Chapter 3 The Balance of Payments 1. Balance of Payments Defined. What is the balance of payments? The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP). 3. Importance of BOP. Business managers and investors need BOP data to anticipate changes in host country economic policies that might be driven by BOP events. From the perspective of business managers and investors, list three specific signals that a country’s BOP data can provide. The BOP is an important indicator of pressure on a country’s foreign exchange rate and thus on the potential for a firm trading with or investing in that country to experience foreign exchange gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange controls. Changes in a country’s BOP may signal the imposition or removal of controls over payment of dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors. The BOP helps to forecast a country’s market potential, especially in the short run. A country experiencing a serious trade deficit is not likely to expand imports as it would if running a surplus. It may, however, welcome investments that increase its exports. 6. Balance. If the BOP always “balances,” then how do countries run a BOP deficit or surplus? The cumulative international economic transactions of the BOP should balance. These include the three main component accounts: current account, capital account, and financial account, in addition to the statistical discrepancies and official reserves. But each of the three component accounts can either show a deficit or a surplus. Countries run BOP deficits when their outflows are higher than their inflows and vice versa. A BOP deficit can be supported by drawing on reserve holdings or by borrowing from abroad. Conversely, an overall BOP surplus is absorbed by adding to the central bank’s reserve holdings or by making foreign loans. 10. Current Account. Is the current account the same as the balance of trade (BOT)? Give debit and credit examples of current account and BOT transactions by a German automobile MNE. The current account is one of the sub-component accounts of the BOP. It comprises the goods trade account (exports and imports of tangible goods); services trade account (exports and imports of intangible services); income account (current investment income as well as wages/salaries of non-resident workers; and current transfers account (personal or corporate financial settlements and inter-country gift and grant transfers. The largest sub-account of the current account is the Balance of Trade (BOT), which makes up the goods and services trade balances. It is generally the most quoted of all BOP accounts. The following are examples of transactions of an automobile MNE headquartered in Germany and operating in many countries. AccountInflowsOutflowsBalance of Trade a) Goods trade account b) Services trade account a) Export proceeds of German cars b) Interest payments for consumer loans a) Imports of Chinese auto-parts b) Payments by subsidiaries to insurance firmsIncome accountDividend earnings from subsidiariesInterest payments on foreign currency loansTransfers accountGermans working in subsidiaries remitting funds back homeSalaries paid to non-German expatriates 13. Classifying Transactions. Classify the following as a transaction reported in a sub-component of the current account or the capital and financial accounts of the two countries involved: a. A U.S. food chain imports wine from Chile. Debit to U.S. goods part of current account, credit to Chilean goods part of current account. b. A U.S. resident purchases a euro-denominated bond from a German company. Debit to U.S. portfolio part of financial account; credit to German portfolio of financial account. c. Singaporean parents pay for their daughter to study at a U.S. university. Credit to U.S. current transfers in current account; debit to Singapore current transfers in current account. d. A U.S. university gives a tuition grant to a foreign student from Singapore. If the student is already in the United States, no entry will appear in the balance of payments because payment is between U.S. residents. (A student already in the United States becomes a resident for balance of payments purposes.) e. A British Company imports Spanish oranges, paying with eurodollars on deposit in London. A debit to the goods part of Britain’s current account; a credit to the goods part of Spain’s current account. f. The Spanish orchard deposits half the proceeds in a eurodollar account in London. No recording in the U.S. balance of payments, as the transaction was between foreigners using dollars already deposited abroad. A debit to the income receipts/payments of the British current account; a credit to the income receipts/payments of the Spanish current account. g. A London-based insurance company buys U.S. corporate bonds for its investment portfolio. A debit to the portfolio investment section of the British financial accounts; a credit to the portfolio investment section of the U.S. balance of payments. h. An American multinational enterprise buys insurance from a London insurance broker. A debit to the services part of the U.S. current account; a credit to the services part of the British current account. i. A London insurance firm pays for losses incurred in the United States because of an international terrorist attack. A debit to the services part of the British current account; a credit to the services part of the U.S. current account. j. Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can fly the return segment of a flight back to Hong Kong. Hong Kong keeps its balance of payments separate from those of the People’s Republic of China. Hence a debit to the goods part of Hong Kong’s current account; a credit to the goods part of the U.S. current account. k. A California-based mutual fund buys shares of stock on the Tokyo and London stock exchanges. A debit to the portfolio investment section of the U.S. financial account; a credit to the portfolio investment section of the Japanese and British financial accounts. l. The U.S. army buys food for its troops in South Asia from vendors in Thailand. A debit to the goods part of the U.S. current account; a credit to the goods part of the Thai current account. m. A Yale graduate gets a job with the International Committee of the Red Cross working in Bosnia and is paid in Swiss francs. A debit to the income part of the Swiss current account; a credit to the income part of the Bosnia current account. This assumes the Yale graduate spends her earnings within Bosnia; should she deposit the sum in the United States, then the credit would be to the income part of the U.S. current account. n. The Russian government hires a Dutch salvage firm to raise a sunken submarine. A debit to the service part of Russia’s current account; a credit to the service part of the Netherlands’s current account. o. A Colombian drug cartel smuggles cocaine into the United States, receives a suitcase of cash, and flies back to Colombia with that cash. This would not get captured in the goods part of the U.S. or Colombian current accounts. Assuming the cash was “laundered” appropriately, from the point of view of the smugglers, bank accounts in the United States or somewhere else (probably not Colombia, possibly Switzerland) would be credited. This imbalance would end up in the errors and omissions part of the U.S. balance of payments. p. The U.S. government pays the salary of a Foreign Service Officer working in the U.S. embassy in Beirut. Diplomats serving in a foreign country are regarded as residents of their home country, so this payment would not be recorded in any balance of payments accounts. If or when the diplomat spent the money in Beirut, at that time a debit should be incurred in the goods or services part of the U.S. current account and a contrary entry in the Lebanon balance of payments. It is doubtful that the goods or services transaction would get reported or recorded, although on a net basis changes in bank balances would reflect half of the transaction. q. A Norwegian shipping firm pays U.S. dollars to the Egyptian government for passage of a ship through the Suez Canal. If the Norwegian firm paid with dollar balances held in the United States and the Suez Canal Authority of Egypt redeposited the proceeds in the United States, no entry would appear in the U.S. balance of payments. Norway would debit a purchase of services, and Egypt would credit a sale of services. r. A German automobile firm pays the salary of its executive working for a subsidiary in Detroit. Germany would record a debit in the income payments/receipts in its current account; the U.S. would record a credit in the income payments/receipts in its current account. s. An American tourist pays for a hotel in Paris with his American Express card. A debit would be recorded in the services part of the U.S. current account; a credit would be recorded in the services part of the French current account. t. A French tourist from the provinces pays for a hotel in Paris with his American Express card. A French resident most likely has a French-issued credit card, issued by the French subsidiary of American Express. In this instance, no entry would appear in either country’s balance of payments. If, later, the French subsidiary of American Express paid a dividend back to the United States, that would be recorded in the income part of the current accounts. u. A U.S. professor goes abroad for a year and lives on a Fulbright grant. The current transfers section of the U.S. current account would be debited for the salary paid to a foreign resident. (Even though an American, the professor is a foreign resident during the time he lives abroad.) The current transfers section of the host country’s current account would be credited. 18. BOP Transactions. Identify the correct BOP account for each of the following transactions. a. A German-based pension fund buys U.S. government 30-year bonds for its investment portfolio. Financial account: portfolio investment liabilities b. Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to Copenhagen. Current account: Goods: Exports FOB c. Hong Kong students pay tuition to the University of California, Berkeley. Current account: Services: credit d. The U.S. Air Force buys food in South Korea to supply is air crews. Current account: Goods: Imports e. A Japanese auto company pays the salaries of its executives working for its U.S. subsidiaries. Current account: Services: credit f. A U.S. tourist pays for a restaurant meal in Bangkok. Current account: Services: debit g. A Colombian citizen smuggles cocaine into the United States, receives cash, and smuggles the dollars back into Colombia. Unrecorded but should be a current account item. h. A U.K. corporation purchases a euro-denominated bond from an Italian MNE. Does not enter the U.S. balance of payments 19. BOP and Inflation. What are the direct and indirect relationships between the balance of payments and inflation? The current account and the level of imports have the potential to lower or raise a country’s inflation rate. If the inflation rate in the exporting country rises, then imported inflation will result. Moreover, if the domestic currency devalues, imported goods and services will become more expensive. On the other hand, imports of cheaper goods and services place pressures on domestic competitors to reduce the prices of comparable goods and services. Thus, the components and price levels of the imports (as appearing on the current account) can substantially impact prices, especially in import-oriented economies. 20. J-Curve Dynamics. What is the J-Curve adjustment path? A country’s trade balance may change as a result of an exchange rate change in the shape of a flattened “j.” International economic analysis characterizes the trade balance adjustment process as occurring in three stages: (1) the currency contract period, (2) the pass-through period, and (3) the quantity adjustment period. Assuming that the trade balance is already in deficit prior to the devaluation, a devaluation may actually result in the trade balance first worsening before improving as a result of the three distinct commercial periods.
