International Finance
FINA 5331
Lecture 5: Balance of Payments
Read: Chapters 3
Aaron Smallwood Ph.D.
Balance of Payments Example
• Suppose that Maplewood Bicycle in
Maplewood, Missouri, USA imports
$100,000 worth of bicycle frames from
Mercian Bicycles in Darby England.
• There will exist a $100,000 credit recorded
by Mercian that offsets a $100,000 debit at
Maplewood’s bank account.
• This will lead to a rise in the supply of
dollars and the demand for British pounds.
Balance of Payments Accounts
• The balance of payments accounts are those
that record all transactions between the
residents of a country and residents of all foreign
nations.
• They are composed of the following:
– The Current Account
– The Financial Account
• The Official Reserves Account
– The Capital Account
– Statistical Discrepancy
The Current Account
• Includes all imports and exports of goods and
services, including financial services (invisible
trade or investment income).
• Includes unilateral transfers of foreign aid.
• If the debits exceed the credits, then a country is
running a trade deficit.
• If the credits exceed the debits, then a country is
running a trade surplus.
• It is thought that the current responds to changes
in income and the exchange rate.
The current account
• Consists of four categories
– Merchandise trade (tangible goods)
– Services (trade in factors of production)
– Investment income (credit if we receive
payment on previous investment, debit if we
make payments on previous investments).
– Unilateral transfers (gifts and aid).
The Current Account
• A credit on the current account results in
foreign reserves flowing in (fixed exchange
rate) or an increase in the demand for
domestic currency in the FOREX market
(flexible exchange rate).
• A debit on the current account results in
foreign reserves flowing out of the domestic
economy (fixed exchange rate) or an
increase in the supply of domestic currency in
the FOREX market (flexible exchange rate).
The Current Account
• When a domestic company sells goods or services to
a foreign resident, there will be a credit recorded on
the current account.
• When a domestic resident buys goods or services
from a foreign firm, there will be a debit recorded on
the current account.
• When a foreign asset pays interest to a domestic
resident, or a domestic resident earns income in the
foreign economy, there will be a credit recorded on the
current account.
• When a domestic asset pays interest to a foreign
resident, or a foreign resident earns income in the
domestic economy, there will be a debit recorded on
the current account.
J-curve Effect
What conditions are necessary for J-curve effect?
εIM is the import demand elasticity = %Δimports divided by %ΔSt.
When εIM is greater than one (in absolute value), a domestic depreciation will lead
to a fall in the RMB value of imports. Import demand is said to be elastic.
When εIM is equal to one (in absolute value), a domestic depreciation will not
change the RMB value of imports.
When εIM is less than one (in absolute value), a domestic depreciation will lead to a
rise in the RMB value of imports. Import demand is inelastic.
The J-curve can only occur when import demand elasticities are inelastic.
Algebra of Import Demand Elasticities
RMB value of imports = S t ( RMB / FC )´ Qimports
%DRMB value of imports = %DS t + %DQimports
%DRMB value of imports %DS t %DQimports
=
+
= 1+ e IM
%DS t
%DS t
%DS t
Since e IM < 0 and %DS t > 0,
ì = 0 if unit elasticity
%DRMB value of imports ïï
< 0 if elastic
í
%DS t
ï
> 0 if inelastic
ïî
ü
ïï
ý
ï
ïþ
J-curve
• The point is your company’s expenditures on
imports may increase following a domestic
currency depreciation.
• While export volumes are expected to increase,
if small, the generated revenue may not fully
cover the increase in costs. Profits could be
reduced.
• For an economy, if imports rise by a larger
amount than exports, the trade balance could
move into deficit.
The Financial Account
• The financial account for China measures the
difference between Chinese sales of assets to
foreigners and Chinese purchases of foreign
assets.
• The financial account is composed of Foreign
Direct Investment (FDI), portfolio investments
and other investments, and technically official
reserves.
• Because of their importance, official reserves
are sometimes treated separately.
The Financial Account
• A credit on the financial account results in
foreign reserves flowing in (fixed exchange
rate) or an increase in the demand for
domestic currency in the FOREX market
(flexible exchange rate).
• A debit on the financial account results in
foreign reserves flowing out of the domestic
economy (fixed exchange rate) or an
increase in the supply of domestic currency in
the FOREX market (flexible exchange rate).
The Financial Account
• When a domestic entity (firm or individual)
sells an asset to a foreign resident, there will
be a credit recorded on the financial account.
• When a domestic resident buys an asset from
a foreign entity, there will be a debit recorded
on the financial account.
• Note – income earned on these assets is
recorded on the current account, NOT the
financial account!!!
The Balance of Payments Identity
BCA + BFA + BRA = 0
BCA = balance on current account
BFA = balance on financial account
BRA = balance on the reserves account
(which assumes no capital account balance and no
statistical discrepancy)
• Note: When a country experiences a currency
crisis, we typically see BRA>0 (and HUGE)
Under a pure flexible exchange rate regime,
BCA + BFA = 0
Because BRA = 0
Official settlements
• The official settlements balance,
sometimes referred to as the overall
balance, is the balance on the current
account plus capital account plus nonofficial reserve component of the financial
account.
• If a country has a balance of -$5 billion in
their official reserves, the official
settlements balance is +$5billion.
Balance of Payments Trends
• Since 1982, the U.S. has experienced
continuous deficits on the current account
and continuous surpluses on the nonofficial reserve component of the financial
account.
• During the same period, China has
experienced surpluses in both and deficit
in official reserves.
China BOP
Japan BOP
USA BOP
Balances on the Current (BCA) and Financial (BKA)
Accounts of United Kingdom
United Kingdom
80
Balances in Billions of US dollars
60
Current Account Balance
Financial Account Balance
40
20
0
-20
-40
-60
-80
-100
1981
1986
1991
1996
2001
2006
2011
Official reserves
• In the US official reserve assets include gold,
foreign currency, and special drawing rights
(issued by the IMF).
• The official settlements balance is BCA+BFA
• When BCA+BFA≠0, the central bank must
acquire or deplete holdings of official reserves.