Economics of International Finance Econ. 315

1. Economics of International FinanceEcon. 315 Chapter 2: Balance of Payments

2. Balance of Payments (BOP) Definition: • A Summary statement in which all TRANSACTIONS of the RESIDENTS in a nation with the residents of all other nations (NON-RESIDENTS) which are recorded during a particular PERIOD of time (usually one calendar year). • What is meant by: • International transactions: • The exchange of a good, service or an asset, between the residents of one nation and the residents of other nations (payments are required for these transactions). • Gifts and other transfer payments are also included (No Payments are required here).

3. 2. The residents and Non-residents: Residents are Persons and other bodies that are normally residents in the country, Note: • Temporary immigrants, e.g., diplomats, tourists and temporary workers are not residents (they are residents of the country in which they hold citizenship). • Corporations are residents of the country in which they are incorporated, but branchesand subsidiaries are not. • International institutions (UN, WB, IMF, WTO ..etc) are non residents at the country in which they are located.

4. The period Usually a calendar year, however most of the countries keep a record on a quarterly basis (e.g., Kuwait).

5. The BALANCE OF PAYMENTS (BOP) Accounts First: Items above the line CURRENT ACCOUNT --Records the country’s trade in currently produced goods and services along with unilateral transfers between countries-- * Good & Services Balance (Exports & Imports) Goods Services( Transportation, Insurance, Travel, Other services) * Income Account Investment Income( current income received & paid on international investment ) * Current Transfers (Unilateral Transfers) * General government ( government grants and other transfers) * Workers remittances

6. The BALANCE OF PAYMENTS (BOP) Accounts CAPITAL & FINANCIAL ACCOUNT • CAPITAL ACCOUNT --Records unilateral transfers of assets between countries, i.e. assets that migrants take with them when they move into or out of a country-- • FINANCIAL ACCOUNT --Records international borrowing, lending, purchases, and sales of assets-- * Direct investments * Portfolio investment * Other investments

7. The BALANCE OF PAYMENTS (BOP) Accounts Second: Items below the line (Balance of official settlements) -- Considers as an account in which official reserve transactions are entered -- All transactions go into this account are conducted by the “official” government authority( Central Bank). -- It reports the net change in a country’s stock of ……. • Monetary gold (gold reserves) • Special drawing rights (SDR) • Reserve position in the IMF (includes local currency, gold, other assets) • Foreign exchange( foreign currency reserves)

8. The BALANCE OF PAYMENTS (BOP) Accounts Important Notes: • The balance on the Current Account represents the relationship between the current income (for individual, firms, governments agencies) and current expenditures. • The Capital & Financial Account represents changes in borrowing and lending or purchases & sales of assets (for individual, firms, governments agencies). • { CA balance + KFA balance + Official settlements balance + Statistical discrepancy = 0}

9. The BALANCE OF PAYMENTS (BOP) ACCOUNTING PRINCIPLES • Credits and Debits Any transaction is described as credit or debit First Credit Transactions: 1. Credit Transactions involve receipts of payments from foreigners (entered with a +ve sign because they involve receipts of payments), e.g., • Export of goods and services • Gifts and aid received from foreigners 2. Capital inflows are considered credit transactions and take two forms: • An increase in foreign assets in the nation (an American investor purchases an asset in Kuwait) • A reduction of the nation’s assets abroad (A Kuwaiti investor sells an asset in the UK)

10. The BALANCE OF PAYMENTS (BOP) ACCOUNTING PRINCIPLES Second Debit Transactions: 1. Debit Transactions involve the making of payments to foreigners (entered with a -ve sign because they involve making of payments), e.g., • Imports of goods and services • Gifts and aid given to foreigners 2. Capital outflows are considered debit transactions and take two forms: • An increase in the nations assets abroad (a Kuwaiti investor purchases an asset in the UK) • A reduction of foreign assets in the nation (an American investor sells an asset in Kuwait)

11. The BALANCE OF PAYMENTS (BOP) ACCOUNTING PRINCIPLES • Double Entry Bookkeeping Each international transaction is recorded twice, once in the credit and once in the debit of an equal amount. The reason for this is that every transaction has two sides (credit and debit).

12. The BALANCE OF PAYMENTS (BOP) ACCOUNTING PRINCIPLES Example 1. Kuwait exports $ 500 mn. of oil to be paid for in three months. • Note the following: • Exports of oil are entered as credits (lead to receipts of payments from foreigners) • The payment itself is entered as a capital outflow (debit), why? When Kuwait agrees to wait for three months for payments, it extends a credit to foreign importers (capital outflows). This is an increase in domestic assets abroad (i.e. a debit)

13. Example 2. Kuwaiti tourists visit London and spend $ 200 mn. on hotels, meals.. etc. Note the following: • Kuwaiti tourists purchased services from foreigners (require payments to foreigners). This is similar to imports (debit). • The payment is entered as a credit, as it represents an increase in foreign claims on Kuwait, i.e. an increase in foreign assets in Kuwait or a capital inflow to Kuwait.

14. Example 3. Kuwait gives a $ 100 mn. bank balance to the government of a less developed country (aid). Note the following: • This unilateral transfer is a debit (requires payments to foreigners). • The payment (an increase in a bank account) itself represents an increase in foreign claims (of assets) in Kuwait.

15. Example 4. A Kuwaiti resident purchases foreign stocks of $ 400 mn. and pays for it by increasing foreign bank balances in Kuwait. Note the following: • The purchase of foreign stocks increases Kuwaiti assets abroad. This is a capital outflow (debit). • The payment is an increase in foreign assets in Kuwait. This is a capital inflow (credit). (Note: If the Kuwaiti resident paid for the foreign stock by reducing bank balances abroad; the payment will be a reduction in Kuwaiti assets abroad, this is also a capital inflow and thus is a credit).

16. Example 5. A foreign investor purchases $ 300 mn. of Kuwaiti treasury bills and pays by drawing down his bank balances in Kuwait. Note the following: • the purchase of the treasury bills is an increase in foreign assets in Kuwait (credit) • The drawing down of Kuwaiti bank balances by foreigners is a reduction in foreign assets in Kuwait. this is a capital outflow (debit).

17. The results of the previous transactions on Kuwait’s balance of payments would be: Capital flows = (-500 +200 +100 +400 -400 +300 -300) = -200 Note: the net capital debit balance -200 is obtained by adding together the seven capital entries Balance of payments

18. Accounting balances and disequilibrium in international transactions 1. The Current Account: • lumps together all sales and purchases of goods and services, investment incomes, and unilateral transfers. • It provides the link between the nations international transactions and its national income. • The current account surplus stimulatesdomestic production and income, while a current deficit dampensdomestic production and income. 2. The capital Account: • Measures the change in the stock of all non-reserve financial assets. • Reserve changes are excluded from the capital account because they represent the government policy (below the line transactions) rather than market forces. • The capital account shows the net increase in the privately ownednet assets abroad.

19. Autonomous transactions. • All transactions in the current account and capital account are called “autonomous”, because they take place for businessorprofitmotives (except for unilateral transfers), and are independent of BOP considerations. • They are sometimes called “the items above the line” Transactions in official reserves. • They are called accommodating transactions (items below the line), because they are needed to balance international transactions. • Below the line items form the “official reserve account”, and its balance is called “the official settlements balance”. Do you know now what do we mean by the line?

20. Balance of payments: Deficit • If total debits exceed credits in current and capital accounts, the net “debit” balance measures the “deficit” in the country’s BOP. Balance of payments: Surplus • If total credits exceed debits, in current and capital account, there will be a surplus in the BOP.

21. Enter the following transactions in the BOP of Kuwait • A Kuwaiti resident purchases a $ 1000 mn foreign stock and pays for it by drawing down her bank balances abroad. • A Kuwaiti resident receives a dividend of $ 100 mn on her foreign stock and deposits it into her bank account abroad. • General Motors Co. purchases $ 100 mn PCs from China. • A Kuwaiti computer manufacturer buys $ 20 mn hard disks from a Chinese company and deposits the proceeds in NBK, China uses the proceeds to purchase oil. • The Kuwaiti government gives a $ 100 mn cash balance in a Kuwaiti bank to a developing nation as part of the foreign aid program. • The developing nation uses the $ 100 mn bank balance to import $100 worth of oil from Kuwait. • An American tourist spends $ 20000 on hotels in Malaysia. • An American investor purchases $ 150 mn Kuwaiti stocks and pays by increasing the seller's bank account in USA. • The American investor receives $ 15 mn on his Kuwaiti Stock and deposits the value in his bank account in Kuwait.