2012 BOP slides

INTERNATIONAL ECONOMICSBalance of Payments (BOP)

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LECTURE OBJECTIVES:

Students should be able to: Understand what is meant by BOP Identify the main accounts of BOP Calculate BOT, BOP etc Explain factors affecting the BOP

position of the country Explain the implications of

disequilibrium BOP Explain & evaluate measures to

correct BOP deficit/surplus.

WHAT HAVE YOU LEARNT SO FAR?

International Trade:Trade theories (CA)TOT & BOTAnti Trade PoliciesEconomic Integration

Physical Exchange of Goods and services. Theory of

international Trade (CA)

Protectionism

Financial Payment after physical exchange Balance of

Payment (BOP)

Exchange rate system

VIDEO

BIGGEST TRADE SURPLUS LATEST 12 MONTHS, IN $ BILLION (2010)

1. Germany, 210.8 (June)2. China, 174.7 (July)3. Russia, 152.6 (June) 4. Saudi Arabia, 104.4 (2009)5. Japan, 81.7 (June)6. Norway, 55.6 (June)7. Ireland, 54.1 (May)8. Netherlands, 53.3 (May)9. S. Korea, 40.1 (July)10. Malaysia, 36.6 (May)

TOP 10 COUNTRIES WITH WHICH U.S HAS A TRADE DEFICIT (NOV 2011)Country Name Deficit in Millions of

U.S. $

China - 25, 871. 59

Japan - 5, 207. 18

Mexico - 5, 514. 12

Germany - 4, 656. 40

Saudi Arabia - 3, 067. 96

Canada - 2, 976. 63

Ireland - 2, 808. 65

Russia - 2, 510. 94

Nigeria - 2, 307. 35

Venesuela - 1, 914. 39

U.S. Census Bureau

It is a record of a country’s transactions with the rest of the world over a calendar year.

Transactions that lead to a payment from foreigners are recorded as a credit item.(+)

E.g. Exports, investment from overseas.

Transactions that lead to a payment to foreigners are recorded as a debit item.(-)

E.g. Imports, investment abroad.

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The BOP of a country is determined by the Current & Capital & Financial account.

BOP

Current A/c Capital & Financial A/c

a) Visible trade (Goods) account

(Balance of trade)

b) Invisible trade (Services) account. (Balance of invisible trade)

c) Unilateral transfers

d) Income flows – interests profits & dividends

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Covers all tangible items including import and export of any form of goods.

E.g. Cars, consumer durables, food items etc.

•The balance in this account is also referred to as the Balance of Trade. • Difference btw the value (P x Qty) of visible exports & visible imports)

BALANCE OF BALANCE OF PAYMENTSPAYMENTS

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A. Current Account

Visible trade balance 55,608.6

Exports of goods + 339,646.8Imports of goods -284,038.2

BOT surplus : X > M

BOT deficit : X < M

Invisibles are intangible items. They consist of different types of services that a country sells to or buys from other countries.

•Shipping, insurance & banking services

•Transportation & travel

•Govt overseas expenditure

• Gifts

• Remittances

• Grants/financial aid

paym

ents

rece

ipts

• Refers to gifts/financial aid to and from relatives/govt/others abroad

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Receipts arise from

• interests on loans to foreign govt/ pte co

•Profits are received from co owned abroad

•Dividends from holding shares in foreign coPayments arise from

• interests paid to foreign depositors

•Profits are remitted overseas by foreign co

•Dividends from holding shares in local co

BALANCE OF PAYMENTSBALANCE OF PAYMENTS

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Current Account

Visible trade balance 55,608.6

Exports of goods + 339,646.8Imports of goods - 284,038.2 Invisible trade balance -5,454.6

Income balance -3,756.8

Transfers -1,943.9

Current Account Balance

Calculate the Current Account Balance.

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Current Account

Visible trade balance 55,608.6

Exports of goods + 339,646.8

Imports of goods - 284,038.2

Invisible trade balance -5,454.6

Income balance -3,756.8Transfers -1,943.9

Current Account Balance 44,453.3

Current A/C surplus: Combined Receipts > Combined Payments

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Capital & Financial A/cCapital & Financial A/c

ST Capital Flows

LT Capital Flows•Speculative

monetary movement (Hot money - speculative monetary movt)

• Direct Investment eg: subsidiaries set up by foreign firms (FDI)

• Portfolio Investment eg: bonds, shares securities (paper assets)

BALANCE OF PAYMENTS BALANCE OF PAYMENTS ACCOUNTSACCOUNTS

Investments/loans abroad now will result in the inflow of profits, dividends & interests in the current account in the future.

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BALANCING ITEM

The current and capital account never adds up to the amount of foreign currency the country actually gain or lost.

The balancing item represents the total errors and omissions which is required to bring the recorded BOP into balance.

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BALANCING ITEMBALANCING ITEM

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Current Account Balance (A) +44,453.3

Capital Account Balance (B) - 24,644.5

Balancing Item (C) + 624.2

Total Currency Flow (D) + 20,433.0

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A positive total currency flow means that Int’l Receipts > Int’l payments BOP surplus

What does a negative total currency flow mean?

Negative total currency flow means that Int’l Receipts < Int’l payments BOP deficit

The BOP is said to be in disequilibrium when the total currency flow (TCF) is either positive or negative.

Thus BOP is in disequilibrium when the overall balance is not zero

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If TCF = 0 BOP Equilibrium

If TCF ≠0 BOP Disequilibrium

A BALANCING ACT……

The BOP accounts are presented as a balanced sheet and all balance sheet must always BALANCE.

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What does it mean when economist say that BOP must always balance?

If outflow > inflow --> BOP deficit.

BOP deficit shows the amount required to cover any shortfalls in the overall BOP transactions.

The account must be balanced by withdrawals from official reserves or by borrowing overseas. These items are counted as inflows to balance the account.

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If outflow < inflow --> BOP surplus

BOP surplus shows the amount of forex earnings available for addition to the country’s forex reserves.

The surplus will be treated as additions to official reserves and repayment of overseas loans or the purchase of external assets. These items are treated as an outflows. 26

OFFICIAL FINANCING (RESERVES)Government can hold reserves of

gold and foreign currencies

Drawing on reserves represents a credit item as it represents an inflow into the BOP accounts.

Building up the reserves represents a debit item as it represents an outflow from the BOP account.

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$ Million

A. Current Account 55,608.6

B. Capital & Financial A/C -24,644.5

C. Balancing item 624.2

D. Total Currency Flow 20,433.0

E. Official Financing A/C -20,433.0

Overall BOP balance 0

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Current AcctVisible Bal (goods) -200Invisible Bal (service) +300Unilateral Transfers -50Current Acct Bal ???

Capital AcctDirect investment +150Portfolio investment -300Capital Acct Bal ???

Balancing Item +12

TCF (Overall Bal) ???

Official Financing Acct ???

BOP Bal 0

BOP (in $m)

Current AcctVisible Bal (goods) -200Invisible Bal (service) +300Unilateral Transfers -50Current Acct Bal +50

Capital AcctDirect investment +150Portfolio investment -300Capital Acct Bal -150

Balancing Item +12

TCF (Overall Bal) -88

Official Financing Acct +88

BOP Bal 0

BOP (in $m)

What causes a BOP deficit?

How can a country eliminate BOP deficit?

BOP DEFICIT International payments >

International receipts (excluding changes in official financing).

Occurs when:Both Current and Capital accounts are in

deficitDeficit in one account exceeds the

surplus in the other account. (e.g. Current account deficit exceeds the

Capital account surplus.)

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Factors affecting the BoP

Domestic income level

Country's stage of development

Long‑term investment prospects

Rate of interest

Changes in the prices of X & M (TOT)

Expected changes in the country's currency exchange rate

Govt Policy

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BOP CONTINUED

WHAT HAVE YOU LEARNT?What is meant by BOP? It is a record of a country’s

transactions with the rest of the world over a calendar year.

What are the main accounts in BOP?

- Current Account- Capital and Financial Account

WHAT DOES CURRENT ACCOUNT CONSIST OF?

a) Visible trade (Goods) account

(Balance of trade)

b) Invisible trade (Services) account. (Balance of invisible trade)

c) Unilateral transfers

d) Income flows – interests profits & dividends

WHAT DOES CAPITAL AND FINANCIAL ACCOUNT CONSIST OF?

ST Capital Flows

LT Capital Flows•Speculative

monetary movement (Hot money - speculative monetary movt)

• Direct Investment eg: subsidiaries set up by foreign firms (FDI)

• Portfolio Investment eg: bonds, shares securities (paper assets)

FACTORS AFFECTING THE BOP POSITION OF THE COUNTRY

Domestic income level

Country's stage of development

Long‑term investment prospects

Rate of interest

Changes in the prices of X & M (TOT)

Expected changes in the country's currency exchange rate

Govt Policy

WHAT ARE THE POSSIBLE REASONS FOR A BOP

DEFICIT?

Current Account deficitCapital Account deficit

POSSIBLE REASONS FOR A DEFICIT IN THE CURRENT ACCOUNT

Rising income increase in dd for m increase in M increase in C increase in production

of gds for domestic C and less for X fall in X revenue.

Poor quality / higher costs of Exports

Increase in the price of Ms: (oil & foodstuff), dd for X & M is price

inelastic increase in M Appreciation in exchange rate

POSSIBLE REASONS FOR A DEFICIT IN THE CAPITAL ACCOUNT

Poor investment climate due to rising GPL & political instability capital outflight

Falling interest rate (lower than other countries) outflow of hot money.

Expect exchange rate to depreciate outflow of capital.

Do countries prefer BOP surplus or BOP deficit?

•A BOP surplus is desirable not only because it leads to an increase in forex reserves which enhances a country’s international purchasing power.

•Export earnings and capital inflow inject multiplier effects on a country’s national income and lead to economic growth.

A country can run a persistent BOP deficit only if it has unlimited reserves of gold and foreign currencies or can borrow persistently from the rest of the world. But these options are not realistic.

Is a BOP deficit definitely undesirable, then?

Well...

It depends:•ST or persistent?•Causes of the deficit?•Size of deficit?

EFFECTS OF PERSISTENTEFFECTS OF PERSISTENT BOP DEFICITBOP DEFICIT

Depletion of foreign reserves.Countries have to draw upon their reserves to cover the deficit.

Incur large external debt Deficit will persist as the debt needs

servicing, representing further outflow

Depreciation of currencyPersistence deficits reflect poor economic management. Lack of confidence

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7

REMEDIES FOR A BOP DEFICIT

•Expenditure-ReducingExpenditure-Reducing•Expenditure-Expenditure-

SwitchingSwitching

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EXPENDITURE REDUCING MEASURES

Reduce the overall expenditure on imports and increase export revenue

Contractionary fiscal policyIncrease income taxesDecrease govt expenditure

Contractionary monetary policyReduce money supply to increase i/r

Loans are less accessible thus reduce demand for imports and domestic product

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ADVANTAGES OF EXPENDITURE-REDUCING

1. Fall in Y Fall in C & M Fall in AD fall in GPL. This increases price competitiveness and demand for exports eventually.

2. Fall in Y Fall in dd for domestic goods more resources will be channeled to produce goods for exports increase X.

3. A tight money policy will raise interest rates which will attract “hot money” into the country which will improve capital balance

DISADVANTAGES OF EXPENDITURE-DISADVANTAGES OF EXPENDITURE-REDUCING REDUCING

1. Limitation : Ineffective if the dd for exports & imports is income and price inelastic.- if dd for imports is income inelastic fall in Y less than proportionate fall in dd for M.- if dd for exports is price inelastic cheaper X less than proportionate increase in Qdx .

DISADVANTAGES OF EXPENDITURE-DISADVANTAGES OF EXPENDITURE-REDUCING REDUCING

2. Other countries may retaliate by imposing trade restrictions.

3. The fall in demand for other countries’ good will result in them losing income which in turn reduce their demand for imports (other countries’ export)

4. Conflicting goals of BOP equilibrium & Full Employment/EG. Contractionary policies fall in Income fall in dd for Ms correct BOP deficit, but result in rise in unN & fall in NY

To cause residents to switch from buying foreign imports to domestic good.

Increase demand for import-substitutesChanging the relative prices of exports

so that more resources are devoted to exportingProtectionism: Tariffs, Quota and

Exchange controlSubsidies/Exports IncentivesDevaluation

EXPENDITURE SWITCHING MEASURES

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EXPENDITURE SWITCHING MEASURES

Protectionist measures :

Tariffs raise the price of imports(Ineffective : if ddm is price inelastic)

Quotas reduce the quantity of imports(Disadv : result in rigidity in the economy as additional gds cannot enter the country prevent firm fr expanding.

Exchange control restricts the amount of foreign currency available for buying imports

(Disadv : fall in confidence of investors as they might find it difficult to repatriate their profits fall in investment)

EXPENDITURE SWITCHING MEASURES

Subsidies/Export Incentives• Subsidies are given to local producers to

make domestically produced goods cheaper than foreign imports(Retaliation by foreign countries) (Protected industries become complacent and inefficient)

• For R&D and to create import substitutes.• Providing detailed information on the market

opportunities on other regions

EXPENDITURE SWITCHING MEASURES

DEVALUATION

Deliberate lowering of the exchange rate of the home currency in terms of other countries’ currency.Intended Effects:

Imports become more expensive in terms of local currency. Switch to locally produced import-substitutes.

Exports made cheaper in terms of foreign currencies

DEVALUATION

Original Exchange rate btw USA & SP

US$1 : S$2

(S$1 : US$0.5)

SP suffers a BOP deficit, devalues her exchange rate

New Exchange rate

Btw USA & SP S$1 : US $ 0.25

Imports : More Expensive in terms of local currency switch to buying local products.

SP Exports : Cheaper in terms of foreign currency

US $1 : S $ 4

Conditions necessary for Devaluation:

1.Demand for exports and imports are price elastic. PEDX >1 → Exports revenue increases

as when PX decrease, Qty ddX increase more than proportionately.

PEDM >1 → Import Expenditure decreases as when PM increase, Qty ddM

decrease more than proportionately. Marshall- Lerner condition. PEDX + PEDM > 1

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J-CURVE ANALYSIS

It has been frequently observed that devaluation to rectify a BOP deficit has often led to an immediate deterioration in BOP position, followed by a subsequent recovery.

This, plotted on a graph is shown below.

J-CURVE

Time

Surplus

Deficit

(+)

(-)

0

Balance of Trade

A

B

C

Conditions necessary for Devaluation:

2. Supply of exports must be price elastic

Only when supply of exports is price elastic (economy is not at full employment; resources can be diverted into the export industries) can producers take advantage of devalution.

Otherwise, there may be a shortage, causing export prices to rise.

Cancel the initial price advantage gained from devaluation.

3. NO retaliation from other countries

Devaluation allows home country to gain at the expense of trading partners.

4. NO speculation/No loss of confidence

Devaluation reduces the external value of a currency and may undermine investment confidence→ foreign investors move their capital out of the country → threat of further weakening of currency → BOP worsen

5. Domestic costs must be kept low Devaluation increase in prices of Ms

higher cost of living especially if demand is price inelastic (foodstuff)

Higher cost of living may trigger wage price spirals as union seeks higher wages increase in price of exports.

6. Exports must not contain a large proportion of imports

Cost of production of exports that contain large proportion of imported raw materials will increase erode initial favourable effects of devaluation

Can we conclude that Persistent BOP deficit is

undesirable and Persistent BOP surplus

is desirable?

A persistent BOP surplus can be undesirable because:

The country is accumulating excess reserves at the expense of other countries →Possible retaliation from trading partner.

Flow of funds and multiplier effect of exports may result in inflation

REMEDIES FOR A BOP SURPLUS

Revaluation of the currencyInflating the economyCurrent account surplus can be eliminated by outflow of funds on the capital account

What is the difference between expenditure reducing and expenditure switching policies to correct BOP disequilibrium?