• Reserves

• COFR

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1
 Chapter 3

The Balance of
Payments
-Capital mobility (self
study)
 What do we want to do?

 DEFINE the balance of payments (BOP).

 To Understand the relationship between

capital and current accounts.

 To gain an appreciation for the linkages

between exchange rates and the balance of
payments.

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3
 The Balance of Payments

•  Definition: balance of payments (BOP) is

an accounting statement that summarizes
(measures) all the economic transactions
between residents of the home country and
the rest of the world in a specified period of
time.


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 The Balance of Payments

• BOP data: a gauge of a nation’s competitiveness or health

(domestic and/or foreign)

• A BOP statement is a statement of cash flows over an interval

of time.

• For a MNE, both home and host country BOP data is important
as:
– An indication of pressure on a country’s foreign exchange
rate
– A signal of the imposition or removal of controls in various
sorts of payments (dividends, interest, license fees,
royalties and other cash disbursements)
– A forecast of a country’s market potential (especially in the
short run)

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 Fundamentals of BOP Accounting

• The BOP must balance.

• It cannot be in disequilibrium unless

something has not been counted or has
been counted improperly.

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 The Accounts of the BOP

• The BOP has three major sub-accounts

– current account,
– the capital account and the financial account.

• Offsetting accounts:
– the official reserves account tracks government
currency transactions
– the net errors and omissions account is produced to
preserve the balance of the BOP.

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 Exhibit 3.1 The U.S. Balance of
Accounts, Summary

Note the inverse relation between the current and financial

accounts.

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 Let’s look at the accounts

 Three Major Accounts:

• CURRENT ACCOUNT
• CAPITAL ACCOUNT (& Financial)
• OFFICIAL RESERVES ACCOUNT

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 The Current Account (X-M)

• The Current Account includes all international economic

transactions with income or payment flows occurring within one
year, the current period. It consists of the following four
subcategories:

– Goods trade and import of goods

– Services trade
– Income
– Current transfers

• Exhibit 3.2 follows with U.S. trade balance on goods and services

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 Exhibit 3.2 U.S. Trade Balances on Goods
and Services

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 JULY 2014 TRADE GAP IS $40.5
BILLION
U.S. international trade in goods and
services

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 The Capital and Financial
Accounts

• The capital and financial accounts:

international economic transactions of
financial assets.

• The capital account is made up of transfers of financial assets

and the acquisition and disposal of nonproduced/nonfinancial
assets.

• The financial account consists of four components—direct

investment, portfolio investment, net financial derivatives,
and other asset investment

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 The Balance of Payments

 Capital Account (financial): records

international borrowing and lending or net
foreign investment. (CI-CO)

– HONDA BUILDS A PLANT IN OHIO

– JAPANESE INVESTORS BUY A GOLF COURSE
IN THE U.S.
– GERMAN RESIDENT BUYS A U.S. T-BILL

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 Exhibit 3.4 Current and Financial/Capital
Account Balances for the United States

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 Net Errors & Omissions/Official
Reserves Accounts
• The Net Errors and Omissions account ensures that
the BOP actually balances.
• 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 (hard currencies).
• 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.

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 SO WHAT DOES THAT
MEAN FOR CURRENCY???

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 BOP Impacts on Key Macroeconomic
Rates

• A country’s balance of payments both

impacts and is impacted by the three
macroeconomic rates of international
finance:
– exchange rates;
– interest rates; and
– inflation rates

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 The BOP and Exchange Rates

• The relationship between the BOP and

exchange rates can be illustrated by use of
a simplified equation:
CA KA FXB

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 The Balance of Payments

How do we link the BOP with

exchange rates?

Double-entry bookkeeping:
every transaction is recorded twice as an entry of credit
and an entry of debit.

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 The Balance of Payments
Credit (foreign currency )
•

Examples:
 – (Current Account)=
 – (Capital Account)=
 – (FXB)=

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 The Balance of Payments

 Debit (foreign currency )

•

Examples:
 – (Current Account)=
 – (Capital Account)=
 – (FXB)=

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 The Balance of Payments

WE NOW ANALYZE THE

BALANCE OF PAYMENTS
RELATIONSHIPS UNDER TWO
EXCHANGE RATE SYSTEMS:

• FLOATING AND FIXED

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 The Balance of Payments

RECALL
• The BOP identity is:

CURRENT ACCOUNT BALANCE

+ CAPITAL ACCOUNT BALANCE
+ CHANGE IN OFFICIAL RESERVES
= BALANCE OF PAYMENTS
=0

OR… CA + KA + FXB = 0

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 The Balance of Payments

• CHARACTERISTICS OF A
FLOATING EXCHANGE SYSTEM

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 The Balance of Payments:
FLOATING EXCHANGE SYSTEM

• NO GOVERNMENT INTERVENTION:

Therefore, BOP=

thus = must hold OR…

= must hold

RULE:

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 The Balance of Payments:
FLOATING EXCHANGE SYSTEM

How does the FX market react to make the

two acct.s balance?

Describe this in terms of supply and demand

of the currency in relation to the two acct.s.
What happens to the US $- appreciates or
depreciates in the process?

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 The Balance of Payments

CHARACTERISTICS OF A FIXED
EXCHANGE RATE SYSTEM:

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 The Balance of Payments:
FIXED EXCHANGE RATE SYSTEM

CHARACTERISTICS OF A FIXED
EXCHANGE RATE SYSTEM

• EXCESS MARKET DEMAND:

• EXCESS MARKET SUPPLY:

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 The Balance of Payments:
FIXED EXCHANGE RATE SYSTEM
• GOVERNMENT INTERVENTION:

• Therefore, BOP:
thus = must hold

• RULE:

• What does the govt. do in a deficit?

• What does the govt. do in a surplus?

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 The Balance of Payments:
FIXED EXCHANGE RATE SYSTEM

• What is the intuition behind the following

identity?
•
thus (CA + KA) = FXB

Hint: Try a simple case where…

• (CA + KA) means an overall surplus or
when

• -(CA + KA) means an overall deficit

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 The BOP and Interest Rates

• Relatively low real interest rates should

normally stimulate an outflow of capital seeking
higher rates elsewhere
• The opposite has occurred in the U.S. due to
perceived growth opportunities and political
stability—allowing it to finance its large fiscal
deficit
• The favorable inflow on the financial account is
diminishing while the current account balance is
worsening—making the U.S. a bigger debtor
nation vis-à-vis the rest of the world

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 The BOP and Inflation

• Imports have the potential to lower a country’s

inflation rate.
• Foreign competition substitutes for domestic
competition to maintain a lower rate of inflation
than might have been the case without imports.
• On the other hand, to the extent that lower-
priced imports substitute for domestic
production and employment, gross domestic
product will be lower and the balance on the
current account will be more negative.

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 Self-study

THE J-CURVE AND

CAPITAL MOBILITY

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 Trade Balances and Exchange
Rates
• A country’s import and export of goods and
services is affected by changes in exchange
rates
• The transmission mechanism is in principle
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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 Exhibit 3.6 Trade Adjustment to
Exchange Rates: The J-Curve

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 Capital Mobility

• The degree to which capital moves freely

across borders is critically important to a
country’s balance of payments
• The United States’ financial account surplus
has at least partially offset the current
account deficits over the last 20 or more
years
• China has run a surplus in each of these
accounts in recent years

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 Capital Mobility

• 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
• Thus, Bretton Woods Agreement was careful to
promote free movement of capital for current
account transactions (e.g., foreign exchange or
deposits) but less so for capital account
transactions (e.g., foreign direct investment)
• 1970s-1990s saw growth in capital openness, the
financial crisis of 1997/1998 stopped that due to
destructive capital outflows and contagion

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 Capital Mobility
• The authors argue that the post-1860 era can be
subdivided into four distinct periods with regard to
capital mobility.
– 1860-1914: continuously increasing capital mobility as the
gold standard was adopted and international trade
relations were expanded
– 1914-1945: global economic destruction, isolationist
economic policies, negative effect on capital movement
between countries
– 1945-1971: Bretton Woods era say a great expansion of
international trade
– 1971-2097: floating exchange rates, economic volatility,
rapidly expanding cross-border capital flows
– China and India attempt to open their markets
• These points are laid out in Exhibit 3.7.

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 Exhibit 3.7 The Evolution of the
Global Monetary System

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 Capital Controls

• A capital control is any restriction that limits or

alters the rate or direction of capital movement
into or out of a country
• Free movement of capital is more the exception
than the rule
• Exhibit 3.8 outlines several methods of and
purposes for capital controls
• Dutch Disease is the name given to the problem of
a substantial currency appreciation due to the
demand for a specific natural resource faced by
several resource-rich smaller nations

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Exhibit 3.8
Purposes of
Capital
Controls

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 Capital Flight

• Capital flight—the rapid outflow of capital in

opposition to or in fear of domestic political and
economic conditions and policies—is one of the
problems that capital controls are designed to
control.
• Although it is not limited to heavily indebted
countries, the rapid and sometimes illegal transfer
of convertible currencies out of a country poses
significant economic and political problems.
• Many heavily indebted countries have suffered
significant capital flight.

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 Globalization of Capital Flows

• Capital inflows are short-term in duration

• Even mature markets can encounter crisis

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Global
Finance in
Practice
3.2

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