Chapter 2

Balance of Payment
 Objectives of the Chapter
• Definition
• Components of BOP
• Factors Affecting International Trade Flows
• Correcting BOT
• DFIs by US Firms
• DFIs in US
• Factors affecting DFIs
• Factors affecting International Portfolio Investment
• Agencies Help correcting BOP
 Definition
“A balance of payments (BOP) sheet is an accounting record of
all monetary transactions between a country and the rest of the
world”. Sloman, John (2004)

“A record of all transactions made between one particular

country and all other countries during a specified period of
time”.

“Balance of payments may be used as an indicator of economic

and political stability”.

“The BOP summarizes international transactions for a specific

period, usually a year, and is prepared in a single currency,
typically the domestic currency for the country concerned”.
 Positive BoP
• Sources of funds for a nation, such as exports or
the receipts of loans and investments, are
recorded as positive or surplus items.

• A Positive balance of payments means that more

money is flowing in the country than going out
 Negative BOP

• Uses of funds, such as for imports or to invest

in foreign countries, are recorded as a negative
or deficit items.

• A negative balance of payments means that

more money is flowing out of the country than
coming in.
 Components of BOP

• Current Account

• Capital Account

• Official Reserve Account

 Current Account
The difference between a nation's
• Total exports of goods, services and transfers,
and its
• Total imports of them.

Current account balance calculations exclude

transactions in financial assets and liabilities.
 Components of Current Account

a) Balance of Trade (BoT)

b) Factor Income

c) Unilateral Transfers
 Balance of Trade (BoT)

• Merchandise (Exports & Imports)

• Services (Exports & Imports)

 Factor Income
Income from:
 Dividends

 Interest

 Income earned by workers overseas

• Compensation of employees
Income of workers employed in an economy where they are
not resident
- (Eg: Pak workers in Microsoft Corporation)
Income of residents employed by nonresident entities
- (Eg: People working in Pierre Cardin situated in
Pakistan)
Personal transfer
It consist of all current transfers in cash or in kind
made or received by resident households to or
from nonresident households.
- (Eg: Mr. A sending money from US to his friend
in Pakistan)
 Unilateral Transfers

• Aids

• Grants

• Gifts
 Capital Account

a) Foreign Direct Investment

b) Portfolio Investment

c) Other Capital
 Foreign Direct Investment
“An investment abroad, usually where the company
being invested in is controlled by the foreign
corporation”.

Investment in real assets in foreign countries

such as:

• Land
• Building
• Existing plant
 Statistical Discrepancy
• It represents errors due to unrecorded transactions
involving smuggling and other capital

• Also known as Errors & Omissions

• Many experts believe that it is the result of large

hidden capital flows, and so the item has been
placed in the capital account part of the BOP
 Factors Affecting Balance of Trade

• Inflation
• National Income
• Government Restrictions
• Exchange Rates
 HIGH INFLATION

Current Account (-) Dr

HIGH INCOME LEVEL

Current Account (-) Dr

 Government Restrictions

• Tariffs
• Quotas
EXCHANGE RATES

Current Account (-) Dr

 INTEREST RATES

Capital Account (+) Cr

 Correcting the trade deficit
• Any policy that increases demand for country’s
goods and services

• It will increase the Balance of Trade

Solution
i. If export price becomes attractive
ii. Floating rate may correct the deficit
iii. Trade deficit may experience an stable currency
i. If export price becomes attractive

It will increase the Balance of Trade

This can occur when a country has:

o Low inflation
o Low currency value
ii. Floating rate may correct the deficit
What is Deficit
• When country is spending more on foreign goods
• When country is receiving less from exports

It means
 When more supply of home currency for sale
 The value of its currency will decrease
 This decrease will encourage more foreign demand of home made
products
 Therefore CA will increase

But this technique may not always work

 What is Floating Exchange Rate
A country's exchange rate regime where its currency
is set by the foreign-exchange market through
supply and demand for that particular currency
relative to other currencies.

Thus, floating exchange rates change freely and are

determined by trading in the forex market.
 iii. Trade deficit may experience stable
currency
Again Recall “DEFICIT”
• Spending more on foreign goods
• Receiving less from exports
• Low demand of currency

Resulting in low value of currency

NOW
• Investment in securities becomes attractive for foreigners
• Increased demand of home currency
Upward pressure on home currency

Therefore the trade imbalance will be offset by positive

capital account
 BUT
Weak Currency may not always be the solution

There may be

•Counter pricing by competitors

•Impact of other weak currencies
•Pre-arranged International Transaction
•Inter Company Trade
 Counter pricing by competitors

- Once low priced items seem more attractive to the

foreign customers
- The competing countries may also lower the price
 Impact of other weak currencies
- The home currency does not necessarily weaken against
all currencies at the same time
Eg:
- It is possible that the Pakistani rupee may weaken against
Indian currency, So Pakistan may stop buying Indian
products
But
- Pakistan may start buying from other countries where Pak
Rupee is still stable i.e. Bangladesh, Srilanka, Iran etc
 Pre-arranged International Transaction
 If the home currency is lower in value

 It is not possible that every country will frequently start buying

from here

 Till the time countries become aware about the cheap product

 Lower rate may not be available till that time

 Due to time lag weak currency strategy is not always

possible
 Inter-Company Trade
• Importers and exporters under the same ownership have unique
relationship

• Many firms use to buy the products from their subsidiaries

• This type of trade makes 50% of trade

• Trade between countries may not affect exchange rates

 Outflow Inflow

• Inflow Outflow
 Correcting BOP
When all components of the BOP sheet are included
• It must balance
• It must sum to zero
• There can be no overall surplus or deficit.
Eg: - If a country imports more than it exports
- It’s trade balance will be in a deficit
But It has to be balanced
By running down reserves or by receiving loans
from other countries.
Lets rename it the imbalance of payments
and announce its normal….
 The Official Reserve Account
“It is the foreign currency and securities held by the
Govt.”

• Usually by its Central bank

• It is used to balance the payments from year to year

• It increases when there is a trade surplus

• It decreases when there is a deficit

• Sometimes the Central Bank use it to change the

exchange rate when the government perceives as more
favorable
 Agencies that help to Correct
BOP Deficit
• IMF
• IBRD
• WTO
• International Financial Corporation
• International Development Association
• Bank of International Settlements
• Regional Development Agencies
 IMF
• A result of UN Monetary & Financial Conference
in 1944
 Objectives of IMF
• To promote Cooperation among countries

• To promote stability in exchange rates

• To provide temporary funds to member countries

attempting to correct imbalances of international
transactions

• To promote free mobility of funds across countries

• To promote free trade

 Compensatory Financing Facility (CFF)
• This facility is mainly used by developing countries

• Each country is assigned a quota

• The amount of fund that a member country can borrow

depends upon its quota

• The country must be willing to work with IMF to resolve

the problem
 SDRs
• An international reserve asset created by IMF in 1969

• The financing by IMF is measured in SDRs

• IMF allocates it to member countries to supplement

currency reserves

• It is not a currency but a unit of account

The SDR basket and Its Valuation

Currency Amount Exchange US $

in 1 SDR Rate vs Equivalent
US $
(1) (2) (1) * (2)
USD 0.5770 1.00000 0.577000
Euro 0.0984 1.42550 0.140269
GBP 0.4260 0.88140 0.375476

• Yen 21.0000 125.07000 0.167906

• Total 1.260651
 IBRD
• Established in 1944
• Structural Adjustment Loan (SAL) in 1980
• It spread its funds through co-financing:
 Official Aid Agencies
(projects)
 Export credit agencies
 Commercial Banks
 Correcting BOP Problems
Roberts, Richard (1999)

• The fundamental function of International Monetary System is to

provide mechanisms to correct imbalances.
• Even a mixture of at least the first two methods may be used.
Methods:
There are three possible methods to correct BOP imbalances
• Adjustments of exchange rates
• Adjustment of a nations internal prices along with its levels of demand
• Rules based adjustment

Note: Improving productivity and competitiveness can also help to enhance the
exports through other means BUT
It is generally assumed that a nation is always trying to develop and sell its
products to the best of its abilities.