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Chapter 2

Balance of Payment

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Objectives of the Chapter

Definition Components of BOP

Factors Affecting International Trade Flows

Correcting BOT DFIs by US Firms

DFIs in US

Factors affecting DFIs Factors affecting International Portfolio Investment

Agencies Help correcting BOP

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DefinitionA balance of payments (BOP) sheet is an accounting record of

all monetary transactions between a country and the rest of the

world. Sloman, John (2004)

A record of all transactions made between one particular

country and all other countries during a specified period oftime.

Balance of payments may be used as an indicator of economic

and political stability.

The BOP summarizes international transactions for a specific

period, usually a year, and is prepared in a single currency,

typically the domestic currency for the country concerned.

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A negative balance of payments means that more

money is flowing out of the country than coming

in.

A Positive balance of payments means that more

money is flowing in the country than going out

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Positive & Negative BOP

Sources of funds for a nation, such as exports or the

receipts of loans and investments, are recorded as

positive or surplus items.

Uses of funds, such as for imports or to invest in

foreign countries, are recorded as a negative or

deficit item.

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Components of BOP Current Account

Capital Account

Official ReserveA

ccount

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Current Account

a) Balance ofTrade

Merchandise (Exports & Imports)

Services (Exports & Imports)

b) Factor Income

c) Unilateral Transfers

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Factor IncomeIncome from:

Dividends

Interest

Income earned by workers overseas Compensation of employeesIncome of workers employed in an economy where they are not resident

- (Eg: Pak workers in Microsoft Corporation)

Income of residents employed by nonresident entities

- (Eg: People working in Pierre Cardin situated in Pakistan)

Personal transfer

It consist of all current transfers in cash or in kind made or received by residenthouseholds to or from nonresident households.

- (Eg: Mr. A sending money from Pakistan to his friend in US)

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c) Unilateral Transfers

Aids

Grants

Gifts

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CapitalA

ccounta) Foreign Direct Investment ---

b) Portfolio Investment

c) Other Capital

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Foreign Direct Investment

Investment in real assets in foreign countries

such as:

Land

Building

Existing plant

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Statistical Discrepancy

It represents errors due to unrecorded transactionsinvolving smuggling and other capital

Also known as Errors & Omissions

Many experts believe that it is the result of large

hidden capital flows, and so the item has beenplaced in the capital account part of the BOP

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Factors Affecting BOT Inflation

National Income

Government Restrictions

Exchange Rates

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HIGH INFLATION

Current Account (-) Dr

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HIGH INCOME LEVEL

Current Account (-) Dr

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Government Restrictions Tariffs

Quotas

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EXCHANGE RATES Current Account (-) Dr

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Correcting the trade deficit

Any policy that increases demand for countrys

goods and services

It will increase the Balance of Trade

Solution

If export price becomes attractive --

Floating rate may correct the deficit --

Trade deficit may experience an stable currency --

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If export price becomes attractive

It will increase the Balance of Trade

This can occur when a country has:

o Low inflation

o Low currency value

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Floating rate may correct the deficit

What is Deficit When country is spending more on foreign goods

When country is receiving less from exports

It means More supply of home currency for sale

The value of its currency should decrease

This decrease will encourage more foreign demand of home madeproducts

Therefore CA will increase

But this technique may not always work

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Trade deficit may experience an stable currency

Again Recall DEFICIT Spending more on foreign goods

Receiving less from exports

Resulting in low value of currency

NOW

Investment in securities becomes attractive for foreigners

Increased demand of home currencyUpward pressure on home currency

Therefore the trade imbalance will be offset by positive

capital account

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Weak Currency may not always be the solution

Counter pricing by competitors

- Once low priced items seem more attractive to the foreign customers

- The competing countries may also lower the price

Impact of other weak currencies

- The home currency does not necessarily weaken against all

currencies at the same time

Eg: It is possible that the Pakistani rupee may weaken against Indiancurrency, So Pakistan may stop buying Indian products

but It may start buying from other countries where Pak Rupee is still

stable i.e. Bangladesh, Srilanka, Iran etc

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Pre-arranged International Transaction

If the home currency is lower in value

It is not possible that every country will frequently start buying from

here

Till the time countries become aware about the cheap product

Lower rate may not be available till that time

Due to time lag it is not always possible

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Inter Company Trade

Importers and exporters under the same ownership have unique

relationship

Many firms use to buy the products from their subsidiaries

This type of trade makes 50% of trade

Trade between countries may not affect exchange rates

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Outflow Inflow

Inflow Outflow

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Correcting BOP

When all components of the BOP sheet are included

It must balance

It must sum to zero

There can be no overall surplus or deficit.

Eg: - If a country imports more than it exports

- Its trade balance will be in a deficit

But It has to be balancedBy running down reserves or by receiving loans

from other countries.

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Lets rename it the imbalance of payments

and announce its normal.

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The Official Reserve Account

It is the foreign currency and securities held by the

Govt.

Usually by its Central bank

It is used to balance the payments from year to year

It increases when there is a trade surplus

It decreases when there is a deficit

Sometimes the Central Bank use it to change the

exchange rate when the government perceives as more

favorable

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Agencies that help to Correct

BOP Deficit

IMF

IBRD

WTO International Financial Corporation

International Development Association

Bank of International Settlements Regional Development Agencies

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IMF

A result of UN Monetary & Financial Conferencein 1944

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Objectives of IMF

To promote Cooperation among countries

To promote stability in exchange rates

To provide temporary funds to member countries

attempting to correct imbalances of international

transactions

To promote free mobility of funds across countries

To promote free trade

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Compensatory Financing Facility (CFF)

This facility is mainly used by developing countries

Each country is assigned a quota

The amount of fund that a member country can borrow

depends upon its quota

The country must be willing to work with IMF to resolve

the problem

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SDRs An international reserve asset created by IMF in 1969

The financing by IMF is measured in SDRs

IMF allocates it to member countries to supplement

currency reserves

It is not a currency but a unit of account

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The SDR basket and Its Valuation

Total 1.260651

Currency Amountin 1 SDR

(1)

Exchange

Rate vs

US $

(2)

US $

Equivalent

(1) * (2)

USD 0.5770 1.00000 0.577000

Euro 0.0984 1.42550 0.140269

GBP 0.4260 0.88140 0.375476

Euro 21.0000 125.07000 0.167906

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IBRD

Established in 1944 Structural Adjustment Loan (SAL) in 1980

It spread its funds through co-financing:

Official Aid Agencies

(projects)

Export credit agencies

Commercial Banks

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Correcting BOP Problems

Roberts,Richard (1999)

The fundamental function of International Monetary System is toprovide mechanisms to correct imbalances.

Even a mixture of at least the first two methods may be used.

Methods:

There are three possible methods to correct BOP imbalances Adjustments of exchange rates

Adjustment of a nations internal prices along with its levels of demand

Rules based adjustment

Note: Improving productivity and competitiveness can also help to enhance theexports through other means BUT

It is generally assumed that a nation is always trying to develop and sell itsproducts to the best of its abilities.