International Financial

Markets

Lecture 01

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 Lecture 01
External Trade: The Balance of Payments
• Current Account

• Capital Account

• Financial Account

• Official International Reserves

• The Macroeconomics of the Balance of Payments

References: Krugman et al. (2022), Ch. 13; Pugel (2024), Ch. 16

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 Learning Objectives

• Discuss concept of current account balance.

• Use the current account balance to extend national income accounting

to open economies.

• Apply national income accounting to the interaction of saving,

investment, and net exports.

• Describe balance of payments accounts and explain their relationship

to the current account balance.

• Relate the current account to changes in a country’s net foreign

wealth.

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 Lecture 1
The Balance of Payments (1/4)

The Balance of Payments (BoP) registers the economic transactions

(goods, services or assets) between residents (households and firms –
independently the nationality of those residents) of a country with the rest
of the world (ROW)

When there is an exchange with the ROW:

1) It is registered a credit (+) when an item for which the country must
be paid. It sets up the basis for a payment by a foreigner into the
country. Is creates a monetary claim ON a foreigner (there is a
supply of foreign currency)

2) It is registered a debit (-) when an item for which the country must
pay. It sets up the basis for a payment by the country to a foreigner –
that is, it creates monetary claim ON a foreigner (there is a demand
of foreign currency)
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 Lecture 1
The Balance of Payments (2/4)

The BoP can be divided into 3 main accounts:

Current Account It is registered the Export and Imports of Goods & Services (Net Exports, NX),
Net Primary Income (Income & interests or dividends) from the ROW &
Net Current Transfers (There is no counterparts of a good/service – private or public)

Financial Account It is registered accounts for flows of financial assets (financial capital).

Capital Account It is registered capital transfers and acquisitions/transfers of non-productive, non-financial

assets (patents, trademarks, copyrights,…).

In the end, the BoP is always balanced:

𝐵𝑃 ≡ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 + 𝐸𝑂 = 0 5
 Lecture 1
The Balance of Payments (3/4)

Case 1
• You import a fax machine from Olivetti.
• Olivetti deposits your check in a U.S. bank.
Fax machine purchase (Current account, U.S. good import) −$1000
negative $1000

Sale of bank deposit (Financial account, U.S. asset sale) +$1000

Case 2
• You buy lunch in France and pay by credit card.
• French restaurant receives payment from your credit card company.
Meal purchase (Current account, U.S. service import) −$200
negative $200

Sale of credit card claim (Financial account, U.S. asset sale) +$200

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 Lecture 1
The Balance of Payments (4/4)

Case 3
• You buy a share of B.P.
• B.P. deposits the money in a U.S. bank.
Stock purchase (Financial account, U.S. asset purchase) −$95
negative $95

Bank deposit (Financial account, U.S. asset sale) +$95

Case 4
• U.S. banks forgive a $5,000 debt owed by the government of Bygonia through
debt restructuring.
• U.S. banks who hold the debt thereby reduce the debt by crediting Bygonia’s
bank accounts.

U.S. banks debt forgiveness (capital account, U.S. transfer −$5,000

negative $5,000

payment)
Reduction in bank’s claims ON Bygonia (financial account, +$5,000
U.S. asset sale)
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 The Financial Account (1/4) Lecture 1
The net value of flows of financial assets and similar claims (excluding official
international reserve asset flows) is the private (or nonofficial) financial account
balance

The values reported in the financial accounts are for the principal amounts only of
assets traded → the flows related with the earnings ON foreign assets are
reported in the current accounts.

Financial inflow
• Foreigners loan to domestic citizens by buying domestic assets.
• Domestic assets sold to foreigners are a credit (+) because the
domestic economy acquires money during the transaction.

Financial outflow
• Domestic citizens loan to foreigners by buying foreign assets.
• Foreign assets purchased by domestic citizens are a debit
because the domestic economy gives up money during the
transaction.
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 Lecture 1
The Financial Account (2/4)

If we focus ON the direction of movement of the financial asset itself, then the
debits and credits are just like exports and imports of goods and services.

Examples of debits (negative sign, – ), i.e., there are outflows of funds:

• A U.S. resident increasing his holding of a foreign financial asset like a stock.
The individual is making a payment to the foreigner.

• A foreign resident decreasing his holding of a U.S. financial asset like a bond.
The U.S. buyer is making a payment to the foreigner.

Examples of credits (positive sign, + ), i.e., there are inflows of funds:

• A U.S. resident decreasing his holding of a foreign financial asset like a stock.
The individual is receiving a payment from the foreigner.

• A foreign resident increasing his holding of a U.S. financial asset like a bond.
The U.S. buyer is receiving a payment from the foreigner.

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 Lecture 1
The Financial Account (3/4)

U.S. Balance of Payments, 2021 in $ billions

Current Account
Exports of goods and services (+) 2,533
Imports of goods and services (-) 3,394
Income received from foreigners (+) 1,091
Income paid to foreigners (-) 916
Unilateral transfers, net -136
Current account balance -822

Financial Account (excluding official international reserves)

Changes in U.S. direct investment abroad (-) 501
Changes in foreign direct investments in the United Status (+) 450
Changes in U.S. holdings of foreign stocks and bonds (-) 604
Changes in foreign holdings of U.S. foreign stocks and bonds (+) 545
Changes in U.S. loans to foreigners and other investments (-) -6
Changes in foreign loans to the U.S. and other investments (+) 637
Financial account balance 533

Official International Reserves

Changes in U.S. official holdings of foreign assets (-) 1
Changes in foreign official holdings of U.S. assets (+) 153
Changes in official international reserves, net 152

Statistical Discrepancy 137

Other important balances:

Goods and services balance -861
Overall balance -152 10
 Lecture 1
The Financial Account (4/4)

Another important part of the balance of payments keeps track of changes in

official holdings of international reserves:

• Money-like assets that are held by governments (central banks) and that are
recognized as fully acceptable for payments between them.

There is a distinction between private (nonofficial) international financial assets

and oficial international reserve assets:

Official refers to assets held by monetary-type officials (not all government

assets – other non-monetary assets are included in the private category)

Why such distinction? The goal of that is to focus on the monetary task of
regulating currency values. Recalling the U.S. case in 2021…
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 Lecture 1
The Macro Meaning of the Current
Account Balance (1/3)

Recalling that the BoP must add to zero (due to the double-entry bookkeeping),
we can discuss the macroeconomic meaning of the current account balance.

Again, since all the items other than the current account are flows of international
financial assets (both private or nonofficial) and official (changes in official
international reserve assets), the country’s current account balance must equal
net foreign investment, 𝐼𝑓:

• If the country has a current account surplus, then its foreign assets are
growing faster that its liabilities → Its net foreign investment is positive → net
lender to the rest of the world.

• If the country has a current account deficit, then its foreign liabilities are
growing faster that its liabilities → Its net foreign investment is negative → net
borrower from the rest of the world.
Again…

Again… 12
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 Lecture 1
The Macro Meaning of the Current
Account Balance (2/3)

A country’s current account is also linked to its national saving (S) and domestic
real investment. The savings can be used to invest at home in domestic capital
formation (𝐼𝑑 ) or in net foreign investment (𝐼𝑓).

Therefore 𝑆 = 𝐼𝑑 + 𝐼𝑓 ⇔ 𝐼𝑓 = 𝑆 − 𝐼𝑑 ⇔ 𝐶𝐴 = 𝑆 − 𝐼𝑑 (country’s current account

balance equals national savings that is not invested in the domestic country).

Let us recall the GDP’s expenditure approach:

𝑌 = 𝐶 + 𝐼𝑑 + 𝐺 + 𝑋 − 𝑀

Being the country’s total expenditures on goods and services, 𝐸 = 𝐶 + 𝐼𝑑 + 𝐺, we

can rewrite the GDP as:
𝑌 = 𝐸+𝑋−𝑀

Approximately, the CA is equal to net exports → CA is equal to the difference

between GDP and national spend on goods and services:
𝐶𝐴 ≈ 𝑋 − 𝑀 = 𝑌 − 𝐸 13
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 Lecture 1
The Macro Meaning of the Current
Account Balance (3/3)

If a country seeks to reduce its current account deficit, it may be accompanied by

an increase in the value of GDP, Y, relative to the value of national expenditure, E.

If Y cannot ↑ much, then E must ↓ → the goal is to reduce imports / increase

exports.
PT CAB in % of GDP
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0
1980
1981
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1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
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2004
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2009
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2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
-2

-4

-6

-8

-10

-12

-14

-16

Current account balance

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 Lecture 1
The Macro Meaning of the Overall
Balance (1/2)

The overall balance should indicate whether a country’s balance of payments

has achieved an overall pattern that is sustainable over time. However, it is not a
perfect indicator.

An indicator often used is based on the division of net foreign investment, 𝐼𝑓 into
two components: the i) net private (nonofficial) capital flows and ii) the net flows
of official reserve assets.

The Official settlements balance (B) measures the sum of the current account
(CA) and the nonofficial account balance (FA):

𝐵 = 𝐶𝐴 + 𝐹𝐴

As the BoP must sum zero, any imbalance in the official settlements balance
must be financed through official reserves (OR):

𝐵 + 𝑂𝑅 = 0 15
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 Lecture 1
The Macro Meaning of the Overall
Balance (2/2)

Therefore:
• If the overall balance B is in surplus it equals an accumulatuion of official
reserve assets by the country or a decrease in foreign official reserve holdings
of the country’s assets.

• If the overall balance B is in deficit it equals a decrease in the country’s

holdings of official reserve assets by the country or an accumulation of
foreign official reserve holdings of the country’s assets.

The official settlements balance measures the net flows of all private transactions
in (i) goods, (ii) services, (iii) income, (iv) transfers, and (v) nonofficial financial
assets. However, it is the counterbalancing items, i.e., the changes in official
reserve holdings, that show the macroeconomic meaning of the official
settlements balance.

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 Lecture 1
The International Investment Position
(1/2)

Complementing the BoP - which record flows of transactions – is the

international investment position (a record of stock of a nation’s international
assets and foreign liabilities at, usually, the end of a year)

Flows changes stocks, and so it is with the balance of payments and the
international position.

The link between the two kinds of accounts relates to a subtle but common
semantic distinction:
• We say that a nation is a lender or a borrower depending on whether its CA
is in surplus or deficit during a time period. (flows)
• We say that a nation is a creditor or debtor depending on whether its net
stock of foreign assets is positive or negative. (stocks)

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 Lecture 1
The International Investment Position
(2/2)

U.S. International Investment Position at the End of Selected Years, 1897-2021 ($ billions)
1897 1914 1930 1946 1960 1980 1994 2021
U.S. investment abroad 1.3 5.0 21.5 39.4 85.6 839.1 3 434.6 35 210.7
Direct investment 0.6 2.7 8.0 7.2 31.9 297.3 1 234.1 11 034.5
U.S. official reserve assets 0.6 1.5 4.3 20.7 19.4 171.4 163.4 712.3
Other 0.1 0.8 9.2 11.5 34.3 370.3 2 037.2 23 463.9

Foreign investments
in the United States 3.4 7.2 8.4 15.2 40.9 542.2 3 544.9 53 311.9
Direct investments - 1.3 1.4 2.5 6.9 99.9 877.4 14 839.9
Other 3.4 5.9 7.0 12.7 34.0 442.4 2 667.6 38 471.9

U.S. net international investment position - 2.1 - 2.2 13.1 26.7 44.7 296.9 - 110.3 - 18 101.2

Source: Pugel (2024)

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