1. Chapter 2
Balance of Payment

2. Objectives of the Chapter
Definition
Components of BOP
Factors Affecting International Trade Flows
Correcting BOT
DFIs by US Firms
DFIs in US
Factors affecting DFIs
Factors affecting International Portfolio Investment
Agencies Help correcting BOP

3. Definition
“A balance of payments (BOP) sheet is an accounting record of all monetary transactions between a country and the rest of the world” Sloman, John (2004)
“A record of all transactions made between one particular country and all other countries during a specified period of time”.
“Balance of payments may be used as an indicator of economic and political stability”.
“The BOP summarizes international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned”.

4. A negative balance of payments means that more money is flowing out of the country than coming in.
A Positive balance of payments means that more money is flowing in the country than going out

5. Positive & Negative BOP
Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items.
Uses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit item.

6. Components of BOP Current Account Capital Account
Official Reserve Account

7. Current Account a) Balance of Trade b) Factor Income
Merchandise (Exports & Imports)
Services (Exports & Imports)
b) Factor Income
c) Unilateral Transfers

8. Factor Income Income from: Dividends Interest
Income earned by workers overseas
Compensation of employees
Income of workers employed in an economy where they are not resident
- (Eg: Pak workers in Microsoft Corporation)
Income of residents employed by nonresident entities
- (Eg: People working in Pierre Cardin situated in Pakistan)
Personal transfer
It consist of all current transfers in cash or in kind made or received by resident households to or from nonresident households.
- (Eg: Mr. A sending money from Pakistan to his friend in US)

9. c) Unilateral Transfers
Aids
Grants
Gifts

10. Capital Account Foreign Direct Investment --- Portfolio Investment
Other Capital

11. Foreign Direct Investment
Investment in real assets in foreign countries
such as:
Land
Building
Existing plant

12. Statistical Discrepancy
It represents errors due to unrecorded transactions involving smuggling and other capital
Also known as Errors & Omissions
Many experts believe that it is the result of large hidden capital flows, and so the item has been placed in the capital account part of the BOP

13. Factors Affecting BOT Inflation National Income
Government Restrictions
Exchange Rates

14. HIGH INFLATION
Current Account (-) Dr

15. HIGH INCOME LEVEL
Current Account (-) Dr

16. Government Restrictions
Tariffs
Quotas

17. EXCHANGE RATES
Current Account (-) Dr

18. Correcting the trade deficit
Any policy that increases demand for country’s goods and services
It will increase the Balance of Trade
Solution
If export price becomes attractive --
Floating rate may correct the deficit --
Trade deficit may experience an stable currency --

19. If export price becomes attractive
It will increase the Balance of Trade
This can occur when a country has:
Low inflation
Low currency value

20. Floating rate may correct the deficit
What is Deficit
When country is spending more on foreign goods
When country is receiving less from exports
It means
More supply of home currency for sale
The value of its currency should decrease
This decrease will encourage more foreign demand of home made products
Therefore CA will increase
But this technique may not always work

21. Trade deficit may experience an stable currency
Again Recall “DEFICIT”
Spending more on foreign goods
Receiving less from exports
Resulting in low value of currency
NOW
Investment in securities becomes attractive for foreigners
Increased demand of home currency
Upward pressure on home currency
Therefore the trade imbalance will be offset by positive capital account

22. Weak Currency may not always be the solution
Counter pricing by competitors
- Once low priced items seem more attractive to the foreign customers
The competing countries may also lower the price
Impact of other weak currencies
The home currency does not necessarily weaken against all currencies at the same time
Eg: It is possible that the Pakistani rupee may weaken against Indian currency, So Pakistan may stop buying Indian products
but It may start buying from other countries where Pak Rupee is still stable i.e. Bangladesh, Srilanka, Iran etc

23. Pre-arranged International Transaction
If the home currency is lower in value
It is not possible that every country will frequently start buying from here
Till the time countries become aware about the cheap product
Lower rate may not be available till that time
Due to time lag it is not always possible

24. Inter Company Trade
Importers and exporters under the same ownership have unique relationship
Many firms use to buy the products from their subsidiaries
This type of trade makes 50% of trade
Trade between countries may not affect exchange rates

25. Outflow Inflow
Inflow Outflow

26. Correcting BOP When all components of the BOP sheet are included
It must balance
It must sum to zero
There can be no overall surplus or deficit.
Eg: - If a country imports more than it exports
- It’s trade balance will be in a deficit
But It has to be balanced
By running down reserves or by receiving loans from other countries.

27. Lets rename it the imbalance of payments and announce its normal….

28. The Official Reserve Account
“It is the foreign currency and securities held by the Govt.”
Usually by its Central bank
It is used to balance the payments from year to year
It increases when there is a trade surplus
It decreases when there is a deficit
Sometimes the Central Bank use it to change the exchange rate when the government perceives as more favorable

29. Agencies that help to Correct BOP Deficit
IMF
IBRD
WTO
International Financial Corporation
International Development Association
Bank of International Settlements
Regional Development Agencies

30. IMF
A result of UN Monetary & Financial Conference in 1944

31. Objectives of IMF To promote Cooperation among countries
To promote stability in exchange rates
To provide temporary funds to member countries attempting to correct imbalances of international transactions
To promote free mobility of funds across countries
To promote free trade

32. Compensatory Financing Facility (CFF)
This facility is mainly used by developing countries
Each country is assigned a quota
The amount of fund that a member country can borrow depends upon its quota
The country must be willing to work with IMF to resolve the problem

33. SDRs An international reserve asset created by IMF in 1969
The financing by IMF is measured in SDRs
IMF allocates it to member countries to supplement currency reserves
It is not a currency but a unit of account

34. The SDR basket and Its Valuation
Currency
Amount in 1 SDR
(1)
Exchange Rate vs US $
(2)
US $ Equivalent
(1) * (2)
USD
0.5770
Euro
0.0984
GBP
0.4260
Total

35. IBRD Established in 1944 Structural Adjustment Loan (SAL) in 1980
It spread its funds through co-financing:
Official Aid Agencies
(projects)
Export credit agencies
Commercial Banks

36. Correcting BOP Problems
Roberts, Richard (1999)
The fundamental function of International Monetary System is to provide mechanisms to correct imbalances.
Even a mixture of at least the first two methods may be used.
Methods:
There are three possible methods to correct BOP imbalances
Adjustments of exchange rates
Adjustment of a nations internal prices along with its levels of demand
Rules based adjustment
Note: Improving productivity and competitiveness can also help to enhance the exports through other means BUT
It is generally assumed that a nation is always trying to develop and sell its products to the best of its abilities.