THE BALANCE OF PAYMENTS J.D. Han, King’s University College 12-1

Key Questions What is the Balance of Payment? Supply and Demand of FOREX 2 methods of BP Accounts What ‘market’ does the BP affect? FOREX What is the equilibrium of the BP? What will happen to FOREX rate if the BP is not in equilibrium. 12-2

12-3 Balance of Payments Accounts A country’s balance of payments accounts shows its payments to and its receipts from foreigners. It shows the flow of “Money”, international currencies or foreign exchanges.

12-4 Balance of Payments Accounts (cont.) The ‘New Format’ of Balance of Payment Accounts are separated into 3 broad accounts:  current account: accounts for flows of goods and services (imports and exports).  financial account: accounts for flows of financial assets (financial capital).  capital account: flows of special categories of assets (capital), typically non-market, non- produced, or intangible assets like debt forgiveness, copyrights and trademarks; minor for the U.S. Economy

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley * A little More details: Each of the 3 broad accounts are more finely divided: Current account: imports and exports 1. merchandise (goods like DVDs) 2. services (payments for legal services, shipping services, tourist meals,…) 3. income receipts (interest and dividend payments, earnings of firms and workers operating in foreign countries 4. net unilateral transfers gifts (transfers) across countries that do not purchase a good or service nor serve as income

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley Balance of Payments Accounts (cont.) Financial account: the difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens. Financial (capital) inflow  Foreigners loan to domestic citizens by acquiring domestic assets.  Foreign owned (sold) assets in the domestic economy are a credit (+) Financial (capital) outflow  Domestic citizens loan to foreigners by acquiring foreign assets.  Domestically owned (purchased) assets in foreign economies are a debit (-)

12-7 Financial account has 3 categories mixed together: 1. All other (“Spontaneous”) financial assets (transactions) by the Private Sector 2. Official (international) reserve assets by the Government 3. Statistical discrepancy

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley Official (international) reserve assets: foreign assets held by central banks to cushion against instability in international markets.  Assets include government bonds, currency, gold and accounts at the International Monetary Fund.  Official reserve assets owned by (sold to) foreign central banks are a credit (+); Capital Inflow.  Official reserve assets owned by (purchased by) the domestic central bank are a debit (-): Capital Outflow. - Overall + means the government is getting credit from elsewhere (as outstanding debt), or running down on the accumulated reserve holdings.

12-9 Balance of Payments Accounts (cont.) The negative value of the official reserve assets is called the official settlements balance or “balance of payments”.  It is the sum of the current account, the capital account, the non-reserve portion of the financial account, and the statistical discrepancy.  A negative official settlements balance may indicate that a country is depleting its official international reserve assets or may be incurring debts to foreign central banks. selling foreign currency by the domestic central bank and buying domestic assets by foreign central banks are credits for official international reserve assets, and therefore reduce the official settlements balance.

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley How Do the Balance of Payments Accounts Balance? 1) “Identity”: Meaning “the left is equal the right all at times” Due to the double entry of each transaction, the Balance of Payments Accounts will balance out at all times: current account + financial account + capital account = 0 2) “Equilibrium Condition”: The Balance of Payment is in equilibrium when Current account + All other ‘Spontaneous’ financial assets transaction account = 0

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley Current Account Balance 2. All other ‘spontaneous’ financial transactions Account in the private sector ____________(‘the above line’ Balance of Payment = Official Settlement Balance) 3. Credits(+)/Debits(-) from Official Reserves = 0 all the time

The above means Items of 1+2 and item 3 are the mirrored terms: of the same size, but of the opposite sign. Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley

Credits in the Official Reserves(flows) are equivalent to Cashing your savings/wealth: When you are in deficits, you cash Your Office Reserves(stock), or issue IOUs and thus get Credits from Official Reserves(flows): “Your Official Reserves decrease(-) as you get Credits from the Official Reserves(+)” Modified by JD. Han based on Materials provided by Pearson Addison-Wesley

U.S. has a very small stock of International Reserves (of FOREX) nge_reserves htm Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley

12-15 The Balance of Payment is the important measure of ‘immediate’ pressures on a country’s Official Reserves and thus on that country’s FOREX rates. * Overall or long-term pressure on the country’s FOREX rate is measured by the Current Account Deficits: eg) pp.298 of Salvatore’s book (7 th edition)

Let’s take two examples of the U.S. BOP table(2003; 2005), and read them so that we can make a sense out of it: Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley

Modified by J.D. Han based on Materials provided by Pearson Addisn-Wesley US Balance of Payments Accounts, 2003 in Billions of Dollars

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley US Balance of Payments Accounts, 2003 in Billions of Dollars (cont.)

U.S. Balance of Payment, 2005 Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley Salvatore’s Page P. 457 Current Account Balance = $-791 billions The ‘Spontaneous’ Financial Account Balance = billions (‘The above line’ Balance of Payment = -224 billions ) _______________________________________________ Changes in Official Reserves = +213 billions Statistical Errors = 11 billions _________________________________ Net = 0

How to interpret this BP Table? The U.S. citizens and government could buy foreign goods and services by $ 791 billions more from abroad than what they sell to abroad. They got financing by selling $ 567 billions of financial and real assets to abroad. And the shortage of $ 213 billions had to be funded by the government’s run- down and borrowings on the ‘safe’ of “Official Reserves”.

BP disequilibrium and Pressures on FOREX rates At disequilibrium, the price would change so that the disequilibrium be eliminated. BP deficits put upward pressures on FOREX and downward pressure on domestic currency. Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley. Summary ‘Above the line BP’ = CA + ‘Spontaneous Part’ of FA = CA + (Financial Account – Official Reserve Assets ) BPA = BP + Net Official Reserve Asset Credit = 0 at all times

IMF Method of BP Account Current Account Capital Account Financial Account Errors Reserves Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley

IMF’s Financial Account 1. (Foreign) Direct Investment abroad(outflows) (Foreign) Direct Investment in the nation(inflows) 2. Portfolio Investment Assets(outflows) Equity Securities; Debt Securities Portfolio Investment Liabilities (inflows) Equity Securities; Debt Securities 3. Financial Derivatives Asset Financial Derivate Liabilities 4. Other Investment Assets Banks; Government and Monetary Authorities Other Investment Liabilities Bank s