1. International Money & Finance Chapter 3: The Balance of Payments
Michael Melvin and Stefan Norrbin

2. Outline of This Chapter
What is the balance of payments (BOP)?
Current account and capital account
Examples of international transactions and how to enter them into the BOP.
The balance of payment equilibrium.
The U.S. trade deficit and foreign debt.

3. What is the Balance of Payments?
The balance of payments records a country’s trade in goods, services, and financial assets with the rest of the world.
It is an accounting statement based on double-entry bookkeeping.
Every transaction is entered on both sides of the balance sheet: a credit and a debit.
If all transactions are included, the sum of all credits must equal to the sum of all debits (total receipts = total payments)
The balance of payment always balances!!!
Credit – entries that bring foreign exchange into the country
Debit – entries that foreign exchanges leave the country.

4. If the BOP always balances, then why we talk about the U. S
If the BOP always balances, then why we talk about the U.S. trade deficit?
For each particular section of the BOP, there could be an imbalance.
When credits > debits → a surplus
When credits < debits → a deficit
Thus, there can be a deficit or surplus in any of the following:
merchandise trade (goods),
services trade,
foreign investment income,
unilateral transfers,
private investment,
the flow of gold and money between central banks and treasuries, or
any combination of these or other international transactions
The statement that a country has a deficit or surplus in its “balance of payments” must refer to some particular class of transactions.

5. Terminology I
Current account – sometime called “balance of trade”. It measures the value of trade from:
Good imports and good exports
+ Service imports and service exports
+ Net receipts of investment income
+ Unilateral transfers
Current Account
Net receipts of investment income = net factor income from abroad.
Foreign payments to capital, labor, and land owned by domestic firms
− Domestic payments to capital, labor, and land owned by foreign firms
Unilateral transfer – ex. gifts, pensions, and foreign aid.
Trade balance = exports – imports
TB > 0 → Exports > Imports → trade surplus
TB < 0 → Exports < Imports → trade deficit
TB = 0 → Exports = Imports → balanced trade

6. This shows the current account deficit and trade deficit
The Current Account of the United States
(+) Credit = bring foreign exchange into the country
(-) Debit = foreign exchange leave the country
This shows the current account deficit and trade deficit

7. The U.S. current account deficit is about $110.3 billion (Quarterly))
International trade on goods – deficit
International trade on services – surplus
Income receipts > Income payments
Net unilateral transfer is negative
Source: BEA

8. Terminology II + The foreign-owned assets at home (2) Capital Account
Capital account – purchases and sales of financial assets (ex. buying private or government bonds, stocks, and bank deposits) and direct investment (ex. purchase of a plant in another country).
− The domestic-owned assets abroad (1)
+ The foreign-owned assets at home (2)
Capital Account
(1) Purchases of U.S. assets by foreigners ↔ Capital Inflow
(2) U.S. residents purchases foreign financial assets ↔ Capital Outflow
Capital account surplus → Net capital inflow
→ the home country received more capital transfers than it made
→ Net borrower (issuing IOUs to lenders)
Capital account deficit → Net capital outflow
→ the home country make capital transfers than it received
→ Net lender (acquiring IOUs from borrowers)

9. The U.S. Capital Account
(+) Credit = bring foreign exchange into the country
(-) Debit = foreign exchange leave the country

10. The Capital Account in the United States
Quarterly Net Capital Inflow

11. Capital account transactions include:
Official transactions
any intervention in the foreign exchange market done by official government sources.
U.S. government assets abroad
Foreign government assets in the U.S.
Private transactions
Direct investment: private sector invests in foreign firms
Security purchases: purchases and sells stocks and bonds
Bank claims and liabilities: bank loans and deposits abroad

12. Official Settlement Balance
Official Settlement Balance – change in U.S. official reserves assets abroad plus change in foreign official assets in the U.S.
It measures the net change in foreign exchange reserves and official government borrowing.
It can serve as a measure for potential foreign exchange pressure on a dollar.

13. Current Account (CA) and Capital Account (KA)
Since the Balance of Payments always balance,
BOP = CA + KA = 0
CA + KA = 0
Current account surplus ↔ Capital account deficit
Current account deficit ↔ Capital account surplus

14. Statistical Discrepancy (SD)
Because not all international transactions are properly recorded, the statistical discrepancy (errors) will be added.
CA + KA + SD = 0
SD = − (CA + KA)

15. How to enter transactions into the BOP? The Current Account Entries
Debit (-) → cause outflow of money Credit (+) → bring in money
Trade in goods:
Import (-)
(-) U.S. farmer purchases German tractor.
Export (+)
(+) India stores buy Apple iPods
Trade in services:
(-) An American takes a cruise on a Norwegian cruise line.
(+) A Brazilian company hires U.S. consulting firm.

16. How to enter transactions into the BOP? The Current Account Entries
Debit (-) → cause outflow of money Credit (+) → bring in money
Investment income receipts and payments
Interest, dividend, and other income paid (-)
(-) The U.S. subsidiary of a Japanese company pays dividends to its parent company in Japan
Interest, dividend, and other income receipts (+)
(+) A Canadian company pays salaries to its executives stationed in New York.
Unilateral Transfers
Remittances by foreigners in the U.S., pension paid and aid offered by the U.S. to its citizens living abroad (-)
Remittances by Americans working abroad, pension paid and aid offered by foreigners to the U.S. (+)

17. How to enter transactions into the BOP? The Capital Account Entries
Direct investment (factories, machines)
Purchases of U.S. physical capital by foreigners (+)
(+) Ford Motor Company sells its factory to British investors.
Purchases of foreign physical capital by U.S. residents (-)
(-) Ford Motor Company builds a factory in Mexico.
Portfolio Investment (stocks, bonds, CDs)
Purchases of U.S. securities by foreigners (+)
(+) A London-based insurance company buys U.S. corporate bonds.
Purchases of foreign securities by U.S. residents (-)
(-) An American buys shares of a European company stock in London Stock Exchange.

18. How to enter transactions into the BOP? The Capital Account Entries
Other investments – loans and currency
Increase in loans and trade credits to U.S. residents by foreigners (+)
(+) A Canadian firm receives a payment for exports from the U.S. firm.
Increases in loans and trade credits to foreigners by U.S. residents (-)
(-) A U.S. firm deposits $1 million in a bank account in London.
Official Reserve Assets
Increases in dollar reserves held by foreign central banks (+)
Increases in holdings of foreign currency reserves by the Fed (-)

19. Examples of BOP Entries
1. French retailer buys $50,000 wheat from farmer Joe in Idaho, and pays with a 90-day note.
$50,000 exports (+ in merchandise trade)
$50, day note (- in private capital account because it is a loan that Joe lends to the French retailer)
2. U.S. resident receives $10,000 in interest from a German bond and is deposited in German bank account.
$10,000 investment income (+ in investment income for the current account)
$10,000 bank deposits in Germany (- in private capital account because it is a portfolio investment)

20. Examples of BOP Entries
3. U.S. government donates $100,000 in wheat to Nicaragua.
$100,000 wheat shipped (+ as exports in merchandise trade)
$100,000 donation (- in the unilateral transfer because it is aid offered to foreigner by the U.S.)
4. U.S. tourist travels to Germany, spend $5,000 on an “Oktober Fest” package deal, and pays a German travel company.
$5,000 Germany trip by American tourist (- as import of services)
$5,000 payments for the trip to German company (+ in private capital account because it is a payment of trade credit to foreigners by U.S. resident)

21. The U.S. BOP from these examples
Credit (+)
Debit (-)
Trade of Merchandises
50,000
(3) 100,000
Trade of Services
(4) 5,000
Investment Income
(2) 10,000
Unilateral Transfer
CA: Current Account
+ 55,000
Private Capital
10,000
Official Capital
KA: Capital Account
- 55,000
BOP: Balance of Payment

22. U.S. Trade Deficit
The current account deficits have been persistent since 1980.
Source: World Bank Databank, World Development Indicators & Global Development Finance

23. Some explanations for large U.S. trade deficit
Unfair trade
The U.S. is open to trade and thus importing a lot. Other countries are closed so that they don’t buy enough from the U.S.
Twin deficit
Because our government runs budget deficit, so we would have trade deficit.
Investment Demand Shift
People like to invest in the U.S. much more than before.

24. Unfair Trade
According to this claim, to explain what happen to the U.S. trade deficit since 1982, two things must happen:
Foreign countries must have suddenly increased their trade protection in 1982.
All countries must have decided to protect themselves against the U.S. at the same time.
Neither of the above statements was true.
In fact, many countries reduced trade protection and opened their economies.
There was no coordinated protection against the U.S.
Thus, it is unlikely that this popular claim is an explanation for the U.S. trade deficit.

25. Twin Deficit: Derive saving and investment
First, we need to go back to our basic macroeconomics to derive the saving and investment relationship.
Let Y be Gross Domestic Product (GDP)
Y = C + I + G + (X – M)
Y = domestic output or income
C = consumption
I = private investment
G = government spending
X = exports
M = imports
(X – M) = net exports or the trade balance

26. Twin Deficit Derive saving and investment (cont.)
Y = C + I + G + (X – M)
Y – C – I – G = (X – M)
Y – T – C – I + T – G = (X – M)
(Y – T – C) – I + (T – G) = (X – M)
Private saving Public saving
Private saving = (Y – T – C) = income-after-tax minus consumption spending
Public saving = (T – G) = tax revenues minus spending

27. Twin Deficit Derive saving and investment (cont.)
(Y – T – C) – I + (T – G) = (X – M)
If the LHS of the equation is negative, the RHS of the equation will also be negative.
Trade deficit comes from the negative value of the LHS of the equation
Negative RHS → (X – M) < 0 → X < M
T – G (public saving)
T > G → budget surplus
T < G → budget deficit
(Y – T – C) – I (private saving (S) minus domestic investment)
S > I → positive net private saving
S < I → overinvestment

28. How does trade deficit arise from government budget deficit?
If the government spending exceeds tax revenue, then
T – G < 0 → government will have to borrow money to finance its spending by issuing bonds (T-bills)
Interest rate in the U.S. will rise.
Suppose that ↑ ius > iJAPAN
Japanese would like to invest in the U.S. (buy T-bills), which will increase demand for the U.S. dollar.
$ will appreciate as Japanese trade ¥ for $.
U.S. exports become more expensive →↓ X
U.S. imports become cheaper → ↑ M
(↓X - ↑M) ↓
Trade deficit

29. Investment Demand Shift
An increase in investment demand could come from 1980s deregulations and 1990s IT boom. These events have increased demand for investment capital and driven the interest rate in the U.S. upward.
Interest rate in the U.S. will rise.
Suppose that ↑ ius > iJAPAN
Japanese would like to invest in the U.S., which will increase demand for the U.S. dollar.
$ will appreciate as Japanese trade ¥ for $.
U.S. exports become more expensive →↓ X
U.S. imports become cheaper → ↑ M
(↓X - ↑M) ↓
Trade deficit

30. How to eliminate the trade deficit?
If twin deficit idea is true, trade deficit is just a symptom of fiscal budget deficit. To eliminate trade deficit, we have to eliminate the fiscal budget deficit.
If the investment demand shift idea is true, trade deficit can be eliminated by banning foreign investment or making the U.S. unappealing for investment. However, these options may not be the best practice for the economy in the long run. Trade deficit is a symptom of foreigners’ belief in the U.S. economy.

31. How big is the U.S. foreign debt?
U.S. residents have over $20 trillion worth of claims on foreign assets, whereas foreigners hold $22.5 trillion in claims of the U.S. assets.
So, we owe $2.5 trillion more than we receive from the rest of the world.
Is it bad?
Not necessarily.
Foreign central banks and governments are holding large amount of U.S. assets as their foreign reserves.
On the private side, our foreign investment pays more than the returns on our assets that foreigners are holding. We generate net investment income surplus.
So, the $2.5 trillion international debt is not a burden to our economy so far.

32. Balance of Payments Equilibrium (or Disequilibrium)
Countries can have an equilibrium balance on the current account that is positive, negative, or zero, depending on what circumstances are sustainable over time.
Ex. the U.S. equilibrium could be with the current account deficit, if the rest of the world are willing to accumulate U.S. assets over time. This involve a U.S. capital account surplus.

33. What happens if there is a disequilibrium in the balance of payments?
Under floating exchange rate: the exchange rate will adjust to restore the BOP equilibrium.
Under fixed exchange rate: the central bank must finance the trade imbalance by international reserve flows (there will be reserve assets losses from deficit countries and reserve accumulation by surplus countries).
Or, countries may use trade restrictions on imports, exports, and/or restrictions on capital flows.

34. Conclusions
The balance of payments records a country’s international transactions: payments and receipts that cross the country’s border.
The balance of payments uses the double-entry bookkeeping method. Each transaction has a debit and a credit entry.
If the value of the credit items on a particular balance of payments account exceeds (is less than) that of the debit items, a surplus (deficit) exists.
The current account is the sum of the merchandise, services, investment income, and unilateral transfers accounts.
The balance of trade is the merchandise exports minus the merchandise imports.
Current account deficits are offset by capital account surpluses.

35. Conclusions
The official settlements balance is equal to changes in financial assets held by foreign monetary agencies and official reserve asset transactions.
An increase (decrease) in the U.S.-owned deposit in foreign bank is a debit (credit) to the U.S. capital. While an increase (decrease) in foreign-owned deposit in the U.S. bank is a credit (debit) to the U.S. capital.
The United States became a net international debtor in 1986.
With floating exchange rates, the equilibrium in the balance of payments can be restored by exchange rate changes
With fixed exchange rate, the balance of payments will not be automatically restored. Thus, central banks must either intervene to finance current account deficits or impose trade restrictions to restore the equilibrium.
Deficits are not necessarily bad, nor are surpluses necessarily good.