Chapter 2 Balance of Payment

Objectives of the Chapter Definition Components of BOP Factors Affecting International Trade Flows Correcting BOT DFIs by US Firms DFIs in US Factors affecting DFIs Factors affecting International Portfolio Investment Agencies Help correcting BOP

Definition “A balance of payments (BOP) sheet is an accounting record of all monetary transactions between a country and the rest of the world”. Sloman, John (2004) “A record of all transactions made between one particular country and all other countries during a specified period of time”. “Balance of payments may be used as an indicator of economic and political stability”. “The BOP summarizes international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned”.

A negative balance of payments means that more money is flowing out of the country than coming in. A Positive balance of payments means that more money is flowing in the country than going out

Positive & Negative BOP Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit item.

Components of BOP Current Account Capital Account Official Reserve Account

Current Account a) Balance of Trade b) Factor Income Merchandise (Exports & Imports) Services (Exports & Imports) b) Factor Income c) Unilateral Transfers

Factor Income Income from: Dividends Interest Income earned by workers overseas Compensation of employees Income of workers employed in an economy where they are not resident - (Eg: Pak workers in Microsoft Corporation) Income of residents employed by nonresident entities - (Eg: People working in Pierre Cardin situated in Pakistan) Personal transfer It consist of all current transfers in cash or in kind made or received by resident households to or from nonresident households. - (Eg: Mr. A sending money from Pakistan to his friend in US)

c) Unilateral Transfers Aids Grants Gifts

Capital Account Foreign Direct Investment --- Portfolio Investment Other Capital

Foreign Direct Investment Investment in real assets in foreign countries such as: Land Building Existing plant

Statistical Discrepancy It represents errors due to unrecorded transactions involving smuggling and other capital Also known as Errors & Omissions Many experts believe that it is the result of large hidden capital flows, and so the item has been placed in the capital account part of the BOP

Factors Affecting BOT Inflation National Income Government Restrictions Exchange Rates

HIGH INFLATION Current Account (-) Dr

HIGH INCOME LEVEL Current Account (-) Dr

Government Restrictions Tariffs Quotas

EXCHANGE RATES Current Account (-) Dr

Correcting the trade deficit Any policy that increases demand for country’s goods and services It will increase the Balance of Trade Solution If export price becomes attractive -- Floating rate may correct the deficit -- Trade deficit may experience an stable currency --

If export price becomes attractive It will increase the Balance of Trade This can occur when a country has: Low inflation Low currency value

Floating rate may correct the deficit What is Deficit When country is spending more on foreign goods When country is receiving less from exports It means More supply of home currency for sale The value of its currency should decrease This decrease will encourage more foreign demand of home made products Therefore CA will increase But this technique may not always work

Trade deficit may experience an stable currency Again Recall “DEFICIT” Spending more on foreign goods Receiving less from exports Resulting in low value of currency NOW Investment in securities becomes attractive for foreigners Increased demand of home currency Upward pressure on home currency Therefore the trade imbalance will be offset by positive capital account

Weak Currency may not always be the solution Counter pricing by competitors - Once low priced items seem more attractive to the foreign customers The competing countries may also lower the price Impact of other weak currencies The home currency does not necessarily weaken against all currencies at the same time Eg: It is possible that the Pakistani rupee may weaken against Indian currency, So Pakistan may stop buying Indian products but It may start buying from other countries where Pak Rupee is still stable i.e. Bangladesh, Srilanka, Iran etc

Pre-arranged International Transaction If the home currency is lower in value It is not possible that every country will frequently start buying from here Till the time countries become aware about the cheap product Lower rate may not be available till that time Due to time lag it is not always possible

Inter Company Trade Importers and exporters under the same ownership have unique relationship Many firms use to buy the products from their subsidiaries This type of trade makes 50% of trade Trade between countries may not affect exchange rates

Outflow Inflow Inflow Outflow

Correcting BOP When all components of the BOP sheet are included It must balance It must sum to zero There can be no overall surplus or deficit. Eg: - If a country imports more than it exports - It’s trade balance will be in a deficit But It has to be balanced By running down reserves or by receiving loans from other countries.

Lets rename it the imbalance of payments and announce its normal….

The Official Reserve Account “It is the foreign currency and securities held by the Govt.” Usually by its Central bank It is used to balance the payments from year to year It increases when there is a trade surplus It decreases when there is a deficit Sometimes the Central Bank use it to change the exchange rate when the government perceives as more favorable

Agencies that help to Correct BOP Deficit IMF IBRD WTO International Financial Corporation International Development Association Bank of International Settlements Regional Development Agencies

IMF A result of UN Monetary & Financial Conference in 1944

Objectives of IMF To promote Cooperation among countries To promote stability in exchange rates To provide temporary funds to member countries attempting to correct imbalances of international transactions To promote free mobility of funds across countries To promote free trade

Compensatory Financing Facility (CFF) This facility is mainly used by developing countries Each country is assigned a quota The amount of fund that a member country can borrow depends upon its quota The country must be willing to work with IMF to resolve the problem

SDRs An international reserve asset created by IMF in 1969 The financing by IMF is measured in SDRs IMF allocates it to member countries to supplement currency reserves It is not a currency but a unit of account

The SDR basket and Its Valuation Currency Amount in 1 SDR (1) Exchange Rate vs US $ (2) US $ Equivalent (1) * (2) USD 0.5770 1.00000 0.577000 Euro 0.0984 1.42550 0.140269 GBP 0.4260 0.88140 0.375476 21.0000 125.07000 0.167906 Total 1.260651

IBRD Established in 1944 Structural Adjustment Loan (SAL) in 1980 It spread its funds through co-financing: Official Aid Agencies (projects) Export credit agencies Commercial Banks

Correcting BOP Problems Roberts, Richard (1999) The fundamental function of International Monetary System is to provide mechanisms to correct imbalances. Even a mixture of at least the first two methods may be used. Methods: There are three possible methods to correct BOP imbalances Adjustments of exchange rates Adjustment of a nations internal prices along with its levels of demand Rules based adjustment Note: Improving productivity and competitiveness can also help to enhance the exports through other means BUT It is generally assumed that a nation is always trying to develop and sell its products to the best of its abilities.