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International Corporate Finance

Balance of Payments

In today's class meeting, we will discuss Balance-of-Payments Accounting and components of Balance-
of-Payments accounts. we will use multiple examples to understand the mechanism.

The balance-of-payments (BOP) is defined as the statistical record of a country's international


transactions over a certain period of time presented in the form of double-entry bookkeeping.

Rule of BOP accounting:

Credit vs. Debit:

Receipt from foreigners -> Credit


payment to foreigners -> Debit

Inflow vs. Outflow:

credit transaction -> positive sign


debit transaction -> negative sign

Sources of credit entries (for USA):

foreign sale of US goods and services


foreign sale of US goodwill
foreign sale of US financial and real assets

Sources of debit entries (for USA):

US purchases of foreign goods and services


US purchases of foreign goodwill
US purchases of foreign financial and real assets

BOP and Exchange Rates:

For USA -

Credit entry -> demand for dollar will increase -> supply of foreign exchange will increase
debit entry -> supply of dollar will increase -> demand for foreign exchange will increase

Example-1:

Suppose Boeing exported a 747 aircraft to Japan Airlines for $50 million, and Japan airlines pays from its
account in Chase Manhattan Bank in NYC.

Debit Credit
Boeing export $50 million

Uddin/Lecture/BOP
Withdrawal from US Bank -$50 million

Example-2:

Suppose Boeing imports jet engines from Rolls Royce for $30 million, and Boeing makes payment by
transferring the fund to the Rolls Royce account in Chase Manhattan Bank.

Debit Credit
Boeing import -$30 million
Deposit at US Bank $30 million

Example-3:

Suppose Ford acquires Jaguar for $750 million, and Jaguar purchases US Treasury notes with the sales
proceed.

Debit Credit
Acquisition of Foreign Company -$750 million
Jaguar's purchase of Treasury $750 million
Notes

Types of BOP accounts:

Current Account
Capital Account
Official Reserve Account

Current Account (BCA): the current account includes export and import of goods and services. it is
defined as export minus imports plus unilateral transfers. current account is divided into 4 categories.
they are described below.

a) Merchandise trade: export and import of tangible goods

Q: What is the difference between BOP and BOT?

b) Services: Payments and receipts for

legal services
consulting services
royalties

c) Factor Income: Payments and receipts of interest, dividend, and other income on previous foreign
investments

Uddin/Lecture/BOP
d) Unilateral Transfers: Unrequited payments such as

foreign aid
reparations
official and private grant
gifts

for the purpose of double entry bookkeeping system, unilateral transfers are regarded as act of buying
goodwill from the recipient countries.

Relationship between trade balance and exchange rates:

trade balance is sensitive to exchange rate changes. Following a depreciation of the currency, trade
balance may deteriorate at first for a while, eventually it will improve over time. This pattern is
commonly referred to as the J-Curve effect.

See: Exhibit 3.2 in your text

Q: What is the underlying reason of observing the J-Curve phenomenon?

Imports and exports are inelastic

difficult to change consumption habits

Capital Account (BKA): the capital account measures the following 2 items:

US sale of assets to foreigners -> capital inflow -> credit


US purchase of foreign assets -> capital outflow -> debit

There are 3 components of the capital account. They are described below:

a) FDI: when investor acquires a measure of control of the foreign business

b) Portfolio Investment: Purchase and sale of foreign financial assets

c) Other investment: the following are the examples of other investments

currency transactions
bank deposits
trade credits

Statistical Discrepancy: BOP transaction recordings are not perfect. A lot of transactions such as invisible
services, are difficult to detect. Thus, BOP always shows a balancing debit or credit as statistical
discrepancy.

Uddin/Lecture/BOP
when we obtain the cumulative BOP including current account, capital account, and statistical
discrepancy, we obtain the overall balance. Overall balance indicates a country's international payment
gap that must be accommodated with the government's official reserve transactions.

Official Reserve Account (BRA): When a country face trade deficit or surplus, the central bank of the
country should take the following actions.

BOP Deficit Run down its official reserve assets


Borrow from foreign central banks
BOP Surplus Retire some of its foreign debts
Acquire additional reserve assets from foreigners
BOP Balanced No action

BOP Identity:

BCA+BKA+BRA=0

Under fixed exchange rate system:

BCA+BKA=-BRA

Under flexible exchange rate system:

BCA=-BKA or

BKA=-BCA

Uddin/Lecture/BOP

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