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Week 11: The Balance of Payments and its Interpretations

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Camilo Jimenez

on 29 September 2016

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Transcript of Week 11: The Balance of Payments and its Interpretations

We can then calculate the value of the U.K. pound relative to the Swiss franc as follows:




Thus, each U.K. pound buys about 1.68 Swiss francs; this is the cross exchange rate between the pound and the franc.
Camilo Jiménez
The Balance of Payments and its implications + Foreign Exchange Market
Agenda
Balance of Payments
What is that?
The balance of payments is a record of the economic transactions between the residents of one country and the rest of the world.

An international transaction is an exchange of goods, services, or assets between residents of one country and those of another.

Residents include businesses, individuals, and government agencies that make the country in question their legal domicile.
Double-Entry Accounting
The arrangement of international transactions

Credit transactions

• Merchandise exports
• Transportation and travel receipts
• Income received from investments abroad
• Gifts received from foreign residents
• Aid received from foreign governments
• Investments in the United States by overseas residents
Debit transactions

• Merchandise imports
• Transportation and travel expenditures
• Income paid on the investments of foreigners
• Gifts to foreign residents
• Aid given by the U.S. government
• Overseas investment by U.S. residents
Balance-of-Payments Structure
Current Account
Statistical Discrepancy: Errors and Omissions
Capital and Financial Account
Refers to the monetary value of international flows associated with transactions in goods, services, income flows, and unilateral transfers.

Combining the exports and imports of goods gives the merchandise trade balance. When this balance is negative, the result is a merchandise trade deficit; a positive balance implies a merchandise trade surplus.

Information about the GDP regarding the net transfer of resources is obtained
Capital and financial transactions in the balance of payments include all international purchases or sales of assets.

The term assets is broadly defined to include items such as titles to real estate, corporate stocks and bonds, government securities, and ordinary commercial bank deposits.
The data-collection process that underlies the published balance-of-payments figures is far from perfect.

When statisticians sum the credits and debits, it is not surprising when the two totals do not match. Because total debits must equal total credits in principle, statisticians insert a residual to make them equal. This corrected entry is known as statistical discrepancy, or errors and omissions.
THE BALANCE OF PAYMENTS IN COLOMBIA
What Does a Current Account Deficit (Surplus) Mean?
Concerning the balance of payments, the current account and the capital and financial account are not unrelated; they are essentially reflections of one another.

If the current account registers a deficit (debits outweigh credits), the capital and financial account must register a surplus, or net capital/financial inflow (credits outweigh debits).
Net Foreign Investment and the Current Account Balance
The home nation experiences capital outflows and thus becomes a net supplier of funds to the rest of the world.

The opposite happens with deficits
Current account deficit = (G – T) + (I – S)
The current account deficit is a macroeconomic phenomenon:

Is a Current Account Deficit a Problem?
It depends. A deficit indicates a shortage of liquidity which must be satisfied through the capital account. The point is to identify what will the country do with the debt incurred. Wasting money or investing money?
Norway provides an example of one of these productive opportunities. In the 1960s, rich petroleum deposits were discovered in the North Sea. Norway was one of the major beneficiaries of this discovery. Getting to these valuable oil and gas deposits required large and repeated investments in off-shore oil platforms, transport pipelines, ships, and helicopters.
Business Cycles, Economic Growth, and the Current Account Norway
Is it possible to indefinitely continue with current account deficits?
It depends. Is it possible to finance indefinitely? There is an increased share ownership of local capital in the hands of foreigners.
1. To hold a deficit will occur when foreigners maintain their investments in the local country.
2. To have an increase in the efficiency and technology
3. To implement policies that stimulate growth abroad → Increased demand for foreign securities.
4. To promote increased national saving -> Increased domestic investment -> Increased exports
What is the Balance of Payments
Double-Entry Accounting
Balance-of-Payments Structure
Current Account
Capital and Financial Account
Errors and Omissions
What Does a Current Account Deficit (Surplus) Mean?

The case of Colombia

Exchange Markets
Foreign Exchange operations
The balance of payments registers Colombia's real and financial flows that the country trades with the rest of the world economies, according to the Manual on Balance of Payments and International Investment Position IMF, version 6.
The financial account, which has the same sign of the current account, registers external funding (if there is current deficit) or the ability to provide resources to the world (if there is current surplus). Financial flows are broken down into direct investment, portfolio investment and other investment (loans, trade credits and other financial transactions) and the variation in international reserves.
It has two major accounts: the current account and the financial account.

The current account recorded our exports and imports of goods and services, income and expenditures for factor income (primary income) and current transfers (secondary income).
Source: Banrep
All this leads to the total account in the balance of payments should ALWAYS be balanced. There is no concept of deficit or surplus in the balance of payments
Deficits or surpluses are specific to subaccounts of the balance of payments.
The current account balance is synonymous with net foreign investment in national income accounting. A current account surplus means an excess of exports over imports of goods, services, investment income, and unilateral transfers.
The current account balance thus represents the bottom line on a nation’s income statement. If it is positive, then the nation is spending less than its total income and accumulating asset claims on the rest of the world. If it is negative, then domestic expenditure exceeds income and the nation borrows from the rest of the world.
For the world as a whole, the sum of all nations’ current account balances must equal zero. What does it mean?
It reflects imbalances between government outlays and taxes as well as imbalances between private investment and saving. Any effective policy to decrease the current account deficit must ultimately reduce these discrepancies.
Thus, a reduction in one nation’s current account deficit must go hand in hand with a decrease in the current account surplus of the rest of the world. A complementary policy in foreign nations, especially those with large current account surpluses, can help in a successful transition.
Video
Net exports of goods and services
Payments and capital income
Net income (dividends and interest) of local overseas

 Unilateral transfers
 Private transfers
 Government transfers
The vast majority of transactions appearing in the capital and financial account come from financial transactions:

Direct Investment: when residents of one country acquire a controlling interest (stock ownership of ten percent or more) in a busi- ness enterprise in another country.

Securities: Securities are private-sector purchases of short- and long-term debt securities, such as Treasury bills, Treasury notes, Treasury bonds, and securities of private enterprises.

Bank Claims and Liabilities: Bank claims consist of loans, overseas deposits, acceptances, foreign commercial paper, claims on affiliated banks abroad, and foreign government obligations.
The acquisition and use of certain non-financial assets. The main types of capital transfers are debt forgiveness and financial products and assets that accompany migrants when leaving or entering the country.
Capital transactions
Examples
Sales and purchases of rights to natural resources, patents, copyrights, trademarks, franchising and leasing.
Currencies
Why international economics is different from other branches of economics? There are different currencies.

What are the typical international transactions?
1. The currency is purchased.
2. International transaction is performed.
Foreign-Exchange Market
Agents buy and / or sell currencies.
People, businesses, governments and banks.
Carbaugh: quoted prices change as often as 20 times a minute. It has been estimated that the world’s most active exchange rates can change up to 18,000 times during a single day.

The foreign-exchange market opens on Monday morning in Hong Kong, which is still Sunday evening in New York. As the day progresses, markets open in Tokyo, Frankfurt, London, New York, Chicago, San Francisco, and elsewhere. As the West Coast markets of the United States close, Hong Kong is only one hour away from opening for Tuesday business. Indeed, the foreign-exchange market is a round- the-clock operation.
"Money never sleeps"!!!
How does a local company make a purchase abroad?

Has this market evolved?
A typical foreign-exchange market functions at three levels:

1. In transactions between commercial banks and their commercial customers, who are the ultimate demanders and suppliers of foreign exchange.
2. In the domestic interbank market conducted through brokers.

3. In active trading in foreign exchange with banks overseas.
Types of Foreign-Exchange Transactions
Spot
A spot transaction is where you can make an outright purchase or sale of a currency now, as in “on the spot.” A spot deal will settle (in other words, the physical exchange of currencies takes place) two working days after the deal is struck.
Forward Transactions
It will protect you against unfavorable movements in the exchange rate, but will not allow gains to be made should the exchange rate move in your favor in the period between entering the contract and final settlement of the currency.
Swap
A currency swap is the conversion of one currency to another currency at one specific time, with an agreement to reconvert it back to the original currency at a specified time in the future.
Banking
"24/7 and everywhere"
An international community of about 400 banks constitute the daily currency exchanges for buyers and sellers worldwide. A bank’s foreign-exchange dealers are in constant contact with other dealers to buy and sell currencies. In most large banks, dealers specialize in one or more foreign currencies.
Reading Foreign-Exchange Quotations
The exchange rate is the price of one currency in terms of another

In shorthand notation, ER = $/£, where ER is the exchange rate. For example, if ER = 2, then purchasing £1 will require $2 (2/1 = 2).

Let's review some concepts:

Currency depreciation means that it takes more units of a nation’s currency to purchase a unit of some foreign currency.

Currency appreciation means that it takes fewer units of a nation’s currency to purchase a unit of some foreign currency.

The exchange rate between any two currencies (such as the franc and the pound) can be derived from the rates of these two currencies in terms of a third currency (the dollar). The resulting rate is called the cross exchange rate.

Foreign-Exchange
The foreign-exchange market is by far the largest and most liquid market in the world. The estimated worldwide amount of foreign-exchange transactions is about $3 trillion a day. Individual trades of $200 to $500 million are not uncommon.
What are the major currencies for the world trade?
The U.S. dollar, the euro, the Japanese yen, and the British pound.
What about the rest of the currencies?
Currencies that are not traded are avoided for reasons ranging from political instability to economic uncertainty. Sometimes a country’s currency is not exchanged for the simple reason that the country produces very few products of interest to other countries.
What are the largest financial markets in the world?
Being online makes the currency-trading process more transparent. Corporate clients can see multiple quotes instantly and shop for the best deal.
Here’s how a spot transaction works:
• A trader calls another trader and asks for the price of a currency, say, the euro. This call expresses only a potential interest in a deal, without the caller indicating whether he or she wants to buy or sell.
• The second trader provides the first trader with prices for both buying and selling.
• When the traders agree to do business, one will send euros and the other will send, say, dollars. By convention, the payment is actually made two days later.
Here’s how a swap transaction works:
• Suppose a U.S. company needs 15 million Swiss francs for a three-month investment in Switzerland.
• It may agree to a rate of 1.5 francs to a dollar and swap $10 million with a company willing to swap 15 million francs for three months.
• After three months, the U.S. company returns the 15 million francs to the other company and gets back $10 million, with adjustments made for interest rate differentials.
How do banks earn profits in foreign-exchange transactions in the interbank market?

They quote both a bid and an offer rate to other banks. The bid rate refers to the price that the bank is willing to pay for a unit of foreign currency; the offer rate is the price at which the bank is willing to sell a unit of foreign currency. The difference between the bid and the offer rate is the
spread
that varies by the size of the transaction and the liquidity of the currencies being traded. At any given time, a bank’s bid quote for a foreign currency will be less than its offer quote. The spread is intended to cover the bank’s costs of implementing the exchange of currencies.
What should the government do?
So? Any conclusions?
Full transcript