This document provides an overview of balance of payments concepts including: - Definitions of the balance of payments and its components such as the current account and capital account. - How the balance of payments works as a source and use of funds statement. - Factors that influence the current account such as exchange rates, income, government policies, and expectations. - Exposure related to the capital account from currency exchange rate movements and interest rate changes. - Different exchange rate arrangements countries use such as floating rates, pegs, currency boards, and dollarization.

1. Chapter 2
Balance of payments

2. Agenda
• Definitions of Balance of payments
• Balance of Payments as a Source and Use of Funds
• Components of Balance of Payments
• Current Account and Economic Fundamentals
• Capital Account, Expectation, and Interest Rate
• U.S. Balance of Payments: Recent Evidence
• Exposure Related to Capital Account
• Exchange Rate Arrangements, Dollarization, and Peg
• Managing Balance of Payment Exposure in the Emerging Market
Economies

3. BOP definitions
• Balance of payments (BOPs) provides a summary of all transactions
involving:
- Real goods, services
- Financial assets (portfolio investments such as stocks, bonds and
bills, etc.)
- Direct investments (i.e., foreign acquisitions, joint ventures,
divestitures),
- Capital (import/export), and
- Transfer payment in cash or in kind between any two individuals,
corporations, government entities, and countries over a specific
period.

4. Balance of Payments as a Source and Use of
Funds
• BOP is virtually a source and use of fund statement as
an accounting identity, where the sources of funds are
those transactions that increase the purchasing power
of a nation that must equal use of fund, those
transactions that reduce the purchasing power of a
country.
• The export of goods and services creates source of
funds and the import of goods and services produces
the use of funds.

5. Cont……
• The export of goods, services, and capital generates
demand for the currency of the exporting country and
supply of foreign currency as foreign buyers use their own
currency to purchase the currency of the exporter to pay
for the export.
• The import of goods, services, and capital generates
supply of currency of the importer and demand for
foreign currency to settle transactions.
• Any imbalance in the supply of and demand for the
currency of the export and/or import creates temporary
disequilibria and exposure to currency and interest rate
risks.

6. COMPONENTS OF BALANCE OF PAYMENTS
• Current Account
- It summarizes all transactions on the net balance of the trading of
goods and services, net balance of income on direct investment and
portfolio investment, and net transfer payments in cash or in kind
over a specific period.
• Capital Account
- It summarizes transactions on the net direct foreign investment
and net portfolio investment in stocks, bonds, T-bills, and other net
short- or long-term financial assets of private sector and/or
government agencies over a specific period.

7. Cont……
• Official Foreign Exchange Reserve
- This is the central bank’s portfolio holding of foreign currencies, gold,
and other certificates and near money, such as special drawing rights
(SDRs), issued as a form of reserve credit to members by the IMF; a
member can borrow from other members up to 625 percent of the
member’s allocation.
• Statistical Discrepancy for Errors and Omissions
- This category is created to balance source and use of fund statements
due to transactions involving barter (i.e., an exchange of service for
service) and underground economic activities (i.e., smuggling, money
laundering, and other illegal transactions) where no entry is made on
the port of entry as to the value of the goods over a specific period of
time.

8. Cont…….
• The components of BOP that produce the balance of payments
equation can be summarized as:
• Current account + Capital account + Official reserve + Statistical
discrepancy = 0
• See exhibit 2.2:

9. Cont…..

10. CURRENT ACCOUNT AND ECONOMIC FUNDAMENTALS
• The current account summarizing all transactions originating
in the asset markets between a country’s residents and the
rest of the world.
• Demand for a particular good in the asset market is a
function of price, income, and price of substitute goods,
where the quantity demanded of a good is inversely related
to its price and directly related to price of substitute goods
and income.
• The same principle is applicable to the demand for imports
and supply of exports originating in current account

11. Cont……
• The factors inducing change in current account can be
summarized as:
- Exchange rate
- Income
- Government
- Expectations
• Inflation and exchange rate affect exchange rate and
consumer confidence respectively and shape individuals’
expectations about their own state in particular and the state
of the economy in general.

12. Exchange Rate
• As the dollar weakens against foreign currencies, requiring
more dollars to acquire foreign currency, the goods and
services made in the United States become relatively more
attractive to foreign buyers.
• Exports are expected to improve as the domestic goods
become cheaper for foreigners to acquire and imports are
expected to fall as foreign goods and services tend to be
more expensive,
• Thus creating an increase and improvement in the current
account balance.

13. EXPOSURE RELATED TO CAPITAL ACCOUNT
• The return of the original capital and the capital gain or loss, royalties,
and interest income are exposed to foreign exchange risk as well as
interest rate and market risk, creating opportunities for a windfall gain
as a result of favorable exchange rate movements and falling interest
rates or losses stemming from unfavorable exchange rate and rising
interest rates.
• Suppose a U.S. money manager invests in one-year bonds denominated
in British pounds promising an 8 percent interest rate. Assume the
pound appreciates by 5 percent during the year.
• What is the return to the U.S. investor?

14. Cont….
The volatility (variance) of the return realized by the U.S. investor is
directly related to the volatility of the U.K. interest rate as well as the
volatility of the percentage change in exchange rate.

15. EXCHANGE RATE ARRANGEMENTS, DOLLARIZATION, AND PEG
• Free Float
• The largest number of countries, about 33, allow market forces to
determine their currency’s value.
• Managed Float
• About 46 countries combine government intervention with market forces
to set exchange rates.
• Pegged to another currency
• Such as the U.S. dollar or euro.
• No national currency
• Some countries do not bother printing their own currency. For example,
Ecuador, Panama, and El Salvador have dollarized. Montenegro and San
Marino use the euro.

16. Cont……
• Currency Board
• Fixed exchange rates combined with restrictions on the
issuing government.
• Eliminates central bank functions such as monetary policy
and lender of last resort (e.g., Hong Kong).
• Conventional Peg
• Exchange rate publicly fixed to another currency or basket
of currencies.
• Country buys or sells foreign exchange or uses other
means to control the price of the currency (e.g., Saudi
Arabia, Jordan, and Morocco).

17. EXCHANGE RATE ARRANGEMENTS,
DOLLARIZATION, AND PEG

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