International Money & Finance Chapter 3: The Balance of Payments Michael Melvin and Stefan Norrbin

Outline of This Chapter What is the balance of payments (BOP)? Current account and capital account Examples of international transactions and how to enter them into the BOP. The balance of payment equilibrium. The U.S. trade deficit and foreign debt.

What is the Balance of Payments? The balance of payments records a country’s trade in goods, services, and financial assets with the rest of the world. It is an accounting statement based on double-entry bookkeeping. Every transaction is entered on both sides of the balance sheet: a credit and a debit. If all transactions are included, the sum of all credits must equal to the sum of all debits (total receipts = total payments) The balance of payment always balances!!! Credit – entries that bring foreign exchange into the country Debit – entries that foreign exchanges leave the country.

If the BOP always balances, then why we talk about the U. S If the BOP always balances, then why we talk about the U.S. trade deficit? For each particular section of the BOP, there could be an imbalance. When credits > debits → a surplus When credits < debits → a deficit Thus, there can be a deficit or surplus in any of the following: merchandise trade (goods), services trade, foreign investment income, unilateral transfers, private investment, the flow of gold and money between central banks and treasuries, or any combination of these or other international transactions The statement that a country has a deficit or surplus in its “balance of payments” must refer to some particular class of transactions.

Terminology I Current account – sometime called “balance of trade”. It measures the value of trade from: Good imports and good exports + Service imports and service exports + Net receipts of investment income + Unilateral transfers Current Account Net receipts of investment income = net factor income from abroad. Foreign payments to capital, labor, and land owned by domestic firms − Domestic payments to capital, labor, and land owned by foreign firms Unilateral transfer – ex. gifts, pensions, and foreign aid. Trade balance = exports – imports TB > 0 → Exports > Imports → trade surplus TB < 0 → Exports < Imports → trade deficit TB = 0 → Exports = Imports → balanced trade

This shows the current account deficit and trade deficit The Current Account of the United States (+) Credit = bring foreign exchange into the country (-) Debit = foreign exchange leave the country This shows the current account deficit and trade deficit

The U.S. current account deficit is about $110.3 billion (Quarterly)) International trade on goods – deficit International trade on services – surplus Income receipts > Income payments Net unilateral transfer is negative Source: BEA

Terminology II + The foreign-owned assets at home (2) Capital Account Capital account – purchases and sales of financial assets (ex. buying private or government bonds, stocks, and bank deposits) and direct investment (ex. purchase of a plant in another country). − The domestic-owned assets abroad (1) + The foreign-owned assets at home (2) Capital Account (1) Purchases of U.S. assets by foreigners ↔ Capital Inflow (2) U.S. residents purchases foreign financial assets ↔ Capital Outflow Capital account surplus → Net capital inflow → the home country received more capital transfers than it made → Net borrower (issuing IOUs to lenders) Capital account deficit → Net capital outflow → the home country make capital transfers than it received → Net lender (acquiring IOUs from borrowers)

The U.S. Capital Account (+) Credit = bring foreign exchange into the country (-) Debit = foreign exchange leave the country

The Capital Account in the United States Quarterly Net Capital Inflow

Capital account transactions include: Official transactions any intervention in the foreign exchange market done by official government sources. U.S. government assets abroad Foreign government assets in the U.S. Private transactions Direct investment: private sector invests in foreign firms Security purchases: purchases and sells stocks and bonds Bank claims and liabilities: bank loans and deposits abroad

Official Settlement Balance Official Settlement Balance – change in U.S. official reserves assets abroad plus change in foreign official assets in the U.S. It measures the net change in foreign exchange reserves and official government borrowing. It can serve as a measure for potential foreign exchange pressure on a dollar.

Current Account (CA) and Capital Account (KA) Since the Balance of Payments always balance, BOP = CA + KA = 0 CA + KA = 0 Current account surplus ↔ Capital account deficit Current account deficit ↔ Capital account surplus

Statistical Discrepancy (SD) Because not all international transactions are properly recorded, the statistical discrepancy (errors) will be added. CA + KA + SD = 0 SD = − (CA + KA)

How to enter transactions into the BOP? The Current Account Entries Debit (-) → cause outflow of money Credit (+) → bring in money Trade in goods: Import (-) (-) U.S. farmer purchases German tractor. Export (+) (+) India stores buy Apple iPods Trade in services: (-) An American takes a cruise on a Norwegian cruise line. (+) A Brazilian company hires U.S. consulting firm.

How to enter transactions into the BOP? The Current Account Entries Debit (-) → cause outflow of money Credit (+) → bring in money Investment income receipts and payments Interest, dividend, and other income paid (-) (-) The U.S. subsidiary of a Japanese company pays dividends to its parent company in Japan Interest, dividend, and other income receipts (+) (+) A Canadian company pays salaries to its executives stationed in New York. Unilateral Transfers Remittances by foreigners in the U.S., pension paid and aid offered by the U.S. to its citizens living abroad (-) Remittances by Americans working abroad, pension paid and aid offered by foreigners to the U.S. (+)

How to enter transactions into the BOP? The Capital Account Entries Direct investment (factories, machines) Purchases of U.S. physical capital by foreigners (+) (+) Ford Motor Company sells its factory to British investors. Purchases of foreign physical capital by U.S. residents (-) (-) Ford Motor Company builds a factory in Mexico. Portfolio Investment (stocks, bonds, CDs) Purchases of U.S. securities by foreigners (+) (+) A London-based insurance company buys U.S. corporate bonds. Purchases of foreign securities by U.S. residents (-) (-) An American buys shares of a European company stock in London Stock Exchange.

How to enter transactions into the BOP? The Capital Account Entries Other investments – loans and currency Increase in loans and trade credits to U.S. residents by foreigners (+) (+) A Canadian firm receives a payment for exports from the U.S. firm. Increases in loans and trade credits to foreigners by U.S. residents (-) (-) A U.S. firm deposits $1 million in a bank account in London. Official Reserve Assets Increases in dollar reserves held by foreign central banks (+) Increases in holdings of foreign currency reserves by the Fed (-)

Examples of BOP Entries 1. French retailer buys $50,000 wheat from farmer Joe in Idaho, and pays with a 90-day note. $50,000 exports (+ in merchandise trade) $50,000 90-day note (- in private capital account because it is a loan that Joe lends to the French retailer) 2. U.S. resident receives $10,000 in interest from a German bond and is deposited in German bank account. $10,000 investment income (+ in investment income for the current account) $10,000 bank deposits in Germany (- in private capital account because it is a portfolio investment)

Examples of BOP Entries 3. U.S. government donates $100,000 in wheat to Nicaragua. $100,000 wheat shipped (+ as exports in merchandise trade) $100,000 donation (- in the unilateral transfer because it is aid offered to foreigner by the U.S.) 4. U.S. tourist travels to Germany, spend $5,000 on an “Oktober Fest” package deal, and pays a German travel company. $5,000 Germany trip by American tourist (- as import of services) $5,000 payments for the trip to German company (+ in private capital account because it is a payment of trade credit to foreigners by U.S. resident)

The U.S. BOP from these examples Credit (+) Debit (-) Trade of Merchandises 50,000 (3) 100,000 Trade of Services (4) 5,000 Investment Income (2) 10,000 Unilateral Transfer CA: Current Account + 55,000 Private Capital 10,000 Official Capital KA: Capital Account - 55,000 BOP: Balance of Payment

U.S. Trade Deficit The current account deficits have been persistent since 1980. Source: World Bank Databank, World Development Indicators & Global Development Finance

Some explanations for large U.S. trade deficit Unfair trade The U.S. is open to trade and thus importing a lot. Other countries are closed so that they don’t buy enough from the U.S. Twin deficit Because our government runs budget deficit, so we would have trade deficit. Investment Demand Shift People like to invest in the U.S. much more than before.

Unfair Trade According to this claim, to explain what happen to the U.S. trade deficit since 1982, two things must happen: Foreign countries must have suddenly increased their trade protection in 1982. All countries must have decided to protect themselves against the U.S. at the same time. Neither of the above statements was true. In fact, many countries reduced trade protection and opened their economies. There was no coordinated protection against the U.S. Thus, it is unlikely that this popular claim is an explanation for the U.S. trade deficit.

Twin Deficit: Derive saving and investment First, we need to go back to our basic macroeconomics to derive the saving and investment relationship. Let Y be Gross Domestic Product (GDP) Y = C + I + G + (X – M) Y = domestic output or income C = consumption I = private investment G = government spending X = exports M = imports (X – M) = net exports or the trade balance

Twin Deficit Derive saving and investment (cont.) Y = C + I + G + (X – M) Y – C – I – G = (X – M) Y – T – C – I + T – G = (X – M) (Y – T – C) – I + (T – G) = (X – M) Private saving Public saving Private saving = (Y – T – C) = income-after-tax minus consumption spending Public saving = (T – G) = tax revenues minus spending

Twin Deficit Derive saving and investment (cont.) (Y – T – C) – I + (T – G) = (X – M) If the LHS of the equation is negative, the RHS of the equation will also be negative. Trade deficit comes from the negative value of the LHS of the equation Negative RHS → (X – M) < 0 → X < M T – G (public saving) T > G → budget surplus T < G → budget deficit (Y – T – C) – I (private saving (S) minus domestic investment) S > I → positive net private saving S < I → overinvestment

How does trade deficit arise from government budget deficit? If the government spending exceeds tax revenue, then T – G < 0 → government will have to borrow money to finance its spending by issuing bonds (T-bills) Interest rate in the U.S. will rise. Suppose that ↑ ius > iJAPAN Japanese would like to invest in the U.S. (buy T-bills), which will increase demand for the U.S. dollar. $ will appreciate as Japanese trade ¥ for $. U.S. exports become more expensive →↓ X U.S. imports become cheaper → ↑ M (↓X - ↑M) ↓ Trade deficit

Investment Demand Shift An increase in investment demand could come from 1980s deregulations and 1990s IT boom. These events have increased demand for investment capital and driven the interest rate in the U.S. upward. Interest rate in the U.S. will rise. Suppose that ↑ ius > iJAPAN Japanese would like to invest in the U.S., which will increase demand for the U.S. dollar. $ will appreciate as Japanese trade ¥ for $. U.S. exports become more expensive →↓ X U.S. imports become cheaper → ↑ M (↓X - ↑M) ↓ Trade deficit

How to eliminate the trade deficit? If twin deficit idea is true, trade deficit is just a symptom of fiscal budget deficit. To eliminate trade deficit, we have to eliminate the fiscal budget deficit. If the investment demand shift idea is true, trade deficit can be eliminated by banning foreign investment or making the U.S. unappealing for investment. However, these options may not be the best practice for the economy in the long run. Trade deficit is a symptom of foreigners’ belief in the U.S. economy.

How big is the U.S. foreign debt? U.S. residents have over $20 trillion worth of claims on foreign assets, whereas foreigners hold $22.5 trillion in claims of the U.S. assets. So, we owe $2.5 trillion more than we receive from the rest of the world. Is it bad? Not necessarily. Foreign central banks and governments are holding large amount of U.S. assets as their foreign reserves. On the private side, our foreign investment pays more than the returns on our assets that foreigners are holding. We generate net investment income surplus. So, the $2.5 trillion international debt is not a burden to our economy so far.

Balance of Payments Equilibrium (or Disequilibrium) Countries can have an equilibrium balance on the current account that is positive, negative, or zero, depending on what circumstances are sustainable over time. Ex. the U.S. equilibrium could be with the current account deficit, if the rest of the world are willing to accumulate U.S. assets over time. This involve a U.S. capital account surplus.

What happens if there is a disequilibrium in the balance of payments? Under floating exchange rate: the exchange rate will adjust to restore the BOP equilibrium. Under fixed exchange rate: the central bank must finance the trade imbalance by international reserve flows (there will be reserve assets losses from deficit countries and reserve accumulation by surplus countries). Or, countries may use trade restrictions on imports, exports, and/or restrictions on capital flows.

Conclusions The balance of payments records a country’s international transactions: payments and receipts that cross the country’s border. The balance of payments uses the double-entry bookkeeping method. Each transaction has a debit and a credit entry. If the value of the credit items on a particular balance of payments account exceeds (is less than) that of the debit items, a surplus (deficit) exists. The current account is the sum of the merchandise, services, investment income, and unilateral transfers accounts. The balance of trade is the merchandise exports minus the merchandise imports. Current account deficits are offset by capital account surpluses.

Conclusions The official settlements balance is equal to changes in financial assets held by foreign monetary agencies and official reserve asset transactions. An increase (decrease) in the U.S.-owned deposit in foreign bank is a debit (credit) to the U.S. capital. While an increase (decrease) in foreign-owned deposit in the U.S. bank is a credit (debit) to the U.S. capital. The United States became a net international debtor in 1986. With floating exchange rates, the equilibrium in the balance of payments can be restored by exchange rate changes With fixed exchange rate, the balance of payments will not be automatically restored. Thus, central banks must either intervene to finance current account deficits or impose trade restrictions to restore the equilibrium. Deficits are not necessarily bad, nor are surpluses necessarily good.