1 Multinational Financial Management Alan Shapiro 10 th Edition John Wiley & Sons, Inc. PowerPoints by Joseph F. Greco, Ph.D. California State University, Fullerton

CHAPTER 5 The Balance of Payments and International Economic Linkages

BALANCE-OF-PAYMENT CATEGORIES A. THE BALANCE OF PAYMENTS (B-O-P) 1.PURPOSE: Measures all financial and economic transactions over a specified period of time 3

BALANCE-OF-PAYMENT CATEGORIES 2.Double-entry bookkeeping a. Currency inflows = credits earn foreign exchange b. Currency outflows = debits expend foreign exchange 4

BALANCE-OF-PAYMENT CATEGORIES 3.Three Major Accounts: a.Current b.Capital c.Official Reserves 4.Current Account records net flow of goods, services, and unilateral transfers. 5

BALANCE-OF-PAYMENT CATEGORIES 5.Capital Account a. Function: records public and private investment and lending. b. Inflows = credits c. Outflows = debits 6

BALANCE-OF-PAYMENT CATEGORIES 5.Capital Account (con’t) d. Transactions classified as 1.) portfolio 2.) direct 3.) short term 7

BALANCE-OF-PAYMENT CATEGORIES 6.Official Reserves Account a. Function: 1.) measures changes in international reserves owned by central banks 2.) reflects surplus/deficit of a.) current account b.) capital account 8

BALANCE-OF-PAYMENT CATEGORIES 6.Official Reserves Account (con’t) b. Reserves consist of 1.) gold 2.) convertible securities 9

BALANCE-OF-PAYMENT CATEGORIES 7. Net Effects: a. Sum of all transactions must be zero: 1.) current account 2.) capital account 3.) official reserves 10

BALANCE-OF-PAYMENT CATEGORIES 8.The Balance-of-payment measures a. Some Definitions: 1.) Basic Balance a.) consists of current account and long- term capital flows 11

BALANCE-OF-PAYMENT CATEGORIES 1.) Basic Balance (con’t) b.) emphasizes long-term trends. 12

BALANCE-OF-PAYMENT CATEGORIES 1.) Basic Balance (con’t) c.) excludes short-term capital flows that heavily depend on temporary factors. 13

BALANCE-OF-PAYMENT CATEGORIES 2.) Net Liquidity Balance: measures the change in private domestic borrowing or lending required to keep payments equal without adjusting official reserves. 14

BALANCE-OF-PAYMENT CATEGORIES 3.) Official Reserve Transactions Balance: measures adjustments needed by official reserves. 15

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL II.LINKS FROM INTERNATIONAL TO DOMESTIC FLOWS A.Global Linkages set of basic macroeconomic identities which link: domestic spending and production to current and capital accounts 16

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL B. Domestic Savings and Investment and the Capital Account 1.National Income Accounting a. National Income (NI) is either spent (C) or saved (S) NI = C + S(5.1) 17

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL b. National spending (NS) is divided into personal spending (C) and investment (I) NS = C + I (5.2) 18

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL c. Subtracting (5.2) - (5.1) NI - NS = S - I(5.3) If NI >NS, S > I which implies that surplus capital spent overseas. 19

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL d.In a freely-floating system, excess saving = the capital account balance e.Implications: 1.)A nation which produces more than it spends will save more than it invests domestically with a net capital outflow producing a capital account deficit. 20

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2.) A nation which spends more than it produces has a net capital inflow producing a capital account surplus 3.)A healthy economy will tend to run a current account deficit 21

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL C. THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTS 1.Beginning identity NI - NS = X - M(5.4) where X= exports M= imports X-M=current account balance (CA) 22

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2.Combining (5.3) + (5.4) S - I = X - M(5.5) 3. If S - I = Net Foreign Investment (NFI) NFI = X - M(5.6) 23

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 4.Implications: a.If CA is in surplus, the nation must be a net exporter of capital. b.If CA is a deficit, the nation is a major capital importer. c.When NS > NI, the excess must be acquired through foreign trade. 24

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL d.Solutions for Improving CA deficits: 1.)Raise national income (output) relative to domestic investment (I). 2.)Increase (S) relative to domestic investment (I). 25

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL D. GOVERNMENT BUDGETS AND CURRENT ACCOUNTDEFICITS 1. CURRENT ACCOUNT BALANCE CA = Saving Surplus - Gov’t budget deficit 26

THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2. CA Deficit means the nation is not saving enough to finance (I) and the deficit. 3. CA Surplus means the nation is saving more than needed to finance its (I) and deficit. 27

COPING WITH THE CURRENT ACCOUNT DEFICIT I.POSSIBLE SOLUTIONS UNLIKELY TO WORK: A.Currency Depreciation B. Protectionism 28

COPING WITH THE CURRENT ACCOUNT DEFICIT II.CURRENCY DEPRECIATION A. U.S. Experience: Does not improve the trade deficit. 29

COPING WITH THE CURRENT ACCOUNT DEFICIT B.Depreciations are ineffective because 1.It takes time to affect trade. 2.J-Curve Effect states that a decline in currency value will initially worsen the deficit before improvement. 30

THE J - CURVE time Net change in trade balance 0 Currency depreciation Trade balance initially deteriorates Trade balance improves 31

COPING WITH THE CURRENT ACCOUNT DEFICIT III.PROTECTIONISM A.Trade Barriers used: 1. Tariffs 2. Quotas B.Results: Most likely will reduce both X and M. 32

COPING WITH THE CURRENT ACCOUNT DEFICIT C.FOREIGN OWNERSHIP one protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows 33

COPING WITH THE CURRENT ACCOUNT DEFICIT D.STIMULATE NATIONAL SAVING change the tax regulations and rates. 34

COPING WITH THE CURRENT ACCOUNT DEFICIT IV.SUMMARY: CURRENT-ACCOUNT DEFICITS - neither bad nor good inherently A.Since one country’s exports are another’s imports, it is not possible for all to run a surplus 35

COPING WITH THE CURRENT ACCOUNT DEFICIT B.Deficits may be a solution to the problem of different national propensities to save and invest. 36

Copyright 2014 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.