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)
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- 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
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- 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
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- 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
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- 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
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- 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)
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- 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)
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- 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
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- 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
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(BOT) even though
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- 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
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–$600
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
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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)
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- 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
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- 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
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- 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
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- 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
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- 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.
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- 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
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reserved. Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2004.
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- 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.
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- 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.
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- 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.
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- 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
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- 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
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- 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
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- 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
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- 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)
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- 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
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- 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
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- 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
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- 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
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- 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
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- 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
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- 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
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- 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
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1860 1880 1900 1920 1940 1960 1980 2000
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Source: “Globalization and Capital Markets,” Maurice Obstfeld and Alan M. Taylor, NBER Conference Paper, May 4-5, 2001, p. 6.
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- 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.
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- 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
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