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Chapter 4
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)
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The Balance of Payments
• BOP data is important for government policymakers and MNEs
as it is a gauge of a nation’s competitiveness or health
(domestic and/or foreign)
• For a MNE, both home and host country BOP data is important
as:
– An indication of pressure on a country’s foreign exchange
rate
– A signal of the imposition or removal of controls in various
sorts of payments (dividends, interest, license fees,
royalties and other cash disbursements)
– A forecast of a country’s market potential (especially in the
short run)
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Typical BOP Transactions
• Each of the following represents an international
economic transaction that is counted in and
captured in the U.S. BOP:
– A U.S. subsidiary of a foreign MNE acts as a distributor for
the MNEs products in the U.S. market
– A U.S. based firm, manages the construction of a major
water treatment facility in a foreign country
– The U.S. subsidiary of a foreign firm pays profits
(dividends) back to a parent in its home (foreign) country
– The U.S. government finances the purchase of military
equipment for a foreign military ally
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Fundamentals of BOP Accounting
• The BOP must balance
• It cannot be in disequilibrium unless
something has not been counted or has
been counted improperly
• Therefore it is incorrect to state that the
BOP is in disequilibrium
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Fundamentals of BOP Accounting
• There are three main elements of the actual process of
measuring international economic activity:
– Identifying what is and is not an international economic
transaction
– Understanding how the flow of goods, services, assets, and
money create debits and credits to the overall BOP
– Understanding the bookkeeping procedures for BOP
accounting
• It is a daunting task to measure all international transactions
that take place in and out of a country over a year
• Exhibit 4.1 presents a sample generic BOP
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Exhibit 4.1 Generic Balance of
Payments
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The BOP as a Flow Statement
• The BOP is often misunderstood as many people
infer from its name that it is a balance sheet,
whereas in fact it is a cash flow statement
• By recording all international transactions over a
period of time such as a year, 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)
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The BOP as a Flow Statement
• Two types of business transactions
dominate the balance of payments:
– Exchange of Real Assets
– Exchange of Financial Assets
• Although assets can be identified as
belonging to distinct groups, it is easier to
think of all assets simply as goods that can
be bought or sold (a clock versus a bond)
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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
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The Current Account
• The Current Account includes all international economic
transactions with income or payment flows occurring within one
year, the current period. It consists of the following four
subcategories:
– Goods trade and import of goods
– Services trade
– Income
– Current transfers
• The Current Account is typically dominated by the first component
which is known as the Balance of Trade (BOT) even though it
excludes service trade
• Exhibit 4.2 documents the U.S. current account from 2002–2010;
Exhibit 4.3 follows with U.S. trade balance on goods and services
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Exhibit 4.2 The United States Current
Account, 2002-2010 (billions of U.S. dollars)
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Exhibit 4.3 U.S. Trade Balances on Goods and
Services, 1985-2010 (billions of US dollars)
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The Current Account
• The deficits in the BOT of the past decade have been
an area of considerable concern for the United
States, in both the public and private sectors
• The goods trade deficit saw the decline of heavy
traditional industries in the U.S. (steel, automobiles,
automotive parts, textiles)
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The Capital/Financial Account
• The Capital Account of the balance of
payments measures all international
economic transactions of financial assets. It
is divided into two major components:
– The Capital Account
– The Financial Account
• The Capital Account is minor (in
magnitude), while the Financial Account is
significant
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The Financial Account
• Financial assets can be classified in a
number of different ways including the
length of the life of the asset (maturity) and
the nature of the ownership (public or
private)
• The Financial Account, however, uses a third
method. This focuses on the degree of
investor control over the assets or
operations
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The Financial Account
• The Financial Account consists of three
components;
– Direct Investment – in which the investor exerts
some explicit degree of control over the assets
– Portfolio Investment – in which the investor has
no control over the assets
– Other Investment – consists of various shortterm and long-term trade credits, cross-border
loans, currency deposits, bank deposits and
other A/R and A/P related to cross-border trade
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Direct Investment
• This is the net balance of capital dispersed from and into the
U.S. for the purpose of exerting control over assets.
• Foreign direct investment arises from 10% ownership of
voting shares in a domestic firm by foreign investors.
• The source of concern over foreign investment in any country
focuses on two topics: control and profit.
• Some countries possess restrictions on what foreigners may
own in their country.
• The general rule or premise is that domestic land, assets and
industry should be owned by residents of the country.
• Concerns over profit stem from the same argument.
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Portfolio Investment
• This is the net balance of capital that flows in and out of the
U.S. but does not reach the 10% threshold of direct
investment.
• The purchase of debt securities across borders is classified as
portfolio investment because debt securities by definition do
not provide the buyer with ownership or control.
• Portfolio investment is motivated by a search for returns
rather than to control or manage the investment.
• As illustrated in Exhibit 4.4, portfolio investment has shown
much more volatile behavior than net foreign direct
investment over the past decade
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Exhibit 4.4 The United States Financial Accounts
and Components, 2002-2010 (billions of U.S.
dollars)
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Other Investment Assets and Liabilities,
Current and Financial Account Balance
Relationships
• Exhibit 4.5 shows the major subcategories of the
U.S. financial account balance from 1985 to 2009:
direct investment, portfolio investment, and other
long-term and short-term capital investment
• Exhibit 4.6 illustrates the current and financial
account balances for the United States over recent
years
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Net Errors & Omissions/Official
Reserves Accounts
• The Net Errors and Omissions account ensures that
the BOP actually balances.
• The Official Reserves Account is the total reserves
held by official monetary authorities within the
country.
• These reserves are normally composed of the major
currencies used in international trade and financial
transactions (hard currencies).
• The significance of official reserves depends
generally on whether the country is operating
under a fixed exchange rate regime or a floating
exchange rate system.
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Exhibit 4.5 The United States Financial Account,
1985-2010 (billions of U.S. dollars)
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Exhibit 4.6 Current and Combined Financial/Capital
Account Balances for the United States, 1992-2010 (billions
of U.S. dollars)
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Breaking the Rules: China’s Twin
Surpluses
• Exhibit 4.7 illustrates China’s highly unusual
twin surplus in both the current and
financial accounts (these relationships are
typically inverse)
• The rapid rise of the Chinese economy has
been accompanied by a 10 fold increase in
foreign exchange reserves (Exhibit 4.8)
• As a result, China’s foreign exchange
reserves are approximately 2.5 times larger
than the next largest (Exhibit 4.9)
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Exhibit 4.7 China’s Twin Surplus, 19982010 (billions of U.S. dollars)
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Exhibit 4.8 China’s Foreign Exchange
Reserves (billions of U.S. dollars)
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Exhibit 4.9 Largest Foreign Exchange Reserves
(billions of U.S. dollars)
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The BOP in Total — Surplus
• Exhibit 4.10 provides a comprehensive overview of
how the individual accounts are combined to create
some of the most useful summary measures for
multinational business managers
• Total of groups A, B, and C form the basic balance;
this is one of the most frequently used summary
measures of the BOP
• A surplus in the BOP implies that the demand for
the country’s currency exceeded the supply and
that the government should allow the currency
value to increase – in value – or intervene and
accumulate additional foreign currency reserves in
the Official Reserves Account
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Exhibit 4.10
The United
States Balance
of Payments,
Analytic
Presentation,
2000-2010
(billions of U.S.
dollars)
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The BOP in Total — Deficit
• A deficit in the BOP implies an excess supply
of the country’s currency on world markets,
and the government should then either
devalue the currency or expend its official
reserves to support its value.
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The BOP Interaction with Key
Macroeconomic Variables
• A nation’s balance of payments interacts
with nearly all of its key macroeconomic
variables
• Interacts means that the BOP affects and is
affected by such key macroeconomic factors
as:
–
–
–
–
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Gross Domestic Product (GDP)
The exchange rate
Interest rates
Inflation rates
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The BOP and GDP
• In a static (accounting) sense, a nation’s GDP can
be represented by the following equation:
GDP = C + I + G + X – M
C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
X – M = the current account balance
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The BOP and Exchange Rates
• A country’s BOP can have a significant
impact on the level of its exchange rate and
vice versa
• The relationship between the BOP and
exchange rates can be illustrated by use of
a simplified equation that summarizes BOP
Data (see next slide)
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The BOP and Exchange Rates
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
Where:
X = exports of goods and services
M = imports of goods and services Current Account Balance
CI = capital inflows
CO = capital outflows
Capital Account Balance
FI = financial inflows
FO = financial outflows
Financial Account Balance
FXB = official monetary reserves
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The BOP and Exchange Rates
• Fixed Exchange Rate Countries
– Under a fixed exchange rate system, the government bears
the responsibility to ensure that the BOP is near zero
• Floating Exchange Rate Countries
– Under a floating exchange rate system, the government
has no responsibility to peg its foreign exchange rate
• Managed Floats
– Countries operating with a managed float often find it
necessary to take action to maintain their desired
exchange rate values
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The BOP and Interest Rates
• Apart from the use of interest rates to intervene in the
foreign exchange market, the overall level of a country’s
interest rates compared to other countries does have and
impact on the financial account of the BOP
• Relatively low real interest rates should normally stimulate
an outflow of capital seeking higher rates elsewhere
• However, in the case of the U.S., the opposite has occurred
due to perceived growth opportunities and political stability
– allowing it to finance its large fiscal deficit
• However, it is beginning to appear that the favorable inflow
on the financial account is diminishing while the current
account balance is worsening – making the U.S. a bigger
debtor nation vis-à-vis the rest of the world
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Trade Balances and Exchange Rates
• A country’s import and export of goods and
services is affected by changes in exchange
rates
• The transmission mechanism is in principle quite
simple: changes in exchange rates change
relative prices of imports and exports, and
changing prices in turn result in changes in
quantities demanded through the price elasticity
of demand
• Theoretically, this is straightforward; in reality
global business is more complex
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Exhibit 4.11 Trade Balance Adjustment to
Exchange Rate Changes: The J-Curve
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Capital Mobility
• The degree to which capital moves freely
across borders is critically important to a
country’s balance of payments
• The United States’ financial account surplus
has at least partially offset the current
account deficits over the last 20 or more
years
• China has run a surplus in each of these
accounts in recent years
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Capital Mobility
• The free flow of capital in and out of an economy
can potentially destabilize economic activity or can
contribute significantly to an economy’s
development
• Thus, Bretton Woods Agreement was careful to
promote free movement of capital for current
account transactions (e.g., foreign exchange or
deposits) but less so for capital account
transactions (e.g., foreign direct investment)
• 1970s - 1990s saw growth in capital openness, the
financial crisis of 1997/1998 stopped that due to
destructive capital outflows and contagion
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Capital Mobility
• The authors argue that the post-1860 era can be
subdivided into four distinct periods with regard to
capital mobility.
– 1860-1914 – continuously increasing capital mobility as
the gold standard was adopted and international trade
relations were expanded
– 1914-1945 – global economic destruction, isolationist
economic policies, negative effect on capital movement
between countries
– 1945-1971 – Bretton Woods era say a great expansion of
international trade
– 1971-2097 – floating exchange rates, economic volatility,
rapidly expanding cross-border capital flows
– China and India attempt to open their markets
• These points are laid out in Exhibit 4.12
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Exhibit 4.12 The Evolution of
Capital Mobility
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Capital Controls
• A capital control is any restriction that limits or
alters the rate or direction of capital movement
into or out of a country
• Free movement of capital is more the exception
than the rule
• Exhibit 4.13 outlines several methods of and
purposes for capital controls
• Dutch Disease – is the name given to the problem
of a substantial currency appreciation due to the
demand for a specific natural resource – faced by
several resource-rich smaller nations
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Exhibit 4.13
Purposes of
Capital
Controls
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Capital Flight
• Although no single definition of capital flight exists,
it has been characterized as occurring when capital
transfers by residents conflict with political
objectives.
• Many heavily indebted countries have suffered
capital flight, compounding their debt service
problems.
• Capital can be moved via international transfers,
with physical currency, collectables or precious
metals, money laundering or false invoicing of
international trade transactions.
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