Chapter 3

Balance of Payments definition

• measurement of all international economic transactions between country residents and foreign residents (cross-border) over a given period

• tracks money coming into/going out of the country

• strongly influences exchange rates

Why is the BOP important for a MNE

• indication of pressure on a country’s forex rate

• signal of imposition or removal of controls in cash disbursements

• forecast of a country’s market potential (esp in short run)

What BOP helps us understand

• exchange rates

• interest rates

• inflation

• economic stability

• capital flows

• trade patterns

questions BOP answers

• is a country spending more abroad than it earns

• is foreign investment entering or leaving the country

• is there pressure on exchange rate

• does the country rely heavily on foreign borrowing

Cash disbursements that signal imposition or removal of controls in BOP

• payments of dividends

• interest

• license fees

• royalties

BOP statement in accounting

• statement of cashflows over an interval in accounting (flow statement)

• records transactions over time, not what a country owns at a point in time (stock)

• must balance (cannot be in disequilibrium)

BOP debit

• records forex spent such as payments for imports or purchases of services

• any outflows of forex (-)

BOP credit

• events, such as export of good/service that records forex earned

• any inflow of forex to country (+)

imbalance in BOP

• measurement errors

• missing data

• recorded under errors and omissions

BOP major sub accounts

• current account

• capital account

• financial account

BOP official reserves account

• tracks gov currency transactions

BOP net errors and omissions account

• preserves balance of the BOP

International Economic transactions

• export of merchandise/imports are international transactions

• purchase of good by a USA tourist is a USA merchandise import

BOP of a flow statement

• exchange of real assets

• exchange of financial assets

Exchange of real assets

• exchange of goods and services for other goods and services or for money

exchange of financial assets

• exchange of financial claims for other financial claims or money

BOP accounting discrepancies

• current, capital, and financial account entries are recorded independently of one another (three major sub accounts)

• if CCF entries were recorded together (double entry bookkeeping), there would be discrepancies between debits and credits

Current Account BOP

• records day to day economic transactions with rest of world

• Goods trade (import/export)

• Services trade (import/export)

• income

• current transfers

CA trade in services

• tourism

• education

• consulting

• transportation

• financial services

Service Surplus and developed countries

• many developed countries have service surpluses

• these can partially offset goods trade deficits

CA income from investments

• current income associated with investments made in previous periods

• interest

• dividends

• profits from past investment

CA current transfers

• any transfer between countries that is one way

• no exchange of goods or services

• gift or grant

• foreign aid

• remittances

Capital and Financial Accounts

• measures all international economic transactions of financial assets

• focus on financial flows, not trade

• record how CA imbalances are financed

capital account

• made up of transfers of financial assets and acquisition and disposal of non produced/nonfinancial assets

• only introduced recently as separate account

• relatively small

• includes debt forgiveness, transfers of non-produced assets (patents, resource rights)

financial account

• records cross border investment flows

financial account components

• direct investment

• portfolio investment

• other asset investment

direct investment financial account

• net balance of capital dispersed from and into a country for the purpose of exerting control over assets

• investor has control

• long term and stable

control definition direct investment

• taking minimum ownership interest of 10%

portfolio investment financial account

• net balance of capital that flows into and out of a country but that does not reach the 10% ownership threshold of direct investment

• stocks and bonds

• no control

• more volatile

other asset investment financial account

• various short term and long term trade credits

• cross border loans from all types of financial institutions (bank loans)

• currency deposits and bank deposits

• other receivables and payables related to cross border trade

relationship between financial and current accounts

• inverse relationship, closely linked

• country has CA deficit, it must be financed by borrowing from abroad or selling domestic assets to foreigners → creates financial account surplus

• country has CA surplus → invest excess savings abroad

Net Errors and Omissions Account

• discrepancies occur because current and financial account entries are recorded separately

• NEO makes sure BOP balances (CA - FA = NEO)

Official reserves account

• total reserves held by official monetary authorities within country

• composed of major currencies used in international trade and financial transactions

China’s twin surpluses

• China has surpluses in both current and financial accounts

• CA surpluses would normally create a FA deficit, but the positive prospects of the Chinese economy have drawn such massive capital inflows into China that the FA too is in surplus

Current Account Balance

• exports - imports

Capital Accounting Balance

• capital inflows - capital outflows

Financial Account balance

• financial inflows - financial outflows

Reserve Balance

FXB - Change in Reserve Balance

BOP calculation

• (X-M) + (CI-CO) + (FI-FO) + FXB = BOP

Fixed exchange rate countries and BOP

• gov bears responsibility to ensure that BOP is near zero

• if sum of current + capital accounts do not approximate zero → gov is expected to intervene in forex market by buying (surplus) or selling (deficit) official forex reserves

floating exchange rate countries and BOP

• gov has no responsibility to peg its forex rate

• fact that current and capital account balances do not sum to zero will automatically alter the exchange rate in the direction necessary to obtain BOP near zero

If Imports > Exports in Floating exchange rate systems BOP (VICE VERSA)

• demand for foreign currency rises

• domestic currency depreciates

Depreciation in floating exchange rate systems BOP (VICE VERSA IF IMPORTS < EXPORTS)

• makes exports cheaper

• makes imports more expensive

• corrects imbalance over time

Managed floats and BOP

• countries with managed float often must take action to maintain their desired exchange rate values

• primary action by gov → change relative interest rates, thus influencing the economic fundamentals of exchange rate determination

BOP and interest rates

• overall level of a country’s interest rates compared to other countries has an impact on the FA of the BOP

• relatively low real interest rates should stimulate an outflow of capital seeking higher interest rates in other country’s currencies

BOP and inflation rates

• imports have potential to lower a country’s inflation rate

• imports of lower-priced goods and services place a limit on what domestic competitors can charge for comparable goods and services

Lower priced imports and GDP (BOP and inf)

• to the extent that lower priced imports substitute for domestic production and employment, GDP will be lower as the balance on the current account falls with rising imports

Trade balances and exchangerates

• countrys imports and export of goods and services is affected by changes in exchange rates

transmission mechanism for trade balances and exchange rates

• changes in exchange rates change relative prices of imports and exports

• changing prices results in changes in quantities demanded through the price elasticity of demand

Trade and Devaluation

• countries occasionally devalue their own currencies as a result of persistent and sizable trade deficits

J curve adjustment path stages

• currency contract period (deficit) → pass through period (deficit) → quantity adjustment period (surplus)

• path of trade balance adjustment takes on shape of flattened j

US Trade balance adjustment path equation

• US trade balance = (P$x*Qx) - ((S$/fc)(PfcM)(Qm))

• P$x - prices of exports in USD

• PfcM - prices of imports in foreign currency

• Qx - export quantity

• Qm - import quantity

• S$fc = spot exhcnage rate

Immediate impact of devaluation of domestic currency on trade balance (CCP)

• devaluation of domestic currency increases the value of the spot exchange rate

• results in immediate deterioration in the trade balance (currency contract period), trade balance improves over time

3 stages of the Trade balance adjustment

• currency contract period

• pass through period

• quantity adjustment period

currency contract period trade balance adj

• existing contracts fixed

• import prices rise immeidately

Pass through period

• after current contracts have matured, new prices reflect partial to full passthrough of exchange rate change

• improvement in trade balance will be evident (prices adjust)

Quantity adjustment period

• price elasticity of demand takes effect, the actual trade balance rises above where it started

Capital mobility

• degree to which capital moves freely across borders (important for BOP)

• US financial account surplus has partially offset current account deficit

• China has surplus in each financial account + current account

pros of high capital mobility

• promotes investment and growth

• improves access to global savings

cons of high capital mobility

• increases volatility

• causes sudden capital flight

Historical patterns of capital mobility

• high mobility under gold standard

• low mobility during interwar years

• liberalization after WWII

• rapid globalization since 1990s

• countries may impose capital control during crises

Current account vs financial account capital flows

• free flow of capital in and out of an economy can potentially destabilize economic activity or can contribute significantly to an economy’s development

Volatility of current capital flows and financial capital flows

• current account capital flows can be more volatile, with capital flowing into and out of an economy and a currency on the basis of short term interest rate differentials and exchange rate expectations

Longer term capital flows

• longer term capital flows reflect more fundamental economic expectations (growth prospects, perceptions of political stability)

Classical Gold Standard capital mobility (1870-1914)

• increasing capital mobility as the gold standard was adopted and international trade relations were expanded

Inter war years capital mobility (1923-1938)

• era of retrenchment, major economic powers returned to policies of isolationism and protectionism

• restricted trade and nearly eliminated capital mobility

Results of Isolationism and protectionism (IWCM)

• financial crisis

• global depression

• rising international political and economic disputes that drove nations into WWII

Fixed Exchange Rates Capital Mobility (1944-1973)

• FER system under Bretton Woods led to economic recovery and growing openness of both international trade and capital flows into and out of countries

Floating exchange rates capital mobility (1973-1997)

• rise of a growing schism between industrialized and emerging market nations

• industrialized nations moved to floating exchange rates by capital mobility

• emerging markets opened trade but maintained restrictions on capital flows

Emerging Era capital mobility (1997-present)

• emerging economies (China+India), attempt to gradually open their markets to global capital

• increasing mobility of capital required that they give up either the ability to manage their currency values or to conduct independent monetary policies (impossible trinity)

Capital Controls (CM)

• restrictions that limit or alter the rate or direction of capital movement into or out of a country

• designed to counter capital flight

forms of capital controls

• tax on specific transactions

• limits on quantity or magnitude of specific capital transactions

• prohibit transactions all together

General Revenue/Finance war effort capital controls

• controls on capital outflows

• higher inflation with a given fixed exchange rate + holds down domestic interest rate

• WWI/WWII

Financial Repression/Credit allocation capital controls

• govs that use the financial system to reward favored industries or raise revenue

• use controls to prevent capital from going abroad to seek higher returns

• developing countries

Correct a balance of payments deficit capital controls

• controls on outflows reduce demand for foreign assets without contractionary monetary policy or devaluation

• allows for higher inflation rate

• US interest equalization tax

Correct a BOP surplus capital controls

• controls on inflows reduced foreign demand for domestic assets without expansionary monetary policy or revaluation

• allows for lower rate of inflation

• German Bardepot scheme

Prevent potentially volatile inflows capital controls

• restricting inflows enhances macroeconomic stability by reducing the pool of capital that can leave a country during a crisis

• Chilean encaje

Prevent financial destabilization capital controls

• capital controls can restrict of change the composition of international capital flows that can worsen distorted incentives in the domestic financial system

• controls inflows

• Chilean encaje

prevent real appreciation capital controls

• restricting inflows prevents necessity of monetary expansion and greater domestic inflation that would cause a real appreciation of the currency

• Chilean encaje

Restrict foreign ownership of domestic assets capital controls

• foreign ownership of certain domestic assets (natural resources) can generate resentment

• control inflows

• Article 27 of Mexican constitution

preserve savings for domestic use capital controls

• benefits of investing in domestic economy may not fully accrue to savers

• economy as a whole can be made better off by restricting outflow of capital

protect domestic financial firms capital controls

• controls that temporarily segregate domestic financial sectors from the rest of the world

• permits domestic firms to attain economies of scale to compete in world markets

• controls inflows + outflows

Primary concern of capital inflows (globalization of capital flows)

• short term in duration

• may flow out with short notice

• characteristics of the politically and economically unstable emerging markets

Largest capital flow crises in recent years

• two of the largest capital flow crises in recent years have occurred within the largest, most highly developed, mature capital markets (US + Western Europe)

BOP for policymakers

• detect external vulnerabilities

• design exchange rate policy

• conduct monetary policy

• anticipate financial crisis

MNE firms BOP

• signal of exchange rate pressure

• risk of capital controls

• information on market opportunities