BALANCE OF PAYMENTS
Per the IMF definition the balance of payments is a statement that
summarizes transactions between residents and nor-residents during a
period. It consists of goods and services account, primary income account,
secondary income account, capital account and financial account. The
highlighted green accounts are the components of the current account.
------------The CURRENT ACCOUNT on the balance of payments-----------FIRST, we have the TRADE IN GOODS (visible balance), the visible
balance is calculated by exports minus imports. The term credit represents a
cash inflow into the country and debit represents a cash outflow from a
country.
SECOND, is the TRADE IN SERVICES (invisible balance), this invisible
balance is the balance of the trade in services. This includes all the services
that are exported from and imported to a country. A great example is
tourism, when tourists visit our country, they bring money earned from their
country to ours to consume our services. The invisible balance is calculated
by exports minus imports.
THIRD, is the PRIMARY INCOME ACCOUNT, also called net investment
income. This is the income earned form investment overseas minus the
income paid to overseas investors. We can earn income from investments
such as investment in businesses overseas, loans to foreign entities and
rental income from properties abroad. There are also payments to be made
for non-residents for the same reason.
And FOURTH, is the SECONDARY INCOME ACCOUNT, this includes current
transfers, which is simply money that is given without something of
economic value in return. Examples include remittances, which occur when
foreign workers transfer money to their home country. Also, included are
donations raised for charity and foreign aid. The money received is a credit
but the money paid out is debit.
HENCE, the current account balance is the total of the credit minus
total of debit. The total balance would result in a positive, negative or zero
current account balance. For example, if it is positive then it can be said that
this economy is experiencing a current account surplus, if negative then a
current account deficit.
--------------CAPITAL AND FINANCIAL FUNCTIONS, THE BALANCING ITEM---------The remaining 3 components of the balance of payments include the
financial account, the capital account and the balancing items. Remember
we are looking at the IMF standard for the balance of payments.
The financial account covers all transactions, including the creation and
liquidation of financial claims, associated with change of ownership in
international financial assets and liabilities. **** Liquidation in finance and
economics is the process of bringing a business to an end and distributing its assets
to claimants. It is an event that usually occurs when a company is insolvent, meaning
it cannot pay its obligations when they are due. In the financial account, you
should be familiar with the three key sections of the financial account:
•
Net Portfolio Investment (debt/equity)
- this includes the transfer of equity (equity is measured for
accounting purposes by subtracting liabilities from the value of the assets. For
example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to
buy the car, the difference of $14,000 is equity) or sale of debt through the
issuance of stocks, bonds and derivatives ******* A derivative is a contract
between two or more parties whose value is based on an agreed-upon underlying
financial asset (like a security) or set of assets (like an index). Common underlying
instruments include bonds, commodities, currencies, interest rates, market indexes, and
stocks.
•
Net Foreign Direct Investment
- this includes investments such as Chinese firm like Huawei
building and developing a research facility in the UK. This represents a credit
to the UK balance of payments and debit to the Chinese balance of
payments.
•
Reserve Assets
- this includes holding of currency, comodities or other
financial capital held by central banks to finance trade imbalances. These
can be used to buy and sell foreign currencies.
The capital account is a relatively minor account for the sake of
this discussion and is unlikely to be examined. What you should be aware of
is that it includes:
•
CAPITAL TRANSFERS which conisists of:
- government debt forgiveness ***** Debt forgiveness
occurs when a government creditor entity in one economy formally
agrees - via a contractual arrangement - with a debtor entity in another
to forgive (extinguish) all, or part, of the obligation of the debtor entity
to the creditor, the amount forgiven is treated as a capital transfer from
the creditor to the debtor.
- investment grants in cash or in kind
- taxes on capital transfers
The balancing item is the difference between the current account
and the capital and financial accounts. It is used as a statistical balance to
account for the differences between the accounts. The balance of payments
should sum to zero and this item exists to address errors.
BALANCE OF PAYMENTS EQUILIBRIUM AND DISEQUILIBRIUM, CAUSES AND
CONSEQUENCES
When we discuss disequilibrium in the balance of payments, we are
generally discussing the state of one of the accounts- the current account,
the capital account or the financial account. We saw in previous notes of
balance of payments always balances, but we need to examine the factors
that cause one of the accounts to tend towards disequilibrium, or where
there is surplus or a deficit in the account. In order to achieve equilibrium,
the debits and credits on the specific accounts of balance of payments must
be equal. We will focus more on the factors that cause disequilibrium in the
current account and then to the financial account. Since the capital is a
minor concern, we will focus on the previous 2.
In the current account, export revenue should equal import expenditure
or an imbalance exists. There could be a variety of reasons that export
revenue is greater than import expenditure and vice versa. If a country’s
export revenue is less than its import expenditure, the country is said to
have a trade deficit which could also indicate a current account deficit. To
determine whether there is absolutely a trade deficit, we need to also factor
in current transfers and income as well.
However, if the export revenue is great than import expenditure, the
country is said to have a current account surplus. To determine whether
there is absolutely a current account surplus, we need to also factor in
current transfers and income as well.
CAUSES OF DISEQUILIBRIUM
The first series of causes of disequilibrium will focus on the current account.
- Economic growth, as an economy experiences economic growth and
its citizens become richer, there is a tendency to import more, moving
towards a greater amount of money spent on imports than is received on
exports. A decrease in economic growth or a recession will lead to a
decreased demand for imports resulting in a tendency towards a current
account surplus and away from deficit.
- The relative price level, if the price level rises in a country relative to its
trade partners, it makes its exports less attractive and decreases the
likelihood of exporting. This can lean the current account towards deficit
depending on the extent of the change of the price level.
- Currency fluctuations, if the currency appreciates, it is likely to reduce
export revenue and to increase import expenditure, resulting in a tendency
towards a current account deficit. if the EUR-USD exchange rate moves from
1.00 to 1.15, it means that the euro has appreciated by 15% against the U.S.
dollar. An appreciation makes exports more expensive and imports cheaper.. A
strong dollar or increase in the exchange rate (appreciation) is often better for
individuals because it makes imports cheaper and lowers inflation. If the
currency depreciates, it is likely to increase export revenue and
decrease import expenditure, resulting in a tendency towards a
current account surplus.
- Trade policies, could impact the current account and the
financial account. They could impact the current account by limiting or
increasing trade with other countries. This could also positively or
negatively influence the level of foreign investment into a country. If
trade policies influence more free trade, it may lead to greater import
expenditure yet attract greater foreign investment, the opposite also
holds true. Free trade occurs when goods and services can be bought and sold
between countries or sub-national regions without tariffs, quotas or other
restrictions being applied. If trade policies are protectionist in nature,
may lead to less import expenditure and foreign investment will
it
increase if an economy is attractive to foreign investors.
Foreign
investment refers to the investment in domestic companies and assets of another
country by a foreign investor.
---This cause of disequilibrium will focus on the financial account---- Political stability, foreign investment will increase if an
economy is attractive to foreign investors. This could be due to supply
side changes, political stability and an overall level of confidence in
the government and economy. The US runs a current account deficit
but attracts a lot of foreign investments, which results in a financial
account surplus.
CONSEQUENCES OF DISEQUILIBRIUM
This list demonstrates the impact on the domestic and external economy
• Increased reliance on imports drives up the risk of imported inflation
If a country imports raw materials and commodities and is reliant
upon imports as the primary source, they are vulnerable to fluctuations in
their prices and exchange rates- for better or for worse.
• Over reliance on trade partners as export markets
If a country has a large export market, its economy's performance is
largely tied to the performance if its trade partners. If its partners suffer
economic downturns, this will have a significant effect on a country’s
economy.
• This could signal a weaker economy and deter foreign investment
If a country is seen to consistently run a current account deficit, it
may be a sign that consumers and businesses to opt for goods and services
produced outside of the country. If this continues for the long run, it may
signal little confidence in domestic production and choice, deterring foreign
investors from exploring investment opportunities.