The Balance of
Payments
Unit
3
Chapter 3.3-Glanville
Chapter Objective:
 The role of BoP; debt items/credit items; the three
components of the balance of payments, relations between
components (i.e. THE CURRENT ACCOUNT = CAPITAL ACCOUNT +
FINANCIAL ACCOUNT); the impact of BoP on forex (eg. i. current
account deficit and, ii. current account surplus)
 Balance of Payments Accounts



The Current Account
The Capital Account
The Financial Account
 External Balance and the Exchange Rate
 Balance of Payments Trends in Major Countries **
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Balance of Payments
The Balance of Payments is
(another def’n)
“a statistical record/statement of a country’s international
economic transactions over a certain period of time”
-- presented in the form of double-entry bookkeeping (zero sum).
Why is it useful ?
 The BOP provides detailed information about where the supply
& demand of/for a country’s currency originates
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 goods in
various categories.
 Financial Account shows how funds invested in real assets (businesses,
commercial real estate AND financial assets move (a nation to RoW)
 Viewed over time, BOP data can help explain important
developments in a country’s comparative advantage and
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international competitiveness.

Balance of Payments
 IMF def’n of BoP: the statistical statement that
summarizes, for a specific time period, the
economic transactions of an economy with the
rest of the world
 eg. …trade in goods and services (i.e. commodities),
inter-national capital transfers and financial
transactions involving the ownership of assets
(i.e. foreign direct investment; bond/debt purchases etc. etc.)
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Balance of Payments
Accounts
 They are composed of the following:

The Current Account
The Capital Account
The Financial Account

“Official Reserve Account”  the foreign currency and


securities held by the government, usually by its central bank, and
used to balance the payments from year to year (fall = sell reserves)
WHEN ALL THREE ADD TO > O -- OFFICIAL RESERVES RISE
WHEN ALL THREE ADD TO <O --OFFICIAL RESERVES FALL
*Current + Capital + Financial Accounts + Change in reserves = 0
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Balance of Payments
Accounts
Current Account
*EACH of these 4 has a + AND a (-) entry
 Records flows of funds between a nation and the RoW for : exports,
imports, investment income, and international financial transfers.
 Trade in Goods (aka Merchandise trade) – export and import of tangible
goods –the visible account
… the invisible account (3 parts below)
 Trade in Services – payments and receipts for legal and consulting fees,
royalties, tourist expenditures
 Income from investments (aka Primary Income) – payments and receipts of
interest, dividends, and other income on foreign investments (rent, profit)
 Transfers which are current (aka Secondary Income) – “unrequited”
payments, ‘free money’ (e.g. Foreign/military/food aid and remittances
aka ‘current transfers’ of wages sent by workers to their home country ).
 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.
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Remittances can be HUGE !
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Balance of Payments
--current account: transfer balances (remittances)
 Large transfers from one country to another
give the receiving country the ability to import
more from abroad (i.e. foreign workers sending money
home leads to increased forex in their home nations)
similarly…later we’ll see types of ‘tied aid’ where
donor countries transfer THEIR OWN CURRENCY
to another country … and require the aid be spent on
the donor-nation’s own goods (i.e. official transfers can
actually harm domestic producers/markets in poor nations– when
donations/spending ends up supporting foreign producers)
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Balance of Payments
--current account: persistent deficits
 Effect on foreign ownership: BoP must equal zero…negative current
account is offset by surplus in capital & financial account –if the
money does not return to buy G & S then it will buy real assets…or
held in reserves of the central bank ..export foreign ownership. To
what extent is this a threat to sovereignty?
 Effect on interest rates: to protect the currency from massive
depreciation much higher interest rates maybe be required (the
interest rate effect)… i.e. deficit countries need to offset this with
financial account surpluses …BUT higher borrowing costs slow
domestic growth (i.e. low C & I in AD…impact X in l-run)
 Effect on indebtedness: foreign ownership of domestic government
bonds and debt...central bank of another nation buys bonds from the
nation which it has a large surplus with--debts get paid with INTEREST
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Balance of Payments
--current account: persistent deficits (US and China)
 Why has the USA avoided the ‘interest rate
effect’ and not had to raise r-rates 2008—2017?
Zero interest rates (C-bank) with persistent current account
deficits is the result of the macro conditions in the USA.
Deflation posed the bigger threat (esp. 2008-2011) so that
fear led to continued high demand for US debt (gov’t bonds).
 August 2010: Chinese central bank held $868 Billion
in US treasury securities. Total US debt (to all foreign
nations) was $4.2 trillion –about 40% of total national
debt …about 25% of the USA’s total GDP (by 2011).
 (17 min) https://www.youtube.com/watch?v=cg17YTtsk2U
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Balance of Payments
Accounts
The Capital Account AND Financial Account (‘K’)
 Capital Account: records sales to foreigners of (i.e. Canadian) capital
assets and (i.e. Canadian) purchases from foreigners of capital assets (build a
hospital overseas?) AND payments (+/-) for licenses, patents, trademarks
 Financial Account is composed of Foreign Direct Investment
(FDI), portfolio investments, and reserve assets (like a balancing item?)



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 (i.e. small & BIG POTS OF $$: c/b
financial firms, sovereign wealth funds, insurance co., pension funds etc.)
RESERVE ASSETS: includes bank deposits, currency investment, trade
credit and the like (e.g. HOT MONEY—banking flows in forex mkts) 10
Balance of Payments
Accounts
The Capital Account ( DETAILS)
 Capital Transfers: (+) Canada gives $2 million to Tanzania
MoEd. to build schools—money transferred from Canada to
Tanzania …a capital account CREDIT for Tanzania
(-) US development agency USAID finances a new port in
Liberia –money recorded as a DEBIT in the US…a transfer of
income from USA to a foreign country
 Debt Forgiveness: The capital account records a CREDIT for the
lender when forgiven (a debit for the forgiven debtor nation)
 Exchanges of non-produced, non-financial assets: the purchase
OR sale of ‘non-productive’ assets such as patents, copyrights, franchises/licenses
and the purchases of land by a government or international org.11
Balance of Payments
Accounts
Net BoP is always going to be zero.
If there is a
deficit/surplus the central bank buys/sells for-ex (reserve
account) * …this happens after all ‘accounts’ are added up.
 Re - the Reserve Account (central bank)
 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 …and
SDRs with any other 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
(again) from foreigners.
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Balance of Payments
Accounts
Statistical Discrepancy
(S.D.)
 There’s going to be some omissions and mis-recorded
transactions—so we use a “plug” figure to get things to
balance.
 pp. 384 shows a discrepancy of $ (-)5 billion (HL practice Q.)
How to calculate?
 BP = 0 when all known transactions are accounted for, so
the S.D. is the "residual" value that will balance the books.
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The Balance of
Payments Identity (HL)
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, where the CB does
not maintain any official reserves, a CA surplus or deficit must
be matched by KA deficit or surplus:
BCA + BKA = 0
 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
(8:30) Tutor4U video summary: https://www.youtube.com/watch?v=KjqjEYJFefg
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Balance of Payments
 Fixed Exchange Rate


BOP determines necessity of government intervention
Can help forecast devaluation/revaluation of currencies
 Floating Exchange Rate

Government has no responsibility as ForeX rates are
determined by market forces
 Managed Floats

Focus of government is on interest rates
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Balance of Payments
(re-determinants of exchange rates)
 1. Differentials in Inflation – generally, low inflation leads to rising
currency values
 2. Differentials in Interest Rates - higher rates offer lenders higher
returns (money flows in c.p.)
 3. Current-Account Deficits- deficits mean the country requires
more foreign exchange –excessive demand lowers rates
 4. Public Debt- large debt encourages inflation – if it is too high
then the debt gets paid off in lower (real) value $ in future
 5. Terms of Trade- the ratio of export prices to import prices;
rising exports leads to increased demand for currency
 6. Political Stability and Economic Performance- political turmoil
leads to uncertainty currency confidence drops (QC in 85, 95) 16
Balance of Payments Trends
in Major Countries
 From 1982-2000, U.S. has had continual annual trade deficits (CA) with the rest of the world (ROW), along with annual capital
surpluses 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. Japan is STILL the
largest holder of US debt !! China (gov’t) actually owns more
US assets though (i.e. the US mortgage agencies)
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Do monetary and fiscal policies affect the
exchange rates and BOP components?
• 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.
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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.
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What about monetary and fiscal
policies?
So what do you think is the net effect?
The overall effect is mixed, but the interest
rate effect will likely dominate in the short
term leading the exchange rate appreciation.
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