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Copyright © 2010 Pearson Prentice Hall. All rights reserved.
Chapter 4
The Balance of
Payments

4-2
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)

4-3
The Balance of Payments
• BOP data is important for government policymakers and
MNEs as it is a gauge of a nations 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)

4-4
Typical BOP Transactions
• Each of the following represents an international
economic transaction that is counted in and
captured in the US BOP:
– A US subsidiary of a foreign MNE acts as a distributor for
the MNEs products in the US market
– A US based firm, manages the construction of a major
water treatment facility in a foreign country
– The US subsidiary of a foreign firm pays profits
(dividends) back to a parent in its home (foreign) country
– The US government finances the purchase of military
equipment for a foreign military ally

4-5
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

4-6
Fundamentals of BOP Accounting
• There are three main elements of the actual process of
measuring international economic activity:
– Identifying what is and is not an international economic
transaction
– Understanding how the flow of goods, services, assets,
and money create debits and credits to the overall BOP
– Understanding the bookkeeping procedures for BOP
accounting
• It is a daunting task to measure all international transactions
that take place in and out of a country over a year

4-7
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)

4-8
The BOP as a Flow Statement
• Two types of business transactions
dominate the balance of payments:
– Exchange of Real Assets
– Exchange of Financial Assets
• Although assets can be identified as
belonging to distinct groups, it is easier to
think of all assets simply as goods that can
be bought or sold (a clock versus a bond)

4-9
The Accounts of the BOP
• The BOP is composed of two primary sub
accounts, the Current Account and the
Capital/Financial Account
• In addition, the Official Reserves account
tracks government currency transactions
• A fourth account, the Net Errors and
Omissions account is produced to
preserve the balance of the BOP

4-10
The Current Account
• The Current Account includes all international
economic transactions with income or payment
flows occurring within one year, the current
period. It consists of the following four
subcategories:
– Goods trade and import of goods
– Services trade
– Income
– Current transfers
• The Current Account is typically dominated by the
first component which is known as the Balance of
Trade (BOT) even though it excludes service trade

4-11
Exhibit 4.3 U.S. Trade Balance and Balance on
Services and Income, 1985-2007 (billions of US
dollars)

4-12
The Current Account
• The deficits in the BOT of the past decade have
been an area of considerable concern for the
United States, in both the public and private
sectors
• The goods trade deficit saw the decline of heavy
traditional industries in the U.S. (steel,
automobiles, automotive parts, textiles)

4-13
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

4-14
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 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

4-15
The Financial Account
• 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
– Other Investment – consists of various short-
term and long-term trade credits, cross-border
loans, currency deposits, bank deposits and
other A/R and A/P related to cross-border trade

4-16
Direct Investment
• This is the net balance of capital dispersed from and into the
US for the purpose of exerting control over assets.
• Foreign direct investment arises from 10% ownership of
voting shares in a domestic firm by foreign investors.
• The source of concern over foreign investment in any
country focuses on two topics: control and profit.
• Some countries possess restrictions on foreigners may own
in their country.
• The general rule or premise is that domestic land, assets
and industry should be owned by residents of the country.
• Concerns over profit stem from the same argument.

4-17
Portfolio Investment
• This is the net balance of capital that flows in and
out of the U.S. but does not reach the 10%
threshold of direct investment.
• The purchase of debt securities across borders is
classified as portfolio investment because debt
securities by definition do not provide the buyer
with ownership or control.
• Portfolio investment is motivated by a search for
returns rather than to control or manage the
investment.

4-18
Exhibit 4.5 The United States Financial Account
1985-2007 (billions of US dollars)

4-19
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.

4-20
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.

4-21
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.

4-22
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 Domestic Product (GDP)
– The exchange rate
– Interest rates
– Inflation rates

4-23
The BOP and GDP
• In a static (accounting) sense, a nation’s
GDP can be represented by the following
equation:
GDP = C + I + G + X – M

4-24
The BOP and GDP
• 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

4-25
The BOP and Exchange Rates
• A country’s BOP can have a significant
impact on the level of its exchange rate
and vice versa
• The relationship between the BOP and
exchange rates can be illustrated by use of
a simplified equation that summarizes BOP
Data (see next slide)

4-26
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
Where:
X = exports of goods and services
M = imports of goods and services
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
FXB = official monetary reserves
Current Account Balance
Capital Account Balance
Financial Account Balance

4-27
• 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

4-28
The BOP and Interest Rates
• Apart from the use of interest rates to intervene in the
foreign exchange market, the overall level of a country’s
interest rates compared to other countries does have and
impact on the financial account of the BOP
• Relatively low real interest rates should normally
stimulate an outflow of capital seeking higher rates
elsewhere
• However, in the case of the U.S., the opposite has
occurred due to perceived growth opportunities and
political stability – allowing it to finance its large fiscal
deficit
• However, it is beginning to appear that the favorable
inflow on the financial account is diminishing while the
current account balance is worsening – making the U.S. a
bigger debtor nation vis-à-vis the rest of the world

4-29
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

4-30
Exhibit 4.8 Trade Balance Adjustment to
Exchange Rate Changes: The J-Curve

4-31
Capital Mobility
• The degree to which capital moves freely
across borders is critically important to a
country’s balance of payments
• The financial account surplus has probably
been one of the major reasons that the
U.S. dollar has been able to maintain its
value over the past 20 years

4-32
Capital Mobility
• The authors argue that the post-1860 era can be subdivided
into four distinct periods with regard to capital mobility.
– 1860-1914 – continuously increasing capital mobility as the gold
standard was adopted and international trade relations were
expanded
– 1914-1945 – global economic destruction, isolationist economic
policies, negative effect on capital movement between countries
– 1945-1971 – Bretton Woods era say a great expansion of
international trade
– 1971-2002 – floating exchange rates, economic volatility,
rapidly expanding cross-border capital flows
0

4-33
0
Exhibit 4.9 A Stylized View of
Capital Mobility in Modern History

4-34
Capital Flight
• Although no single definition of capital flight
exists, it has been characterized as occurring when
capital transfers by residents conflict with political
objectives.
• Many heavily indebted countries have suffered
capital flight, compounding their debt service
problems.
• Capital can be moved via international transfers,
with physical currency, collectables or precious
metals, money laundering or false invoicing of
international trade transactions.
0

4-35
Mini-Case Questions: Turkey’s Kriz (A)
• Where in the current account would the
imported telecommunications equipment
be listed? Would this location correspond
to the increase in magnitude and timing of
the financial account?
• Why do you think that net direct
investment declined from $573 million in
1998 to $112 million in 2000?
• Why do you think that TelSim defaulted on
its payments for equipment imports from
Nokia and Motorola?

Chapter 4
Additional
Chapter Exhibits

4-37
Exhibit 4.1 Generic Balance of
Payments

4-38
Exhibit 4.2 The United States Current
Account, 1998–2007 (billions of U.S.
dollars)

4-39
Exhibit 4.4 The United States Financial Account
and Components, 1998-2007
(billions of U.S. dollars)

4-40
Exhibit 4.6 Current and Combined
Financial/Capital Account Balances
United States, 1992–2007 (billions of U.S.
dollars)

4-41
Exhibit A China’s Foreign Exchange
Reserves (billions of U.S. dollars)

4-42
Exhibit B Rising Reserves in Asia
(billions of U.S. dollars)

4-43
Exhibit 4.7
The United
States
Balance of
Payments,
Analytic
Presentation,
1998–2007
(billions of
U.S. dollars)

4-44
Exhibit 1 Turkey’s Balance of
Payments, 1993–2000

4-45
Exhibit 2 Subaccounts of the Turkish
Current Account, 1998–2000 (millions of
U.S. dollars)

4-46
Exhibit 3 Subaccounts of the
Turkish Financial Account, 1998–
2000 (millions of U.S. dollars)

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