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Foundations of Multinational Financial Management5th EditionAlan ShapiroJ.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

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THE BALANCE OF PAYMENTS AND INTERNATIONAL LINKAGES

CHAPTER 5

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CHAPTER OVERVIEW

I. BALANCE-OF-PAYMENT CATEGORIES

II. THE INTERNATIONAL FLOW OF GOODS, SERVICES,AND CAPITAL

III. COPING WITH CURRENT ACCOUNT DEFICITS

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PART I. BALANCE-OF-PAYMENTCATEGORIES

A.THE BALANCE OF PAYMENTS (B-O-P)

1. PURPOSE:

Measures all financial and economic transactions over a specified period of time.

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BALANCE-OF-PAYMENTCATEGORIES

2. Double-entry bookkeeping

a. Currency inflows = credits earn

foreign exchange

b. Currency outflows = debits

expend foreign exchange

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BALANCE-OF-PAYMENTCATEGORIES

3. Three Major Accounts:

a. Current

b. Capital

c. Official Reserves

4. Current Account

records net flow of goods, services, and unilateral transfers.

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BALANCE-OF-PAYMENTCATEGORIES

5. Capital Account

a. Function: records public and private investment and lending.

b. Inflows = credits

c. Outflows = debits

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BALANCE-OF-PAYMENTCATEGORIES

5. Capital Account (con’t)

d. Transactions classified as

1.) Portfolio

2.) Direct

3.) Short term

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BALANCE-OF-PAYMENTCATEGORIES

6. Official Reserves Account

a. Function:

1.) Measures changes in international reserves owned by central banks.

2.) Reflects surplus/deficit of

a.) Current account

b.) Capital account

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BALANCE-OF-PAYMENTCATEGORIES

6. Official Reserves Account (con’t)b. Reserves consist of

1.) Gold

2.) Convertible securities

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BALANCE-OF-PAYMENTCATEGORIES

7. Net Effects:a. Sum of all transactions must be

zero:

1.) Current account2.) Capital account3.) Official reserves

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BALANCE-OF-PAYMENTCATEGORIES

8. The Balance-of-payment measures

a. Some Definitions:

1.) Basic Balance

a.) Consists of current account and long-term capital flows.

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BALANCE-OF-PAYMENTCATEGORIES

1.) Basic Balance (con’t)

b.) Emphasizes long-term trends.

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BALANCE-OF-PAYMENTCATEGORIES

1.) Basic Balance (con’t)

c.) Excludes short-term capital flows that heavily depend on temporary factors.

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BALANCE-OF-PAYMENT CATEGORIES

2.) Net Liquidity Balance:

Measures the change in private domestic borrowing or

lending require to keep payments equal without adjusting official reserves.

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BALANCE-OF-PAYMENTCATEGORIES

3.) Official Reserve Transactions Balance

-Measures adjustments needed

by official reserves.

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PART II. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

II. LINKS FROM INTERNATIONAL TO DOMESTIC FLOWSA. Global Linkages

set of basic macroeconomic identities which link:

-Domestic spending and production to current and capital accounts.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

B. Domestic Savings and Investmentand the Capital Account1. National Income Accounting a. National Income (NI) is either

spent (C) or saved (S)

NI = C + S (5.1)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

b. National spending (NS) is

divided into personal spending (C) and investment (I)

NS = C + I (5.2)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

c. Subtracting (4.2) - (4.1)

NI - NS = S - I (5.3)

If NI >NS, S > I which implies that surplus capital spent overseas.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

d. In a freely-floating system,excess saving = the capital account balance

e. Implications:1. A nation which produces

more than it spends will save more than it invests domestically

with a net capital outflow producing a capital account deficit.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

2. A nation which spends more than it produces has a

net capital inflow producing a capital account surplus.

3. A healthy economy will tend to

run a current account deficit.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

C.THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTS

1. Beginning identityNI - NS = X - M (5.4)where X = exports

M = importsX-M=current account balance

(CA)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

2. Combining (5.3) + (5.4)

S - I = X - M (5.5)

3. If S - I = Net Foreign Investment (NFI)

NFI = X - M (5.6)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

4. Implications:a. If CA is in surplus, the nation must

be a net exporter of capital.b. If CA is a deficit, the nation is a

major capital importer.c. When NS > NI, the excess must be

acquired through foreign trade.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

d. Solutions for Improving CA deficits:1.) Raise national income (output)

relative to domestic investment (I).2.) Increase (S) relative to domestic

investment (I).

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

D. GOVERNMENT BUDGETS AND

CURRENT ACCOUNT DEFICITS

1. CURRENT ACCOUNT BALANCE

CA = Saving Surplus - Gov’t budget deficit

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

2. CA Deficit means: The nation is not saving enough to

finance (I) and the deficit.

3. CA Surplus means: The nation is saving more than needed to

finance its (I) and deficit.

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PART III. COPING WITH THE CURRENT ACCOUNT DEFICIT

I. POSSIBLE SOLUTIONS UNLIKELY TOWORK:

A. Currency Depreciation

B. Protectionism

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COPING WITH THE CURRENT ACCOUNT DEFICIT

II.CURRENCY DEPRECIATION

A. U.S. Experience:

Does not improve the trade deficit.

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COPING WITH THE CURRENT ACCOUNT DEFICIT

B. Depreciations are ineffective because

1. It takes time to affect trade.

2. J-Curve EffectStates that a decline in currency

value will initially worsen the deficit before improvement.

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THE J - CURVE

TIME

Net changein trade balance

0

Currency depreciation

Trade balance initially deteriorates

Trade balanceimproves

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COPING WITH THE CURRENT ACCOUNT DEFICIT

III. PROTECTIONISM

A. Trade Barriers used:

1. Tariffs

2. Quotas

B. Results:

Most likely will reduce both X and M.

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COPING WITH THE CURRENT ACCOUNT DEFICIT

C. FOREIGN OWNERSHIP

One protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows.

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COPING WITH THE CURRENT ACCOUNT DEFICIT

D. STIMULATE NATIONAL SAVING

change the tax regulations and rates.

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COPING WITH THE CURRENT ACCOUNT DEFICIT

III. SUMMARY: CURRENT-ACCOUNT

DEFICITS

- neither bad nor good inherently

1. Since one country’s exports are another’s imports, it is not

possible for all to run a surplus

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COPING WITH THE CURRENT ACCOUNT DEFICIT

2.Deficits may be a solution to the problem of different national propensities to save and invest.