Balance of payments

What is the price of a country’s What is the price of a country’s currency?currency?

If we know the factors affecting If we know the factors affecting demand & supply, then we shall demand & supply, then we shall know the factors influencing know the factors influencing exchange ratesexchange rates

Hence, the considerable interest inHence, the considerable interest inmaintaining a record of the factorsmaintaining a record of the factorsbehind the supply & demand of abehind the supply & demand of acountry’s currencycountry’s currency

Can be visualised as an itemisation of the Can be visualised as an itemisation of the factors behind the demand & supply of a factors behind the demand & supply of a currencycurrency

Why is the BOP account published?

To report the country’s To report the country’s international performance in international performance in trading with other nationstrading with other nations

Factors affecting exports & hence the demand for home currency

Home prices v/s comparable goods Home prices v/s comparable goods abroadabroad

Foreign incomeForeign income

Foreign import duties & quotasForeign import duties & quotas

Principles of BOP accounting

Double entry bookkeepingDouble entry bookkeeping It is a cash flow statementIt is a cash flow statement Designed to always balance; rules Designed to always balance; rules

for debits and creditsfor debits and credits The way it is balanced tells us how The way it is balanced tells us how

a country is doing in its transactions a country is doing in its transactions with other countrieswith other countries

Components of BOP

Current accountCurrent account

Capital/financial accountCapital/financial account

Net errors and omissionsNet errors and omissions

Official reserves accountOfficial reserves account

Current account

GoodsGoods ServicesServices Investment incomeInvestment income TransfersTransfers

Current account balance

Fair indicator of a country’s Fair indicator of a country’s international competitivenessinternational competitiveness

A current account surplus will A current account surplus will strengthen the currencystrengthen the currency

Current account balance

Affected by:Affected by:

InflationInflation

A comparatively high economic A comparatively high economic growth- increase in imports while growth- increase in imports while demand for exports lag behinddemand for exports lag behind

Capital / Financial Account

Capital accountCapital account

Transfers of financial assets and Transfers of financial assets and

the acquisition and disposal ofthe acquisition and disposal of

non-produced/ non-financial non-produced/ non-financial

assetsassets

Financial Account

Direct investmentDirect investment

Portfolio investmentPortfolio investment

Other investment assets/ liabilitiesOther investment assets/ liabilities

Current & Capital Account Relationship

Inverse relation between the Inverse relation between the current and capital accountcurrent and capital account

Countries experiencing large Countries experiencing large current account deficits “ finance” current account deficits “ finance” these purchases through equally these purchases through equally large surpluses in the capital large surpluses in the capital accountaccount

Official Reserves Account

Total reserves held by official Total reserves held by official monetary authorities within the monetary authorities within the country.country.

Normally composed of the major Normally composed of the major currencies used in international currencies used in international trade and financial transactionstrade and financial transactions

Net Errors & Omissions

Reasons?Reasons?

Capital MobilityCapital Mobility

Capital FlightCapital Flight

Link Between Current & CapitalAccount

National Income = Consumption + SavingsNational Income = Consumption + Savings

National spending= Consumption+InvestmentNational spending= Consumption+Investment

National Income- National spending =National Income- National spending =

Savings – InvestmentsSavings – Investments

Savings – Investments = surplus capital Savings – Investments = surplus capital

( that must be invested overseas)( that must be invested overseas)

i.e Savings = Domestic Inv + Net Foreign Inv Net Foreign Inv= Nation’s net public & private capital flows = capital account deficit

Alternatively,A national savings deficit = capital account surplus( net borrowing from abroad)This borrowing finances the excess of national spending over income.

If we subtract expenses on domestic goods & services from National Product,the remaining goods & services must be exports

Similarly, subtracting spending domestic goods & services from total expenditure, the remaining goods & services must be imports

We have now another national income identity:

National Income – National spending = Exports – Imports = Net Foreign Investment

Thus, in a freely floating exchange rate system,

The current account balance & the capital account balance must exactly offset each other

Question

A deficit or surplus in the current A deficit or surplus in the current account is it inherently “good” or account is it inherently “good” or “bad”? “bad”?