INTERNATIONAL FINANCIAL MANAGEMENT

1. INTERNATIONAL FINANCIAL MANAGEMENT Fourth Edition EUN / RESNICK

2. 3 The Balance of Payments Chapter Three Chapter Objective: This chapter serves to introduce the student to the balance of payments. How it is constructed and how balance of payments data may be interpreted. INTERNATIONAL FINANCIAL MANAGEMENT Fourth Edition EUN / RESNICK

3. Chapter Three Outline • Balance of Payments Accounting • Balance of Payments Accounts • The Current Account • The Capital Account • Statistical Discrepancy • Official Reserves Account • The Balance of Payments Identity • Balance of Payments Trends in Major Countries

4. Balance of Payments Accounting • The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. N.B. when we say “a country’s balance of payments” we are referring to the transactions of its citizens and government.

5. Balance of Payments Example • Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle frames from Mercian Bicycles in Darby England. • There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood’s bank account. • This will lead to a rise in the supply of dollars and the demand for British pounds.

6. Balance of Payments Accounts • The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. • They are composed of the following: • The Current Account • The Capital Account • The Official Reserves Account • Statistical Discrepancy

7. The Current Account • Includes all imports and exports of goods and services. • Includes unilateral transfers of foreign aid. • If the debits exceed the credits, then a country is running a trade deficit. • If the credits exceed the debits, then a country is running a trade surplus.

8. The Capital Account • The capital account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets. • In 2004, the U.S. enjoyed a $611.2 billion capital account surplus—absent of U.S. borrowing from foreigners, this “finances” our trade deficit. • The capital account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

9. Statistical Discrepancy • There’s going to be some omissions and misrecorded transactions—so we use a “plug” figure to get things to balance. • Exhibit 3.1 shows a discrepancy of $51.9 billion in 2004.

10. The Official Reserves Account • Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF.

11. The Balance of Payments Identity BCA + BKA + BRA = 0 where BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account Under a pure flexible exchange rate regime, BCA + BKA = 0

12. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 U.S. Balance of Payments Data

13. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 U.S. Balance of Payments Data In 2004, the U.S. imported more than it exported, thus running a current account deficit of $665.9 billion.

14. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 U.S. Balance of Payments Data During the same year, the U.S. attracted net investment of $611.2 billion—clearly the rest of the world found the U.S. to be a good place to invest.

15. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 U.S. Balance of Payments Data Under a pure flexible exchange rate regime, these numbers would balance each other out.

16. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 U.S. Balance of Payments Data In the real world, there is a statistical discrepancy.

17. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 U.S. Balance of Payments Data Including that, the balance of payments identity should hold: BCA + BKA = – BRA ($665.9) + $611.2+ $51.9 = ($2.8)

18. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 Balance of Payments and the Exchange Rate Exchange rate $ P S D Q

19. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 Balance of Payments and the Exchange Rate Exchange rate $ P S D Q As U.S. citizens import, they are supply dollars to the FOREX market.

20. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 Balance of Payments and the Exchange Rate Exchange rate $ P S D Q As U.S. citizens export, others demand dollars at the FOREX market.

21. Credits Debits Current Account 1 Exports $1,516.2 2 Imports ($2,109.1) 3 Unilateral Transfers $16.4 ($89.4) Balance on Current Account ($665.9) Capital Account 51.9 4 Direct Investment $115.5 ($248.5) 5 Portfolio Investment $794.4 ($90.8) 6 Other Investments $524.3 ($483.7) Balance on Capital Account $611.2 7 Statistical Discrepancies Overall Balance $2.8 Official Reserve Account $2.8 Balance of Payments and the Exchange Rate Exchange rate $ P S S1 D Q As the U.S. government sells dollars, the supply of dollars increases.

22. Balance of Payments Trends • Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account. • During the same period, Japan has experienced the opposite.

23. Balances on the Current (BCA) and Capital (BKA) Accounts of the United States Source: IMF International Financial Statistics Yearbook, various issues

24. Balances on the Current (BCA) and Capital (BKA) Accounts of United Kingdom Source: IMF International Financial Statistics Yearbook, various issues

25. Balances on the Current (BCA) and Capital (BKA) Accounts of Japan Source: IMF International Financial Statistics Yearbook, various issues

26. Balances on the Current (BCA) and Capital (BKA) Accounts of Germany Source: IMF International Financial Statistics Yearbook, various issues

27. Balances on the Current (BCA) and Capital (BKA) Accounts of China Source: IMF International Financial Statistics Yearbook, various issues

28. Balance of Payments Trends • Germany traditionally had current account surpluses. • From 1991 to 2001Germany experienced current account deficits. • This was largely due to German reunification and the resultant need to absorb more output domestically to rebuild the former East Germany. • Since 2001 Germany returned to its earlier pattern. • What matters is the nature and causes of the disequilibrium.

29. Balances on the Current (BCA) and Capital (BKA) Accounts of Five Major Countries Source: IMF International Financial Statistics Yearbook, 2000

30. Sources of the U.S. Trade Deficit Balance of Payment and National Income Accounting 3A Chapter Three Appendix Chapter Objectives: Introduction to the mathematical expression between balance-of-payments and National Income Accounting. Investigate causes behind continuous U.S. trade deficits and possible solutions to correct the trade imbalance between U.S. and its trade partners.

31. Balance-of-Payments and National Income Accounting • GNP: Total value of all final goods and services produced and sold in the markets. • National Income Identity • GNP ≡ C+I+G+(X-M) • Where C: Consumption, I: Investment, G: Government Spending, X: Exports of Goods and Services, M: Imports of Goods and Services

32. Import and Export • C+I+G is the total use of goods and services in a country, • If X-M <0, then GNP<C+I+G, i.e., the country consumes and invests more than it produces.. • If X-M>0 , then GNP>C+I+G, i.e., the country consumes and invests less than it produces.

33. Sources of Trade Deficit • Notice that savings S ≡ GNP-C-T, where T is Taxes, so S=C+I+G+X-M-C-T • Then (S-I)+(T-G)=X-M≡BCA • CA deficit can be caused by low savings, excess investment or government spending.

34. Possible Sources • Excess Consumption • Excess Investment • Excess Government Spending • Low Savings • Strong Dollars • Attractive Financial Markets and Investment Environment • Foreign Countries’ Unfair Trade Practices • Uncompetitive US Business

35. Excess Consumption

36. Government Spending

37. Government Spending

38. Low Savings

39. Strong Dollars • Strong $ makes domestic products less competitive. • High interest rate causes $ strong.

40. U.S. as the Best Investment Place in the World • High return/risk ratio • More opportunities

41. Unfair Trade Practices • Are foreign countries (e.g. China, Japan) using unfair trade practices to gain advantages in the U.S. Market? • Will reducing trade deficits with China and Japan help improve the U.S. trade balance?

42. End Chapter Three