1. International Finance
Lecture 4: Balance of Payments
Read: Chapters 3
Aaron Smallwood Ph.D.

2. Balance of Payments Example
Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle frames from Mercian Bicycles in Darby England.
There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood’s bank account.
This will lead to a rise in the supply of dollars and the demand for British pounds.

3. Balance of Payments Accounts
The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations.
They are composed of the following:
The Current Account
The Financial Account
The Official Reserves Account
The Capital Account
Statistical Discrepancy

4. The Current Account
Includes all imports and exports of goods and services, including financial services (invisible trade).
Includes unilateral transfers of foreign aid.
If the debits exceed the credits, then a country is running a trade deficit.
If the credits exceed the debits, then a country is running a trade surplus.
It is thought that the CA responds to changes in income and the exchange rate.

5. The current account Consists of four categories
Merchandise trade (tangible goods)
Services (trade in factors of production)
Investment income (credit if receive payment on previous investment, debit if we make payments on previous investments).
Unilateral transfers (gifts and aid).

6. The Current Account
A credit on the current account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).
A debit on the current account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

7. The Current Account
When a domestic company sells goods or services to a foreign resident, there will be a credit recorded on the current account.
When a domestic resident buys goods or services from a foreign firm, there will be a debit recorded on the current account.
When a foreign asset pays interest to a domestic resident, or a domestic resident earns income in the foreign economy, there will be a credit recorded on the current account.
When a domestic asset pays interest to a foreign resident, or a foreign resident earns income in the domestic economy, there will be a debit recorded on the current account.

8. J-curve Effect

9. What conditions are necessary for J-curve effect?
εIM is the import demand elasticity = %Δimports divided by %ΔSt.
When εIM is greater than one (in absolute value), a domestic depreciation will lead to a fall in the RMB value of imports. Import demand is said to be elastic.
When εIM is equal to one (in absolute value), a domestic depreciation will not change the RMB value of imports.
When εIM is less than one (in absolute value), a domestic depreciation will lead to a rise in the RMB value of imports. Import demand is inelastic.
The J-curve can only occur when import demand elasticities are inelastic.

10. Algebra of Import Demand Elasticities

11. J-curve
The point is your company’s expenditures on imports may increase following a domestic currency depreciation.
While export volumes are expected to increase, if small, the generated revenue may not fully cover the increase in costs. Profits could be reduced.
For an economy, if imports rise by a larger amount than exports, the trade balance could move into deficit.

12. The Financial Account
The financial account measures the difference between Chinese sales of assets to foreigners and Chinese purchases of foreign assets.
The financial account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

13. The Financial Account
A credit on the financial account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).
A debit on the financial account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

14. The Financial Account
When a domestic entity (firm or individual) sells an asset to a foreign resident, there will be a credit recorded on the financial account.
When a domestic resident buys an asset from a foreign entity, there will be a debit recorded on the financial account.
Note – income earned on these assets is recorded on the current account, not the financial account.

15. The Balance of Payments Identity
BCA + BFA + BRA = 0
BCA = balance on current account
BFA = balance on financial account
BRA = balance on the reserves account
(which assumes no capital account balance and no statistical discrepancy)
Note: When a country experiences a currency crisis, we typically see BRA>0 (and HUGE)
Under a pure flexible exchange rate regime,
BCA + BFA = 0
Because BRA = 0

16. Balance of Payments Trends
Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the financial account.
During the same period, China has experienced surpluses in both and deficit in official reserves.

17. China BOP

18. Japan BOP

19. USA BOP

20. Balances on the Current (BCA) and Financial (BKA) Accounts of United Kingdom

21. Official reserves
In the US official reserve assets include gold, foreign currency, and special drawing rights (issued by the IMF).
The official settlements balance is BCA+BFA
When BCA+BFA≠0, the central bank must acquire or deplete holdings of official reserves.

22. More recent data (billions $)
Current
Account
Fin
FDI In
Out
Port.
Assets
Liab.
Reserve
2011:Q1
26.587
108.80
67.70
-6.10
-2.80
0.200
2011:Q2
50.720
112.80
61.80
-11.30
3.40
7.700
2011:Q3
31.195
69.00
41.70
-15.90
4.10
5.800
2011:Q4
27.498
-30.50
60.40
-15.10
1.60
-0.300
2012:Q1
49.264
54.60
48.80
-14.8
5.900
2012:Q2
58.064
-42.10
41.10
-13.3
2.50
8.700
11.800
2012:Q3
59.348
-52.50
38.50
-13.7
-10.6
15.200
0.400
2012:Q4
26.424
19.00
62.60
-20.6
-1.70
24.500
-34.1
2013:Q1
73.996
88.50
32.00
-21.3
-2.90
17.000
2013:Q2
54.230
27.7
45.60
-15.7
-4.90
14.900

23. More recently
Smaller current account surpluses for China. (in billions)
2011: $136.0, 2012: $193.1, 2013: $128.2
Surprisingly in Feb of this year, China ran a deficit of $23 billion.
More private investment in China than Chinese investment abroad
Official reserve holdings declined to $387.8 billion in 2011, and even further to $96.5 billion in 2012 ($203.6 billion through Q2 2013).
Real GDP has slowed slightly. According to the World Bank, from 10.4% in 2010 to 7.8 % in 2012.

24. Balance of Payments and National Income Accounting
GNP = Y = C + I + G + X – M
Y = C + S + T
X – M = (S- I) + (T- G)
If a developing economy experiences large trade deficits (X-M <0), the remedies are:
Savings must increase, S↑
Investment must fall, I↓
Government spending must fall, G↓
Taxes must rise, T↑

25. In class project Let’s classify several hypothetical transactions
A Japanese insurance company purchases $1,000,000 worth of bonds from a US company. The Japanese company owns 2% of the outstanding shares of the US company. They pay for the bonds out of a bank account kept in New York City.
A US computer programmer is hired by a Chinese company for consulting and gets paid $60,000 from a US bank account maintained by the Chinese company.
An American living in Los Angeles sends a check for $20,000 drawn on his LA bank account as a gift to his parents in Bombay.
The Federal Reserve sells yen and acquires $500,000 on the open market from a US car dealer. The car dealer uses their proceeds of yen to acquire $500,000 worth of Hondas.
A Dutch trader receives a dividend check from IBM for $25,000. The check is drawn on a bank in New York.