GUIDE TO THE BOP
The Balance of Payments
International business transactions occur in
many different forms over the course of a
year
The measurement of all international
economic transactions between the residents
of a country and foreign residents is called
the balance of payments (BOP).
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The Balance of Payments
BOP data is important for government policymakers and
MNEs as it is a gauge of a nation’s competitiveness or health
(domestic and/or foreign)
For a MNE both home and host country BOP data is
important as:
An indication of pressure on a country’s foreign
exchange rate.
A signal of the imposition or removal of controls in
various sorts of payments (dividends, interest, license
fees, royalties and other cash disbursements).
A forecast of 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.
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The BOP as a Flow Statement
The BOP is often misunderstood as many people
infer from its name that it is a balance sheet,
whereas in fact it is a cash flow statement.
By recording all international transactions over a
period of time such as a year, it tracks the
continuing flows of purchases and payments
between a country and all other countries.
It does not add up the value of all assets and
liabilities of a country on a specific date (as an
individual firm’s balance sheet would do).
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Data for over 100 countries are available in the
International Monetary Fund (IMF) annual
Balance of Payments Statistics Yearbook.
The BOP accounts should sum to zero. That is, for
period t,
Current Accountt + Financial Accountt + Capital
Accountt = 0. (1)
In practice,
Current Accountt + Financial Accountt + Capital
Accountt +
Reserve Assetst + Errorst and Omissionst = 0
(2)
Fundamentals of BOP Accounting
The BOP must balance.
It cannot be in disequilibrium unless
something has not been counted or has been
counted improperly.
Therefore it is incorrect to state that the BOP
is in disequilibrium.
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Current account
The current account consists of
trade in goods and services,
income streams coming off international positions,
current transfers.
For goods and services, exports are credits and
enter positively.
Imports enter negatively because money is flowing
out to purchase the good or service.
Major factors responsible for high CAD are:
Low export demand from the developed
countries due to slowdown,
High crude oil prices which forms the bulk
import to India.
What should be the net global current account
balance?
Zero. Because somebody’s import is someone
else’s export.
But it is not so. Evidence from IMF data shows so.
The Economist says, “ Planet Earth appears to be
running a current account surplus in its trade
with extraterrestrials” (Article: Are aliens buying
Louis Voitton Handbags)
Possible reasons: Over or under invoicing taxes,
purchasing restrictions, etc.
Capital account
The capital account shows transfers of
existing fixed assets.
For example, when the United States
returned a rather large fixed asset to
Panama (Panama Canal), that transfer was
an entry in the capital account.
Capital-account transactions are usually
tiny.
Financial account
The financial account includes transactions
in assets such as bonds, equities, and
companies.
It includes three main subcategories:
direct investment
portfolio investment (in debt securities
and equities),
the other investment (mostly bank loans).
In addition, a fourth category has recently
been added: derivatives.
Net Errors & Omissions/Official Reserves
Accounts
The Net Errors and Omissions account ensures
that the BOP actually balances.
The Official Reserves Account is the total
reserves held by official monetary authorities
within the country.
These reserves are normally composed of the
major currencies used in international trade and
financial transactions (hard currencies).
The significance of official reserves depends
generally on whether the country is operating
under a fixed exchange rate regime or a floating
exchange rate system.
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The BOP in Total — Surplus
A surplus in the BOP implies that the demand
for the country’s currency exceeded the
supply and that the government should allow
the currency value to increase – in value – or
intervene and accumulate additional foreign
currency reserves in the Official Reserves
Account.
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The BOP in Total — Deficit
A deficit in the BOP implies an excess supply
of the country’s currency on world markets,
and the government should then either
devalue the currency or expend its official
reserves to support its value.
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The BOP Interaction with Key Macroeconomic Variables
A nation’s balance of payments interacts with
nearly all of its key macroeconomic variables.
Interacts means that the BOP affects and is
affected by such key macroeconomic factors as:
Gross National Product (GNP)
The exchange rate
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The BOP and GNP
A nation’s GNP can be represented by the
following equation:
GNP = C + I + G + X – M
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The BOP and GNP
The variables from the formula on the
previous page are defined as:
C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
X – M = the current account balance
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the link between the current account and the
financial+capital account
What is the connection between the trade
deficit and the exchange rate?
Link between the Capital and Current
Account
Y = C + G + I + NX
What this means?
It is GNP broken into its components, with NX standing
for net exports, or exports less imports.
NX is the current account.
Which is the capital account?
Rearranging terms, the capital account becomes visible.
Y – C – G – I = NX
Inserting taxes as an outflow to
consumers and an inflow to the
government allows one to see exactly
where the capital account is:
(Y – C – T) + (T- G) – I = NX
One will recognize these as private
and public savings and, therefore:
S – I = NX
S – I is net foreign investment or the capital
account and it has to be equal to NX which is the
current account.
What does this look like for a closed economy?
In this setting
S – I = NX = 0
Shifting to the more interesting case of
open economies, one possibility is that:
S – I = NX > 0
What does this mean?
When NX > 0, a country is exporting more
than it is importing. In terms of the capital
account, savings exceed investments and this
means that the country is lending to the rest
of the world.
How does positive net exports require lending
to the rest of the world?
The rest of the world needs to finance their
excess purchases of our goods and we lend
them the money to facilitate those purchases.
Consider the possibility that:
S – I = NX < 0
In this case, a country has a current
account deficit as it is importing more
than it exports.
This is reflected in the capital account
as purchasing more than it sells from
the rest of the world;
This requires borrowing from the rest
of the world.
Trade deficits are unsustainable.
What is the problem here?
Why not S – I = NX < 0 forever?
The important intuition is that borrowing has to be repaid.
Investment story: The investments being made will
eventually yield good returns, exports will increase, and
the money borrowed from the rest of the world will be
paid off.
Savings story: There is no guarantee that the rest of the
world will continue to lend money to us to support high level
of consumption and eventually the country will have to
moderate consumption and increase its savings rate to pay
off the rest of the world.
CHINA’S case
page 107 of Eiteman
https://www.safe.gov.cn/en/
2021/0930/1871.html
The BOP and Exchange
Rates
Fixed Exchange Rate Countries
◦ Under a fixed exchange rate system, the government
bears the responsibility to ensure that the BOP is near
zero.
Floating Exchange Rate Countries
◦ Under a floating exchange rate system, the government
has no responsibility to peg its foreign exchange rate.
Managed Floats
◦ Countries operating with a managed float often find it
necessary to take action to maintain their desired
exchange rate values. Change interest rates.
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https://saylordotorg.github.io/
text_international-economics-theory-and-
policy/s25-04-central-bank-intervention-
with.html
Central Bank Intervention to Maintain a Fixed Exchange Rate
Another Central Bank Intervention
to Maintain a Fixed Exchange Rate
Unholy Trinity
Is it possible to live in the following, seemingly very
desirable world? What happens in a country where we
want to have:
Fixed exchange rates
Open capital markets
Monetary autonomy (freedom to set your own interest
rates)
Trade Balances and Exchange Rates
A country’s import and export of goods and
services is affected by changes in exchange
rates
The transmission mechanism is in principle
quite simple: changes in exchange rates change
relative process of imports and exports, and
changing prices in turn result in changes in
quantities demanded through the price
elasticity of demand
Theoretically, this is straightforward, in reality
global business is more complex.
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Trade Balance Adjustment to Exchange Rate Changes:
The J-Curve
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