CH 3: The Balance of Payments

The Balance of Payments is the statistical record of a country’s international transactions over a period of time.

“A country's balance of payments” refers to the transactions of its citizens and government.

Composed of:

• The current account

• The capital account

• The financial account

• The official reserves account

• Statistical Discrepancy

The Current Account

Includes the export and import of goods and services.

Includes unilateral transfers of foreign aid.

*If debit exceeds credit, then the country is running a trade deficit.

*If the credits exceed debits, then the country is running a surplus.

Divided into 4 categories:

1. Goods trade - oil, wheat

2. Services - Legal consulting, financing, royalties

3. Primary income - interest, dividends, other foreign investments

4. Secondary income - Involves “unrequited” payments

The Financial Account

Can be divided into 3 categories:

1. Foreign Direct Investment (FDI) occurs when the investor acquires a measure of control of the foreign business.

2. Portfolio investments are sales and purchases of foreign financial assets, such as stocks and bonds, that do not involve a transfer of control.

3. Other investments include transactions in currency, bank deposits, and trade credits.

The Official Reserves Account

Assets include Gold, foreign currency, Special Drawing Rights (SDR), and reserve positions in the IMF.

Balance of payments identity:

BCA+BKA+BFA+BRA=0

However, under a pure flexible exchange rate regime:

BCA+BKA+BFA=0

Mercantilism holds that a country should avoid trade deficits at all costs, even imposing import restrictions. Criticized by Adam smith, and David Ricardo, the main source of wealth in a country is its productive capacity, not trade surpluses.

Textbook notes

When goods, services or assets are provided without a corresponding return of something of economic value, the corresponding entry is made as a transfer.

The Capital Account

Includes capital transfers and acquisitions and disposal of nonproduced, nonfinancial assets between Canadians and foreigners.

Capital transfers unlike current transfers (secondary income) involve change of ownership, acquisition, or disposal of an asset and tend to be large and infrequent. Include nonfinancial assets.

The Financial Account

Canadian sales (exports) of assets are recorded as credits, result in capital inflow.

Purchases (imports) of foreign assets are recorded as debit, lead to capital outflow.

Portfolio investment comprises equity, debt, and derivative securities.

Sovereign wealth funds are government-controlled, play a positive role in stabilizing the global banking system, and help the balance of payment situations of the host countries. Under scrutiny due to their sheer size and the lack of transparency.

• Responsible for recycling foreign exchange reserves of Asian and Middle Eastern countries swelled by trade surpluses and oil revenues.

A country’s current account deficit must be paid for either by borrowing from foreigners or selling off past foreign investments.

Official Reserves Account

If a country has a surplus on its overall balance, its central bank will wither retire some of its foreign debts or acquire additional reserves from foreigners.

This account includes transactions undertaken by the authority to finance the overall balance and intervene in the foreign exchange market.

After 1945, international reserve assets included:

1. Gold

2. Foreign Exchange

3. Special Drawing Rights (SDRs)

4. Reserve positions in the International Monday Fund (IMF)

When a government wants to support the value of the dollar in the foreign exchange market, it sells foreign exchange, SDRs, or gold to “buy” dollars. Give rise to demand. Will be recorded as a positive entry under official reserves.

When a government wants to see a weaker dollar, they “sell” dollars and buy gold, foreign exchange, and so forth. Give rise to supply. Recorded as a negative entry under official reserves.

The Balance of Payments Identity

BOPI indicates a country is able to run a balance of payments (BOP) surplus or deficit by increasing or decreasing its official reserves.

Under Fixed Exchange Rate

BCA+BKA+BFA= BRA

If a country runs a deficit on the overall balance:

BCA+BKA+BFA= -BRA

The central bank of the country can supply foreign exchanges out of its reserve holdings, but if the deficit persists, may have to devalue its own currency.

Under Flexible Exchange Rate

The central bank will not intervene. no need to maintain official reserves.

BCA+BKA= -BFA

A current account surplus or deficit must be matched by a financial account deficit or surplus, and vice-versa.

If the global imbalance is to be reduced, it would be desirable for deficit countries to consume less and save more and for Surplus countries to consume more and save less.

The capital account includes capital transfers and acquisitions and disposals of non-produced, nonfinancial assets between U.S residents and foreigners.

The balance of payment records international trade and cross-border investments.

A balance of payments surplus means a country is receiving more foreign currency that it is spending, often due to strong exports and foreign investment inflows.

The current account balance is a component of the country’s GNP. Other components of GNP include consumption and investment and government expenditure

The main approaches to forecasting exchange rates are: Efficient market, Fundamental, and technical approaches

If exchange rate follows a random walk, the future exchange rate is expected to be the same as the current exchange rate.

The efficient markets hypothesis states current asset prices fully reflect all the available and relevant information.

Uncovered interest rate parity is an economic theory that suggests the difference in interest rates between 2 countries should equal the expected change in exchange rates over time.

IRP is best defined as an arbitrage condition that must hold when international financial markets are in equilibrium.

When IRP does not hold, there are opportunities for covered interest arbitrage

the random walk hypothesis suggests that the best predictor of the future exchange rate is the current exchange rate.

An arbitrage is best defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain guaranteed profits.