Chapter 3 The Balance of Payments Management 3460 Institutions and Practices in International Finance Fall 2003 Greg Flanagan

September 30, Chapter Objectives: The student will be able to: Explain the balance of payments accounts; interpret the accounts; explain the BP effect on floating exchange rates; Explain the effect of government intervention on the FE market; Be aware of the trends in international BP.

September 30, Outline Balance of Payments Accounts The Current Account The Capital Account Statistical Discrepancy Official Reserves Account The Balance of Payments Identity Canadian Balance of Payments Data The effect of BP on exchange rates Balance of Payments Trends in Major Countries

September 30, Balance of Payments Accounting The Balance of Payments is the statistical record of a specific country’s international transactions over a certain period of time (annual) using double-entry bookkeeping.

September 30, Balance of Payments Accounts records all transactions between the residents of a country and residents of all foreign nations. composed of the following: The Current Account The Capital Account The Official Reserves Account Statistical Discrepancy

September 30, The Current Account iMports and eXports of goods “balance of merchandise trade” mercantalism and imports and exports of services including: investment income; unilateral transfers (foreign aid).

September 30,

8

9

10

September 30, The Current Account Current account balance If balance < 0 (debits exceed credits), then a country is running a trade deficit. If balance > 0 (credits exceed debits), then a country is running a trade surplus.

September 30,

September 30, The Capital Account The capital account measures the difference between sales of assets to foreigners and purchases of foreign assets. The capital account is composed of direct investment (FDI); portfolio investments and; other investments. Reported as Canadian Assets Abroad and Canadian Liabilities to non-residents

September 30, Difference between Capital and Current account balance The balance of payments (BP) must balance! Official reserves can rise and fall assets include gold, foreign currencies, SDRs, reserve positions in the IMF. Statistical discrepancy some omissions and errors therefore a estimate makes the accounts balance.

September 30, The Balance of Payments Identity BCA + BKA + BRA = 0 Where: BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account

September 30, Cdn Balance of Payments 2002 Goods & services -1,853 of which: travel -8,330Balance 66,653Payments 58,323Receipts Services 57,846Balance 356,459Payments 414,305Receipts Goods 49,516Balance 423,112Imports 472,628Exports 1,361Balance Current transfers -27,511Balance 29,643 of which: interest 59,149Payments 31,638Receipts Investment income $'000, ,366 Balance 487,902Payments 511,268Receipts Total 1+2+3=4 Current Account

September 30, ,816 Capital account 62,864 Total Canadian liabilities to non-residents 9,464Other investments 3,782Money market 18,712Bonds -1,436Stocks Portfolio liabilities 32,342 Direct investment in Canada -80,825 Total Canadian assets abroad -10,657Other investment assets -6,243Bonds -18,707Stocks Portfolio assets -45,217Direct investment abroad -17,961Financial account -13,145Total = = 5 $'000,000 Capital and Financial Account

September 30, Effect of Balance of Payments on the Foreign Exchange Market Reciprocal markets Demand for foreign goods (imports) = demand for FE Demand for Cdn goods (exports) = supply of Cdn$ Debits = demand for foreign exchange/ supply of Cdn$. Credits = supply of foreign exchange/ demand for Cdn$.

September 30, Floating Foreign Exchange Market If the current account + capital account > 0 i.e. Trade surplus  Qs > Qd  Cdn$  If the current account + capital account < 0 i.e. Trade deficit  Qd > Qs  Cdn$ 

September 30, Foreign Exchange Market BP < 0 (Trade deficit) Cdn$ Q US$  S D Cdn$ Q US$ BP > 0 (Trade surplus) S Qd D A floating exchange rate adjusts automatically Qs Qd Qs  Cdn$ depreciatesCdn$ appreciates

September 30, Intervention in the Foreign Exchange Market the current account + capital account < 0  Qs < Qd  Cdn$  Bank of Canada sells foreign exchange = increase in supply of FE  Cdn$  If the current account + capital account > 0 If  Qd < Qs  Cdn$  Bank of Canada buys foreign exchange = increase in demand of FE  Cdn$ 

September 30, Foreign Exchange Market B of C sells FE Cdn$ Q US$ US$ S D B of C buys FE S US$ D D* S* The Bank of Canada can intervene in the FE market   Cdn$ appreciates Cdn$ depreciates Q US$ Cdn$

September 30, 2003 Balance of Payments Trends Canada has usually experienced surpluses on the current account and deficits on the capital account. Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account. During the same period, Japan has experienced the opposite of the U.S., similar to Canada.

September 30, Balances on the Current (BCA) and Capital (BKA) Accounts of the United States Source: IMF International Financial Statistics Yearbook, 2000

September 30, Balances on the Current (BCA) and Capital (BKA) Accounts of United Kingdom Source: IMF International Financial Statistics Yearbook, 2000

September 30, Balances on the Current (BCA) and Capital (BKA) Accounts of Japan Source: IMF International Financial Statistics Yearbook, 2000

September 30, Balances on the Current (BCA) and Capital (BKA) Accounts of Germany Source: IMF International Financial Statistics Yearbook, 2000

September 30, Balances on the Current (BCA) and Capital (BKA) Accounts of China Source: IMF International Financial Statistics Yearbook, 2000

September 30, 2003 Balance of Payments Trends Germany traditionally had current account surpluses, since 1991 Germany has been experiencing current account deficits. This is largely due to German reunification and the resultant need to absorb more output domestically to rebuild the former East Germany. What matters is the nature and causes of the disequilibrium.

September 30, Balances on the Current (BCA) and Capital (BKA) Accounts of Five Major Countries Source: IMF International Financial Statistics Yearbook, 2000