Chapter The Balance of Payments Learning Objectives To understand the fundamental principles of how countries measure international business activity, the balance of payments To examine the similarities of the current and capital accounts of the balance of payments To understand the critical differences between trade in merchandise and services and why international investment activity has recently been controversial in the United States To review the mechanical steps of how exchange rates are transmitted into altered trade prices and eventually trade volumes To understand how countries with different government policies toward international trade and investments, or different levels of economic development, differ in their balance of payments Introduction The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP) The two major sub accounts of the balance of payments are: Current account Capital account Fundamentals of Balance of Payments Accounting The balance of payments must balance Subaccounts may be imbalanced Three main elements to the process of measuring international economic activity include: Identifying what is and is not an international economic transaction Understanding how the flow of goods, services, assets, and money creates debits and credits to the overall BOP Understanding the bookkeeping procedures for BOP accounting Defining International Transactions Identifying many international transactions is ordinarily not difficult However, some international transactions are not obvious The BOP as a Flow Statement The BOP is often believed to be a balance sheet rather than a cash flow statement There are two types of business transactions that dominate the BOP: Real assets Financial assets BOP Accounting: DoubleEntry Bookkeeping BOP employs an accounting technique called double-entry bookkeeping In this age-old method every transaction produces a debit and a credit of the same amount A debit is created whenever: An asset is increased A liability is decreased An expense is increased A credit is created whenever: An asset is decreased A liability is increased An expense is decreased BOP Accounting: DoubleEntry Bookkeeping The measurement of all international transactions in and out of a country over a year is a difficult task Mistakes, errors, and statistical discrepancies will and occur Current and capital account entries are recorded independent of one another, not together as this accounting method would prescribe The Accounts of the Balance of Payments The BOP is comprised of two primary subaccounts: Current Account Financial/Capital Account Two additional and important subaccounts of the BOP include: Net Errors and Omissions Account Official Reserves Account The Current Account This account includes all international economic transactions with income or payment flows occurring within the year, the current period It consists of four subcategories: Goods trade Services trade Income Current transfers This account is typically dominated by Goods Trade 10 The Current Account The Balance on Trade (BOT) refers specifically to the balance of exports and imports of goods trade only The deficits in the BOT of the past decade have been an area of concern for the U.S Merchandise trade is the core of international trade and has three major components: Manufactured goods Agriculture Fuels The most encouraging news for U.S manufacturing trade is the growth of exports in recent years 11 The Capital and Financial Account This account of the BOP measures all international economic transactions of financial assets It is divided into two major components: Capital Account Financial Account 12 The Capital Account The Capital Account is made up of transfers of: Financial assets The acquisition and disposal of nonproduced/nonfinancial assets 13 The Financial Account The Financial Account consists of three components: Direct investment Portfolio investment Other asset investments The contents of this account are for all intents and purposes the same as those of the Capital Account under IMFs BOP accounting framework used prior to 1996 14 Net Direct Investment This is the net balance of capital dispersed out of and into the U.S for the purpose of exerting control over assets Follows the 10% ownership threshold rule The source of concern over foreign investments in any country focuses on two topics: Control Profit 15 Portfolio Investment This is the net balance of capital that flows in and out of the U.S., but does not reach the 10% ownership threshold of direct investment It is capital invested in activities that are purely profit-motivated rather than ones made in the prospect of controlling or managing the investment These have shown much more volatile behavior than net direct investments over the past decade 16 Other Investment Assets/Liabilities This category consists of: Short-term trade credits Long-term trade credits Cross-border loans from all types of financial institutions Currency deposits Bank deposits Other accounts receivable Accounts payable 17 Official Reserves Account This is the total currency and metallic reserves held by official monetary authorities within the country Its significance depends on whether the country is operating under: A fixed exchange rate regime A floating exchange rate system 18 The Balance of Payments-Total The International Monetary Fund (IMF) is the multinational organization that collects the BOP statistics for over 160 different countries around the globe The current, capital, and financial accounts combine to form the basic balance and is one of the most frequently used summary measures of the BOP The current, capital, financial, and net errors and omissions accounts combine to form the summary measure known as the overall balance or official settlements balance 19 The Balance of Payments and Economic Crises The sum of cross-border international economic activity can be used by international managers to forecast economic conditions and in some cases, the likelihood of economic crises The mechanics of international economic crises often follow a similar path of development 20 The Asian Crisis The roots of this currency crisis extended from a fundamental change in the economics of the region It started as early as 1990 in Thailand The most visible roots were the excesses in capital flows into Thailand in 1996 and early 1997 Corporate socialism, corporate governance, banking liquidity and management are underlying causes that apply to every nation facing economic crisis 21 Capital Mobility The degree to which capital moves freely cross-border is critical to a country’s balance of payments The ability of capital to move involves economic and political factors Obstfeld and Taylor (2001) studied the globalization of capital markets and argued the post-1860 era can be subdivided into four distinct periods 22 Capital Flight Capital flight is the sudden and shocking outflow of capital from a nation’s economy in which it is perceived there is political, economic, or currency crises forthcoming Five primary mechanisms exist by which capital may be moved from one country to another 23 The Cases of China and Turkey The Chinese balance of payments serves as an interesting example of one country’s ongoing efforts to manage its current and financial accounts Turkey’s economic and financial crisis of 2000-2001 serves as a prime example of how a country’s balance of payments can deteriorate or essentially collapse in a very short period of time 24 ... procedures for BOP accounting Defining International Transactions Identifying many international transactions is ordinarily not difficult However, some international transactions are not obvious... cross-border international economic activity can be used by international managers to forecast economic conditions and in some cases, the likelihood of economic crises The mechanics of international. .. imbalanced Three main elements to the process of measuring international economic activity include: Identifying what is and is not an international economic transaction Understanding how the flow