The Balance of Payments 3 Chapter 3 Chapter Objective: This chapter serves to introduce the student to the balance of payments, how it is constructed and how balance of payments data may be interpreted. Chapter Outline Balance of Payments Accounts The Current Account The Capital Account External Balance and the Exchange Rate Balance of Payments Trends in Major Countries

Balance of Payments 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. Why is it useful to examine a country’s BOP? The BOP provides detailed information about the supply and demand of the country’s currency. The trade statistics in the Current Account, for example, show the composition of trade – what a country imports and what it exports. The Capital Account shows inflows and outflows of capital in various categories. Viewed over time, BOP data can shed light on important developments in a country’s comparative advantage and international competitiveness.

Balance of Payments Accounts They are composed of the following: The Current Account The Capital Account The Official Reserve Account

Balance of Payments Accounts Current Account Records flows of exports, imports, investment income, and international financial transfers. Merchandise trade – export and import of tangible goods Services – payments and receipts for legal and consulting fees, royalties, tourist expenditures Investment income – payments and receipts of interest, dividends, and other income on foreign investments Unilateral Transfers – “unrequited” payments (e.g. Foreign aid). If the debits exceed the credits, then a country is running a trade deficit. If the credits exceed the debits, then a country is running a trade surplus.

Balance of Payments Accounts The capital account Records sales to foreigners of Canadian financial assets and Canadian purchases of foreign financial assets. The capital account is composed of Foreign Direct Investment (FDI), portfolio investments, and other investment. Direct investment involves acquisitions of controlling interests in foreign businesses. Portfolio investment represents investment in foreign shares and bonds that do not involve acquisitions of control. Other investment includes bank deposits, currency investment, trade credit and the like.

Balance of Payments Accounts The Reserve Account The Reserve Account of BOP records changes in the amount of “official” reserve assets held by the Bank of Canada. Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF. If a country must make net payment to foreigners because of BOP deficit, the country could either run down its official reserve assets or borrow anew from foreigners.

Balance of Payments Accounts Statistical Discrepancy There’s going to be some omissions and misrecorded transactions—so we use a “plug” figure to get things to balance. Exhibit 3.4 shows a discrepancy of $0.8 billion in 2002. How to calculate? BP = 0 when all known transactions are accounted for, so the SD is the "residual" value that will balance the books.

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 Under a pure flexible exchange rate regime, where the CB does not maintain any official reserves, a CA surplus or deficit must be matched by KA deficit or surplus: BCA + BKA = 0 Under the fixed exchange rate regime, the combined balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the official reserves: BCA + BKA = -BRA

Balance of Payments Fixed Exchange Rate Floating Exchange Rate BOP determines necessity of government intervention Can help forecast devaluation/revaluation of currencies Floating Exchange Rate Government has no responsibility as FX rates are determined by market forces Managed Floats Focus of government is on interest rates

Balance of Payments Trends in Major Countries From 1982-2000, U.S. has had continual annual trade deficits (-CA) with the rest of the world (ROW), along with annual capital surpluses (+KA), in roughly equal annual amounts.  U.S. has been a "net debtor" nation over this period. Over the same period, Japan has had annual trade surpluses with ROW, along with annual capital outflows, also in roughly equal amounts.  Japan is a "net creditor" nation, investing its trade surplus in foreign stocks, bonds, real estate, government debt (T-bonds, etc.), businesses (FDI), art, etc.  Japan has been accused of "mercantilism," i.e. erecting trade barriers, or protectionist trade policies to restrict or limit imports.

Balances on the Current (BCA) and Capital (BKA) Accounts of the U.S. Source: IMF International Financial Statistics Yearbook, 2000

Balances on the Current (BCA) and Capital (BKA) Accounts of Japan Source: IMF International Financial Statistics Yearbook, 2000

Balances on the Current (BCA) and Capital (BKA) Accounts of United Kingdom Source: IMF International Financial Statistics Yearbook, 2000

Balances on the Current (BCA) and Capital (BKA) Accounts of China Source: IMF International Financial Statistics Yearbook, 2000

Balance of Payments Trends in Major Countries Like the U.S., the United Kingdom recently experienced continuous current account deficits, coupled with capital account surpluses. The magnitude, however, is far less that that of the United States. Germany traditionally had current account surpluses. Since 1991 Germany has been experiencing current account deficits. This is largely due to German reunification and the resultant need to absorb more output domestically to rebuild the former East Germany. This has left less output available for exports. China has been running trade surpluses AND capital account surpluses.  For example, in 2002 China had a $35.4B trade surpluses and a $6.4B capital inflow.  Reason: Official reserve holdings of dollars has increased.  Chinese govt. buys up dollars with Yuan, to keep the dollar strong and the Yuan low, and the Yuan/$ rate stable.   

Impact on Currency CA: All the other factors constant, a deficit balance on a country’s current account implies that there is excess supply of its currency in the foreign markets. Hence, its currency should depreciate. KA: All other factors constant, a surplus balance in a country’s financial account implies that there is excess demand for assets denominated in its currency. Hence, its currency should appreciate.

Affects on the Economy Is a nations current account balance, by itself, a good measure of its economic health? NO; there is no law, economic or political, which states that the current account balance must be positive. Unlike running a budget deficit in which a person or institution spends more than it makes, running a deficit in the current account, simply means a country imports more than it exports. Is a current account surplus and financial account deficit by itself an indication of economic strength? NO, particularly not if the exodus of the financial capital occurs because there are a few good investment opportunities in the country. Is the net inflow of capital bad? NO, if the capital is being invested in such a way as to enhance the productive capacity of the country.

Do monetary and fiscal policies affect the exchange rates and BOP components? Monetary Policy: An unanticipated shift to expansionary monetary policy will lead to more rapid economic growth, accelerated inflation and lower real interest rates BOP effects: Higher income and higher domestic prices stimulate imports and discourage exports. Lower real rates discourage foreign and domestic investment at home. Exchange rate effects : The adverse impact of the country’s current account will increase the supply of currency in the fx markets; causing the currency to depreciate. The adverse impact of the country’s financial account will decrease demand for the country’s currency, causing it to depreciate.

Do monetary and fiscal policies affect the exchange rates and BOP components? Fiscal Policy: An unanticipated shift to more expansive fiscal policy will result in budget deficits, increase in aggregate demand, inflation and an increase in real interest rates. BOP effect:Increase demand will encourage imports & discourage exports, which moves the current account towards deficit. Meanwhile, the higher interest rates attract foreign investment and discourage domestic investment from leaving the country, moving the financial account surplus. Exchange rate effects: The adverse impact of the current account will increase the SUPPLY of the country’s currency, causing the currency to depreciate. The positive impact of the KA will increase demand causing the currency to appreciate.

What about monetary and fiscal policies? So what do you think is the net effect? The overall effect is mixed, but the interest rate effect will likely dominate in the short term leading the exchange rate appreciation.