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Economics of International Finance

Econ. 315

Chapter 2:
Balance of Payments

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:


1. 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).

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 branches and subsidiaries are not.

International institutions (UN, WB, IMF, WTO ..etc) are non


residents at the country in which they are located.

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

The BALANCE OF PAYMENTS (BOP) Accounts


First: Items above the line
CURRENT ACCOUNT
--Records the countrys 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

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

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 countrys 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)

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}

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 nations assets abroad (A Kuwaiti investor sells an asset


in the UK)

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)

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).

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)

Credit)+(
OIL EXPORTS
CAPITAL OUTFLOWS (an increase in
Kuwaiti assets abroad)

Debit)-(

500
500

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.

Credit (+)
Travel services purchased from foreigners
Capital inflow (a rise in foreign assets in Kuwait)

Debit (-)
200

200

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.

Credit (+)
Unilateral transfers (aid)
Capital inflow

Debit (-)
100

100

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).

Credit
(+)

Capital outflow (purchase of foreign stocks)


Capital inflow (the increase in foreign bank
balances)

Debit (-)

400
400

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).

Credit (+)

Capital inflow (purchase of Kuwaiti


treasury bill by foreigner)
Capital outflow (the reduction in foreign
bank balances in Kuwait)

Debit (-)

300

300

The results of the previous transactions on Kuwaits 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
Credit (+)
Goods (oil)
Services
Unilateral transfers
Capital net
Total debits and credits

Debit (-)

500

-------500

200
100
200
------500

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 stimulates domestic production and


income, while a current deficit dampens domestic 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 owned
net assets abroad.

Autonomous transactions.
All transactions in the current account and capital account are
called autonomous, because they take place for business or
profit motives (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?

Balance of payments: Deficit


If total debits exceed credits in current and capital accounts,
the net debit balance measures the deficit in the countrys
BOP.

Balance of payments: Surplus


If total credits exceed debits, in current and capital account,
there will be a surplus in the BOP.

Enter the following transactions in the BOP of Kuwait


1.
2.
3.
4.
5.
6.
7.
8.
9.

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.