International Financial Management: INBU 4200 Fall Semester 2004 Lecture 5: Part 2 Balance of Payments (Chapter 3)

The Balance of Payments Balance of Payments (BOP): –A measurement of all international economic and financial transactions between the residents of a country and foreign residents. –The International Monetary Fund (IMF) is the primary source of similar statistics worldwide. –Think of a country’s BOP as a country cash flow account (statement); NOT as a balance sheet. Represents transactions over some period of time

Use of BOP Data by Businesses Multinational businesses use BOP measures to assess the growth and health of specific types of trade or financial transactions by country. –BOP helps to forecast a country’s market potential; where business may opportunities exist. –What are country’s buying (imports), selling (imports), etc. BOP is important indicator of potential pressure on a country’s exchange rate. –Surplus countries generally have strong currencies. –Deficit countries generally have weak currencies. –Thus, BOP indicates suggests the potential exposure from international activities. Or, the potential losses or gains from foreign currency exposed positions of business firms.

Two Types of BOP Transactions Cross Border purchase (or Sale) of Real Assets: –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. Cross Border purchase (or Sale) of Financial Assets: –Equity Stocks –Debt Bonds, bank loans.

Balance in the BOP While individual components in a country’s BOP are likely to out of balance, the overall BOP must be in balance. Why? –Transactions recorded using a double-entry accounting bookkeeping methodology (in theory). Thus, in theory, each BOP transaction should be recorded as both a debit and a credit entry. In reality the two transactions are recorded independently Thus, the debits and credits are not likely to be equal. –BOP is balances through an errors and omissions account.

Debit or Credit Transactions Basic Rule to determine debit or credit BOP transaction. Follow the flow of money! –If money is flowing out of a country, it is recorded as a debit transactions, and hence a BOP deficit. –If money is flowing into a country, it is recorded as a credit transaction, and hence a BOP surplus.

Example of BOP Flows Japan Airlines purchase aircraft from Boeing (United States) –From U.S. BOP standpoint: Sale of real asset. Money inflow to U.S. manufacturer: Credit transaction. Aircraft exports from the U.S.: Surplus transaction –From Japan’s BOP standpoint: Purchase of real asset. Money outflow from Japan: Debit transaction. Aircraft imports from the U.S.: Deficit transaction

Example of BOP Flows British company acquires a U.S. company. –From U.S. BOP standpoint: Sale of real asset. Money flow to U.S. company (shareholders): Credit transaction. Foreign direct investment in U.S.: Surplus transaction. –From U.K.’s BOP standpoint: Purchase of real asset. Money outflow from U.K. company (shareholders): Debit transaction. Foreign direct investment overseas: Deficit transaction

Example of BOP Flows Canadian worker in U.S. sends money home to family in Vancouver, B.C.. –From U.S. BOP standpoint: remittances abroad. Money outflow from U.S.: Debit transaction. Net transfer abroad. Deficit transaction. –From Canada’s BOP standpoint: remittances from abroad. Money inflow from U.S.: Credit transaction. Net transfer (from) abroad: Surplus transaction.

Balance of Payments Accounts The BOP 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).

Balance of Payments Accounts Capital/Financial Account captures cross border investments during the recorded period. These include: –Purchases (or sales) of real estate. –(net) Direct investment (FDI). FDI in the U.S. minus U.S. FDI abroad (positive number if net direct investment into the U.S.; and thus capital inflow) –(net) Portfolio investment Non-controlling equity investments (<10%) Debt investments. –Either personal or institutional (mutual funds) –Portfolio investment in the U.S. minus U.S. portfolio investment abroad (positive number if net portfolio investment in the U.S.; and thus capital inflow). –(net) Other financial transactions Bank loans, trade credit

Other BOP Accounts Two additional BOP accounts are: –Official Reserve Account: tracks the transactions by the official monetary authorities (central bank and treasury department) of a country: Increase in international reserves (major currencies of the world: dollar, yen, euro, gold). –Net Errors and Omissions: Balancing account; included because transactions are collected individually (double entry bookkeeping in theory).

Current and Capital Account The two major sub-accounts of the BOP, the Current and Financial Account, summarize the current trade and international capital flows of the country respectively The Current and Financial Account are typically inverse, i.e., one in surplus while the other is in deficit –In fact, a deficit in a country’s current account needs to be financed through a surplus in its financial account! –If not, pressures will be placed on the exchange rate! –Issuing facing the United States today! Reason for the U.S. dollar performance of late!

Current and Financial/Capital Account Balances for the United States, Annual Data (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 back to previous slide.

Thailand’s BOP in the 1990s Source: International Financial Statistics, International Monetary Fund, Washington DC, monthly.

Thai Baht in 1997

SOURCE OF BOP DATA The Economist –Trade Balance, Current Account Balance and Forecasts Economic and Financial Indicator Section OECD Country data (Current Account) – %2Cen_2649_33715_ _119656_1_1 _1%2C00.htmlhttp:// %2Cen_2649_33715_ _119656_1_1 _1%2C00.html