3.4: Balance of Payments

Definitions

Balance of payments account is a record of the value of all the transactions between the residents of one country with residents of all other countries over a given period of time, usually a year.
Current account is measure of the flow of funds from trade in goods and services, plus other income flows. It is usually divided into four parts, namely the balance of trade in goods, balance of trade in services, income and current transfers.
Balance of trade in goods is a measure of the revenue received from the exports of tangible goods minus the expenditure of the imports of tangible goods over a given period of time.
Balance of trade in services is a measure of the revenue received from the exports of tangible services minus the expenditure of the imports of tangible services over a given period of time.
Net incomes is a measure of the net monetary movement of profit, interest and dividends moving into and out of the country over a given period of time, as a result of financial investment abroad.
Current transfers is a measurement of the net transfers of money, which are payments made between countries when no goods or services change hands.
Foreign direct investment (FDI) is a measure of the purchase of the long-term assets by multinational corporations in another country, where the purchaser aims to gain a lasting interest in a company in another country.
Portfolio investment is a measure of stock and bond purchases, which are not direct investment since they do not lead to a lasting interest in a company.
Expenditure-switching policies are policies implemented by the government that attempt to switch the expenditure of domestic consumers away from imports towards domestically produced goods and services. If successful, expenditure of imports will fall and so the current account deficit will improve.
Expenditure-reducing policies are policies implemented by the government that attempt to reduce overall expenditure of the economy, so shifting AD to the left. Expenditure on all goods and services should fall, including expenditure of imports, thus improving the current account deficit.
Marshall-Lerner condition states that a depreciation, or a devaluation, of a currency will only lead to an improvement in the current account balance if the elasticity of demand for imports plus the elasticity of demand for exports are greater than one.
J-curve effect suggests that in the short term, even if the Marshall-Lerner condition is fulfilled, a fall in the value of the currency will lead to worsening of the current account deficit, before things improve in the long term.

The Balance of Payments Account

Record of value of transactions between residents of one country → residents of all other countries in the world in a given time period.
Three main parts: Current Account, Capital Account and Financial Account.
Transactions entering the country from abroad → Credit → Positive value.
Transactions leaving the country to go abroad → Debit → Negative value.

Current account

Measure of flow of funds from trade in goods and services + other income flows.
Divided into four components:

1. Balance of trade in goods

Revenue received from exported goods – Expenditure on imported goods.
Exports = Inflows.
Imports = Outflows.
Export revenue > Import expenditure → Surplus.
Export revenue < Import expenditure → Deficit.

2. Balance of trade in services

Revenue received from exported services – Expenditure on imported services.

3. Income flows

Measure of net monetary movement of profit, interest and dividends moving into and out of the country over a given time period, as a result of financial investment abroad.
Domestic firms setting up branches in other countries → Positive item.
Profits sent out of the country by foreign firms → Negative item.
Payment of interest to foreign investors leaving the country → Negative item.
Residents and firms receiving dividends from foreign firms → Positive item.
Any dividends paid by domestic firms to foreign stakeholders → Negative item.

4. Current transfers.

Net transfers of money.
No goods or services change hands between countries.
Examples include subsidies and grants.

CURRENT ACCOUNT BALANCE = BALANCE OF TRADE IN GOODS + BALANCE OF TRADE IN SERVICES + NET INCOME FLOWS + NET TRANSFERS

Capital Account

Doesn’t have a significant effect on the balance of payments account.
Consists of two components:

1. Capital transfers

Measure of net monetary movements gained or lost.
Done through actions such as transfer of goods and financial assets by migrants entering or leaving the country, debt forgiveness, gift taxes, inheritance taxes, death duties.

2. Transactions in non-produced, non-financial assets

Consists of net international sales and purchases of non-produced assets.
Examples include purchasing brand names, franchises, copyrights, patents, land, natural resources, international sales and purchases of intangible assets.

Financial Account

Measures the net change in foreign ownership of domestic financial assets.
Increase in foreign ownership of domestic assets → Financial account surplus.
Increase in domestic ownership of foreign assets → Financial account deficit.
Consists of three components:

1. Direct investment

Measure of purchase of long term assets.
Purchaser is aiming to gain a lasting interest in a company in another economy.
Examples include buying properties, purchasing firms or buying stocks/shares of a firm.
Investment doesn’t have to be paid back. Buyer of the asset has all the risk.
Mostly in form of Foreign Direct Investment (FDI).

2. Portfolio investment

Measure of stock and bond purchases, which aren’t direct investment.
Doesn’t leave lasting interest in a company in another economy.
Buying and selling things such as treasury bills and government bonds.
Expected to go through the process of borrowing and lending in an international market.

3. Reserve assets

Movements into and out of this component determines the balance of payments account reaches zero.
Surplus in current and financial account → Increase in official reserve account.
Deficit in current and financial account → Decrease in official reserve account.

IMPORTANT!! There is always transactions that aren’t recorded due to too much transactions going on at the same time. So in order to balance out the balance of payments account, “NET ERRORS AND OMISSIONS” is added to the accounts to make sure the account does balance.

Relationship between Current Account and Exchange Rate

Deficit in the BOP account → Downward pressure on the exchange rate of the currency.
In fixed exchange rate regime, implication is that the value of the currency is too high.
In the short run, deficit is covered by increases in capital and financial accounts + government using reserve assets to balance the accounts.
This can’t go on since reserve assets will run out, so exchange rate → depreciated.
In floating exchange rate regime, implication is that there’s an excess supply of the currency in the foreign exchange markets.
Cause might be fall in demand for exports → fall in demand for currencies → increase in demand for imports → increase in demand for foreign currencies → greater supply of domestic currency on the foreign exchange market.
Surplus in the BOP account → Upward pressure on the exchange rate of the currency.
In fixed exchange rate regime, implication is that the value of the currency is too low.
In the short run, this may offset by deficits on the capital and financial account or increases in the reserve assets.
Other countries will be unhappy with artificially low exchange rate → demand higher rates or threaten protectionist measures against the country’s exports.
In floating exchange rate regime, implication is that there’s an excess demand of the currency in the foreign exchange markets.
Cause might be rise in demand for exports → rise in demand for currencies → decrease in demand for imports → decrease in demand for foreign currencies → lower supply of domestic currency on the foreign exchange market.

Consequences of current account deficit

Foreign exchange reserves may be used to increase capital account and so to regain balance with a deficit in the current account.

Reserves taken out of the official reserves account → positive item in capital account.
Eventually all reserves run out, no matter how rich or poor a country is.

High level of purchasing assets for ownership for financing the current account deficit.

Inflows in the capital account are funding the current account deficit.
Might lead to economic sovereignty due to foreign countries believing their ownership of domestic assets was too great.
Fall in confidence → foreign investors shifting assets to other countries.
Selling assets → increases supply → fall in its value.

High level of lending from abroad for financing the current account deficit.

High interest rates → Short-term drain → Increase current account deficit.
Lead to massive selling of currencies and sharp fall in the exchange rate.

Consequences of current account surplus

Allows a country to have a deficit on its capital account by building up its official reserve account or by purchasing assets abroad.

One country’s deficit = Another country’s surplus.
Might lead to protectionism by other countries to reduce their own deficits.

Leads to appreciation of the currency on the foreign exchange market due to increase in demand for the currency.

Results in cheaper imports → Reducing inflationary pressures.
Costlier exports → Harms exporting industries.

Methods of correcting a persistent current account deficit

1. Expenditure-switching policies

Policies implemented by the government that attempt to switch expenditure of domestic goods away from imports → domestically produced goods and services.
If successful, expenditure on imports falls → Improves current account deficit.
Examples include:
Government policies to depreciate/devaluate the value of the currency
Exports → Less expensive.
Imports → More expensive.
Protectionist measures
Reducing availability of imports by quotas, embargoes, export restraints, administrative, health and safety, environment barriers.
Increase prices using tariffs.
This leads to domestic consumers switching their spending from imports → domestic goods.
Governments are reluctant to use these policies as it leads to retaliation and often are against World Trade Organization’s agreements.
Protecting domestic industries → reduces competition → encourage inefficiency.

2. Expenditure-reducing policies

Policies implemented by the government that attempt to reduce overall expenditure in the economy.
Decreasing aggregate demand in an economy → shifting AD curve to the left.
Expenditure on all goods and services, including imports falls → improvement in the current account deficit.
Size of fall in imports depends on level of marginal propensity to import.
Reducing current account deficit → Fall in domestic employment → Fall in rate of economic growth.
Examples include:
Deflationary fiscal policies
Increasing direct tax rates and reducing government expenditure.
Unpopular decision for the government to make.
Deflationary monetary policies
Increasing interest rates or reducing money supply.
High interest rates → Increase capital flows from abroad as foreigners put money into financial institutions attracted by higher rates → Surplus on the capital account → Improve the current account deficit.
High unpopular decision as well.

Marshall-Lerner Condition

A rule that tells how successful a depreciation or devaluation of a country’s exchange rate will be as a means to improve a current account deficit in the balance of payments.
Reducing the value of the exchange rate will only be successful if the total value of PED for exports and PED for imports is greater than one.
PED_imports + PED_exports > 1
If PED for exports was inelastic and price fell as a result of a fall in the exchange rate → Proportionate increase in the quantity of exports demanded < proportionate decrease in the price of exports → export revenue would fall.
If PED for exports was inelastic and price rose as a result of a fall in the exchange rate → Proportionate fall in the quantity of imports demanded < proportionate increase in the price of imports → import expenditure would increase.

Paper 3 Question

Complete the balance of payments account for Country X.