Payments A record of international transactions between residents of one country and the rest of the world International transactions include exchanges of goods, services or assets. “Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations Principle of Double Entry Booking

Accounts Overview Current Account (all real transfers) Merchandise trade Service trade Transfers Capital and Financial Account (transfers of ownership, financial assets, and liabilities) Changes in private assets The Official Reserves Account Purchases and sales of International Reserve Assets such as Foreign currencies and gold Statistical Discrepancy

Current Account The current account is that balance of payments account in which all short-term flows of payments are listed: Goods and services balance (exports – imports) Merchandise trade balance (exports – imports) Services balance (exports – imports) Income Current transfers Private transfer payments Governmental transfers

What are Services? Travel and tourism Trade transportation Insurance Education Financial, technical, and marketing services Telecommunication Use of property rights (royalties) Other professional and consulting services

What is Income? Financial Income: Payment to holders of foreign financial assets, including: Interest on bonds and loans Dividends and other claims on profits by owners of foreign businesses Payments made to temporary (nonresident) workers

Current Transfers Official government grants in aid to foreign governments Charitable giving (e.g., famine relief) Migrant workers transfers to families in their home countries

Capital Account The capital (financial) account is that balance of payments account in which all cross-border transactions involving financial assets are listed. This includes transactions between foreign and domestic residents, and foreign and domestic governments. All purchases or sales of assets, including: Direct investment Securities (debt) Bank claims and liabilities When domestic citizens buy foreign securities or when foreigners buy domestic securities, they are listed here as outflows and inflows, respectively. FDI is the purchase of assets to establish financial control of a foreign entity. Generally ownership of 10% or more of a company’s outstanding stock is considered FDI. Portfolio investment involves little management control or interest, and is solely for financial gain.

Official Reserve Assets In the early of the 20th century, this was primarily gold. Now primarily financial assets denominated in a foreign currency that is widely accepted in international transactions: Euro assets (heavily used by U.S.) Yen and Yuan assets (heavily used by U.S.) U.S. dollar assets (key currency worldwide) Reserve positions in IMF SDRs (created by IMF): A currency basket of 5 major currency IMF created as foreign exchange reserve. Official transactions are transactions between government and private sectors.

Double Entry Booking Keeping (Accounting) Accounting system is based on the principle that for every Debit entry, there will always be an equal Credit entry, known as the Duality Principal. Credit entries: Transaction for the source of cash inflows Increase in liability, equity, or income Decrease in assets or expense Debit entries: Transaction for the source of cash outflows Increase in assets or expenses Decrease in liability, equity, or income Double Entry is recorded in a manner that the Accounting Equation is always in balance. Assets = Liabilities + Equity Difference between assets and income Assets exist but income/expense are generated for a certain time. Asset increase -> cash outflows, Income increase -> cash inflows

Examples of Double Entry Purchase of machine by cash Debit: Machine (Increase in Asset) Credit: Cash (Decrease in Asset) Payment of utility bills Debit: Utility Expense (Increase in Expense) Interest received on bank deposit account Debit: Cash (Increase in Asset) Credit: Financial Income (Increase in Income) Receipt of bank loan Credit: Bank Loan (Increase in Liability) Issue of ordinary shares for cash Credit: Capital Stock (Increase in Equity)

Double-entry Accounting in the BOP Credit transactions result in receipt of payment from foreigners. Merchandise exports to foreign countries Transportation and travel receipts from foreigners Income received from investments abroad Gifts received from foreign residents, Aid received from foreign governments (Credits in the current transfer) $20 of Toys from foreign residents. $20 Credits in the current transfer and $20 Debits in the import Credits occurs in Increase in Export (Income) Increase in Liability (to foreigners) US bank deposits $s to the local bank in Korea to facilitate financial transaction between US and Korea. From the view point of Korea, it is an increase in liability. Decrease in Assets (Financial claims on foreign residents) or Foreign reserves

Double-entry Accounting (Cont’d) Debit transactions involve to payments to foreigners Merchandise imports Transportation and travel expenditures of home country’s residents Income from securities owned by foreigners Gifts to foreign residents, Aid given by home government, (Debit in the unilateral transfer) Overseas investments by home country’s residents Debits occurs in Increase in Import, Assets (Financial claim on foreign residents) or Foreign reserves Decrease in Liability (to foreign residents) US importer asks her US bank to send $100 million from her account. US bank withdraws $100 million from its saving account in Korean local banks to make payments to Korean exporters.

Double-entry Accounting Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance. Normal transaction occurs in terms of exchanging something for another. Current Account + Capital Account + Official foreign reserves ≃ 0. Suppose that a Korean company exports $ 100 millions of merchandise and received $ 100 million accounts receivable. Trade account in Korea: Credits of $100 million (export) capital account in Korea: Debits of $100 million (increase in financial assets) The balance of payments is in balance. (Credits = Debits)

Double Entry Book-Keeping Boeing (US) Corporation exported a Boeing 747 aircraft to Japan Airlines for $ 50 million. Japan Airlines paid $50 million from its bank account of Chasse Manhattan Bank in New York City: Boeing’s export transaction of $ 50 mil. will be recorded as credit in current (trade) account of US. $ 50 million will be withdrawn from the bank account of Japan Airlines at Chase Manhattan Bank. Chase Manhattan Bank’s liability reduction by $50 mil. $50 million of debits recorded in the capital account of US.

Double Entry Book-Keeping Boeing (US) imports jet engines produced by Rolls-Royce (Germany) for $30 million. Boeing makes payment by transferring the funds to Rolls-Royce’s account in the New York bank. $30 million import by Boeing will be recorded as debit in current account of US. $30 million credit in the capital account of US. New York bank’s liability (to Rolls-Royce, the foreign company) increases (Cash inflows)

Double Entry Book-Keeping Ford acquires Jaguar, a British car manufacturer for $ 750 million of cash. Debit in Capital Account of US because of asset increase in US. Credit in Capital Account of U.S because of $750 million of cash reduction(asset decrease). Jaguar deposits the money in Barclays Bank in London. No record because Barclays bank is a British bank. In turn, Jaguar uses $750 million to purchase U.S. treasury notes. Credit (Cash Inflows) in Capital Account of US: Decrease in Assets Debit in Capital Account of US: Increase in Assets (Cash).

Double Entry Book-Keeping Current transfers: The American Red Cross donates goods of $100,000 for earthquake relief to Nicaragua. $100,000 debit in current transfer of US (because American Red Cross’ net worth is reduced.) $100,000 credit in current account (U.S. exports)

The Balance of Payments Identity BCA + BFA + BRA = 0 where BCA = balance on current account BFA = balance on capital account BRA = balance on the official reserves account If the government does not intervenes in foreign exchange market, BRA is close to zero.

Statistical Discrepancy There’s going to be some omissions and misrecorded transactions—so we use a “plug” figure to get things to balance. Mostly illegal cash inflow and outflow

U.S. Balance of Payments Data (2010)   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

U.S. Balance of Payments Data   Credits Debits Current Account 1 Exports $1,418.6 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 In 2010, the U.S. imported more than it exported, thus running a current account deficit of $444.69 billion.

U.S. Balance of Payments Data During the same year, the U.S. attracted net investment of $444.26 billion—clearly the rest of the world found the U.S. to be a good place to invest.   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

U.S. Balance of Payments Data   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Under a pure flexible exchange rate regime, these numbers would balance each other out.

U.S. Balance of Payments Data   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 In the real world, there is a statistical discrepancy.

U.S. Balance of Payments Data   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Including that, the balance of payments identity should hold: BCA + BFA = – BRA ($444.69) + $444.26 + $0.73 = $0.30= –($0.30)

Balance of Payments and the Exchange Rate   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 P S D Q

Balance of Payments and the Exchange Rate   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 P S D Q As U.S. citizens import, they supply dollars to the FOREX market.

Balance of Payments and the Exchange Rate   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 P S D Q As U.S. citizens export, foreigners demand dollars at the FOREX market.

Balance of Payments and the Exchange Rate   Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance on Capital Account $444.26 7 Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 P S S1 D Q As the U.S. government sells dollars, the supply of dollars increases.

Balance of Payments Trends Since 1982, the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account. During the same period, Japan has experienced the opposite.

Balances on the Current (BCA) and Capital (BKA) Accounts of the United States (Unit: $ billion) Source: IMF International Financial Statistics Yearbook, 2000

Balances on the Current (BCA) and Capital (BKA) Accounts of the United States (Unit: $ billion)

Balances on the Current (BCA) and Capital (BKA) Accounts of China (unit: USD billion) Source: IMF International Financial Statistics Yearbook, 2000

Balances on the Current (BCA) and Capital (BKA) Accounts of China (unit: USD billion)

Balances on the Current (BCA) and Capital (BKA) Accounts of Germany (unit: USD billion)

The International Flow of Goods, Services, and Capital National Income Accounting National Income (NI) is either spent (C) or saved (S) NI = C + S (5.1) National spending (NS) is divided into personal spending (C) and investment (I) NS = C + I (5.2) Subtracting (5.2) - (5.1) NI - NS = S - I (5.3) On Capital (Income) Side, if NI > NS, S > I which implies that surplus capital spent overseas. (capital outflow=capital account deficit) On Expenditure Side, if NI > NS, S > I which also implies that surplus products & service spent overseas. (Current Account Surplus)

The International Flow of Goods, Services, and Capital In a freely-floating system (there is no (big) change in government official reserves.) excess saving = capital outflow in capital account balance Implications: A nation which produces more than it spends will save more than it invests domestically, resulting in a net capital outflow producing a capital account deficit. S-I = surplus capital = net foreign investment = capital outflow = capital account deficit

The International Flow of Goods, Services, and Capital A nation which saves less than it invests has a net capital inflow producing a capital account surplus. On the expenditure side, a nation with (S – I) < 0 has deficit of goods and services since the nation spends more than produce, producing a current account deficit.

The International Flow of Goods, Services, and Capital Link between Current and Capital Accounts Beginning identity NI - NS = X - M (5.4) where X = exports M = imports X-M = current account balance (CA) Combining (5.3) + (5.4), S - I = X - M (5.5) If S - I = Net Foreign Investment (NFI) NFI = X - M (5.6)

The International Flow of Goods, Services, and Capital Implications: If CA is in surplus, the nation must be a net exporter of capital. Capital Account Deficit If CA is in deficit, the nation is a major capital importer. Capital Account Surplus When NS > NI, the excess must be offset by capital account deficit.

The International Flow of Goods, Services, and Capital Government Budgets and Current Account Deficits National Income = Private Consumption + Private Savings + Taxes 1) National Spending = Private Consumption + Private Investment + Government Expenditure 2) 1)-2) National Income - National Expenditure = Private Savings Surplus – Government Deficit where Government Deficit = Government Expenditure - Taxes

The International Flow of Goods, Services, and Capital Current Account Balance CA = Private Saving Surplus - Gov’t budget deficit CA Deficit means the nation is not saving enough to finance private investment (I) and the government deficit. Capital account surplus indicates foreigner’s lending or foreigner’s purchasing financial securities Net capital flow → someday net capital outflow (Debt crisis can happen) CA Surplus means the nation is saving more than needed to finance its (I) and government surplus. Any country with external debt crisis is due to either negative private saving surplus or government deficit. Private sector’s over-investment (S < I) or the debt crisis of private sector Government spend much more than tax revenues.

US Government Deficit as a share of GDP (%) Source: White House, Office of Management and Budget

Source: Department of Commerce

Cope with the Current Account Deficit Possible Solutions Unlikely to Work in short term period: Currency Depreciation (real deprecation of home currency) Protectionism Tax Incentive to save more

Cope with the Current Account Deficit Currency Depreciation U.S. Experience: Does not improve the trade deficit immediately.

Cope with the Current Account Deficit Depreciation may not be effective. Lagged Effect: It takes time to affect trade.

Cope with the Current Account Deficit J-Curve Effect: A decline in currency value will initially worsen the deficit before improvement. Domestic currency depreciation immediately increases the current account deficit since export and import price immediately increase in terms of the domestic currency. Domestic currency depreciation gradually improves current account balance of export over the long run.

THE J - CURVE Trade balance Net change improves in trade Currency depreciation TIME Trade balance initially deteriorates

Depreciations may not be effective. Positive Relation between Depreciation and Inflation Depreciation initiated by the government increases competitiveness of domestic production -> More demand of domestic products and services by foreigners -> Increase in domestic production price. Inflation can moderate the effect of depreciation on the current account balance.

Protectionism Trade Barriers Foreign Ownership Limit Tariffs Quotas Most likely will reduce both X and M. Foreign Ownership Limit One protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows. Reduce supply of capital -> High interest rate -> increase saving and reduce investment -> Low economic growth -> Currency depreciation Have to suffer the low growth of domestic economy

Stimulate National Saving Providing the tax incentive to save more Government budget deficit may increase. In US Private Savings turned to be negative in 2000, while Japanese have higher savings. Social security benefits in US may provide low incentive for US citizens to save in the future. Tax benefits may not increase the private savings of US if US citizens believe that they can rely on the social security benefits after retirement.

Deficits of Trade and Gov. Budget in U.S. Year Trade Deficit ($ billion.) Gov. Budget Deficit 2004 $ 668 $ 412 2005 $ 727 $ 318 2006 $ 763 $ 248 2007 $ 702 $ 161 2008 $ 699 $ 459 2009 $ 375 $ 1,414 NI – NS = X-M = Private Savings Surplus – Government Budget Deficit

Summary: Current Account Deficit Neither bad nor good inherently Since one country’s exports are another’s imports, it is not possible for all to run a surplus Deficits may be a solution to the problem of different national propensities to save and invest. However, deficits can not continue forever. NI – NS = X-M = Private Savings Surplus – Government Budget Deficit Either private sectors or government may face financial distress. Note that capital flows can move in a moment.