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balance of payments

Page history last edited by Brian D Butler 9 years ago

 

 

 

 

 

Balance of Payments

A concept in International Finance and international economics.   It is like the overall balance sheet for a country.  As the name implies, the BOP must balance (or = 0).  Total assets must equal total liabilities.  Total deficits must equal total surpluses.  In a free floating exchange rate regime, there is no way for a country to have a balance of payments crisis because the Currency will adjust.  But when the currency has a fixed exchange rate, or pegged to another currency, it is possible to have a BOP crisis (think "tequila crisis" in Mexico).

 

see also: 

 

 

 

 

Table of Contents:


 

 

 

The Balance of payments

for a country includes two main parts:  

  1. Current Account (imports / exports, goods, services, gifts)
  2. Capital Account (financials, treasury bonds, IBM shares, etc).

 

If the Balance of payments were a balance sheet, then the

  • Debits (left side) would be = everything coming into a country (-)...imports
  • Credits (right side) would be= everything going out of a country (+) ...exports

 

Must Balance...

The net effect of the current + capital accounts should be approximately =0 (balance).  It never is exactly =0, however...so, as a result of the slight imbalance, if there is a deficit, the the country must dip into their "reserves"(ie, gold, or foreign exchange reserves) and pay out the difference.  If there is a deficit, then the FX currency should depreciate (devalue).  If there is a floating exchange rate, then it happens automatically, but if the currency is fixed, then the government will have to continue paying out gold (or currency) to defend the currency level.  If it doesn't have enough reserves, then you could see a Balance of Payments crisis, as happened in Mexico.  Note that the USA uses gold as the reserve currency, but has not needed to dip into their gold supply very often over the past 30 years (even though the USA has continuously had a current account deficit). 

 

If there is an overall B.O.P deficit, then ...

  1. currency must devalue (depreciation)
  2. Government will be unhappy....leading to new laws that will:

 

 

National Accounts:  

 

see discussion on GDP (from GloboTrends)

see great summary here:  http://userwww.sfsu.edu/~pgking/690pdfs/690%20notes%20for%20assn%204.pdf 

 

Current Account deficits / surplus:

 

  • GDP (Y) = Consumption (C) + Government spending (G) + Investment (I) + [Exports-Imports (Current Account - (x))]
  • Y = C +G+I+x

 

or, re-written....

  • Current account (CA) = Y - (C+G+I)

 

so, if you have a:

  • Current Account SURPLUS:   then Y > CGI  .... or, income (production) is greater than spending (investment)
  • Current Account DEFICIT:     then Y < CGI  .... or, income (production) is LESS than spending (investment)

 

How does the country finance this excess spending? It borrows.

  • Q: what do we do when we spend more than we earn?
  • A: we use a credit card (borrow money that has to be paid later).

 

The current account shows the amount of international lending or borrowing. Essentially, a CA deficit is trading current consumption for future consumption. A current account surplus is like giving up current consumption in exchange for future consumption

 

 

 

 

 

 

 

USA Balance of payments

 

 

Note that the USA has a massive current account deficit (importing more than exporting), but makes up for the balance by having a massive Capital Account surplus (more foreigners are investing in the US, so more money is coming in than is going out).   There is a massive amount of T-bills being purchased by foreign central banks (such as China, etc) that are doing so in order to keep their currency level low.  Note that China has over $1 trillion investment in the USA.  They pay for these investments with the money that they earn from trade.  Since their overall B.O.P must balance, and since they have a massive current account surplus, then they must also have a massive Capital account deficit.  So, the money must be invested overseas.

 

The USA model = keep a current account deficit, and finance the gap with foreign investments.  This has worked well for the US over the past 30 years.  Should countries such as Mexico do the same thing?  Is this a model for success for others to follow?  Not necessarily.  This "business model" only works as long as foreigners have a very high level of confidence in your currency.  If they loose confidence in your stability, or growth, then they will no longer demand your investments, and the model breaks down.   Warning to the USA:  don't do things to destroy foreign confidence in your country.  If you loose that advantage, then you will loose your capital account surplus.  If you loose the capital account surplus, then you will also loose your ability to run a current account deficit, ending imports. 

 

UK, deriviatives, and shadow banking market

 

Residents in the UK were the largest purchaser of US corporate debt over the past few years. Corporate debt – in the US balance of payments data – includes asset-backed securities. Foreign purchases of such debt soared – especially from 2004 to 2007 – before falling off a cliff during the crisis.

 

 

 

Can the USA continue running such a large current account deficit?

 

There is a lot of debate in this area.  The key is "confidence". As long as the world continues to show confidence in the US, then it will continue to be desirable for foreign investment.  Foreigners will want to purchase US treasury bonds because they are seen as "risk free investments". 

 

As China and India continue to open up their economies, they will need to meet the pent-up demand of their citizens to invest money out of the countries.  Much of this investment will likely go to the USA (as long as confidence remains high).  With this happening, it is possible that the US could run a current account deficit for the next 30+ years (as they have done for the past 30 years) without much problem.  As it currently stands, Indian and Chinese consumers have very limited ability to invest overseas.  Some economists predict that as their economies open up, that we should see increased demand for US investments.   As long as the US is able to run a capital account surplus, then they should have no trouble maintaining the current account deficit.  This balance should be fed by India / China for many years to come. 

 

 

 

Balance of payments (FX currency) model

 

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance.  A nation with a trade deficit will experience reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. In the end, this could cause a balance of payments crisis.  The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

 

Like PPP, the balance of payments (FX currency) model focuses largely on trade-able goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

 

 

 

Trends:

 

A recent trend has been for a weakening US dollar, which should help the US reduce its trade deficit and should help overt potential balance of payments crisis in the future (see discussion below)....

 

 

Wikipedia definition

 

The balance of payments, (or BOP) measures the payments that flow between any individual country and all other countries. It is used to summarize all international economic transactions for that country during a specific time period, usually a year. The BOP is determined by the country's exports and imports of goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits). Balance of payments is one of the major indicators of a country's status in international trade, with net capital outflow.

 

 

 

Components

     countries in current account surplus (2005)      countries in current account deficit (2005)
     countries in current account surplus (2005)      countries in current account deficit (2005)
 

The Balance of Payments for a country is the sum of the current account, the financial account (formerly capital account), and the change in official reserves.

The current account is the sum of net sales from trade in goods and services, net factor income (such as interest payments from abroad), and net unilateral transfers from abroad. Positive net sales to abroad corresponds to a current account surplus; negative net sales to abroad corresponds to a current account deficit. Because exports generate positive net sales, and because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports.

 

The Income Account or Net Factor Income, a sub-account of the Current Account, is usually presented under the headings "Income Payments", as outflows, and "Income Receipts", as inflows. If the Income Account is negative, the country is paying more than it is taking in interest, dividends, etc. For example, the United States' net income has been declining exponentially since it allowed the Dollar's price relative to other currencies to be determined by the market to a point where income payments and receipts are roughly equal. The difference between Canada's Income Payments and Receipts have been declining exponentially as well since its central bank in 1998 began its strict policy not to intervene in the Canadian Dollar's foreign exchange.[1] The various subcategories in the Income Account are linked to specific respective subcategories in the Financial account. From here, economists and central banks determine implied rates of return on the different types of capital exchanged in the Financial Account. The United States, for example, gleans a substantially larger rate of return from foreign capital than foreigners from domestic capital.

 

When analyzing the current account theoretically, it is often written as a function X of the real exchange rate, p, domestic GDP, Y, and foreign GDP, Y*. Thus the current account can be written as X(p, Y, Y*). According to theory, the current account X should increase if (1) the domestic currency depreciates (p increases), (2) domestic GDP decreases, or (3) foreign GDP increases. A domestic currency depreciation makes domestic goods relatively cheaper, boosting exports relative to imports. A decrease in domestic GDP reduces domestic demand for foreign goods, lowering imports without affecting exports. An increase in foreign GDP increases foreign demand for domestic goods, increasing exports without affecting imports.

Current account =

  • Trade Balance
    • Net Exports (Exports - Imports) of Merchandise (tangible goods)
    • Net Exports (Exports - Imports) Services (such as legal and consulting services)
  • + Net Factor Income From Abroad (such as interest and dividends)
  • + Net Unilateral Transfers From Abroad (such as foreign aid, grants, gifts, etc.)

 

 

 

Capital Account

The capital account "records the international flows of transfer payments relating to capital items". It therefore records a country's inflows and outflows of payments and transfer of ownership of fixed assets (capital goods). Examples of such goods could be factories and so on. Summing up: the Capital Account accounts for the transfer of capital goods. (source: see book reference list)

 

 

 

 

Financial Account

The financial account is the net change in foreign ownership of domestic financial assets. If foreign ownership of domestic financial assets has increased more quickly than domestic ownership of foreign assets in a given year, then the domestic country has a financial account surplus. On the other hand, if domestic ownership of foreign financial assets has increased more quickly than foreign ownership of domestic assets, then the domestic country has a financial account deficit

The accounting entries in the financial account record the purchase and sale of domestic and foreign assets. These assets are divided into categories such as Foreign Direct Investment (FDI), Portfolio Investment (which includes trade in stocks and bonds), and Other Investment (which includes transactions in currency and bank deposits).

Financial account =

  • Increase in foreign ownership of domestic assets - Increase of domestic ownership of foreign assets

 

 

 

Current Account

This section covers the flow of goods, services and income in and out of a given country and also financial aid from governments abroad:

  • Trade in goods is also known as trade in visibles or tangibles,
  • Trade in services is also known as trade in invisibles or intangibles.
  • Income refers not only to the money given back from investments made abroad (attention!: investments are recorded in the financial account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad that send money to their families back home (this is usual only in diasporas and developing countries). (source: see book reference list)

 

Official reserves

The official reserves account records the current stock of reserve assets (and often simply referred to as foreign exchange reserves) available to and controlled by the country's authorities for financing of international payment imbalances, foreign exchange intervention and other uses.[2] Reserves include official gold reserves, foreign exchange reserves, and IMF Special Drawing Rights (SDRs), all denominated in foreign currency (although the amounts may be expressed in any relevant unit). Changes in the official reserves account for the differences between the capital account and current account, and effectively represent foreign exchange interventions; the magnitude of these changes will depend on monetary policy.

In general, net decreases in official reserves indicate that a country is buying its domestic currency to support its value relative to whatever foreign currency they are selling in exchange for the domestic one. Countries with large net increases in official reserves are effectively attempting to keep the price of their currency low by selling domestic currency and purchasing foreign currency, increasing official reserves.[3][1] For countries with floating exchange rates, the official reserves will tend to change less, and be used as another tool of monetary policy to influence intervention by directly controlling the domestic money supply (by buying or selling foreign currency); however, this usage has been challenged by economists such as Milton Friedman who in an interview on Icelandic television said that a central bank can control an exchange rate or control inflation but cannot do both:

Interest in official reserve positions as a measure of balance of payments greatly diminished after 1973 as the major countries gave up their commitment to convert their currencies at fixed exchange rates. This reduced the need for reserves and lessened concern about changes in the size of reserves.[4]

Countries that attempt to control the price of their currency will tend to have large net changes in their official reserves. Some of the most extreme examples include China and Japan. In 2003 and 2004, Japan had an outflow of reserves, yen, by more than equivalently one third of one trillion US Dollars if calculated using exchange rates prevailing at the time.

 

 

More Comments

 

 

Balance of international transactions

 

A country’s balance of international payments is a systematic statement of all economic transactions between that country and the rest of the world.

 

Major components: Current Account and the Financial Account

 

Current Account

– Merchandise (trade balance); Services, Investment income, unilateral transfers.

 

Financial Account

– Private, Government, Official reserve changes, Others

 

In the area of international economics, the key accounts are a nation’s balance of payments. A country’s balance of international payments is a systematic statement of all economic transactions between that country and the rest of the world. Its major components are the Current account and the financial account.

 

The balance of payments records each transaction as either a plus or a minus.

 

The general rule in balance of payments accounting is:

 

If a transaction earns foreign currency for the nation, it is called a credit and is recorded as a plus item. If a transaction a transaction involves spending foreign currency, it is a debt and is recorded as a negative item. In general, exports are credits and imports are debits.

 

 

Balance of Current account – Includes all items of income and outlay – imports and exports of goods and services, investment income, and transfer payments.

 

 

Trade balance - Consist of merchandise imports or exports.

 

The composition of the merchandise imports and exports consists mainly of primary commodities (like food and fuels) and manufactured goods.

 

In an earlier era, the mercantilists strove for a trade surplus calling this a favorable balance of trade. They hoped to avoid and unfavorable trade balance, by which they meant a trade deficit. Today trade deficit is not necessarily harmful.

 

The trade deficit is really a reflection of the imbalance between domestic investment and domestic saving.

Often, a nation has a trade deficit because its domestic capital is highly profitable and it is beneficial to borrow abroad to invest at home and rise domestic incomes.

 

Services, are increasingly important in international trade. Services consist of such items as shipping, financial services, and foreign travel. A third item in the current account is investment income, which includes the earnings of foreign investment.

 

A final element is transfers, which represent payments not in return for goods and services.

 

 

 

 

 

 

 

 

 

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