Economics of International Finance Econ. 315

1. Economics of International FinanceEcon. 315 Chapter 1: Balance of Payments

2. Balance of Payments (BOP) Definition: • A Summary statement in which all TRANSACTIONS of the RESIDENTS in a nation with the residents of all other nations (NON-RESIDENTS) which are recorded during a particular PERIOD of time (usually one calendar year). • What is meant by: • International transactions: • The exchange of a good, service or an asset, between the residents of one nation and the residents of other nations (payments are required for these transactions). • Gifts and other transfer payments are also included (No Payments are required here).

3. The residents and Non-residents: Residents are Persons and other bodies that are normally residents in the country, Note: • Temporary immigrants, e.g., diplomats, tourists and temporary workers are not residents (they are residents of the country in which they hold citizenship). • Corporations are residents of the country in which they are incorporated, but branchesand subsidiaries are not. • International institutions (UN, WB, IMF, WTO ..etc) are non residents at the country in which they are located.

4. The period • Usually a calendar year, however most of the countries keep a record on a quarterly basis (e.g., Kuwait). BOP Accounting principles • Credits and debits • Credit Transactions: involvereceipts of paymentsfrom foreigners (entered with a +ve sign because they involve receipts of payments), e.g., • Export of goods and services • Gifts and aid received from foreigners • Capital inflows

5. Debit Transactions:involve the making of payments to foreigners (entered with a -ve sign because they involve making of payments), e.g., • Imports of goods and services • Gifts and aid given to foreigners • Capital outflows • Capital inflows (credit): take two forms: - Anincrease in foreign assets in the nation (an American investor purchases an asset in Kuwait) - A reduction of the nation’s assets abroad (A Kuwaiti investor sells an asset in the UK) They both involve a receipt of payments from foreigners (i.e., capital inflows and are thus credit transactions)

6. Capital outflows (debit):take two forms: - an increase in the nations assets abroad (a Kuwaiti investor purchases an asset in the UK) - reduction of foreign assets in the nation (an American investor sells an asset in Kuwait) They both Involve payments to foreigners (i.e., capital outflows and are thus debit transactions). • Double entry bookkeeping • Each international transaction is recorded twice, once in the credit and once in the debit of an equal amount. The reason for this is that every transaction has two sides (credit and debit).

7. Example 1. Kuwait exports $ 500 mn. of oil to be paid for in three months. • Note the following: • Exports of oil are entered as credits (lead to receipts of payments from foreigners) • The payment itself is entered as a capital outflow (debit), why? When Kuwait agrees to wait for three months for payments, it extends a credit to foreign importers (capital outflows). This is an increase in domestic assets abroad (i.e. a debit)

8. Example 2. Kuwaiti tourists visit London and spend $ 200 mn. on hotels, meals.. etc. Note the following: • Kuwaiti tourists purchased services from foreigners (require payments to foreigners). This is similar to imports (debit). • The payment is entered as a credit, as it represents an increase in foreign claims on Kuwait, i.e. an increase in foreign assets in Kuwait or a capital inflow to Kuwait.

9. Example 3. Kuwait gives a $ 100 mn. bank balance to the government of a less developed country (aid). Note the following: • This unilateral transfer is a debit (requires payments to foreigners). • The payment (an increase in a bank account) itself represents an increase in foreign claims (of assets) in Kuwait.

10. Example 4. A Kuwaiti resident purchases foreign stocks of $ 400 mn. and pays for it by increasing foreign bank balances in Kuwait. Note the following: • The purchase of foreign stocks increases Kuwaiti assets abroad. This is a capital outflow (debit). • The payment is an increase in foreign assets in Kuwait. This is a capital inflow (credit). (Note: If the Kuwaiti resident paid for the foreign stock by reducing bank balances abroad; the payment will be a reduction in Kuwaiti assets abroad, this is also a capital inflow and thus is a credit).

11. Example 5. A foreign investor purchases $ 300 mn. of Kuwaiti treasury bills and pays by drawing down his bank balances in Kuwait. Note the following: • the purchase of the treasury bills is an increase in foreign assets in Kuwait (credit) • The drawing down of Kuwaiti bank balances by foreigners is a reduction in foreign assets in Kuwait. this is a capital outflow (debit).

12. The results of the previous transactions on Kuwait’s balance of payments would be: Capital flows = (-500 +200 +100 +400 -400 +300 -300) = -200 Note: the net capital debit balance -200 is obtained by adding together the seven capital entries Balance of payments

13. Accounting balances and disequilibrium in international transactions • The Current Account: • Lumps together all sales and purchases of goods and services, investment incomes, and unilateral transfers. • It provides the link between the nations international transactions and its national income. • The current account surplus stimulatesdomestic production and income, while a current deficit dampensdomestic production and income. 2. The capital Account: • Measures the change in the stock of all non-reserve financial assets. • Reserve changes are excluded from the capital account because they represent the government policy (below the line transactions) rather than market forces. • The capital account shows the net increase in the privately ownednet assets abroad.

14. Autonomous transactions. • All transactions in the current account and capital account are called “autonomous”, because they take place for businessorprofitmotives (except for unilateral transfers), and are independent of BOP considerations. • They are sometimes called “the items above the line” Transactions in official reserves. • They are called accommodating transactions (items below the line), because they are needed to balance international transactions. • Below the line items form the “official reserve account”, and its balance is called “the official settlements balance”. Do you know now what do we mean by the line?

15. Balance of payments: Deficit • If total debits exceed credits in current and capital accounts, the net “debit” balance measures the “deficit” in the country’s BOP. • The deficit is settled with an equalnet “credit” (to offset the deficit), in the official reserve account. Deficit, can thus be measured by the excess of credits over debits in the official reserve account. Balance of payments: Surplus • If total credits exceed debits, in current and capital account, there will be a surplus in the BOP. • The surplus is settled by an equal net “debit” in the official reserve account. The surplus, can thus be measured by the excess of debits over credits in the official reserve account.

16. Revision. Enter the following transactions in the BOP of Kuwait • A Kuwaiti resident purchases a $ 1000 mn foreign stock and pays for it by drawing down her bank balances abroad. • A Kuwaiti resident receives a dividend of $ 100 mn on her foreign stock and deposits it into her bank account abroad. • General Motors Co. purchases $ 100 mn PCs from China. • A Kuwaiti computer manufacturer buys $ 20 mn hard disks from a Chinese company and deposits the value in NBK, China uses the proceeds to purchase oil. • The Kuwaiti government gives a $ 100 mn cash balance in a Kuwaiti bank to a developing nation as part of the foreign aid program. • The developing nation uses the $ 100 mn bank balance to import $100 worth of oil from Kuwait. • An American tourist spends $ 20000 on hotels in Malaysia. • An American investor purchases $ 150 mn Kuwaiti stocks and pays by increasing the seller's bank account in USA. • The American investor receives $ 15 mn on his Kuwaiti Stock and deposits the value in his bank account in Kuwait.

17. Current Account

18. Capital Account

19. Reserve Assets (CBK)

20. Key Terms • Balance of payments Capital account • Credit transactions Autonomous transactions • Debit transactions Accommodating transactions • Capital inflow Official reserve account • Capital outflow Official settlements balance • Double-entry bookkeeping Deficit in the balance of payments • Unilateral transfers Surplus in the balance of payments • International investment position Current account