Balance of Payments Analysis (BOP)

Topic2 Balance of Payments Analysis (BOP) 1

BOP Statement A statistic measurement of all transactions between domestic and foreign residents over a specified period of time. 2

Business Transactions which Dominate BOP Exchange of real assets - Goods & services Exchange of financial assets - Exchange of financial claims 3

Meaning of Resident: International institutions: - World bank, IMF etc Foreign enterprises in the host country Home country s ambassador in a foreign country US soldiers in Iraq China s journalist in Washington 4

Balance of Payments Each transaction is recorded as both a credit and a debit, i.e. double-entry bookkeeping. The transactions are presented in three groups a current account, capital and financial account, and errors & omissions.

Balance of Payments The current account summarizes the flow of funds between one specified country and all other countries due to the purchases of goods or services, the provision of income on financial assets, or unilateral current transfers (e.g. government grants and pensions, private remittances). A current account deficit suggests a greater outflow of funds from the specified country for its curren transactions.

Categories of Capital Account Capital transfers Acquisitions or disposal of nonproduced, nonfinancial assets 7

Capital Transfers Different with current transfers May be in cash or in kind - If in cash, the transfer is linked to, or conditional on,the acquisition or disposal of a fixed asset by one or both parties to the transaction - E.g.:government grant 8

Capital Transfers If in kind, it consists of - The transfer of ownership of a fixed asset or - Forgiveness, by mutual agreement between creditor and debtor 9

Acquisitions or Disposal of Nonproduced, Nonfinancial assets - Transactions associated with tangible assets that may be used or necessary for production of goods and services but are not actually produced - E.g.:land, subsoil assets 10

Acquisitions or Disposal of Nonproduced, Nonfinancial assets Transactions associated with nonproduced, intangible assets - E.g.:patents, copyrights, trademarks, franchises etc and leases or other transferable contracts 11

Balance of Payments The financial account (which was called the capital account previously) summarizes the flow of funds resulting from the sale of assets between one specified country and all other countries. Assets include official reserves, other government assets, direct foreign investments, investments in securities, etc.

Summary of U.S. International Transactions (For the Year of 2000 in Millions of Dollars) Exports of goods and services and income receipts 1418568 Goods, balance of payments basis 772210 Services 293492 Income receipts 352866 Imports of goods and services and income receipts - 1809099 Goods, balance of payments basis -1224417 Services -217024 Income payments -367658 Source: U.S. Bureau of Economic Analysis Current Account 13

Summary of U.S. International Transactions (For the Year of 2000 in Millions of Dollars) Capital Account Capital account transactions, net 705 Source: U.S. Bureau of Economic Analysis 14

Summary of U.S. International Transactions (For the Year of 2000 in Millions of Dollars) U.S.-owned assets abroad, net (increase/financial outflow) -580952 U.S. official reserve assets, net -290 Other U.S. Gov t assets, net -944 U.S. private assets, net -579718 Foreign-owned assets in the U.S., net (increase/financial inflow) 1024218 Foreign official assets in the U.S., net 37619 Other foreign assets in the U.S., net 986599 Net financial flows 443266 Statistical discrepancy (sum of items in all accounts with sign reversed) 696 Source: U.S. Bureau of Economic Analysis Financial Account 15

Financial Account Long-term capital : - foreign direct investment(fdi), - portfolio investment, - loans by international financial institutions(except IMF) 16

Financial Account Short-term capital: - hot money - capital flight - speculation - trade settlement - bank s transfer of fund etc 17

Financial Account Official reserve: - gold reserve - foreign exchange reserve - ordinary drawing rights in IMF - special drawing rights (SDR in IMF) 18

BOP Statement Current a/c balance + Capital & Financial a/c balance + Errors& Omissions = 0 current a/c + Capital a/c + Financial a/c + E&O = 0-444667 + 705 + 443266 + 696 = 0 19

Double Entry Bookkeeping A. The sum of all debit entries must equal the sum of all credit entries. Debit entry - Outflow or uses of funds Credit entry - Inflow or sources of funds 20

Credit Transactions(+) Export of goods and services. Investment and interest earnings. Unilateral transfers received from foreign residents. Investment and loans from foreign residents. Long-term or short-term claims on foreigners decrease Long-term or short-term liabilities to foreigners increase Official reserve of gold decreases 21

Debit Transactions(-) Imports of goods and services. Dividends and interest paid to foreign residents. Transfer payments abroad. Investment and loans to foreigners. Short term claims on foreigners increase Short-term liabilities to foreigners decrease Official reserve of gold increases 22

Example:Merchandise Trade(1) An American company sells $30,000 worth of machinery to a British company, and this British firm pays for the machinery in 90 days. In US BOP: - Debit :Short-term capital: $30,000 ( an increase in US short-term claims on foreigners) - Credit Exports: $30,000 ( an decrease in merchandise available to US residents) 23

Example:Merchandise Trade(2) 90 days later: In US BOP: - Transfer of fund - Short-term capital - Debit $30,000 (short-term claims on foreigners increase) - Credit $30,000 ( short-term claims on foreigners decrease-check) 24

In the Previous Example Suppose the US exporting company now decides to convert the payment in British pound to his own currency. He does this through his own clearing bank. In US BOP: - No record 25

Following the Previous Example If the clearing bank decides to sell the British pounds acquired in the previous example to US central bank in exchange for US dollar. In US BOP: - Debit (Official reserves of foreign currency) - Credit( Short-term claims on foreigners decreases) 26

Another case If the above mentioned importer s currency of payment is not a convertible currency, and the US clearing bank sells it to the US central bank. In the US BOP: - No balance of payments entry - The short-term claim on foreigners would merely have been shuffled from the clearing bank to the central bank, and since the short-term claim was not convertible foreign currency it would not count as part of the official reserves. 27

Example:Service Trade An American woman visits her husband in Japan. She cashes $5000 worth of US traveler s checks at Japanese hotel and spends the $5000 in Japan before returning to the US. In US BOP: Debit (Tourist services): $5000 ( US purchases of travel services) Credit( Short-term capital): $5000 (increase in US liabilities to foreigners) 28

Example:Unilateral Transfer Suppose the US Red Cross sends $20,000 worth of flood-relief goods to Chile. In US BOP: Debit (Transfer of payment): $20,000 ( real assets of US has reduced) Credit (Exports): $20,000 ( sale or unilateral transfer is credited) 29

Example:Long-term Capital An American purchases$5000 worth of French bonds and pays for it with a check drawn on a Los Angeles bank account. In US BOP: Debit (Portfolio investment): $5,000 ( increase in US portfolio investment in foreign countries) Credit(Short-term capital): $5000 ( increase in US liabilities to foreigners) 30

Example:Short-term Capital A 90 day loan is provided by a resident of the US to a borrower in Canada. In US BOP: - Debit (Short-term capital): $10,000 ( increase in US claims to foreigners) - Credit(Short-term capital): $10,000 ( increase in demand deposits held by foreigners against the US bank) 31

Reasons for BOP Disequilibrium Business cycle Value of money National income Economic structure 32

Why Should We Adjust BOP Disequilibrium? Deficit Surplus 33

Measures of BOP Adjustment Economic leverage Economic policies - Trade policy - Macroeconomic policies International economic cooperation 34

Adjustment of Economic Leverage-Exchange Rate Exchange rate - BOP deficit Devaluation of h.c- dollar price of export decreases and h.c cost of import increases- -- BOP promoted - Prerequisites - Price level comparatively stable - Limitation Marshall-Lerner condition J curve effect 35

Marshall-Lerner Condition- 5 cases after devaluation Export increases,import Decreases Export increases, import constant, Export constant,import decreases, Export increases,import increases, but export increase > import increase Export decreases,import decreases, but export decrease < import decrease 36

J curve Effect BOP surplus Time Lag Time BOP Deficit 37

Adjustment of Economic Leverage-Interest Rate BOP deficit BOP surplus Prerequisites limitation 38

Adjustment of Economic Leverage-Price Level BOP deficit--- lower export price --- export increases Prerequisite - Export subsidy Negative impacts - Anti-dumping duty - Trade disorder 39

Adjustment of Trade Policy Promotion of export Restriction of import - Tariff barrier - Non-tariff barrier 40

Adjustment of Macroeconomic Policies (1) BOP Deficit Deflationary Monetary Policy Discount rate increases Reserve requirement rate increases Open market operationssell bonds Export increases Import decreases Expansionary Fiscal Policy Mkt D decreases Price decreases 41

Adjustment of Macroeconomic Policies (2) BOP Surplus Inflationary Monetary Policy Discount rate decreases Reserve requirement rate decreases Open market operationsbuy bonds Export decreases Import increases Deflationary Fiscal Policy Mkt D increases Price increases 42

Coordination of Macroeconomic Policies Internal & External Situation Fiscal P. Monetary P. 1 Expansion & Surplus Contractionary Inflationary 2 Expansion & Deficit Contractionary Deflationary 3 Contraction & Surplus Expansionary Inflationary 4 Contraction & Deficit Expansionary Deflationary 43

International Economic Cooperation Trade cooperation Regional cooperation To allow the free movement of factors of production - To realize optimal reallocation of resources worldwide 44

Discussion Euro Asian common currency Dollarization 45

Analyzing Euro

Development of European Monetary Integration 1957: Treaty of Rome 1979:joint float 1987: Single European Act 1991-1992: Maastricht Treaty 1997: Treaty of Amsterdam

Convergence Criteria Nominal inflation should be no more than 1.5% above the average for the three members of the EU with the lowest inflation rates during the previous. Long-term interest rates should be no more than 2% above the average for the three members with the lowest interest rates. The fiscal deficit should be no more than 3% of the gross domestic product. Government debt should be no more than 60% of gross domestic product.

Member countries of Euro Zone Austria Germany France Italy Spain Luxembourg Belgium Finland Ireland Finland Ireland Netherlands Portugal Greece (2001) Slovenia (2007) Malta (2008) Cyprus (2008) Slovakia (2009) Estonia (2011) Latvia (2014)

Monetary Unification - Euro Zone Within EU single market, people, goods, services, and capital are supposed to move without restrictions.

Euro Affects Market in Three Ways Member countries enjoy cheaper transaction costs. Currency risk and costs related to exchange rate uncertainty are reduced All consumers and businesses both inside and outside enjoy price transparency and increased price-based competition.

Some European Countries outside Euro Zone UK Norway Denmark Sweden Switzerland New members of EEC - from 15 to 27 countries

A Strong Central Bank - European Central Bank (ECB) Established in Frankfurt in accordance with the Treaty. ECB is modeled after the US Federal Reserve System. The most important mandate is to promote price stability within the EU. ECB formed TARGET- The Transeuropean Automated Real-time Gross Settlement Express Transfer system. - The mechanism by which the ECB will settle all crossborder payments in the conduct of EU banking business and regulation. - It will allow the ECB to quickly and costlessly conduct monetary policy and other intra-banking system capital movements.

Challenges ahead of Euro Independent fiscal policy Different political standpoint

Analyzing Dollarization 55

Proportion of Key Currencies in Foreign Exchange Reserve (1999-2007, %) 1999 2003 2004 2005 2006 2007 US$ 71.0 65.9 65.9 66.9 65.5 63.9 17.9 25.2 24.8 24.1 25.1 26.5 J 6.4 3.9 3.8 3.6 3.1 2.9 2.9 2.8 3.4 3.6 4.4 4.7 others 1.8 2.2 2.0 1.9 2.0 2.0 56

Proportion of Key Currencies in Foreign Exchange Reserve in Developed Countries (1999-2007, %) 1999 2003 2004 2005 2006 2007 US$ 73.0 69.8 70.9 73.0 71.3 69.4 16.5 22.6 21.4 19.6 21.0 23.1 J 6.6 3.8 3.5 3.4 3.5 3.1 2.2 1.6 2.0 2.2 2.6 2.8 others 1.6 2.2 2.3 1.8 1.6 1.6 57

Proportion of Key Currencies in Foreign Exchange Reserve in Developing Countries (1999-2007, %) 1999 2003 2004 2005 2006 2007 US$ 68.8 62.0 61.0 61.7 61.2 60.7 19.4 27.8 28.3 27.8 28.1 28.4 J 6.1 4.1 4.1 3.7 2.8 2.8 3.6 4.0 4.8 4.8 5.7 5.8 others 2.1 2.2 1.8 1.9 2.2 2.2 58

What is Dollarization? The use of US dollar as the official currency of the country. - Panama - Salvador - Ecuador - Honduras - Cambodia - Argentina etc 59

Attraction of Dollarization Monetary policy becomes essentially the one followed by the US and the exchange rate is fixed forever. The sound monetary and exchange rate policies no longer depend on the intelligence and discipline of the domestic policymakers. 60

Benefits of Dollarization Removes any currency volatility (against the dollar) Theoretically eliminate the possibility of future currency crises. Expectation of greater economic integration with the US and other dollar-based markets, both products and financial markets. 61

Major Arguments against Dollarization Independent monetary policy is lost. Political influence on monetary policy is eliminated. The country loses the power of seigniorage. - The benefit from its ability to print its own money. - Seigniorage contributes to 2.5% of US GDP every year. 62

Major Arguments against Dollarization ( continued) The central bank can no longer serve as the lender of last resort - It no longer has the ability to create money within its economic and financial system. - No ability to provide liquidity to save financial institutions that may be on the brink of failure during times of financial crises. 63