ECON A342F Selected Topics

in Hong Kong Economic and

Public Policy Analysis

Topic 1.3: The balance

of payments
January 2024

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Contents

1.3.1 The national income accounts in an open

economy
1.3.2 The balance of payments accounts
1.3.3 Do current account deficits matter?

References: Krugman et al. Chp.13, Hong Kong

Annual Digest of Statistics

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 Hong Kong as an open economy
• Being an international financial centre, Hong Kong
necessarily deals with financial flows with the rest
of the world in large volumes.
• They arise on the basis of open capital and goods
markets operating in different countries, with
different currencies.
• The actions taken by national central banks and
individuals can/will spill over into other countries.
• In an open economy, domestic savings no longer
equal domestic investment.

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1.3.1 The national income accounts in
an open economy
• Such international flows of capital are
measured in an economy’s ‘balance of
payments’ (BoP).
• In this topic we extend what we know about
macroeconomics (and monetary economics) to
the international arena.
• The BoP is the record of a country’s trade with
other countries in goods, services, and assets.

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1.3.1 Background:
• The equation for GDP:
Y = C + I + G + NX

• Gross domestic product measures the final value of

all goods and services that are produced within a
country in a given time period, regardless of the
nationality of producers.
• The item NX involves trade across borders, it
necessarily involves changes in the BoP.

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 1.3.1 Background
• Gross National income (GNI): a more precise measure
of national income is GDP adjusted for the primary
income of foreign nationals in Hong Kong and the
primary income earned by Hong Kong while overseas.

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 1.3.2 The balance of payments accounts

• Primary income refers to flows of income with non-

residents of Hong Kong that relate to economic
production.
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 1.3.2 The balance of payments accounts

• Primary income refers to flows of income with non-

residents of Hong Kong that relate to economic
production.
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1.3.2 The balance of payments accounts
• Some basic definitions of the BoP:
• Current account (CA), Financial account (FA),
Capital account (KA).
CA = -(FA+KA) Think about it as debit and credit entries
CA+(FA+KA)=0
CA = NX + net income + net transfers
FA = Capital inflow – capital outflow
KA = aid + migrants’ transfers
+ trade balance in non-produced and non-financial
assets
royalties, copyrights etc.
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1.3.2 Background:
• Using the identities on macroeconomics again:
S = Sprivate + Spublic
Spublic = T-G, Sprivate = Y-T-C, (assuming TR=0)

Y=C+I+G+NX
∴Y-C=I+G+NX
minus T: Y-T-C=I+(G-T)+NX
Sprivate =I+NX-Spublic
Sprivate +Spublic=I+NX
S=I+NX or S=I+NFI
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1.3.2 Background
S=I+NX or S=I+NFI
• Based on this equation, we can say that:
+ NX represents our net gain in assets
- NX is net loss of assets

• +NX gains foreign currency, but foreign currency

can only be used overseas, so we use it to buy
more foreign assets, hence we make ‘positive net
foreign investment (+NFI)’.
• Similarly, -NX means foreigners earn local currency,
which is used to buy local assets, hence ‘-NFI’.
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1.3.2 The balance of payments accounts
• While in concept NFI and NX are useful in recording
the international flow of funds, it is much more
common to talk about these in terms of the three
accounts used in the BoP.
• We now rephrase the previous identities with
respect to the BoP:
CA = NX + net income + net transfers
• Simplify by omitting net income and net transfers:
For large and middle sized Y = C + I + G + (X – M)
economies, CA is almost equal to NX
= C + I + G + (CA)
• What we mean by +NX and +NFI is actually equal to
+CA (current account surplus, or net gain in assets)
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1.3.2 The balance of payments accounts
CA = X – M = Y – (C + I + G )

• When production > domestic expenditure

exports > imports, then:

current account > 0 and trade balance > 0

➢when a country exports more than it imports, it

earns more income from exports than it spends
on imports
➢net foreign wealth is increasing (+NFI or +CA)
➢S = I + CA, (CA > 0) 13
1.3.2 The balance of payments accounts
CA = X – M = Y – (C + I + G )

• When production < domestic expenditure

exports < imports, then:

current account < 0 and trade balance < 0

✓when a country exports less than it imports, it

earns less income from exports than it spends on
imports
✓net foreign wealth is decreasing (-NFI or –CA)
✓S = I + CA, (CA < 0) 14
1.3.2 What do these equations mean?
CA = X – M = Y – (C + I + G )
Slide 10
• We know from slide 8 that when there is a trade
surplus, S = I + NX, and S > I. So local people use
the extra saving to buy up foreign assets (-FA).

• Frequently, that happens through lending the

money to foreigners, which converts the foreign
currency into a stream of future income from
overseas.

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1.3.2 What do these equations mean?
CA = X – M = Y – (C + I + G )

• If NX<0, then it means that S < I. That is, local

saving is not enough, and people must borrow
money from overseas or sell assets overseas (+FA or
-CA).
• That means local people are financing present
consumption by borrowing from overseas.
• When they repay these loans (with interest) in the
future, their future consumption will decrease.
• Note the relation of –CA or +FA (a flow concept for
funds) with incurring debt (a stock concept). 16
1.3.2 Examples of BoP Accounting
1. An American imports a fax machine from Olivetti,
an Italian firm. Olivetti deposits the cheque in a
U.S. bank.
US BoP
Fax machine (current account, U.S. good import)
–$80
Bank deposit (financial account, U.S. asset sale)
+$80

How does the mechanism of international payments

work and how does it affect both countries? 17
1.3.2 Example 1 of BoP Accounting

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1.2 Detailed version of E.G. 1

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1.3.2 Examples of BoP Accounting
2. You buy lunch in France and pay by credit card.
French restaurant receives payment from your credit
card company.

HK BoP
Meal purchase (current account, HK service import)
–$30
Sale of credit card claim (financial account, HK asset
sale) +$30

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1.3.2 Example 2 of BoP Accounting

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1.3.2 Examples of BoP Accounting
3. Someone in HK buys a share of BP (a UK company),
BP deposits the money in a bank in HK.
HK BoP
Stock purchase (financial account, HK asset purchase)
–$90 (-FA, capital outflow)
Bank deposit (financial account, HK asset sale)
+$90 (+FA, capital inflow)
• The ownership of funds is with UK, but there is no
-CA for HK because using money to exchange for
shares both represent financial flows, so both go
into the FA.
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1.3.2 Examples of BoP Accounting
4. U.S. banks forgive a $50 M debt owed by the
government of Argentina through debt restructuring.
U.S. banks who hold the debt thereby reduce the debt
by crediting Argentina's bank accounts.
US BoP
Debt forgiveness (capital account, U.S. transfer
payment)
–$50 M
Reduction in bank’s claims (financial account, U.S.
asset sale)
+$50 M (reduction of capital outflow,
similar to capital inflow)

• Notice how KA+FA=0, no CA entry so CA=0.

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1.3.2 Statistical discrepancy in the BoP
• While the identity says CA=KA+FA, they are not
always in balance in reality.
• Data from a transaction may come from different
sources that differ in coverage, accuracy, and
timing. The exchange rates used at different times
may not be the same.
• The statistical discrepancy (error) is the account
added to or subtracted from the FA to make it
balance with the CA and KA.
• See the table below with 4 items: (A)CA, (B)KA+FA,
(C)Error, (D)Reserve assets.
(A)+(B)+(C)+(D)=0
(C)=-[(A)+(B)+(D)]
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1.3.2 Official (international) reserve assets
• These are foreign assets held by central banks to
cushion against financial instability (commonly
called forex or FX reserves).
– Assets include government bonds, (foreign) currency,
gold, and accounts at the International Monetary Fund.
– Official reserve assets owned by (sold to) foreign central
banks are a credit (+) to the local BoP (like a capital
inflow).
– Official reserve assets owned by (purchased by) the
domestic central bank are a debit (–) to the local BoP
(like a capital outflow).
– However, because of large errors, in the table that
follows it is not always easy to interpret reserve asset
numbers. 25
1.3.2 How come forex reserves are
negative in the BoP?
• Such reserves are sometimes called the Official
Settlement Balance.
• In theory, such reserves are made up of +NX or +NFI
earning foreign currency. We can think of it as the
local economy exporting savings to finance
overseas people’s spending, so it is recorded as
negative (just like capital outflow).
• See the table below with 4 items: (A)CA, (B)KA+FA,
(C)Error, (D)Reserve assets.
(A)+(B)+(C)+(D)=0
(D)=-[(A)+(B)+(C)]
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1.3.2 Official reserve transactions
• Official reserve transactions are simply the sale
and purchase of foreign currency between central
banks. These usually include two main things:
1. The exchange of currency in the normal course of
international trade (see E.g. 1 of BoP
transactions), or due to foreign portfolio
investment, that is, cross-border capital flows.
2. Central bank intervention in the foreign exchange
market to influence the value of the domestic
currency.
• They both affect the volume of international
reserves assets held by the central bank.
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1.3.2 Understanding trade balances
• From time to time, we hear politicians talk about a
country’s trade deficit with one particular country.
These are called bilateral trade balances.
• Economically, that is almost always irrelevant,
because a bilateral trade deficit with one country
may not mean there is an overall trade deficit.
• The country may have a trade surplus with some
other countries.
• For example, there are 3 countries in the world, A, B
and C.
• Each one’s trade balance and direction of trade is
shown in the following diagram. 28
1.3.2 Understanding trade balances

Each economy here

exports and
imports $100m, so
they all have trade
balance of zero.

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1.3.2 Understanding trade balances
• If for example Country B complains to Country A that
they have a trade deficit of $100m, and makes trade
policy based on that only, then it is missing out on
the larger picture of multilateral trade, and the
surplus with Country C.
• Usually, an economy with persistent large overall
current account deficits (or surpluses) have some
issues with the structure of the domestic economy.
• Trade policy alone is unlikely to correct these
imbalances and restore current account balance
while ensuring economic growth at the same time.
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1.3.2 Hong Kong current account (excerpt)

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1.3.2 Hong Kong capital and financial 32

accounts (excerpt)
1.3.2 Hong Kong balance of payments 33

(excerpt)
1.3.2 Hong Kong balance of payments
Some things need explaining:
• Secondary income in CA refers to transfers which do
not involve any production.
• Positive numbers in the CA means a surplus.
• In the CA, the primary income surplus is even higher
than the net exports (goods and services) surplus. In
other words, NX is not the most important source of
foreign income for Hong Kong, unlike most other
larger economies in the world.

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1.3.2 Hong Kong balance of payments
Some things need explaining:
• Negative numbers in the KA + FA refers to capital
outflow from Hong Kong.
• The ‘Overall balance of payments’ surplus (deficit)
means foreign exchange reserves in Hong Kong has
increased (decreased). This is not officially part of
the IMF definitions, but allows readers an easy to
understand summary of the BoP situation in Hong
Kong.

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1.3.2 US current account and net foreign 36

wealth (Krugman et al. 12 ed. Figure 13.2)

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1.3.3 Do current account deficits (CAD) or
surpluses (CAS) matter?
• A question that is asked very often is whether
sustained CADs are acceptable in the world.
• That question arises because some advanced
industrial countries, notably USA, UK, Australia,
New Zealand etc. have very large CADs. But that
does not seem to make them poorer.
• Why is that? We can make some general
observations with our knowledge of economic
theory.
• A corresponding question that is asked less often is
whether long term CASs are a good thing.
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1.3.3 Do current account deficits (CAD) or
surpluses (CAS) matter?
• A corresponding question that is asked less often is
whether long term CASs are a good thing.
• Hong Kong has a long run CAS, so the economic risks
and problems from BoP are not really the same.
• To appreciate the payoffs and risks that Hong Kong
faces with CAS, it is necessary to know more about
theories of exchange rate regimes, so we will come
back to this issue in a later topic.

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1.3.3 Do current account deficits (CAD)
matter?
• We know that persistent CADs mean:
1. The NFI position of the country will deteriorate.
2. There is a deficit in saving (S=I+CA, CA<0), so
borrowing from overseas will build up.
3. Foreign debt incurs interest expense, reducing
future consumption.
4. If foreign desire to lend to the local economy
decreases, then local C and I will crash.
5. (4) has happened to many countries before
leading to recessions and/or financial crises. 39
1.3.3 Do current account deficits (CAD)
matter?
• However, some economists are not worried because:
1. Sustained CADs mean foreigners are confident in
investing in the local economy for the long term.
2. Usually it must be because expected returns are
high and safe (sound institutional environment).
3. Extra FDI (sometimes even FPI) from overseas can
create jobs for local residents.
4. So long as interest and dividend payments are paid
in full and on time to foreigners, then there is no
reason for this trend to stop.
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1.3.3 Do current account deficits (CAD)
matter?
• Obstfeld and Rogoff (1996) suggest that having a
CAD can be the result of optimising behaviour of the
country’s residents, rearranging income and
spending over different periods of time. In that
sense, it can bring better economic outcomes to the
country. So long as the CADs are not extremely
large, then they can be sustainable.

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1.3.3 Persistent CAD?
• Another feature of CADs in countries like USA, UK,
Australia and New Zealand is that they have lasted
for many decades. But they do not have BOP crises
because of that. Is there an exception to what they
are doing so that such crises do not happen?
• Some economists have actually highlighted that it is
possible to have CADs for a long time, and the
country may not have a problem.
• On top of the Obstfeld-Rogoff conditions, Milesi-
Ferretti and Razin (1996) and Edwards (2005) suggest
that CAD sustainability must also consider willingness
to pay by the debtor and willingness to lend of
foreign investors. 42
1.3.3 Persistent CAD?
• Their reasoning can be broadly summarised in the
following way. Without resorting to any math or
statistics:
Every country has what is called an ‘International
Investment Position’ (IIP), which is the cumulation of
its ownership of assets overseas minus what
foreigners own of local assets.
Every year, when there is a CAS, then the IIP will rise
because some saving is used to buy overseas assets.

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1.3.3 Persistent CAD?
Since the CA is mainly made up of the trade balance,
so CAS≈+NX and CAD≈-NX. A positive IIP earns
dividend and interest income every year, while a
negative IIP requires net payments from the country
every year.
If we extend our thinking about IIP to the long run,
then it means that there is a stream of income from
+IIP which contributes to a CAS. At the same time, a
country can have a trade deficit (-NX) which worsens
the CA.
Looked at this way, the issue about having a CAD in
the long term is simply based on initial wealth.
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1.3.3 Persistent CAD?
If a large initial +IIP from the past has been built up,
then it is possible to run CADs for many years and no
problem will happen.
A more nuanced look will confirm that even if the
initial IIP is negative, a country can still have
consistent CADs without problems.
1. That is because economies usually grow every year.
GDP will rise, so potentially there is more income
every year to pay for CADs. If CA=0 and the
economy grows every year, then CA/GDP will drop.
2. Against that is the interest and dividends sent
overseas due to –IIP. That worsens the CA and
foreign debt can build up.
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1.3.3 Persistent CAD?
3. At the same time, a country’s CA also contains NX
and +NX can reduce the CAD.
• Considering all three factors together, it is possible
that when an economy has long run growth, and NX
performance is not too negative, then a country can
sustain a small CAD every year in the long run, even
with the -IIP.
• New Zealand is a case in point, its growth in nominal
GDP was about 5%p.a. from 1992-2019, and since +NX
is quite consistent, she can contain the CAD/GDP
ratio to an acceptable level over the long term.
• Of course, if GDP growth slows down for some years,
then CADs will become a problem. 46
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1.3 Persistent CAD?
• In line with the arguments above, Quiggin (2004)
distinguishes that persistent CAD is possible, but a
large and persistent trade deficit (-NX) is not. He
uses US data as an example.
• That is because large –NX will raise the foreign debt.
The extra interest payments can only be balanced by
even faster economic growth, until it reaches a
number that is unreasonably large.
• When that happens, then a financial crisis may result.
• With the same US BoP data, Edwards (2005)
predicted a crisis would happen in the US, which did
in 2008.
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1.3 Persistent CAD?
• Many other countries have had BoP or other financial
crises in the past based on CADs.
• They usually do not have an acceptable combination
of the three factors to get a sustainable CAD. Either
their growth is not high over the long run, or their
CADs are simply too large.
• Their economic policies usually tend not to foster
long run economic growth, so the problems build up
over a long period of time.

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 References
Bank for International Settlements, (2022), Triennial
Central Bank Survey of foreign exchange and Over-
the-counter derivative markets in 2022.

Census and Statistics Department (2023), Annual Digest

of Statistics, HKSAR Government.

Edwards, S. (2005), ‘Is the U.S. current account

deficit sustainable? And if not, how costly is
adjustment likely to be?’, NBER Working Paper No.
11541.

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 References
Milesi-Ferretti, G. M. and Razin A. (1996),
‘Sustainability of persistent current account
deficits’, NBER Working Paper No. 5467.

Pilbeam, K. (2013), International Finance, Palgrave

Macmillan, Chapter 7, ISBN 978-0-230-36289-5.

Quiggin, J. (2004), ‘The unsustainability of U. S. trade

deficits’, The Economists’ Voice, vol. 1, issue 3,
article 2.

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