The Balance of Payments. Balance of Payments. Balance of Payments Accounts. Balance of Payments Accounts. They are composed of the following:

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1 The Balance of Payments Chapter Objective: This chapter serves to introduce the student to the balance of payments, how it is constructed and how balance of payments data may be interpreted. Chapter Outline Accounts The Current Account The Capital Account External Balance and the Exchange Rate Trends in Major Countries 1 The is the statistical record of a country s international transactions over a certain period of time presented in the form of double-entry bookkeeping. Why is it useful to examine a country s BOP? The BOP provides detailed information about the supply and demand of the country s currency. The trade statistics in the Current Account, for example, show the composition of trade what a country imports and what it exports. The Capital Account shows inflows and outflows of capital in various categories. Viewed over time, BOP data can shed light on important developments in a country s comparative advantage and international competitiveness. 2 Accounts They are composed of the following: The Current Account The Capital Account The Official Reserve Account Accounts Current Account Records flows of exports, imports, investment income, and international financial transfers. Merchandise trade export and import of tangible goods Services payments and receipts for legal and consulting fees, royalties, tourist expenditures Investment income payments and receipts of interest, dividends, and other income on foreign investments Unilateral Transfers unrequited payments (e.g. Foreign aid). If the debits exceed the credits, then a country is running a trade deficit. If the credits exceed the debits, then a country is running a trade surplus. 3 4

2 Accounts Accounts The capital account Records sales to foreigners of financial assets and purchases of foreign financial assets. The capital account is composed of Foreign Direct Investment (FDI), portfolio investments, and other investment. Direct investment involves acquisitions of controlling interests in foreign businesses. Portfolio investment represents investment in foreign shares and bonds that do not involve acquisitions of control. Other investment includes bank deposits, currency investment, trade credit and the like. 5 The Reserve Account The Reserve Account of BOP records changes in the amount of official reserve assets held by the Bank of Canada. Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF. If a country must make net payment to foreigners because of BOP deficit, the country could either run down its official reserve assets or borrow anew from foreigners. 6 The Balance of Payments Identity BCA + BKA + BRA = where BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account Under a pure flexible exchange rate regime, where the CB does not maintain any official reserves, a CA surplus or deficit must be matched by KA deficit or surplus: BCA + BKA = Under the fixed exchange rate regime, the combined balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the official reserves: BCA + BKA = -BRA 7 Fixed Exchange Rate BOP determines necessity of government intervention Can help forecast devaluation/revaluation of currencies Floating Exchange Rate Government has no responsibility as FX rates are determined by market forces Managed Floats Focus of government is on interest rates 8

3 Trends in Major Countries Balances on the Current (BCA) and Capital (BKA) Accounts of the U.S. From , U.S. has had continual annual trade deficits (- CA) with the rest of the world (ROW), along with annual capital surpluses (+KA), in roughly equal annual amounts. U.S. has been a "net debtor" nation over this period. Over the same period, Japan has had annual trade surpluses with ROW, along with annual capital outflows, also in roughly equal amounts. Japan is a "net creditor" nation, investing its trade surplus in foreign stocks, bonds, real estate, government debt (Tbonds, etc.), businesses (FDI), art, etc. Japan has been accused of "mercantilism," i.e. erecting trade barriers, or protectionist trade policies to restrict or limit imports Source: IMF International Financial Statistics Yearbook, 2 U.S. BCA U.S. BKA 1 Balances on the Current (BCA) and Capital (BKA) Accounts of Japan Balances on the Current (BCA) and Capital (BKA) Accounts of United Kingdom Japan BCA Japan BKA UK BCA UK BKA Source: IMF International Financial Statistics Yearbook, 2 11 Source: IMF International Financial Statistics Yearbook, 2 12

4 Balances on the Current (BCA) and Capital (BKA) Accounts of China Trends in Major Countries Source: IMF International Financial Statistics Yearbook, 2 China BCA China BKA 13 Like the U.S., the United Kingdom recently experienced continuous current account deficits, coupled with capital account surpluses. The magnitude, however, is far less that that of the United States. Germany traditionally had current account surpluses. Since 1991 Germany has been experiencing current account deficits. This is largely due to German reunification and the resultant need to absorb more output domestically to rebuild the former East Germany. This has left less output available for exports. China has been running trade surpluses AND capital account surpluses. For example, in 22 China had a $35.4B trade surpluses and a $6.4B capital inflow. Reason: Official reserve holdings of dollars has increased. Chinese govt. buys up dollars with Yuan, to keep the dollar strong and the Yuan low, and the Yuan/$ rate stable. 14 Impact on Currency Do monetary and fiscal policies affect the exchange rates and BOP components? CA: All the other factors constant, a deficit balance on a country s current account implies that there is excess supply of its currency in the foreign markets. Hence, its currency should depreciate. KA: All other factors constant, a surplus balance in a country s financial account implies that there is excess demand for assets denominated in its currency. Hence, its currency should appreciate. Monetary Policy: An unanticipated shift to expansionary monetary policy will lead to more rapid economic growth, accelerated inflation and lower real interest rates BOP effects: Higher income and higher domestic prices stimulate imports and discourage exports. Lower real rates discourage foreign and domestic investment at home. Exchange rate effects : The adverse impact of the country s current account will increase the supply of currency in the fx markets; causing the currency to depreciate. The adverse impact of the country s financial account will decrease demand for the country s currency, causing it to depreciate

5 Do monetary and fiscal policies affect the exchange rates and BOP components? Fiscal Policy: An unanticipated shift to more expansive fiscal policy will result in budget deficits, increase in aggregate demand, inflation and an increase in real interest rates. BOP effect:increase demand will encourage imports & discourage exports, which moves the current account towards deficit. Meanwhile, the higher interest rates attract foreign investment and discourage domestic investment from leaving the country, moving the financial account surplus. Exchange rate effects: The adverse impact of the current account will increase the SUPPLY of the country s currency, causing the currency to depreciate. The positive impact of the KA will increase demand causing the currency to appreciate. 17 Many countries operate with a trade and current account surplus good examples are China, Germany, Norway and emerging market countries with strong export sectors. There are several causes and each country will have a unique set of circumstances: Export-oriented growth: Some countries have set out to increase the capacity of their export industries as a growth strategy. Investment in new capital provides the means by which economies of scale can be exploited, unit costs driven down and comparative advantage can be developed. Foreign direct investment: Strong export growth can be the result of a high level of foreign direct investment where foreign affiliates establish production plants and or exporting. 18 Undervalued exchange rate: A trade surplus might result from a country attempting to depreciate its exchange rate to boost competitiveness. Keeping the exchange rate down might be achieved by currency intervention by a nation s central bank, i.e. selling their own currency and accumulating reserves of foreign currency. One of the persistent disputes between the USA and China has revolved around allegations that the Chinese have manipulated the Yuan so that export industries can continue to sell huge volumes into North American markets. High domestic savings rates: Some economists attribute current account surpluses to high levels of domestic savings and low domestic consumption of goods and services. China has a high household saving ratio and a huge trade surplus; in contrast the savings ratio in the United States has collapsed and their trade deficit has got bigger. 19 Closed economy some countries have a low share of national income taken up by imports perhaps because of a range of tariff and non-tariff barriers. Strong investment income from overseas investments: A part of the current account that is often overlooked is the return that investors get from purchasing assets overseas it might be the profits coming home from the foreign subsidiaries of multinational businesses, or the interest from money held on overseas bank accounts, or the dividends from taking equity stakes in foreign companies. 2

6 I. POSSIBLE SOLUTIONS UNLIKELY TO WORK: A. Currency Depreciation II.CURRENCY DEPRECIATION A. U.S. Experience: Does not improve the trade deficit. B. Protectionism THE J - CURVE B. Depreciations are ineffective because 1. It takes time to affect trade. Net change in trade balance Currency depreciation Trade balance improves 2. J-Curve Effect states that a decline in currency value will initially worsen the deficit before improvement. Trade balance initially deteriorates TIME 23 24

7 III. PROTECTIONISM A. Trade Barriers used: 1. Tariffs 2. Quotas B. Results: Most likely will reduce both X and M. C. FOREIGN OWNERSHIP one protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows D. STIMULATE NATIONAL SAVING change the tax regulations and rates. III. SUMMARY: CURRENT-ACCOUNT DEFICITS - neither bad nor good inherently 1. Since one country s exports are another s imports, it is not possible for all to run a surplus 27 28

8 2. Deficits may be a solution to the problem of different national propensities to save and invest. 29