Chapter 3 Notes

1. Fundamentals of BOP Accounting

•The measurement of all international economic transactions between the residents of a country and
foreign residents is called the balance of payments (BOP)

•BOP data is important for government policymakers and MNEs as it is a gauge of a nation’s
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,

•A forecast of a country’s market potential (especially in the short run)

•A BOP statement is a statement of cash flows over an interval of time.

•A credit is an event, such as the export of a good or service, that records foreign exchange
earned—an inflow of foreign exchange to the country.

•A debit records foreign exchange spent, such as payments for imports or purchases of services
—an outflow of foreign exchange

•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.

2.The Accounts of the BOP

•The BOP has three major sub-accounts:

•the current account

•the capital account

•the financial account

•In addition,

• the official reserves account tracks government currency transactions.

•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 (financial services of banks, travel services of airlines, etc.)

•Income (transfers from subsidiary to parent company)

•Current transfers (gifts, grants, global remittances, etc.)

•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

•Exhibit 3.2 follows with U.S. trade balance on goods and services

•Merchandise trade is the original core of international trade.

•The manufacturing of goods was the basis of the industrial revolution and the focus of the theory of
comparative advantage in international trade.

•Declines in steel, automobiles, automotive parts, textiles, and shoe manufacturing have caused
massive economic and social disruption since the 1980’s

•The capital and financial accounts of the balance of payments measure all international economic
transactions of financial assets.
•The capital account is made up of transfers of financial assets and the acquisition and disposal of
nonproduced/nonfinancial assets.

•Has only been introduced recently as a separate account

•The financial account consists of four components:

•Direct investment

•Portfolio investment

•Net financial derivatives

•Other asset investment

•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 degree of control over assets or operations to classify financial
assets.
•Direct investment is the net balance of capital dispersed from and into the U.S. for the purpose of
exerting control over assets.

•The source of concern over foreign investment in any country focuses on two topics: control
and profit.

•Some countries possess restrictions on what foreigners may own in their country.

•Concerns over profit stem from the same argument.

•Portfolio investment 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

•Note the inverse relation between the current and financial 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.

•Exhibit 3.5 illustrates China’s highly unusual twin surplus in both the current and financial accounts
(these relationships are typically inverse).

•Note that the financial account surplus fell sizably in 2012, only to rise to a record level in 2013—as a
result of continuing deregulation of capital inflows into the country’s economy.

•The reserves allow the Chinese government to manage the value of the Chinese yuan and its impact on
Chinese competitiveness in the world economy.

3.BOP Impacts on Key Macroeconomic Rates

•A country’s balance of payments both impacts and is impacted by the three macroeconomic rates of
international finance:

•exchange rates;

•interest rates; and

•inflation rates
•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

•Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates
elsewhere
 •The opposite has occurred in the U.S. due to perceived growth opportunities and political
stability—allowing it to finance its large fiscal deficit

•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

•Imports have the potential to lower a country’s inflation rate.

•Foreign competition substitutes for domestic competition to maintain a lower rate of inflation
than might have been the case without imports.

•On the other hand, to the extent that lower-priced imports substitute for domestic production and
employment, gross domestic product will be lower and the balance on the current account will be more
negative.

4.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
prices 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

•A country’s trade balance is essentially the net of import and export revenues.

•The U.S. trade balance, expressed in U.S. dollars, is then expressed as follows:
5.Capital Mobility

•The degree to which capital moves freely across borders is critically important to a country’s balance of
payments

•The United States’ financial account surplus has at least partially offset the current account
deficits over the last 20 or more years

•China has run a surplus in each of these accounts in recent years

•The free flow of capital in and out of an economy can potentially destabilize economic activity or can
contribute significantly to an economy’s development

•Thus, Bretton Woods Agreement was careful to promote free movement of capital for current account
transactions (e.g., foreign exchange or deposits) but less so for capital account transactions (e.g., foreign
direct investment)

•1970s-1990s saw growth in capital openness, the financial crisis of 1997/1998 stopped that due to
destructive capital outflows and contagion

•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

•1971-1997: floating exchange rates, economic volatility, rapidly expanding crossborder capital flows

•China and India attempt to open their markets

•A capital control is any restriction that limits or alters the rate or direction of capital movement into or
out of a country

•Free movement of capital is more the exception than the rule

•Exhibit 3.8 outlines several methods of and purposes for capital controls

•Dutch Disease is the name given to the problem of a substantial currency appreciation due to the
demand for a specific natural resource faced by several resource-rich smaller nations
•Capital flight—the rapid outflow of capital in opposition to or in fear of domestic political and economic
conditions and policies—is one of the problems that capital controls are designed to control.

•Although it is not limited to heavily indebted countries, the rapid and sometimes illegal transfer of
convertible currencies out of a country poses significant economic and political problems.

•Many heavily indebted countries have suffered significant capital flight.

To do exercises!

•Questions 1-24

•Problems: 1-24 (many questions are similar though)