Lesson 64
The Balance of Payments
Recall from the lesson on the circular flow of income that imports and exports were considered,
respectively, to cause a leakage and an injection of income. Clearly, for every good or service that
crosses a border, there is a corresponding movement of money in the opposite direction. The balance of
payments is simply the record of all these flows of money in and out of a country over a period of time.
Money coming into the country (from the sale of exports, for instance) is recorded as a credit in the
accounts, while money going out (say, to purchase a foreign asset) is recorded as a debit. While there
are a number of ways to record the balance of payments, the I.B. has chosen to follow the conventions
laid out by the I.M.F. which specify three accounts - the current account, the financial account and the
capital account. While theoretically the balance of payments should always have a zero balance as
deficits or surpluses in the current account ought to be funded by inflows or outflows registered in the
financial or capital accounts, in reality rounding and reporting errors make this very unlikely. The
balancing item (also called ‘net error’ or ‘residual’) is therefore included to ensure that the balance of
payments does indeed balance.
Thus:
Balance of Payments = Current Account + Financial Account + Capital Account + Balancing Item
Each of these ‘sub-accounts’ looks at different transactions and transfers. The current account looks at:
1.
The balance of trade in goods – export revenue (receipts) is set against import spending
(payments) related to trade in tangible, physical goods.
2.
The balance of trade in services – export revenue (receipts) is set against import
spending (payments) related to trade in intangible, non-physical items such as
transportation, travel and tourism, insurance and consulting or financial services.
3.
Income. Dividends and interest payments that are paid from foreign sources (receipts)
are set against similar payments made to foreigners holding domestic assets.
4.
Current transfers, which are primarily the remittances paid by workers employed
overseas to their families at home, where they are used to pay for current consumption.
The balance of trade in goods is commonly called the visible trade balance (as visible, tangible goods
crossing the border are involved), while the following three sub-accounts are commonly called the
invisible balance (as there are no visible, tangible items crossing the border to account for the receipts
and payments).
The financial account, meanwhile, looks at the payments and receipts related to the purchase and sale
of assets, which by definition generate income. The 3 main categories of asset transactions covered are:
1.
Direct investment. When a foreign firm or individual buys or develops a factory or other
business in a country using capital from their home base, it is considered direct
investment. Such assets are considered physical or real assets. Such investment is
desired by countries as it involves a relatively high level of commitment to the country
benefiting from the investment.
2.
Portfolio investment. When foreigners invest their capital in another country’s stock or
bond market (but do not take a controlling stake in the firms they are investing in) it is
considered portfolio investment. Such investment is not as stable as it is relatively easy
for foreigners to sell their holdings if economic conditions take a turn for the worse.
3.
Changes in reserve assets. Reserve assets are financial assets which can only be bought
and sold by central banks or other monetary authorities. When central banks intervene
in the foreign exchange market to buy or sell currency the transactions are recorded
under this sub-account. More specifically, when central banks sell foreign currency to
buy domestic currency it is recorded as a credit (as your currency is coming into the
country from the foreign exchange markets) while when central banks buy or
accumulate foreign currency on the foreign exchange markets (by selling domestic
currency) it is recorded as a debit.
The capital account, finally, accounts for very few transactions. Primarily it deals with capital transfers
which, unlike current transfers, are intended for investment, not consumption. Examples of capital
transfers would include official debt forgiveness and the money brought into a country by migrants
(which is significant in countries that offer citizenship to investor-immigrants).
While theoretically the overall balance of payments is always in balance, the individual accounts are
often out of balance. For instance, the United States has historically had a net outflow of money in its
visible trade balance (ie a trade deficit – more imports than exports), but a compensating net inflow in
its invisible trade balance and financial account.
Under a system of floating exchange rates, where currency exchange rates are set by the relative supply
and demand for currencies on foreign exchange markets, any incipient balance of payments imbalances
(narrowly defined to exclude the activities of the central bank in the financial account) should be
corrected automatically. The reason for this is that a country’s goods, services and assets need to be
bought with that country’s money which, along with the money of other countries, is traded in foreign
exchange markets. For example, if a country’s invisible trade balance, financial account and capital
account are all at zero (ie inflows = outflows) while its visible trade balance is positive ( ie it is exporting
more goods than it is importing), in the foreign exchange market foreigners are going to want to buy
more of your money (to allow them to buy your relatively large quantity of exports) than your people
will want to sell (to allow them to buy foreign currencies to facilitate their buying a relatively small
quantity of imports). This imbalance should result in a rise in the value of your currency relative to other
currencies. This in turn will make your goods, services and assets more expensive to foreigners, and
foreign goods, services and assets cheaper for your people. Ceteris paribus, this should result in
foreigners reducing their demand for your goods, services and assets, and your people increasing their
demand for foreign goods, services and assets until the balance of payments is once again in balance.
Exercise 64
1.
Define:
a. THE BALANCE OF PAYMENTS
b. CREDIT
c. THE CURRENT ACCOUNT
d. THE FINANCIAL ACCOUNT
e. PORTFOLIO INVESTMENT
f. CURRENT TRANSFERS
2.
From the point of view of Singapore, classify each of the following transactions as either
a debit or a credit, and identify in which account and sub-account each would be
recorded.
a. Japanese-made cars are sold in Singapore
b. A Singaporean bank sells financial services to rich Indonesians
c. Foreign mutual funds or unit trusts buy shares in Singaporean banks
d. Singaporeans spend money on holiday in Thailand
e. Bangladeshi workers in Singapore send money home to their families
f. Singaporean-made computer components are sold to Taiwan
g. Singaporean investors build a casino and hotel complex in China
h. A Singaporean company pays bond interest to a Malaysian investor
i. The Singaporean government forgives a loan made to East Timor in order to aid East
Timor’s economic development
j) The Monetary Authority of Singapore (Singapore’s central bank) increases its holdings
of foreign exchange reserves by buying Australian dollars and selling Singapore dollars
on the foreign exchange market
3.
A country records the following balance of payments information for Balancia.
Identify each entry as either a debit or a credit in Balancia’s balance of payments
accounts.
Exports of goods
Imports of goods
Exports of services
Imports of services
Dividend and interest payments made to Balancians by foreigners
Dividend and interest payments made to foreigners by Balancians
Tourist spending by foreigners in Balancia
Tourist spending by Balancians abroad
Remittances sent by Balancians working abroad
Remittances sent abroad by foreigners working in Balancia
Direct investment spending by foreigners in Balancia
Direct investment spending by Balancians abroad
Portfolio investment by foreigners in Balancia
Portfolio investment by Balancians abroad
Reduction in value of foreign currency reserves (reserve assets)
Investment brought into Balancia by recent immigrants
Debt forgiveness granted as international development assistance
$50 billion
$46 billion
$ 7 billion
$12 billion
$ 4 billion
$ 3 billion
$ 6 billion
$ 7 billion
$ 2 billion
$ 6 billion
$10 billion
$ 9 billion
$10 billion
$ 7 billion
$ 1 billion
$ 0.5 billion
$ 0.5 billion
a)
Calculate Balancia’s current account, financial account and capital account balances.
b)
What is its overall balance of payments? Without the change in official reserve assets,
what would have been its overall balance of payments?
c)
If the central bank had not sold foreign currency reserves on the foreign exchange
market, what would have likely happened to the exchange value of the Balancian dollar
under a floating exchange rate system?
d)
Using Balancia’s balance of payments accounts, do you think Balancia is a developed or
a developing country? Explain your answer.