Balance of Payment

Balance of Payments
The account is published to report the country s international performance in trading with other nations and to maintain a record of the volume of capital flowing in and out of the country.
The structure of this topic A. Principles of Balance of Payment Accounting B. Constructing The Balance of Payment
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Balance of Payments
A record of international transactions between residents of one country and the rest of the world International transactions include exchanges of goods, services or assets Residents means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations
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Balance of Payments Accounts

A country s balance of payments accounts
keep track of both its payments to and its receipts from foreigners. Every international transaction automatically enters the balance of payments twice: once as a credit (+) and once as a debit (-).
Each transaction is classified according to the payment or receipts that it generates

Transactions that generate a receipt of a payment from foreigners are a credit item in the accounts with a + sign
These represent a supply of foreign exchange ($) and a demand for the local currency ()
Transactions that comprise a payment to foreigners are reported as a debit item with a sign
=> These represent demand for foreign exchange ($) and a supply of the local currency ()

Three types of international transactions are recorded in the balance of payments: Exports or imports of goods or services in the current account Purchases or sales of financial assets in the financial account Transfers of wealth between countries in the capital account.

The Current Account The balance of payments accounts divide exports and imports into three categories: Merchandise trade Exports or imports of goods Services Payments for legal assistance, tourists expenditures, and shipping fees Income International interest and dividend payments and the earnings of domestically owned firms operating abroad
B. Factor
4. The balance of payments on current account
The balance of payments on current account consists of exports and imports of goods, services, and income, plus net unilateral transfers. The current account is in deficit by $14 billion. (line 36)
1) A deficit in the current account must be financed by borrowing from abroad or by divestment of foreign assets.
2) A surplus must be loaned abroad or invested in foreign assets.

The Capital Account
It records asset transfers.
The Financial Account

It measures the difference between sales of assets to foreigners and purchases of assets located abroad.
Financial inflow (capital inflow)
A loan from the foreigners with a promise that they will be repaid
Financial outflow (capital outflow)

A transaction involving the purchase of an asset from foreigners
The balance of payments on Current Account
Records transactions arising from trade in goods and services The visible trade balance
payments and receipts from the import/export of tangible goods (cars, food, textiles,) The invisibles trade balance payments and receipts for financial services, shipping and tourism, interest and dividends payments on investments, etc.
The balance of payments on Capital Account

Records transactions related to international movements in the ownership of financial assets The purchase of foreign investments by UK citizens brings assets to the UK (in exchange for money) and are referred to as a capital outflow to purchase these foreign assets, locals have to buy $=> debit (negative) entry in the Capital Account
b) The balance of payments on Capital Account (cont.)

Foreign investment into the UK increases UK liabilities to foreigners, and it is a capital inflow foreigners have to buy to undertake their investments
credit (positive) entry in the Capital Account
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The exchange rate is the price of the in terms of other currencies (e.g. $) If the exchange rate is freely floating then it will adjust to ensure that the demand for s = the supply of s inflows = outflows in the BoP BoP is exactly = zero Since BoP = Current Account + Capital Account: a Current Account surplus => a Capital Account deficit a Current Account deficit => a Capital Account surplus

The Fundamental Balance of Payments Identity
Any international transaction automatically gives rise to two offsetting entries in the balance of payments resulting in a fundamental identity: Current account + financial account + capital account = 0

The Statistical Discrepancy
Data associated with a given transaction may come from different sources that differ in coverage, accuracy, and timing.
This makes the balance of payments accounts seldom balance in practice. Account keepers force the two sides to balance by adding to the accounts a statistical discrepancy. It is very difficult to allocate this discrepancy among the current, capital, and financial accounts.
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Exchange Rates
The rate at which one currency can be exchanged for another e.g. 1 = $1.90 1 = 1.50 Important in trade
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Exchange Rates
Converting currencies: To convert into (e.g.) $ Multiply the sterling amount by the $ rate To convert $ into - divide by the $ rate: e.g.
To convert 5.70 to $ at a rate of 1 = $1.90, multiply 5.70 x 1.90 = $10.83 To convert $3.45 to at the same rate, divide 3.45 by 1.90 = 1.82
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Exchange Rates
Determinants of Exchange Rates: Exchange rates are determined by the demand for and the supply of currencies on the foreign exchange market The demand and supply of currencies is in turn determined by:
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Exchange Rates
Relative interest rates The demand for imports (D) The demand for exports (S) Investment opportunities Speculative sentiments Global trading patterns Changes in relative inflation rates
Exchange Rates
Appreciation of the exchange rate: A rise in the value of in relation to other currencies each buys more of the other currency e.g. 1 = $1.85 1 = $1.91 UK exports appear to be more expensive ( Xp) Imports to the UK appear to be cheaper ( Mp)
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Exchange Rates
Depreciation of the Exchange Rate A fall in the value of the in relation to other currencies - each buys less of the foreign currency e.g. 1 = 1.50 1 = 1.45 UK exports appear to be cheaper ( Xp) Imports to the UK appear more expensive ( Mp)
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Exchange Rates
A depreciation in exchange rate should lead to a rise in D for exports, a fall in demand for imports the balance of payments should improve An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in demand for imports the balance of payments should get worse BUT
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Exchange Rates
The volumes and the actual amount of income and expenditure will depend on the relative price elasticity of demand for imports and exports.
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Exchange Rates
$ per S
The rise in Assume an Investing in demand creates a initial exchange the UK would shortage in the rate of 1 = now be more $1.85. There relationship are rumours attractive between demand that for and UK is and the supply demand going to increase the would for price (exchange rate) interest rates rise would rise
1.90 1.85
Shortage D Q1 Q3
D1
Q2
Quantity on ForEx Markets
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Exchange Rates
Floating Exchange Rates:
Price determined only by demand and supply of the currency no government intervention
Fixed Exchange Rates:

The value of a currency fixed in relation to an anchor currency not allowed to fluctuate Dirty Floating or Managed Exchange Rate: rate influenced by government via central bank around a preferred rate
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Exchange Rates
Purchasing Power Parity (PPP)
The relationship between the exchange rate and the price level in different countries. The price of in the foreign currency = Foreign Country price level/UK price level
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Exchange Rates
The exchange rate would be a proper reflection of the purchasing power in each country if the relative values bought the same amount of goods in each country. E.g. If the price of a pint of Stella in the UK was 3.00 and in Europe 4.50, the exchange rate between the two countries should be 1 = 1.50 If any lower than this value, the would be undervalued and if any higher, the would be overvalued.
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Balance of Payment

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Balance of Payment

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Balance of Payments

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