bop session 14
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The Balance of Payments: Linking theDomestic Economy to the InternationalEconomy
Open economy An economy that
has interactions in trade or finance
with other countries.
Closed economy An economy that has
no interactions in trade or finance with
other countries.
Balance of payments The record of
a countrys trade with other countries
in goods, services, and assets.
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Balance of Payments (BOP)
A record of international transactions betweenresidents of one country and the rest of the world.
International transactions include exchanges ofgoods, services or assets.
Residents means businesses, individuals and
government agencies, including citizens temporarilyliving abroad, but excluding local subsidiaries offoreign corporations.
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Balance of Payments (BOP)
The Balance of Payments (BOP) is also the
record of a countrys sources (supply) and uses
(demand) of foreign exchange.
Foreign exchangeis simply all currencies other
than the domestic currency of a given country.
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For example
BOP transactions (US side)
Daimler-Chrysler purchases manufacturer in
Chicago.
GM China pays dividends to parent in US.
An American tourist purchases a necklace in
India.
A Mexican lawyer purchases US bond viainvestment broker in New York.
Rule of thumb: follow the cash flow
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Balance of Payments Accounts(cont.)
The balance of payment accounts are separated into 3
broad accounts:
current account: accounts for flows of goods and
services (imports and exports).
financial account: accounts for flows of financial
assets (financial capital).
capital account: flows of special categories of assets
(capital), typically non-market, non-produced, orintangible assets like debt forgiveness, copyrights and
trademarks.
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B of PA. Current Account
A. Net exports/imports goods&services (Balance of Trade)
B. Net Income (investment income from direct portfolio investment plus employeecompensation)
C. Net transfers (sums sent home by migrant abroad)
B. Capital Account
Capital transfers related to purchase and sale of fixed assets such as real estate
C. Financial Account
A. Net foreign direct investment
B. Net portfolio investment
C. Other financial items
D. Net Errors and Omissions
Missing data such as illegal transfers
E. Reserves and Related Items
Changes in official monetary reserves including gold and foreign exchange reserves
(A:E) = Overall Balance
Basic Balance = A+B+C
Overall Balance = A+B+C+D
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BOP Accounting
The BOP must balance
How to measure international economic activity?
Is it an international economic transaction?
How do flow of goods/services/assets/money translate indebits & credits?
Bookkeeping procedures for BOP?
Main transactions in BOP:
Exchange of real assets.
Exchange of financial assets.
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Double-entry Accounting in the BOP
All transactions are either debit or credit transactions
Credit transactions result in receipt of payment from
foreigners Merchandise exports
Transportation and travel receipts
Income received from investments abroad
Gifts received from foreign residents
Aid received from foreign governments
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Double-entry Accounting(Contd)
Debit transactions involve to payments to foreigners Merchandise imports
Transportation and travel expenditures
Income paid on investments of foreigners
Gifts to foreign residents Aid given by home government
Overseas investments by home country residents
Each credit transaction has a balancing debit transaction, andvice versa, so the overall balance of payments is always in
balance.
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The Current Account
A countrys current accountis the sum
of its:
net exports (exports minus imports)
net income received from investmentsabroad, and
net transfer payments from abroad.
Exports earnforeign exchange and area credit (+) item on the current account.
Imports use upforeign exchange and
are a debit () item.
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The Current Account
The balance of tradeis the differencebetween a countrys exports of goods andservices and its imports of goods and services.
A trade deficitoccurs when a countrysexports are less than its imports.
Net exports of goods and services (EX
IM),is the difference between a countrystotal exports and total imports.
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The Current Account
Investment incomeconsists of holdings of
foreign assets that yield dividends, interest,
rent, and profits paid to Indian asset holders
(a source of foreign exchange).
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The Current Account
Net transfer paymentsare the difference
between payments from India to foreigners
and payments from foreigners to India.
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The Current Account
The balance on current accountconsists ofnet exports of goods, plus net exports of
services, plus net investment income, plus net
transfer payments. It shows how much anation has spent relative to how much it has
earned.
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The Current Account
Goods Trade or Balance of Trade (BOT) export/import of goods.
Services Trade export/import of services (financial, construction, andtourism).
Income predominately current incomeassociated with investmentsmade in previous periods, + wages & salaries paid to non-resident workers.
Current Transfers financial settlements due to change in ownership ofreal resources or financial items. Any transfer b/n countries which is one-
way, a gift or a grant.
CA typically dominated by export/import of goods, for this reasonBalance of Trade (BOT)is widely quoted.
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For example
Trade balance
Debit: Sun Microsystems buys LCDs from Hong Kong.
Credit: Singapore Airlines buys Boeing jet.
Trade in services
Debit: American rents an apartment in Singapore.Credit: TUI - Germany places an ad in the NYT.
Income paymentsDebit: Honda US pays dividend to Honda Japan.
Credit: Bank Austria pays salary to rep in NY office.Unilateral Current Transactions
Debit: Peace Corps pays US volunteer teachers in Bosnia.
Credit: TotalFina pays tuition of employee for Stern MBA.
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The Balance of Payments: Linking theUnited States to the International Economy
The Current AccountTrade Flows for the United
States and Japan, 2009
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The Balance of Payments: Linking theUnited States to the International Economy
Net Exports Equals the Sum of the Balance of Trade and the
Balance of Services
The Balance of
Payments of the United
States, 2009 (billions of
dollars)
CURRENT ACCOUNT
Exports of goods $1,149
Imports of goods 1,965
Balance of trade 816
Exports of services 479Imports of services 372
Balance of services 107
Income received on investments 782
Income payments on investments 708
Net income on investments 74
Net transfers 104
Balance on current account 739
The Current Account
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The Capital Account
For each transaction recorded inthe current account, there is anoffsetting transaction recorded inthe capital account.
The capital accountrecords the
changes in assets and liabilities.
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The Capital/Financial Account
Capital account: transfers of fixed assets, realestate, acquisitions/disposal of non-produced/non-
financial assets
Financial account: three components; classified bydegree of control,
Direct Investment Net balance of capital which is
dispersed from and into US for the purpose of exerting
control over assets. E.g. US company acquires foreign company stake (-)
Foreign company acquires US company stake (+)
foreign direct investment (FDI): 10%+ of voting shares acquired.
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The Capital/Financial Account
Portfolio Investment Net balance of capital which flowsin/out of US but does not reach 10% ownership.
No voting or control rights over the asset.
Purchase/sale of equity securities.
Purchase/sale of debt securities. Far more volatile than FDI.
Other Investment Assets/Liabilities Short & long-termtrade credits, cross-border loans, currency & bank
deposits, & other accounts receivable and payable incross-border trade.
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The Capital Account
The balance on capital accountin India is
the sum of the following (measured in a given
period):
the change in private Indian assets abroad
the change in foreign private assets in India
the change in Indian government assets abroad,
and
the change in foreign government assets in the India
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The Capital Account
In the absence of errors, the balance on
capital account would equal the negative of
the balance on current account.
If the capital account is positive, the change
in foreign assets in the country is greater
than the change in the countrys assetsabroad, which is a decrease in the net
wealth of the country.
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The Balance of Payments: Linking theUnited States to the International Economy
Net Exports Equals the Sum of the Balance of Trade and the
Balance of Services
The Balance of
Payments of the United
States, 2009 (billions of
dollars)
CURRENT ACCOUNT
Exports of goods $1,149
Imports of goods 1,965
Balance of trade 816
Exports of services 479Imports of services 372
Balance of services 107
Income received on investments 782
Income payments on investments 708
Net income on investments 74
Net transfers 104
Balance on current account 739
The Current Account
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The Balance of Payments: Linking theUnited States to the International Economy
FINANCIAL ACCOUNT
Increase in foreign holdings of assets in the United States 1,864
Increase in U.S. holdings of assets in foreign countries 1,206
Balance on financial account 658
BALANCE ON CAPITAL ACCOUNT -2
Statistical discrepancy 83
Balance of payments 0
The Current Account
The Balance of Payments of the
United States, 2009 (billions of
dollars) (continued)
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Statistical Discrepancy?
It is the net result of errors and omissions on both thecredit and debit sides.
Where do these errors come from? Under-reporting merchandise imports
Under-reporting investment incomes
Under-reporting capital exports
Basically, people succeed in hiding their imports, foreigninvestment incomes, capital flight from their governments
for tax and other purposes.
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Account Overview (Level 2)
Current AccountMerchandise trade
exportsimportsTrade Balance
Servicesmilitary trans. (net)other services, netService Balance
Balance on goods & services
Investment income, net
Unilateral transfersUS government grants
US govt pensions, andother transfers
Private remittances andother transfers
All transfers, net
Balance on current account
Capital AccountChanges in US assets abroad, net
other US govt assetsUS private assetsAll changes, net
Changes in foreign assets in the US,
net foreign private assetsAll changes, net
Changes in holdings of officialinternational reserves, net
Statistical discrepancy
Balance on capital account
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Current Account Surplus and Deficit:Implications
A current account surplus means exports of goodsand services, investment income and transfers
exceed imports and outflows.
A current account deficit means imports of goods
and services, and outflows are greater than
exports and inflows; must be financed by
borrowing (capital account inflows).
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BOP Surplus and Deficit
In terms of the supply and demand of anations currency, there is:
A balance of payments surplus if quantity demanded
for a currency exceeds quantity supplied, putting
upwardpressure on the value of the nations currency.
A balance of paymentsdeficitif quantity supplied of a
currency exceeds quantity demanded, putting
downwardpressure on the value of the nations
currency.
B l f P t
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Balance of PaymentsAccounting
Consider three transactions:1) Wal-Mart buys $100M worth of clothing from a Chinese
Manufacturer. Wal-Mart pays for the clothing by writing a
check drawn off its account at Bank of America.
2) Warren Buffet collects $50M in interest payments from his
financial investments overseas. The Payment is made by
crediting Warrens bank account in London.
3) Microsoft sells $20M worth of software to the French
government. They pay in cash.
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Balance of Payments Accounts
Current Account
Exports
Goods:
Services:
ImportsGoods:
Services:
Net Factor Income:
Net Unilateral Transfers:
CA Balance:
Capital & Financial Account
Foreign acquisition of US assets:
US Treasuries:
Private Securities:
FDI:Currency:
US acquisition of foreign assets:
FDI:
Foreign Securities:
Official Reserve AssetsForeign acquisition of US ORA:
US acquisition of foreign ORA:KFA Balance:
-$100M (1)
$100M (1)
$50 (2)
-$50 (2)
$20M (3)
-$20M (3)
-$30M
$30M
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Tsunami Relief Aid
President Bush authorized $350M in aid for the Asiancountries affected by the Tsunami.
This will appear in the BOP accounts under unilateral
transfers.
Assume this transfer is paid in cash
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Balance of Payments Accounts
Current Account
Exports
Goods:
Services:
ImportsGoods:
Services:
Net Factor Income:
Net Unilateral Transfers: -$350M
CA Balance: -$350M
Capital & Financial Account
Foreign acquisition of US assets:
US Treasuries:
Private Securities:
FDI:Currency: $350M
US acquisition of foreign assets:
FDI:
Portfolio Investment:
Official Reserve AssetsForeign acquisition of US ORA:
US acquisition of foreign ORA:KFA Balance: $350
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National Income Identitiesand the Current Account Balance
Recall the aggregate expenditure equation in
our study of macroeconomics:
AE (=AD) = C + I + G + X - M
Leakages are:S + T + M
Injections are:
I + G + X
=> In equilibrium:injections= leakages
S + T + M=I + G + X
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The balance of payments on Current Account could be re-
written as:
(X - M) = (T - G) + (S - I)
or
(M - X) = (G - T) + (I - S)
trade = government + private sectordeficit balance balance
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Trade deficit = government deficit + priv. sector
deficit
An increase in govt. expenditure (G), or a
reduction in private saving (S) worsens the
trade balance (i.e. raises trade deficit)
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Are trade deficits a problem?
A trade deficit is not necessarily a bad thing (e.g. when growingdomestic industries attract foreign investments)
if borrowing is financing investment (which generates economic growth
and income in future) then it is not a problem
However, if a country persistently runs a trade deficit this is
something to worry about (e.g. vulnerability to loss of foreign
investors confidence)
excessive borrowing on capital account to finance consumption on
current account will incur higher interest payments and eventually leadto reduction in consumption
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The Effect of a GovernmentBudget Deficit on Investment
The Twin Deficits,
19782008
During the early 1980s, large federal budget deficits occurred at the same time as large current account deficits, but twin
deficits did not occur in the 1990s.
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