Learning Objectives To understand the fundamental principles of how countries measure international business activity, the balance of payments To examine the similarities of the current and capital accounts of the balance of payments To understand the critical differences between trade in merchandise and services and why international investment activity has recently been controversial in the United States To review the mechanical steps of how exchange rates are transmitted into altered trade prices and eventually trade volumes To understand how countries with different government policies toward international trade and investments, or different levels of economic development, differ in their balance of payments

1. 1
Chapter 6
The Balance of
Payments

2. 2
Learning Objectives
To understand the fundamental principles of how countries
measure international business activity, the balance
of payments
To examine the similarities of the current and capital
accounts of the balance of payments
To understand the critical differences between trade in
merchandise and services and why international investment
activity has recently been controversial in the United States
To review the mechanical steps of how exchange rates are
transmitted into altered trade prices and eventually trade
volumes
To understand how countries with different government
policies toward international trade and investments, or
different levels of economic development, differ in their
balance of payments

3. 3
Introduction
The measurement of all international
economic transactions between the
residents of a country and foreign
residents is called the balance of
payments (BOP)
The two major sub accounts of the
balance of payments are:
Current account
Capital account

4. 4
Fundamentals of Balance of
Payments Accounting
The balance of payments must
balance
Subaccounts may be imbalanced
Three main elements to the process of
measuring international economic
activity include:
Identifying what is and is not an international
economic transaction
Understanding how the flow of goods, services,
assets, and money creates debits and credits to
the overall BOP
Understanding the bookkeeping procedures for

5. 5
Defining International Transactions
Identifying many
international
transactions is
ordinarily not difficult
However, some
international
transactions are not
obvious

6. 6
The BOP as a Flow
Statement
The BOP is often
believed to be a
balance sheet rather
than a cash flow
statement
There are two types of
business transactions
that dominate the BOP:
Real assets
Financial assets

7. 7
BOP Accounting: Double-
Entry Bookkeeping
BOP employs an
accounting
technique called
double-entry
bookkeeping
In this age-old
method every
transaction
produces a debit
and a credit of the
same amount
A debit is created
whenever:
An asset is increased
A liability is decreased
An expense is
increased
A credit is created
whenever:
An asset is decreased
A liability is increased
An expense is
decreased

8. 8
BOP Accounting: Double-
Entry Bookkeeping
The measurement of all international
transactions in and out of a country
over a year is a difficult task
Mistakes, errors, and statistical
discrepancies will and do occur
Current and capital account entries
are recorded independent of one
another, not together as this
accounting method would prescribe

9. 9
The Accounts of the
Balance of Payments
The BOP is comprised of two
primary subaccounts:
Current Account
Financial/Capital Account
Two additional and important
subaccounts of the BOP include:
Net Errors and Omissions Account
Official Reserves Account

10. 10
The Current Account
This account includes all
international economic
transactions with income or
payment flows occurring within
the year, the current period
It consists of four subcategories:
Goods trade
Services trade
Income
Current transfers
This account is typically
dominated by Goods Trade

11. 11
The Current Account
The Balance on Trade (BOT) refers
specifically to the balance of exports and
imports of goods trade only
The deficits in the BOT of the past decade
have been an area of concern for the U.S.
Merchandise trade is the core of
international trade and has three major
components:
Manufactured goods
Agriculture
Fuels
The most encouraging news for U.S.
manufacturing trade is the growth of exports
in recent years

12. 12
The Capital and Financial
Account
This account of the BOP
measures all international
economic transactions of
financial assets
It is divided into two major
components:
Capital Account
Financial Account

13. 13
The Capital Account
The Capital Account is made up
of transfers of:
Financial assets
The acquisition and disposal of
nonproduced/nonfinancial assets

14. 14
The Financial Account
The Financial Account
consists of three components:
Direct investment
Portfolio investment
Other asset investments
The contents of this account
are for all intents and
purposes the same as those
of the Capital Account under
IMFs BOP accounting
framework used prior to 1996

15. 15
Net Direct Investment
This is the net balance of capital
dispersed out of and into the U.S. for
the purpose of exerting control over
assets
Follows the 10% ownership threshold
rule
The source of concern over foreign
investments in any country focuses on
two topics:
Control
Profit

16. 16
Portfolio Investment
This is the net balance of capital that
flows in and out of the U.S., but does
not reach the 10% ownership threshold
of direct investment
It is capital invested in activities that
are purely profit-motivated rather than
ones made in the prospect of
controlling or managing the investment
These have shown much more volatile
behavior than net direct investments
over the past decade

17. 17
Other Investment
Assets/Liabilities
This category consists of:
Short-term trade credits
Long-term trade credits
Cross-border loans from all types of
financial institutions
Currency deposits
Bank deposits
Other accounts receivable
Accounts payable

18. 18
Official Reserves Account
This is the total currency
and metallic reserves held
by official monetary
authorities within the
country
Its significance depends on
whether the country is
operating under:
A fixed exchange rate regime
A floating exchange rate
system

19. 19
The Balance of Payments--
Total
The International Monetary Fund (IMF) is the
multinational organization that collects the
BOP statistics for over 160 different
countries around the globe
The current, capital, and financial accounts
combine to form the basic balance and is
one of the most frequently used summary
measures of the BOP
The current, capital, financial, and net errors
and omissions accounts combine to form the
summary measure known as the overall
balance or official settlements balance

20. 20
The Balance of Payments
and Economic Crises
The sum of cross-border international
economic activity can be used by
international managers to forecast
economic conditions and in some
cases, the likelihood of economic
crises
The mechanics of international
economic crises often follow a similar
path of development

21. 21
The Asian Crisis
The roots of this currency crisis extended
from a fundamental change in the
economics of the region
It started as early as 1990 in Thailand
The most visible roots were the excesses
in capital flows into Thailand in 1996 and
early 1997
Corporate socialism, corporate
governance, banking liquidity and
management are underlying causes that
apply to every nation facing economic
crisis

22. 22
Capital Mobility
The degree to which capital moves
freely cross-border is critical to a
country’s balance of payments
The ability of capital to move
involves economic and political
factors
Obstfeld and Taylor (2001) studied
the globalization of capital markets
and argued the post-1860 era can
be subdivided into four distinct
periods

23. 23
Capital Flight
Capital flight is the sudden
and shocking outflow of
capital from a nation’s
economy in which it is
perceived there is political,
economic, or currency crises
forthcoming
Five primary mechanisms
exist by which capital may be
moved from one country to
another

24. 24
The Cases of China and
Turkey
The Chinese
balance of
payments serves
as an interesting
example of one
country’s ongoing
efforts to manage
its current and
financial
accounts
Turkey’s economic
and financial crisis
of 2000-2001
serves as a prime
example of how a
country’s balance
of payments can
deteriorate or
essentially
collapse in a very
short period of
time