1. Lecture 5 Balance of Payments

2. Learning Objectives
Understand balance of payments account categories, the relationship between them and the identities
Comprehend the double-entry recording system in the balance of payments statement
Gain knowledge of international economic linkages through the balance of payments
Discuss the relationship between trade deficits and macroeconomic fundamentals
Reading: Madura and Fox, Ch 2; Bekaert and Hodrick, Ch 4; Peijin Wang, Ch4

3. Motivation We have examined parity conditions
But not yet the ‘real’ side of economies
So this is what we will turn to now
How to measure financial flows between countries
Different types of activity
Measuring the financial flows which result
Also how these determine exchange rates
Whether considering the value of assets
Or these financial flows

4. Balance of Payments (BOP)
A statistical statement or record
Of a country’s international economic transactions
With another country or the rest of the world
Over a certain period of time, often a year
This measures
Flows of goods, services and capital
out of and into the country.

5. How is balance of payments measured?
Double entry bookkeeping
Transactions
-- Involve flows of goods, services and capital.
Are presented in the form of double-entry bookkeeping,
i.e. every transaction is recorded as both a credit and a debit
With equal values and opposite signs.
The net balance of all entries in the statement is in theory zero.
Although there may be statistical errors (minor)

6. Transactions and Transfers
Most entries in the balance of payments refer to transactions
Economic values are provided or received
In exchange for other economic values.
Therefore, offsetting credit and debit entries are entered for the transaction.
Transfers
When items are given away rather than exchanged,
Or when a recording is one-sided for other reasons,
special types of entries – referred to as transfers – are made as the required offsets.

7. Real Resources and Financial Items
We should distinguish between
Real resources
Goods
Services
Income
Financial items
Investments (private)
Reserves (government)
However treatment of them in Balance of Payments is similar

8. The Balance of Payments - Credit Entries and Debit Entries
An intuitive rule for determining credits and debits
Credit transactions give rise to conceptual inflows or sources of foreign exchange; the purchases of goods and assets by foreign residents from domestic residents are credits because they are a source of foreign exchange
Debit transactions give rise to conceptual outflows or uses of foreign exchange; the purchases of goods and assets by domestic residents from foreign residents are debits because they cause an outflow of foreign exchange

9. Credit Entries and Debit Entries
For each of these there may be
Credit entries (+) recorded for
Real resources: exports of goods and services
Financial items: deductions in foreign assets or increases in foreign liabilities.
Debit entries (-) recorded for
Real resources: imports of goods and services
Financial items: increases in foreign assets or decreases in foreign liabilities.

10. Categories in the Balance of Payments
There are three categories:
Current account
Capital and financial account
Capital account
Financial account
Statistical discrepancies
- representing omitted and miss-recorded transactions.

11. Current Account The major components in the current account
Exports of goods and services (+)
Imports of goods and services (-)
(Referred to as the trade balance)
Income
Income receipts (+)
(Interest and dividend receipts)
Income payments (-)
(Interest and dividend payments)
Current transfer
Transfer payments between countries (e.g., gifts or aid)

12. Capital and Financial Account
Capital Account
Capital transfers
-- Acquisition/disposal of non-produced, non-
financial assets

13. Capital and Financial Account
-- The financial account records public and private investment and lending.
-- It consists of
Foreign direct investment
abroad (-), in reporting economy (+)
Portfolio investments
assets (-), liabilities (+)
Other investments
Reserve assets/Official reserves

14. Reserve Assets/Official Reserves
Reserve assets cover transactions in assets
Considered by the monetary authorities
As available for use in funding payments imbalances and meeting other financial needs.
It reflects surplus and deficit in the current account
And private sector transactions
in the capital and financial account
It consists of
Reserve gold
SDRs - reserve position in the IMF
foreign exchange assets (currency, deposits, and securities).
16/11/2018
HUBS

15. Example
Suppose the US computer maker Dell sells $20 million of computer to Komatsu, a Japanese manufactory. Komatsu pays Dell by transferring dollars from its dollar-denominated bank account at Citibank in New York to Dell’s bank account in Japan. What are the credit and debit items on the US balance of payments?
US BOP
Credit
Debit
Computer purchase by Komatsu from Dell
(Current account, US, good export)
+$20m
Citibank foreign deposit decrease
(Capital account; capital outflow from the US)
-$20m
16/11/2018

16. Exercise
Suppose LVMH, a French luxury goods company, buys €1.5 million of consulting services from the London Consulting Group (LCG). LVMH pays by writing a check on its euro-denominated bank account at a Paris bank. What are the credit and debit items on the French balance of payments?
4 minutes

17. The Balance of Payments Identity
Sum of all transactions must be zero
Under a pure flexible exchange rate regime
Current Account + Capital & Financial Account = 0
CA + KFA = 0
Under a managed exchange rate regime
Need to also consider the Official Reserve Account
CA + KFA + ORA = 0

18. U.S. Balance of Payment for 2009 (billions of dollars; credits, +; debits, –)

19. Table 1: Current Account Balances for the G7 Countries as a Percentage of GDP

20. Trade Deficits ~ Macroeconomic Fundamentals
Given the fact that most developed countries are experiencing the trade deficits, can the trade deficits be explained by macroeconomic fundamentals?

21. Trade Deficits ~ Macroeconomic Fundamentals
Linking the Current Account to National Income
Gross National Income = Gross domestic product + Net Foreign Income
GNI = GDP + NFI (1)
By definition of GDP, GDP = C+ I + G + NX
Where
C - consumption
I – investment
G - government purchases
NX – net exports

22. Trade Deficits ~ Macroeconomic Fundamentals
GNI = C+ I + G + NX + NFI (2) Re-arranging eq(2) GNI – (C + G) - I = (NX + NFI) (3) S - I = CA (4) Where S - Savings

23. Trade Deficits ~ Macroeconomic Fundamentals
If CA < 0 , then S – I < 0 or S < I.
That is domestic savings do not suffice to finance investment.
In other words, the given country borrows from abroad.
This implies a Capital/Financial Account surplus(due to the capital inflow) and a CA deficit.
On the other hand, if CA > 0, then S – I >0, or S > I
Implies an increase in net foreign wealth (ie, saving) and lending abroad.
In summary, the CA depends on the relative balance between S and I.

24. Conclusions