Chapter 2 The Balance of Payments

What is the Balance of Payments?

The balance of payments is a statistical record of all the economic transactions between residents
of the reporting country and residents of the rest of the world.
The balance of payments reveals how many goods and services the country has been exporting and
importing and whether the country has been borrowing from or lending money to the rest of the
world.
o It also shows whether or not the central monetary authority (usually the central bank) has
added to or reduced its reserves of foreign currency.
Some issues:
Definition of the term residents domestic or foreign? (Refer to page 31).
o Multinationals are, by definition, resident in more than one country. For the purpose of
balance of payments reporting, the subsidiaries of a multinational are treated as being a
resident in the country in which they are located (even if their shares are not actually
owned by domestic residents).
Treatment of international organisations such as the IMF, the World Bank, the United Nations, and
the European Commission.
o Treated as foreign residents even though they may actually be located in the reporting
country.
o E.g. IMF is located in Washington, yet, contributions by the US government to the Fund
are included in the US balance of payments because they are regarded as transactions
with a foreign resident.
Tourists are regarded as foreign residents if they stay in the reporting country for less than a year.
The criterion for a transaction to be included in the balance of payments is that it must involve a
transaction between a resident of the reporting country and a resident of the rest of the world.
o Purchases and sales between residents of the same country are excluded.
Collection, Reporting, and Presentation of the Balance of Payments Statistics
The balance of payments statistics record all the transactions between domestic and foreign
residents, be they purchase or sale of goods, services, or financial assets such as bonds, equities,
and banking transactions.
Reported figures are normally in the domestic currency of the reporting country.
o Figures provide only an estimate of the actual transactions because collecting statistics
every transaction between domestic and foreign residents is impossible. Thus, statistics
are based on reliable sampling techniques.
Balance of Payments Accounting and Accounts

Based upon the principle of double-entry bookkeeping.

Each transaction between a domestic and foreign resident has two sides two it, a receipt and
payments, and both of these are recorded in the balance of payments statistics.
o Receipt of a currency from residents of the rest of the world is recorded as a credit item.
o Payments to residents of the rest of the world recorded as a debit.

The main three sections of the Balance of Payments:

1. The current account income flows.
2. The capital and financial account changes in assets and liabilities of the private sector
and non-central bank sector.
3. The settlements account changes in assets and liabilities of the central bank.

Table 2.1 on page 33

An Overview of the Sub-Accounts in the Balance of Payments

The Trade Balance

Represents the difference between receipts for exports of goods and expenditure on imports of
goods which can be visibly seen crossing frontiers.
o Receipt for exports credit in balance of payments.
o Payment for imports debit in balance of payments.

When the trade balance is in surplus, this means that the country has earned more from its exports
of goods than it has paid for its imports of goods.

The Current Account Balance

The current account balance is the sum of the visible trade balance and the invisible trade balance.
The invisible balance shows the difference between revenue received for exports of services and
payments made for imports of services such as shipping, tourism, insurance, and banking.
o Receipts and payments of interest, dividends, and profits are recorded in the invisible
balance because they represent the reward for investment in overseas companies,
financial assets (bonds and equities).
o Payments reflect the rewards to foreign residents for their investment in the domestic
economy.
Receipts and payments for the services of capital than earn and cost the country income, just as do
exports and imports.
Unilateral transfers are included in the invisible balance these are payments or receipts for which
there is no corresponding quid pro quo.
o E.g. migrant workers remittances to their families back home, the payment of pensions to
foreign residents, and foreign aid.
Such receipts and payments represent a redistribution of income between
domestic and foreign residents.
Unilateral payments can be viewed as a fall in domestic income due to payments to foreigners and
so are recorded as a debit.
Unilateral receipts are viewed as an increase in income due to receipts from foreigners and
consequently are recorded as a credit.

The Capital and Financial Account

The capital and financial account records transactions concerning the movement of capital into and
out of the country.
Capital comes into the country by borrowing, sales of overseas assets, and investment in the
country by foreigners.
o These items are referred to as capital inflows and are recorded as credit items in the
balance of payments.

Capital inflows are, in effect, a decrease in the countrys holding of foreign assets or an increase in
liabilities to foreigners.

Capital inflows are recorded as pluses, and the easiest way to understand why they are pluses is to
think of foreign borrowing as the export as an IOU.
Investment by foreign residents in the domestic economy can be thought of as the export of equity
or bonds, while sales of overseas investments to foreigners is an export f those investments to
foreigners.
Capital leaves the country due to lending, buying of overseas assets and purchases of domestic
assets owned by foreign residents.

Represents capital outflows and are recorded as debits in the capital account.

Capital outflows are, in effect, an increase in the countrys holding of foreign assets or a decrease in
liabilities to foreigners.

Capital outflows are recorded as debits as they represent the purchase of an IOU from foreigners,
the purchase of foreign bonds or equity and the purchase of investments in the foreign economy.

The summation of the capital inflows and outflows gives the financial account balance.

Settlements Balance

The settlements balance shows transactions (if any occur) undertaken by the central bank.
There are two key items that are recorded in the settlements account:
1. Rises and falls in foreign exchange reserves.
2. Borrowing funds or repayments of loans to international organisations such as the IMF.

A central bank normally holds a stock of reserves made up of foreign currency assets, principally
US Treasury bonds (the US authorities hold mainly euro and yen Treasury bonds).
o Such reserves are held primarily to enable the central bank to purchase its currency
should it wish to prevent it depreciating.
If a central bank intervenes in the foreign exchange market to purchase its currency, then its
foreign exchange reserves fall and this is recorded as a plus in the settlements account.
If a central bank intervenes in the foreign exchange market to sell its currency then its foreign
exchange reserves rise and this is recorded as a minus in the settlements account.

Reserves increase when the authorities have been purchasing foreign currency because the domestic
currency is strong. This implies that the other items in the balance of payments are in surplus, so
reserve increases have to be recorded as a debit to ensure overall balance.
Reserves fall when the authorities have been supporting a currency that is weak, that is, all other items
sum to a deficit so reserves falls must be recorded as a plus to ensure overall balance.

If a country has to borrow funds from the IMF, then this is an increase in its liabilities and is
recorded as a plus in the settlements account.
o Borrowing from the IMF usually comes with strict conditions attached and repayments on
the loans are expected to occur within three to five years.
When a country pays back the loan to the IMG, then this is a reduction in its liabilities and is
recorded as a minus in its settlements account.

The Statistical Error

Given the huge statistical problems involved in compiling the balance of payments statistics, there
will usually be a discrepancy between the sum of all the items recorded in the current account,
financial account, and the official settlements balance which in theory should sum to zero.
To ensure that the credits and debits are equal, it is necessary to incorporate a statistical error for
any difference between the sum of credits and debits in the three accounts.
Sources of error:
o Impossible to keep track of all the transactions between domestic and foreign residents
reported statistics are based on sampling estimates.
o Desire to avoid taxes transactions in the capital and financial account become
underreported.
o Dishonest firms may deliberately under-invoice their exports and over-invoice their
imports to deflate (artificially) their profits.
o Leads and lags good may be imported, but the payments could be delayed. Time
discrepancy may means that the two sides of the transaction are not recorded in the same
set of figures.

Recording of Transactions in the Balance of Payments

There are five types of economic transactions that can take place between domestic and foreign
residents:
1. An exchange of goods/services in returns for a financial asset.
2. An exchange of goods/services in return for other goods/services. Such trade is known as
barter or countertrade.
3. An exchange of a financial item in return for a financial item.
4. A transfer of goods or services with no corresponding quid pro quo (for example, military
and food aid).
5. A transfer of financial assets with no corresponding quid pro quo (for example, migrant
workers remittances to their families abroad or a money gift).
Table 2.2 on page 36

Since each credit in the accounts has a corresponding debit elsewhere, the sum of all items (the
balance of payments) should be equal to zero.
o This naturally raises the question as to what is meant by a balance of payments deficit or
surplus.

What is meant by a Balance of Payments Surplus or Deficit?

While the overall balance of payments always balances, this does not mean that each of the
individual accounts that make up the balance of payments is necessarily in balance.
o For example, the current account can be in surplus which the capital account is in deficit.
When talking about a balance of payments deficit or surplus, economists are really saying that a
subset of items in the balance of payments are in surplus or deficit.
The Trade Account and Current Account
What makes a current account surplus or deficit important is that a surplus means that the country
as a whole is earning more than it is spending and, as such, is increasing its stock of claims on the
rest of the world or is reducing it indebtedness.
A deficit means that the country as a whole is spending more than it is earning and is therefore
reducing its net claims on the rest of the world or is increasing its indebtedness.
The current account can be incorporated into economic analysis of an open economy.
o The current account is likely to quickly pick up changes in other economic variances,
such as changes in the real exchange rate, domestic and foreign economic growth, and
relative price inflation.
The Basic Balance
This is the current account balance plus the net balance on long-term capital flows.
o Viewed as bringing together the stable elements in the balance of payments.
It has been argued that any significant change in the basic balance must be a sign of a fundamental
change in the direction of the balance of payments.
o The more volatile elements such as short-term capital flows and changes in official
reserves were regarded as below-the-line items.
Although a worsening of the basic balance is supposed to be a sign of a worsening economic
situation, having an overall basic balance deficit is not necessarily a bad thing
A country may have a current account deficit that is reinforced by a large long-term capital outflow so
that the basic balance is in a large deficit. However, the capital outflow will yield future profits,
dividends, and interest receipts that will help to generate future surpluses on the current account.

A surplus in the basic balance is not necessarily a good thing. A current account deficit which is more
than covered by a net capital inflow so that the basic balance is in surplus could be open to two
interpretations:
It might be argued that because the country is able to borrow over the long run there is nothing
to worry about since the country is regarded as viable by those foreigners who are prepared to
lend money over the long-run to the country.
Basic balance surplus is a problem because the long-term borrowing will lead to future
interest, profits, and dividend payments which will worsen the current account deficit.

The principal problem with the basic balance concerns the classification of short and long-term
capital flows.

The basic balance concept could have some relevance if we take into account net foreign direct
investment (FDI) as the long-term capital account balance.
A country that has a current account deficit but is a net recipient of FDI could be interpreted as a
sign of confidence in the long-term prospects of the economy.
o The FDI will increase the countrys capital stock and future export earnings.
A country that has a current account deficit and net FDI outflows could be interested as a sign of a
struggling economy in which investment opportunities lie abroad rather than at home.
China seems to have a virtuous circle whereby a surplus in the current account and a positive net FDI
inflow lead to an increase in their net exports in the future.
The Settlements Balance

The official settlements balance focus on the operations that the monetary authorities have to
undertake to finance any combined imbalance n the sum of the current account and financial
account.
The autonomous items are all the current and financial and capital account transactions (including
errors), while the accommodating items are those transactions that the monetary authorities have
undertaken as indicated, by the settlements balance.

If the sum of the current and capital accounts is negative, the country can be regarded as being in
deficit as this has to be financed by the authorities drawing on their reserves of foreign currency,
borrowing from foreign monetary authorities or the IMF.

The official settlements concept of a surplus or deficit is not as relevant to countries that have
floating exchange rates as it is to those with fixed exchange rates.
o This is because if exchange rates are left to float freely, the official settlements balance
will tend to zero because the central authorities neither purchase nor sell their currency
and so there will be no changes in their reserves.
If the sales of a currency exceed (are less than) the purchases, the currency will depreciate
(appreciates).
The settlements concept is very important under fixed exchange rates because it shows the amount
of pressure on the authorities to devalue or revalue the currency.
Under a fixed exchange rate system, a country that is running an official settlements deficit will
find that sales of its currency exceed purchases, and to avert a devaluation of the currency
authorities have to sell reserves of foreign currency to purchase the home currency.
o There is no intervention under a floating exchange rates the official settlements balance
automatically tends to zero.

Capital controls and interest rates could also be used to defend the exchange rate.

Liquid liabilities held by domestic and foreign residents that might switch suddenly out of the
currency pose a real threat to the domestic currency and official reserves.

Table 2.4 on page 41

The Net International Investment Position and the Balance of Payments

When a country invests abroad in foreign bonds, equities, and money markets securities, it is
increasing its holding of external financial assets.
When foreigners purchase domestic bonds, equities, and domestic money market securities, these
financial investments are liabilities of the domestic residents to the foreign residents
The difference between a countrys ownership of foreign financial assets and its financial liabilities
to foreign residents is known as its net international investment position (NIIP).

If the external financial assets are grater than the external financial liabilities, then the NIIP of the
country will be positive and the country is a net creditor nation.
o If liabilities are greater than the assets, then the NIIP of the country is negative and it is a
net debtor.

If a country runs a current account deficit then this will mean it has to be financed by either selling
assets to foreigners or borrowing the funds, which will worsen its NIIP position by making it less
positive or more negative, other things being equal.
If a country runs a current account surplus then it earns more than it spends as a country so thereby
lends money to the rest of the world and/or repays debts it owes to the rest of the world, so
increasing its assets and/or decreasing its liabilities, so making it NIIP less negative or more
positive, other things being equal.
Such a countrys current account deficit/surplus can, over time, have a significant impact on its
NIIP position.

The NIIP affected by other factors, other than the current account.
o Valuation changes in the external financial assets and liabilities of the country.
If foreign stock markets and foreign bonds held by domestic residents rise (fall)
in value, ten the NIIP position improves (deteriorates).
A fall (rise) in the valuation of domestic financial securities held by foreign
residents will improve (deteriorate) the NIIP.
o Fluctuations in the exchange rate (see below).

The US has a negative NIIP since the value of its foreign assets, measured in US dollars, is less than
the value of its liabilities as measured in US dollars.
If the US dollar depreciates (appreciates) by 10%, then its foreign assets become worth
more (less), measured in US dollars, while its liabilities are not directly affected by the
fall in the dollar and thus improves (worsening) its NIIP.
For foreign economies such as Japan and China, a depreciation of the dollar will mean an
appreciation of their currencies which reduces the value of their claims on the US when
measured in yen and renminbi. This leads to a deterioration in their NIIP positions as
measured in yen and renminbi.
Table 2.5 on page 42
US has gone from being a net creditor country of $360 billion in 1980 ti a bet debtor nation of
$2,471 billion in 2010.
o A major cause of this has been the fact that the US has been running current account
deficits ever since 1982, which has to be financed either by selling assets to foreign
residents or increasing liabilities to foreign residents.
The NIIP is also affected by changes in the market value of assets and liabilities.

Even though the US had large current account deficits in 2009 and 2010, its NIP actually improved
from minus $3,260 billion in 2008 to minus $2,471 billion as the market value of its liabilities,
measured in dollars, rose by less than the market value of its assets measured In US dollars.

Countries that run persistent deficits have to finance the deficits by selling foreign assets and
increasing their liabilities.

Countries with persistent surpluses increase their foreign assets by lending and/or are able to
reduce their liabilities to foreign residents.

Do the United States Current Account Deficits Matter?

Pp. 43 46 - photocopy
Some Open Economy Identities

Equation (2.3) is an important identity that states that a current account deficit has a counterpart in
either private dissaving (private investment greater than private savings) and/or in a government deficit
(government expenditure greater than government taxation revenue).

The equation is just an identity, and does not say anything about causation.
It is often said that the current account deficit is due to the lack of private savings and/or
government budget deficit, however, it is possible that the causation runs the other way in that it is
in fact the current account deficit that is responsible for the lack of private savings or budget
deficit.

Open Economy Multipliers

Pp. 49 53 (government expenditure, foreign trade or export, and current account multiplier)

The assumption underlying basic multiplier analysis are:

o Both domestic prices and the exchange rate are fixed.
o The economy is operating at less than full employment so that increases in demand result
in an expansion of output.
o The authorities adjust the money supply to changes in money demand by pegging the
domestic interest rate.

The final assumption is important:

Increases in output that lead to a rise in money demand would, with a fixed money supply, lead to
a rise in the domestic interest rate it is assumed that the authorities passively expand the money
stock to meet any increase in money demand so that interest rates do not have to change.
There is no inflation resulting from the money supply expansion because it is merely a response to
the increase in money demand.