Economics of International Finance Econ. 315 Chapter 2: Balance of Payments.

Economics of International FinanceEconomics of International FinanceEcon. 315Econ. 315

Chapter 2:Chapter 2:

Balance of PaymentsBalance of Payments

Balance of Payments (BOP) Definition:Balance of Payments (BOP) Definition:

A Summary statement in which all A Summary statement in which all TRANSACTIONSTRANSACTIONS of the of the RESIDENTSRESIDENTS in a nation with the residents of all other in a nation with the residents of all other nations (nations (NON-RESIDENTSNON-RESIDENTS) which are recorded during a ) which are recorded during a particular particular PERIODPERIOD of time (usually one calendar year). of time (usually one calendar year).

What is meant by:What is meant by:

1.1. International transactions:International transactions:- The exchange of a The exchange of a goodgood, , serviceservice or an or an asset,asset, between between

the residents of one nation and the residents of other the residents of one nation and the residents of other nations (nations (payments are required for these transactionspayments are required for these transactions). ).

- Gifts and other transfer payments are also included Gifts and other transfer payments are also included ((No Payments are required hereNo Payments are required here).).

2. The residents and Non-residents:2. The residents and Non-residents:

Residents are Residents are Persons and other bodies that are Persons and other bodies that are normally residents in the country, Note:normally residents in the country, Note:

• Temporary immigrantsTemporary immigrants, e.g., diplomats, tourists and , e.g., diplomats, tourists and temporary workers are temporary workers are not residentsnot residents (they are residents of (they are residents of the country in which they hold citizenship). the country in which they hold citizenship).

• CorporationsCorporations are residents of the country in which they are are residents of the country in which they are incorporated, but incorporated, but branchesbranches and subsidiariesand subsidiaries are not. are not.

• International institutionsInternational institutions (UN, WB, IMF, WTO ..etc) are non (UN, WB, IMF, WTO ..etc) are non residents at the country in which they are located. residents at the country in which they are located.

3.3. The period The period Usually a Usually a calendar year, calendar year, however most of the however most of the countries keep a record on a quarterly basis (countries keep a record on a quarterly basis (e.g., e.g., KuwaitKuwait).).

The BALANCE OF PAYMENTS (BOP) AccountsThe BALANCE OF PAYMENTS (BOP) Accounts

First: Items above the lineFirst: Items above the lineCURRENT ACCOUNTCURRENT ACCOUNT--Records the country’s trade in currently produced goods and services along with --Records the country’s trade in currently produced goods and services along with

unilateral transfers between countries--unilateral transfers between countries--

* Good & Services Balance (Exports & Imports)* Good & Services Balance (Exports & Imports)GoodsGoods

ServicesServices ( Transportation, Insurance, Travel, Other ( Transportation, Insurance, Travel, Other services)services)

* Income Account* Income Account Investment IncomeInvestment Income ( current income received & paid on international ( current income received & paid on international

investment )investment )

* Current Transfers (Unilateral Transfers)* Current Transfers (Unilateral Transfers) * General government * General government ( government grants and other transfers)( government grants and other transfers) * Workers remittances* Workers remittances


CAPITAL & FINANCIAL ACCOUNT CAPITAL & FINANCIAL ACCOUNT

CAPITAL ACCOUNT CAPITAL ACCOUNT --Records unilateral transfers of assets between countries, i.e. assets that migrants --Records unilateral transfers of assets between countries, i.e. assets that migrants

take with them when they move into or out of a country--take with them when they move into or out of a country--

FINANCIAL ACCOUNT FINANCIAL ACCOUNT --Records international borrowing, lending, purchases, and sales of assets----Records international borrowing, lending, purchases, and sales of assets--

* Direct investments * Direct investments

* Portfolio investment* Portfolio investment

* Other investments * Other investments


Second: Items below the line (Balance of official Second: Items below the line (Balance of official settlements)settlements)

-- Considers as an account in which official reserve transactions are entered -- Considers as an account in which official reserve transactions are entered -- All transactions go into this account are conducted by the “official” government -- All transactions go into this account are conducted by the “official” government

authority( Central Bank).authority( Central Bank).-- It reports the net change in a country’s stock of …….-- It reports the net change in a country’s stock of …….

• Monetary gold Monetary gold (gold reserves)(gold reserves)

• Special drawing rights Special drawing rights (SDR)(SDR)

• Reserve position in the IMF Reserve position in the IMF (includes local currency, gold, other (includes local currency, gold, other assets)assets)

• Foreign exchangeForeign exchange ( foreign currency reserves)( foreign currency reserves)


Important Notes:Important Notes:

- The balance on the Current Account represents the relationship The balance on the Current Account represents the relationship between the current income (for individual, firms, governments between the current income (for individual, firms, governments agencies) and current expenditures.agencies) and current expenditures.

- The Capital & Financial Account represents changes in borrowing The Capital & Financial Account represents changes in borrowing and lending or purchases & sales of assets (for individual, firms, and lending or purchases & sales of assets (for individual, firms, governments agencies).governments agencies).

- { CA balance + KFA balance + Official settlements balance + { CA balance + KFA balance + Official settlements balance + Statistical discrepancy = 0}Statistical discrepancy = 0}

The BALANCE OF PAYMENTS (BOP) ACCOUNTING The BALANCE OF PAYMENTS (BOP) ACCOUNTING PRINCIPLESPRINCIPLES

Credits and DebitsCredits and Debits Any transaction is described as credit or debitAny transaction is described as credit or debit

First Credit Transactions:First Credit Transactions:

1. 1. Credit Transactions Credit Transactions involve involve receipts of paymentsreceipts of payments from foreigners ( from foreigners (entered with a entered with a +ve sign because they involve receipts of payments+ve sign because they involve receipts of payments), e.g., ), e.g., Export of goods and servicesExport of goods and services Gifts and aid received from foreignersGifts and aid received from foreigners

2. 2. Capital inflows are considered credit transactions and Capital inflows are considered credit transactions and take two forms: take two forms: An increase in foreign assets in the nation (An increase in foreign assets in the nation (an American investor an American investor

purchases an asset in Kuwaitpurchases an asset in Kuwait)) A reduction of the nation’s assets abroad (A reduction of the nation’s assets abroad (A Kuwaiti investor sells an asset A Kuwaiti investor sells an asset

in the UKin the UK))


Second Debit Transactions:Second Debit Transactions:

1. 1. Debit TransactionsDebit Transactions involve the involve the making of paymentsmaking of payments to foreigners ( to foreigners (entered with a entered with a -ve sign because they involve making of payments-ve sign because they involve making of payments), e.g., ), e.g., Imports of goods and servicesImports of goods and services Gifts and aid given to foreignersGifts and aid given to foreigners

2. 2. Capital outflows are considered debit transactions and Capital outflows are considered debit transactions and take two forms: take two forms: An increase in the nations assets abroad (An increase in the nations assets abroad (a Kuwaiti investor purchases an a Kuwaiti investor purchases an

asset in the UKasset in the UK)) A reduction of foreign assets in the nation (A reduction of foreign assets in the nation (an American investor sells an an American investor sells an

asset in Kuwaitasset in Kuwait))


Double Entry BookkeepingDouble Entry Bookkeeping

Each international transaction is recorded Each international transaction is recorded twice,twice, once in the credit and once once in the credit and once in the debit of an equal amount. The reason for this is that every in the debit of an equal amount. The reason for this is that every transaction has two sides (credit and debit). transaction has two sides (credit and debit).


Example 1.Example 1. Kuwait exports $ 500 mn. of oil to be paid for in three months. Kuwait exports $ 500 mn. of oil to be paid for in three months.

Note the following: Note the following:

Exports of oil are entered as credits (Exports of oil are entered as credits (lead to receipts of payments from lead to receipts of payments from foreignersforeigners))

The payment itself is entered as a capital outflow (debit), The payment itself is entered as a capital outflow (debit), why?why?

When Kuwait agrees to wait for three months for payments, it extends When Kuwait agrees to wait for three months for payments, it extends a credita credit to foreign importers (capital outflows). to foreign importers (capital outflows). This is an increase in domestic assets This is an increase in domestic assets abroad (i.e. a debit)abroad (i.e. a debit)

)+(Credit )-(Debit

OIL EXPORTS 500

CAPITAL OUTFLOWS (an increase in Kuwaiti assets abroad)

500

Example 2.Example 2. Kuwaiti tourists visit London and spend $ 200 mn. on hotels, Kuwaiti tourists visit London and spend $ 200 mn. on hotels, meals.. etc. meals.. etc. Note the following:Note the following:

Kuwaiti tourists purchased services from foreigners (require payments to Kuwaiti tourists purchased services from foreigners (require payments to foreigners). This is similar to imports (foreigners). This is similar to imports (debitdebit). ).

The payment is entered as a credit, as it represents an increase in The payment is entered as a credit, as it represents an increase in foreign foreign claims on Kuwaitclaims on Kuwait, i.e. , i.e. an an increase in foreign assetsincrease in foreign assets in Kuwait or a in Kuwait or a capital capital inflowinflow to Kuwait. to Kuwait.

Credit (+)Credit (+) Debit (-)Debit (-)

Travel services purchased from foreignersTravel services purchased from foreigners

Capital inflow (a rise in foreign assets in Kuwait)Capital inflow (a rise in foreign assets in Kuwait) 200200

200200

Example 3.Example 3. Kuwait gives a $ 100 mn. Kuwait gives a $ 100 mn. bank balancebank balance to the government of a less to the government of a less developed country (developed country (aidaid). ). Note the following:Note the following:

This unilateral transfer is a debit (This unilateral transfer is a debit (requires payments to foreignersrequires payments to foreigners).).

The payment (an increase in a bank account) itself represents an increase in The payment (an increase in a bank account) itself represents an increase in foreign claims (of assets) in Kuwait.foreign claims (of assets) in Kuwait.


Unilateral transfers (aid)Unilateral transfers (aid)

Capital inflowCapital inflow 100100

100100

Example 4.Example 4. A Kuwaiti resident purchases foreign stocks of $ 400 mn. and pays A Kuwaiti resident purchases foreign stocks of $ 400 mn. and pays for it by increasing foreign bank balances in for it by increasing foreign bank balances in KuwaitKuwait. . Note the following: Note the following:

The purchase of foreign stocks increases Kuwaiti assets abroad. This is a The purchase of foreign stocks increases Kuwaiti assets abroad. This is a capital outflow (capital outflow (debitdebit). ).

The payment is an increase in foreign assets in Kuwait. This is a capital The payment is an increase in foreign assets in Kuwait. This is a capital inflow (inflow (creditcredit). ).

(Note: If the Kuwaiti resident paid for the foreign stock by reducing bank (Note: If the Kuwaiti resident paid for the foreign stock by reducing bank balances abroad; the payment will be a reduction in Kuwaiti assets abroad, balances abroad; the payment will be a reduction in Kuwaiti assets abroad, this is also a capital inflow and thus is a credit). this is also a capital inflow and thus is a credit).

Credit Credit (+)(+)

Debit (-)Debit (-)

Capital outflow (purchase of foreign stocks)Capital outflow (purchase of foreign stocks)

Capital inflow (the increase in foreign bank Capital inflow (the increase in foreign bank balances)balances)

400400

400400

Example 5.Example 5. A foreign investor purchases $ 300 mn. of Kuwaiti treasury bills A foreign investor purchases $ 300 mn. of Kuwaiti treasury bills and pays by drawing down his bank balances in and pays by drawing down his bank balances in KuwaitKuwait. . Note the Note the following:following:

the purchase of the treasury bills is an increase in foreign assets in Kuwait the purchase of the treasury bills is an increase in foreign assets in Kuwait ((creditcredit))

The drawing down of Kuwaiti bank balances by foreigners is a reduction in The drawing down of Kuwaiti bank balances by foreigners is a reduction in foreign assets in Kuwait. this is a capital outflow (foreign assets in Kuwait. this is a capital outflow (debitdebit).).


Capital inflow (purchase of Kuwaiti Capital inflow (purchase of Kuwaiti treasury bill by foreigner)treasury bill by foreigner)

Capital outflow (the reduction in foreign Capital outflow (the reduction in foreign bank balances in Kuwait)bank balances in Kuwait)

300300

300300

The results of the previous transactions on Kuwait’s balance of The results of the previous transactions on Kuwait’s balance of payments would be:payments would be:

Capital flows = (Capital flows = (-500 -500 +200 +100 +400 +200 +100 +400 -400 -400 +300 +300 -300-300) =) = -200 -200

Note: the net capital debit balance Note: the net capital debit balance -200 -200 is obtained by adding is obtained by adding together the seven capital entriestogether the seven capital entries

Balance of payments Balance of payments


Goods (oil)Goods (oil)

ServicesServices

Unilateral transfersUnilateral transfers

Capital netCapital net

Total debits and creditsTotal debits and credits

500500

----------------

500500

200200

100100

200200

--------------

500500

Accounting balances and disequilibrium in international Accounting balances and disequilibrium in international transactionstransactions

1. The Current Account: 1. The Current Account: lumps together all sales and purchases of lumps together all sales and purchases of goodsgoods and and servicesservices, ,

investment incomesinvestment incomes, and , and unilateral transfersunilateral transfers. . It provides the link between the nations international transactions It provides the link between the nations international transactions

and its and its national incomenational income. . The current account surplus The current account surplus stimulatesstimulates domestic production and domestic production and

income, while a current deficit income, while a current deficit dampensdampens domestic production and domestic production and income. income.

2. The capital Account: 2. The capital Account: Measures the change in the stock of all Measures the change in the stock of all non-reservenon-reserve financial assets. financial assets. Reserve changes are Reserve changes are excludedexcluded from the capital account because they from the capital account because they

represent the government policy (represent the government policy (below the line transactionsbelow the line transactions) ) rather than market forcesrather than market forces..

The capital account shows the net increase in the The capital account shows the net increase in the privately ownedprivately owned net assets abroad. net assets abroad.

Autonomous transactions.Autonomous transactions. All transactions in the current account and capital account are All transactions in the current account and capital account are

called “called “autonomousautonomous”, because they take place for ”, because they take place for businessbusiness oror profitprofit motivesmotives (except for unilateral transfers), and are (except for unilateral transfers), and are independentindependent of BOP considerations. of BOP considerations.

They are sometimes called “They are sometimes called “the items above the linethe items above the line””

Transactions in official reserves. Transactions in official reserves. They are called They are called accommodating transactionsaccommodating transactions ( (items below the items below the

lineline), because they are needed to balance international ), because they are needed to balance international transactions. transactions.

Below the line items form the “Below the line items form the “official reserve accountofficial reserve account”, and its ”, and its balance is called “balance is called “the official settlements balancethe official settlements balance”.”.

Do you know now what do we mean by the line?Do you know now what do we mean by the line?

Balance of payments: DeficitBalance of payments: Deficit If total debits exceed credits in current and capital accounts, If total debits exceed credits in current and capital accounts,

the net “the net “debitdebit” balance measures the “” balance measures the “deficitdeficit” in the country’s ” in the country’s BOP. BOP.

Balance of payments: SurplusBalance of payments: Surplus

If total credits exceed debits, in current and capital account, If total credits exceed debits, in current and capital account, there will be a there will be a surplussurplus in the BOP. in the BOP.

Enter the following transactions in the BOP of KuwaitEnter the following transactions in the BOP of Kuwait

1.1. A Kuwaiti resident purchases a $ 1000 mn foreign stock and pays for it by A Kuwaiti resident purchases a $ 1000 mn foreign stock and pays for it by drawing down her bank balances abroad. drawing down her bank balances abroad.

2.2. A Kuwaiti resident receives a dividend of $ 100 mn on her foreign stock and A Kuwaiti resident receives a dividend of $ 100 mn on her foreign stock and deposits it into her bank account abroad. deposits it into her bank account abroad.

3.3. General Motors Co. purchases $ 100 mn PCs from China. General Motors Co. purchases $ 100 mn PCs from China.

4.4. A Kuwaiti computer manufacturer buys $ 20 mn hard disks from a Chinese A Kuwaiti computer manufacturer buys $ 20 mn hard disks from a Chinese company and deposits the proceeds in NBK, China uses the proceeds to company and deposits the proceeds in NBK, China uses the proceeds to purchase oil. purchase oil.

5.5. The Kuwaiti government gives a $ 100 mn cash balance in a Kuwaiti bank to The Kuwaiti government gives a $ 100 mn cash balance in a Kuwaiti bank to a developing nation as part of the foreign aid program. a developing nation as part of the foreign aid program.

6.6. The developing nation uses the $ 100 mn bank balance to import $100 worth The developing nation uses the $ 100 mn bank balance to import $100 worth of oil from Kuwait. of oil from Kuwait.

7.7. An American tourist spends $ 20000 on hotels in Malaysia. An American tourist spends $ 20000 on hotels in Malaysia.

8.8. An American investor purchases $ 150 mn Kuwaiti stocks and pays by An American investor purchases $ 150 mn Kuwaiti stocks and pays by increasing the seller's bank account in USA. increasing the seller's bank account in USA.

9.9. The American investor receives $ 15 mn on his Kuwaiti Stock and deposits The American investor receives $ 15 mn on his Kuwaiti Stock and deposits the value in his bank account in Kuwait. the value in his bank account in Kuwait.

Economics of International Finance Econ. 315 Chapter 2: Balance of Payments.

Documents

Transcript of Economics of International Finance Econ. 315 Chapter 2: Balance of Payments.