INTERNATIONAL FINANCIAL MANAGEMENT Lecture 3 Topic: Balance of Payments

The Balance of Payments Defining Balance of Payments (BOP):  A measurement of all international economic and financial transactions between the residents of a particular country and the rest of the world.  Think of a country’s BOP as a country cash flow account. Represents transactions over some period of time  The International Monetary Fund and the OECD are primary sources of individual country statistics.  The Department of Commerce is a good source of U.S. balance of payments data.

Use of BOP Data by Global Businesses Multinational businesses use BOP measures to assess the potential growth of specific types of trade or business opportunities by country.  BOP helps to forecast a country’s market potential; i.e., where business opportunities exist.  What are country’s buying (imports), selling (imports), etc. Currency forecasters use BOP as an important indicator of the potential pressure on a country’s exchange rate.  Surplus BOP countries generally produce strong currencies.  Deficit BOP countries generally produce weak currencies.  Thus, for global businesses, BOP measures are one indication of the potential risk from currency exposures resulting from their international activities.

There are Two Types of BOP Transactions: Real and Financial Cross Border transactions in Real Assets; i.e., purchase or sale of:  Goods: Cars, computers, clothing, agricultural products, industrial products…  Services: Banking, consulting, air travel, student exchange programs, foreign workers.  Enterprises: Cross border acquisitions of companies in other countries. Joint ventures with foreign partners. Cross Border transactions in Financial Assets; i.e. purchase or sale of:  Equity Common Stock  Long term Debt Bonds  Private and Government.  Short term Assets Deposits in overseas banks Money market instruments

BOP Surplus and Deficit Transactions BOP transactions can be conceptualized as either a surplus or deficit transaction. Basic Rule in determining whether the transaction is a surplus or deficit BOP transaction is to:  Follow the flow of money, or  If as a result of the transaction money flows into a country, it is surplus transaction  If as a result of the transaction, money flows out of a country, the transaction it is a deficit transaction.

Example of BOP Real Asset Transaction Assume: Japan Airlines purchases aircraft from Boeing (United States manufacturer)  From U.S. BOP standpoint the transaction is the sale of real assets. As a result of Boeing’s aircraft exports, money flows to U.S.  Thus, this is a surplus BOP transaction.  From Japan’s BOP standpoint the transaction is the purchase of real assets. As a result of Japan Airlines, money flows out of Japan.  Thus, this is a deficit BOP transaction.

Example of BOP Real Asset Transaction British company acquires a U.S. company.  From U.S. BOP standpoint the transaction is the sale of a real asset. As a result of the sale of the U.S. company, money flows to U.S. (shareholders)  Thus, this is a surplus BOP transaction.  From U.K.’s BOP standpoint the transaction is the purchase of a real asset. As a result of the UK’s purchase of the U.S. company, money flows out of the U.K..  Thus, this is a deficit BOP transaction. Note: this is an example of foreign direct investment (DFI).

Example of BOP Financial Asset Transaction An American mutual fund buys stock listed on the Mexican stock market.  From U.S. BOP standpoint the transaction is the purchase of financial assets. As a result of the purchase of stock, money flows out of the U.S.  Thus, this is a deficit BOP transaction.  From Mexico’s BOP standpoint the transaction is the sale of financial assets. As a result of Mexico’s sale of stock, money flows into Mexico.  Thus, this is a surplus BOP transaction. Note: this is an example of portfolio investment.

Specific Balance of Payments Accounts The Balance of Payments of any country is divided into two major accounts:  the Current Account and the Capital/Financial Account.  Current Account tracks: Balance of Trade: (net) merchandise exports and imports. Services Balance: (net) financial services and travel (other) services  Financial: Provided by banks to non-residents.  Travel/other: Provided by domestic entities to foreign country residents, such as meals, hotels, air travel, student exchanges, construction. Income Balance: (net) investment income from abroad and to foreign entities (arises from previous investments). Net Transfers: (net) private remittances to residents abroad (money/gifts) or by governments (aid).

Specific Balance of Payments Accounts The Capital and Financial Accounts capture cross border investments during a recorded period. Capital Account:  Purchases (or sales) of real estate. Financial Account:  (net) Foreign Direct investment (FDI). FDI in the U.S. minus U.S. FDI abroad  (net) Portfolio investment Non-controlling equity investments, i.e., common stock (<10%) Debt instrument investments (i.e., bonds).  Include both personal and institutional (mutual funds)  (net) Other financial transactions Bank loans.

Two Other BOP Accounts Two additional BOP accounts are:  Official Reserve Account: tracks the transactions of the official monetary authorities (i.e., central bank and treasury department) of a country: Involves international reserves (major currencies of the world, such as, dollars, yen, euros, and gold).  Errors and Omissions: BOP Balancing account. In theory, every BOP transaction is recorded using a double-entry accounting bookkeeping methodology. In reality, however, the two transactions are recorded independently The Errors and Omissions (or Statistical Discrepancy) account balances the overall BOP.

Current and Capital Account As noted, the current account summarizes a country’s trade position and the financial account a country’s international capital flows. The Current and Financial Account are typically inverse, i.e., if one is in surplus, the other is generally in deficit.  In fact, a deficit in a country’s current account needs to be financed through a surplus in its financial account or else downward pressures will be placed on the exchange rate  Look at the U.S. in 1997 and 1998 and Thailand in 1997 (see slides which follow) Exam what happened to each country’s exchange rate during these years.

Current and Financial/Capital Account Balances for the United States, (billions of US$) Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2000.

Response of Exchange Rate to 1997 and 1998 U.S. Current and Capital Account Imbalance. Note: Relate exchange rate changes back to previous slide.

Current and Financial/Capital Account Balances for Thailand, (billions of US$)

Response of Exchange Rate to 1997 Thailand Current and Capital Account Imbalance.

Balance of Payments Trends Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account.  This offsetting pattern has been seen in other countries as well, for example the U.K. During the same period, Japan has experienced the opposite with surpluses on its current account and deficits on its capital account. Finally, some countries do not exhibit this offsetting pattern.  For example, China has seen surpluses on both it current account and its capital account.  This has been a major factor in putting upward pressure on the Chinese currency.

Balances on the Current (BCA) and Capital (BKA) Accounts of the United States

Balances on the Current (BCA) and Capital (BKA) Accounts of United Kingdom

Balances on the Current (BCA) and Capital (BKA) Accounts of Japan

Balances on the Current (BCA) and Capital (BKA) Accounts of China

Current U.S. Balance of Payments Data; Major Accounts Third Quarter 2006 Current Account:-$225.6B  Goods:-$218.6B  Services:+ 18.3B  Net Income- 3.8B Payments from Abroad: B Payments to Foreigners: B Capital Account:-$ 0.6B Financial Account:+$176.4B Statistical Discrepancy:+ 49.7B  Date of Date Release: Dec, 18, 2006

U.S. Dollar Exchange Rate: Third Quarter 2006 Given the discrepancy between the current account and the capital account for the third quarter, 2006, what do you think happened to the U.S. dollar during this period?  Answer: In the third quarter, the U.S. dollar depreciated 1 percent on a trade- weighted basis against a group of 7 major currencies.

Sources Of Balance of Payments Data The Economist Magazine  Trade Balance, Current Account Balance and Forecasts Economic and Financial Indicator Section US data:    Link to International OECD Country data  15_ _119656_1_1_1%2C00.html 15_ _119656_1_1_1%2C00.html IMF data 