BALANCE OF PAYMENTS

Economics - A Course Companion(Blink & Dorton, p289-301)

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Balance of Payments Cycle

Jan 7th 2010From The Economist print edition

                                                                               

COUNTRY TRADE BALANCELatest 12 months $BN

CURRENT ACCOUNT BALANCE

Latest 12 months $Bn

% of GDP 2009

United States -711.1 -469.9 -3.3Japan +20.6 +153.3 +2.4China +172.9 +303.2 +4.0Britain -158.3 -40.9 -2.0Canada -5.3 -53.4 -2.9Germany +197.8 +192.3 +5.1Venezuela +36.6 +22.4 +8.0

BALANCE OF PAYMENTS – INTERNATIONAL COMPARISONS

Source: The Economist Magazine (Print Edition) Date: October 27th 2011

The Balance of Payments Account

• The Balance of Payments account is a record of the value of all the transactions between the residents of one country with the residents of all other countries in the world over a given period of time.

• There are two main parts to the Balance of Payment account: The Current Account & The Capital Account.

The Balance of Payments Names of Specific Accounts

• There are many different names used to identify the various parts of the Balance of Payments Account.

• The headings change from country to country and even from time to time within the same country.

• Where possible, alternative names will be provided.

THE CURRENT ACCOUNT

• The Current Account is a measure of the flow of funds from trade in goods and services, plus other income s.

• It is usually sub divided into three parts: 1. The Balance of Trade in Goods2. The Balance of Trade in Services3. Net Income Flows

THE CURRENT ACCOUNT1. The Balance of Trade in Goods

• The Balance of Trade in Goods is also variously known as the visible trade balance, the merchandise account balance or simply the balance of trade.

• It is a measure of the revenue received from the exports of tangible (physical) goods minus the expenditure on imports of tangible goods over a given period of time.

• It includes trade in all tangible goods from airplanes to chickens.

THE CURRENT ACCOUNT1. The Balance of Trade in Goods

• Exports occur when an international transaction relating to goods or services leads to an inflow of money into the country.

• Imports occur when an international transaction relating to goods or services leads to an outflow of money from the country.

THE CURRENT ACCOUNT1. The Balance of Trade in Goods

Surplus on the Balance of Trade in Goods• When export revenue is greater than import

expenditure, there is a surplus on the balance of trade in goods.

Deficit on the Balance of Trade in Goods• When import expenditure is greater than

export revenue, then there is a deficit on the balance of trade in goods.

THE CURRENT ACCOUNT2. The Balance of Trade in Services

• The Balance of Trade in Service is also known as the invisible balance, the service balance or net services.

• It is a measure of the revenue received from the exports of services minus the expenditure on the imports of services over a given period of time.

THE CURRENT ACCOUNT2. The Balance of Trade in Services

• It includes the import and export of all services such as banking, insurance and tourism.

• An Italian tourist on holiday in Vienna would be spending money that represents an invisible export to the Austrian economy (money coming in) and therefore an invisible import to the Italian economy (money going out)

THE CURRENT ACCOUNT3. Net Income Flows

This is usually split into two sections:

• Net Investment Incomes (Net Factor Income from abroad)

• Net Transfer of Money (Current Transfers or net unilateral transfer from abroad)

THE CURRENT ACCOUNT3. Net Income Flows

Net Investment Incomes (Net Factor Income)• This is a measure of the net monetary movement of

profit, interest and dividends moving into and out of country over a given period of time as a result of financial investment abroad.

• Domestic firms may set up branches in other countries and any profits being repatriated will count as a positive item in the account.

• In the same way, profits sent out of the country by foreign firms within the country will count as a negative item.

THE CURRENT ACCOUNT3. Net Income Flows

Net Investment Incomes• Residents and institutions in the country may

have invested in banks and other financial institutions in other countries and any interest received from these financial investments will count as a positive item.

• In the same way, any payment of interest to foreign investors that leaves the country will count as a negative item.

THE CURRENT ACCOUNT3. Net Income Flows

Net Investment Incomes• Residents and institutions may have

purchased shares in foreign companies and any dividends received from those companies will count as a positive item.

• In the same way, any dividends paid by domestic firms to foreign shareholders will count as a negative item.

THE CURRENT ACCOUNT3. Net Income Flows

Net Transfers of Money • Also called Current Transfers or Net Unilateral

Transfers from Abroad) • These are payments between countries when no

goods or services change hands. • At the government level it includes items such as

foreign aid and grants. • At an individual level it includes foreign workers

sending money back to their families in their home country (remittances) or private gifts sent from a person in one country to a person in another.

THE CURRENT ACCOUNTCurrent Account Balance

Current Account Balance =Balance of Trade in Goods + Balance of Trade in Services +Net Income Flows

THE CURRENT ACCOUNTCurrent Account Balance

• Any account might be in surplus or deficit at any given time – there could be a deficit on the trade in goods, a surplus on the trade in services, a surplus on net income flows and an overall surplus on the current account.

• The current account balance is an overall balance and may be in deficit or in surplus.

THE CAPITAL ACCOUNT

• The capital account is a measure of the buying and selling of assets between countries.

What is classified as an asset?• Assets in this case includes anything that can

be owned and that has value, such as land, real estate, companies, bank deposits, stocks and shares, treasury bills, government bonds foreign currency and all other types of financial instruments.

THE CAPITAL ACCOUNT

• In some countries, the capital account is now called the Financial Account and in some countries there is a both a Capital Account and a Financial Account.

• For simplicity, the buying and selling of assets is taught under the sole classification of the capital account.

THE CAPITAL ACCOUNT

• The capital account measures the net change in foreign ownership of domestic assets.

• If foreign ownership of domestic assets increases more quickly than domestic ownership of foreign assets then there is more money coming into the country than going out and so there is a capital account surplus.

• In the same way, if domestic ownership of foreign assets increases more quickly than foreign ownership of domestic assets, then there is more money going out of the country than coming in and so there is a capital account deficit

THE CAPITAL ACCOUNTTypes of Assets

It possible to distinguish between two different types of assets:Assets than represent ownership • This includes buying property, purchasing a business, or

purchasing stocks or shares in a business.• In all cases the asset is expected to have a positive

return in the future by making profits or by increasing in value over time.

• The investment does not have to be paid back and there is no guarantee that it will provide a positive return.

• The buyer of the asset is taking a risk.

THE CAPITAL ACCOUNTTypes of Assets

Assets that Represent Lending• This includes treasury bills, government bonds

and saving account deposits. • In these cases the investor is lending the money in

order to purchase the asset in the expectation that interest will be paid upon the investment and the money will be repaid at a given point in time.

• These assets are simply borrowing and lending on the international market.

THE CAPITAL ACCOUNTTypes of Assets

• Sometimes assets may be classified in other ways:

Foreign Direction Investment (FDI)• investment by MNCs in another country.Portfolio Investment• Investment in stocks and sharesOther Investment• Currency transactions and bank and saving

account deposits.

CAPITAL ACCOUNTOfficial Reserve Account

• Included in the capital account or financial account are changes in the official reserve account.

• All countries hold reserves of gold and foreign currencies, which are itemised in the official reserve account and it is movements into and out of this account that ensure that the Balance of Payments will always balance to zero.

CAPITAL ACCOUNTOfficial Reserve Account

• If there is a surplus on all of the other accounts combined, then the official reserve account total will increase.

• If there is a deficit on all the other accounts combined, then the official reserve account total will decrease.

• It is net changes in the official reserve account over the period of time being considered that balances the accounts.

Does the BOP actually balance exactly?

• In realty the accounts will not balance because there are simply too many individual transactions taking place for the measurement to be exact.

• There will be some transactions that have not yet been recorded when the figures are being put together.

• In addition, black markets (eg: the drug trade) mean that many transaction may be only partly recorded if at all.

• A balancing item (sometimes known as net errors and omissions or statistical discrepancy) is therefore put into the accounts to ensure they do balance.

• As trading accounts are revised over the years, more data come to light and the balancing items become smaller.

THE CONSEQUENCES OF CURRENT ACCOUNT AND CAPITAL ACCOUNT IMBALANCES

• The existence of a deficit or surplus in either the current or capital account will have economic consequences that can impact on the whole economy.

• However, the extent of this impact and its long term implications is greatly debated among economists.

Consequences of a Current Account Deficit (CAD)

• If the current account is in deficit then the capital account will have to be in surplus in order to balance out the current account deficit. This means one of three things:

1. Foreign Exchange Reserves may be used to increase the capital account and so regain balance with a deficit in the current account.

If reserves are taken from the official reserve account, then they are a positive entry into the capital account.

However, no country no matter how rich or powerful is able to fund long term account deficits from its reserves. Eventually the reserves would run out.

Consequences of a Current Account Deficit (CAD)

2. Foreign Ownership of AssetsA High Level of Buying Assets for Ownership is financing the current account deficit.

Foreign investors may be purchasing such things as property, businesses or stocks or shares in businesses.

In this case this inflow into the capital account is funding the current account deficit, but as it must be based upon foreign confidence in the domestic economy, it is not considered harmful.

However, there are sometimes fears that if foreign ownership of domestic assets were to become too great, then this may be a threat to economic sovereignty.

Consequences of a Current Account Deficit (CAD)

2. Foreign Ownership of Assets (continued) If there is a drop in confidence, then foreign

investors might prefer to shift their assets to other countries.

Selling the assets would result in an increase in supply of the currency and fall in its value.

Consequences of a Current Account Deficit (CAD)

3. Lending From Abroad It may be that the CAD is financed by high levels of lending from

abroad. If this is the case, then high rates of interest may have to be paid

which will be a short term drain on the economy and will further increase the CAD.

However, if interest rates are lower in other countries it could be a smart move to borrow from overseas. BUT..

There is always the danger that the governments or people lending the money may, at some time, withdraw their money. This would lead to massive selling of the currency and a very sharp fall in the exchange rate.

Consequences of Current & Capital Account Surpluses

1. A current account surplus allows a country to have a deficit on the capital account by building up its official reserve account or by purchasing assets abroad. However, one country’s surplus is another country’s deficit and it may lead to protectionism by other countries in order to reduce their own deficits.

Consequences of Current & Capital Account Surpluses

• A current account surplus usually leads to an appreciation of the currency on the foreign exchange market as it implies an increase in demand for the currency.

• This will make imports cheaper, so reducing inflationary pressures, but it will also make exports more expensive, which harms exporters.

How big is a`big` current account deficit or surplus?

There are two ways to interpret the size of the current account deficit or surplus.(1) The value of the total(2) In the context of the country’s GDP.

• It is lot easier to understand the magnitude of the deficit in the context of GDP.

• The burden of a deficit depends on the ability to pay.• A current account surplus is less of a concern, than a

CAD. • A CAD is a concern when they reach a certain percentage

of GDP.

METHODS OF CORRECTING A PERSISTENT CURRENT ACCOUNT DEFICIT

There are two main policy approaches:1 Expenditure-switching policies • Government policies to depreciate or devalue the

currency. • Protectionist measures.

2. Expenditure-reducing policies • Deflationary Fiscal Policies • Deflationary Monetary Policies

METHODS OF CORRECTING A CADExpenditure-switching Policies

• Expenditure-switching policies are any policies implemented by the government that attempt to switch expenditure from imports towards domestically produced goods and services.

• If successful, then expenditure on imports will fall and so the CAD should improve.

METHODS OF CORRECTING A CADExpenditure-switching Policies

Government Policies to Depreciate/Devalue the Currency• If the government adopts policies that will reduce

the level of the exchange rate then exports should become less expensive and imports should become more expensive.

• Depending on how responsive domestic consumers and foreign consumers are to these price changes, this should see an improvement in the CAD as export revenue rises and import expenditure falls.

METHODS OF CORRECTING A CADExpenditure-switching Policies

Protectionist Measures• The government may attempt to restrict

imports of products either by reducing their availability using embargos, quotas or increasing their prices through tariffs.

• However, such measures can lead to retaliation from other countries and encourage inefficient domestic industries.

METHODS OF CORRECTING A CADExpenditure-reducing Policies

• Expenditure-reducing policies are any policies implemented by the government that attempt to reduce overall expenditure in the economy, so shifting AD to the left.

• If this occurs, then expenditure on all goods and services should fall and, since this would include expenditure on imports, the CAD should improve.

• The size of the fall in imports will depend upon the level of the marginal propensity to import.

METHODS OF CORRECTING A CADExpenditure-reducing Policies

Deflationary Fiscal Policies• Increasing direct tax rates and or reducing

government expenditure. • This would be unpopular and government may

be reluctant to implement.

METHODS OF CORRECTING A CADExpenditure-reducing Policies

Deflationary Monetary Policies• Increasing the rate of interest and/or reducing

the money supply• The higher interest rates should increase

capital flows from abroad. This would lead to a surplus on the capital account, which helps to offset the CAD.

• This policy would also be politically unpopular.

METHODS OF CORRECTING A CADExpenditure-reducing Policies

Problems with Expenditure-Reducing Policies• There is a conflict between external and

internal objectives. • Deflating the economy may reduce the CAD,

but the policy is likely to lead to a fall in domestic employment and fall in GDP.

METHODS OF CORRECTING A CAD

EXPORT PROMOTION POLICIES• Both expenditure -switching policies and

expenditure-reducing policies have problems and therefore many governments, prefer to pursue export promotion policies.

• This may include government run trade missions, hoping to develop new markets and government sponsored advertising campaigns.