The Balance of Payments

INTERNATIONAL FINANCIAL MANAGEMENT eventh Edition EUN / RENICK The Balance of ayments Chapter Objective: 3 Chapter Three INTERNATIONAL FINANCIAL MANAGEMENT This chapter serves to introduce students to the balance of payments how it is constructed, and how BO data may be interpreted. Fourth Edition EUN / RENICK 3-0 Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved. 3-1 Chapter Three Outline Balance of ayments Accounting l Balance of ayments Accounting l pecific Balance of ayments Accounts n n n Official Reserves Account n tatistical iscrepancy l Balance of ayments Identity l BO Trends in Major Countries l The Balance of ayments is the statistical record n of a country s international transactions n over a certain period of time n presented in the form of double-entry book-keeping. N.B. when we talk about a country s balance of payments, we are referring to the transactions of its citizens and government. 3-2 3-3 BO: Basic rinciple Balance of ayments Example l Transactions that lead to an increase in the supply of a country s currency are recorded as debits in that country s BO n Examples: importing bicycles from abroad, purchasing foreign assets (financial assets, physical assets, etc.) l Transactions that lead to an increase in demand for a country s currency are recorded as credits in that country s BO n Examples: exports of goods, services, sales of assets l uppose that Maplewood Bicycle Inc. in Maplewood, Missouri, UA imports $100,000 worth of bicycle frames from Mercian Bicycles Ltd. in arby, England. l There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood s bank account. l This will lead to a rise in the supply of dollars and the demand for British pounds. 3-4 3-5 1

A. Balance of ayments Accounts Balance of ayments Accounts l The balance of payments accounts are those that record all transactions between (i) the residents of a country and (ii) residents of all foreign nations. l They comprise the following accounts: n (ACCT-240 analogy: rofits & Loss ) n (ACCT-240 analogy: Balance heet ) n Official Reserves Account n tatistical iscrepancy 3-6 3-7 1. The (CA) The (CA) l Includes all imports/exports of goods & services. n Trade balance (civilian & military goods) n Invisibles balance (services) n Investment income balance l Accounting n Exports of G& are entered as credits u because they create cash inflows for the domestic country n Imports of G& are entered as debits u because they lead to cash outflows from the domestic country l Includes all imports/exports of goods & services n Trade, Invisibles, Factor income, Foreign aid l Unilateral transfers of foreign aid n ebit (Idea: import goodwill ) n ouble-entry -> what gets credited? G&: CA; cash: KA l If the debits exceed the credits, then BCA<0 n i.e., the country is running a CA ( trade ) deficit l If the credits exceed the debits, then BCA>0 n i.e., the country is running a CA ( trade ) surplus 3-8 3-9 The (CA) 2. The (KA) l Much lower deficit in 2009 than in 2008 à Why? l The capital account records domestic residents n sales of financial assets to foreigners n purchases of foreign financial assets l Accounting n Asset sales to foreigners are entered as credits u exporting financial assets leads to cash inflows into the domestic (home) country n urchases of foreign financial assets are entered as debits u importing financial assets is associated with cash outflows from the home country 3-10 3-11 2

3-12 The (KA) l The KA balance measures the gap between residents assets sales to foreigners and the same residents purchases of foreign assets. l The U.. enjoys a huge KA surplus (2007: $790bn; 2011: $410.1bn) absent official U.. borrowing abroad, this surplus finances the U.. trade deficit l etails for 2011 (from Economic Report to the resident) n Increase in foreign-owned assets in UA: $1,001bn n Increase in U privately-owned assets abroad: $ 484bn n ee handout: 05b_U_Bo erp_b103&b107 2013 The (KA) l The capital account is composed of n Foreign irect Investment u FI; control 10% or more; n ortfolio investments u stocks & bonds without control; n Other investments u trade credits, bank deposits, 3-13 The (KA) Flows vs. tocks: KA vs. NII l Much lower net flows in 2009 than in 2008 l Why? l Capital account (KA) n Is a flow measure u measures capital flows between a country and the rest of the world (ROW) l Net international investment position (NII) n Is a stock measure u measures whether a country is a net creditor (e.g., China) or debtor (e.g., U) with respect to the ROW. 3-14 3-15 Flows vs. tocks: KA vs. NII 3. tatistical iscrepancy 3-16 l There are going to be some omissions and misrecorded transactions so we use a plug figure to get things to balance l Exhibit 3.1 (three slides down) shows discrepancy of +$200bn in 2008, later adjusted to -$59bn n iscrepancy sometimes even larger u biggest «initial» discrepancies observed in 91, 98 & 2008-10 n why? sign? (2008: initial=+$200bn; 2010: initial=+$216.7bn) u initial discrepancies are often revised in later years n 2000: initial estimate = plus $0.73bn, revised = minus $74bn 3-17 3

There are going to be some omissions and misrecorded transactions so we use a plug figure to get things to balance. Exhibit 3.1 shows a discrepancy of $79.40 billion in 2011. tatistical iscrepancy 1 Exports $2,843.7 2 Imports ($3,182.8) 3 Unilateral Transfers $19.5 ($154.0) Balance on ($473.6) 4 irect Investment $227.9 ($406.2) 5 ortfolio Investment $166.9 ($14.7) 6 Other Investments $395.8 $40.4 Balance on $410.1 $79.4 $15.9 Official Reserve Account ($15.9) 4. The Official Reserves Account l Official-reserves assets include n Gold u used to make up most of a country s reserves l as recently as the early 1980 s, still half of all reserves u now less than 1% of the total @ $35/1oz (9.8% @ mkt prices) l 12-08: 83% held by OEC countries ( 19.6% @ market value) n Foreign currencies ($11.4trn held as of 3-2013) u at end of 2013, made up 99% of non-gold official reserves u U accounts for 61.4% of FX reserves; EUR: 24.1% (3 2013) n Rs + Reserve ositions in the IMF l OEC countries hold over a third of world reserves 3-18 3-1 8 3-19 ORA s Flip ide l Foreign Holdings of U.. Treasury ecurities (ec. 2013, U billion) B. The Balance of ayments Identity BCA + BKA + BRA = 0 where BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account Under a pure flexible exchange rate regime, BCA + BKA = 0 3-20 3-21 U.. Balance of ayments ata 2011 U.. Balance of ayments ata 2011 1 Exports $2,843.7 2 Imports ($3,182.8) 3 Unilateral Transfers $19.5 ($154.0) Balance on ($473.6) 4 irect Investment $227.9 ($406.2) 5 ortfolio Investment $166.9 ($14.7) 6 Other Investments $395.8 ($40.4) Balance on $410.1 $79.4 $15.9 Official Reserve Account ($15.9) 1 Exports $2,843.7 2 Imports ($3,182.8) 3 Unilateral Transfers $19.5 ($154.0) Balance on ($473.6) 4 irect Investment $227.9 ($406.2) 5 ortfolio Investment $166.9 ($14.7) 6 Other Investments $395.8 ($40.4) Balance on $410.1 $79.4 $15.9 Official Reserve Account ($15.9) In 2011, the U.. imported more than it exported, thus running a current account deficit of $473.6 billion. 3-22 Copyright 2014 by the McGraw-Hill Companies, Inc. Copyright 2007 by The McGraw-Hill Companies, Inc. All All rights reserved. 3-22 3-23 Copyright 2014 by the McGraw-Hill Companies, Inc. Copyright 2007 by The McGraw-Hill Companies, Inc. All All rights reserved. 3-23 4

U.. Balance of ayments ata 2006 U.. Balance of ayments ata 2006 3-24 Balance on ($811.3) Balance on $826.9 In 2006, the current account deficit was a whopping $811.3 billion (highest ever) 3-25 Balance on ($811.3) Balance on $826.9 uring the same year, the U.. attracted net investment of $826.9 billion clearly, the rest of the world found the U.. to be a good place to invest (why?) U.. Balance of ayments ata 2006 U.. Balance of ayments ata 2006 Balance on ($811.3) Balance on $826.9 Under a pure flexible exchange rate regime, these numbers would balance each other out. Balance on ($811.3) Balance on $826.9 In the real world, there is a statistical discrepancy; sometimes (as in here) but not very often, it is small 3-26 3-27 U.. Balance of ayments ata 2006 3-28 Balance on ($811.3) Balance on $826.9 Including that, the balance of payments identity should hold: BCA + BKA = BRA ($811.3) + $826.9 + = 3-29 C. Balance of ayments and the Balance on ($811.3) Balance on $826.9 5

3-30 Balance of ayments and the Balance on ($811.3) Balance on $826.9 As U.. citizens import, they are supply dollars to the FOREX market. 3-31 Balance of ayments and the Balance on ($811.3) Balance on $826.9 As U.. citizens export, others demand dollars at the FOREX market. 3-32 Balance of ayments and the Balance on ($811.3) Balance on $826.9 As the U.. gov t buys dollars with FX, the supply of dollars decreases. 1 3-33 Balance of ayments and the Balance on ($811.3) Balance on $826.9 Consequently, the $ appreciates (its foreign-currency price rises) 1. 3-34 overeign Wealth Funds l Government-controlled investment funds are playing an increasingly visible role in international investments. l WFs (overeign Wealth Funds) n Mostly domiciled in Asia and Middle-East n though Norway/Botswana/Russia all have large WFs u Transparency? Motives? n Usually responsible for recycling these countries foreign exchange reserves (swelled by trade surpluses and commodity revenues) 3-35. Balance of ayments Trends l ince 1982, the U.. has had continuous current account deficits and surpluses on capital account. n ole exception: small CA surplus in 1991 ($2.9bn). n Just how big did deficits grow? u 2000: $ 444.7bn (E&R5; latest revised figures: $ 416.3 bn) u 2004: $ 628bn (latest Economic Report to the resident) u 2006: $ 800bn (based on 2013 ER; highest ever) u 2012: $ 477bn (estimate based on 1st 3 quarters, 2013 ER) l uring that period, Japan experienced reverse u 2011-3: U deficit stable (why?), Japan now has a CA deficit 6

Balance-of-ayments Trends: 1982-2011 Balance-of-ayments Trends: 1982-2011 U.. BCA and BKA are almost mirror images 3-36 3-36 3-37 3-37 Balance-of-ayments Trends: 1982-2011 Balance of ayments Trends l Germany traditionally had CA surpluses l For a decade after 1991, Germany experienced CA deficits. l This was largely due to German reunification n Need to absorb more output domestically to rebuild the former East Germany. l What matters = nature / causes of disequilibrium n To wit, the CA has been back in the black since 2001 3-38 3-38 3-39 Balances on the Current (BCA) and Capital (BKA) Accounts of Germany ource: IMF International Financial tatistics Yearbook, various issues 3-40 3-41 Balance of ayments Trends l Asian countries have traditionally had current account surpluses l Both China and Japan have tried to keep their currencies not too strong against the dollar. l To do so, they have been buying dollars and selling their own currencies. l The net result is a massive accumulation of FX (especially $) reserves by those nations central banks. (but, is it the whole story? 05c_Asian FX reserves 0905) 7

ource: IMF International Financial tatistics Yearbook, various issues ource: IMF, International Financial tatistics. 3-42 3-42 3-43 3-43 BO Trends in Emerging Markets Int l Investment ositions (% of G) l Latin America n CA>0 since 2002 (why?) l eveloping Asia n CA>0, KA>0 (why both?) l Eastern Europe n CA<0, KA >0 (problem?) l References: IMF GFR (2006-2013 issues) 3-44 3-45 Int l Investment ositions (% of G) BO and Fundamentals Cumulative CA deficits (% of G) l National income or GN is the sum of: GN = C + I + G + (X - M) l GN, alternatively, can be viewed as the sum of: GN = C + + T l o, it must be that: 0 = (I ) + (G - T) + (X-M), i.e., BCA = X M = ( - I) + (T - G) 3-46 3-47 8

How to eliminate a CA deficit? Bottom Line: Why do we Care? l We know that BCA = X M = ( - I) + (T - G) n Increase private savings / reduce government deficit n Import restrictions? 3-48 u uotas or tariffs? (Who gets the price increase? oes T go up?) u Unlikely to work anyways n shifts demand to non-restricted imports (why? + example: steel) n revent foreigners from acquiring domestic assets? n Manipulate the FX rate downward u J-curve problem (Why? demand / supply elasticities. UA 08?) l Composition of trade l Competitiveness n Implicit in the fact that BCA>0 n Caveat: where is the causality? 3-49 u U.. BCA<0 -> U.. BKA>0 n Need to get foreigners to finance the trade deficit u or U.. BKA>0 -> U.. BCA<0? n Foreigners willingness to invest in the U.. makes the dollar appreciate, which in turn reduces competitiveness? An Aside Capital Controls End Chapter Three l When they can make sense n hort-term flows can reverse very quickly u Evidence that these reversals are costly u lowing contagion is helpful n Affect the split between long-term and short-term flows u Example: put restrictions on short-term flows n Chile: 30% deposit in escrow account n Examples of impact (see handouts): Brazil, China 3-50 3-51 9