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BALANCE OF PAYMENTS
Economics - A Course Companion
(Blink & Dorton, p289-301)
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Date Accessed: 13/1/2010
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Balance of
Payments
Cycle
BALANCE OF PAYMENTS – INTERNATIONAL COMPARISONS
Source: Go to Economist.com. Click on Economics & then markets & data.
Finally click on the link which says Trade, Exchange Rates & Budget Balances.
COUNTRY
United States
Japan
China
Britain
Canada
Germany
TRADE BALANCE
Latest 12 months
$BN
CURRENT ACCOUNT BALANCE
Balance of Payments
Introduction Video
• Watch the 2 minute video on an introduction to
the Balance of Payment from Investopedia.
• There is a lot of information and its really fast.
• Devise 5 questions based on the content..
• Test a friends understanding…
• Watch the video again at SP media or youtube.
Youtube Source:
https://www.youtube.com/watch?v=YlQgeyKV-QM
The Balance of Payments Account
• The Balance of Payments account is a record
of the value of all the transactions between
the residents of one country with the
residents of all other countries in the world
over a given period of time.
• There are two main parts to the Balance of
Payment account: The Current Account & The
Capital Account.
The Balance of Payments
Names of Specific Accounts
• There are many different names used to
identify the various parts of the Balance of
Payments Account.
• The headings change from country to country
and even from time to time within the same
country.
• Where possible, alternative names will be
provided.
THE CURRENT ACCOUNT
• The Current Account is a measure of the flow
of funds from trade in goods and services, plus
other income s.
• It is usually sub divided into three parts:
1. The Balance of Trade in Goods
2. The Balance of Trade in Services
3. Income (Net Income Flows)
4. Current Transfers (Net Current Transfers)
THE CURRENT ACCOUNT
1. The Balance of Trade in Goods
• The Balance of Trade in Goods is also variously
known as the visible trade balance, the
merchandise account balance or simply the
balance of trade.
• It is a measure of the revenue received from the
exports of tangible (physical) goods minus the
expenditure on imports of tangible goods over a
given period of time.
• It includes trade in all tangible goods from
airplanes to chickens.
THE CURRENT ACCOUNT
1. The Balance of Trade in Goods
• Exports occur when an international
transaction relating to goods or services leads
to an inflow of money into the country.
• Imports occur when an international
transaction relating to goods or services leads
to an outflow of money from the country.
THE CURRENT ACCOUNT
1. The Balance of Trade in Goods
Surplus on the Balance of Trade in Goods
• When export revenue is greater than import
expenditure, there is a surplus on the balance
of trade in goods.
Deficit on the Balance of Trade in Goods
• When import expenditure is greater than
export revenue, then there is a deficit on the
balance of trade in goods.
THE CURRENT ACCOUNT
2. The Balance of Trade in Services
• The Balance of Trade in Service is also known
as the invisible balance, the service balance
or net services.
• It is a measure of the revenue received from
the exports of services minus the expenditure
on the imports of services over a given period
of time.
THE CURRENT ACCOUNT
2. The Balance of Trade in Services
• It includes the import and export of all
services such as banking, insurance and
tourism.
• An Italian tourist on holiday in Vienna would
be spending money that represents an
invisible export to the Austrian economy
(money coming in) and therefore an invisible
import to the Italian economy (money going
out)
THE CURRENT ACCOUNT
3. Income
Net Investment Incomes (Net Factor Income)
• This is a measure of the net monetary movement
of profit, interest and dividends moving into and
out of country over a given period of time as a
result of financial investment abroad.
• Domestic firms may set up branches in other
countries and any profits being repatriated will
count as a positive item in the account.
• In the same way, profits sent out of the country
by foreign firms within the country will count as a
negative item.
THE CURRENT ACCOUNT
3. Income
Net Investment Incomes
• Residents and institutions in the country may
have invested in banks and other financial
institutions in other countries and any interest
received from these financial investments will
count as a positive item.
• In the same way, any payment of interest to
foreign investors that leaves the country will
count as a negative item.
THE CURRENT ACCOUNT
3. Income
Net Investment Incomes
• Residents and institutions may have
purchased shares in foreign companies and
any dividends received from those companies
will count as a positive item.
• In the same way, any dividends paid by
domestic firms to foreign shareholders will
count as a negative item.
THE CURRENT ACCOUNT
4. Current Transfers – Net Transfers of Money
• These are payments between countries when
no goods or services change hands.
• At the government level it includes items such
as foreign aid and grants.
• At an individual level it includes foreign
workers sending money back to their families
in their home country (remittances) or private
gifts sent from a person in one country to a
person in another.
THE CURRENT ACCOUNT
Current Account Balance
Current Account Balance =
Balance of Trade in Goods +
Balance of Trade in Services +
Net Income Flows +
Net Current Transfers
THE CURRENT ACCOUNT
Current Account Balance
• Any account might be in surplus or deficit at
any given time – there could be a deficit on
the trade in goods, a surplus on the trade in
services, a surplus on net income flows and an
overall surplus on the current account.
• The current account balance is an overall
balance and may be in deficit or in surplus.
THE CAPTIAL ACCOUNT
• Relatively small part of the BOP. Two
components.
Capital Transfers
• Measures of the net monetary movement
gained or lost through actions such as the
transfer of goods/financial assets by migrants.
• Debt Forgiveness.
• Gift Taxes, Inheritance Taxes
THE CAPITAL ACCOUNT
Transactions in Non-Produced Financial Assets
• Intangible assets, such as patents, copyrights,
brand names or franchises.
• Buying the right to use natural resources.
THE FINANCIAL ACCOUNT
• The financial account is a measure of the buying
and selling of assets between countries.
What is classified as an asset?
• Assets in this case includes anything that can be
owned and that has value, such as land, real
estate, companies, bank deposits, stocks and
shares, treasury bills, government bonds foreign
currency and all other types of financial
instruments.
THE FINANCIAL ACCOUNT
Classifications
Direct Investment
• Includes Foreign Direct Investment (FDI)
• Investment by MNCs in another country.
Portfolio Investment
• Investment in stocks, shares, bonds (treasury
notes)
Reserve Assets
THE FINANCIAL ACCOUNT
• The financial account measures the net change in
foreign ownership of domestic assets.
• If foreign ownership of domestic assets increases
more quickly than domestic ownership of foreign
assets then there is more money coming into the
country than going out and so there is a capital
account surplus.
• In the same way, if domestic ownership of foreign
assets increases more quickly than foreign
ownership of domestic assets, then there is more
money going out of the country than coming in
and so there is a financial account deficit.
THE FINANCIAL ACCOUNT
Types of Assets
It possible to distinguish between two different
types of assets:
Assets than represent ownership
• This includes buying property, purchasing a business,
or purchasing stocks or shares in a business.
• In all cases the asset is expected to have a positive
return in the future by making profits or by increasing
in value over time.
• The investment does not have to be paid back and
there is no guarantee that it will provide a positive
return.
• The buyer of the asset is taking a risk.
THE FINANCIAL ACCOUNT
Types of Assets
Assets that Represent Lending
• This includes treasury bills, government bonds
and saving account deposits.
• In these cases the investor is lending the money
in order to purchase the asset in the expectation
that interest will be paid upon the investment
and the money will be repaid at a given point in
time.
• These assets are simply borrowing and lending on
the international market.
FINANCIAL ACCOUNT
Official Reserve Account – Reserve Assets
• Included in the capital account or financial
account are changes in the official reserve
account Or
• All countries hold reserves of gold and foreign
currencies, which are itemised in the official
reserve account and it is movements into and
out of this account that ensure that the
Balance of Payments will always balance to
zero.
FINANCIAL ACCOUNT
Official Reserve Account
• If there is a surplus on all of the other
accounts combined, then the official reserve
account total will increase.
• If there is a deficit on all the other accounts
combined, then the official reserve account
total will decrease.
• It is net changes in the official reserve account
over the period of time being considered that
balances the accounts.
Does the BOP actually
balance exactly?
• In realty the accounts will not balance because there
are simply too many individual transactions taking
place for the measurement to be exact.
• There will be some transactions that have not yet been
recorded when the figures are being put together.
• In addition, black markets (eg: the drug trade) mean
that many transaction may be only partly recorded if at
all.
• A balancing item (sometimes known as net errors and
omissions or statistical discrepancy) is therefore put
into the accounts to ensure they do balance.
• As trading accounts are revised over the years, more
data come to light and the balancing items become
smaller.
THE CONSEQUENCES OF CURRENT ACCOUNT
AND CAPITAL ACCOUNT IMBALANCES
• The existence of a deficit or surplus in either
the current or capital account will have
economic consequences that can impact on
the whole economy.
• However, the extent of this impact and its long
term implications is greatly debated among
economists.
Consequences of a
Current Account Deficit (CAD)
• If the current account is in deficit then the capital
account will have to be in surplus in order to balance
out the current account deficit. This means one of
three things:
1. Foreign Exchange Reserves may be used to increase
the capital account and so regain balance with a
deficit in the current account.
 If reserves are taken from the official reserve account,
then they are a positive entry into the capital account.
 However, no country no matter how rich or powerful
is able to fund long term account deficits from its
reserves. Eventually the reserves would run out.
Consequences of a
Current Account Deficit (CAD)
2. Foreign Ownership of Assets



A High Level of Buying Assets for Ownership is financing
the current account deficit.
Foreign investors may be purchasing such things as
property, businesses or stocks or shares in businesses.
In this case this inflow into the capital account is funding
the current account deficit, but as it must be based upon
foreign confidence in the domestic economy, it is not
considered harmful.
However, there are sometimes fears that if foreign
ownership of domestic assets were to become too great,
then this may be a threat to economic sovereignty.
Consequences of a
Current Account Deficit (CAD)
2. Foreign Ownership of Assets (continued)
 If there is a drop in confidence, then foreign
investors might prefer to shift their assets to
other countries.
 Selling the assets would result in an increase
in supply of the currency and fall in its value.
Consequences of a
Current Account Deficit (CAD)
3. Lending From Abroad




It may be that the CAD is financed by high levels of
lending from abroad.
If this is the case, then high rates of interest may have to
be paid which will be a short term drain on the economy
and will further increase the CAD.
However, if interest rates are lower in other countries it
could be a smart move to borrow from overseas. BUT..
There is always the danger that the governments or
people lending the money may, at some time, withdraw
their money. This would lead to massive selling of the
currency and a very sharp fall in the exchange rate.
Consequences of
Current & Capital Account Surpluses
1. A current account surplus allows a country to
have a deficit on the capital account by
building up its official reserve account or by
purchasing assets abroad.
However, one country’s surplus is another
country’s deficit and it may lead to
protectionism by other countries in order to
reduce their own deficits.
Consequences of
Current & Capital Account Surpluses
• A current account surplus usually leads to an
appreciation of the currency on the foreign
exchange market as it implies an increase in
demand for the currency.
• This will make imports cheaper, so reducing
inflationary pressures, but it will also make
exports more expensive, which harms
exporters.
How big is a`big` current account
deficit or surplus?
There are two ways to interpret the size of the current
account deficit or surplus.
(1) The value of the total
(2) In the context of the country’s GDP.
•
•
•
•
It is lot easier to understand the magnitude of the
deficit in the context of GDP.
The burden of a deficit depends on the ability to pay.
A current account surplus is less of a concern, than a
CAD.
A CAD is a concern when they reach a certain
percentage of GDP.
METHODS OF CORRECTING A PERSISTENT
CURRENT ACCOUNT DEFICIT
There are two main policy approaches:
1 Expenditure-switching policies
• Government policies to depreciate or devalue
the currency.
• Protectionist measures.
2. Expenditure-reducing policies
• Deflationary Fiscal Policies
• Deflationary Monetary Policies
METHODS OF CORRECTING A CAD
Expenditure-switching Policies
• Expenditure-switching policies are any policies
implemented by the government that attempt
to switch expenditure from imports towards
domestically produced goods and services.
• If successful, then expenditure on imports will
fall and so the CAD should improve.
METHODS OF CORRECTING A CAD
Expenditure-switching Policies
Government Policies to Depreciate/Devalue
the Currency
• If the government adopts policies that will reduce
the level of the exchange rate then exports
should become less expensive and imports
should become more expensive.
• Depending on how responsive domestic
consumers and foreign consumers are to these
price changes, this should see an improvement in
the CAD as export revenue rises and import
expenditure falls.
METHODS OF CORRECTING A CAD
Expenditure-switching Policies
Protectionist Measures
• The government may attempt to restrict
imports of products either by reducing their
availability using embargos, quotas or
increasing their prices through tariffs.
• However, such measures can lead to
retaliation from other countries and
encourage inefficient domestic industries.
METHODS OF CORRECTING A CAD
Expenditure-reducing Policies
• Expenditure-reducing policies are any policies
implemented by the government that attempt to
reduce overall expenditure in the economy, so
shifting AD to the left.
• If this occurs, then expenditure on all goods and
services should fall and, since this would include
expenditure on imports, the CAD should improve.
• The size of the fall in imports will depend upon
the level of the marginal propensity to import.
METHODS OF CORRECTING A CAD
Expenditure-reducing Policies
Deflationary Fiscal Policies
• Increasing direct tax rates and or reducing
government expenditure.
• This would be unpopular and government
may be reluctant to implement.
METHODS OF CORRECTING A CAD
Expenditure-reducing Policies
Deflationary Monetary Policies
• Increasing the rate of interest and/or reducing
the money supply
• The higher interest rates should increase
capital flows from abroad. This would lead to
a surplus on the capital account, which helps
to offset the CAD.
• This policy would also be politically unpopular.
METHODS OF CORRECTING A CAD
Expenditure-reducing Policies
Problems with Expenditure-Reducing Policies
• There is a conflict between external and
internal objectives.
• Deflating the economy may reduce the CAD,
but the policy is likely to lead to a fall in
domestic employment and fall in GDP.
METHODS OF CORRECTING A CAD
EXPORT PROMOTION POLICIES
• Both expenditure -switching policies and
expenditure-reducing policies have problems
and therefore many governments, prefer to
pursue export promotion policies.
• This may include government run trade
missions, hoping to develop new markets and
government sponsored advertising campaigns.