Balance of Payment

1. 1
The Balance of
Payments
Chapter Objective:
 This chapter serves to introduce the student to the balance of
payments, how it is constructed and how balance of
payments data may be interpreted.
Chapter Outline
 Balance of Payments Accounts
 The Current Account
 The Capital Account
 External Balance and the Exchange Rate
 Balance of Payments Trends in Major Countries
3Chapter 3

2. 2
Balance of Payments
The Balance of Payments is the statistical record of a country’s
international transactions over a certain period of time
presented in the form of double-entry bookkeeping.
Why is it useful to examine a country’s BOP?
 The BOP provides detailed information about the supply and
demand of the country’s currency.
 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 in various
categories.
 Viewed over time, BOP data can shed light on important
developments in a country’s comparative advantage and
international competitiveness.

3. 3
 They are composed of the following:
 The Current Account
 The Capital Account
 The Official Reserve Account
Balance of Payments
Accounts

4. 4
Balance of Payments
Accounts
Current Account
 Records flows of exports, imports, investment income, and international
financial transfers.
 Merchandise trade – export and import of tangible goods
 Services – payments and receipts for legal and consulting fees,
royalties, tourist expenditures
 Investment income – payments and receipts of interest, dividends, and
other income on foreign investments
 Unilateral Transfers – “unrequited” payments (e.g. Foreign aid).
 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.

5. 5
Balance of Payments
Accounts
The capital account
 Records sales to foreigners of Canadian financial assets and
Canadian purchases of foreign financial assets.
 The capital account is composed of Foreign Direct Investment
(FDI), portfolio investments, and other investment.
 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.
 Other investment includes bank deposits, currency investment, trade
credit and the like.

6. 6
Balance of Payments
Accounts
The Reserve Account
 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,
SDRs, 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 from foreigners.

7. 7
Balance of Payments
Accounts
Statistical Discrepancy
 There’s going to be some omissions and misrecorded
transactions—so we use a “plug” figure to get things to
balance.
 Exhibit 3.4 shows a discrepancy of $0.8 billion in 2002.
How to calculate?
 BP = 0 when all known transactions are accounted for, so
the SD is the "residual" value that will balance the books.

8. 8
The Balance of
Payments Identity
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

9. 9
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 FX rates are
determined by market forces
 Managed Floats
 Focus of government is on interest rates

10. 10
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 (+KA), 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 (T-
bonds, 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.

11. 11
Balances on the Current (BCA) and
Capital (BKA) Accounts of the U.S.
-500
-400
-300
-200
-100
0
100
200
300
400
500
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
U.S. BCA
U.S. BKA
Source: IMF International Financial Statistics Yearbook, 2000

12. 12
Balances on the Current (BCA) and
Capital (BKA) Accounts of Japan
-150
-100
-50
0
50
100
150
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Japan BCA
Japan BKA
Source: IMF International Financial Statistics Yearbook, 2000

13. 13
Balances on the Current (BCA) and Capital
(BKA) Accounts of United Kingdom
-50
-40
-30
-20
-10
0
10
20
30
40
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
UK BCA
UK BKA
Source: IMF International Financial Statistics Yearbook, 2000

14. 14
Balances on the Current (BCA) and
Capital (BKA) Accounts of China
-15
-10
-5
0
5
10
15
20
25
30
35
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
China BCA
China BKA
Source: IMF International Financial Statistics Yearbook, 2000

15. 15
Balance of Payments Trends
in Major Countries
 Like the U.S., the United Kingdom recently experienced continuous
current account deficits, coupled with capital account surpluses. The
magnitude, however, is far less that that of the United States.
 Germany traditionally had current account surpluses. Since 1991
Germany has been experiencing current account deficits. This is
largely due to German reunification and the resultant need to absorb
more output domestically to rebuild the former East Germany. This
has left less output available for exports.
 China has been running trade surpluses AND capital account
surpluses. For example, in 2002 China had a $35.4B trade surpluses
and a $6.4B capital inflow. Reason: Official reserve holdings of
dollars has increased. Chinese govt. buys up dollars with Yuan, to
keep the dollar strong and the Yuan low, and the Yuan/$ rate stable.

16. Impact on Currency
 CA: All the other factors constant, a deficit balance
on a country’s current account implies that there is
excess supply of its currency in the foreign markets.
Hence, its currency should depreciate.
 KA: All other factors constant, a surplus balance in
a country’s financial account implies that there is
excess demand for assets denominated in its
currency. Hence, its currency should appreciate.
16

17. Affects on the Economy
 Is a nations current account balance, by itself, a good measure
of its economic health?
 NO; there is no law, economic or political, which states that the
current account balance must be positive. Unlike running a budget
deficit in which a person or institution spends more than it makes,
running a deficit in the current account, simply means a country
imports more than it exports.
 Is a current account surplus and financial account deficit by
itself an indication of economic strength?
 NO, particularly not if the exodus of the financial capital occurs
because there are a few good investment opportunities in the
country.
 Is the net inflow of capital bad?
 NO, if the capital is being invested in such a way as to enhance the
productive capacity of the country. 17

18. Do monetary and fiscal policies affect the
exchange rates and BOP components?
18
• 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.

19. 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. 19

20. 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.
20