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The Balance of Payments

     • International business transactions occur
       in many different forms over the course
       of a year
     • The measurement of all international
        economic transactions between the
        residents of a country and foreign
        residents is called the balance of
        payments (BOP)
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The Balance of Payments

      • BOP data is important for government policymakers
        and MNEs as it is a gauge of a nations competitiveness
        or health (domestic and/or foreign)
      • 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
Copyright ©(especially in the short run)
             2007 Pearson
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reserved.                                           1-2
Typical BOP Transactions

      • Each of the following represents an
        international economic transaction that is
        counted in and captured in the US BOP:
          – A US subsidiary of a foreign MNE acts as a
            distributor for the MNEs products in the US market
          – A US based firm, manages the construction of a
            major water treatment facility in a foreign country
          – The US subsidiary of a foreign firm pays profits
            (dividends) back to a parent in its home (foreign)
            country
          – The US government finances the purchase of
Copyright ©military equipment for a foreign military ally
             2007 Pearson
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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
     • Therefore it is incorrect to state that the
       BOP is in disequilibrium
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Fundamentals of BOP Accounting

      • There are three main elements of the actual process of
        measuring international economic activity:
         – Identifying what is and is not an international
           economic transaction
         – Understanding how the flow of goods, services,
           assets, and money create debits and credits to the
           overall BOP
         – Understanding the bookkeeping procedures for
           BOP accounting
      • It is a daunting task to measure all international
         transactions that take place in and out of a country over
Copyright © 2007 Pearson
         a year
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The BOP as a Flow Statement

      • The BOP is often misunderstood as many people infer
        from its name that it is a balance sheet, whereas in fact
        it is a cash flow statement
      • By recording all international transactions over a
        period of time such as a year, it tracks the continuing
        flows of purchases and payments between a country
        and all other countries
      • It does not add up the value of all assets and liabilities
         of a country on a specific date (as an individual firm’s
         balance sheet would do)
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The BOP as a Flow Statement

     • Two types of business transactions
       dominate the balance of payments:
         – Exchange of Real Assets
         – Exchange of Financial Assets
     • Although assets can be identified as
        belonging to distinct groups, it is easier
        to think of all assets simply as goods that
        can be bought or sold (a clock versus a
        bond)
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The Accounts of the BOP

     • The BOP is composed of two primary
       sub accounts, the Current Account and
       the Capital/Financial Account
     • In addition, the Official Reserves account
       tracks government currency transactions
     • A fourth account, the Net Errors and
        Omissions account is produced to
        preserve the balance of the BOP
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The Current Account

      • 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
      • The Current Account is typically dominated by the first
         component which is known as the Balance of Trade
Copyright © 2007 Pearson it excludes service trade
         (BOT) even though
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Exhibit 3.3 U.S. Trade Balance & Balance on
          Services & Income, 1985-2003 (billions of US$)
         $200


         $100


           $0


        –$100


        –$200


        –$300


        –$400


        –$500


Copyright © 2007 Pearson
     –$600
           1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
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                             Balance on goods               Balance on services and income
reserved.                                                                          1-10
                Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2004.
The Current Account

     • The deficits in the BOT of the past decade have
       been an area of considerable concern for the
       United States, in both the public and private
       sectors: WHY? What is potential impact of
       large CA deficits?
     • The goods trade deficit saw the decline of
       heavy traditional industries in the U.S. (steel,
       automobiles, automotive parts, textiles)
Copyright © 2007 Pearson
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The Capital/Financial Account

     • The Capital Account of the balance of
       payments measures all international
       economic transactions of financial assets.
        It is divided into two major components:
         – The Capital Account
         – The Financial Account
     • The Capital Account is minor (in
        magnitude), while the Financial Account
        is significant
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The Financial Account

     • Financial assets can be classified in a
       number of different ways including the
       length of the life of the asset (maturity)
       and the nature of the ownership (public
       or private)
     • The Financial Account, however, uses a
        third method. This focuses on the degree
        of investor control over the assets or
        operations
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The Financial Account

      • The Financial Account consists of three
        components;
         – Direct Investment – in which the investor exerts
           some explicit degree of control over the assets
         – Portfolio Investment – in which the investor has
           no control over the assets
          – Other Investment – consists of various short-term
            and long-term trade credits, cross-border loans,
            currency deposits, bank deposits and other A/R and
Copyright ©A/P related to cross-border trade
             2007 Pearson
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Direct Investment

      •   This is the net balance of capital dispersed from and into the US
          for the purpose of exerting control over assets.
      •   Foreign direct investment arises from 10% ownership of voting
          shares in a domestic firm by foreign investors.
      •   The source of concern over foreign investment in any country
          focuses on two topics: control and profit.
      •   Some countries possess restrictions on foreigners may own in
          their country.
      •   The general rule or premise is that domestic land, assets and
          industry should be owned by residents of the country.
      • Concerns over profit
Copyright © 2007 Pearsonstem from the same argument.
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Portfolio Investment

     • This is the net balance of capital that flows in
       and out of the U.S. but does not reach the 10%
       threshold of direct investment.
     • The purchase of debt securities across borders
       is classified as portfolio investment because
       debt securities by definition do not provide the
       buyer with ownership or control.
     • Portfolio investment is motivated by a search
        for returns rather than to control or manage the
        investment.
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Exhibit 3.6 Current and Financial/Capital
           Account Balances for the United States,
           1992-2003 (billions of US$)
 $600


 $400


 $200


   $0


–$200


–$400


–$600
      1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
  Copyright © 2007 Pearson                                                                        2003

  Addison-Wesley. All Current Account Capital/Financial Account
                               rights
  reserved. Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2004.
                                                                            1-17
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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The BOP in Total — Surplus

     • A surplus in the BOP implies that the
       demand for the country’s currency
       exceeded the supply and that the
       government should allow the currency
       value to increase – in value – or
       intervene and accumulate additional
       foreign currency reserves in the Official
       Reserves Account.
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The BOP in Total — Deficit

     • A deficit in the BOP implies an excess
       supply of the country’s currency on
       world markets, and the government
       should then either devalue the currency
       or expend its official reserves to support
       its value.


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Recording of BOP transactions
     •   Recording of BOP transactions
     •   Transaction that earn FX are recorded as +, "credit". Credit is issued
         when a good or service is sold to a "non-resident" of a country.
     •   Example: if Boeing sells a Jet to France, the transaction is recorded as a
         credit to U.S. BOT account, while France's account in U.S will be
         debited:
     •   Transaction                          Credit                         Debit
     •   Export plane                         +100M
     •   Withdraw funds                                                      -100M
     •   Transactions that expend FX are recorded as "debit" and assigned a
         negative sign (-)
     •          Transaction                   Credit                         Debit
     •   Import material                                                     -100M

     •   Deposit funds             100M
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The BOP Interaction with Key
     Macroeconomic Variables

     • A nation’s balance of payments interacts with
       nearly all of its key macroeconomic variables
     • Interacts means that the BOP affects and is
       affected by such key macroeconomic factors
       as:
          – Gross Domestic Product (GDP)
          – The exchange rate
          – Interest rates
          – Inflation rates
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The BOP and GDP

     • In a static (accounting) sense, a nation’s
       GDP can be represented by the following
       equation:
           GDP = C + I + G + X – M




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The BOP and GDP

     • The variables from the formula on the
       previous page are defined as:
         C = consumption spending
         I = capital investment spending
         G = government spending
         X = exports of goods and services
         M = imports of goods and services
CopyrightX – M = the current account balance
          © 2007 Pearson
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The BOP and Exchange Rates

     • A country’s BOP can have a significant
       impact on the level of its exchange rate
       and vice versa
     • The relationship between the BOP and
       exchange rates can be illustrated by use
       of a simplified equation that summarizes
       BOP Data (see next slide)
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The BOP and Exchange Rates

         (X – M) + (CI – CO) + (FI – FO) + FXB = BOP

      Where:
         X = exports of goods and services
                                                Current Account Balance
         M = imports of goods and services
         CI = capital inflows     Capital Account Balance
         CO = capital outflows
         FI = financial inflows     Financial Account Balance
         FO = financial outflows
         FXB = official monetary reserves
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The BOP and Exchange Rates

      • Fixed Exchange Rate Countries
          – Under a fixed exchange rate system, the
            government bears the responsibility to ensure that
            the BOP is near zero
      • Floating Exchange Rate Countries
          – Under a floating exchange rate system, the
            government has no responsibility to peg its foreign
            exchange rate
      • Managed Floats
          – Countries operating with a managed float often find
            it necessary to take action to maintain their desired
Copyright ©exchange rate values
             2007 Pearson
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The BOP and Interest Rates

      • Apart from the use of interest rates to intervene in the
         foreign exchange market, the overall level of a country’s
         interest rates compared to other countries does have and
         impact on the financial account of the BOP
      • Relatively low real interest rates should normally
         stimulate an outflow of capital seeking higher rates
         elsewhere
      • However, in the case of the U.S., the opposite has
         occurred due to perceived growth opportunities and
         political stability – allowing it to finance its large fiscal
         deficit
      • However, it is beginning to appear that the favorable
         inflow on the financial account is diminishing while the
         current account balance is worsening – making the U.S. a
Copyright © 2007 Pearson
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         bigger debtor nation
reserved.                                                1-28
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 process 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
Copyright © 2007 Pearson is more complex
        global business
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Exhibit 3.8 – The J Curve
                Trade Balance
              (domestic currency)
                                                                            Trade Balance



    Initial Trade
Balance Position
 (typically in deficit)                                                            Time
                                                                                   (months)
                                        t1                     t2




                                    Currency   Exchange Rate    Quantity
                                    Contract   Pass-Through    Adjustment
   Copyright © 2007 Pearson          Period       Period         Period
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   reserved.                                                        1-30
Capital Mobility

     • The degree to which capital moves freely
       across borders is critically important to a
       country’s balance of payments
     • The financial account surplus has
       probably been one of the major reasons
       that the U.S. dollar has been able to
       maintain its value over the past 20 years
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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
         – 1971-2002 – floating exchange rates, economic volatility,
           rapidly expanding cross-border capital flows
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Exhibit 3.10 A Stylized View of
              Capital Mobility in Modern History
      Capital Mobility
                                                                                                           2000
      High
                   Gold Standard
                    1880-1914
                                                 1914
                                                 •                                                       •
                                  1900
                                         •                                                Float
                                                                                        1971-2000



                                                            1929

                           •                                •
                                                                                            •
                                                                   Bretton Woods
                             1880                                                               1980
                                                                     1945-1971
              •                                         •                      • •
     Low        1860                                                       1960
                                             1918
                                                    •    1925
                                             Interwar, 1914-1945      •
                                                                                   1971
                                                                    1945
   Copyright © 2007 Pearson
            1860         1880         1900         1920         1940         1960       1980         2000
   Addison-Wesley. All rights
Source: “Globalization and Capital Markets,” Maurice Obstfeld and Alan M. Taylor, NBER Conference Paper, May 4-5, 2001, p. 6.
   reserved.                                                                                1-33
Capital Flight

     • Although no single definition of capital flight
       exists, it has been characterized as occurring
       when capital transfers by residents conflict
       with political objectives.
     • Many heavily indebted countries have suffered
       capital flight, compounding their debt service
       problems.
     • Capital can be moved via international
        transfers, with physical currency, collectables
        or precious metals, money laundering or false
        invoicing of international trade transactions.
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Mini-Case Questions: Turkey’s Kriz (A)

     • Where in the current account would the
        imported telecommunications equipment be
        listed? Would this location correspond to the
        increase in magnitude and timing of the
        financial account?
     • Why do you think that net direct investment
        declined from $573 million in 1998 to $112
        million in 2000?
     • Why do you think that TelSim defaulted on its
        payments for equipment imports from Nokia
Copyright © 2007 Pearson
        and Motorola?
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Bop

  • 1. The Balance of Payments • International business transactions occur in many different forms over the course of a year • The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-1
  • 2. The Balance of Payments • BOP data is important for government policymakers and MNEs as it is a gauge of a nations competitiveness or health (domestic and/or foreign) • 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 Copyright ©(especially in the short run) 2007 Pearson Addison-Wesley. All rights reserved. 1-2
  • 3. Typical BOP Transactions • Each of the following represents an international economic transaction that is counted in and captured in the US BOP: – A US subsidiary of a foreign MNE acts as a distributor for the MNEs products in the US market – A US based firm, manages the construction of a major water treatment facility in a foreign country – The US subsidiary of a foreign firm pays profits (dividends) back to a parent in its home (foreign) country – The US government finances the purchase of Copyright ©military equipment for a foreign military ally 2007 Pearson Addison-Wesley. All rights reserved. 1-3
  • 4. Fundamentals of BOP Accounting • The BOP must balance • It cannot be in disequilibrium unless something has not been counted or has been counted improperly • Therefore it is incorrect to state that the BOP is in disequilibrium Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-4
  • 5. Fundamentals of BOP Accounting • There are three main elements of the actual process of measuring international economic activity: – Identifying what is and is not an international economic transaction – Understanding how the flow of goods, services, assets, and money create debits and credits to the overall BOP – Understanding the bookkeeping procedures for BOP accounting • It is a daunting task to measure all international transactions that take place in and out of a country over Copyright © 2007 Pearson a year Addison-Wesley. All rights reserved. 1-5
  • 6. The BOP as a Flow Statement • The BOP is often misunderstood as many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement • By recording all international transactions over a period of time such as a year, it tracks the continuing flows of purchases and payments between a country and all other countries • It does not add up the value of all assets and liabilities of a country on a specific date (as an individual firm’s balance sheet would do) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-6
  • 7. The BOP as a Flow Statement • Two types of business transactions dominate the balance of payments: – Exchange of Real Assets – Exchange of Financial Assets • Although assets can be identified as belonging to distinct groups, it is easier to think of all assets simply as goods that can be bought or sold (a clock versus a bond) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-7
  • 8. The Accounts of the BOP • The BOP is composed of two primary sub accounts, the Current Account and the Capital/Financial Account • In addition, the Official Reserves account tracks government currency transactions • A fourth account, the Net Errors and Omissions account is produced to preserve the balance of the BOP Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-8
  • 9. The Current Account • 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 • The Current Account is typically dominated by the first component which is known as the Balance of Trade Copyright © 2007 Pearson it excludes service trade (BOT) even though Addison-Wesley. All rights reserved. 1-9
  • 10. Exhibit 3.3 U.S. Trade Balance & Balance on Services & Income, 1985-2003 (billions of US$) $200 $100 $0 –$100 –$200 –$300 –$400 –$500 Copyright © 2007 Pearson –$600 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Addison-Wesley. All rights Balance on goods Balance on services and income reserved. 1-10 Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2004.
  • 11. The Current Account • The deficits in the BOT of the past decade have been an area of considerable concern for the United States, in both the public and private sectors: WHY? What is potential impact of large CA deficits? • The goods trade deficit saw the decline of heavy traditional industries in the U.S. (steel, automobiles, automotive parts, textiles) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-11
  • 12. The Capital/Financial Account • The Capital Account of the balance of payments measures all international economic transactions of financial assets. It is divided into two major components: – The Capital Account – The Financial Account • The Capital Account is minor (in magnitude), while the Financial Account is significant Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-12
  • 13. The Financial Account • Financial assets can be classified in a number of different ways including the length of the life of the asset (maturity) and the nature of the ownership (public or private) • The Financial Account, however, uses a third method. This focuses on the degree of investor control over the assets or operations Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-13
  • 14. The Financial Account • The Financial Account consists of three components; – Direct Investment – in which the investor exerts some explicit degree of control over the assets – Portfolio Investment – in which the investor has no control over the assets – Other Investment – consists of various short-term and long-term trade credits, cross-border loans, currency deposits, bank deposits and other A/R and Copyright ©A/P related to cross-border trade 2007 Pearson Addison-Wesley. All rights reserved. 1-14
  • 15. Direct Investment • This is the net balance of capital dispersed from and into the US for the purpose of exerting control over assets. • Foreign direct investment arises from 10% ownership of voting shares in a domestic firm by foreign investors. • The source of concern over foreign investment in any country focuses on two topics: control and profit. • Some countries possess restrictions on foreigners may own in their country. • The general rule or premise is that domestic land, assets and industry should be owned by residents of the country. • Concerns over profit Copyright © 2007 Pearsonstem from the same argument. Addison-Wesley. All rights reserved. 1-15
  • 16. Portfolio Investment • This is the net balance of capital that flows in and out of the U.S. but does not reach the 10% threshold of direct investment. • The purchase of debt securities across borders is classified as portfolio investment because debt securities by definition do not provide the buyer with ownership or control. • Portfolio investment is motivated by a search for returns rather than to control or manage the investment. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-16
  • 17. Exhibit 3.6 Current and Financial/Capital Account Balances for the United States, 1992-2003 (billions of US$) $600 $400 $200 $0 –$200 –$400 –$600 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Copyright © 2007 Pearson 2003 Addison-Wesley. All Current Account Capital/Financial Account rights reserved. Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2004. 1-17
  • 18. 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-18
  • 19. The BOP in Total — Surplus • A surplus in the BOP implies that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase – in value – or intervene and accumulate additional foreign currency reserves in the Official Reserves Account. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-19
  • 20. The BOP in Total — Deficit • A deficit in the BOP implies an excess supply of the country’s currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-20
  • 21. Recording of BOP transactions • Recording of BOP transactions • Transaction that earn FX are recorded as +, "credit". Credit is issued when a good or service is sold to a "non-resident" of a country. • Example: if Boeing sells a Jet to France, the transaction is recorded as a credit to U.S. BOT account, while France's account in U.S will be debited: • Transaction Credit Debit • Export plane +100M • Withdraw funds -100M • Transactions that expend FX are recorded as "debit" and assigned a negative sign (-) • Transaction Credit Debit • Import material -100M • Deposit funds 100M Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-21
  • 22. The BOP Interaction with Key Macroeconomic Variables • A nation’s balance of payments interacts with nearly all of its key macroeconomic variables • Interacts means that the BOP affects and is affected by such key macroeconomic factors as: – Gross Domestic Product (GDP) – The exchange rate – Interest rates – Inflation rates Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-22
  • 23. The BOP and GDP • In a static (accounting) sense, a nation’s GDP can be represented by the following equation: GDP = C + I + G + X – M Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-23
  • 24. The BOP and GDP • The variables from the formula on the previous page are defined as: C = consumption spending I = capital investment spending G = government spending X = exports of goods and services M = imports of goods and services CopyrightX – M = the current account balance © 2007 Pearson Addison-Wesley. All rights reserved. 1-24
  • 25. The BOP and Exchange Rates • A country’s BOP can have a significant impact on the level of its exchange rate and vice versa • The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP Data (see next slide) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-25
  • 26. The BOP and Exchange Rates (X – M) + (CI – CO) + (FI – FO) + FXB = BOP Where: X = exports of goods and services Current Account Balance M = imports of goods and services CI = capital inflows Capital Account Balance CO = capital outflows FI = financial inflows Financial Account Balance FO = financial outflows FXB = official monetary reserves Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-26
  • 27. The BOP and Exchange Rates • Fixed Exchange Rate Countries – Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero • Floating Exchange Rate Countries – Under a floating exchange rate system, the government has no responsibility to peg its foreign exchange rate • Managed Floats – Countries operating with a managed float often find it necessary to take action to maintain their desired Copyright ©exchange rate values 2007 Pearson Addison-Wesley. All rights reserved. 1-27
  • 28. The BOP and Interest Rates • Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries does have and impact on the financial account of the BOP • Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere • However, in the case of the U.S., the opposite has occurred due to perceived growth opportunities and political stability – allowing it to finance its large fiscal deficit • However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the current account balance is worsening – making the U.S. a Copyright © 2007 Pearson Addison-Wesley. All rights vis-à-vis the rest of the world bigger debtor nation reserved. 1-28
  • 29. 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 process 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 Copyright © 2007 Pearson is more complex global business Addison-Wesley. All rights reserved. 1-29
  • 30. Exhibit 3.8 – The J Curve Trade Balance (domestic currency) Trade Balance Initial Trade Balance Position (typically in deficit) Time (months) t1 t2 Currency Exchange Rate Quantity Contract Pass-Through Adjustment Copyright © 2007 Pearson Period Period Period Addison-Wesley. All rights reserved. 1-30
  • 31. Capital Mobility • The degree to which capital moves freely across borders is critically important to a country’s balance of payments • The financial account surplus has probably been one of the major reasons that the U.S. dollar has been able to maintain its value over the past 20 years Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-31
  • 32. 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 – 1971-2002 – floating exchange rates, economic volatility, rapidly expanding cross-border capital flows Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-32
  • 33. Exhibit 3.10 A Stylized View of Capital Mobility in Modern History Capital Mobility 2000 High Gold Standard 1880-1914 1914 • • 1900 • Float 1971-2000 1929 • • • Bretton Woods 1880 1980 1945-1971 • • • • Low 1860 1960 1918 • 1925 Interwar, 1914-1945 • 1971 1945 Copyright © 2007 Pearson 1860 1880 1900 1920 1940 1960 1980 2000 Addison-Wesley. All rights Source: “Globalization and Capital Markets,” Maurice Obstfeld and Alan M. Taylor, NBER Conference Paper, May 4-5, 2001, p. 6. reserved. 1-33
  • 34. Capital Flight • Although no single definition of capital flight exists, it has been characterized as occurring when capital transfers by residents conflict with political objectives. • Many heavily indebted countries have suffered capital flight, compounding their debt service problems. • Capital can be moved via international transfers, with physical currency, collectables or precious metals, money laundering or false invoicing of international trade transactions. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-34
  • 35. Mini-Case Questions: Turkey’s Kriz (A) • Where in the current account would the imported telecommunications equipment be listed? Would this location correspond to the increase in magnitude and timing of the financial account? • Why do you think that net direct investment declined from $573 million in 1998 to $112 million in 2000? • Why do you think that TelSim defaulted on its payments for equipment imports from Nokia Copyright © 2007 Pearson and Motorola? Addison-Wesley. All rights reserved. 1-35