INTERNATIONAL ECONOMICS

Balance of Payments (BOP)

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LECTURE OBJECTIVES:
Students should be able to: Understand what is meant by BOP Identify the main accounts of BOP Calculate BOT, BOP etc Explain factors affecting the BOP position of the country Explain the implications of disequilibrium BOP Explain & evaluate measures to correct BOP deficit/surplus.

WHAT HAVE YOU LEARNT SO FAR?

International Trade: Trade theories (CA) TOT & BOT Anti Trade Policies Economic Integration

Physical Exchange of Goods and services.

Theory

of international Trade (CA) Protectionism

Financial Payment after physical exchange Balance of Payment (BOP) Exchange rate system

VIDEO

BIGGEST TRADE SURPLUS LATEST 12 MONTHS, IN $ BILLION (2010) Germany, 210.8 (June) 2. China, 174.7 (July) 3. Russia, 152.6 (June) 4. Saudi Arabia, 104.4 (2009) 5. Japan, 81.7 (June) 6. Norway, 55.6 (June) 7. Ireland, 54.1 (May) 8. Netherlands, 53.3 (May) 9. S. Korea, 40.1 (July) 10. Malaysia, 36.6 (May)
1.

TOP 10 COUNTRIES WITH WHICH U.S HAS A TRADE DEFICIT (NOV 2011)
Country Name China Japan Mexico Germany Deficit in Millions of U.S. $ - 25, 871. 59 - 5, 207. 18 - 5, 514. 12 - 4, 656. 40

Saudi Arabia Canada Ireland Russia Nigeria Venesuela

- 3, 067. 96 - 2, 976. 63 - 2, 808. 65 - 2, 510. 94 - 2, 307. 35 - 1, 914. 39

U.S. Census Bureau

 It

is a record of a countrys transactions with the rest of the world over a calendar year. that lead to a payment from foreigners are recorded as a credit item.(+) E.g. Exports, investment from overseas. that lead to a payment to foreigners are recorded as a debit item.(-) E.g. Imports, investment abroad.
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Transactions

Transactions

The BOP of a country is determined by the Current & Capital & Financial account.

BOP
Current A/c
Capital & Financial A/c

a) Visible trade (Goods) account

(Balance of trade) b) Invisible trade (Services) account. (Balance of invisible trade) c) Unilateral transfers

d) Income flows interests profits & dividends

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 Covers

all tangible items including import and export of any form of goods. E.g. Cars, consumer durables, food items etc.

The balance in this account is also referred to as the Balance of Trade. Difference btw the value (P x Qty) of visible exports & visible imports)

BALANCE OF PAYMENTS
A. Current Account Visible trade balance Exports of goods Imports of goods 55,608.6

+ 339,646.8 -284,038.2

BOT surplus : X > M BOT deficit : X < M

12

Invisibles are intangible items. They consist of different types of services that a country sells to or buys from other countries.

Shipping, insurance & banking services

Transportation & travel Govt overseas expenditure

 Refers to gifts/financial aid to and from relatives/govt/others abroad Gifts

Remittances

Grants/financial aid

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Receipts arise from interests on loans to foreign govt/ pte co Profits are received from co owned abroad Dividends from holding shares in foreign co Payments arise from interests paid to foreign depositors Profits are remitted overseas by foreign co

Dividends from holding shares in local co

Calculate the Current Account Balance. BALANCE OF PAYMENTS Current Account Visible trade balance Exports of goods Imports of goods Invisible trade balance Income balance Transfers Current Account Balance 55,608.6

+ 339,646.8 - 284,038.2 -5,454.6 -3,756.8 -1,943.9

16

Current Account Visible trade balance Exports of goods 55,608.6 + 339,646.8 -5,454.6 -3,756.8 -1,943.9 44,453.3

- 284,038.2 Imports of goods Invisible trade balance Income balance Transfers

Current Account Balance

Current A/C surplus: Combined Receipts >

Combined Payments
17

BALANCE OF PAYMENTS ACCOUNTS

Capital & Financial A/c

ST Capital Flows LT Capital Flows

Speculative monetary movement (Hot money speculative monetary movt)

Direct Investment eg: subsidiaries set up by foreign firms (FDI) Portfolio Investment eg: bonds, shares securities (paper assets) 18

Investments/loans abroad now will result in the inflow of profits, dividends & interests in the current account in the future.
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BALANCING ITEM
The

current and capital account never adds up to the amount of foreign currency the country actually gain or lost.
balancing item represents the total errors and omissions which is required to bring the recorded BOP into balance.

The

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BALANCING ITEM
Current Account Balance (A)
Capital Account Balance (B) Balancing Item (C) Total Currency Flow (D)

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+44,453.3 - 24,644.5 + 624.2 + 20,433.0

A positive total currency flow means that Intl Receipts > Intl payments BOP surplus
What does a negative total currency flow mean?

Negative total currency flow means that Intl Receipts < Intl payments BOP deficit 21

 The

BOP is said to be in disequilibrium when the total currency flow (TCF) is either positive or negative. Thus BOP is in disequilibrium when the overall balance is not zero

If TCF = 0 If TCF 0

BOP Equilibrium BOP Disequilibrium

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A BALANCING ACT
The BOP accounts are presented as a balanced sheet and all balance sheet must always BALANCE.

23

What does it mean when economist say that BOP must always balance?

24

 If

outflow > inflow --> BOP deficit.

BOP

deficit shows the amount required to cover any shortfalls in the overall BOP transactions. account must be balanced by withdrawals from official reserves or by borrowing overseas. These items are counted as inflows to balance the account.
25

The

 If

outflow < inflow --> BOP surplus

BOP

surplus shows the amount of forex earnings available for addition to the countrys forex reserves. surplus will be treated as additions to official reserves and repayment of overseas loans or the purchase of external assets. These items are treated as an outflows.

The

26

OFFICIAL FINANCING (RESERVES)

Government

can hold reserves of gold and foreign currencies on reserves represents a credit item as it represents an inflow into the BOP accounts. up the reserves represents a debit item as it represents an outflow from the BOP account.
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Drawing

Building

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$ Million A. Current Account B. Capital & Financial A/C C. Balancing item D. Total Currency Flow E. Official Financing A/C 55,608.6 -24,644.5 624.2 20,433.0 -20,433.0

Overall BOP balance

BOP (in $m)

Current Acct Visible Bal (goods) Invisible Bal (service) Unilateral Transfers Current Acct Bal
Capital Acct Direct investment Portfolio investment Capital Acct Bal Balancing Item -200 +300 -50 ??? +150 -300 ??? +12

TCF (Overall Bal)

Official Financing Acct

???
???

BOP Bal

BOP (in $m)

Current Acct Visible Bal (goods) Invisible Bal (service) Unilateral Transfers Current Acct Bal
Capital Acct Direct investment Portfolio investment Capital Acct Bal Balancing Item -200 +300 -50 +50 +150 -300 -150 +12

TCF (Overall Bal)

Official Financing Acct

-88
+88

BOP Bal

What

causes a BOP deficit? How can a country eliminate BOP deficit?

BOP DEFICIT
International

payments > International receipts (excluding changes in official financing). Occurs when: Both Current and Capital accounts are in deficit Deficit in one account exceeds the surplus in the other account. (e.g. Current account deficit exceeds the Capital account surplus.)

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Factors affecting the BoP

Domestic income level Country's stage of development Long-term investment prospects

Rate of interest
Changes in the prices of X & M (TOT) Expected changes in the country's currency exchange rate Govt Policy
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BOP CONTINUED

WHAT HAVE YOU LEARNT?

What

is meant by BOP?

It is a record of a countrys transactions with the rest of the world over a calendar year.
What
-

are the main accounts in BOP?

Current Account Capital and Financial Account

WHAT DOES CURRENT ACCOUNT CONSIST OF? a) Visible trade (Goods) account (Balance of trade) b) Invisible trade (Services) account. (Balance of invisible trade) c) Unilateral transfers

d) Income flows interests profits & dividends

WHAT DOES CAPITAL AND FINANCIAL ACCOUNT CONSIST OF?

ST Capital Flows LT Capital Flows

Speculative monetary movement (Hot money speculative monetary movt)

Direct Investment eg: subsidiaries set up by foreign firms (FDI) Portfolio Investment eg: bonds, shares securities (paper assets)

FACTORS AFFECTING THE BOP POSITION OF THE COUNTRY

Domestic income level

Country's stage of development

Long-term investment prospects Rate of interest Changes in the prices of X & M (TOT) Expected changes in the country's currency exchange rate Govt Policy

WHAT ARE THE POSSIBLE REASONS FOR A BOP DEFICIT?

Current

Account deficit Capital Account deficit

POSSIBLE REASONS FOR A DEFICIT IN THE

CURRENT ACCOUNT
Rising

income

increase in dd for m increase in M increase in C increase in production of gds for domestic C and less for X fall in X revenue.

Poor

quality / higher costs of Exports Increase in the price of Ms:

(oil & foodstuff), dd for X & M is price inelastic increase in M

Appreciation in exchange rate

POSSIBLE REASONS FOR A DEFICIT IN THE CAPITAL ACCOUNT

Poor

investment climate due to rising GPL & political instability capital outflight Falling interest rate (lower than other countries) outflow of hot money. Expect exchange rate to depreciate outflow of capital.

Do countries prefer BOP surplus or BOP deficit?

A BOP surplus is desirable not only because it leads to an increase in forex reserves which enhances a countrys international purchasing power. Export earnings and capital inflow inject multiplier effects on a countrys national income and lead to economic growth.

A country can run a persistent BOP deficit only if it has unlimited reserves of gold and foreign currencies or can borrow persistently from the rest of the world. But these options are not realistic.

Is a BOP deficit definitely undesirable, then?

Well...
It depends:
ST or persistent? Causes of the deficit? Size of deficit?

EFFECTS OF PERSISTENT BOP DEFICIT

Depletion

of foreign reserves. Countries have to draw upon their reserves to cover the deficit. large external debt Deficit will persist as the debt needs servicing, representing further outflow

Incur

Depreciation

of currency Persistence deficits reflect poor economic management. Lack of confidence

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REMEDIES FOR A BOP DEFICIT

Expenditure-Reducing Expenditure-Switching

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EXPENDITURE REDUCING MEASURES

Reduce

the overall expenditure on imports and increase export revenue Contractionary fiscal policy Increase income taxes Decrease govt expenditure
Contractionary

monetary policy Reduce money supply to increase i/r Loans are less accessible thus reduce demand for imports and domestic product
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ADVANTAGES OF EXPENDITUREREDUCING
1.

2.

3.

Fall in Y Fall in C & M Fall in AD fall in GPL. This increases price competitiveness and demand for exports eventually. Fall in Y Fall in dd for domestic goods more resources will be channeled to produce goods for exports increase X. A tight money policy will raise interest rates which will attract hot money into the country which will improve capital balance

DISADVANTAGES OF EXPENDITUREREDUCING
1.

Limitation : Ineffective if the dd for exports & imports is income and price inelastic. - if dd for imports is income inelastic fall in Y less than proportionate fall in dd for M. - if dd for exports is price inelastic cheaper X less than proportionate increase in Qdx .

DISADVANTAGES OF EXPENDITUREREDUCING
2.

3.

4.

Other countries may retaliate by imposing trade restrictions. The fall in demand for other countries good will result in them losing income which in turn reduce their demand for imports (other countries export) Conflicting goals of BOP equilibrium & Full Employment/EG. Contractionary policies fall in Income fall in dd for Ms correct BOP deficit, but result in rise in unN & fall in NY

EXPENDITURE SWITCHING MEASURES

To

cause residents to switch from buying foreign imports to domestic good. Increase demand for import-substitutes Changing the relative prices of exports so that more resources are devoted to exporting Protectionism: Tariffs, Quota and Exchange control Subsidies/Exports Incentives Devaluation
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EXPENDITURE SWITCHING MEASURES

Protectionist measures :
Tariffs raise the price of imports (Ineffective : if ddm is price inelastic)
Quotas

reduce the quantity of imports (Disadv : result in rigidity in the economy as additional gds cannot enter the country prevent firm fr expanding.

EXPENDITURE SWITCHING MEASURES

Exchange

control restricts the amount of foreign currency available for buying imports

(Disadv : fall in confidence of investors as they might find it difficult to repatriate their profits fall in investment)

EXPENDITURE SWITCHING MEASURES

Subsidies/Export Incentives Subsidies are given to local producers to make domestically produced goods cheaper than foreign imports (Retaliation by foreign countries) (Protected industries become complacent and inefficient) For R&D and to create import substitutes. Providing detailed information on the market opportunities on other regions

DEVALUATION
Deliberate

lowering of the exchange rate of the home currency in terms of other countries currency. Intended Effects: Imports become more expensive in terms of local currency. Switch to locally produced importsubstitutes. Exports made cheaper in terms of foreign currencies

DEVALUATION
Original Exchange rate btw USA & SP US$1 : S$2 (S$1 : US$0.5)

SP suffers a BOP deficit, devalues her exchange rate

New Exchange rate

Btw USA & SP

US $1 : S $ 4

S$1 : US $ 0.25

Imports : More Expensive in terms of local currency switch to buying local products. SP Exports : Cheaper in terms of foreign currency

Conditions necessary for Devaluation: 1. Demand for exports and imports are price elastic. PEDX >1 Exports revenue increases as when PX decrease, Qty ddX increase more than proportionately. PEDM >1 Import Expenditure decreases as when PM increase, Qty ddM decrease more than proportionately. Marshall- Lerner condition. PEDX + PEDM > 1
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J-CURVE ANALYSIS
It

has been frequently observed that devaluation to rectify a BOP deficit has often led to an immediate deterioration in BOP position, followed by a subsequent recovery.
plotted on a graph is shown below.

This,

J-CURVE
Balance of Trade

Surplus (+) 0 A Deficit (-) B

Time

Conditions necessary for Devaluation:

2.

Supply of exports must be price elastic

Only when supply of exports is price elastic (economy is not at full employment; resources can be diverted into the export industries) can producers take advantage of devalution. Otherwise, there may be a shortage, causing export prices to rise. Cancel the initial price advantage gained from devaluation.

3.

NO retaliation from other countries

Devaluation allows home country to gain at the expense of trading partners.

4.

NO speculation/No loss of confidence

Devaluation reduces the external value of a currency and may undermine investment confidence foreign investors move their capital out of the country threat of further weakening of currency BOP worsen

5.

Domestic costs must be kept low

Devaluation increase in prices of Ms higher cost of living especially if demand is price inelastic (foodstuff) Higher cost of living may trigger wage price spirals as union seeks higher wages increase in price of exports. 6. Exports must not contain a large

proportion of imports

Cost of production of exports that contain large proportion of imported raw materials will increase erode initial favourable effects of devaluation

Can we conclude that Persistent BOP deficit is undesirable and Persistent BOP surplus is desirable?

A persistent BOP surplus can be undesirable because:

The

country is accumulating excess reserves at the expense of other countries Possible retaliation from trading partner. Flow of funds and multiplier effect of exports may result in inflation

REMEDIES FOR A BOP SURPLUS

Revaluation

of the currency Inflating the economy Current account surplus can be eliminated by outflow of funds on the capital account

What is the difference between expenditure reducing and expenditure switching policies to correct BOP disequilibrium?