November 2013

The Balance of Payments A record of the value of all the transactions between the residents of one country with the residents of all other countries in the world over a given period of time.

The Balance of Payments Credits: inflows, payments received from other countries. Debits: outflows, payments made to other countries

The Balance of Payments == Current Account Measure of the flow of funds from trade in goods and services, plus other income flows == Capital Account Measure of the flow of funds from trade in non financial assets == Financial account Measure of the flow of funds from trade in financial assets

Current Account Balance of trade in goods = visible trade balance Balance of trade in services = invisible balance = net services Together these two items make up the balance of trade Income (Wages, rents, interest and profits) Current transfers: net unilateral transfers from abroad, payments made when no goods or services change hands (gifts, foreign aid, taxes and payments to the EU)

Balance of Trade

Trade in Goods Manufactured Goods Energy Products Semi-finished products Raw Materials Consumer and Capital Goods

Trade in Services Banking and Insurance Consultancy Tourism Transport and Shipping Education ETC.

Current Account Imports represent an Outflow of money Exports represent an Inflow of money

Capital account and financial account Assets = anything that can be owned and that has value (land, real estate, stocks, treasury bills, government, bonds, foreign currency, bank deposits)

Capital Account Small part of BoP - Capital tranfers: Net monetary movements due to debt forgiveness, transfer of goods and financial assets by migrants entering or leaving the country, sale of fixed assets, gift taxes, inheritance taxes and death duties. - Transaction in non-produced, non-financial assets Net international sales and purchases of non-produced assets (land, rights to natural resources), and the net international transactions of intangible assets like patents, copyright, brand names and franchises.

Financial Account Direct investment: purchases of long term assets, where the buyer is aiming to gain a lasting interest in a company in another economy (property, purchase of a business). Portfolio investment: financial investments, such as stocks and bonds, saving accounts. Does not lead to a lasting interest. These are simply borrowing and lending.

Official reserves (or Reserve assets): reserves of gold and foreign currencies which all countries hold. It is movements into and out of this account that ensure that the BOP will always balance to zero. If there is a surplus on all the other accounts combined, then the official reserve account total will increase. If there is a deficit on all the other accounts, then the official reserve total will decrease.

Net Errors and Omissions Balance of payments = Balance sheet That means that IT MUST BALANCE!!!! Official reserves: in gold and in foreign currencies make up the difference WHY does it not always balance??? Mistakes, failure to record all items, generally due to a time delay can lead to a small discrepancy Current Account Balance + Capital Account Balance + Financial account balance Net Errors and Ommisions + Net Balance of Payment = 0

Balance of payments

CumulativeCumulative Current Account Balance based on the IMF dataIMF

CumulativeCumulative Current Account Balance per capita based on the IMF data

Pakistan New Turkey

Current account deficit what does it mean? Deficit on current account must be outweighed on the capital account and financial account  HOW? -Foreign exchange reserves -Foreign investors -Borrowing from abroad

Consequences of persistent CA deficits 1. Possible need for higher interest rates to attract foreign investors. 2. Risk of default if debt accumulated over long periods of time. This leads to currency depreciation, difficulties of getting more loans and painful D-side policies. 3. Depreciating exchange rate, which might increase inflation. 4. Poor int’al credit ratings, making it more difficult to get more loans in the future. In that case higher interest rates might be needed.

5. Painful demand side policies to reduce imports. 6. Fewer imports of needed capital goods. 7. Cost of paying interest on loans and 7 imply lower economic growth in the future.

Correction of persistent CA deficits 1.Expenditure switching: away from imports and towards domestic goods -Depreciation. Leads to higher import prices and risk of cost push inflation (capital goods and inputs become more expensive) -Protectionism. Higher domestic prices of protected goods, lower consumption, inefficiency and global misallocation of resources, risk of retaliation.

2. Expenditure-reducing policies: influence X and M by reducing domestic expenditures through lower AD. - Contractionary fiscal policies - Contractionary monetary policies The lower AD reduces inflation, which makes exports more competitive. Disadvantages: risk of a recession, plus higher interest rates may appreciate the currency offsetting the effects of the policies.

3. Supply-side policies to increase competitiveness. Market oriented policies intend to lower costs of production and by shifting SRAS and LRAS to the right can result in lower inflation rates. Interventionist policies can be used to promote industries that produce for export: support for training, education, R&D and industrial policies.

Current account surplus what does it mean? Surplus on current account must be outweighed on the capital account and financial account  HOW? -Foreign exchange reserves building up -Investing abroad -Appreciation of currency One country’s surplus is another country’s deficit  possibility for protectionism

Possible problems: 1. Low domestic consumption 2. Insufficient domestic investment. Financial account deficit: funds are leaving the country  risk of insufficient domestic investment  less growth in the future. 3. Appreciation  lower X and higher M  lower AD. 4. Reduced export competitiveness (3)