© 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved PowerPoint® Presentation Prepared By Charles Schell The Balance of Payments Chapter 3

Slide 3-1 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Chapter Three Outline Balance of Payments Accounting Balance of Payments Accounts The Current Account The Capital Account Statistical Discrepancy Official Reserves Account The Balance of Payments Identity Balance of Payments Trends in Major Countries

Slide 3-2 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved BoP Credits vs. Debits Credit – money flowing into the country Debit – money flowing out of the country Canadian firm pays dividends to UK investors: debit for Canada, credit for UK Mexican farm worker in Leamington sends remittances to his family (remesas familiares) in Oaxaca: debit for Canada, credit for Mexico.

Slide 3-3 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 3.2Balance of Payments Accounting The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. N.B. when we say “a country’s balance of payments” we are referring to the transactions of its citizens and government.

Slide 3-4 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Balance of Payments Example Suppose that Maple Bicycle in Maple, Ontario imports $100,000 worth of bicycle frames from Mercian Bicycles in Derby England. There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maple’s bank account. UK current account credit; Canada current account debit. This will lead to a rise in the supply of dollars and the demand for British pounds.

Slide 3-5 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Balance of Payments Accounts The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. They are composed of the following: The Current Account The Capital Account The Official Reserves Account Statistical Discrepancy: due to diverse data sources, default assumption: SD = 0

Slide 3-6 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The Current Account (3 components) Exports and imports of goods and services: Net exports = exports – imports. Invisibles means services. Net foreign investment earnings FIE, i.e., interest, dividends: FIE of Canadians – FIE of non- Canadians on Canadian securities. Unilateral transfers e.g. foreign aid, family remittances.

Slide 3-7 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Trade Account vs. Current Account Trade account = net exports If net exports < 0, trade account deficit If net exports > 0, trade account surplus Current account = net exports + Net foreign investment earnings + net unilateral transfers If the current account debits exceed the credits, then a country is running a current account deficit If the current account credits exceed the debits, then a country is running a current account surplus

Slide 3-8 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s Increasing ‘Openness’

Slide 3-9 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Capital Account (KA, K means capital) Refers to money raised from the issuance of securities Manulife issues bonds to Australian superannuation funds: Canadian KA credit, Australian KA debit BHP issues new shares in London: Australian KA credit, UK KA debit

Slide 3-10 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s International Financial Flows

Slide 3-11 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The Balance of Payments Identity BCA + BKA + BRA = 0 where BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account -BRA = increase in central bank reserves BCA + BKA = increase in central bank reserves Under a pure flexible exchange rate regime, BCA + BKA = 0 (approximately)

Slide 3-12 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Examples of Entries in Canada’s BoP Credits Current Account a. The Alberta Natural Gas Company exports natural gas to California. b. Bombardier sells aircraft to Australia. c. Corel sells a license to a Mexican software producer. d. The Barenaked Ladies give a concert in New York and deposit their receipts in a Toronto Bank. Capital Account e. Fidelity Mutual Fund of New York buys 10,000 shares of Nortel Networks. Debits Current Account a. Ford (Canada) buys automobile transmissions from a supplier in Michigan. b. The LCBO buys wine from Italy. c. Tom McNeil of Charlottetown goes to the London School of Economics and takes $20,000 to pay tuition and expenses. Capital Account d. Altamira Investments (Toronto) buys shares in Xerox (USA ). e. Barrick buys a gold mine in Peru.

Slide 3-13 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s International BoP Current Account $m Total receipts 513, , , , ,293 Goods and services 480, , , , ,028 Goods 420, , , , ,060 Services 60,065 63,483 61,134 63,863 64,968 Travel 16,437 16,741 14,776 16,745 16,460 Transportation 10,625 11,060 9,896 11,024 11,632 Other services 33,003 35,681 36,462 36,093 36,877 Investment income 25,990 30,502 29,469 37,532 48,199 Direct investments 6,391 13,766 13,706 20,677 25,994 Portfolio investments 8,070 8,859 8,955 10,182 12,644 Other investments 11,529 7,877 6,807 6,673 9,561 Transfers 6,968 6,890 6,744 7,427 8,066

Slide 3-14 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s International BoP Current Account $m Total payments 488, , , , ,491 Goods and services 417, , , , ,896 Goods 350, , , , ,210 Services 67,874 70,707 72,980 76,580 78,686 Travel 18,487 18,401 18,727 20,747 22,260 Transportation 13,970 14,438 14,366 16,001 17,528 Other services 35,417 37,868 39,887 39,831 38,898 Investment income 65,320 60,799 59,403 62,346 67,010 Direct investments 22,266 21,529 23,744 27,489 30,953 Portfolio investments 30,668 30,804 29,041 28,139 27,192 Other investments 12,386 8,466 6,618 6,717 8,865 Transfers 5,384 6,902 7,122 7,746 8,585

Slide 3-15 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s International BoP Current Account $m Balance on Current Account 25,104 19,778 14,103 27,633 31,802 goods and services 62,850 50,088 44,416 52,765 51,132 goods 70,659 57,311 56,262 65,482 64,850 services 27,809 27, , , ,718 travel 22,050 21,659 23,951 24,002 25,800 transportation 23,345 23,378 24,470 24,977 25,897 other services 22,414 22,187 23,425 23,738 22,021 Investment income 239, , , , ,811 Direct investments 215,875 27, ,038 26,812 24,960 portfolio investments 222, , , , ,548 other investments transfers 1,

Slide 3-16 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s Trade in Goods

Slide 3-17 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The Capital Account The capital account measures the difference between Canadian sales of assets to foreigners and Canadian purchases of foreign assets. There are two main categories, recorded in the accounts: Foreign direct investment Portfolio investment In 2005 Canada sent $41.3bn in FDI abroad, while foreigners invested $40bn in Canada. Outbound portfolio investment was 1.6bn, inbound portfolio investment was $8.5bn

Slide 3-18 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved US Balance of Payments

Slide 3-19 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s Balance of Payments

Slide 3-20 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Statistical Discrepancy There are going to be some omissions and mis- recorded transactions—so we use a “plug” figure to get things to balance. Default assumption: statistical discrepancy = zero.

Slide 3-21 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The Official Reserves Account Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF. Official reserves held by the country’s central bank: Bank of Canada, the Fed, Reserve Bank of Australia, People’s Bank of China, el Banco Central de la República Dominicana, Bank Negara Malaysia, etc.

Slide 3-22 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30).73

Slide 3-23 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data In 2000, the U.S. imported more than it exported, thus running a current account deficit of $ billion. CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30).73

Slide 3-24 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30).73 During the same year, the U.S. attracted net investment of $ billion— clearly the rest of the world found the U.S. to be a good place to invest.

Slide 3-25 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30).73 Under a pure flexible exchange rate regime, these numbers would balance each other out.

Slide 3-26 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 In the real world, there is a statistical discrepancy.

Slide 3-27 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Including that, the balance of payments identity should hold: BCA + BKA = – BRA ($444.69) + $ $0.73 = $0.30

Slide 3-28 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Nexus: Market for USDs & US BoP debits/credits USD supply curve linked to US BoP debits: US entities are supplying USDs to purchase non-US goods/services USD demand curve linked to US BoP credits: Non-US entities are demanding USDs to purchase US good/services

Slide 3-29 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Q P Market for $s S D

Slide 3-30 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Q P Market for $s S D As U.S. citizens import, they supply dollars to the FOREX market.

Slide 3-31 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Q P Exchange rate $ S D As U.S. citizens export, others demand dollars at the FOREX market.

Slide 3-32 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved U.S. Balance of Payments Data = 0 CreditsDebits Current Account 1Exports$1, Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $ Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

Slide 3-33 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 3.2Balance of Payments Trends Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account. During the same period Canada has moved from a current account deficit to a surplus.

Slide 3-34 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved US Current and Capital Account Balances

Slide 3-35 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Canada’s Balance of Payments

Slide 3-36 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Balance of Payments Trends Like Japan, China tends to have a persistent current account surplus. Unlike Japan, China tends to have a capital account surplus as well. In 2006, for instance, China had over a billion dollar surplus in both its capital and current accounts – this suggests that reserves must have increased: Its actual reserves have increased to over one trillion dollars in recent years.

Slide 3-37 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved China’s Balance of Payments

Slide 3-38 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Summary The Balance of Payments can be defined as the statistical record of a country’s international transactions over a certain period of time. In the Balance of Payments, any transaction resulting in a receipt from foreigners is recorded as a credit, with a positive sign, whereas any transaction resulting in a payment to foreigners is recorded as a debit, with a minus sign. A country’s international transactions can be grouped into three main categories: Current Account, Capital Account, Official reserve account.

Slide 3-39 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Summary The Current Account is divided into four subcategories: Merchandise trade, Services, Factor income (net foreign investment income) Transfers. The Capital Account is divided into two subcategories: Direct investment, Portfolio investment When we compute the cumulative Balance of Payments including the Current Account, Capital Account and the statistical discrepancies, we obtain the overall balance or official settlement balance. A country can run a balance-of-payments surplus or deficit by increasing or decreasing its official reserves.