1 The Balance of Payments System Lect 4/Wk 5, w/c 18 th October Dr Michael Wynn-Williams

2  Internal transactions can be of two types  Trade related Trade exposure ratio = (X+M)/gdp  Investment related FDI Portfolio investment Invisible earnings Unrequited transfers  Balance of payments is the “statement of international transactions” – shows balance of countries trade and transactions with the rest of the world

3  Comprises two main accounts  Current account – trade in merchandise Sum of the balance of trade (exports – imports) Value of visibile trade – merchandise, commodities etc. Service sector – payments and receipts Private and official transfers  Capital account (IMF financial account) – sale and purchase of assets Long-term capital flows – investment in firms Short-term capital flows – speculation

4  Balancing the books -  A trade surplus The current account must swell on incoming funds Capital account deficit as overseas liabilities increase Rising currency value Accumulation of foreign exchange to suppress own currency value  A trade deficit The current account is shrinking Depletion of foreign exchange Falling currency value The funds return as loans in the capital account – “owned by foreigners” Increase in capital due to incoming FDI

5  Exports  Measured fob  Imports  Measured cif  Exports minus imports gives TRADE BALANCE  Trade data is available from Customs Department of Ministry of Finance/ Commerce, Most countries follow the 10 digit HS system  An improvement over the BTN, SITC-1, and SITC-2, and SITC- 3  Represents harmonization between customs and excise duties  10 digit disaggregate classification 1= agriculture 13 = agri products 138 = agri products processed 1382 = agri…processed, made from milk

6  Services are the “invisibles”  Current classification describes seven types of invisibles Travel, debit & credit Transportation“ Insurance“ GNIE“ Investment income“ Miscellaneous“ Transfers“  This data is reported by the Central Bank of the country

7  The capital account has following aggregates  Official transactions, IMF, Aid, etc (PL480)  Portfolio investment  Commercial Borrowing  Gapfil Borrowing/ exceptional financing  Changes in reserves Negative sign implies accretion to reserves

8  Exports = 28,000  Imports = 40,000  Trade balance= -12,000  Invisibles, net= 6,000  Balance on current a/c= -6,000  To be financed by  Official transactions= 3,000  Portfolio investments= 1,000  Commercial borrowing= 2,000  Exceptional financing= 0  Changes in reserves= 0

9  Exports = 28,000  Imports = 40,000  Trade balance= -12,000  Invisibles, net= 6,000  Balance on current a/c= -6,000  To be financed by  Official transactions= 3,000  Portfolio investments= 2,000  Commercial borrowing= 2,000  Exceptional financing= 0  Changes in reserves= -1,000

10  Exports = 28,000  Imports = 40,000  Trade balance= -12,000  Invisibles, net= 6,000  Balance on current a/c= -6,000  To be financed by  Official transactions= 1,000  Portfolio investments= 1,000  Commercial borrowing= 2,000  Exceptional financing= 2,000+interest upfront  Changes in reserves= 0

11  Current account deficit:  Export opportunities are poor  Import opportunities are good  Rising consumerism  Current account surplus  Export opportunities are good  Import opportunities are poor  Rising production levels

12  You are a business adviser to your national government  The country is currently running a large current account surplus  With the global recession dragging on, your government needs to know what kind of industries to encourage  Your advice will show:  Plan for short-term recovery  Plan for long-term sustainability

13

14  What is the BOP condition?

15  What is the BOP condition?  What is the ability to pay for imports?

16  What is the BOP condition?  What is the ability to pay for imports?  What quantity of imports is needed?

17  What is the BOP condition?  What is the ability to pay for imports?  What quantity of imports is needed?

18  Measuring the 3 memo items  [a] cad/gdp ratio Should be in similar prices, either constant or current should be less than 2%  [b] debt service ratio (I +A)/ (Xr + Ir) should be less than 20%  [c] import reserve ratio (Reserves/imports)* 12 should be more than 3 months of imports

19  Economies can be divided into three sectors  Primary (agri + mining)  Secondary (manufacturing+food processing)  Services (banking, insurance etc)  Transition takes place from  Primary -> Secondary -> Services

20  A (-) sign in the changes in reserves figures implies an accretion to reserves  In exceptional financing, interest is paid upfront, with interest being added to the investment income component of invisibles  This will result in two current account deficits, ex-ante and ex-post  The US/ World Bank does not consider private (unrequited) transfers as part of invisibles. Thus the CAD tend to get inflated

21  Read the article on Australia’s CAD/GDP ratio

22  IMF Balance of Payments Manual (5 th ed.)  Online tutorial Tutor2U balance-of-payments-deficits.html  Abhijit Sen and C. P. Chandrasekhar Balance of Payments Adjustment: Some Issues and Estimates in Economic and Political Weekly, Vol. 26, No. 11/12, Annual Number (Mar., 1991), pp