CRICOS code 00025B
FINM 7406
Lecture 4:
Balance of Payments
Instructor: Dr Khoa Hoang
Reading: Eun Resnick Chapter 3
CRICOS code 00025B
• The BOP is a statistical record of the flow of all of the payments between the
residents of a country and the rest of the world in a given year.
Multinational businesses use various BOP measures to gauge the growth
and health of specific types of trade or financial transactions by country
and regions of the world against the home country
Monetary and fiscal policy must take the BOP into account at the national
level---the BOP gives indications of the demand and supply of a
country’s currency.
The Balance of Payments (BOP)
FINM7406 2
CRICOS code 00025B
Overview
Σ (A:E) = Overall Balance
FINM7406 3
A. Current Account
A. Net exports/imports of goods and services (Balance of Trade)
B. Net Income (investment income from direct portfolio investment
plus employee compensation
C. Net transfers (sums sent home by migrant and permanent
workers abroad)
B. Capital Account
Capital transfers related to purchase and sale of fixed assets such as real estate
C. Financial Account
A. Net foreign direct investment
B. Net portfolio investment
C. Other financial items
D. Net Errors and Omissions
Missing data such as illegal transfers
E. Reserves and Related Items
Changes in official monetary reserves including gold and foreign exchange
reserves
CRICOS code 00025B
• Transactions are recorded on the basis of double entry bookkeeping – by
definition it has to balance
Every “source” must have a “use”
• Every economic transaction recorded as a credit brings about an equal and
offsetting debit entry.
• BOP is a statement of flows, thus like a cash flow statement, not a balance
sheet
Fundamentals of BOP Accounting
FINM7406 4
CRICOS code 00025B
• Any transaction resulting in a payment to foreigners is entered in the BOP
accounts as a debit and is given a negative sign.
• Any transaction resulting in a receipt from foreigners is entered as a credit
and given a positive sign.
• To reiterate, every international transaction automatically enters twice, once
as a credit and once as a debit
Accounting Principles
FINM7406 5
CRICOS code 00025B
• It is record of a country’s trade in goods and services and of unilateral
transfers.
• It is divided into 3 sub-categories:
Merchandise Trade: physical goods like beef, cars etc.
Services: interest payments, dividends, consulting etc.
Unilateral transfers: foreign aid, wages repatriated
• The sum of the three sub-categories = CA balance
CA = Exports (X) – Imports (M)
The Current Account (CA)
FINM7406 6
CRICOS code 00025B
The Current Account (cont.)
• Current Account Deficit: M > X → CA < 0
• Current Account Surplus: M < X → CA > 0
Current Account Balance = Change in Net Foreign
Wealth/Assets
Implication: A country with a CA deficit must be increasing its net foreign debts by the amount
of the deficit
CA = Exports (X) – Imports (M)
FINM7406 7
CRICOS code 00025B
The Australian Current Account
FINM7406 8
CRICOS code 00025B
China Current Account
FINM7406 9
CRICOS code 00025B
• It includes all short- and long-term financial transactions pertaining to both
international trade and flows associated with portfolio shifts (stocks, bonds
etc.)
KA = Capital Inflow (cr) – Capital outflow (dr)
• The two main categories:
Portfolio investment
Direct investment (takeover or acquiring a substantial portion of a foreign
company)
• KA balance = Sum of portfolio investment and direct investment
The Capital Account (KA)/Financial Account
FINM7406 10
CRICOS code 00025B
• Net Errors and Omissions (Balancing Item) – Account is used to account for
statistical errors and/or untraceable monies within a country
• Official Reserves – total reserves held by official monetary authorities within a
country.
These reserves are typically comprised of major currencies that are used in
international trade and financial transactions and reserve accounts (SDRs)
held at the IMF.
 Important account for fixed-rate regime countries.
• For floating rate regime countries, such as the U.S., official reserves relatively
unimportant.
The Other Accounts
FINM7406 11
CRICOS code 00025B
Example:
 Dell sells $20 mil of computers to Komatsu, a Japanese manufacturer of construction and mining
equipment. Komatsu transfers dollars from its dollar-denominated bank account at Citibank in New
York? What are the credit and debit items on the US balance of payments?
FINM7406 12
US BOP Dr Cr
Computer exports (CA) $20 mil
Citibank foreign deposits
decrease (KA outflow)
$20 mil
CRICOS code 00025B
Example:
 LVMH, a French luxury goods buys EUR1.5 mil of consulting services from Boston Consulting
Group (BCG). The firm writes a check on its euro-denominated bank account at different Paris
Bank, BNP Paribas. What are the credit and debit items on the French balance of payments?
FINM7406 13
French BOP Dr Cr
Purchase of consulting
services (CA or KA)
??? ???
BNP deposits (CA or KA) ??? ???
CRICOS code 00025B
In Sum, …
Σ (A:E) = Overall Balance
FINM7406 14
A. Current Account
A. Net exports/imports of goods and services (Balance of Trade)
B. Net Income (investment income from direct portfolio investment
plus employee compensation
C. Net transfers (sums sent home by migrant and permanent
workers abroad)
B. Capital Account
Capital transfers related to purchase and sale of fixed assets such as real estate
C. Financial Account
A. Net foreign direct investment
B. Net portfolio investment
C. Other financial items
D. Net Errors and Omissions
Missing data such as illegal transfers
E. Reserves and Related Items
Changes in official monetary reserves including gold and foreign exchange
reserves
CRICOS code 00025B
• Assuming change in official reserves and errors approximately zero:
Current Account = (-) Capital/Financial Account
The Balance of Payments
This will hold approximately
for floating rate countries.
FINM7406 15
CRICOS code 00025B
US Current & Capital Accounts (1982-2015)
FINM7406 16
CRICOS code 00025B
• The two major sub-accounts of the BOP, the Current and Capital/Financial
Account, summarize the current trade flows and international capital flows of
a country.
• The Current and Capital/Financial Account are typically inverse on balance,
one in surplus while the other experiences deficit. (CA ≈ -KA) or (-CA ≈ KA)
• Although most nations strive for Current Account surpluses, it is not clear that
a zero balance or a surplus on the Current Account is necessarily desirable.
Summary so far
FINM7406 17
CRICOS code 00025BFINM7406 18
BOP of Five Countries (1982 - 2015)
CRICOS code 00025BFINM7406 19
Current & Capital Accounts (1982-2015)
CRICOS code 00025B
• A real depreciation makes imports look expensive and exports competitive.
• However, the change in spending patterns takes time.
• In the interim, we have nearly the same level of imports and exports.
• But the price of imports relative to domestic output has increased, causing a
decline in the trade balance.
The J-Curve
N
et
c
ha
ng
e
in
T
ra
de
B
al
an
ce
+
0
-
Time
Trade balance eventually improves
Trade balance initially deteriorates
Currency Depreciation
FINM7406 20
CRICOS code 00025B
• The trade balance adjustment process is occurred in three stages:
- The currency contract period;
- the pass-through period; and
- the quantity adjustment period.
• Australian trade balance =
Export (X) - Import (M)( ) − (/)
The J-curve adjustment process
FINM7406 21
CRICOS code 00025B
Figure 11.5 – Trade balance adjustment to exchange
rate changes: the J-curve
Source: Eiteman et al., Page 80
Export (X) - Import (M)( ) − (/)
FINM7406 22
CRICOS code 00025B
• Formal analysis of interpreting a current account deficit as
1. “a country is living beyond its means”
OR
2. “a country is an oasis of opportunity”
Is the Current Account Deficit necessarily bad?
FINM7406 23
CRICOS code 00025B
• A country must finance its current account deficit by borrowing from
foreigners, or, drawing down its previously accumulated foreign wealth.
• A country with a current account surplus acquires claims on foreign assets,
or, increases its net foreign wealth.
Is the Current Account Deficit necessarily bad?
FINM7406 24
CRICOS code 00025B
International Investment Position
Persistent current account
deficits cumulate. The result
is foreigners own more U.S.
assets than Americans own
foreign assets.
FINM7406 25
CRICOS code 00025B
• Y = National Income =GDP
• C + I + G = Domestic Residents Spending / Absorption
• CA = excess of spending over income earned (Income – Spending)
• CA Deficit → CA < 0 → Borrowing from Abroad to finance domestic spending
• CA Surplus → CA > 0 → Lending Abroad
The National Income Identity
Y = C + I + G + CA
Y - (C + I + G) = CA
National Saving = S = Y – C – G
S = I + CA
S = Domestic Investment (I) + Net Foreign Investment (CA)
Y-C-G=I+CA
CA=X-M
Y-C-G = I+CA
FINM7406 26
CRICOS code 00025B
• A country must finance its current account deficit by borrowing from
foreigners, or, drawing down its previously accumulated foreign wealth.
• A country with a current account surplus acquires claims on foreign assets,
or, increases its net foreign wealth.
So...
S = I + CA or S - I = CA = Net Foreign Investment
S = Domestic Investment (I) + Net Foreign Investment (CA)
Recall (slide 10) Current Account Balance = Change in Net Foreign Wealth/Assets
FINM7406 27
CRICOS code 00025B
• Macro identities for a country:
• Eq 1: National Income = Consumption + Savings
• Eq 2: National Spending = Consumption + Investment
• Eq1 – Eq2:
National Income – National Spending = Savings – Investment
= Net foreign investment
= CA ≈ -KA
• If National Savings > National Investment,
Net foreign investment > 0
 If a country’s income exceeds its spending, savings will exceed domestic
investment, yielding surplus capital. This surplus capital will be invested overseas,
and will be reflected as a capital account deficit for that country (more capital is
flowing out of the country than into it).
Macroeconomic Accounting Identities
Recall: S - I = CA=Net foreign investment
FINM7406 28
CRICOS code 00025B
• Conversely:
• If National Saving < National Investment,
• Or National Investment > National Saving
• = Net foreign investment < 0
• If a country’s spending exceeds its income, domestic savings is not enough to fund
domestic investment, the country will import capital. This deficit of capital will come
from overseas, and will be reflected as a capital account surplus for that country.
• The link between the capital and current account:
• National Income – National spending = Exports – Imports
• Savings – Investment = Exports – Imports
Macroeconomic Accounting Identities
Recall :
Savings – Investment
= Net foreign investment
= CA ≈ -KA or -CA ≈ KA
FINM7406 29
CRICOS code 00025B
• Government budget deficits and current account deficits:
• National spending (NS) = Household (HH) spending + private investment
(PI) + govt. spending
• HH spending = National income (NI) – private savings (PS) – taxes (T)
• So, National spending = NI – PS – T + PI + Govt. Spend
• NI – NS = (PS – PI) + (Taxes – govt. spend)
= Savings surplus + Govt. surplus
= Exports – Imports
• Current account deficit implies private savings + govt. budget is in deficit
Macroeconomic Accounting Identities
FINM7406 30
CRICOS code 00025B
• Thus, a current account deficit means a country is not saving enough to
finance its domestic investment + government budget deficit
• Thus, a current account deficit represents a collective national decision to
consume and invest more than the nation is producing.
NI – NS = (PS – PI) + (Taxes – govt. spend)=CA
Macroeconomic Accounting Identities
FINM7406 31
CRICOS code 00025B
• A growing economy can expect to run a current account deficit (CAD)
Countries that have large investment opportunities can run large current account deficits. Sometimes it
makes sense to borrow abroad temporarily. (recall CA = S – I)
• The absolute level of both savings and investment are important
A CAD caused by low savings (high consumption spending) is less likely to be sustainable than a CAD
because of high investment (recall CA = S – I)
This is because higher investment increases future production capacity and the ability to pay back
foreign liabilities
• Composition of Investment Spending is important (recall CA=X-M)
The more the investment is in traded goods, then more likely to generate trade surpluses.
(recall CA=X-M)
• The manner in which CA deficits are financed matters
Sustainability of Current Account Deficits
FINM7406 32
CRICOS code 00025B
• Explanations:
Lagged Effects
J-Curve (discussed earlier)
Demand for a country’s assets
• Responses:
Currency Depreciation
Protectionism
Restrictions on Foreign Investors
Boosting the savings rate
NI – NS = (PS – PI) + (Taxes – govt. spend)
CA Deficits: Explanations and Responses
-CA = X-CA ≈ +KA
FINM7406 33
CRICOS code 00025B
Thank you