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Week 11: The Balance of Payments and its Interpretations

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Camilo Jimenez

on 26 April 2018

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

Camilo Jiménez
The Balance of Payments and its implications + Foreign Exchange Market
Balance of Payments
What is that?
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.
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.
What Does a Current Account Deficit (Surplus) Mean?
Balance of payments: double entry accounting system

Total credits = total debits

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).
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 be financed 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
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
Net exports of goods and services
Payments and capital income
Net income (dividends and interest) of local overseas

 Unilateral transfers
 Private transfers
 Government transfers
What should the government do?
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
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.
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.
"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.
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
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.
So? Any conclusions?
Registration of economic transactions between the residents of a country and the rest of the world.

International transaction: Exchange of goods and services or assets between the RESIDENTS of one country and another.

Resident: Companies, individuals, government agencies ... all with legal domicile in a certain country.
The net foreign investment and the balance of the current account
The local country becomes a lender or net provider of funds.

The opposite occurs with deficits.
Net debt = (G – T) + (I – S)
The above is a macroeconomic phenomenon.
The balance of the current account is synonymous with net foreign investment in national income accounting.

A surplus of the current account means an excess of exports over imports of goods and services, also, an excess of investment income and unilateral transfers.
The balance of the current account represents the bottom line of a nation's income statement. If it is positive, then the nation spends less of its total income and accumulates collections of assets in the rest of the world. If it is negative, then national spending exceeds income and the nation borrows from the rest of the world.
Government deficit
Private investment
Private savings
The balance of the current account is a zero-sum game. What does it mean?
It reflects the imbalances between government expenditures and taxes as well as imbalances between private investment and savings.
A reduction in a country's current account deficit goes hand in hand with a decrease in the current account surplus of the rest of the world. The complementary policy in foreign countries, especially those with large current account surpluses, can help a successful transition.
Then we can calculate the value of the pound of the United Kingdom in relation to the Swiss franc as follows:

Thus, each sterling pound buys about 1.68 Swiss francs; This is the exchange rate between the pound and the franc.
How to Read Currency Exchange Rates
The exchange rate is the price of one currency in terms of another

In abbreviated notation, ER = $ / £, where ER is the exchange rate.

For example, if ER = 2, then the purchase of 1 £ will require $ 2 (2/1 = 2).

Let's review some concepts:

Depreciation of the currency means that more units of the currency of a country are needed for the purchase of a unit of some foreign currency.

Currency appreciation means that less units of a nation's currency are needed to buy a unit of some foreign currency.

The exchange rate between 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 rate.
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