TOPIC 1 BALANCE OF PAYMENTS Contents Balance of Payments Accounting Foreign Debt Expected Trade Balances

BALANCE OF PAYMENTS ACCOUNTING

Definition: The Balance of Payments is an aggregate statement of a countrys international transactions in a given period of time.
*Double entry book keeping for every debit there is a credit

*One of the entries in the BoP reflects the purchase (or sale) of a good, service or financial asset. The other entry reports what has been given in exchange, the payment for the good, service, or asset.
Debit: Any transaction resulting in a payment to foreigners is entered into the balance of payments account as a debit as is given a negative (-) sign. Credit: Any transaction resulting in a receipt from foreigners is entered into the balance of payments account as a credit as is given a positive (+) sign. * Consists of a number of sub accounts
2

Current Account (CA)

Measures a country's net exports of goods and services and net international income receipts (difference between income receipts on domestically owned assets abroad and income payments on foreign owned assets at home, including interest payments, dividends and profits). Exports are recorded as a credit (+) on the balance of payments. Imports are recorded as a debit (-) on the balance of payments.

Financial Account (FA) Net change in foreign ownership of investment assets Measures the difference between sales of assets to foreigners and purchases of foreign owned assets. Sales of assets to foreigners be it direct, portfolio, investment in financial derivatives or other investment (including currency and deposits) is recorded as a credit entry on the BoP. Purchases of assets located abroad are recorded as a debit entry on the BoP.

A brief detour the balance of payments and the foreign exchange market Transactions in the market for goods and services (recorded in the current account) and in the financial market (recorded in the financial account) give rise to demand for and supply of foreign currencies. The demand for foreign exchange is derived demand. The demand for a particular currency is derived from the demand for the goods, services and assets denominated in that currency. The demand for foreign exchange comes from imports and capital outflow. The supply of foreign exchange comes from exports and capital inflow.

Example 1 Suppose an Australian resident wants to purchase something in Japan and thus needs Japanese currency to make the purchase.

Since currency is an asset, both sides of the transaction are recorded on the financial account.
The Australian currency sold is recorded as a credit entry in the financial account. Ownership changes from an Australian resident to a foreign resident. The Japanese yen purchased is recorded as a debit entry on the financial account, valued at the current exchange value.

Example 2 Assume that the Australian resident uses his yen to purchase a camera from a store in Japan and then brings it back to Australia. The item sold in this case is Japanese currency, reflecting a decrease in holdings of foreign exchange. This is recorded as a credit entry on the financial account. The good imported into Australia is recorded as a debit entry on the current account.

Example 3
Assume that the Australian resident uses his yen to purchase a Japanese government bond. The transaction is recorded on the financial account as a debit entry representing the increase in domestic holdings of foreign bonds, and as a credit entry reflecting a decrease in holdings of foreign exchange.

Official Reserve Transactions Official international reserves are foreign assets held by the central bank. Consider the examples above. Private foreigners in Japan might not wish to retain all of these newly obtained $A balances. If Japan is receiving more $A than it requires for the purchase of Australian assets and imports from Australia, then there is an excess supply of Australian dollars. The price of the $A in terms of Yen will decline, and the exchange value of the Yen will increase. However, the Bank of Japan may hold the view that the foreign exchange value of the Yen is inappropriately high in which case they might purchase $A in exchange for their domestic currency in order to moderate the increase in the exchange value of the Yen.

Official Reserve Transactions If the Central Bank is adding to its stock of Official Reserves it is recorded in the Balance of Payments statistics as a debit. (Similar to the treatment of a private citizen purchasing foreign assets, which is also recorded as a negative in the Financial Account of the Balance of Payments) A reduction in the Central Banks Stock of Foreign Exchange assets is recorded as a a credit in the Balance of Payments. Note: Under a pure floating or a flexible exchange rate the Central Bank does not buy or sell foreign exchange

Capital Account ( KA) A minor account of the Balance of Payments. Records nonfinancial transfers in wealth

Covers: Capital Transfers eg migrants transferring their wealth to the domestic economy The acquisition or disposal of non produced non- financial assets such as copyrights.
Foreign Aid of a long term nature eg aid to build a bridge.

10

Summary

BOP = CA + FA + KA + IR = 0
Typically the KA is relatively small and can be neglected.

BOP = CA + FA + IR = 0
The balance of payments must always balance.

With no Central Bank intervention:

BOP = CA +FA = 0 CA = -FA If there is Central Bank intervention: If IR < 0 (the Central Bank is increasing its stock of foreign exchange reserves), then CA + FA > 0.
11

Financing a Current Account Deficit If the Current Account is in deficit (negative) the shortfall must be financed

There are three ways in which the shortfall can be financed

1. The domestic economy can borrow from the rest of the world by issuing financial claims (liabilities) on itself which are financial assets for the rest of the world. This is recorded as a credit entry in the financial account. Resulting in a reduction in wealth of the domestic economy as its financial liabilities are increasing.

2 Rather than add to debt, the domestic economy can sell off its financial assets, both domestic and foreign, to the rest of the world. This would appear as a capital inflow and therefore as a credit entry in the financial account. If the domestic economy is reducing its stock of financial assets it is decreasing its wealth.
12

3 The Central Bank can also finance the shortfall by running down its stocks of foreign exchange reserves which also results in a reduction in the domestic economys wealth. # Under a fixed exchange rate the Central Bank buys and sells foreign exchange as necessary to maintain the value of the currency so part of a current account deficit can be financed by the Central Bank. # Under a pure floating or a flexible exchange rate the Central Bank does not buy or sell foreign exchange so the Central Bank does not finance any part of a current account deficit.

13

Foreign Debt Overseas borrowings, by itself, does not add to net foreign debt. There will be an increase in foreign holdings of domestic bonds, recorded as a credit entry on the financial account, but an offsetting increase in the domestic holding of foreign currency, recorded as a debit entry on the financial account. There is therefore no net change in a countrys financial account and no net change in that countrys financial wealth. Foreign loans are counter balanced, there are three possibilities: 1. purchases of foreign goods and services by domestic residents (including income payments) 2. purchases of claims on foreigners (purchasing foreign currency assets) 3 financing the acquisition of foreign reserves
14

Foreign Debt

Net foreign debt can only increase if borrowing is financing a current account deficit. Otherwise, borrowing from overseas will be increasing foreign claims on domestic assets but at the same time they will be increasing foreign currency assets.

15

Expected Future Trade Balances Assuming no central bank intervention: A country that runs a Current Account Deficit must be issuing liabilities on it self (or selling its financial assets) thereby running a financial account surplus and so can be considered to be borrowing from the rest of the world and increasing its Net Foreign Debt.

The country must generate trade balance surpluses in the future in order to service its foreign debt.
A country that runs a Current Account Surplus must be purchasing foreign financial assets thereby running a financial account deficit and so can be considered to be lending to the rest of the world. The country can therefore afford to run future trade balance deficits.
16

Consider an economy that lasts for only two periods, period 1 and period 2. Let NX1 denote the current account balance in period 1, NX2 the current account balance in period 2, and B*0 the countrys net foreign asset position at the end of period 0. Let r denote the interest rate paid on investments held for one period. Assume no international lending or borrowing in period 2, as the world ends in period 2. Therefore B*2= 0.

We can state that B*0 = NX1/(1+r) - NX2/(1+r)2 A countrys initial net foreign asset position must equal the present discounted value of its future trade deficits.

A negative initial net foreign asset position implies that the country must generate trade balance surpluses in the future.
Suppose the country is a net debtor to the rest of the world (B*0 < 0). Clearly, if it never runs a trade balance surplus (NX1 0 and NX2 0) then the left hand side of the above equation is negative while the right hand side is positive, violating the equation.