balance of paymentS

MH BOUCHET/CERAM (c)
Country Risk Analysis
The Balance of Payments II
Capital Account
February 2008
Professor: M.H. Bouchet

Balance of payments
Accounting framework and statistical record of
all the economic and financial flows that take place
over a specified time period between residents of
the reporting country and the rest of the world
The time period itself is arbitrary but it is common practice to
supply balance of payments data on a monthly, quarterly and
yearly basis (IMF)
Flows refer to income and expenditure or changes in levels of
outstanding assets and liabilities.
The accumulation of flows leads to asset or debt stocks.

 Double bookkeeping: Summary statement that records
as a credit (+) any transaction resulting in a receipt from the
rest of the world and as a debit (-) any transaction resulting
in a payment
 These transactions lead to changes in supply and demand
for foreign exchange, hence an impact on exchange rates,
reserve assets and on foreign exchange markets

 Risk assessment is rooted in balance of
payments analysis!
1. Trade flows and competitiveness
2. Structural or short-term deficits?
3. Exchange rate variations
4. External financing flows
5. Capital flight
6. Debt crisis!

* The US CAD dilemma *
2006 Trade deficit= US=760 billion (6% of GDP)
CAD= -6,6% of GDP
= - US$ 870 billion
 Need to shrink the deficit by boosting exports and
reducing import growth with a weaker $
 BUT need to finance the deficit by attracting US$2,4
billion/day foreign capital inflows with stronger $!
 Capital sources = surplus countries = Germany + China +
Japan + Korea
 Need to maintain positive real interest rates to enhance the
dollar attractiveness and competitiveness
Engine of world growth

The US CAD dilemma… revisited
(1)
 Large US CAD, though:
1. The US net liabilities have risen less than the
cumulative CAD
2. Decline in US net liabilities/GDP
3. Minimal debt servicing burden
NYFed staff report n°271 12/2006

The US CAD dilemma… revisited
(2)
A dollar depreciation alone will NOT curb the US deficit,
because:
1. Use of the dollar in international trade transactions (all US
exports and imports are invoiced in $, hence insensitivity
to exchange rate changes): Asia
2. Market share concern of foreign exporters, hence desire to
remain competitive in the large US market)
3. High marketing and distribution costs of US imports
might insulate the final consumption price of imported
goods
 However, foreign demand for US goods will increase
Fed RB NY, June 2007

 Capital account
– Reflects changes in country’s ownership of assets
– Reflects international market access
– Financing flows lead to changes in external debt stock,
and to future debt servicing payment outflows
– Financing sources: debt, equity/FDI, international
borrowing in the capital markets (Eurobonds,
Eurocredits, official financing, ODA, short-term
flows…)

Capital account
 The financial analyst must focus not only on the
volume of financing to match the financing
requirements of the current account deficit, but also
the nature of financing sources (private/public) and
the sustainability of the financing (short term/long
term, volatility, floating/fixed rates, repayment
conditions…)

The capital account
Capital account
+ (-) Direct investment (non debt creating flows)
+ (-) Portfolio investment (NDCF)
+ (-) Other long-term capital (private + official)
+ (-) Other short-term capital (private + official)
+ (-) Net errors and omissions
+ (-) Counterpart items
+ (-) Change in reserves
= Capital account balance
+ Exceptional Financing
From less liquid items to more liquid items!

The Capital/Financial Account
 The Capital Account of the balance of
payments measures all international
economic transactions of financial assets. It
is divided into two major components:
– The Capital Account
– The Financial Account
 The Capital Account is minor (in
magnitude), while the Financial Account is
significant.
Source: Eiteman/Pearson

The Financial Account
 Financial assets can be classified in a number
of different ways including the length of the
life of the asset (maturity) and the nature and
source of the ownership (public or private).
 The Financial Account, however, uses a third
method. This focuses on the degree of
investor control over the assets or operations.

 The Financial Account consists of three
components:
– Direct Investment – in which the investor exerts
some explicit degree of control over the assets
– Portfolio Investment – in which the investor has
no control over the assets nor any participation in
the management
– Other Investment – consists of various short-
term and long-term trade credits, cross-border
loans, currency deposits, bank deposits and other
capital flows related to cross-border trade

Developing countries that have relied less on
foreign capital have grown faster! (IMF/03-2007)

Sources of external financing
Official bilateral +
multilateral
 Paris Club (government
to government credits)
 Export credit agencies
 IFIs
 RDBs
Private
 FDI
 Portfolio Investment
 International bank
loans
 Working capital lines
 ST Trade credits
 Bonds

Where do capital flows go?

Balance on current account
-800
-600
-400
-200
0
200
400
600
800
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Developing countries OECD
In US$ billion
Source: IIF, IMF-WEO 2006

Major net Exporters of Capital
Source: IMF 2007

Major net Importers of Capital
Source: IMF 2007

Net external capital sources for EMCs
-100
0
100
200
300
400
500
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
private
public
IIF/IMF
US$ billion

Net Private Capital Flows to EMCs (Equity, FDI,
Portfolio, Banks + non-banks)
0
100
200
300
400
500
600
1990 1994 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Total
Asia
Lat America
Billion of US$
Source: IIF/IMF

Net FDI and portfolio capital flows to EMCs
0
50
100
150
200
250
300
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Equity
ASIA
Am Latina
US$ billion
Source: IMF/IIF

1. Direct investment and portfolio investment
The difference between direct investment and portfolio investment
resolves around whether or not the investor intends to take an
active role in the management of the enterprise whose assets are
being acquired.
When the investor’s purpose is to have an effective voice in the
management of the foreign enterprise, it is considered as a direct
investment. Examples:
 Bonds, debentures and the like are portfolio investments in so far
as they confer no management or voting rights on their owners (ST
and relatively volatile investment)
 Foreign branches, wholly owned subsidiaries and joint ventures
are clearly direct investments (depending on percentage!)

FDI Flows worldwide 2006
in % of total volume
0
2
4
6
8
10
12
14
16
USA UK China/HK France Netherlands Canada Germany Belgium Spain Russia
Source: CNUCED/2006 Total= $1230 billion
* IDE In = $81 billion, et IDE Out= $115 billion (OCDE et BDF)
France= $81 billion* (7,1% of total)

Total FDI inflows in US$ trillion
Post-2003 bounceback has been
driven by OECD markets.
FDI flows to EMCs will remain
buoyant in 2007-10, averaging
over US$400bn per year, but
growth rates will be modest as
privatisation tails off and the
global economy slows.

OECD
(81%)
EMCs (19%)
ASIA
(64%)
LATIN
AMERICA
(29%)
GLOBAL ECONOMY
EMCs
LATIN AMERICA
MEXICO
(32%)
CHILE
(10%)
PERU
(4%)
CHINA
(80%)
ASIA
GLOBAL FDI FLOWS 2006-07
Source: IIF, OECD

3%
1%
75%
4%
12%
4% 1%
Argentina
Chile
China,P.R.:Hong Kong
Korea
Mexico
Thailand
Peru
FDI FLOWS
(US$ billion)
-10 000
0
10 000
20 000
30 000
40 000
50 000
60 000
70 000
80 000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006f
Argentina Chile China,Hong Kong Korea Mexico Thailand Peru Vietnam
IIF/FMI

30 most attractive
Emerging markets
for FDI
1. India
2. Russia
3. Vietnam
4. Ukraine
5. China
6. Chile
7. Latvia
8. Slovenia
9. Croacia
10. Turkey
11. Tunisia
12. Thailand
13. Korea
14. Malaysia
15. Macedonia
16. UAE
17. Arabia Saudita
18. Slovakia
19. México
20. Egypt
21. Bulgaria
22. Rumania
23. Hungary
24. Taiwan
25. Bosnia
26. Lituania
27. Brasil
28. Morroco
29. Colombia
30. Kazajstan
Σ Economic + Political risk
Market potential
AT Kearney GRDI 2006

Most attractive emerging markets in 2006
High
Risk
Lows
Risk

World Economic
Forum
Global
Competitiveness
Ranking
Switzerland 1
Finland 2
Sweden 3
Denmark 4
Singapore 5
United States 6
Japan 7
Germany 8
Netherlands 9
United Kingdom 10
Hong Kong SAR 11
Norway 12
Taiwan, China 13
Island 14
Israel 15
Canada 16
Austria 17
France 18

China: FDI Flows
0
10
20
30
40
50
60
70
80
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
Inflows
Outflows
In billions of US$
Source: OECD

FDI Flows in Vietnam
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
FDI
registered
In millions of US$
Source: IMF

Overview of FDI in Vietnam
 Opening of the Vietnamese economy to FDI in 1987, fast
growth of the 1990s, rapid increase in FDI inflows 1988-
1996, drop in the 1997-98 Asian crisis, rise since 2004

Main sources of FDI in Vietnam
WHO?
 Japan
 Singapore
 South Korea
 Netherlands
 Taiwan
 Hongkong
 France
 Thailand
 USA
WHERE?
Sectors
 Industry
 Oil
 Mining
 Tourism

FDI in Vietnam by Sector

TOP 10 INVESTOR NATIONS IN VIETNAM

Contribution of FDI to Vietnam’s Economy
 FDI companies contribute 13.3 % to GDP, 23% to
export, 25% to state budget revenues.
 On other hand the FDI attracted into Vietnam is by
regional standards quite modest ( about 2% of FDI
into China)
 Employment: 750,000 workers

France: FDI Flows In & Out
Flux d'IDEEntrants et Sortants en milliards de US$ 1975-2006
-200
-150
-100
-50
0
50
100
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
OUT
IN
Ratio OUT/IN= 1,8
Source: FMI & OCDE 2007

Cumulative negative net FDI flows 1997-2006
-400
-350
-300
-250
-200
-150
-100
-50
0
France Japon RU Suisse Pays-Bas Espagne Italie Canada Allemagne Norvège
In billions of US$
France= - $391 billion (15% GDP)
Source: FMI/2007

Outsourcing and job losses in Europe
Source: European Fondation for the improvement of living and working conditions/2006

Outsourcing and sectoral job losses in Europe
Source: European Restructuring Monitor/2006

Offshoring and job losses in Europe

Distribution of FDI benefits for the capital
exporting countries
0 0,2 0,4 0,6
USA
France
Germany
Cost reduction
Larger profits
Productivity
Source McKinsey Report 08/2005
1. Cost reduction and better
price competitiveness
2. Export income and
dividend remittences
3. Growing jobs in new high
value added activities
0,74/1$
0,86/1$
1,15/1$

FDI’s Benefits and challenges
Benefits Challenges
Additional resources available for productive
investment
Risk sharing with the rest of the world (equity)
Greater external market discipline on
macroeconomic policy
Greater exploitation of comparative economic
advantages
Enhanced access to technology, information, ideas
and management skills
Broader access to export markets through foreign
partners
Training and broader exposure of national staff
Greater liquidity to meet domestic financing needs
Broadening and deepening of national capital
markets
Improvement of financial sector skills
Currency appreciation
Reduced scope for independent
macroeconomic policy actions
Greater exposure to external shocks
Demands for protection in local markets
Lesser control of foreign owned domestic
industry
Disruption of national capital markets,
asset inflation
Risk of rising volatility in financial and
exchange markets

2. Other capital is a residual category that groups all the capital
transactions that have not been included in direct investment,
portfolio investment end reserves.
Two categories:
# Long-term capital
# Short-term capital
Non-negotiable instruments > 1 year or more such as London
Club bank loans and mortgages, syndicated credits, euroloans...
* Financial assets < 1 year, such as currency, deposits and bills,
interbank credit lines, trade credits… (Source: BIS)

Gross private capital flows to LACs
Overall Disbursements from private creditors in US$
0
5000000000
10000000000
15000000000
20000000000
25000000000
30000000000
35000000000
40000000000
45000000000
50000000000
1
9
7
0
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4

3. Change in reserves
Reserves include:
 Hard currency assets + Monetary gold (gold held by
the authorities as a financial asset)
 Special drawing rights (SDRs): reserves created by
IMF as book-keeping entries and credited to the
accounts of IMF member countries according to
quotas
 Reserve position in the Fund: (member’s quota +
other claims on the Fund)

 Foreign Exchange Reserves
 The largest component of total international liquidity. It
includes monetary authorities’ claims on non-residents in
the form of bank deposits, treasury bills, short-term and
long-term government securities, and other claims usable in
the event of balance of payments need, including non-
marketable claims from inter-central bank and
intergovernmental arrangements, without regard as to
whether the claim is denominated in the currency of the
debtors or the creditors.
 A + sign in the BOP means a financing flow in
the capital account, i.e., a decrease in the stock
of reserves!

China’s rising official reserve assets
0
200
400
600
800
1000
1200
1400
1600
1800
2000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
US$ billion

4. Counterpart items: offsetting amounts
Counterparts items are analogous to unrequited
transfers in the current account.
They arise because of the double entry system in
balance of payments accounting and refer to
adjustments in reserves owing to monetization of gold,
allocation or cancellation of SDRs and revaluation of
the various components of total reserves.
These BOP items do not stem from international
transactions.

5. Net errors and omissions
Statistical difficulties involved in
gathering balance of payments data (and
capital flight!).
Other sources of E&Os:
leads and lags in trade flows,
underinvoicing of exports and
overinvoicing of imports, undeclared
short-term capital movements…

Net errors and omissions ?
 An examination of the size and direction of
NE&Os may shed some light on the accuracy
of BoP estimates. The adoption of the double
entry accounting system means that the net
sum of all credit and debit entries should equal
zero.
 In practice, any discrepancies are recorded in
NE&Os, reflecting the net effect of differences
in coverage, timing and valuation. An amount
> 5% of the gross sum of merchandise exports
and imports is a source of concern!

EMCs: Errorsand omissions, net
-80000
-60000
-40000
-20000
0
20000
2001 2002 2003 2004 2005 2006e 2007f
In millions of US$ Source: IIF

Russia: Net Errors & Omissions in US$ billion
-20000
-15000
-10000
-5000
0
5000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: IMF-IFS/IIF

Peru and Capital flight
Peruvian non-bank private external deposits in international banks overseas in
US$ million
0
500
1000
1500
2000
2500
3000
3500
4000
4500
Q
4
1
9
7
7
Q
1
1
9
7
9
Q
2
1
9
8
0
Q
3
1
9
8
1
Q
4
1
9
8
2
Q
1
1
9
8
4
Q
2
1
9
8
5
Q
3
1
9
8
6
Q
4
1
9
8
7
Q
1
1
9
8
9
Q
2
1
9
9
0
Q
3
1
9
9
1
Q
4
1
9
9
2
Q
1
1
9
9
4
Q
2
1
9
9
5
Q
3
1
9
9
6
Q
4
1
9
9
7
Q
1
1
9
9
9
Q
2
2
0
0
0
Q
3
2
0
0
1
Q
4
2
0
0
2
Q
1
2
0
0
4
Q
2
2
0
0
5
-1000
-800
-600
-400
-200
0
200
400
600
800
Stock
Change in flows

6. Exceptional Financing
 IMF Drawings
 World Bank’s HIPC Initiative
 London Club debt reduction and
restructuring workouts
 Paris Club debt relief
 Debt swap transactions

Table of Uses and Sources
SOURCES USES
Exports of Goods
Services (shipment, travel)
Investment Income
Official transfers
Workers’ remittances
FDI (equity capital)
Portfolio Investment
Long-term Capital Inflows
Short-term Capital Inflows
Reserve Increase
Imports of Goods
Payments of services
Long-term Debt Payments
Short-term Debt Payments
Reserve Decrease

+ Export of goods f.o.b.
- Imports of goods f.o.b.
= Trade balance
+/- Exports/Imports of non-financial services
+ /- Investment income/expenditures (credit/debit)
+ (-) Private/Official unrequited transfers
= Current account balance
+/- FDI
+/- Portfolio capital Flows
+ LT Capital Inflows
- Debt Servicing Payments
+/- ST Capital Flows
Reserve Variation
Risk Management and BOP Analysis

External Finance Analysis:
The dual face of Country Risk
Liquidity Risk
 Debt Service Ratio:
(P+I/X)
 Interest Ratio (I/X)
 Current account/GDP
 Reserve/Import ratio
 Elasticity of exports
 Growth rate of exports/
Average external interest
rate
Solvency Risk
 Debt/Export ratio
 Debt/GDP ratio
 Debt/Reserves
 ST Debt/Reserves

Liquidity and Solvency Thresholds
Stock variable
 Solvency = Debt/GDP < 100%
Debt/Exports < 150%
Reserves/months of Imports > 6 months
Flow variable
 Liquidity = Debt Service ratio < 33% of X
Interest/X ratio < 25%

US Payments statistics: the basic balance
 Basic balance = balance on current account
and long-term capital
 It puts “below the line” changes in reserves
and all short-term capital movements
(including errors & omissions). It stresses
the importance of demand management
policies affecting net international
transactions in goods and services

US International Investment Position
 US-owned assets
abroad: $6473
 US government assets:
$244 (official reserves)
 US private assets: $6229
 FDI: $2302
 Foreign securities: $1847
 Non-bank claims: $891
 US Bank claims: $1455
 Foreign-owned assets in
the US: $9079
 Foreign official assets:
$1133
 FDI: $2007
 US Treasury securities:
$504
 Corporate bonds: $1690
 Corporate stocks: $1170
 US currency: $297
 US bank liabilities: $1407

Net US external investment position
in US$ billion
-3000
-2500
-2000
-1500
-1000
-500
0
500
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2003 2004
NEP

Net US external investment position
in US$ billion
 FRB of NY: Current issues in economics and finance, December 2005, N°12:
 End-2004: - 2500 billion, or 22% of GDP, but the US
earned US$36 billion more on its foreign assets than it
paid out to service its foreign liabilities!
 Despite the surge in net liabilities, investment income
has remained positive, largely because US MNCs earn a
higher rate of return than do foreign firms operating in
the US. The continuing buildup in liabilities, however,
will push the US income balance negative, hence
boosting the CAD!

The History of the U.S. Balance of Payments
Stage I: The U.S. is a young debtor nation (1770-1870) -Current
account deficit due to the need to import most goods and inability to
produce many goods for export. -Capital account surplus due to a great
deal of foreign investment in the U.S. in the areas of roads, farming,
cattle ranches, railroads, and canals.
Stage II: The U.S. is a mature debtor nation (1870-1920) - Current
account deficit due to large investment income being paid back to
foreign investors based on the investment of stage I. Merchandise
account in surplus -- exports > imports.
Stage III: The U.S. is a young creditor nation (1920-1945) -Huge
surplus in the current account due to large volume of postwar (WWI)
exports. -Capital account in deficit due to a great deal of U.S.
investment in Europe for postwar reconstruction.
Source: http://www.digitaleconomist.com/bop_4020.html

Stage IV: The U.S. is a mature creditor nation (1945-1980) -
Merchandise deficit -- exports < imports but an investment income
surplus with a slight net surplus overall. -Capital account is in deficit
largely due to postwar (WW II) reconstruction in Europe and Japan.
Stage V: (1980- ) -Large (and growing) deficit in the merchandise
accounts (Trade Deficit) and slight surplus in the investment income
accounts. -Large surplus in the capital account partially to finance the
above merchandise deficit (foreign individuals and banks lending
money to individuals in the U.S.) Additionally, since the U.S. has had
a low inflation rate since 1982 and consistent economic growth , the
U.S. has been a good place to invest relative to the rest of the world.
However the current inflow of capital investment could eventually
lead to large investment income payments in the near future. The
investment income surplus may soon be eroded thus worsening the
current account deficit.

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