Balance of Payments (BoP)

IF & Trade

Batch 2010

syllabus

• Balance of Payments

• International Monetary System

• An overview of International Financial Markets

• Exchange Rate Determination and Forecasting

BOP

BOP

– http://rbidocs.rbi.org.in/rdocs/Content/docs/FSBPS3031_Full.xls

National Income Accounting• GDP: National Spending = National Income

– Y = C + I + G + X – M– Y = GDP; C = Consumption; I = Physical Investment; G =

Government Spending; X = Exports; M = Imports

– C + I + G = Domestic Absorption (spending on domestic output)

– (X – M) = Trade Balance = Net Exports

• Trade Balance = Nat’l Income less Domestic Absorption– X – M = Y – (C + I + G)

• Trade Balance = Net Domestic Saving– Y = C + Saving + Taxes = C + I + G + X – M– X – M = (S – I) + (T – G) – Trade Imbalances must be met with International Borrowing or

Lending, i.e., trade deficit borrow from rest of world.

• Note No Causation Implied!

BOP

• The balance of payments of a country is a systematic accounting record of all economic transactions during a given period of time between residents of the country and residents of foreign countries– Flow

Balance of Payments

The BOP is a statistical record of the flow of all of the payments between the residents of a country and the rest of the world in a given year.

Transactions are recorded on the basis of double entry bookkeeping – by definition it has to balance. Every “source” must have a “use”.

The two main components are: Current Account Capital/Financial Account

Accounting Principles in BOP

Uses of FX

DEBIT

Sources of FX

CREDIT

Capital Outflow

Capital Inflow

Accounting Principles

1. Any transaction resulting in a payment to foreigners is entered in the BOP accounts as a debit and is given a negative sign.

2. Any transaction resulting in a receipt from foreigners is entered as a credit and given a positive sign.

3. Current Account records transactions involving exports and imports of goods and services

4. Capital Account records transactions involving the purchase and sale of assets.

5. Double-Entry book keeping: Every international transaction automatically enters twice, once as a credit and once as a debit.

Examples of Transactions

Credit Transactions (+ve): Provision of goods and services to non-residents Income receivable from non-residents A decrease in foreign financial assets An increase in foreign financial liabilities

Debit Transactions (-ve): Purchase of goods & services from non-residents Income payable to non-residents An increase in foreign financial assets A decrease in foreign financial liabilities

Balance of Payments• Record of Payments to & Receipts from

Foreign Entities– Double-entry bookkeeping system.

• Every transaction has two entries – a credit (+) and a debit (-)!

– Payment = Debit (-)– Receipt = Credit (+)– Multiple Accounts

• Current Account (CA) and Capital Account (KA)– Is a summary (net) record of flows, not stocks

BOP

Current account

Invisibles

a. Services

b. Transfers

c. income

Merchandise

Capital account

1. Travel

2. Transportation

3. Insurance

4. Govt not eslewhere specified

5. miscellaneous

Official

Private

1. Investment income

2. Compensation to Employees

BOPCurrent Account

Capital Account 1. Foreign Investments

2. Loans (a+b-c)

3. Banking capital

4. Rupee Debt Service

5. Other Capital

1. In India: Direct; Portfolio +

2. Abroad

a. External Assistance ( by India, to India)

b. Commercial Borrowing (MT+LT)

c. Short term

a. Commercial Banks

(assets, liabilities, NRI

deposits)

b. others

Balance of Payments

Current Account (CA)

This is record of a country’s trade in goods and services in the current period.

CA = Exports (X) – Imports (M)

It is divided into 4 sub-categories: Goods trade Services trade Income Current transfers

The sum of the four sub-categories = CA balance

Capital Account (KA)

This includes all short- and long-term transactions pertaining to financial assets.

KA = Capital Inflow (cr) – Capital outflow (dr)

The two main components: Capital account. Financial account (direct, portfolio, other).

KA balance = Sum of capital account and financial account.

Official Reserves

Records the purchase or sale of official reserve assets by the central bank. These assets include

Commercial paper, Treasury bills and bonds Foreign currency Money deposited with the IMF

This account shows the change in foreign exchange reserves held by the central bank.

Since the BOP must balance

CA + KA + RFX = 0

CA + KA = – RFX

The Balance of Payments Identity

For floating rate regime countries, such as the U.S., official reserves are relatively unimportant.

Statistical Discrepancy (E&O)

The identity CA + KA = – RFX assumes that all transactions are measured accurately.

Inaccurate recording of transactions (errors & omissions), results in the above equality not holding. For BOP to balance,

CA + KA + E&O = – RFX

Assuming changes in official reserves, errors are approximately zero:

Current Account = (–) Capital Account

This will hold approximately for floating rate countries

Country A exported 500 worth goods to country B

Country A Exporter gets his bank account credited with a bank in B country

Invoice in B currency and paid in B

currency

The balance in Exporter A country is an asset for Country A and a liability for B Country

BOP country A

Cu.A/c Cr DtMerchandise Ex 500

Cap. a/c

Up in claims on a Foreign Bank

500Normal a/c

Anchor the a/c entry on claims

Exchanged 300 worth Leather goods for crude oil

BOP country A

Cu.A/c Cr Dt

Merchandise Ex 300

Merchandise Imports 300

Cap. a/c

A bank in country A purchases B country Govt securities and pays by drawing its correspondent

bank a/c in B country

BOP country A

Cu.A/c Cr Dt

Cap. a/c

Up in Foreign Bank holdings 200

Fall in Foreign Bank deposits

200

A country gifts medical supplies, blankets..worth 150

BOP country A

Cu.A/c Cr Dt

Merchandise Ex 150

Unrequited transfers 150

Cap. a/c

country A resident makes a gift of 50 in A’s currency to a charitable organisation in B

BOP country A

Cu.A/c Cr Dt

Unrequited transfers 50

Cap. a/c

Increase in Foreign Liabilities

50

Example Transactions• Record transactions in the following accounts

– CA: A = merchandise; B = services; C = invest. income; D = Unilateral Transfers

– KA: E = Change in U.S. claims on foreign assets; F = Change in foreign claims on U.S. assets

• U.S. firm sells $1m wheat to Romania, paid for out of Romanian-owned deposit account in U.S.– A (+), F(-):

• merchandise export is credit • decrease in foreign-owned dollar deposits = K-out = decreased foreign

claims on U.S.

• U.S. tourist spends DM10,000 deposit in German bank while traveling in Germany– B(-), E(+)

• tourist spending abroad is service import ~ a debit• decrease in U.S. claims on foreigners ~ K-in

Example Transactions, cont.• U.S. citizen receives DM10k interest payment from German

bonds, deposits in German bank– C (+), E(-)

• U.S. citizen converts DM to US$ at German Bank– E (+), F(-)

• debit = K-out = decrease foreign claims on U.S. (they gave up $)• credit = K-in = decrease in U.S. claims on foreigners (we gave up DM)

• U.S. Bank loans US$ to German Bank– F(+), E(-)

• debit = K-out = increase in U.S. claims on foreigner (future debt payments)

• credit = K-in = increase in foreign claims on U.S. (acquire $)

• German resident sells U.S Government Bond to French resident– does not show on U.S. Balance of Payments!

• U.S. charity donates medicine to Nicaragua– A (+), D(-): merchan. export, paid for by “gift” (unilateral transfer)

Valuation and Timing

• Market Prices – willingness of parties

• F.O.B. Vs. C.I.F – former is preferred

• India’s exports are valued @ fob; imports are cif

• Translation

• Timing : exports are recorded when cleared by customs, imports when payment is made - conventions

Balance in BOP

• “imbalance” refers to disequilibrium

• Autonomous transactions arising from normal business

• Accommodating transactions undertaken with the motive of settling the imbalances– funding deficits arising out of autonomous

transactions

Balance in BOP

• Trade balance

• Balance in Goods & services

• Current account Balance

• Balance on CA and LT capital

A surplus in the BOP implies that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase – in value – or intervene and accumulate additional foreign currency reserves in the Official Reserves Account.

A deficit in the BOP implies an excess supply of the country’s currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value.

BOP in Total

Country faces current account deficit…

• Policy shift by Govt to increase short term interest rates to attract short term capital inflow to prevent depreciation of currency

•Tighten credit & money supply and make it difficult for domestic banks and firms to borrow the home currency to invest abroad; force exporters realise export earnings quickly & bring it home

INTERLINKAGES IN FINANCIAL MARKETS

Cap Money Market Bullion Market

inflation interest rate

currency

exchange rate

Commodity derivatives

Balance in BOP

• Corporate Finance Managers monitor the data on a regular basis to understand how pressures in international market will impact their firm in short term or long term

Interpretation of Deficit and Surplus

• This is a difficult issue. Ever wonder why economics is called a “dismal science”? An account deficit theoretically means that foreign goods are more competitive and that perhaps national industries aren’t making competitive products, which could then signal recession, depression, or closure of economies or business firms .

• A surplus, could theoretically mean there is excess demand, that could trigger inflation and eventual economic slowdown.

Interpretation: Does it matter?

• Another group of people believe the interpretations of deficit and surplus are only good for politicians. They believe that with globalization, the older interpretations of deficit and surplus are becoming meaningless.

A nation’s balance of payments interacts with nearly all of its key macroeconomic variables.

Interacts means that the BOP affects and is affected by such key macroeconomic factors as:– Gross Domestic Product (GDP)– Exchange rate– Interest rates– Inflation rates

BOP & Macroeconomic Variables

A country’s BOP can have a significant impact on the level of its exchange rate and vice versa.

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes the BOP (see next slide).

BOP & Exchange Rates

(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:X = exports of goods and servicesM = imports of goods and servicesCI = capital inflowsCO = capital outflowsFI = financial inflowsFO = financial outflowsFXB = official monetary reserves

Current Account Balance

Capital Account Balance

Financial Account Balance

BOP & Exchange Rates

Fixed Exchange Rate Countries– Under a fixed exchange rate system, the

government bears the responsibility to ensure that the BOP is near zero.

Floating Exchange Rate Countries– Under a floating exchange rate system,

surpluses/deficits influence exchange rate.

BOP & Exchange Rates

A country’s import and export of goods and services is affected by changes in exchange rates.

The transmission mechanism is in principle quite simple: changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand.

Theoretically, this is straightforward, in reality global business is more complex.

Trade Balances & Exchange Rates

Trade Balances & Exchange Rates

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