THE BALANCE OF PAYMENTS

THE STRUCTURE OF THE BALANCE OF PAYMENTS OBJECTIVES Define the term ‘balance of payments’ Outline the role of balance of payments Distinguish between debit items and credit items in the balance of payments HOMEWORK: components of B.O.P accounts

Definition Balance of payments(BOP) refers to a record of the value of all transactions of a country with the rest of the world over a period of time.

Role of BOP It shows all payments received from transactions with other countries, called CREDIT It shows all payments made from transactions to other countries, called DEBIT

Distinguish between credit and debit items in a BOP Any transactions that lead to money entering the country from abroad e.g. export goods such as cash crops, food crops, manufactured goods, etc exportation of services such as tourism, skills, etc It gives a positive value Any transactions that lead to money leaving the country to go abroad e.g. import goods such as food items, manufactured goods, machinery, etc Importation of services such as tourism, expertise, insurance, etc It gives a negative value

COMPONENTS OF BOP CURRENT ACCOUNT It is a measure of the flow of funds from trade in goods and services, plus other income flows It is divided into FOUR components: Balance of trade in goods/ Visible trade balance/Merchandise account/Balance of trade Balance of trade in services/ Invisible trade balance/Net services Income/Net investment income Current transfers

Balance of trade in goods/ Visible trade balance/Merchandise account/Balance of trade It measures the revenue received from the export of tangible goods minus the expenditure on the imports of tangible goods over a given time period NOTE: Exports lead to inflow of money while imports lead to an out flow of money There is a surplus when X>M There is a deficit when M>X

Balance of trade in service/ Invisible trade balance/Service balance/Net services It measures the revenue received from the export of services minus the expenditure on the imports of services over a given time period Examples of these services include: Banking Insurance Tourism Transport Postal and courier services Communication services Financial services

Income/Net investment income It is a measure of the net monetary movement of profit, interest, and dividends moving into and out of the country over a given period of time, as a result of financial investment abroad. Examples: Profits, Interests and Dividends from portfolio Direct investments Compensation of employees (wages and salaries) Returns from rental resources e.g. granting fishing, grazing mining, and forestry rights.

Current transfers It is a measurement of the net transfers of money, often known as net unilateral transfers from abroad. It refers to transfers with nothing received in return Examples: Worker’s remittances Donations Grants Foreign aid Food aid and emergency aid after natural disasters.

The sum of net export of goods and services, net income and net current transfers over a period of time is defined as current account balance. It is referred to as a current account surplus if it is positive while a current account deficit if it is negative.

NOTE: The current account of the balance of payments of a country is composed of the sum of the balance of trade (recording exports minus imports of goods) plus the balance on service, or invisible balance (recording exports of service minus imports of services), plus net income plus net transfers. The most important part of the current account in most countries is the balance of trade.

CAPITAL ACCOUNT This section of the BOP includes the following: Capital transfers receivable and payable i.e. the net monetary movements gained or lost through actions such as the transfer of goods and financial assets by migrants entering or leaving the country. Note: These items of value that have not been produced e.g. land or natural resources. Other examples include: Gift taxes Inheritance taxes Death duties Debt forgiveness

2. Transaction in non – produced, non- financial assets This consists of the net international sales and purchases of non – produced assets such as land and the rights to natural resources, and the net international sales and purchases if intangible assets such as patents, copyrights, brand names or franchises. NOTE: THE CAPITAL ACCOUNT IS SMALL AND OF MINOR IMPORTANCE

FINANCIAL ACCOUNT This account includes investments and assets. It measures the net change in foreign ownership of domestic financial assets. If foreign ownership of domestic financial assets > domestic ownership of foreign financial assets, then there is more money coming into the country than going out and so there is a financial account surplus. The vice versa leads to a financial account deficit.

COMPONENTS OF THE FINANCIAL ACCOUNT Direct investment: this is also referred to as Foreign Direct Investment (FDI) when a resident in one country acquires control or a significant degree of influence on the management of a firm in another economy (normally more than 10%) It is a measure of the purchase of long – term assets. It includes things such as: Buying of property Outright purchasing of a business Purchasing of stocks or shares in a business.

2. PORTFOLIO INVESTMENT It refers to a measure of stock and bond purchases – these do not lead to a lasting interest in a company. It includes: Treasury bills Government bonds Saving account deposits NOTE: THESE ASSETS ARE SIMPLY BORROWING AND LENDING ON THE INTERNATIONAL MARKET.

3. RESERVE ASSETS/ OFFICIAL RESERVES This includes the assets that the Central Bank holds to finance balance of payments needs and to intervene in the foreign exchange market It includes the reserves of gold and foreign currencies which all countries hold. It is movements into and out of this account that ensures that the BOPs will always balance to zero.

CURRENT ACCOUNT = CAPITAL ACCOUNT + FINANCIAL ACCOUNT+ NET ERRORS AND OMISSIONS

RELATIONSHIP BETWEEN CURRENT ACCOUNT AND THE EXCHANGE RATES A deficit in the current account of the BOP results in a downward pressure on the exchange rate of a currency. This mostly affects the fixed exchange rate more than the floating exchange rate. A surplus in the current account of the BOP may result in an upward pressure on the exchange rate of the currency.

HL: CONSEQUENCES OF CURRENT ACCOUNT AND CAPITAL IMBALANCES CONSEQUENCES OF A CURRENT ACCOUNT DEFICIT If the current account is in deficit, the capital account will have to be in surplus in order balance the current account benefit. It means the economy is not earning enough FOREX from its imports and income earnings from abroad to finance its imports.

SOLUTION Running down FOREX reserves – this can only be down for a short period of time because these reserves are limited. Surplus from the combined Capital and Finance Accounts: This can only be done it two ways: Sale of domestic assets (businesses, stock or property) to foreigners – they might want at low prices. This may lead to loss of economic sovereignty. Borrowing from abroad – this involves future repayment either in the short or long run – opportunity cost will be diversion in the future of national income; since repayment is in FOREX and this implies diversion away from purchase of import consumer or capital goods

METHODS OF CORRECTING A PERSISTENT CURRENT ACCOUNT DEFICIT 1. Expenditure reducing strategies – this includes policies that decrease AD ( decrease spending on imports), for example contractionary fiscal and monetary policies. Decrease in AD will lead to decrease in inflation, exports may benefit from increased competitiveness. Shrinking imports and increasing exports will help narrow the current account deficit.

2. Expenditure switching policies - this includes devaluation, as well as increased trade protection that renders imports more expensive. NOTE – devaluation increases exports but may leads to inflation. Trade protection restricts imports but may lead to trade friction.

3. Supply – side policies – these are more of a long run nature and they include decreasing domestic monopoly power, increasing labor market flexibility and improving incentives. They increase the competitiveness of the economy and especially of the export sector.

IS A CURRENT ACCOUNT SURPLUS A PROBLEM? DISCUSS! QUESTION? IS A CURRENT ACCOUNT SURPLUS A PROBLEM? DISCUSS!

THE MARSHALL-LERNER CONDITION DEVALUATION (SHARP DEPRECIATION) WILL IMPROVE A TRADE DEFICIT IF: PED (X) + PED (M) > 1

http://www.youtube.com/watch?v=VgCFN9M2aFE ( The Marshall Lerner condition)

THE J – CURVE EFFECT http://www.youtube.com/watch?v=HSd7ybLJUuw (J – curve)

REFERENCES Blink and Dorton, (2012), Economics: Course Companion, Oxford University Press, New York Ziogas, C., (2012), IB study guide, Oxford university Press, New York. Welker’s Wikinomics videos lectures.