Lecture 5 Balance of Payments

Learning Objectives Understand balance of payments account categories, the relationship between them and the identities Comprehend the double-entry recording system in the balance of payments statement Gain knowledge of international economic linkages through the balance of payments Discuss the relationship between trade deficits and macroeconomic fundamentals Reading: Madura and Fox, Ch 2; Bekaert and Hodrick, Ch 4; Peijin Wang, Ch4

Motivation We have examined parity conditions But not yet the ‘real’ side of economies So this is what we will turn to now How to measure financial flows between countries Different types of activity Measuring the financial flows which result Also how these determine exchange rates Whether considering the value of assets Or these financial flows

Balance of Payments (BOP) A statistical statement or record Of a country’s international economic transactions With another country or the rest of the world Over a certain period of time, often a year This measures Flows of goods, services and capital out of and into the country.

How is balance of payments measured? Double entry bookkeeping Transactions -- Involve flows of goods, services and capital. Are presented in the form of double-entry bookkeeping, i.e. every transaction is recorded as both a credit and a debit With equal values and opposite signs. The net balance of all entries in the statement is in theory zero. Although there may be statistical errors (minor)

Transactions and Transfers Most entries in the balance of payments refer to transactions Economic values are provided or received In exchange for other economic values. Therefore, offsetting credit and debit entries are entered for the transaction. Transfers When items are given away rather than exchanged, Or when a recording is one-sided for other reasons, special types of entries – referred to as transfers – are made as the required offsets.

Real Resources and Financial Items We should distinguish between Real resources Goods Services Income Financial items Investments (private) Reserves (government) However treatment of them in Balance of Payments is similar

The Balance of Payments - Credit Entries and Debit Entries An intuitive rule for determining credits and debits Credit transactions give rise to conceptual inflows or sources of foreign exchange; the purchases of goods and assets by foreign residents from domestic residents are credits because they are a source of foreign exchange Debit transactions give rise to conceptual outflows or uses of foreign exchange; the purchases of goods and assets by domestic residents from foreign residents are debits because they cause an outflow of foreign exchange

Credit Entries and Debit Entries For each of these there may be Credit entries (+) recorded for Real resources: exports of goods and services Financial items: deductions in foreign assets or increases in foreign liabilities. Debit entries (-) recorded for Real resources: imports of goods and services Financial items: increases in foreign assets or decreases in foreign liabilities.

Categories in the Balance of Payments There are three categories: Current account Capital and financial account Capital account Financial account Statistical discrepancies - representing omitted and miss-recorded transactions.

Current Account The major components in the current account Exports of goods and services (+) Imports of goods and services (-) (Referred to as the trade balance) Income Income receipts (+) (Interest and dividend receipts) Income payments (-) (Interest and dividend payments) Current transfer Transfer payments between countries (e.g., gifts or aid)

Capital and Financial Account Capital Account Capital transfers -- Acquisition/disposal of non-produced, non- financial assets

Capital and Financial Account -- The financial account records public and private investment and lending. -- It consists of Foreign direct investment abroad (-), in reporting economy (+) Portfolio investments assets (-), liabilities (+) Other investments Reserve assets/Official reserves

Reserve Assets/Official Reserves Reserve assets cover transactions in assets Considered by the monetary authorities As available for use in funding payments imbalances and meeting other financial needs. It reflects surplus and deficit in the current account And private sector transactions in the capital and financial account It consists of Reserve gold SDRs - reserve position in the IMF foreign exchange assets (currency, deposits, and securities). 16/11/2018 HUBS

Example Suppose the US computer maker Dell sells $20 million of computer to Komatsu, a Japanese manufactory. Komatsu pays Dell by transferring dollars from its dollar-denominated bank account at Citibank in New York to Dell’s bank account in Japan. What are the credit and debit items on the US balance of payments? US BOP Credit Debit Computer purchase by Komatsu from Dell (Current account, US, good export) +$20m Citibank foreign deposit decrease (Capital account; capital outflow from the US) -$20m 16/11/2018

Exercise Suppose LVMH, a French luxury goods company, buys €1.5 million of consulting services from the London Consulting Group (LCG). LVMH pays by writing a check on its euro-denominated bank account at a Paris bank. What are the credit and debit items on the French balance of payments? 4 minutes

The Balance of Payments Identity Sum of all transactions must be zero Under a pure flexible exchange rate regime Current Account + Capital & Financial Account = 0 CA + KFA = 0 Under a managed exchange rate regime Need to also consider the Official Reserve Account CA + KFA + ORA = 0

U.S. Balance of Payment for 2009 (billions of dollars; credits, +; debits, –)

Table 1: Current Account Balances for the G7 Countries as a Percentage of GDP

Trade Deficits ~ Macroeconomic Fundamentals Given the fact that most developed countries are experiencing the trade deficits, can the trade deficits be explained by macroeconomic fundamentals?

Trade Deficits ~ Macroeconomic Fundamentals Linking the Current Account to National Income Gross National Income = Gross domestic product + Net Foreign Income GNI = GDP + NFI (1) By definition of GDP, GDP = C+ I + G + NX Where C - consumption I – investment G - government purchases NX – net exports

Trade Deficits ~ Macroeconomic Fundamentals GNI = C+ I + G + NX + NFI (2) Re-arranging eq(2) GNI – (C + G) - I = (NX + NFI) (3) S - I = CA (4) Where S - Savings

Trade Deficits ~ Macroeconomic Fundamentals If CA < 0 , then S – I < 0 or S < I. That is domestic savings do not suffice to finance investment. In other words, the given country borrows from abroad. This implies a Capital/Financial Account surplus(due to the capital inflow) and a CA deficit. On the other hand, if CA > 0, then S – I >0, or S > I Implies an increase in net foreign wealth (ie, saving) and lending abroad. In summary, the CA depends on the relative balance between S and I.

Conclusions