Topic 3
Balance of Payments
Reading: Ch.3
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FIN6108
International Financial Management
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At the end of this topic, you should be able to:
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 Describe the importance of balance of payments (BOP)
 Distinguish the main components in the BOP account
 Tell the twin surpluses in China’s BOP account
 Analyze the implications of a surplus / deficit BOP account on exchange
rate movements and on official reserves
 Explain how BOP interact with macroeconomic variables
 Describe how the trade-balance adjusts as a result of a change in exchange
rate: The J-curve
 Distinguish capital mobility, capital controls and capital flight
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The Balance of Payments
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 The measurement of all international economic transactions (e.g., imports
& exports of goods & services and cross-border investments in businesses,
bank accounts, bonds, stocks, and real estate) between the residents of a
country and foreign residents is called the balance of payments (BOP).
Residents
of a
country
Residents
of foreign
countries
International
economic
transactions
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BOP data is important for government policymakers and MNEs as it is a gauge of a
nation’s competitiveness or health:
 BOP provides information concerning the demand for and supply of a country’s
currency.
 (e.g., if UK exports more than imports, pound sterling is likely to appreciate)
 A country’s BOP data signals its potential as a business partner for the rest of the
world.
 (e.g., a country with BOP deficit may try to reduce imports and discourage
capital outflow)
 BOP data can be used to evaluate the performance of the country in international
economic competition.
 (e.g., year-after-year trade deficits may imply the country’s industries lack
international competitiveness)
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The BOP as a Flow Statement
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 The BOP is NOT a balance sheet, BUT it is a cash flow statement.
 By recording all international transactions over a period of time (e.g., a
year), it tracks the continuing flows of purchases and payments between a
country and other countries.
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TWO types of business transactions dominate the balance of payments:
(1) Exchange of Real Assets: the exchange of goods (e.g., computers,
watches, etc.) & services (e.g., banking, travel services, etc.) for other
goods & services or for money.
(2) Exchange of Financial Assets: the exchange of financial claims
(e.g., stocks, bonds, loans, and purchases or sales of companies) for other
financial claims or money.
 Although assets can be identified as belonging to distinct groups, it is
easier to think of all assets simply as goods that can be bought or sold
(e.g., a clock vs. a bond).
 Transactions of these assets/goods lead to cash flows into / out of a
country.
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Fundamentals of BOP Accounting
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 The BOP must balance unless something has not been counted or has
been counted improperly.
 So, it is incorrect to state that the BOP is in disequilibrium.
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BOP Accounts
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The BOP is composed of four accounts:
(1) Current Account
(2) Capital Account and Financial Account
(3) Official Reserves Account (tracks government currency transactions)
(4) Net Errors and Omissions Account is produced to preserve the balance
of the BOP
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Balance of Payments Accounts
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Capital &
Financial
Account
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The Current Account (CA)
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CA includes all international economic transactions with income or
payment flows occurring within one year, the current period. It consists of
the following 4 sub-categories:
 Goods trade (includes exports & imports of tangible goods like
wheat, clothes, computers, etc.)
 Services trade (includes payments & receipts for legal, consulting,
royalties, insurance premiums, tourist expenditures, etc.)
 Factor income (consists largely of payments & receipts of interest,
dividends, & other income of previously-made foreign investments)
 Current transfers (includes foreign aids, gifts, private grant, etc.)
 CA typically dominated by the first component which is known as the
Balance of Trade (BOT) even though it excludes services trade
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The US Current Account (CA) 2015-2021 (US$ Millions)
11 https://data.imf.org/regular.aspx?key=62805740 (visit IMF data and choose United States)
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The Capital and Financial Account
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The Capital and Financial Account (KAFA) measures all international
economic transactions of financial assets.
 It is divided into 2 major components:
(a)The Capital Account: made up of the acquisition & disposal of non-
produced/non-financial assets.
(e.g., land, patents, copyrights, trademarks & franchises, etc.)
The magnitude of capital transactions covered is minor.
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(b) The Financial Account measures international economic
transaction of financial assets
 assets can be classified in a number of different ways including the length
of the life of the asset (maturity) and the nature of the ownership (public
or private).
 The Financial Account focuses on the degree of investor control over the
assets or operations.
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(b) The Financial Account consists of 3 main components:
(i) Direct
Investment
in which the investor exerts some explicit degree of
control over the assets (e.g., build a factory or purchase
a company in another country)
(ii) Portfolio
Investment
in which the investor has no control over the assets
(iii) Other
Investment
consists of various short-term and long-term trade
credits, cross-border loans, currency deposits, bank
deposits and other accounts receivable and payable
related to cross-border trade
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(i) Direct investment
 This is the net balance of capital dispersed from and into the domestic
country for the purpose of exerting control over assets.
 (e.g., in U.S., foreign direct investment arises from 10% ownership of
voting shares in a domestic firm by foreign investors)
 Some countries possess restrictions on what foreigners may own in their
country (the media industry in particular).
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(ii) Portfolio Investment
 This is the net balance of capital that flows in and out of the domestic
country but does not reach the threshold (e.g., 10% in US) of direct
investment.
 The purchase of debt securities (e.g., bonds) across borders is classified
as portfolio investment because debt securities by definition do not
provide the buyer with ownership or control.
 Portfolio investment is motivated by a search for returns rather than to
control or manage the investment.
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(iii) Other investment
 Consists of various short-term & long-term trade credits, cross-border
loans from all types of financial institutions, currency deposits and bank
deposits, and other accounts receivable and payable related to cross-
border trade.
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The US Capital and Financial Accounts and Components, 2015 - 2021 (US$ Millions)
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Official Reserves Accounts and Net Errors & Omissions
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The Official Reserves Account is the total reserves held by official monetary
authorities within the country.
 These reserves are normally composed of the major currencies used in
international trade and financial transactions (e.g., US$, euro, Japanese
yen, gold and SDRs).
 The significance of official reserves depends generally on whether the
country is operating under a fixed exchange rate regime or a floating
exchange rate system.
 Under a fixed exchange rate system, more official reserves are required
because the government has the obligation to buy/sell foreign exchange
in order to maintain a fixed rate.
The Net Errors and Omissions account ensures that the BOP actually
balances.
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The US Official Reserves Accounts and Net Errors & Omissions, 2015-2021 (US$ Millions)
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The BOP Identity
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 If BOP accounts are recorded correctly, Net Errors & Omissions
account will be zero, then the combined balance of the current account
(CA), the capital and financial account (KAFA) and the official reserves
account (OR) must be zero:
CA + KAFA + OR = 0
 The equation above indicates that a country can run a BOP surplus
(deficit) by increasing (decreasing) its official reserves.
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 Under the fixed exchange rate regime, if CA+KAFA is positive,
without adjusting the exchange rate, central banks will buy foreign
currency and that leads to a rise in the official reserves (but in opposite
sign).
CA + KAFA = -OR
 Under a pure floating exchange regime, central banks will not
intervene in the foreign exchange market and so not required to hold
foreign reserves. OR will be zero and
CA = -KAFA
 i.e., a current account surplus (deficit) must be matched by a capital &
financial account deficit (surplus), & vice versa.
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International flow of goods, services, and capital
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 According to the above analysis, the KAFA balance is related to the CA
balance, but what exactly determines the size of CA?
 Since CA is determined mainly by exports & imports of goods and
services …..
Basic identities:
National spending:
E = C + I + G + X – M
National Income (or national product):
Y= C + Sp + T where Sp is private saving & T is taxes
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Equilibrium in product market is found by equating expenditure with
output, i.e., E = Y
C + I + G + X – M = C + Sp + T
I – Sp –T + G + X – M = 0
I – (Sp + Sg) + X – M = 0 where Sg (govt. saving) = T - G
(I – Sn) + (X – M) = 0 where Sn (national saving) = Sp + Sg
OR
Sn – I = X – M
 If a nation’s saving exceeds its domestic investment, its surplus capital has
to be invested overseas. The nation will run a deficit KAFA, but a surplus
in CA.
 Sn – I can be interpreted as net foreign investment
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Relationship between CA and KAFA
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 US: It saves less than it invests (Sn < I), it must run a deficit CA
(M>X) , and “finance” the CA deficits through surpluses in KAFA.
(-)CA + KAFA =0
 Japan: As Japan has a high saving rate, Sn > I, hence X>M. Japan’s CA
surplus is matched against a KAFA deficit.
CA + (-)KAFA =0
 China: Surpluses in both CA and KAFA, it accumulates lots of foreign
reserves over the years.
CA + KAFA = -OR
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China’s Twin Surpluses, 1998-2016 (US$ bn.)
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The rapid rise of the Chinese economy has been accompanied by a 10-fold
increase in foreign exchange reserves (see figure below; US$ bn.)
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As a result, China’s foreign exchange reserves are approximately 2.5 times
larger than the next largest, Japan (see figure below; US$ bn.)
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The BOP in Total
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 The table next page provides a comprehensive overview of how the
individual accounts are combined to create some of the most useful
summary measures for multinational business managers.
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The US Balance of Payments, Analytic Presentation, 2015-2021 (millions of U.S. $)
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A
B
C
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The BOP in Total — Surplus & deficit
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 Total of groups A, B, and C (in former table) form the basic balance;
this is one of the most frequently used summary measures of the BOP
 A surplus in basic balance implies an excess demand for the
country’s currency in foreign exchange market, and the government
should allow the currency value to increase – in value – or intervene
and accumulate additional foreign currency reserves in the Official
Reserves Account (e.g., China in slide 25: CA + KAFA = -OR)
 A deficit in basic balance implies an excess supply of the
country’s currency in foreign exchange market, and the government
should then either devalue the currency or expend its official reserves
to support its value.
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The BOP interaction with key macroeconomic
variables
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 A nation’s balance of payments interacts with nearly all of its key
macroeconomic variables
 “Interacts” means that the BOP affects and is affected by such key
macroeconomic factors as:
 Gross Domestic Product (GDP)
 The exchange rate
 Interest rates
 Inflation rates
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The BOP and GDP
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 In a static (accounting) sense, a nation’s GDP can be represented by the
following equation:
GDP = C + I + G + X – M
C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
X – M = the current account balance (when including current income
and transfers)
 A positive (negative) current account balance increases (decreases)
GDP.
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 In a dynamic (cash flow) sense, an increase or decrease in GDP
contributes to the current account deficit or surplus.
 As GDP grows, so does disposable income and capital investment.
Increased disposable income leads to more consumption and imports.
 GDP ↑ → import ↑ → (X - ↑M)↓
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The BOP and Exchange Rates
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The relationship between the BOP and exchange rates can be illustrated
by an equation that summarizes BOP Data:
(X – M) + (CI – CO) + (FI – FO) + OR = BOP
Where:
X = exports of goods and services
M = imports of goods and services
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
OR = official monetary reserves
CA Balance
KAFA Balance
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 Fixed Exchange Rate Countries
 the government bears the responsibility to ensure that the BOP is near
zero.
 e.g., If CA + KAFA > 0, an excess demand for the domestic currency
exists. Govt. must sell domestic currency for foreign currencies or gold.
 Floating Exchange Rate Countries
 the government has no responsibility to peg/fix its foreign exchange
rate.
 Managed Floats
 Countries operating with a managed float often find it necessary to take
action to maintain their desired exchange rate values.
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The BOP and Interest Rates
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 Apart from the use of interest rates to intervene in the foreign exchange
market, the overall level of a country’s interest rates compared to other
countries does have an impact on the capital & financial account of the
BOP
 Relatively low (high) real interest rates in domestic country should
normally stimulate an outflow (inflow) of capital seeking higher rates
elsewhere (here)
 r↑→ capital & financial inflows↑
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The BOP and inflation rate
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 Imports have the potential to lower a country’s inflation rate
imports ↑→ inflation↓
 In case lower-priced imports substitute for domestic production and
employment, GDP will be lower, and the balance of current account will
be more negative.
imports ↑→ domestic production↓ & employment↓→GDP↓→CA↓
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Trade Balances and Exchange Rates
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 A country’s import and export of goods and services is affected by
changes in exchange rates.
 In principle, the transmission mechanism is quite simple: changes in
exchange rates change relative prices of imports and exports and changing
prices in turn result in changes in quantities demanded through the price
elasticity of demand.
 Theoretically, this is straightforward; in reality global business is more
complex.
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Trade Balance Adjustment to Exchange Rate Changes: The J-Curve
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Trade balance = (PX
$QX) – (S
$/fc PM
fcQM)
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Capital Mobility, Capital Controls & Capital Flight
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 The degree to which capital moves freely across borders is critically
important to a country’s balance of payments
 The free flow of capital in and out of an economy can potentially
destabilize economic activity or can contribute significantly to an
economy’s development.
 A capital control is any restriction that limits or alters the rate or
direction of capital movement into or out of a country.
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Capital flight, though no single definition, is characterized as occurring
when capital transfers by residents' conflict with political objectives.
 Capital can be moved via international transfers, with physical
currency, collectables or precious metals, money laundering or false
invoicing of international trade transactions.
 Many heavily indebted countries have suffered capital flight, that not
only compounding their debt service problems but also leading to
significant changes in exchange rate.
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end