International Finance Balance of

NBAE 5540, Fall 2008
NBAE 5540 : International Finance

Lecture 2: Balance of Payments and
Foreign Investment
Professor Gordon Bodnar
Gordon Bodnar, 2008
Balance of Payment
Balance of Payments (BOP)

z
a record of transactions between the residents of

one country and residents of the rest of the world
BOP accounting uses double-entry bookkeeping.
Credit (+) transactions represent demands for US dollars
result from purchases by foreigners of goods, services,

goodwill, financial and real assets, gold, or foreign
exchange from Americans
export of good/service or financial equivalent of IOU
Debit (-)
( ) transactions represent supplies of US dollars
result from purchases by Americans of goods, services,

goodwill, financial and real assets, gold and foreign
exchange from foreigners
import of good or financial equivalent of IOU
The BOP is usually divided into two components

f
the current account and the capital (financial) account

NBAE 5540: Lecture 2, Slide # 2
Current Account
Movements of goods and services, income

payments, and goodwill
z
exports
p
of g
goods and services,, X
f
sale of goods/services produced in the US to foreigners
exports give rise to a demand for dollars; recorded as (+)

exports of goods are known as merchandise trade
exports of services include foreigners expenditures on US
tourism, transportation, education, royalties and business
services
imports of goods and services, M

f
purchase of goods/services produces abroad by residents
imports give rise to supply of dollars; recorded as (-)

services also include US tourism and travel expenditures
abroad, payments for communications, financial and computer
services, royalties and license fees, and many types of other
business services
Net Exports = Trade Balances
Balance on merchandise trade:

TBG = XG - MG
f
(values)
or TBG = XG + MG
(BOP)
a measure of the net trade position in tangible goods
the difference between the value of merchandise exports and

imports or the sum of the BOP value of merchandise exports
(credit) plus the BOP value of merchandise imports (debit)
US historically runs large deficits on this account (~3-5% GDP)
Balance on services:
TBS = XS - MS
f
(values)
( l
)
or TBS = XS + MS
(BOP)
a measure of the net trade position in services (intangibles)
the difference between the value of service exports and imports

or the sum of the BOP value of service exports (credit) plus the
BOP value of service imports (debit)
US historically runs small surpluses on this account (~1% GDP)
Other Components of Current Account
Balance of payments on income payments, I

f
the net income payments made for the use factors of production
(capital or direct labor)
TBI = XI - MI
(values)
or TBI = XI + MI (BOP)
measures only the payments for the use of non resident capital
(dividends or interest) and non resident labor
US historically runs surplus on this account (~0.5% GDP)
Unilateral transfers, Tr
f
the net implicit value of goodwill flowing from unilateral

payments into and out of the country
unilateral payments include foreign aid, non-military assistance,

pensions, private gifts and donations to parties overseas
the goodwill is the offset entry to the unilateral flow of money
ex: a transfer of funds to foreigners is recorded as a debit under
unilateral transfers (import of goodwill)
US historically runs a deficit on this account (~0.5% GDP)
US Trade Balances
Merchandise, Services, and Income, plus Unilateral Transfers
1960-2007
2.0%
1.0%
0.0%
-2.0%
-3.0%
Merchandise
Income Payments
Total Balance
-4.0%
-5.0%
Services
Unilateral Transfers
-6.0%
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
-7.0%
1960
% of GDP
-1.0%
Current Account Balance
Current Account Balance (CA)

f
the sum of total exports (BOP) and total imports including income
flows (BOP) plus net unilateral transfers (BOP)
CA = XT + MT + Tr
(BOP accounting)
where XT , MT, and Tr are the BOP values of exports, imports and
transfers sent abroad (credits for USD inflows, debits for USD outflows)
or CA = XT - MT - Tr
(values)
where XT, MT, and Tr are simply the USD values of exports, imports and
transfers sent abroad
f
the current account indicates the broad balance of trade including

g
goods, services, income payments (for capital rental) and
unilateral transfers of goodwill (gifts)
if the CA is not zero, exports do not balance with imports

and transfers, then the imbalance must be offset with net
trade in financial assets
this is the capital/financial account of the BOP

Capital and Financial Account
International flow of financial assets over period

capital account line refers to non financial assets
z
financial account consists of two main categories

f
US owned assets abroad (Net) (increase is a debit)
US official reserve assets, net
US government assets other than official reserves (net)
private assets abroad
liquid assets held by the FED and Treasury, includes gold and FX
new loans and loan repayments involving US government
investments by US private firms/individuals in foreign assets
direct investment - investment with 10 percent ownership
portfolio investment - securities,
securities bank assets and other credits
f
Foreign owned assets in the US (Net) (increase is a credit)
foreign official assets in the US (single official category)
other foreign assets in the US
US dollar assets held by foreign governments in the US

net changes in holdings of US assets by private foreigners
again by direct investment and portfolio investment classifications
Balance on Capital/Financial Account

Balance on capital account (KA)
the balance on capital account is the result of the trade in financial

assets between the US and the rest of the world
we can think of KA as:
KA = US owned assets abroad + Foreign owned assets in US

debits
credits
KA is the difference between the net outflow of US money into
foreign assets and the net inflows of foreign money into US assets
when KA > 0
foreigners are increasing their ownership of local assets more than

US residents are increasing their ownership of foreign assets
the US is decreasing its net foreign asset position

the US is a net foreign borrower
when KA < 0
US residents are increasing their ownership of foreign assets more

than foreigners are increasing their ownership of local assets
the US is increasing its net foreign asset position

the US is a net foreign creditor
KA and Change in Net Foreign Assets
KA is also the opposite of the change in the

countrys net foreign asset (-NFA) position
this ignores the net valuation effect on the existing net foreign
assets from changes in underlying asset prices and exchange
rate changes
so the net balance on capital flows, KA = -NFA

f
when KA > 0 => NFA < 0 so residents experience a decrease

in their net foreign asset position
the country is a net foreign borrower for that period

they decreased their net foreign asset position / increased their
indebtedness to the rest of the world
when KA < 0 => NFA > 0 so residents experience an increase

in their net foreign asset position
the country is a net foreign lender for that period

they increased their net foreign asset position / decreased their
indebtedness to the rest of the world
Relation Between CA and KA
Because of double-entry accounting, the current

account and the capital account balances sum to 0:
CA + KA = 0
z
since CA + KA = 0 and KA = - NFA, by substitution we

have
CA = NFA
f
the current account is the change in the countrys net foreign

asset position
ignoring valuation and XR effects on existing assets
the current account indicates whether the country is

borrowing or lending money to the rest of the world
CA deficit means that a country is borrowing money from the rest of

the world
this is how they afford to import more than they export or what they do
CA surplus means that a country is lending money to the rest of the

world
CA and NFA
Implication of this relation: CA = NFA

z
a trade deficit implies a country is decreasing its net

foreign assets
f
thi occurs b
this
by
selling some of its foreign assets back to foreigners
selling some of its domestic assets to foreigners
obtaining credit (borrowing) from foreign country
either way a country must decrease its net foreign assets

(increase its net foreign liabilities) to fund the trade deficit
you pay for the extra goods you import by reducing your pile of
assets (either foreign or domestic) or borrowing from foreign
sources
US experience
f
the US experience of continuing CA deficits imply that the US

has been decreasing its net foreign assets position
it has been selling its assets and borrowing from the rest of the
world to finance its trade deficits
Other Concern over KA
It is also possible to think of the KA = PKA + OKA

f
the sum of private and official (govt) capital accounts
PKA = private capital account balance

= in private ownership of assets abroad + in private foreign ownership of local assets
OKA = official capital account balance

= in official ownership of assets abroad + in official foreign ownership of local assets
f
OKA is important because it mostly reflects a countrys net

change in FX reserves, R
countries maintain FX reserves, R, in order to facilitate official

payments and to maintain value of / stabilize local currency
for countries trying to control their XR, having FX reserves is critical
note the relation that follo

followss from the BOP identit
identity
CA + KA = 0 => CA + PKA + OKA = 0 => CA + PKA = -OKA
-OKA = CA + PKA is a measure of the change in FX reserves
example: when a current account deficit (CA <0) is not fully funded by
net private borrowing (PKA < CA) then OKA > 0 which means the
government is using FX reserves to balance out relation (R <0)
so -OKA = change in FX reserves = R

US Current Account Balance and NIIP

1976 - 2007
500
Annual Trade balance

2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
USD (billions)
U
-500
-1,000
-1,500
-2,000
-2,500
Since 1976, cumulative US trade

deficits sum to over $6.6T. The US Net
Investment Position is only about $2.5T, largely because the US started
with a $
$0.5T surplus
p
and has seen
greater capital appreciation of its assets
abroad compared to the ROWs assets
in the US and the USD depreciation.
Note that in 1987 the US became a net
debtor nation, soon thereafter the largest
in the world
Net Investment
Position
Is CA Deficit a Problem?
First lets look at how the CA relates to economy

z
from national income accounting we have

Absorption:
Y = C + I + G + (X - M)
E
Expenditures:
dit
Y=C+S+T+T
Tr
Y = National Income or GNP;

C=consumption,
I=private investment;
G= government purchases,
X=exports,
M=imports;
S= private savings;
T=taxes;
Tr = net unilateral transfers to foreigners (debit opposite of BOP accounting measurement)
setting the two equal we have :

C + I + G + (X - M) = Y = C + S + T + Tr
X - M - Tr = S - I
+ T - G
rewriting:
iti
CA
=
(S - I)
+
(T - G)
Current
Account
z
Net Private
Net Public
Savings +
Savings
the current account is definitionly equal to the sum of

net private savings and net public savings
f
CA deficits indicate a shortfall in national savings

8.0%
Current Account, Net Public

Savings, and Net Private Savings
From 1980 - 1995 the CA
deficit was the result of
negative net public
savings,
i
b
butt d
decline
li since
i
1997 is more related to
negative net private
savings
6.0%
Pi t
Private
Savings (S-I)
4.0%
2005
2
2002
2
1999
1
1996
1
1993
1
1990
1
1987
1
1984
1
1981
1
1978
1
1975
1
1972
1
1969
1
1966
1
-2.0%
1963
1
0.0%
1960
1
% of GDP
2.0%
-4.0%
Public
Savings (T-G)
-6.0%
-8.0%
Current Account
Balance (CA)
Are CA Deficits Good or Bad?
Current accounts reflect a tradeoff between

consumption (savings) and investment today
f
f
good side of CA deficit is it allows more C or I for given Y

b d side
bad
id off CA d
deficit
fi it iis it iimplies
li greater
t claims
l i
on ffuture
t
Y
CA deficits are not a problem

f
if good investments are occurring to produce higher future Y to

repay lending
in this case the CA deficit might be allowing greater investment

than otherwise or than without having to forego C today
examples: Japan and Korea after the wars, or new technologies
CA deficits are more of a problem

f
if imported funds only finance current consumption and no

investment for future Y
in this case income for consumption in the future will be lower

have a big party now and leave the bill for future generations
no general answer to CA question as it is case specific

Savings and Investment in the US
As for the US, it is difficult to determine if CA

deficit is good or bad
f
gross private domestic investment has since strong since 1991
gross private savings has slowed down, especially in late

90s,but has picked up again, along with investment
part of US economic boom during the 1990s
but is it the cause or the result of consumption smoothing in

response to higher future income due to high investment
24.0%
Gross
Investment
% of GDP
20 0%
20.0%
16.0%
Gross
Savings
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
12.0%
More Detail on US Savings Decline

1960- 2007
25.0%
Gross Savings
20.0%
15.0%
Depreciation
10.0%
Net Savings
Personal Net Savings
5.0%
Corporate Net Savings
0.0%
Government Net Savings
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
-5.0%
The CA Deficit Cannot Grow Forever
Depends on foreigners willingness to finance the deficit
this relates to their interest in holding USD assets
current deficits in nominal size (~$750b) can continue indefinitely

GDP growth will reduce the size of deficit as % of GDP and net
foreign debt will top out at about 50%
current deficits at 5-6% of GDP can also continue if US grows
net foreign debt grows to 100% of GDP, but trade in G&S has to
move to balance unless return on foreign debt less than 5%
foreigners may be willing to hold that many USD assets
what cant happen is the deficit as % of GDP to continue to grow
this is unsustainable as foreign

g debt ratio would g
grow continuously
y
at some point foreigners refuse to provide any additional borrowing
at that point US must balance its accounts with national savings
with foreign debt service, trade in G&S would have to be in surplus
this would likely requires large relative price adjustments
large USD depreciation or other form of USD price decrease

10
CA Deficits and Financial Crises
CA deficits can trigger financial crisis

z
growing CA deficits fuel fears of solvency which lead to

depreciation as investors rush to get out of domestic
currency
f
f
this rush leads to a faster and farther fall in the currency

resulting large depreciation of XR can have harmful domestic
effects
domestic agents (banks) with loans in foreign currencies unable

to repay with weaker domestic currency and default
this can lead to a domestic banking
g crisis with resulting
g negative
g
impacts of domestic economy
lack of financing makes it impossible for exporters to sell despite the
competitive advantage of the exchange rate drop
this is a rough description of what happened in Mexico in 1994

and in SE Asia in 1997
key policy lesson is to control size of CA deficits

Net Investment Position of the US
Lets look at the stock of NFA instead of flows

z
BOP transactions only shows the flows of capital

f
it does not tell us about the stocks of outstanding international

assets and liabilities
we need the Net International Investment Position account
it is divided into two parts

f
US assets abroad and Foreign assets in US
this account is analogous to the balance sheet of a firm
looks like the capital account of the BOP table
change in figures for US over time are staggering

f
using market values the net investment position of the US

changed from a +$97B in 1985 to a -$2.5T in 2006
reflects an net increase in foreign ownership of the US of more

than $2.6T over the past 20 years due to trade deficits
2006 US net liabilities to foreigners are about 18% of GDP
11
How Much Does the US Own?
For 30 years after WWII, the US was the

world's major provider of foreign investment
f
US consistently ran current account surpluses throughout

the 50s and 60s
by 2006 the US owned approximately $13.8 trillion of

assets outside of the US
almost all of which (less $300b) are private assets

this has grown from about $1.1 trillion in 1985
a growth rate of around 12%/year
breakdown of US assets abroad (2006)
$2.9 trillion is direct investment (market prices)

$9.2 trillion is portfolio investment
inlcudes $1.1T in bonds; $4.3T in stocks; $3T in bank assets
US official reserve assets ($219b) consist primarily of gold

($165b) and FX reserves ($40b)
How Much Do Foreigners Own?
Prior to 1980 most foreign investment in the US

consisted of foreign government ownership
f
in 1985, foreigners owned about $1.2 trillion
by 2006, foreigners owned $16.3 trillion
about 20% of this was US Treasury securities
by now it is mostly private assets, $12.3 trillion

this grew from $1.0 trillion in private assets in 1985
a growth rate of ~14%/year
breakdown (2006)
$2.1 trillion in direct foreign investment in the US (at market value)
$10.2 trillion in private portfolio investment in the US

$594B in Treasury securities, $364B in US currency, $2.7T in bonds;
$2.5T in equities, and and $3.3T in bank assets
$2.7 trillion foreign official assets in the US (up from $1,567b in 2003)
$2.1T in US Treasury securities (>40% of total held by public)
12
International Investment
Distinguish between different forms of foreign

investment:
z
official investment
f
investment made by other governments/official agencies

typically by central banks
private investment
f
foreign direct investment
involves foreign control of businesses and properties (FDI)

US defines control as 10% or more ownership
typically long term investment not easily reversed
portfolio investment
involves ownership of private and government

securities and bank deposits and passive equity stakes (less
than 10%)
also known as indirect investment or hot money due to its ease
of movement and reinvestment
U.S. Direct Investment Position

Abroad by Major Area
1982
2003
Asia and Middle East

Pacific
2%
%
14%
Canada
10%
International
3%
Africa
1%
Asia and
Pacific
16%
Europe
44%
Canada
20%
Middle East
1%
Europe
52%
Latin America
Africa
3% Latin Am
14%
Largest Countries (2003) :

U.K - $272b
Bermuda $84b
Singapore $57b
Australia $40b
20%
Canada $192b
Germany $80b
Ireland $55b
Spain $38b
Netherlands $178b
Luxembourg $66b
France $47b
Brazil $29b
Historical cost basis for more info see http://www.bea.doc.gov/bea/di/di1usdbal.htm
Switzerland $86b
Mexico $62b
Hong Kong $44b
Belgium $25b
13
Foreign Direct Investment Position

in the United States by Major Area
1982
2003
Middl E
Eastt
Asia and Middle
4%
Pacific
9%
Canada
9%
Latin Am
11%
Largest Countries (2003) :

U.K - $230b
France $143b
UK Carrib $28b
Canada
C
8%
Middle East
1%
Asia and Pacific

15%
Latin Am
4%
Europe
67%
Japan $159b
Switzerld $112b
Ireland $26b
p
Europe
73%
Germany $148b
Canada $105b
Australia $24b
Historical cost basis for more info see http://www.bea.doc.gov/bea/di/di1usdbal.htm
Netherlands $146b
Luxembourg $104b
Sweden $19b
14

International Finance Balance of

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NBAE 5540, Fall 2008

NBAE 5540 : International Finance

Gordon Bodnar, 2008

Balance of Payments (BOP)

a record of transactions between the residents of

BOP accounting uses double-entry bookkeeping.

Credit (+) transactions represent demands for US dollars

result from purchases by foreigners of goods, services,

result from purchases by Americans of goods, services,

The BOP is usually divided into two components

the current account and the capital (financial) account

NBAE 5540, Fall 2008

Movements of goods and services, income

sale of goods/services produced in the US to foreigners

exports give rise to a demand for dollars; recorded as (+)

imports of goods and services, M

purchase of goods/services produces abroad by residents

imports give rise to supply of dollars; recorded as (-)

Net Exports = Trade Balances

Balance on merchandise trade:

a measure of the net trade position in tangible goods

the difference between the value of merchandise exports and

a measure of the net trade position in services (intangibles)

the difference between the value of service exports and imports

NBAE 5540, Fall 2008

Other Components of Current Account

Balance of payments on income payments, I

the net implicit value of goodwill flowing from unilateral

unilateral payments include foreign aid, non-military assistance,

NBAE 5540: Lecture 2, Slide # 6

NBAE 5540, Fall 2008

Current Account Balance

Current Account Balance (CA)

the current account indicates the broad balance of trade including

if the CA is not zero, exports do not balance with imports

this is the capital/financial account of the BOP

Capital and Financial Account

International flow of financial assets over period

financial account consists of two main categories

US owned assets abroad (Net) (increase is a debit)

US official reserve assets, net

US government assets other than official reserves (net)

private assets abroad

Foreign owned assets in the US (Net) (increase is a credit)

foreign official assets in the US (single official category)

other foreign assets in the US

US dollar assets held by foreign governments in the US

NBAE 5540, Fall 2008

Balance on Capital/Financial Account

the balance on capital account is the result of the trade in financial

we can think of KA as:

KA = US owned assets abroad + Foreign owned assets in US

foreigners are increasing their ownership of local assets more than

the US is decreasing its net foreign asset position

US residents are increasing their ownership of foreign assets more

the US is increasing its net foreign asset position

NBAE 5540: Lecture 2, Slide # 9

KA and Change in Net Foreign Assets

KA is also the opposite of the change in the

so the net balance on capital flows, KA = -NFA

when KA > 0 => NFA < 0 so residents experience a decrease

the country is a net foreign borrower for that period

when KA < 0 => NFA > 0 so residents experience an increase