Balance of payment
Balance of payment
Definition: Record of all economic transactions between the residents of a country and the rest of the world in a particular period.
Balance = Credit – Debit
Money coming into the country is recorded as credit items Money leaving the country is recorded as debit items.
Current account
4 components：
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Current transfer: Transfers of money, goods and services which are sent out or come into the country, not in return for anything else.
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trade in goods: balance of trade = visible export – visible import
-
trade in service (insurance, tourism, transportation and consulting): invisible balance
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income compensation of employees: wages, salaries and other benefits earned investment income: profits, dividends, and interest receipts
Current account deficit
is where the net balance from the sum of trade in goods and services, current transfer, and income is negative in a given year.
Current account surplus
is where the net balance from the sum of trade in goods and services, current transfer, and income transfer is positive in a given year.
Causes of current account deficit
- Cyclical deficit: low income abroad and high incomes at home
- A high exchange rate [inflation rate & interest rate]: means high export prices and low import prices
- Structural problem:
Problem with the production ability for some products Costs incurred to produce them Prices at which they are sold ---international competitiveness Strategies adopted for marketing them
Consequences
(Current account deficit becomes a problem, if it is widening & exceeds 5%-6% of the country’s GDP.)
- High foreign ownership of domestic assets
- ER will fall - currency depreciation (current account 对汇率有贬值压力)
- Higher IR (interest rate)
- High foreign indebtedness
- International credit ratings will be harmed, confidence in economy and currency will be loss
- Demand management will be restricted
- Lower standard of living in the future
Method to correct
- Expenditure switching policies:
Understanding: is designed to persuade purchasers of goods and services both at home and abroad to purchase more of that country’s goods and services and less of the goods and services produced by others. A fall in import expenditure and a rise in export earnings. The former will lead to a fall in the supply of a country’s currency on the foreign exchange market. The latter will lead to a rise in the demand for the country’s currency on the market. Both will lead to upward pressure on the exchange rate.
Explanation: Marshall-Lerner condition states that a depreciation or devaluation of a currency will only lead to an improvement in the current account balance if the elasticity of demand for exports plus the elasticity of demand for imports is greater than one (PED exports + PED imports > 1) If the sum of the two PED is less than one, devaluation / depreciation will worsen the trade balance (will make the trade deficit larger) M-L condition is typically not satisfied in Short Run but in Long Run. J-curve effect suggests that in the short term, a depreciation or devaluation will worsen the current account deficit (due to inelastic demand for exports and imports), before things improve in the long term.
Evaluation: A fall in import expenditure and a rise in export earnings. The former will lead to a fall in the supply of a country’s currency on the foreign exchange market. The latter will lead to a rise in the demand for the country’s currency on the market. Both will lead to upward pressure on the exchange rate.
- Expenditure reducing policies:
Understanding: Any action taken by a government which is designed to reduce the total level of spending in an economy. There will be fewer purchases of imported goods and services. Domestic producers will find that their domestic market is dampened and is more difficult to sell in. As a result, they may try to make up for the decrease in sales domestically with increases in sales abroad. Overall impacts should be a fall in imports and a rise in exports.
How: Deflationary fiscal policy: rise income tax decrease government spending
Deflationary monetary policy: increase legal reserve rises interest selling bonds
Evaluation: There is a conflict here between external and internal objectives. Deflating the economy may reduce the current account deficit but the policy is likely to lead to a fall in domestic employment and a fall in the rate of economic growth. This makes it a difficult decision for a government to make.
Capital account
records the transactions involving ownership of capital and transaction in non- produced, non-financial assets between a nation and all other nations.
2 components:
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Capital transfers: transfers of fixed (tangible) assets: transfers of goods and financial assets by migrants entering or leaving the country, debt forgiveness, transfers relating to the sale of fixed assets, gift taxes, inheritance taxes, and death duties.
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non-produced assets: land, rights to natural resources (by a government / international organization). [intangible, non-financial assets: patents, copyrights, brand names, trademarks, franchises, licenses]
Financial account
measures the exchanges between a nation and the rest of the world involving ownership of financial and real assets. (Financial assets, high liquidity)
3 components：
- Direct investment (FDI): a measure of the purchase of long-term assets, where the purchaser is aiming to gain a lasting interest/profit in a company or increasing value in another economy.
real assets: property, factories, office buildings financial assets: business, stocks/shares in business
- Portfolio investment: a measure of stock and bond purchases, which are not direct investment since they do not lead to a lasting interest in a company. (short term)
- Reserve assets: the reserves of gold and foreign currencies which all countries hold and which are itemized in the official reserve account. It is movements into and out of this account that ensure that the balance of payments will always balance to zero.
gold, foreign currencies, foreign government bonds
- Official borrowing
Net errors and omissions
The balance of payments as a whole must always balance. This is because any credit item has to be matched by a corresponding debit item. In practice, however, with so many transactions involved, it is difficult to keep an accurate record. Some mistakes are likely to be made and some transactions may not be included. To compensate for this, a net errors and omissions figure (balancing item) is included.
Calculate the following balances
- Current account = (goods X – goods M) + (services X – services M) + net income + net current transfers
- Capital account = capital transfers + transaction in non-produced, non-financial assets
- Financial account (excluding net change in official reserves) = direct investment + portfolio investment
- Net change in official reserve = – (CA balance + CpA balance + FA balance)
Current account = - (capital account + financial account+ errors and omissions) Current account + capital account + financial account + errors and omissions =0
Current account and financial account are interdependent
Capital and financial account are the opposite/inverse of Current Account. (BoP balances/sums to zero) Current account deficit can be countered by capital & financial account surplus.
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