THE BALANCE OF PAYMENTS J.D. Han, King’s University College 12-1.

THE BALANCE OF PAYMENTS

J.D. Han,

King’s University College

12-1

Key Questions

• What is the Balance of Payment?

Supply and Demand of FOREX

2 methods of BP Accounts

• What ‘market’ does the BP affect?

FOREX

• What is the equilibrium of the BP?

• What will happen to FOREX rate if the BP is not in equilibrium.

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Balance of Payments Accounts

• A country’s balance of payments accounts shows its payments to and its receipts from foreigners.

• It shows the flow of “Money”, international currencies or foreign exchanges.

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Balance of Payments Accounts (cont.)

• The ‘New Format’ of 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, or intangible assets like debt forgiveness, copyrights and trademarks; minor for the U.S. Economy

Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley. 12-5

* A little More details:• Each of the 3 broad accounts are more finely

divided:• Current account: imports and exports

1. merchandise (goods like DVDs) 2. services (payments for legal services, shipping

services, tourist meals,…)3. income receipts (interest and dividend payments,

earnings of firms and workers operating in foreign countries

4. net unilateral transfers gifts (transfers) across countries that do not

purchase a good or service nor serve as income



• Financial account: the difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens.

• Financial (capital) inflow Foreigners loan to domestic citizens by acquiring domestic

assets. Foreign owned (sold) assets in the domestic economy are a

credit (+)

• Financial (capital) outflow Domestic citizens loan to foreigners by acquiring foreign

assets. Domestically owned (purchased) assets in foreign

economies are a debit (-)

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• Financial account has3 categories mixed together:

1. All other (“Spontaneous”) financial assets (transactions) by the Private Sector

2. Official (international) reserve assets by the Government

3. Statistical discrepancy


• Official (international) reserve assets: foreign assets held by central banks to cushion against instability in international markets. Assets include government bonds, currency, gold

and accounts at the International Monetary Fund. Official reserve assets owned by (sold to) foreign

central banks are a credit (+); Capital Inflow. Official reserve assets owned by (purchased by)

the domestic central bank are a debit (-): Capital Outflow.

- Overall + means the government is getting credit from elsewhere (as outstanding debt), or running down on the accumulated reserve holdings.

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• The negative value of the official reserve assets is called the official settlements balance or “balance of payments”. It is the sum of the current account, the capital account, the

non-reserve portion of the financial account, and the statistical discrepancy.

A negative official settlements balance may indicate that a country is depleting its official international reserve assets or may be incurring debts to foreign central banks.

• selling foreign currency by the domestic central bank and buying domestic assets by foreign central banks are credits for official international reserve assets, and therefore reduce the official settlements balance.


How Do the Balance of Payments Accounts Balance?

1) “Identity”:

Meaning “the left is equal the right all at times”

Due to the double entry of each transaction, the Balance of Payments Accounts will balance out at all times:

current account + financial account + capital account = 0

2) “Equilibrium Condition”:

The Balance of Payment is in equilibrium when

Current account + All other ‘Spontaneous’ financial assets transaction account = 0


1. Current Account Balance

2. All other ‘spontaneous’ financial transactions Account in the private sector

____________ (‘the above line’ Balance of Payment

= Official Settlement Balance)

3. Credits(+)/Debits(-) from Official Reserves

1+ 2 + 3 = 0 all the time

The above means

Items of 1+2 and item 3 are the mirrored terms: of the same size, but of the opposite sign.


• Credits in the Official Reserves(flows) are equivalent to Cashing your savings/wealth:

• When you are in deficits, you cash Your Office Reserves(stock), or issue IOUs and thus get Credits from Official Reserves(flows):

“Your Official Reserves decrease(-) as you get Credits from the Official Reserves(+)”

Modified by JD. Han based on Materials provided by Pearson Addison-Wesley. 12-13

U.S. has a very small stock of International Reserves (of FOREX)

http://en.wikipedia.org/wiki/Foreign_exchange_reserves

http://www.ustreas.gov/press/releases/20106291240258293.htm




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• The Balance of Payment is the important measure of ‘immediate’ pressures on a country’s Official Reserves and thus on that country’s FOREX rates.

* Overall or long-term pressure on the country’s FOREX rate is measured by the Current Account Deficits:

eg) pp.298 of Salvatore’s book (7th edition)

Let’s take two examples of the U.S. BOP table(2003; 2005), and read them so that we can make a sense out of it:


Modified by J.D. Han based on Materials provided by Pearson Addisn-Wesley. 12-17

US Balance of Payments Accounts, 2003 in Billions of Dollars


US Balance of Payments Accounts, 2003 in Billions of Dollars (cont.)

U.S. Balance of Payment, 2005


Salvatore’s Page P. 457

Current Account Balance = $-791 billions

The ‘Spontaneous’ Financial Account Balance = + 567 billions

(‘The above line’ Balance of Payment = -224 billions )_______________________________________________

Changes in Official Reserves = +213 billions

Statistical Errors = 11 billions_________________________________Net = 0

How to interpret this BP Table?

• The U.S. citizens and government could buy foreign goods and services by $ 791 billions more from abroad than what they sell to abroad. They got financing by selling $ 567 billions of financial and real assets to abroad.

• And the shortage of $ 213 billions had to be funded by the government’s run-down and borrowings on the ‘safe’ of “Official Reserves”.

BP disequilibrium and Pressures on FOREX rates

• At disequilibrium, the price would change so that the disequilibrium be eliminated.

• BP deficits put upward pressures on FOREX and downward pressure on domestic currency.


Modified by J.D. Han based on Materials provided by Pearson Addison-Wesley.

Summary

• ‘Above the line BP’ = CA + ‘Spontaneous Part’ of FA

= CA + (Financial Account – Official Reserve Assets )

• BPA = BP + Net Official Reserve Asset Credit

= 0 at all times

IMF Method of BP Account

• Current Account

• Capital Account

• Financial Account

• Errors

• Reserves


IMF’s Financial Account 1. (Foreign) Direct Investment abroad(outflows)

(Foreign) Direct Investment in the nation(inflows)

2. Portfolio Investment Assets(outflows)

Equity Securities; Debt Securities

Portfolio Investment Liabilities (inflows)

Equity Securities; Debt Securities

3. Financial Derivatives Asset

Financial Derivate Liabilities

4. Other Investment Assets

Banks; Government and Monetary Authorities

Other Investment Liabilities

Bank s

THE BALANCE OF PAYMENTS J.D. Han, King’s University College 12-1.

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