Chapter 3

The Balance of Payments

The Balance of Payments

• International business transactions occur in many

different forms over the course of a year

• The measurement of all international economic

transactions between the residents of a country and
foreign residents is called the balance of payments
(BOP)
Fundamentals of BOP Accounting

• The BOP must balance

• Three main elements of actual process of

measuring international economic activity
– Identifying an international economic transaction
– Understanding how transactions create debits and credits
– Understanding the bookkeeping procedures for BOP
accounting

• Double-entry bookkeeping in theory but not in

practice
The U.S. BOP Accounts Summary
BOP as a Flow Statement

• The BOP is often misunderstood as a balance sheet,

whereas in fact it is a cash flow statement

• It tracks the continuing flows of purchases and

payments between a country and all other countries

• It does not add up the value of all assets and

liabilities of a country on a specific date (as an
individual firm’s balance sheet would do)
The Accounts of the BOP

• The BOP is composed of two primary sub

accounts, the Current Account and the
Capital/Financial Account

• In addition, the Official Reserves account tracks

government currency transactions

• A fourth account, the Net Errors and Omissions

account is produced to preserve the balance of
the BOP
The Current Account

• Goods Trade – export/import of goods.

• Services Trade – export/import of services.

• Income – predominately current income associated with

investments that were made in previous periods and wages
& salaries to nonresident workers

• Current Transfers – any transfer between countries that is

one way (a gift or grant)

• Typically dominated by the export/import of goods, for this

reason the Balance of Trade (BOT) is widely quoted
For example… (Maybe question in test)

Examples for components of the current account for the United States

Goods Trade: (Db to goods part of the US current account; Cr to goods part of the foreign country current account)
Debit: U.S. firm purchases German machine tools.
Credit: Singapore Airlines buys a Boeing jet.

Services Trade: (Db to services part of the US current account; Cr to services part of the foreign country current
account)

Debit: An American takes a cruise on a Dutch cruise line.

Credit: The Brazilian tourist agency places an ad in The New York Times.

Income: (Db to income part of the US current account; Cr to income part of the foreign country current account)
Debit: The U.S. subsidiary of a Taiwan computer manufacturer pays dividends to its parent in Taiwan.
Credit: A British company pays the salary of its executive stationed in New York.

Current Transfers: (Db to current transfer part of the US current account; Cr to current transfer part of the
foreign country current account)
Debit: The U.S.-based International Rescue Committee pays for an American working on the Afghan border.
Credit: A Spanish company pays tuition for an employee to study for an MBA in the United States.

8
U.S. Trade Balances on Goods and Services
The Capital and Financial Accounts

• The capital and financial accounts of the balance of

payments measure all international economic
transactions of financial assets.
 The Capital and Financial Accounts
• Financial account consists of three components and
uses degree of control over assets to classify them
– Direct Investment – Net balance of capital which is
dispersed from and into a country for the purpose of
exerting control over assets.
• Control is defined as taking a minimum ownership
interest of 10% (Buying stock) (ex: Gm buys 30% of outstanding
Honda stock – However, if its 90% of bond, it is not considered Direct investmet-
Not control)

– Portfolio Investment – Net balance of capital which flows

in and out of the country but does not reach the 10%
ownership threshold of direct investment.
• This capital is purely return motivated
– Other Asset Investment – Consists of various short and
long-term trade credits, cross-border loans, currency
deposits and bank deposits, and other accounts receivable
and payable related to cross-border trade
For example… (question in test)

Examples for subcomponents of the financial account for the United States

Direct Investment:
•Debit: Ford Motor Company builds a factory in Australia. (Debit to direct investment section of the US financial account
•Credit to direct investment section of the foreign country’s financial account.
Credit: Ford Motor Company sells its factory in Britain to British investors.

Portfolio Investment:
Debit: An American buys 9% shares of stock of a European food chain on the Frankfurt Stock Exchange.
Credit: A British company buys U.S. Treasury bills.

Other Asset Investment:

Debit: A U.S. firm deposits $1 million in a bank account in London.
Credit: A U.S. firm gets a loan from a bank in Japan
The U.S. Financial Accounts
Current and Combined Financial/Capital
Account Balances for the United Sates
Net Errors & Omissions/Official Reserves
Accounts

• Net Errors and Omissions Account

– Because current and financial account entries are collected
and recorded separately, errors or statistical discrepancies
will occur
– The net errors and omissions account ensures that the
BOP actually balances

• Official Reserves
– the total reserves held by official monetary authorities
within a country.
– Typically comprised of major currencies and reserve
accounts held at the IMF
– The significance depends on whether the country is
operating under a fixed exchange rate regime or a floating
exchange rate system (ex in notes)
Breaking the Rules: China’s Twin
Surpluses

• China’s twin surpluses also known as a “double

surplus” in the current and financial accounts is
highly unusual

• Typically, these relationships are inverses of one

another

• The reason for the twin surpluses is due to the

exceptional growth of the Chinese economy
China’s Twin Surplus
Breaking the Rules: China’s Twin
Surpluses

• China’s foreign exchange reserves increased by a

factor of 16 from 2001 to 2013- rising from $200
billion to nearly $3.7 trillion.

• China is now able to manage it currency to

maintain competitiveness worldwide

• China can also maintain a relatively stable fixed

exchange rate against other major currencies
The BOP and Exchange Rates

where:
X = Exports
M = Imports
CI = Capital Inflows
CO = Capital Outflows
FI = Financial Inflows
FO = Financial Outflows
FXB = Change in Reserve Balances
BOP = Balance of Payments
The BOP and Exchange Rates (important, 3 exam questions,
check the example to know the way to solve it)

• Floating Exchange Rate Countries

– Government has no responsibility to peg its foreign
exchange rate
– The fact that the current and capital account balances do
not sum to zero will automatically—in theory—alter the
exchange rate in the direction necessary to obtain a BOP
near zero

• Fixed Exchange Rate Countries

– Government bears the responsibility to ensure that the
BOP is near zero
– If the sum of the current and capital accounts do not
approximate zero, the government is expected to
intervene in the foreign exchange market by buying or
selling official foreign exchange reserves
The BOP and Interest Rates (1 exam question in
interest rate and inflation)

• The overall level of a country’s interest rates

compared to other countries has an impact on the
financial account of the BOP

• Relatively low interest rates should normally

stimulate an outflow of capital seeking higher
interest rates in other country-currencies

• The opposite has occurred in the U.S. as a result of

attractive growth rate prospects, high levels of
productive innovation, and perceived political
stability
The BOP and Inflation Rates

• Imports have the potential to lower a country’s

inflation rate

• Imports of lower-priced goods and services place a

limit on what domestic competitors can charge for
comparable goods and services

• On the other hand, to the extent that lower-priced

imports substitute for domestic production and
employment, gross domestic product will be lower
as the balance on the current account falls with
rising imports
Trade Balances and Exchange Rates

• A country’s import and export of goods and

services is affected by changes in exchange rates

• A simple concept in principle: Changes in

exchange rates changes the relative prices of
imports and exports which in turn result in
changes in quantities demanded

• In reality the process is less straight-forward

• Countries occasionally devaluate their own

currency to improve the trade balance
The J-Curve Adjustment Path

• Trade balance adjustment occurs in three stages

over a varying and often lengthy period of time
1. The currency contract period
– Adjustment is uncertain due to existing contracts
2. The pass-through period
– Importers and exporters pass the exchange rate changes
through to their own product prices
3. Quantity adjustment period
– The expected balance of trade is eventually realized

• The path of adjustment takes on the shape of a

flattened “j”
Trade Balance Adjustment to
Exchange Rate Changes: The J-Curve
Trade Balance Adjustment Path: The
Equation

• Trade balance = (P$xQx) – (S$/fc PfcM QM)

– The immediate impact of a devaluation is to increase the

value of the spot exchange rate, S$/fc
– Deteriorating the trade balance due to existing contracts.
– Only after a period of time when the quantities demanded
and offered are adjusted to new prices, a trade balance
improves.