Chapter Three

Balance of Payments

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 Overview
• Balance of Payments Accounting
• Balance of Payments Accounts
– The Current Account
– The Capital Account
– The Financial Account
– Statistical Discrepancy
– Official Reserves Account
• The Balance of Payments Identity
• Balance of Payments Trends in Major Countries

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 Balance of Payments Accounting
• Balance of payments is the statistical record of a
country’s international transactions over a certain
period of time presented in the form of double-entry
bookkeeping
• Important to study for a few reasons:
1. Provides detailed information concerning the demand
and supply of a country’s currency
2. May signal its potential as a business partner for the rest
of the world
3. Used to evaluate the performance of the country in
international economic competition

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 Balance of Payments Accounting (Continued)
• Any transaction that results in a receipt from
foreigners will be recorded as a credit, with a
positive sign, in the Canadian balance of payments
– E.g., foreign sales of Canadian goods and services,
goodwill, financial claims, and real assets
• Any transaction that gives rise to a payment to
foreigners will be recorded as a debit, with a
negative sign, on the Canadian balance of
payments
– E.g., Canadian purchases of foreign goods and services,
goodwill, financial claims, and real assets

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 Balance of Payments Accounts
• International transactions can be grouped into the
following four main types:
1. Current account includes the export and import of
goods and services
2. Capital account consists of capital transfers and the
cross-border acquisition and disposal of nonproduced
nonfinancial assets
3. Financial account (excluding official reserves)
includes all purchases and sales of financial assets,
such as stocks, bonds, bank accounts, etc.
4. Official reserve account covers all purchases and
sales of international reserve assets
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 Summary of the U.S. Balance of Payments for 2020
($ billion) 1

Credits Debits
Current Account
[1] Exports 2,134.4
[1.1] Goods 1,428.8
[1.2] Services 705.6
[2] Imports −2,811.1
[2.1] Goods −2,350.8
[2.2] Services −460.3
[3] Primary income 957.9 −769.4
[4] Secondary income 166.3 −294.2
Balance on current account [[1] + [2] + [3] + [4]] −616.1
Capital Account 0.4 −5.9
Balance on capital account −5.5

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 Summary of the U.S. Balance of Payments for 2020
($ billion) 2

Credits Debits
Financial Account
[5] Direct investment 211.3 −311.7
[6] Portfolio investment 715.9 −220.0
[6.1] Equity securities 648.4 −241.8
[6.2] Debt securities 61.7 21.8
[6.3] Derivatives, net 5.8
[7] Other investment 535.1 −268.6
Balance on financial account [[5] + [6] + [7]] 662.0
[8] Statistical discrepancies −31.4
Overall balance 9.0
Official Reserve Account −9.0

• Source: The U.S. Bureau of Economic Analysis.

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 The Current Account
Divided into four finer categories:
1. Goods trade represents exports and imports of tangible
goods (for example, oil, wheat, clothes, automobiles,
computers, etc.)
2. Services include payments and receipts for legal,
consulting, financial, engineering, and other services;
royalties for patents and intellectual properties; shipping
fees; and tourist expenditures.
3. Primary income consists largely of payments and receipts
of interest, dividends, and other income on foreign
investments that were previously made.
4. Secondary income involves “unrequited” payments called
current transfers (for example, foreign aid, remittances, etc).
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 The Current Account (Continued)
• Current account balance, especially the trade
balance, tends to be sensitive to exchange rate
changes
– Currency depreciation tends to increase exports and
decrease imports.
– Currency depreciation or devaluation can improve
(worsen) the trade balance if imports and exports are
responsive (inelastic)
• J-curve effect refers to the initial deterioration
and eventual improvement of trade balance
following the depreciation of a country’s currency
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 The Capital Account
• Includes capital transfers and acquisitions and disposals
of nonproduced, nonfinancial assets between domestic
residents and foreigners.
• For example, land, mineral rights, and air space, brand and
domain names; and contracts, leases, and licenses.
• Capital transfers, unlike current transfers, involve change
of ownership, acquisition, or disposal of an asset and tend
to be large and infrequent.
• The amount of the capital account is often negligible.

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10
 The Financial Account
• Measures the difference between Canadian sales of assets to foreigners
and Canadian purchases of foreign assets
• Trades in financial assets affect future payments and receipts of primary
income.
• Although sales of assets to foreigners are recorded as credits and result in
capital inflow, they create future liabilities.
• Although purchases of foreign assets are recorded as debits and lead to
capital outflow, they will result in future payments from foreigners.
• Can be divided into three categories:
1. Foreign direct investment (FDI) occurs when the investor acquires
a measure of control of the foreign business
2. Portfolio investment mostly represents sales and purchases of
foreign financial assets, such as stocks and bonds, that do not
involve a transfer of control
3. Other investment includes transactions in currency, bank deposits,
trade credits, etc.
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 Examples of Entries in Canada’s BoP
Credits Debits
Current Account Current Account
a. The Alberta Natural Gas Company a. Ford (Canada) buys automobile
exports natural gas to California. transmissions from a supplier in
b. Bombardier sells aircraft to Australia. Michigan.
c. Corel sells a license to a Mexican b. The LCBO buys wine from Italy.
software producer. c. Tom McNeil of Charlottetown goes
d. Nickelback gives a concert in New to the London School of Economics
York and deposit their receipts in a and takes $20,000 to pay tuition and
Toronto Bank. expenses.

Financial Account Financial Account

e. Fidelity Mutual Fund of New York d. Altamira Investments (Toronto) buys
buys 10,000 shares of Rogers shares in Xerox (USA ).
Communications (Toronto). e. Barrick buys a gold mine in Peru.
 Statistical Discrepancy
• Recordings of payments and receipts arising from
international transactions are done at different times
and places, possibly using different methods. Thus,
the recordings are imperfect.
• Financial transactions may be mainly responsible for
the discrepancy.
• Overall balance is the cumulative balance of
payments including the current account, capital
account, financial account, and the statistical
discrepancies.
• A country’s international payment gap that must be
accommodated with official reserves.
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 The Official Reserves Account
• Official reserve account includes transactions undertaken by
the central bank to finance the overall balance and intervene
in foreign exchange markets
• International reserve assets comprise:
1. Gold
2. Foreign exchanges
3. Special drawing rights (SDRs)
4. Reserve positions in the IMF

Foreign exchange accounts for about 96 percent of the total

reserve assets held by I M F member countries.

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 The Balance of Payments Identity (BOPI)
BCA + BKA + BFA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BFA = balance on financial account
BRA = balance on the reserves account
• Under the fixed exchange regime, countries maintain official
reserves that allow them to have BOP disequilibrium.
• Under the pure flexible exchange regime, overall balance must
balance, and central banks do not need to maintain official
reserves.
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 BOP Trends in Major Countries
• U.S. has experienced continuous deficits on the
current accounts since 1982 and continuous
surpluses on the financial account; with the sole
exception of 1991
– Magnitude of U.S. current account deficits is far
greater than any that other countries ever
experienced during the 36-year sample period
• U.K. recently experienced continuous current
account deficits, coupled with financial account
surpluses
– Magnitude is far less than that of the U.S.
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 BOP Trends in Major Countries (Continued)
• Germany traditionally had current account
surpluses, but between 1991-2001 experienced
current account deficits
• Attributed to German reunification and the resultant need
to absorb more output domestically to rebuild the East
German region
• Since 2002, Germany has returned to their earlier pattern
• Japan has had an unbroken string of current
account surpluses (and financial account deficits)
since 1982 even though the value of the yen rose
steadily until the mid-1990s
• A major creditor nation.
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 BOP Trends in Major Countries (Concluded)
• China tends to have a surplus on the current
account, as well as the financial account (until
recently)
• Consequently, China’s official reserves have increased
sharply.

• “Global imbalance”
– Overall, U.S. and U.K. generally use up more outputs
than they produce, whereas the opposite holds for
China, Japan and Germany

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 Top U.S. Trading Partners, 2020 ($ billion)
Rank Country Imports Exports Trade Balance Total Trade
1 China 435.4 124.6 −310.8 560.1
2 Mexico 325.4 212.7 −112.7 538.1
3 Canada 270.4 255.4 −15.0 525.8
4 Japan 119.5 64.1 −55.4 183.6
5 Germany 115.1 57.8 −57.3 172.9
6 Korea, Republic 76.0 51.2 −24.8 127.2
7 United Kingdom 50.2 59.0 8.8 109.2
8 Switzerland 74.8 18.0 −56.8 92.8
9 Taiwan 60.4 30.5 −29.9 90.9
10 Vietnam 79.6 10.0 −69.6 89.6
11 India 51.2 27.4 −23.8 78.6
12 Ireland 65.5 9.6 −55.9 75.0
13 Netherlands 27.5 45.5 18.0 73.0

14 France 43.0 27.4 −15.6 70.4

15 Italy 49.5 19.9 −29.6 69.4

• Source: U.S. Census Bureau.

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 Impact on Currency
• CA: All the other factors constant, a deficit
balance on a country’s current account implies
that there is excess supply of its currency in the
foreign markets. Hence, its currency should
depreciate.
• FA: All other factors constant, a surplus balance
in a country’s financial account implies that there
is excess demand for assets denominated in its
currency. Hence, its currency should appreciate.

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 Affects on the Economy
• Is a nations current account balance, by itself, a good
measure of its economic health?
• NO; there is no law, economic or political, which states that
the current account balance must be positive. Unlike running
a budget deficit in which a person or institution spends more
than it makes, running a deficit in the current account, simply
means a country imports more than it exports.
• Is a current account surplus and financial account deficit
by itself an indication of economic strength?
• NO, particularly not if the exodus of the financial capital
occurs because there are a few good investment
opportunities in the country.
• Is the net inflow of capital bad?
• NO, if the capital is being invested in such a way as to
enhance the productive capacity of the country.

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 Do monetary and fiscal policies affect the exchange rates and
BOP components?
• Monetary Policy: An unanticipated shift to expansionary
monetary policy will lead to more rapid economic growth,
accelerated inflation and lower real interest rates
• BOP effects: Higher income and higher domestic prices
stimulate imports and discourage exports. Lower real rates
discourage foreign and domestic investment at home.
• Exchange rate effects : The adverse impact of the
country’s current account will increase the supply of
currency in the fx markets; causing the currency to
depreciate. The adverse impact of the country’s financial
account will decrease demand for the country’s currency,
causing it to depreciate.

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 Do monetary and fiscal policies affect the exchange
rates and BOP components?
• Fiscal Policy: An unanticipated shift to more expansive fiscal policy
will result in budget deficits, increase in aggregate demand, inflation
and an increase in real interest rates.
• BOP effect:Increase demand will encourage imports & discourage
exports, which moves the current account towards deficit.
• Meanwhile, the higher interest rates attract foreign investment and
discourage domestic investment from leaving the country, moving
the financial account surplus.
• Exchange rate effects: The adverse impact of the current account
will increase the SUPPLY of the country’s currency, causing the
currency to depreciate.
• The positive impact of the FA will increase demand causing the
currency to appreciate.
•So what do you think is the net effect?
•The overall effect is mixed, but the interest rate effect will likely
dominate in the short term leading the exchange rate appreciation.