The Balance of Payments Chapter 4 The Balance of Payments

The Balance of Payments International business transactions occur in many different forms over the course of a year The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP)

The Balance of Payments BOP data is important for government policymakers and MNEs as it is a gauge of a nation’s competitiveness or health (domestic and/or foreign) For a MNE, both home and host country BOP data is important as: An indication of pressure on a country’s foreign exchange rate A signal of the imposition or removal of controls in various sorts of payments (dividends, interest, license fees, royalties and other cash disbursements) A forecast of a country’s market potential (especially in the short run)

Typical BOP Transactions Each of the following represents an international economic transaction that is counted in and captured in the U.S. BOP: A U.S. subsidiary of a foreign MNE acts as a distributor for the MNEs products in the U.S. market A U.S. based firm, manages the construction of a major water treatment facility in a foreign country The U.S. subsidiary of a foreign firm pays profits (dividends) back to a parent in its home (foreign) country The U.S. government finances the purchase of military equipment for a foreign military ally

Fundamentals of BOP Accounting The BOP must balance It cannot be in disequilibrium unless something has not been counted or has been counted improperly Therefore it is incorrect to state that the BOP is in disequilibrium

Fundamentals of BOP Accounting There are three main elements of the actual process of measuring international economic activity: Identifying what is and is not an international economic transaction Understanding how the flow of goods, services, assets, and money create debits and credits to the overall BOP Understanding the bookkeeping procedures for BOP accounting It is a daunting task to measure all international transactions that take place in and out of a country over a year Exhibit 4.1 presents a sample generic BOP

Exhibit 4.1 Generic Balance of Payments

The BOP as a Flow Statement The BOP is often misunderstood as many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement By recording all international transactions over a period of time such as a year, it tracks the continuing flows of purchases and payments between a country and all other countries It does not add up the value of all assets and liabilities of a country on a specific date (as an individual firm’s balance sheet would do)

The BOP as a Flow Statement Two types of business transactions dominate the balance of payments: Exchange of Real Assets Exchange of Financial Assets Although assets can be identified as belonging to distinct groups, it is easier to think of all assets simply as goods that can be bought or sold (a clock versus a bond)

The Accounts of the BOP The BOP is composed of two primary sub accounts, the Current Account and the Capital/Financial Account In addition, the Official Reserves account tracks government currency transactions A fourth account, the Net Errors and Omissions account is produced to preserve the balance of the BOP

The Current Account The Current Account includes all international economic transactions with income or payment flows occurring within one year, the current period. It consists of the following four subcategories: Goods trade and import of goods Services trade Income Current transfers The Current Account is typically dominated by the first component which is known as the Balance of Trade (BOT) even though it excludes service trade Exhibit 4.2 documents the U.S. current account from 2002–2010; Exhibit 4.3 follows with U.S. trade balance on goods and services

Exhibit 4.2 The United States Current Account, 2002-2010 (billions of U.S. dollars)

Exhibit 4.3 U.S. Trade Balances on Goods and Services, 1985-2010 (billions of US dollars)

The Current Account The deficits in the BOT of the past decade have been an area of considerable concern for the United States, in both the public and private sectors The goods trade deficit saw the decline of heavy traditional industries in the U.S. (steel, automobiles, automotive parts, textiles)

The Capital/Financial Account The Capital Account of the balance of payments measures all international economic transactions of financial assets. It is divided into two major components: The Capital Account The Financial Account The Capital Account is minor (in magnitude), while the Financial Account is significant

The Financial Account Financial assets can be classified in a number of different ways including the length of the life of the asset (maturity) and the nature of the ownership (public or private) The Financial Account, however, uses a third method. This focuses on the degree of investor control over the assets or operations

The Financial Account The Financial Account consists of three components; Direct Investment – in which the investor exerts some explicit degree of control over the assets Portfolio Investment – in which the investor has no control over the assets Other Investment – consists of various short-term and long-term trade credits, cross-border loans, currency deposits, bank deposits and other A/R and A/P related to cross-border trade

Direct Investment This is the net balance of capital dispersed from and into the U.S. for the purpose of exerting control over assets. Foreign direct investment arises from 10% ownership of voting shares in a domestic firm by foreign investors. The source of concern over foreign investment in any country focuses on two topics: control and profit. Some countries possess restrictions on what foreigners may own in their country. The general rule or premise is that domestic land, assets and industry should be owned by residents of the country. Concerns over profit stem from the same argument.

Portfolio Investment This is the net balance of capital that flows in and out of the U.S. but does not reach the 10% threshold of direct investment. The purchase of debt securities across borders is classified as portfolio investment because debt securities by definition do not provide the buyer with ownership or control. Portfolio investment is motivated by a search for returns rather than to control or manage the investment. As illustrated in Exhibit 4.4, portfolio investment has shown much more volatile behavior than net foreign direct investment over the past decade

Exhibit 4.4 The United States Financial Accounts and Components, 2002-2010 (billions of U.S. dollars)

Other Investment Assets and Liabilities, Current and Financial Account Balance Relationships Exhibit 4.5 shows the major subcategories of the U.S. financial account balance from 1985 to 2009: direct investment, portfolio investment, and other long-term and short-term capital investment Exhibit 4.6 illustrates the current and financial account balances for the United States over recent years

Net Errors & Omissions/Official Reserves Accounts The Net Errors and Omissions account ensures that the BOP actually balances. The Official Reserves Account is the total reserves held by official monetary authorities within the country. These reserves are normally composed of the major currencies used in international trade and financial transactions (hard currencies). The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system.

Exhibit 4.5 The United States Financial Account, 1985-2010 (billions of U.S. dollars)

Exhibit 4.6 Current and Combined Financial/Capital Account Balances for the United States, 1992-2010 (billions of U.S. dollars)

Breaking the Rules: China’s Twin Surpluses Exhibit 4.7 illustrates China’s highly unusual twin surplus in both the current and financial accounts (these relationships are typically inverse) The rapid rise of the Chinese economy has been accompanied by a 10 fold increase in foreign exchange reserves (Exhibit 4.8) As a result, China’s foreign exchange reserves are approximately 2.5 times larger than the next largest (Exhibit 4.9)

Exhibit 4.7 China’s Twin Surplus, 1998-2010 (billions of U.S. dollars)

Exhibit 4. 8 China’s Foreign Exchange Reserves (billions of U. S Exhibit 4.8 China’s Foreign Exchange Reserves (billions of U.S. dollars)

Exhibit 4. 9 Largest Foreign Exchange Reserves (billions of U. S Exhibit 4.9 Largest Foreign Exchange Reserves (billions of U.S. dollars)

The BOP in Total — Surplus Exhibit 4.10 provides a comprehensive overview of how the individual accounts are combined to create some of the most useful summary measures for multinational business managers Total of groups A, B, and C form the basic balance; this is one of the most frequently used summary measures of the BOP A surplus in the BOP implies that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase – in value – or intervene and accumulate additional foreign currency reserves in the Official Reserves Account

Exhibit 4.10 The United States Balance of Payments, Analytic Presentation, 2000-2010 (billions of U.S. dollars)

The BOP in Total — Deficit A deficit in the BOP implies an excess supply of the country’s currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value.

The BOP Interaction with Key Macroeconomic Variables A nation’s balance of payments interacts with nearly all of its key macroeconomic variables Interacts means that the BOP affects and is affected by such key macroeconomic factors as: Gross Domestic Product (GDP) The exchange rate Interest rates Inflation rates

The BOP and GDP In a static (accounting) sense, a nation’s GDP can be represented by the following equation: GDP = C + I + G + X – M C = consumption spending I = capital investment spending G = government spending X = exports of goods and services M = imports of goods and services X – M = the current account balance

The BOP and Exchange Rates A country’s BOP can have a significant impact on the level of its exchange rate and vice versa The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP Data (see next slide)

The BOP and Exchange Rates (X – M) + (CI – CO) + (FI – FO) + FXB = BOP Where: X = exports of goods and services M = imports of goods and services CI = capital inflows CO = capital outflows FI = financial inflows FO = financial outflows FXB = official monetary reserves Current Account Balance Capital Account Balance Financial Account Balance

The BOP and Exchange Rates Fixed Exchange Rate Countries Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero Floating Exchange Rate Countries Under a floating exchange rate system, the government has no responsibility to peg its foreign exchange rate Managed Floats Countries operating with a managed float often find it necessary to take action to maintain their desired exchange rate values

The BOP and Interest Rates Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries does have and impact on the financial account of the BOP Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere However, in the case of the U.S., the opposite has occurred due to perceived growth opportunities and political stability – allowing it to finance its large fiscal deficit However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the current account balance is worsening – making the U.S. a bigger debtor nation vis-à-vis the rest of the world

Trade Balances and Exchange Rates A country’s import and export of goods and services is affected by changes in exchange rates The transmission mechanism is in principle quite simple: changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand Theoretically, this is straightforward; in reality global business is more complex

Exhibit 4.11 Trade Balance Adjustment to Exchange Rate Changes: The J-Curve

Capital Mobility The degree to which capital moves freely across borders is critically important to a country’s balance of payments The United States’ financial account surplus has at least partially offset the current account deficits over the last 20 or more years China has run a surplus in each of these accounts in recent years

Capital Mobility The free flow of capital in and out of an economy can potentially destabilize economic activity or can contribute significantly to an economy’s development Thus, Bretton Woods Agreement was careful to promote free movement of capital for current account transactions (e.g., foreign exchange or deposits) but less so for capital account transactions (e.g., foreign direct investment) 1970s - 1990s saw growth in capital openness, the financial crisis of 1997/1998 stopped that due to destructive capital outflows and contagion

Capital Mobility The authors argue that the post-1860 era can be subdivided into four distinct periods with regard to capital mobility. 1860-1914 – continuously increasing capital mobility as the gold standard was adopted and international trade relations were expanded 1914-1945 – global economic destruction, isolationist economic policies, negative effect on capital movement between countries 1945-1971 – Bretton Woods era say a great expansion of international trade 1971-2097 – floating exchange rates, economic volatility, rapidly expanding cross-border capital flows China and India attempt to open their markets These points are laid out in Exhibit 4.12

Exhibit 4.12 The Evolution of Capital Mobility

Capital Controls A capital control is any restriction that limits or alters the rate or direction of capital movement into or out of a country Free movement of capital is more the exception than the rule Exhibit 4.13 outlines several methods of and purposes for capital controls Dutch Disease – is the name given to the problem of a substantial currency appreciation due to the demand for a specific natural resource – faced by several resource-rich smaller nations

Exhibit 4.13 Purposes of Capital Controls

Capital Flight Although no single definition of capital flight exists, it has been characterized as occurring when capital transfers by residents conflict with political objectives. Many heavily indebted countries have suffered capital flight, compounding their debt service problems. Capital can be moved via international transfers, with physical currency, collectables or precious metals, money laundering or false invoicing of international trade transactions.