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Dr. Mitchell/ECO 315/Spring 2002
1
Lecture9-BOP
The Balance of Payments Accounts
Double-entry bookkeeping
2 sides to each transaction
the flow of goods & services, or assets
the corresponding payments.
Example: US importer buys UK cars for $1mil
$1 mil debit (cars in)
$1 mil credit (money out)
“exports” are credits (+)
“imports” are debits (-)
3 Major Accounts in BOP accounts
Current Account
Capital Account
Official Settlements Account
Notes:
Balance on the 3 accounts must sum to zero. The total value of goods, services, and
assets that come in must equal the value that flow out.
Data problems lead to a statistical discrepancy.
Oftentimes Official Settlements appear as a sub-account in the Capital Account.
Dr. Mitchell/ECO 315/Spring 2002
2
Lecture9-BOP
Current Account (Trade in Goods & Services)
The entries in the current account represent the flow of actual goods, services, etc.
The “trade balance” used to be defined as the balance on merchandise trade. Now it is
defined as the combined balances on merchandise trade and trade in services.
Interpreting the balance on the current account
Current account surplus
When the credits are more than the debits.
The country is exporting more than it is importing.
Current account deficit
The opposite.
Capital Account (International Borrowing & Lending & Exchange
of Assets)
Purchase of a foreign asset (such as stocks, bonds, real estate) or lending
abroad
Also called a capital outflow, because the money flows out.
When this is extreme, it is called, “capital flight”. Capital flight occurs when residents
are become nervous that domestic investment is risky.
Sale of a domestic asset to a foreigner or borrowing from abroad
Called a capital inflow.
Interpreting the balance on the capital account
Capital account surplus
Means credits > debits.
The country is a net seller of assets. Foreigners buy more of its assets than it buy of theirs.
Capital account deficit
They are net investors abroad.
Dr. Mitchell/ECO 315/Spring 2002
3
Lecture9-BOP
Official Settlements Account (All Official Transactions)
This account keeps track of official holdings of foreign exchange reserves.
Negative Balance
If there is a negative balance, this means that the stock of foreign exchange reserves has
increased (they have “imported” foreign exchange reserves). This means there are fewer
units of foreign exchange, more units of the domestic currency in circulation.
Interpretation in Flexible exchange rate environment: Central banks are trying to
decrease the value of the domestic currency by selling it.
Interpretation in Fixed exchange rate environment: At the current exchange rate, the
quantity demanded of foreign exchange is less than the quantity supplied. (The value of
the domestic currency is set below the equilibrium rate.)
Positive Balance
If there is a positive balance, this means that the official stock of foreign exchange
reserves has decreased. There are more foreign currencies, fewer units of domestic
currency in circulation.
Interpretation in Flexible exchange rate environment: Central banks are trying to
increase the value of the domestic currency by buying it up.
Interpretation in Fixed exchange rate environment: At the current exchange rate, the
quantity demanded of foreign exchange is greater than the quantity supplied. (The value
of the domestic currency is above below the equilibrium rate.)
Dr. Mitchell/ECO 315/Spring 2002
4
Lecture9-BOP
“The” Balance of Payments
CAB + KAB + OSB = 0
CAB + KAB = - OSB
“The balance of payments” is often used in the vernacular to refer to the combined
balances of the current and capital accounts. This is a correct usage. It is also often
popularly confused with the balance on the current account and even the balance of trade.
“The balance of payments” represents net official transactions, in other words, net
intervention in the foreign exchange markets.
Balance of payments deficit
A surplus (positive balance) in the official settlements account.
Net official sales of foreign exchange or net foreign official accumulation of dollars.
The gov’t(s) is (are) trying to increase the value of this country’s currency. In the case of
a fixed exchange rate, the market is placing downward pressure on the value of the
domestic currency which the gov’t is forced to counteract.
Note that in order to maintain this situation for long periods of time this country will need
to have a reliable source of foreign exchange, such as export revenues, loans of hard
currencies, international aid in hard currencies.
Balance of payments surplus
Opposite.
The gov’t is trying to bring down the value of this country’s currency.
Balance of payments = zero
Expect this if the exchange rate is primarily set in the market (floating or lightly managed
float).
Expect this if a fixed exchange rate is set at about the right level, since the gov’t sales and
purchases of foreign exchange will offset each other.
Important note
If BOP = 0, then the current account and capital account balances must be of equal size
and opposite sign!
Dr. Mitchell/ECO 315/Spring 2002
5
Lecture9-BOP
Balance of Payments Crisis
A balance of payments crisis occurs when a country runs out of foreign exchange reserves
(or comes close).
General description of a balance of payments crisis
A fixed exchange rate is set pegging the currency to, say, the US dollar. There is a
growing demand for dollars over time. (In a flexible exchange rate environment, the
value of the local currency would be falling over time.)
In order to maintain the fixed exchange rate, the local central bank is forced to buy more
and more of the local currency, selling dollars in exchange. But what happens when the
local central bank begins to run low on US dollars?
Market response: Speculative Attack
As international investors become aware that the central bank is running low on foreign
exchange, they realize that there is a good chance the country won’t be able to “defend”
its current exchange rate. They conclude that the value of the currency is likely to drop.
Therefore they begin selling it off as fast as they can. The more they want to sell, the
more pressure there is on the exchange rate, and the faster foreign exchange reserves fall,
making the fears come true. Some actors may begin to bet against the local currency in
other ways, such as by selling forward contracts on the local currency or taking out loans
denominated in the local currency (do you see why?)
Government Response: Floating Rates or Exchange controls
These days, worldwide market forces are much larger than the resources of a typical
country. The government may decide to let the currency float. It may decide to maintain
the fixed rate but institute exchange controls that limit the amount of currency that can be
traded (may need a permit). Another feature of exchange controls may be that any
resident that earns hard currencies (say, through exporting goods) is obligated to trade the
hard currency for the local currency.
IMF Response: Loans or Guarantees
The IMF has the option to give or lend US dollars to the country to use in its fight against
the speculative attack. It can also guarantee the country that it will provide the amount
needed. It is hoped that IMF action will help directly but also that it will convince people
that the government can now defend its exchange rate, thereby lessening the demand for
dollars and reducing the magnitude of the problem.