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Chapter Three

The Balance
of Payments INTERNATIONAL 3
FINANCIAL
MANAGEMENT
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.
EUN / RESNICK
Second Edition
Chapter Three Outline
 Balance of Payments Accounting
 Balance of Payments Accounts
 The Current Account
 The Capital Account
 Statistical Discrepancy
 Official Reserves Account
 The Balance of Payments Identity
 Balance of Payments Trends in Major
Countries
McGraw-Hill/Irwin 3-2 Copyright © 2001 by The McGraw-Hill
Balance of Payments Accounting
 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.

N.B. when we say “a country’s balance of


payments” we are referring to the transactions of
its citizens and government.

McGraw-Hill/Irwin 3-3 Copyright © 2001 by The McGraw-Hill


Balance of Payments Example
 Suppose that Maplewood Bicycle in
Maplewood Missouri, USA imports
$100,000 worth of bicycle frames from
Mercian Bicycles in Darby England.
 There will exist a $100,000 credit recorded
by Mercian that offsets a $100,000 debit at
Maplewood’s bank account.
 This will lead to a rise in the supply of
dollars and the demand for British pounds.

McGraw-Hill/Irwin 3-4 Copyright © 2001 by The McGraw-Hill


Balance of Payments Accounts
 The balance of payments accounts are those that
record all transactions between the residents of a
country and residents of all foreign nations.
 They are composed of the following:

 The Current Account


 The Capital Account
 Statistical Discrepancy
 The Official Reserves Account

McGraw-Hill/Irwin 3-5 Copyright © 2001 by The McGraw-Hill


The Current Account
 Includes all imports and exports of goods and
services.
 Includes unilateral transfers of foreign aid.

 If the debits exceed the credits, then a country is

running a trade deficit.

McGraw-Hill/Irwin 3-6 Copyright © 2001 by The McGraw-Hill


The Capital Account
 The capital account measures the difference
between U.S. sales of assets to foreigners and U.S.
purchases of foreign assets.
 The U.S. enjoys about a $150,000,000,000 capital

account surplus—absent of U.S. borrowing from


foreigners, this “finances” our trade deficit.
 The capital account is composed of Foreign Direct

Investment (FDI), portfolio investments and other


investments.
McGraw-Hill/Irwin 3-7 Copyright © 2001 by The McGraw-Hill
Statistical Discrepancy
 There’s going to be some omissions and
misrecorded transactions—so we use a “plug”
figure to get things to balance.
 Exhibit 3.1 shows a discrepancy of $96.76 billion

in 1997.

McGraw-Hill/Irwin 3-8 Copyright © 2001 by The McGraw-Hill


The Official Reserves Account
 Official reserves assets include gold, foreign
currencies, SDRs, reserve positions in the IMF.

McGraw-Hill/Irwin 3-9 Copyright © 2001 by The McGraw-Hill


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,


BCA + BKA = 0
McGraw-Hill/Irwin 3-10 Copyright © 2001 by The McGraw-Hill
U.S. Balance of Payments Data
Credits Debits
Current Account
1 Exports $1,167.61
2 Imports ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
Balance on Current Account ($166.80)
Capital Account
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
Balance on Capital Account $264.58
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02
Official Reserve Account ($1.02)

McGraw-Hill/Irwin 3-11 Copyright © 2001 by The McGraw-Hill


U.S. Balance of Payments Data
Credits Debits
Current Account In 1997, the
1 Exports $1,167.61
U.S. imported
2 Imports ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
more than it
Balance on Current Account ($166.80) exported, thus
Capital Account
running a
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28) current account
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) deficit of
$264.58
7 Statistical Discrepancies ($96.76) $166.8 billion.
Overall Balance $1.02
Official Reserve Account ($1.02)

McGraw-Hill/Irwin 3-12 Copyright © 2001 by The McGraw-Hill


U.S. Balance of Payments Data
Credits Debits During the same
Current Account
1 Exports $1,167.61
year, the U.S.
2 Imports ($1,295.53)
attracted net
3 Unilateral Transfers $6.13 ($45.01) investment of
Balance on Current Account ($166.80) $264.58 billion
Capital Account
4 Direct Investment $107.93 ($119.44)
—clearly the
5 Portfolio Investment $387.62 ($79.28) rest of the world
6 Other Investments $194.95 ($227.2)
Balance on Capital Account $264.58
found the U.S.
7 Statistical Discrepancies ($96.76) to be a good
Overall Balance
Official Reserve Account
$1.02
($1.02)
place to invest.

McGraw-Hill/Irwin 3-13 Copyright © 2001 by The McGraw-Hill


U.S. Balance of Payments Data
Credits Debits
Current Account
1 Exports $1,167.61
Under a pure
2 Imports ($1,295.53)
flexible
3 Unilateral Transfers $6.13 ($45.01) exchange rate
Balance on Current Account ($166.80) regime, these
Capital Account
4 Direct Investment $107.93 ($119.44) numbers would
5 Portfolio Investment $387.62 ($79.28) balance each
6 Other Investments $194.95 ($227.2)
Balance on Capital Account $264.58
other out.
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02
Official Reserve Account ($1.02)

McGraw-Hill/Irwin 3-14 Copyright © 2001 by The McGraw-Hill


U.S. Balance of Payments Data
Credits Debits
Current Account
1 Exports $1,167.61
In the real
2 Imports ($1,295.53)
world, there
3 Unilateral Transfers $6.13 ($45.01) is a statistical
Balance on Current Account ($166.80) discrepancy.
Capital Account
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
Balance on Capital Account $264.58
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02
Official Reserve Account ($1.02)

McGraw-Hill/Irwin 3-15 Copyright © 2001 by The McGraw-Hill


U.S. Balance of Payments Data
Credits Debits
Current Account
1 Exports $1,167.61
Including that,
2 Imports ($1,295.53)
the balance of
3 Unilateral Transfers $6.13 ($45.01) payments identity
Balance on Current Account ($166.80) should hold:
Capital Account
4 Direct Investment $107.93 ($119.44) BCA + BKA = - BRA
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
Balance on Capital Account $264.58
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02
Official Reserve Account ($1.02)
($166.80) + $264.58 + ($96.76) = $1.02= –($1.02)
McGraw-Hill/Irwin 3-16 Copyright © 2001 by The McGraw-Hill
Balance of Payments and the
Exchange Rate
Credits Debits
Current Account
1 Exports $1,167.61 P S
2 Imports ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
Balance on Current Account ($166.80)
Capital Account
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
$264.58
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02 Q
Official Reserve Account ($1.02) Exchange rate $
McGraw-Hill/Irwin 3-17 Copyright © 2001 by The McGraw-Hill
Balance of Payments and the
Exchange Rate
Credits Debits
Current Account
1 Exports $1,167.61 P S
2 Imports ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
Balance on Current Account ($166.80)
Capital Account
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
$264.58
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02 Q
Official Reserve Account ($1.02) Exchange rate $
As U.S. citizens import, they are supply dollars to the FOREX market.
McGraw-Hill/Irwin 3-18 Copyright © 2001 by The McGraw-Hill
Balance of Payments and the
Exchange Rate
Credits Debits
Current Account
1 Exports $1,167.61 P S
2 Imports ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
Balance on Current Account ($166.80)
Capital Account
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
$264.58
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02 Q
Official Reserve Account ($1.02) Exchange rate $
As U.S. citizens export, others demand dollars at the FOREX market.
McGraw-Hill/Irwin 3-19 Copyright © 2001 by The McGraw-Hill
Balance of Payments and the
Exchange Rate
Credits Debits
Current Account
1 Exports $1,167.61 P SS
2 Imports ($1,295.53) 1

3 Unilateral Transfers $6.13 ($45.01)


Balance on Current Account ($166.80)
Capital Account
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments
Balance on Capital Account
$194.95 ($227.2) D
$264.58
7 Statistical Discrepancies ($96.76)
Overall Balance $1.02 Q
Official Reserve Account ($1.02) Exchange rate $
As the U.S. government sells dollars, the supply of dollars increases.
McGraw-Hill/Irwin 3-20 Copyright © 2001 by The McGraw-Hill
Balance of Payments Trends
 Since 1982 the U.S. has experienced continuous
deficits on the current account and continuous
surpluses on the capital account.
 During the same period, Japan has experienced the

opposite.

McGraw-Hill/Irwin 3-21 Copyright © 2001 by The McGraw-Hill


Balance of Payments Trends
U.S. Balance of Payments Trends

200
Balance of Payments ($b)

150
100
50
Current Account
0
Capital Account
-50
82

84

86

88

90

92

94

96
19

19

19

19

19

19

19

19
-100
-150
-200
Year

McGraw-Hill/Irwin 3-22 Copyright © 2001 by The McGraw-Hill


Balance of Payments Trends
Japan's Balance of Payments Trend

150
Balance of Payments ($b)

100

50
Current Account
0
Capital Account
-50
82

84

86

88

90

92

94

96
19

19

19

19

19

19

19

19
-100

-150
Year

McGraw-Hill/Irwin 3-23 Copyright © 2001 by The McGraw-Hill


Balance of Payments Trends
 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.
 What matters is the nature and causes of the

disequilibrium.
McGraw-Hill/Irwin 3-24 Copyright © 2001 by The McGraw-Hill
Balance of Payments Trends
Germany's Balance of Payments Trend

80
Balance of Payments ($b)

60
40
20
Current Account
0
Capital Account
-20
82

84

86

88

90

92

94

96
19

19

19

19

19

19

19

19
-40
-60
-80
Year

McGraw-Hill/Irwin 3-25 Copyright © 2001 by The McGraw-Hill


End Chapter Three

McGraw-Hill/Irwin 3-26 Copyright © 2001 by The McGraw-Hill