The Balance of Payments and International Linkages

1. The Balance of Payments and International Linkages • An accounting statement which measures all financial and economic transactions between domestic and foreign residents over a specified period of time. • National Level • Corporate Level • Forecasting international competitiveness • Judging pressure placed on exchange rate • Signaling possible imposition of capital controls • Fundamentals of BOP Accounting • Measures flows rather than stocks. • Is based on a double-entry bookkeeping system. • Always balances; i.e., it must be equal to zero. • THE BALANCE OF PAYMENTS (B-O-P) • PURPOSE: • Measures all financial and economic transactions over a specified period of time • Double-entry bookkeeping • Currency inflows = credits earn foreign exchange • Currency outflows = debits expend foreign exchange

2. Balance of Payments Accounts • Three Major Accounts: • Current • Capital • Official Reserves • Current Account • records net flow of goods, services, and unilateral transfers. • In other words current account can be classified as • Trade Balance (BOT) • Service Balance • Income Balance • Unilateral Transfers • Capital Account • Function: records public and private investment and lending. • Inflows = credits • Outflows = debits • Transactions classified as • Direct Investments • Portfolio Investments • Other Financial Items

3. Balance of Payments Accounts contd. • Official Reserves Account • Function: measures changes in international reserves owned by central banks. • reflects surplus/deficit of • current account • capital account • Reserves consist of • gold • convertible securities • Net Effects: • Sum of all transactions must be zero: • current account • capital account • official reserves • The Balance-of-payment measures • Some Definitions: • Basic Balance • consists of current account and long-term capital flows. • emphasizes long-term trends • excludes short-term capital flows that heavily depend on temporary factors • Net Liquidity Balance: measures the change in private domestic borrowing or lending required to keep payments equal without adjusting official reserves. • Official Reserve Transactions Balance measures adjustments needed by official reserves.

4. Generic Balance of Payments Current Account 1. Trade Balance 2. Service Balance 3. Income Balance 4. Net Transfers A (1 through 4) = Current Account Balance ____________________________________________________ B. Capital Account ____________________________________________________ C. Financial Account 1. Net Foreign Direct Investment 2. Net Portfolio Investment 3. Other Financial Items A + B + C = Basic Balance ____________________________________________________ D. Net Errors and Omissions A + B + C + D = Overall Balance ____________________________________________________ E. Official Reserves and Related Items

5. Links from international to domestic flows A. Global Linkages set of basic macroeconomic identities which link: domestic spending and production to current and capital accounts B. Domestic Savings and Investment and the Capital Account 1. National Income Accounting a. National Income (NI) is either spent (C) or saved (S) NI = C + S (5.1) b. National spending (NS) is divided into personal spending (C) and investment (I) NS = C + I (5.2) c. Subtracting (5.2) - (5.1) NI - NS = S - I (5.3) If NI >NS, S > I which implies that surplus capital spent overseas. d. In a freely-floating system, excess saving = the capital account balance e. Implications: • A nation which produces more than it spends will save more than it invests domestically with a net capital outflow producing a capital account deficit. • A nation which spends more than it produces has a net capital inflow producing a capital account surplus. • A healthy economy will tend to run a current account deficit.

6. The Link between Capital and Current Accounts 1. Beginning identity NI - NS = X - M (5.4) where X = exports M = imports X-M=current account balance (CA) 2. Combining (5.3) + (5.4) S - I = X - M (5.5) 3. If S - I = Net Foreign Investment (NFI) NFI = X - M (5.6) 4. Implications: a. If CA is in surplus, the nation must be a net exporter of capital. b. If CA is a deficit, the nation is a major capital importer. c. When NS > NI, the excess must be acquired through foreign trade. • Solutions for Improving CA deficits: 1.) Raise national income (output) relative to domestic investment (I). 2.) Increase (S) relative to domestic investment (I). • Government budgets and current account deficits • CURRENT ACCOUNT BALANCE CA = Saving Surplus - Gov’t. budget deficit • CA Deficit means the nation is not saving enough to finance (I) and the deficit • CA Surplus means the nation is saving more than needed to finance its (I) and deficit.

7. COPING WITH THE CURRENT ACCOUNT DEFICIT • Possible solutions unlikely to work: • Currency Depreciation • Protectionism • Currency depreciation • U.S. Experience: Does not improve the trade deficit. • Depreciations are ineffective because • It takes time to affect trade. • J-Curve Effect states that a decline in currency value will initially worsen the deficit before improvement. • Protectionism • Trade Barriers used: • Tariffs • Quotas • Results: • Most likely will reduce both X and M.

8. COPING WITH THE CURRENT ACCOUNT DEFICIT contd. • Foreign ownership • one protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows. • Stimulate national saving • change the tax regulations and rates. • Summary: current-account Deficits • neither bad nor good inherently • Since one country’s exports are another’s imports, it is not possible for all to run a surplus • Deficits may be a solution to the problem of different national propensities to save and invest.