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Chapter 6

The Balance of Payments

The Balance of Payments

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Learning ObjectivesTo understand the fundamental principles of how countries measure international business activity, the balance of paymentsTo examine the similarities of the current and capital accounts of the balance of paymentsTo understand the critical differences between trade in merchandise and services and why international investment activity has recently been controversial in the United StatesTo review the mechanical steps of how exchange rates are transmitted into altered trade prices and eventually trade volumesTo understand how countries with different government policies toward international trade and investments, or different levels of economic development, differ in their balance of payments

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Introduction

The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP)The two major sub accounts of the balance of payments are:

Current accountCapital account

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Fundamentals of Balance of Payments Accounting

The balance of payments must balanceSubaccounts may be imbalanced

Three main elements to the process of measuring international economic activity include:

Identifying what is and is not an international economic transactionUnderstanding how the flow of goods, services, assets, and money creates debits and credits to the overall BOPUnderstanding the bookkeeping procedures for BOP accounting

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Defining International Transactions

Identifying many international transactions is ordinarily not difficultHowever, some international transactions are not obvious

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The BOP as a Flow Statement

The BOP is often believed to be a balance sheet rather than a cash flow statementThere are two types of business transactions that dominate the BOP:

Real assetsFinancial assets

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BOP Accounting: Double-Entry Bookkeeping

BOP employs an accounting technique called double-entry bookkeepingIn this age-old method every transaction produces a debit and a credit of the same amount

A debit is created whenever:

An asset is increasedA liability is decreasedAn expense is increased

A credit is created whenever:

An asset is decreasedA liability is increasedAn expense is decreased

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BOP Accounting: Double-Entry Bookkeeping

The measurement of all international transactions in and out of a country over a year is a difficult taskMistakes, errors, and statistical discrepancies will and do occurCurrent and capital account entries are recorded independent of one another, not together as this accounting method would prescribe

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The Accounts of the Balance of Payments

The BOP is comprised of two primary subaccounts:

Current AccountFinancial/Capital Account

Two additional and important subaccounts of the BOP include:

Net Errors and Omissions Account Official Reserves Account

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The Current AccountThis account includes all international economic transactions with income or payment flows occurring within the year, the current periodIt consists of four subcategories:

Goods tradeServices tradeIncomeCurrent transfers

This account is typically dominated by Goods Trade

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The Current AccountThe Balance on Trade (BOT) refers specifically to the balance of exports and imports of goods trade onlyThe deficits in the BOT of the past decade have been an area of concern for the U.S.Merchandise trade is the core of international trade and has three major components:

Manufactured goodsAgricultureFuels

The most encouraging news for U.S. manufacturing trade is the growth of exports in recent years

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The Capital and Financial Account

This account of the BOP measures all international economic transactions of financial assetsIt is divided into two major components:

Capital AccountFinancial Account

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The Capital AccountThe Capital Account is made up of transfers of:

Financial assetsThe acquisition and disposal of nonproduced/nonfinancial assets

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The Financial AccountThe Financial Account consists of three components:

Direct investmentPortfolio investmentOther asset investments

The contents of this account are for all intents and purposes the same as those of the Capital Account under IMFs BOP accounting framework used prior to 1996

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Net Direct InvestmentThis is the net balance of capital dispersed out of and into the U.S. for the purpose of exerting control over assetsFollows the 10% ownership threshold rule The source of concern over foreign investments in any country focuses on two topics:

ControlProfit

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Portfolio InvestmentThis is the net balance of capital that flows in and out of the U.S., but does not reach the 10% ownership threshold of direct investmentIt is capital invested in activities that are purely profit-motivated rather than ones made in the prospect of controlling or managing the investmentThese have shown much more volatile behavior than net direct investments over the past decade

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Other Investment Assets/Liabilities

This category consists of:Short-term trade creditsLong-term trade creditsCross-border loans from all types of financial institutionsCurrency depositsBank depositsOther accounts receivableAccounts payable

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Official Reserves Account

This is the total currency and metallic reserves held by official monetary authorities within the countryIts significance depends on whether the country is operating under:

A fixed exchange rate regime A floating exchange rate system

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The Balance of Payments--Total

The International Monetary Fund (IMF) is the multinational organization that collects the BOP statistics for over 160 different countries around the globeThe current, capital, and financial accounts combine to form the basic balance and is one of the most frequently used summary measures of the BOPThe current, capital, financial, and net errors and omissions accounts combine to form the summary measure known as the overall balance or official settlements balance

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The Balance of Payments and Economic Crises

The sum of cross-border international economic activity can be used by international managers to forecast economic conditions and in some cases, the likelihood of economic crisesThe mechanics of international economic crises often follow a similar path of development

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The Asian CrisisThe roots of this currency crisis extended from a fundamental change in the economics of the regionIt started as early as 1990 in ThailandThe most visible roots were the excesses in capital flows into Thailand in 1996 and early 1997Corporate socialism, corporate governance, banking liquidity and management are underlying causes that apply to every nation facing economic crisis

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Capital MobilityThe degree to which capital moves freely cross-border is critical to a country’s balance of paymentsThe ability of capital to move involves economic and political factorsObstfeld and Taylor (2001) studied the globalization of capital markets and argued the post-1860 era can be subdivided into four distinct periods

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Capital FlightCapital flight is the sudden and shocking outflow of capital from a nation’s economy in which it is perceived there is political, economic, or currency crises forthcoming

Five primary mechanisms exist by which capital may be moved from one country to another

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The Cases of China and Turkey

The Chinese balance of payments serves as an interesting example of one country’s ongoing efforts to manage its current and financial accounts

Turkey’s economic and financial crisis of 2000-2001 serves as a prime example of how a country’s balance of payments can deteriorate or essentially collapse in a very short period of time