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Chapter 4

Chapter 4. International Business Transaction: The Balance of Payments. The Goals of Chapter 4. Explain what the balance of payments (BOP) is Study how to analyze BOP

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Chapter 4

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  1. Chapter 4 International Business Transaction: The Balance of Payments

  2. The Goals of Chapter 4 • Explain what the balance of payments (BOP) is • Study how to analyze BOP • Discuss the relationship between the BOP and the gross domestic product (GDP), the exchange rate, the interest rate, and the inflation rate • Introduce the history of the degree of the capital mobility and the mechanisms for capital movement (postponed until I teach Ch 3)

  3. The Balance of Payments 4-3

  4. The Balance of Payments • The measurement of different forms of international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP)(國際收支帳) (Note that the resident is a economic concept, and it includes individuals, firms, nonprofit communities, and the government) • BOP influences and is influenced by other variables, such as gross domestic product (GDP), employment levels, price levels, exchange rates, and interest rates • Government policymakers need the data of BOP to evaluate the general competitiveness of domestic industries, to set the exchange or interest rate, to determine the monetary and fiscal policy, etc.

  5. The Balance of Payments • BOP data is also important for MNEs as it is a gauge of a nation’s competitiveness or health • For a MNE, both home and host country BOP data is important because: • BOP is an indication of pressure on a country’s foreign exchange rate • Change in a country’s BOP may signal the imposition or removal of controls in various sorts of payments, e.g., removal of the capital outflow control may reduce the balance of the financial account in BOP • A forecast of a country’s market potential (especially in the short run), e.g., a country with trade deficit may welcome investments that can increase its exports

  6. Typical BOP Transactions • Each of the following represents an international economic transaction that is counted in and captured in the U.S. BOP: • A U.S. subsidiary of a foreign MNE acts as a distributor for the MNE’s products in the U.S. market • A U.S.-based firm manages the construction of a major water treatment facility in a foreign country • The U.S. subsidiary of a foreign firm pays profits (usually by distributing dividends to shareholders) back to the parent firm in its home (foreign) country • A Mexican lawyer purchases a U.S. corporate bond through an investment broker in the U.S.

  7. The Accounts of the BOP ※The classification of accounts of the BOP in this chapter follows the definition of the International Monetary Fund (IMF) ※ Because the IMF is the primary sources of statistics for BOPs, its terminologies are more wildly accepted ※ In fact, this system is also used by the Organization for Economic Cooperation and Development (OECD) and United Nations System of National Accounts (UNSNA)

  8. The Accounts of the BOP • The BOP is composed of three primary accounts, the Current Account, the Capital Account, and the Financial Account • In addition, the Official Reserves Account tracks government currency transactions • The fourth account, the Net Errors and Omissions Account, is produced to preserve the balance of the BOP • Later, I will introduce the theoretical double-entry bookkeeping rule of the BOP, and you will understand that BOP should balance • However, it is impossible to record all international transactions associated with a nation, so in practice the organizations to produce BOP reports collect national data for different accounts separately, which could result in the imbalances of the BOP

  9. The Current Account • The Current Account (經常帳)includes all international economic transactions with income or payment flows occurring within the current year. It consists of the following four subcategories: • Goods trade • The export and import of goods • The most traditional international economic activities • The current account is typically dominated by this component, which is known as the Balance of Trade (BOT)(貿易帳) • Services trade • The export and import of services • Including financial services provided by banks to foreign importers and exporters, travel services of airlines, and construction services of domestic firms in other countries • For the major industrial countries, like the U.S., this subaccount grows fast in the past decade

  10. The Current Account • Income • The dividend income from subsidiaries is the income receipts • The wages and salaries paid to nonresident workers are income payments • Current transfers • The change in ownership of real resources or financial items is called a transfer • Any transfer between countries that is one-way–a gift or grant–is termed a current transfer • For example, funds provided by the U.S. government to aid a less-developed nation, or money sent home by migrants and permanent workers abroad ※Although the information of balance of trade (BOT) is so widely quoted in the business press in most countries, this number is somewhat misleading for large industrialized countries because the service trade is not taken into account

  11. U.S. Trade Balance & Balance on Services & Income, 1985-2007 (billions of US$) ※The U.S. goods trade balance has been consistently negative, but has been slightly offset by the continuous surplus in the balance of services trade

  12. The Current Account • The deficits in the BOT of the U.S. in the past two decades have been wildly debated since merchandise trade is the original core of international trade • Reasons for the deficits in the BOT of the U.S. • Relatively high income in the U.S. creates the import demand • The price of the imported products after passing the exchange rate is cheaper, which may be caused by that many trading partners of the U.S. adopt the policy of depreciating their currency against US$ to maintain the competitive power in the U.S. market • The biggest bilateral deficits are with China and Japan, which maintain relative weakness of their currencies by buying massive amounts of U.S. dollars (usually investing in Treasury bonds) while selling corresponding amounts of their own currencies

  13. The Current Account • FYI, at the end of 2009, Japan and China held the largest amount of Treasury bonds in the world, each of which owns 768.8 billion and 755.4 billion US$, respectively • Later, you will see the above actions will increase the cash inflow for the financial account and thus cause the surplus of the financial account of the U.S. • The deficit in the BOT results in the decline of heavy traditional industries in the U.S. (steel, automobiles, automotive parts, textiles) • The consistent surplus in the services trade account may be from travel and passenger fares, transportation services, expenditures by foreign students pursuing studies in the U.S., telecommunications services, financial services, etc.

  14. The Capital and Financial Account • The capital account is made up of capital transfers related to the purchase and sale of fixed assets such as real estates, plants, or equipment, etc. • If a U.S. firm purchases a building in another country, this is a cash outflow in the capital account of the U.S. • The capital account has been introduced as a separate component in the IMF’s balance of payments only recently • The magnitude of capital transaction is relatively minor, so we include it in principle in the following discussion of the financial account

  15. The Financial Account • The financial account in the balance of payments measures all international economic transactions of financial assets • The financial account is classified into three components, depending on the degree of investor control over the assets or operations • Direct Investment – in which the invested financial assets exerts some explicit degree of control over the real assets • Portfolio Investment – in which the invested financial assets has no control over the real assets • Other Financial Investment – consists of bank deposits, various short-term and long-term trade credits, cross-border loans, currency deposits,, and other A/R and A/P related to cross-border trade

  16. Direct Investment • This is the net balance of capital dispersed from and into the U.S. for the purpose of exerting control over real assets • If U.S. investors hold 10% or more of the voting shares in a foreign company, that company is considered the foreign affiliate of a U.S. company, and this investment is classified as a direct investment • The source of concern over foreign direct investment in any country focuses on two topics: control and profit

  17. Direct Investment • Some countries possess restrictions on foreigners to own assets in their country, e.g., domestic land, assets, and industry should be owned only by residents of the country • However, the U.S. has few restrictions on what foreign residents or firms can own or control assets in the U.S. • As for profit, the concern of possible profit outflow may limit the foreign investment in some countries • There are evidences indicating that foreign firms in the U.S. reinvest most of their profits in their U.S. business (at a higher rate than domestic firms in the U.S.) • The capital inflow in the form of direct investment is generally welcomed in the U.S. due to the possible increase of jobs, production, services, technology, etc.

  18. 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 also 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 asset • The motivating forces for portfolio investment flows are only return and risk, so the series of the flow of portfolio investment is less predictable (Exhibit 3.5)

  19. Financial Account Balances for the United States, 1985-2007 (billions of US$)

  20. Transaction Bookkeeping in BOP • Before introducing the net errors and omissions and reserves accounts in the BOP, the theoretical bookkeeping process for BOP is introduced first • There are three main elements of the actual process of recording international economic activities: • Identifying what is and is not an international economic transaction (definition on Slide 4-4 and examples on Slide 4-6) • Understanding how the flows of goods, services, assets, and money create debits and credits to the overall BOP • Understanding the bookkeeping procedures for BOP accounting • The rule of thumb aids the understand of BOP accounting: “Follow the cash flow.” • Credits (+) (貸方): cash inflow • Debits (–)(借方): cash outflow

  21. Transaction Bookkeeping in BOP • Ex 1: The U.S. exports $2mil. goods to the U.K., and 1) the importer in the U.K. pays the money into the accountof the U.S. exporter in the U.K.; or 2) the importer in the U.K. uses the money in its account in the U.S. to pay the bill ※ Export of goods to foreign country will bring cash inflow for the U.S. in the account of Export of goods in Current Account 1) The increase of deposits of U.S. firms in foreign banks means a cash outflow for the U.S in the account of Other financial items in Financial Account 2) The decrease of deposits of foreign firms in U.S. means a cash outflow for the U.S in the account of Other financial items in Financial Account

  22. Transaction Bookkeeping in BOP • Ex 2: The U.S. imports $6mil. services from the U.K., and 1) the importer in the U.S. pays the money into the accountof the U.K. exporter in the U.S.; or 2) the importer in the U.S. use the money in its account in the U.K. to pay the bill ※Import of services from foreign countries will cause a cash outflow for the U.S. in the account of Import of services in Current Account 1) The increase of deposits of foreign firms in U.S. banks means a cash inflow for the U.S. in the account of Other financial items in Financial Account 2) For the U.S., drawing money from U.K. banks by its residents means a cash inflow in the account of Other financial items in Financial Account

  23. Transaction Bookkeeping in BOP • Ex 3: The U.S. government transfers $1mil. goods as a grant to Nicaragua ※ Export of goods to foreign country should bring cash inflow for the U.S. in the account of Export of goods in Current Account ※Transferring $1mil. goods as a grant to foreign country means a cash outflow for the U.S.in the account of Transfers in Current Account

  24. Transaction Bookkeeping in BOP • Ex 4: A U.K. firm purchases $5mil. U.S. Treasury bonds and pays the money from its accountsin the U.S. banks ※Purchasing U.S. Treasury bonds, which is a portfolio investment, brings cash inflow for the Net portfolio investment in Financial Account of the U.S. ※The decrease of deposits of foreign firms in U.S. banks means a cash outflow for Other financial items in Financial Account in the U.S.

  25. 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 • 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) • 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 • According to the above double-entry bookkeeping rule, the BOP must balance theoretically

  26. Net Errors & Omissions/Official Reserves Accounts • The official reserves account (or foreign exchange reserves) (外匯存底)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 (so-called hard currencies like the U.S. dollar, Euro, British pound, Japanese yen, gold, or SDRs) • Since the data of the current, capital, financial, and official reserves accounts are collected and recorded separately or there are possibly illegal transfers, errors could occur and thus the BOP may not balance in practice • The net errors and omissions account ensures that the BOP actually balances

  27. The U.S. BOP from 1998-2007 There is a surplus on the basic balance, which means a net cash inflow of 45 billion US$ to the U.S. + : cash inflow (demand) – : cash outflow (supply) The U.S. government uses its official reserves to buy 2 billion US$, i.e., it creates a net demand of 2 billion US$ by purchasing US$ with its official reserves in the exchange rate markets The U.S. government sells 4 billion US$ in exchange for increasing official reserves, i.e., providing net supply of US$ by using US$ to purchase foreign currencies Basic balance

  28. The Analysis of BOP 4-28

  29. Fixed and Float Exchange Rate Regimes • Fixed exchange rate regime • The domestic currency, guaranteed by the government, is convertible into a fixed amount of a foreign currency, a basket of currencies, or another measure of value, such as gold • Devaluation (revaluation): A deliberate downward (upward) adjustment to a country’s official exchange rate, also called the parity rate, relative to other currencies • In a fixed exchange rate regime, only a decision by a country’s government (i.e., the central bank) can alter the official value of the currency • Float exchange rate regime • A currency’s value is allowed to fluctuate according to the demand and supply in the foreign exchange market • Depreciation (appreciation): refers to a drop (increase) in the foreign exchange value of a floating currency

  30. The BOP in Total — Surplus • A surplus in the BOP  net cash inflow for the domestic country  foreign residents demand the domestic currency to pay the cash to the domestic residents  the demand of the domestic currency exceed the supply of the domestic currency • The domestic currency has the pressure to appreciate • If the government wants to maintain the fixed exchange rate, it can intervene the market by selling its own currency in exchange for other currencies and thus building up its stores of hard currencies, i.e., its foreign exchange reserves • Selling its own currency causes a cash outflow (supply) which diminishes the surplus in the BOP

  31. The BOP in Total — Deficit • A deficit in the BOP  net cash outflow for the domestic country  domestic residents demand the foreign currency to pay bills to foreign residents  an excess supply of the country’s currency in foreign exchange markets worldwide • The domestic currency has the pressure to depreciate • To maintain the fixed exchange rate, a government can intervene the market by purchasing it own currency at the expense of its foreign exchange reserves to support the domestic currency value • Buying its own currency causes a cash inflow (demand) which offsets the deficit in the BOP

  32. Official Reserves Accounts • 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 • In a fixed-rate system, the government decides the fixed exchange rate, also called the parity rate, to exchange for other foreign currencies • For excess supply (demand) of the domestic currency, to prevent the value of the domestic currency from falling (rising), the government should spend its official reserves (domestic currency) to purchase the domestic currency (official reserves) to support (calm down) the value of the domestic currency • Under a floating-rate system, governments have no such responsibility and the role of official reserves is diminished

  33. Current and Financial Account Balance Relationships • Since the BOP should balance, it is possible to infer the inverse relation between the current account and the financial account, which are the two major accounts in the BOP • In the examples on Slides 4-21 and 4-22, it is found that the double-entry bookkeeping in theory requires that the current and financial accounts offset for each other • Intuitively, countries experiencing current account deficits “finance” these purchases through equally large surpluses in the financial account (like the U.S.) • For the U.S., both real and financial assets possessed by foreigners increases, the country become a “net debtor” • On the other hand, for Japan, the current account surplus is matched against a financial account deficit

  34. Current and Financial/Capital Account Balances for the U.S., 1992-2007 (billions of US$) ※The above figure shows the inverse relationship between the balances of the current account and the capital/financial accountin the U.S.

  35. Current and Financial Account Balance Relationships • The surplus or deficit in the current account cannot be the signal for the performance of the economy • For the U.S., the well investment environment attracts capital and financial investments and this cash inflow finances the deficits in the current account • For Latin America • In 1980s, there was surplus in the current account, but the pessimistic prospects of the economy caused deficits in the capital and financial accounts • In 1990s, there are better expectations of the future economy, so there are surpluses in the capital and financial accounts, but together with the deficits in the current account • For rapidly growing countries (countries in recession), importing more (less) goods and services will decrease (increase) the balance of the current account or even generate deficits (surpluses) in the current account

  36. The China BOP from 1998-2007 There is a surplus on the basic balance, which means a net cash inflow of US$437 billion to China + : cash inflow (demand) – : cash outflow (supply) The China government sells Renminbi equivalent to 461 billion US$ in exchange for increasing official reserves, i.e., providing net supply of Renminbi by using Renminbi to purchase foreign currencies ※ Due to maintain the fixed exchange rate or said to diminish the appreciation pressure, the China governmentintervenes foreign currency markets by issuing more Renminbi to purchase foreign currencies ※ The results are the increase of foreign exchange reserves and a possible inflation problem

  37. Current and Financial Account Balance Relationships for China • The double surplus in China • Surpluses in both the current and financial accounts is called the double surplus phenomenon • This unusual phenomenon reflects how exceptional the growth of the Chinese economy is • Although the current account surplus should create a financial account deficit, the positive prospects of the Chinese economy have drawn such massive capital inflows in recent year and thus the financial account becomes in surplus • The underestimated value of Renminbi strengthens the capital inflows • This phenomenon also reflects that China is a world factory–attract international capital, build factories, produce goods, and export them

  38. Current and Financial Account Balance Relationships for China • The China government conduct a lot of intervention to maintain its balance of payment and thus the relatively fixed exchange rate against the U.S. dollar • The appropriate solution is to allow the Renminbi to float and appreciate. However, it is not in line with China’s current political plan

  39. The BOP Interaction with Macroeconomic Variables 4-39

  40. The BOP Interaction with Key Macroeconomic Variables • A nation’s balance of payments interacts with nearly all of its key macroeconomic variables • Interaction means that the BOP affects and is affected by key macroeconomic factors such as: • Gross Domestic Product (GDP) • Exchange rates • Interest rates • Inflation rates

  41. The BOP and GDP • In a static (accounting) sense, a nation’s GDP can be represented by the following macroeconomic accounting identity: GDP = C + I + G + X – M where C = consumption spending I = capital investment spending G = government spending X = exports of goods and services M = imports of goods and services X – M = the sum of balances of the first two subaccounts in the current account, which is close to the total balance on the current account and thus used to “approximate” the balance on the current account

  42. The BOP and GDP • In the same period, a positive current account balance (surplus) contributes directly to increasing the measure of GDP, but a negative current account balance (deficit) decreases GDP • Taking multiple periods into account • GDP ↑ disposable income ↑ consumption ↑ import ↑ balance of current account ↓ • GDP ↑ capital investment ↑ export ↑ balance of current account ↑ ※Thus, in a dynamic sense, the relationship between GDP and balance of the current account is uncertain ※BTW, GDP↑ capital investment ↑ employment rate ↑ (could be offset by the foreign sourcing, i.e., the import of cheaper goods and services from foreign countries), so the BOP also influences the employment rate

  43. The BOP and Exchange Rates • A country’s BOP can have a significant impact on the level of its exchange rate and vice versa, depending on that country’s exchange rate regime • In fact, the value of BOP has predicting power for exchange rates on the long-term trend, but performs poor on the short-term movement • Fixed Exchange Rate Countries • Under a fixed exchange rate system, the government is responsible to ensure that the BOP is near zero by intervening markets and matching the demand and the supply of the domestic currency • When there is a deficit for the overall balance, if the country run out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue

  44. The BOP and Exchange Rates • Floating Exchange Rate Countries • Under a floating exchange rate system, the government has no responsibility to peg its foreign exchange rate • Surplus on the BOP  currency appreciation  price of export goods ↑, price of import goods ↓  export ↓, import ↑ BOT ↓  BOP ↓ • Deficit on the BOP  currency depreciation  price of export goods↓, price of import goods↑ export ↑, import ↓ BOT ↑  BOP ↑ ※Thus, the floating exchange rate regime can adjust the BOP automatically • However, the effect of the change of the exchange rate will not affect the BOP in the right direction immediately • For deficits in the BOP, the effect of currency depreciation will let the deficits get worse in the short run, but moves back toward equilibrium in the long run (J-curve effect discussed later)

  45. The BOP and Exchange Rates • Managed Floating Regime • Countries adopting this regime have desired exchange rates, but they allow the exchange rate to derivate from the desired level to some extent • They often find that it is necessary to take action to maintain their desired exchange rate levels • In addition to intervening the foreign exchange market, they usually try to alter the exchange rate by influencing the motivations of market participants • For example, to deal with the depreciation pressure from the deficit in the BOP, governments may raise domestic interest rate to attract additional capital from aboard, which creates additional demand for the domestic currency and alleviates the depreciation pressure (in the meanwhile, diminishes the deficit in the BOP)

  46. The BOP and Interest Rates • Apart from the use of interest rates to intervene the foreign exchange market, the overall level of a country’s interest rates compared to other countries DOES have impact on the financial account of the BOP • Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere • In the case of the U.S., even with low real interest rates, the opposite has occurred due to perceived growth opportunities and political stability, which allows 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

  47. The BOP and Inflation Rates • The effect of increasing imports • Due to the comparative advantage theory in international trade, imports of goods and services are usually cheaper and have the potential to lower a country’s inflation rate • Imports ↑ balance on current account ↓ BOP ↓ ※If the BOP declines with the increase of the import, the inflation rates may decrease in the meantime • In addition, imports ↑ foreign competition substitutes for domestic competition  domestic production ↓, employment rate ↓ GDP ↓ (this argument is consistent with the macroeconomic accounting identity, i.e., imports ↑  GDP ↓)

  48. Trade Balances and Exchange Rates J-Curve Adjustment • A country’s import and export of goods and services are 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, i.e., changing prices in turn result in changes in quantities demanded through the price elasticity of demand

  49. Exhibit 4.8 – The J-Curve Effect ※ There are three stages to adjust the deficit of the balance of trade ※ The adjustment path of the trade balance is like the shape of a flattened “J” ※ In the pass-through period, import prices ↑ and export prices ↓ due to the currency depreciation (explained on the next slide) ※ In the quantity adjustment period, import demand ↓ and export demand ↑, so the balance of trade–exports less imports–improves eventually

  50. Trade Balances and Exchange Rates J-Curve Adjustment • The reason why the sudden depreciation of the domestic currency deteriorates the trade deficit immediately in the J-curve adjustment • Most exports were priced in US$, but most imports were contracts denominated in foreign currency • Sudden depreciation: because all the contracts of exports and imports are in effect and the cost to U.S. importers rise as they spent more dollars to buy foreign currencies, whereas the revenues earned by U.S. exporters remain unchanged, it deteriorates the trade deficit immediately • The “J-curve” adjustment path gives the reason that many countries, e.g., Taiwan in 1997, adopted the devaluation strategy to improve the trade balance

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