Sri Sharada Institute Of I ndian Management - Research
SriSiim Foundation-Approved by AICTE
Plot No. 7, Phase-II, Institutional Area, Behind the Grand Hotel, Vasant
Kunj,
New Delhi – 110070
Tel.: 2612409090 / 91; Fax: 26124092
E-mail: [email protected]; Website: www.srisim.org
PROJECT REPORT
ON
INTERNATIONAL FINANCIAL MANAGEMENT
“BALANCE OF PAYMENT”
Submitted to: Submitted By:
Prof. Harpreet Singh
ACKNOWLEDGEMENT
We would like to take the opportunity for expressing our sincere thanks
and gratitude to prof. Harpreet Singh, SRISIIM, New Delhi for his
support and guidence in giving a detailed insight on Saturday
development day project and also imparting us with various knowledge
and skills required to make the project report happen.
Balance Of Payments - BOP
What Does Balance Of Payments - BOP Mean?
A record of all transactions made between one particular country and all
other countries during a specified period of time. BOP compares the
dollar difference of the amount of exports and imports, including all
financial exports and imports. A negative balance of payments means that
more money is flowing out of the country than coming in, and vice versa.
Balance Of Payments - BOP
Balance of payments may be used as an indicator of economic and
political stability. For example, if a country has a consistently positive
BOP, this could mean that there is significant foreign investment within
that country. It may also mean that the country does not export much of
its currency.
This is just another economic indicator of a country's relative value and,
along with all other indicators, should be used with caution. The BOP
includes the trade balance, foreign investments and investments by
foreigners.
A balance of payments (BOP) sheet is an accounting record of all
monetary transactions between a country and the rest of the world. These
transactions include payments for the country's exports and imports of
goods, services, and financial capital, as well as financial transfers. The
BOP summarises international transactions for a specific period, usually a
year, and is prepared in a single currency, typically the domestic currency
for the country concerned. Sources of funds for a nation, such as exports
or the receipts of loans and investments, are recorded as positive or
surplus items. Uses of funds, such as for imports or to invest in foreign
countries, are recorded as a negative or deficit item.
When all components of the BOP sheet are included it must balance –
that is, it must sum to zero – there can be no overall surplus or deficit. For
example, if a country is importing more than it exports, its trade balance
will be in deficit, but the shortfall will have to be counter balanced in
other ways – such as by funds earned from its foreign investments, by
running down reserves or by receiving loans from other countries.
While the overall BOP sheet will always balance when all types of
payments are included, imbalances are possible on individual elements of
the BOP, such as the current account. This can result in surplus countries
accumulating hoards of wealth, while deficit nations become increasingly
indebted. Historically there have been different approaches to the
question of how to correct imbalances and debate on whether they are
something governments should be concerned about. With record
imbalances held up as one of the contributing factors to the financial
crisis of 2007–2010, plans to address global imbalances are now high on
the agenda of policy makers for 2010.
Composition of the balance of payments sheet
Since 1974, the two principal divisions on the BOP have been the current
account and the capital account.
The current account shows the net amount a country is earning if it is in
surplus, or spending if it is in deficit. It is the sum of the balance of trade
(net earnings on exports – payments for imports) , factor income
(earnings on foreign investments – payments made to foreign investors)
and cash transfers. Its called the current account as it covers transactions
in the "here and now" - those that don't give rise to future claims.
The capital account records the net change in ownership of foreign
assets. It includes the reserve account (the international operations of a
nation's central bank), along with loans and investments between the
country and the rest of world (but not the future regular repayments /
dividends that the loans and investments yield, those are earnings and will
be recorded in the current account).
Expressed with the standard meaning for the capital account, the BOP
identity is:
The balancing item is simply an amount that accounts for any statistical
errors and make sure the current and capital accounts sum to zero. At
high level, by the principles of double entry accounting, an entry in the
current account gives rise to an entry in the capital account, and in
aggregate the two accounts should balance. A balance isn't always
reflected in reported figures, which might, for example, report a surplus
for both accounts, but when this happens it always means something has
been missed—most commonly, the operations of the country's central
bank.
[3]
An actual balance sheet will typically have numerous sub headings under
the principal divisions. For example, entries under Current account
might include:
? Trade – buying and selling of goods and services
o Exports – a credit entry
o Imports – a debit entry
? Trade balance – the sum of Exports and Imports
? Factor income – repayments and dividends from loans and
investments
o Factor earnings – a credit entry
o Factor payments – a debit entry
? Factor income balance – the sum of earnings and
payments.
Especially in older balance sheets, a common division was between
visible and invisible entries. Visible trade recorded imports and exports of
physical goods (entries for trade in physical goods excluding services is
now often called the merchandise balance). Invisible trade would record
international buying and selling of services, and sometimes would be
grouped with transfer and factor income as invisible earnings.
Discrepancies in the use of term "balance of payments"
According to economics writer J. Orlin Grabbe the term Balance of
Payments is sometimes misused by people who aren't aware of the
accepted meaning, not only in general conversation but in financial
publications and the economic literature.
A common source of confusion is to exclude the reserve account entry
which records the activity of the nation's central bank. Once this is done,
the BOP can be in surplus (which implies the central bank is building up
foreign exchange reserves) or in deficit (which implies the central bank is
running down its reserves or borrowing from abroad ) The term can also
be misused to mean just relatively narrow parts of the BOP such as the
trade deficit, which means excluding parts of the current account and the
entire capital account. Another cause of confusion is the different naming
conventions in use. Before 1973 there was no standard way to break
down the BOP sheet, with the separation into invisible and visible
payments sometimes being the principal divisions. The IMF have their
own standards for the BOP sheet, at high level it's the same as the
standard definition, but it has different nomenclature, in particular with
respect to the meaning given to the term capital account.
The IMF definition
The IMF use a particular set of definitions for the BOP, which is also
used by the OECD , and the United Nations' SNA
The main difference with the IMF definition is that they use the term
financial account to capture transactions that in the standard definition
are recorded in the capital account. The IMF do use the term capital
account, to designate a subset of transactions that according to usage
common in the rest of the world form a small part of the overall capital
account. The IMF separate these transaction out to form an additional top
level division of the BOP sheet. Expressed with the IMF definition, the
BOP identity can be written:
The IMF use the term current account with the same meaning as the
standard definition, although they have their own names for their three
leading sub divisions, which are:
? The goods and services account (the overall trade balance)
? The primary income account (factor income such as from loans and
investments)
? The secondary income account (transfer payments)
Imbalances
The US dollar has been the leading reserve asset since the end of the gold
standard.
While the BOP has to balance overall, surpluses or deficits on its
individual elements can lead to imbalances between countries. In general
there is concern over deficits in the current account. Countries with
deficits in their current accounts will build up increasing debt and/or see
increased foreign ownership of their assets. The types of deficits that
typically raise concern are
? A visible trade deficit where a nation is importing more physical
goods than it exports (even if this is balanced by the other
components of the current account.)
? An overall current account deficit.
? A basic deficit which is the current account plus foreign direct
investment (but excluding other elements of the capital account like
short terms loans and the reserve account.)
As discussed in the history section below, the Washington Consensus
period saw a swing of opinion towards the view that there is no need to
worry about imbalances. Opinion swung back in the opposite direction in
the wake of financial crisis of 2007–2009. Mainstream opinion expressed
by the leading financial press and economists, international bodies like
the IMF—as well as leaders of surplus and deficit countries—has
returned to the view that large current account imbalances do matter.
Some economists do, however, remain relatively unconcerned about
imbalances and there have been assertions, such as by Michael P. Dooley,
David Folkerts-Landau and Peter Garber , that nations need to avoid
temptation to switch to protectionism as a means to correct imbalances.
Causes of BOP imbalances
There are conflicting views as to the primary cause of BOP imbalances,
with much attention on the US which currently has by far the biggest
deficit. The conventional view is that current account factors are the
primary cause - these include the exchange rate, the government's fiscal
deficit, business competitiveness , and private behaviour such as the
willingness of consumers to go into debt to finance extra consumption.
An alternative view, argued at length in a 2005 paper by Ben Bernanke ,
is that the primary driver is the capital account, where a global savings
glut caused by savers in surplus countries, runs ahead of the available
investment opportunities, and is pushed into the US resulting in excess
consumption and asset price inflation.
[13]
Reserve asset
In the context of BOP and international monetary systems, the reserve
asset is the currency or other store of value that is primarily used by
nations for their foreign reserves.BOP imbalances tend to manifest as
hoards of the reserve asset being amassed by surplus countries, with
deficit countries building debts denominated in the reserve asset or at
least depleting their supply. Under a gold standard, the reserve asset for
all members of the standard is gold. In the Bretton Woods system , either
gold or the US Dollar could serve as the reserve asset, though its smooth
operation depended on countries apart from the US choosing to keep most
of their holdings in dollars.
Following the ending of Bretton Woods, there has been no de jure reserve
asset, but the US dollar has remained by far the principal de facto reserve.
Global reserves rose sharply in the first decade of the 21st century, partly
as a result of the 1997 Asian Financial Crisis, where several nations ran
out of foreign currency needed for essential imports and thus had to
accept deals on unfavourable terms. The IMF estimate that between 2000
to mid-2009, official reserves rose from $1,900bn to $6,800bn. Global
reserves had peaked at about $7,500bn in mid 2008, then declined by
about $500 as countries without their own reserve currency used them to
shield themselves from the worst effects of the financial crisis. From Feb
2009 global reserves began increasing again to reach approximatley
$8,400bn by May 2010.
[16]
As of 2009 approx 65% of the world's $6,800bn total is held in US
dollars, with approx 25% in Euro. The UK Pound , Japanese yen, IMF
SDRs , and precious metal, also play a role. In 2009 Zhou Xiaochuan ,
governor of the People's Bank of China , proposed a gradual move
towards increased use of SDRs, and also for the national currencies
backing SDRs to be expanded to include the currencies of all major
economies. Dr Zhou's proposal has been described as one of the most
significant ideas expressed in 2009.
While the current central role of the dollar does give the US some
advantages such as lower cost of borrowings, it also contributes to the
pressure causing the US to run a current account deficit, due to the Triffin
dilemma . In a November 2009 article published in Foreign Affairs
magazine, economist C. Fred Bergsten argued that Dr Zhou's suggestion
or a similar change to the international monetary system would be in the
United States' best interests as well as the rest of the world's. Since 2009
there has been a notable increase in the number of new bilateral
agreements which enable international trades to be transacted using a
currency that isn't a traditional reserve asset, such as the renminbi, as the
Settlement currency.
Balance of payments crisis
A BOP crisis, also called a currency crisis, occurs when a nation is
unable to pay for essential imports and/or service its debt repayments.
Typically, this is accompanied by a rapid decline in the value of the
affected nation's currency. Crises are generally preceded by large capital
inflows, which are associated at first with rapid economic growth.
However a point is reached where overseas investors become concerned
about the level of debt their inbound capital is generating, and decide to
pull out their funds. The resulting outbound capital flows are associated
with a rapid drop in the value of the affected nation's currency. This
causes issues for firms of the affected nation who have received the
inbound investments and loans, as the revenue of those firms is typically
mostly derived domestically but their debts are often denominated in a
reserve currency. Once the nation's government has exhausted its foreign
reserves trying to support the value of the domestic currency, its policy
options are very limited. It can raise its interest rates to try to prevent
further declines in the value of its currency, but while this can help those
with debts in denominated in foreign currencies, it generally further
depresses the local economy.
Balancing mechanisms
One of the three fundamental functions of an international monetary
system is to provide mechanisms to correct imbalances.
Broadly speaking, there are three possible methods to correct BOP
imbalances, though in practice a mixture including some degree of at
least the first two methods tends to be used. These methods are
adjustments of exchange rates; adjustment of a nations internal prices
along with its levels of demand; and rules based adjustment. Improving
productivity and hence competitiveness can also help, as can increasing
the desirability of exports through other means, though it is generally
assumed a nation is always trying to develop and sell its products to the
best of its abilities.
Rebalancing by changing the exchange rate
An upwards shift in the value of a nation's currency relative to others will
make a nation's exports less competitive and make imports cheaper and
so will tend to correct a current account surplus. It also tends to make
investment flows into the capital account less attractive so will help with
a surplus there too. Conversely a downward shift in the value of a nation's
currency makes it more expensive for its citizens to buy imports and
increases the competitiveness of their exports, thus helping to correct a
deficit (though the solution often doesn't have a positive impact
immediately due to the Marshall–Lerner condition.
Exchange rates can be adjusted by government
in a rules based or
managed currency regime, and when left to float freely in the market they
also tend to change in the direction that will restore balance. When a
country is selling more than it imports, the demand for its currency will
tend to increase as other countries ultimately need the selling country's
currency to make payments for the exports. The extra demand tends to
cause a rise of the currency's price relative to others. When a country is
importing more than it exports, the supply of its own currency on the
international market tends to increase as it tries to exchange it for foreign
currency to pay for its imports, and this extra supply tends to cause the
price to fall. BOP effects are not the only market influence on exchange
rates however, they are also influenced by differences in national interest
rates and by speculation.
Rebalancing by adjusting internal prices and demand
When exchange rates are fixed by a rigid gold standard, or when
imbalances exist between members of a currency union such as the
Eurozone, the standard approach to correct imbalances is by making
changes to the domestic economy. To a large degree, the change is
optional for the surplus country, but compulsory for the deficit country. In
the case of a gold standard, the mechanism is largely automatic. When a
country has a favourable trade balance, as a consequence of selling more
than it buys it will experience a net inflow of gold. The natural effect of
this will be to increase the money supply, which leads to inflation and an
increase in prices, which then tends to make its goods less competitive
and so will decrease its trade surplus. However the nation has the option
of taking the gold out of economy (sterilising the inflationary effect) thus
building up a hoard of gold and retaining its favourable balance of
payments. On the other hand, if a country has an adverse BOP its will
experience a net loss of gold, which will automatically have a
deflationary effect, unless it chooses to leave the gold standard. Prices
will be reduced, making its exports more competitive, and thus correcting
the imbalance. While the gold standard is generally considered to have
been successful up until 1914, correction by deflation to the degree
required by the large imbalances that arose after WWI proved painful,
with deflationary policies contributing to prolonged unemployment but
not re-establishing balance. Apart from the US most former members had
left the gold standard by the mid 1930s.
A possible method for surplus countries such as Germany to contribute to
re-balancing efforts when exchange rate adjustment is not suitable, is to
increase its level of internal demand (i.e. its spending on goods). While a
current account surplus is commonly understood as the excess of earnings
over spending, an alternative expression is that it is the excess of savings
over investment. That is:
where CA = current account, NS = national savings (private plus
government sector), NI = national investment.
If a nation is earning more than it spends the net effect will be to build up
savings, except to the extent that those savings are being used for
investment. If consumers can be encouraged to spend more instead of
saving; or if the government runs a fiscal deficit to offset private savings;
or if the corporate sector divert more of their profits to investment, then
any current account surplus will tend to be reduced. However in 2009
Germany amended its constitution to prohibit running a deficit greater
than 0.35% of its GDP and calls to reduce its surplus by increasing
demand have not been welcome by officials, adding to fears that the
2010s will not be an easy decade for the eurozone. In their April 2010
world economic outlook report, the IMF presented a study showing how
with the right choice of policy options governments can transition out of a
sustained current account surplus with no negative effect on growth and
with a positive impact on unemployment.
Rules based rebalancing mechanisms
Nations can agree to fix their exchange rates against each other, and then
correct any imbalances that arise by rules based and negotiated exchange
rate changes and other methods. The Bretton Woods system of fixed but
adjustable exchange rates was an example of a rules based system, though
it still relied primarily on the two traditional mechanisms. Keynes, one of
the architects of the Bretton Woods system had wanted additional rules to
encourage surplus countries to share the burden of rebalancing, as he
argued that they were in a stronger position to do so and as he regarded
their surpluses as negative externalities imposed on the global economy.
Keynes suggested that traditional balancing mechanisms should be
supplemented by the threat of confiscation of a portion of excess revenue
if the surplus country did not choose to spend it on additional imports.
However his ideas were not accepted by the Americans at the time. In
2008 and 2009, American economist Paul Davidson had been promoting
his revamped form of Keynes's plan as a possible solution to global
imbalances which in his opinion would expand growth all round with out
the downside risk of other rebalancing methods.
History of balance of payments issues
Historically, accurate balance of payments figures were not generally
available. However, this did not prevent a number of switches in opinion
on questions relating to whether or not a nations government should use
policy to encourage a favourable balance.
Pre-1820: Mercantilism
Up until the early 19th century, measures to promote a trade surplus such
as tariffs were generally favoured. Power was associated with wealth, and
with low levels of growth, nations were best able to accumulate funds
either by running trade surpluses or by forcefully confiscating the wealth
of others. From about the 16th century, Mercantilism was a prevalent
theory influencing European rulers, who sometimes strove to have their
countries out sell competitors and so build up a "war chest" of gold.
[42][43]
This era saw low levels of economic growth; average global per capita
income is not considered to have significantly risen in the whole 800
years leading up to 1820, and is estimated to have increased on average
by less than 0.1% per year between 1700 - 1820. With very low levels of
financial integration between nations and with international trade
generally making up a low proportion of individual nations GDP, BOP
crises were very rare.
1820–1914: Free trade
Gold was the primary reserve asset during the gold standard era.
From the late 18th century, mercantilism was challenged by the ideas of
Adam Smith and other economic thinkers favouring free trade. After
victory in the Napoleonic wars Great Britain began promoting free trade,
unilaterally reducing her trade tariffs. Hoarding of gold was no longer
encouraged, and in fact Britain exported more capital as a percentage of
her national income than any other creditor nation has since. Great
Britain's capital exports further helped to correct global imbalances as
they tended to be counter cyclical, rising when Britain's economy went
into recession, thus compensating other states for income lost from export
of goods.
According to historian Carroll Quigley, Great Britain could afford to act
benevolently in the 19th century due to the advantages of her
geographical location, her naval power and her economic ascendancy as
the first nation to enjoy an industrial revolution. A view advanced by
economists such as Barry Eichengreen is that the first age of
Globalization began with the laying of transatlantic cables in the 1860s,
which facilitated a rapid increase in the already growing trade between
Britain and America.
Though Current Account controls were still widely used (in fact all
industrial nations apart from Great Britain and the Netherlands actually
increased their tariffs and quotas in the decades leading up to 1914,
though this was motivated more by a desire to protect "infant industries"
than to encourage a trade surplus) , capital controls were largely absent,
and people were generally free to cross international borders without
requiring passports.
A gold standard enjoyed wide international participation especially from
1870, further contributing to close economic integration between nations.
The period saw substantial global growth, in particular for the volume of
international trade which grew tenfold between 1820–1870 and then by
about 4% annually from 1870 to 1914. BOP crises began to occur, though
less frequently than was to be the case for the remainder of the 20th
century. From 1880 - 1914, there were approximately 8 BOP crises and 8
twin crises - a twin crises being a BOP crises that coincides with a
banking crises.
[edit] 1914–1945: Deglobalisation
The favourable economic conditions that had prevailed up until 1914
were shattered by the first world war, and efforts to re-establish them in
the 1920s were not successful. Several countries rejoined the gold
standard around 1925. But surplus countries didn't "play by the rules",
sterilising gold inflows to a much greater degree than had been the case in
the pre-war period. Deficit nations such as Great Britain found it harder to
adjust by deflation as workers were more enfranchised and unions in
particular were able to resist downwards pressure on wages. During the
great depression most countries abandoned the gold standard, but
imbalances remained an issue and international trade declined sharply.
There was a return to mercantilist type "beggar thy neighbour" policies,
with countries competitively devaluing their exchange rates, thus
effectively competing to export unemployment. There were
approximately 16 BOP crises and 15 twin crises (and a comparatively
very high level of banking crises.
1945–1971: Bretton Woods
Following World War II, the Bretton Woods institutions (the
International Monetary Fund and World Bank) were set up to support an
international monetary system designed to encourage free trade while also
offer states options to correct imbalances without having to deflate their
economies. Fixed but flexible exchange rates were established, with the
system anchored by the dollar which alone remained convertible into
gold, The Bretton Woods system ushered in a period of high global
growth, known as the Golden Age of Capitalism, however it came under
pressure due to the inability or unwillingness of governments to maintain
effective capital controls and due to instabilities related to the central role
of the dollar.
Imbalances caused gold to flow out of the US and a loss of confidence in
the United States ability to supply gold for all future claims by dollar
holders resulted in escalating demands to convert dollars, ultimately
causing the US to end the convertibility of the dollar into gold, thus
ending the Bretton Woods system.
[23]
The 1945 - 71 era saw
approximately 24 BOP crises and no twin crises for advanced economies,
with emerging economies seeing 16 BOP crises and just one twin
crises.
[23]
1971–2009: Transition, Washington Consensus, Bretton Woods II
Manmohan Singh, currently PM of India, showed that the challenges
caused by imbalances can be an opportunity when he led his country's
successful economic reform programme after the 1991 crisis.
The Bretton Woods system came to an end between 1971 and 1973.
There were attempts to repair the system of fixed exchanged rates over
the next few years, but these were soon abandoned, as were determined
efforts for the US to avoid BOP imbalances. Part of the reason was
displacement of the previous dominant economic paradigm –
Keynesianism – by the Washington Consensus, with economists and
economics writers such as Murray Rothbard and Milton Friedman
arguing that there was no great need to be concerned about BOP issues.
According to Rothbard:
Fortunately, the absurdity of worrying about the balance of payments is
made evident by focusing on inter-state trade. For nobody worries about
the balance of payments between New York and New Jersey, or, for that
matter, between Manhattan and Brooklyn, because there are no customs
officials recording such trade and such balances.
In the immediate aftermath of the Bretton Woods collapse, countries
generally tried to retain some control over their exchange rate by
independently managing it, or by intervening in the Forex as part of a
regional bloc, such as the Snake which formed in 1971. The Snake was a
group of European countries who tried to retain stable rates at least with
each other; the group eventually evolved into the ERM by 1979. From the
mid 1970s however, and especially in the 1980s and early 90s, many
other countries followed the US in liberalising controls on both their
capital and current accounts, in adopting a somewhat relaxed attitude to
their balance of payments and in allowing the value of their currency to
float relatively freely with exchange rates determined mostly by the
market.
Developing countries who chose to allow the market to determine their
exchange rates would often develop sizeable current account deficits,
financed by capital account inflows such as loans and investments,
though this often ended in crises when investors lost confidence. The
frequency of crises was especially high for developing economies in this
era - from 1973–1997 emerging economies suffered 57 BOP crises and
21 twin crises. Typically but not always the panic among foreign
creditors and investors that preceded the crises in this period was usually
triggered by concerns over excess borrowing by the private sector, rather
than by a government deficit. For advanced economies, there were 30
BOP crises and 6 banking crises.
A turning point was the 1997 Asian BOP Crisis, where unsympathetic
responses by western powers caused policy makers in emerging
economies to re-assess the wisdom of relying on the free market; by 1999
the developing world as a whole stopped running current account deficits
while the US current account deficit began to rise sharply. This new form
of imbalance began to develop in part due to the increasing practice of
emerging economies, principally China, in pegging their currency against
the dollar, rather than allowing the value to freely float. The resulting
state of affairs has been referred to as Bretton Woods II. According to
economics writer Martin Wolf, in the eight years leading up to 2007,
"three quarters of the foreign currency reserves accumulated since the
beginning of time have been piled up". In contrast to the changed
approach within the emerging economies, US policy makers and
economists remained relatively unconcerned about BOP imbalances. In
the early to mid naughties, many free market economists and policy
makers such as US Treasury secretary Paul O'Neill and Fed Chairman
Alan Greenspan went on record suggesting the growing US deficit was
not a major concern. While several emerging economies had intervening
to boost their reserves and assist their exporters from the late 1980s, they
only began running a net current account surplus after 1999. This was
mirrored in the faster growth for the US current account deficit from the
same year, with surpluses, deficits and the associated build up of reserves
by the surplus countries reaching record levels by the early 2000s and
growing year by year. Some economists such as Kenneth Rogoff and
Maurice Obstfeld began warning that the record imbalances would soon
need to be addressed from as early as 2001, joined by Nouriel Roubini in
2004, but it wasnt until about 2007 that their concerns began to be
accepted by the majority of economists.
2009 and later: Post Washington Consensus
Speaking after the 2009 G-20 London summit , Gordon Brown
announced "the Washington Consensus is over". There is now broad
agreement that large imbalances between different countries do matter;
for example mainstream US economist C. Fred Bergsten has argued the
US deficit and the associated large inbound capital flows into the US was
one of the causes of the financial crisis of 2007–2010. Since the crisis,
government intervention in BOP areas such as the imposition of capital
controls or forex intervention has become more common and in general
attracts less disapproval from economists, international institutions like
the IMF and other governments.
In 2007 when the crises began, the global total of yearly BOP imbalances
was $1680bn. On the credit side, the biggest current account surplus was
China with approx. $362Bn, followed by Japan at $213Bn and Germany
at £185BN, with oil producing countries such as Saudi Arabia also having
large surpluses. On the debit side, the US had the biggest current account
deficit at over £700Bn, with the UK, Spain and Australia together
accounting for close to a further $300Bn.
While there have been warnings of future cuts in public spending, deficit
countries on the whole did not make these in 2009, in fact the opposite
happened with increased public spending contributing to recovery as part
of global efforts to increase demand . The emphases has instead been on
the surplus countries, with the IMF, EU and nations such as the US,
Brazil and Russia asking them to assist with the adjustments to correct the
imbalances.
Economists such as Gregor Irwin and Philip R. Lane have suggested that
increased use of pooled reserves could help emerging economies not to
require such large reserves and thus have less need for current account
surpluses. Writing for the FT in Jan 2009, Gillian Tett says she exspects
to see policy makers becoming increasingly concerned about exchange
rates over the coming year.
[65]
In June 2009, Olivier Blanchard the chief
economist of the IMF wrote that rebalancing the world economy by
reducing both sizeable surpluses and deficits will be a requirement for
sustained recovery.
2008 and 2009 did see some reduction in imbalances, but early
indications towards the end of 2009 were that major imbalances such as
the US current account deficit are set to begin increasing again.
[9]
[67]
Japan had allowed her currency to appreciate through 2009, but has only
limited scope to contribute to the rebalancing efforts thanks in part to her
aging population. The Euro used by Germany is allowed to float fairly
freely in value, however further appreciation would be problematic for
other members of the currency union such as Spain, Greece and Ireland
who run large deficits. Therefore Germany has instead been asked to
contribute by further promoting internal demand, but this hasn't been
welcomed by German officials.
[62]
China has been requested to allow the Renminbi to appreciate but until
2010 had refused, the position expressed by her premier Wen Jiabao
being that by keeping the value of the Renmimbi stable against the dollar
China has been helping the global recovery, and that calls to let her
currency rise in value have been motivated by a desire to hold back
China's development.
[63]
After China reported favourable results for her
December 2009 exports however, the Financial Times reported that
analysts are optimistic that China will allow some appreciation of her
currency around mid 2010.
[68]
In April 2010 a Chinese official signalled the government is considering
allowing the renminbi to appreciate,
[69]
but by May analysts were widely
reporting the appreciation would likely be delayed due to the falling value
of the Euro following the 2010 European sovereign debt crisis.
[70]
China
announced the end of the renminbi's peg to the dollar in June 2010; the
move was widely welcomed by markets and helped defuse tension over
imbalances prior to the 2010 G-20 Toronto summit. However the
renminbi remains managed and the new flexibility means it can move
down as well as up in value; two months after the peg ended the renminbi
had only appreciated against the dollar by about 0.8%.
[71]
While some leading surplus countries including China have been taking
steps to boost domestic demand, these have not yet been sufficient to
rebalance out of their current account surpluses. By June 2010, the US
monthly current account deficit had risen back to $50 Billion, a level not
seen since mid 2008. With the US currently suffering from high
unemployment and concerned about taking on additional debt, fears are
rising that the US may resort to protectionist measures.
[72]
The balance of payments (BOP) is the place where countries record their
monetary transactions with the rest of the world. Transactions are either
marked as a credit or a debit. Within the BOP there are three separate
categories under which different transactions are categorized: the current
account, the capital account and the financial account. In the current
account, goods, services, income and current transfers are recorded. In the
capital account, physical assets such as a building or a factory are
recorded. And in the financial account, assets pertaining to international
monetary flows of, for example, business or portfolio investments, are
noted. In this article, we will focus on analyzing the current account and
how it reflects an economy's overall position. (For background reading,
see What Is The Balance Of Payments?)
The Current Account
The balance of the current account tells us if a country has a deficit or a
surplus. If there is a deficit, does that mean the economy is weak? Does a
surplus automatically mean that the economy is strong? Not necessarily.
But to understand the significance of this part of the BOP, we should start
by looking at the components of the current account: goods, services,
income and current transfers.
1. Goods - These are movable and physical in nature, and in order for
a transaction to be recorded under "goods", a change of ownership
from/to a resident (of the local country) to/from a non-resident (in a
foreign country) has to take place. Movable goods include general
merchandise, goods used for processing other goods, and non-
monetary gold. An export is marked as a credit (money coming in)
and an import is noted as a debit (money going out).
2. Services - These transactions result from an intangible action such
as transportation, business services, tourism, royalties or licensing.
If money is being paid for a service it is recorded like an import (a
debit), and if money is received it is recorded like an export
(credit).
3. I ncome - Income is money going in (credit) or out (debit) of a
country from salaries, portfolio investments (in the form of
dividends, for example), direct investments or any other type of
investment. Together, goods, services and income provide an
economy with fuel to function. This means that items under these
categories are actual resources that are transferred to and from a
country for economic production.
4. Current Transfers - Current transfers are unilateral transfers with
nothing received in return. These include workers' remittances,
donations, aids and grants, official assistance and pensions. Due to
their nature, current transfers are not considered real resources that
affect economic production.
Now that we have covered the four basic components, we need to look at
the mathematical equation that allows us to determine whether the current
account is in deficit or surplus (whether it has more credit or debit). This
will help us understand where any discrepancies may stem from, and how
resources may be restructured in order to allow for a better functioning
economy.
The following variables go into the calculation of the current account
balance (CAB):
X = Exports of goods and services
M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers
The formula is:
CAB = X - M + NY + NCT
What Does It Tell Us?
Theoretically, the balance should be zero, but in the real world this is
improbable, so if the current account has a deficit or a surplus, this tells
us something about the state of the economy in question, both on its own
and in comparison to other world markets.
A surplus is indicative of an economy that is a net creditor to the rest of
the world. It shows how much a country is saving as opposed to
investing. What this means is that the country is providing an abundance
of resources to other economies, and is owed money in return. By
providing these resources abroad, a country with a CAB surplus gives
other economies the chance to increase their productivity while running a
deficit. This is referred to as financing a deficit.
A deficit reflects an economy that is a net debtor to the rest of the world.
It is investing more than it is saving and is using resources from other
economies to meet its domestic consumption and investment
requirements. For example, let us say an economy decides that it needs to
invest for the future (to receive investment income in the long run), so
instead of saving, it sends the money abroad into an investment project.
This would be marked as a debit in the financial account of the balance of
payments at that period of time, but when future returns are made, they
would be entered as investment income (a credit) in the current account
under the income section. (For more insight, read Current Account
Deficits.)
A current account deficit is usually accompanied by depletion in foreign-
exchange assets because those reserves would be used for investment
abroad. The deficit could also signify increased foreign investment in the
local market, in which case the local economy is liable to pay the foreign
economy investment income in the future.
It is important to understand from where a deficit or a surplus is
stemming because sometimes looking at the current account as a whole
could be misleading.
Analyzing the Current Account
Exports imply demand for a local product while imports point to a need
for supplies to meet local production requirements. As export is a credit
to a local economy while an import is a debit, an import means that the
local economy is liable to pay a foreign economy. Therefore a deficit
between exports and imports (goods and services combined) - otherwise
known as a balance of trade deficit (more imports than exports) - could
mean that the country is importing more in order to increase its
productivity and eventually churn out more exports. This in turn could
ultimately finance and alleviate the deficit.
A deficit could also stem from a rise in investments from abroad and
increased obligations by the local economy to pay investment income (a
debit under income in the current account). Investments from abroad
usually have a positive effect on the local economy because, if used
wisely, they provide for increased market value and production for that
economy in the future. This can allow the local economy eventually to
increase exports and, again, reverse its deficit.
Conclusion
The volume of a country's current account is a good sign of economic
activity. By scrutinizing the four components of it, we can get a clear
picture of the extent of activity of a country's industries, capital market,
services and the money entering the country from other governments or
through remittances. However, depending on the nation's stage of
economic growth, its goals, and of course the implementation of its
economic program, the state of the current account is relative to the
characteristics of the country in question. But when analyzing a current
account deficit or surplus, it is vital to know what is fueling the extra
credit or debit and what is being done to counter the effects (a surplus
financed by a donation may not be the most prudent way to run an
economy). On a separate note, the current account also highlights what is
traded with other countries, and it is a good reflection of each nation's
comparative advantage in the global economy.
Understanding Capital And Financial Accounts In The Balance Of
Payments
• The current account, the capital account and the financial account
make up a country's balance of payments (BOP). Together these
three accounts tell a story about the state of an economy, its
economic outlook and its strategies for achieving its desired goals.
A large volume of imports and exports, for example, can indicate
an open economy that supports free trade. On the other hand, a
country that shows little international activity in its capital or
financial account may have an underdeveloped capital market and
little foreign currency entering the country in the form of foreign
direct investment. (For an overview of how each of these accounts
functions, see What Is The Balance Of Payments? and
Understanding The Current Account In The Balance Of Payments.)
Here we focus on the capital and financial accounts, which tell the
story of investment and capital market regulations within a given
country.
The Capital and Financial Accounts
Along with transactions pertaining to non-financial and non-produced
assets, the capital account relates to dealings including debt forgiveness,
the transfer of goods and financial assets by migrants leaving or entering
a country, the transfer of ownership on fixed assets, the transfer of funds
received to the sale or acquisition of fixed assets, gift and inheritance
taxes, death levies, patents, copyrights, royalties and uninsured damage to
fixed assets.
Detailed in the financial account are government-owned assets (i.e.
special drawing rights at the International Monetary Fund (IMF) or
foreign reserves), private sector assets held in other countries, local assets
held by foreigners (government and private), foreign direct investment,
global monetary flows related to investment in business, real estate,
bonds and stocks.
Capital that is transferred out of a country for the purpose of investing is
recorded as a debit in either of these two accounts. This is because money
is leaving the economy. But because it is an investment, there is an
implied return. This return - whether a capital gain from portfolio
investment (a debit under the financial account) or a return made from
direct investment (a debit under the capital account) - is recorded as a
credit in the current account (this is where income investment is recorded
in the BOP). The opposite is true when a country receives capital: paying
a return on a said investment would be noted as a debit in the current
account.
What Does This Mean?
Theoretically, the BOP should be zero. Thus, the current account on one
side and the capital and financial account on the other should balance
each other out. When an economy, however, has positive capital and
financial accounts (a net financial inflow), the country's debits are more
than its credits (due to an increase in liabilities to other economies or a
reduction of claims in other countries). This is usually in parallel with a
current account deficit; an inflow of money means that the return on an
investment is a debit on the current account. Thus, the economy is using
world savings to meet its local investment and consumption demands. It
is a net debtor to the rest of the world.
If the capital and financial accounts are negative (a net financial outflow),
the country has more claims than it does liabilities either because of an
increase in claims by the economy abroad or a reduction in liabilities
from foreign economies. The current account should be recording a
surplus at this stage, indicating that the economy is a net creditor,
providing funds to the world.
Liberal Accounts
The capital and financial accounts are intertwined because they both
record international capital flows. In today's global economy, the
unrestricted movement of capital is fundamental to ensuring world trade
and eventually, according to theory, greater prosperity for all. For this to
happen, however, countries are required to have "open", or "liberal"
capital and financial account policies. Today, many developing
economies implement as part of their economic reform program (often in
conjunction with the IMF) "capital account liberalization", a process that
removes restrictions on capital movement. This unrestricted movement of
capital means that governments, corporations and individuals are free to
invest capital in other countries. This then paves the way not only for
more foreign direct investment (FDI) into industries and development
projects, but for portfolio investment in the capital market as well. Thus,
companies striving for bigger markets and smaller markets seeking
greater capital and domestic economic goals can expand into the
international arena, resulting in a stronger global economy.
The benefits the recipient country reaps from an FDI include an inflow of
foreign capital into its country as well as the sharing of technical and
managerial expertise. The benefits for a company making a FDI is the
ability to expand market share into a foreign economy, thus collecting
greater returns. Some have argued that even the country's domestic
political and macroeconomic policies become affected in a more
progressive fashion because foreign companies investing in a local
economy have a valued stake in the local economy's reform process.
These foreign companies become "expert consultants" to the local
government on policies that will facilitate businesses.
Portfolio foreign investments can encourage capital-market deregulation
and stock-exchange volumes. By investing in more than one market,
investors are able to diversify their portfolio risk while increasing their
returns, which result from investing in an emerging market. A deepening
capital market, based on a reforming local economy and a liberalization
of the capital and financial accounts, can thus speed up the development
of an emerging market.
Measures of Balance
As stated at the beginning of this monograph, analysts and government
officials are keenly interested in the balances shown by selected
combinations of balance-of-payments accounts. Three of these measures
are shown on lines 25 to 27 of the table.
The first and simplest of these measures is the balance on goods
and services, which is derived by computing the net excess of debits or
credits in those accounts. In our hypothetical statement there is a net debit
balance, or ?deficit,? of $20 million.
Such a debit balance, reflecting an excess of imports over exports,
indicates that the United States received more real resources (goods and
services) from other countries than it transferred to them during the
period
covered by the statement, while a credit balance would indicate the
reverse. The balance on goods and services is of interest not only as an
approximation of such net transfers of real resources but also because it is
defined in roughly the same way as the ??net exports of goods and
services‘‘
that comprise part of the nation‘s gross domestic product or expenditure.
The second measure, the balance on current account, is the net
excess of debits or credits in the accounts for goods, services, income,
and
unilateral transfers, that is, the balance on all accounts other than the
financial claims, or ?capital,? accounts. Because total debits must equal
total credits in the balance of payments, the balance on the current
accounts must equal the balance on the remaining, or capital, accounts
(except, of course, for the statistical discrepancy). Thus, the current-
account
balance is an approximation of the change in the net claims of U.S.
residents on the rest of the world; it is a major component of the change
in
the country‘s net international investment position, or ?net worth,? vis-a`
-vis
the rest of the world.
As a rule, it is more difficult to interpret the third measure,
?Transactions in U.S. official reserve assets and in foreign official assets
in
the United States.‘‘ From a simple accounting perspective, this balance
measures the difference between the change in U.S. official reserves and
the change in foreign official claims on the United States. A credit
balance,
such as that shown in the statement, indicates that foreign official claims
on
this country have risen more (or fallen less) than U.S. official reserve
assets,
while a debit balance would indicate the reverse. The description of
transaction 8 makes clear that this $25 million credit arose from central
bank
operations in support of the foreign-exchange value of the dollar. The
amount of this credit (support) along with any observed decline in the
foreign-exchange value of the dollar would then provide a joint indication
of the weakness of the dollar in the foreign-exchange markets during the
period in question.
Such interpretations require knowledge of the details of transactions
such as #8, and the details are often difficult to come by. For example,
foreign officials sometimes acquire dollar balances for investment or
reserve purposes rather than as a result of supporting the dollar. In such
cases dollar purchases by foreign central banks testify to the desirability
or
strength of the dollar in the foreign-exchange markets, rather than to its
weakness.
So, a deficit is not necessarily a bad thing for an economy, especially for
an economy in the developing stages or under reform: an economy
sometimes has to spend money to make money. To run a deficit
intentionally, however, an economy must be prepared to finance this
deficit through a combination of means that will help reduce external
liabilities and increase credits from abroad. For example, a current
account deficit that is financed by short-term portfolio investment or
borrowing is likely more risky. This is because a sudden failure in an
emerging capital market or an unexpected suspension of foreign
government assistance, perhaps due to political tensions, will result in an
immediate cessation of credit in the current account.
From Theory to Reality: a Little Control Can Be Good
Aside from political ideologies, some sound economic theories state
why some capital account control can be good. Recall the Asian
financial crises in 1997. Some Asian countries had opened up their
economies to the world, and an unprecedented amount of foreign
capital was crossing borders into these economies, mostly in the
form of portfolio investment (a financial account credit and a
current account debit). This meant that investments were short term
and easy to liquidate instead of more long term and harder to
dispose of quickly.
When speculation rose and panic spread throughout the region, the
first thing that happened was a reversal in capital flows: money was
now being pulled out of these capital markets. Asian economies
now had to pay their short-term liabilities (debits in the current
account) as securities were sold off before capital gains could be
reaped. Not only did stock market activity suffer, but foreign
reserves were depleted, local currencies depreciated and financial
crises set in.
Analysts argue that financial disaster may have been less severe had
there had been some capital account controls. For instance, had the
amount of foreign borrowing been limited (which is a debit in the
current account), short-term obligations would have been limited
and the damage to the economy could have been less severe.
One Step Forward, Two Steps Backward
Lessons from the Asian financial crises have resulted in new
debates about the best way to liberalize capital and financial
accounts. Indeed, the IMF and World Trade Organization have
historically supported free trade in goods and services (current
account liberalization) and are now faced with the complexities of
capital freedom. Experience has proven, however, that without any
controls a sudden reversal of capital flows can not only destroy an
economy, but can also result in increased poverty for a nation.
Effect on various factors due to Deficit in BOP statement
Persistent deficit in the BOP statement of a country indicates a
fundamental disequilibrium in the economy. This may be the cumulative
effect on the variety of factors such as
• Changes in consumer tastes in the country or abroad which reduces
the country‘s exports and increases its imports
• Low competitive strength in world market which adversely affects
exports
• Continuous fall in the country‘s foreign exchange to reserves due to
supply inelasticities of exports, and excessive demand for foreign
goods and services
• Inflationary pressures in the economy which make exports dearer
• Changes in the supply or direction of long-term capital flows
• GDP growth or decline which is likely to affect exports and imports
of a country
Other Items In The BOP Statement
The Balance of Payments statement has three more items, namely
• Errors and Omissions
• Overall Balance(total of Current and Capital Accounts and Errors
and Omissions)
• Monetary Movements
? IMF
? Foreign exchange reserves(increase/decrease)
Errors and Omissions
The large volume of statistical data required for the presentation of the
Balance of Payments statement is collected partly from official records
and partly on the basis of estimates. As a result, the total credits and total
debits are unlikely to match. There is likely to be some statistical
discrepancy in the BOP statement. This is recorded as ?Errors and
Omissions‘‘ in BOP statement
Overall Balance
Overall balance is arrived at by summing up all the items in the current
account , capital account and the errors and omissions figures. It is the net
balance between international receipt and payments of the country. The
Overall Balance may show deficit or surplus depending on whether the
total debits exceeds the total credits or vice versa
IMF
The IMF has created a reserve asset termed SDRs (Special Drawing
Rights) which are allocated to member countries. SDRs may be held as
reserves by member countries and used for settling international
payments between countries. A countries facing overall deficit in the
BOP statement may purchase SDRs from the IMF for meeting the deficit
Foreign Excahange Reserves
Foreign exchange reserves of countries include different types of assests
such as gold, foreign currencies, deposits of foreign currencies in foreign
central banks, investment in foreign government securities and SDR
holdings. These assests are held by the central bank for the purpose of
meeting intenational commitments arising from international transactions.
So when a country faces overall deficit in its BOP statement, it may use
its foreign exchange resereves to meet the deficits
doc_146324487.docx
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PROJECT REPORT
ON
INTERNATIONAL FINANCIAL MANAGEMENT
“BALANCE OF PAYMENT”
Submitted to: Submitted By:
Prof. Harpreet Singh
ACKNOWLEDGEMENT
We would like to take the opportunity for expressing our sincere thanks
and gratitude to prof. Harpreet Singh, SRISIIM, New Delhi for his
support and guidence in giving a detailed insight on Saturday
development day project and also imparting us with various knowledge
and skills required to make the project report happen.
Balance Of Payments - BOP
What Does Balance Of Payments - BOP Mean?
A record of all transactions made between one particular country and all
other countries during a specified period of time. BOP compares the
dollar difference of the amount of exports and imports, including all
financial exports and imports. A negative balance of payments means that
more money is flowing out of the country than coming in, and vice versa.
Balance Of Payments - BOP
Balance of payments may be used as an indicator of economic and
political stability. For example, if a country has a consistently positive
BOP, this could mean that there is significant foreign investment within
that country. It may also mean that the country does not export much of
its currency.
This is just another economic indicator of a country's relative value and,
along with all other indicators, should be used with caution. The BOP
includes the trade balance, foreign investments and investments by
foreigners.
A balance of payments (BOP) sheet is an accounting record of all
monetary transactions between a country and the rest of the world. These
transactions include payments for the country's exports and imports of
goods, services, and financial capital, as well as financial transfers. The
BOP summarises international transactions for a specific period, usually a
year, and is prepared in a single currency, typically the domestic currency
for the country concerned. Sources of funds for a nation, such as exports
or the receipts of loans and investments, are recorded as positive or
surplus items. Uses of funds, such as for imports or to invest in foreign
countries, are recorded as a negative or deficit item.
When all components of the BOP sheet are included it must balance –
that is, it must sum to zero – there can be no overall surplus or deficit. For
example, if a country is importing more than it exports, its trade balance
will be in deficit, but the shortfall will have to be counter balanced in
other ways – such as by funds earned from its foreign investments, by
running down reserves or by receiving loans from other countries.
While the overall BOP sheet will always balance when all types of
payments are included, imbalances are possible on individual elements of
the BOP, such as the current account. This can result in surplus countries
accumulating hoards of wealth, while deficit nations become increasingly
indebted. Historically there have been different approaches to the
question of how to correct imbalances and debate on whether they are
something governments should be concerned about. With record
imbalances held up as one of the contributing factors to the financial
crisis of 2007–2010, plans to address global imbalances are now high on
the agenda of policy makers for 2010.
Composition of the balance of payments sheet
Since 1974, the two principal divisions on the BOP have been the current
account and the capital account.
The current account shows the net amount a country is earning if it is in
surplus, or spending if it is in deficit. It is the sum of the balance of trade
(net earnings on exports – payments for imports) , factor income
(earnings on foreign investments – payments made to foreign investors)
and cash transfers. Its called the current account as it covers transactions
in the "here and now" - those that don't give rise to future claims.
The capital account records the net change in ownership of foreign
assets. It includes the reserve account (the international operations of a
nation's central bank), along with loans and investments between the
country and the rest of world (but not the future regular repayments /
dividends that the loans and investments yield, those are earnings and will
be recorded in the current account).
Expressed with the standard meaning for the capital account, the BOP
identity is:
The balancing item is simply an amount that accounts for any statistical
errors and make sure the current and capital accounts sum to zero. At
high level, by the principles of double entry accounting, an entry in the
current account gives rise to an entry in the capital account, and in
aggregate the two accounts should balance. A balance isn't always
reflected in reported figures, which might, for example, report a surplus
for both accounts, but when this happens it always means something has
been missed—most commonly, the operations of the country's central
bank.
[3]
An actual balance sheet will typically have numerous sub headings under
the principal divisions. For example, entries under Current account
might include:
? Trade – buying and selling of goods and services
o Exports – a credit entry
o Imports – a debit entry
? Trade balance – the sum of Exports and Imports
? Factor income – repayments and dividends from loans and
investments
o Factor earnings – a credit entry
o Factor payments – a debit entry
? Factor income balance – the sum of earnings and
payments.
Especially in older balance sheets, a common division was between
visible and invisible entries. Visible trade recorded imports and exports of
physical goods (entries for trade in physical goods excluding services is
now often called the merchandise balance). Invisible trade would record
international buying and selling of services, and sometimes would be
grouped with transfer and factor income as invisible earnings.
Discrepancies in the use of term "balance of payments"
According to economics writer J. Orlin Grabbe the term Balance of
Payments is sometimes misused by people who aren't aware of the
accepted meaning, not only in general conversation but in financial
publications and the economic literature.
A common source of confusion is to exclude the reserve account entry
which records the activity of the nation's central bank. Once this is done,
the BOP can be in surplus (which implies the central bank is building up
foreign exchange reserves) or in deficit (which implies the central bank is
running down its reserves or borrowing from abroad ) The term can also
be misused to mean just relatively narrow parts of the BOP such as the
trade deficit, which means excluding parts of the current account and the
entire capital account. Another cause of confusion is the different naming
conventions in use. Before 1973 there was no standard way to break
down the BOP sheet, with the separation into invisible and visible
payments sometimes being the principal divisions. The IMF have their
own standards for the BOP sheet, at high level it's the same as the
standard definition, but it has different nomenclature, in particular with
respect to the meaning given to the term capital account.
The IMF definition
The IMF use a particular set of definitions for the BOP, which is also
used by the OECD , and the United Nations' SNA
The main difference with the IMF definition is that they use the term
financial account to capture transactions that in the standard definition
are recorded in the capital account. The IMF do use the term capital
account, to designate a subset of transactions that according to usage
common in the rest of the world form a small part of the overall capital
account. The IMF separate these transaction out to form an additional top
level division of the BOP sheet. Expressed with the IMF definition, the
BOP identity can be written:
The IMF use the term current account with the same meaning as the
standard definition, although they have their own names for their three
leading sub divisions, which are:
? The goods and services account (the overall trade balance)
? The primary income account (factor income such as from loans and
investments)
? The secondary income account (transfer payments)
Imbalances
The US dollar has been the leading reserve asset since the end of the gold
standard.
While the BOP has to balance overall, surpluses or deficits on its
individual elements can lead to imbalances between countries. In general
there is concern over deficits in the current account. Countries with
deficits in their current accounts will build up increasing debt and/or see
increased foreign ownership of their assets. The types of deficits that
typically raise concern are
? A visible trade deficit where a nation is importing more physical
goods than it exports (even if this is balanced by the other
components of the current account.)
? An overall current account deficit.
? A basic deficit which is the current account plus foreign direct
investment (but excluding other elements of the capital account like
short terms loans and the reserve account.)
As discussed in the history section below, the Washington Consensus
period saw a swing of opinion towards the view that there is no need to
worry about imbalances. Opinion swung back in the opposite direction in
the wake of financial crisis of 2007–2009. Mainstream opinion expressed
by the leading financial press and economists, international bodies like
the IMF—as well as leaders of surplus and deficit countries—has
returned to the view that large current account imbalances do matter.
Some economists do, however, remain relatively unconcerned about
imbalances and there have been assertions, such as by Michael P. Dooley,
David Folkerts-Landau and Peter Garber , that nations need to avoid
temptation to switch to protectionism as a means to correct imbalances.
Causes of BOP imbalances
There are conflicting views as to the primary cause of BOP imbalances,
with much attention on the US which currently has by far the biggest
deficit. The conventional view is that current account factors are the
primary cause - these include the exchange rate, the government's fiscal
deficit, business competitiveness , and private behaviour such as the
willingness of consumers to go into debt to finance extra consumption.
An alternative view, argued at length in a 2005 paper by Ben Bernanke ,
is that the primary driver is the capital account, where a global savings
glut caused by savers in surplus countries, runs ahead of the available
investment opportunities, and is pushed into the US resulting in excess
consumption and asset price inflation.
[13]
Reserve asset
In the context of BOP and international monetary systems, the reserve
asset is the currency or other store of value that is primarily used by
nations for their foreign reserves.BOP imbalances tend to manifest as
hoards of the reserve asset being amassed by surplus countries, with
deficit countries building debts denominated in the reserve asset or at
least depleting their supply. Under a gold standard, the reserve asset for
all members of the standard is gold. In the Bretton Woods system , either
gold or the US Dollar could serve as the reserve asset, though its smooth
operation depended on countries apart from the US choosing to keep most
of their holdings in dollars.
Following the ending of Bretton Woods, there has been no de jure reserve
asset, but the US dollar has remained by far the principal de facto reserve.
Global reserves rose sharply in the first decade of the 21st century, partly
as a result of the 1997 Asian Financial Crisis, where several nations ran
out of foreign currency needed for essential imports and thus had to
accept deals on unfavourable terms. The IMF estimate that between 2000
to mid-2009, official reserves rose from $1,900bn to $6,800bn. Global
reserves had peaked at about $7,500bn in mid 2008, then declined by
about $500 as countries without their own reserve currency used them to
shield themselves from the worst effects of the financial crisis. From Feb
2009 global reserves began increasing again to reach approximatley
$8,400bn by May 2010.
[16]
As of 2009 approx 65% of the world's $6,800bn total is held in US
dollars, with approx 25% in Euro. The UK Pound , Japanese yen, IMF
SDRs , and precious metal, also play a role. In 2009 Zhou Xiaochuan ,
governor of the People's Bank of China , proposed a gradual move
towards increased use of SDRs, and also for the national currencies
backing SDRs to be expanded to include the currencies of all major
economies. Dr Zhou's proposal has been described as one of the most
significant ideas expressed in 2009.
While the current central role of the dollar does give the US some
advantages such as lower cost of borrowings, it also contributes to the
pressure causing the US to run a current account deficit, due to the Triffin
dilemma . In a November 2009 article published in Foreign Affairs
magazine, economist C. Fred Bergsten argued that Dr Zhou's suggestion
or a similar change to the international monetary system would be in the
United States' best interests as well as the rest of the world's. Since 2009
there has been a notable increase in the number of new bilateral
agreements which enable international trades to be transacted using a
currency that isn't a traditional reserve asset, such as the renminbi, as the
Settlement currency.
Balance of payments crisis
A BOP crisis, also called a currency crisis, occurs when a nation is
unable to pay for essential imports and/or service its debt repayments.
Typically, this is accompanied by a rapid decline in the value of the
affected nation's currency. Crises are generally preceded by large capital
inflows, which are associated at first with rapid economic growth.
However a point is reached where overseas investors become concerned
about the level of debt their inbound capital is generating, and decide to
pull out their funds. The resulting outbound capital flows are associated
with a rapid drop in the value of the affected nation's currency. This
causes issues for firms of the affected nation who have received the
inbound investments and loans, as the revenue of those firms is typically
mostly derived domestically but their debts are often denominated in a
reserve currency. Once the nation's government has exhausted its foreign
reserves trying to support the value of the domestic currency, its policy
options are very limited. It can raise its interest rates to try to prevent
further declines in the value of its currency, but while this can help those
with debts in denominated in foreign currencies, it generally further
depresses the local economy.
Balancing mechanisms
One of the three fundamental functions of an international monetary
system is to provide mechanisms to correct imbalances.
Broadly speaking, there are three possible methods to correct BOP
imbalances, though in practice a mixture including some degree of at
least the first two methods tends to be used. These methods are
adjustments of exchange rates; adjustment of a nations internal prices
along with its levels of demand; and rules based adjustment. Improving
productivity and hence competitiveness can also help, as can increasing
the desirability of exports through other means, though it is generally
assumed a nation is always trying to develop and sell its products to the
best of its abilities.
Rebalancing by changing the exchange rate
An upwards shift in the value of a nation's currency relative to others will
make a nation's exports less competitive and make imports cheaper and
so will tend to correct a current account surplus. It also tends to make
investment flows into the capital account less attractive so will help with
a surplus there too. Conversely a downward shift in the value of a nation's
currency makes it more expensive for its citizens to buy imports and
increases the competitiveness of their exports, thus helping to correct a
deficit (though the solution often doesn't have a positive impact
immediately due to the Marshall–Lerner condition.
Exchange rates can be adjusted by government
in a rules based or
managed currency regime, and when left to float freely in the market they
also tend to change in the direction that will restore balance. When a
country is selling more than it imports, the demand for its currency will
tend to increase as other countries ultimately need the selling country's
currency to make payments for the exports. The extra demand tends to
cause a rise of the currency's price relative to others. When a country is
importing more than it exports, the supply of its own currency on the
international market tends to increase as it tries to exchange it for foreign
currency to pay for its imports, and this extra supply tends to cause the
price to fall. BOP effects are not the only market influence on exchange
rates however, they are also influenced by differences in national interest
rates and by speculation.
Rebalancing by adjusting internal prices and demand
When exchange rates are fixed by a rigid gold standard, or when
imbalances exist between members of a currency union such as the
Eurozone, the standard approach to correct imbalances is by making
changes to the domestic economy. To a large degree, the change is
optional for the surplus country, but compulsory for the deficit country. In
the case of a gold standard, the mechanism is largely automatic. When a
country has a favourable trade balance, as a consequence of selling more
than it buys it will experience a net inflow of gold. The natural effect of
this will be to increase the money supply, which leads to inflation and an
increase in prices, which then tends to make its goods less competitive
and so will decrease its trade surplus. However the nation has the option
of taking the gold out of economy (sterilising the inflationary effect) thus
building up a hoard of gold and retaining its favourable balance of
payments. On the other hand, if a country has an adverse BOP its will
experience a net loss of gold, which will automatically have a
deflationary effect, unless it chooses to leave the gold standard. Prices
will be reduced, making its exports more competitive, and thus correcting
the imbalance. While the gold standard is generally considered to have
been successful up until 1914, correction by deflation to the degree
required by the large imbalances that arose after WWI proved painful,
with deflationary policies contributing to prolonged unemployment but
not re-establishing balance. Apart from the US most former members had
left the gold standard by the mid 1930s.
A possible method for surplus countries such as Germany to contribute to
re-balancing efforts when exchange rate adjustment is not suitable, is to
increase its level of internal demand (i.e. its spending on goods). While a
current account surplus is commonly understood as the excess of earnings
over spending, an alternative expression is that it is the excess of savings
over investment. That is:
where CA = current account, NS = national savings (private plus
government sector), NI = national investment.
If a nation is earning more than it spends the net effect will be to build up
savings, except to the extent that those savings are being used for
investment. If consumers can be encouraged to spend more instead of
saving; or if the government runs a fiscal deficit to offset private savings;
or if the corporate sector divert more of their profits to investment, then
any current account surplus will tend to be reduced. However in 2009
Germany amended its constitution to prohibit running a deficit greater
than 0.35% of its GDP and calls to reduce its surplus by increasing
demand have not been welcome by officials, adding to fears that the
2010s will not be an easy decade for the eurozone. In their April 2010
world economic outlook report, the IMF presented a study showing how
with the right choice of policy options governments can transition out of a
sustained current account surplus with no negative effect on growth and
with a positive impact on unemployment.
Rules based rebalancing mechanisms
Nations can agree to fix their exchange rates against each other, and then
correct any imbalances that arise by rules based and negotiated exchange
rate changes and other methods. The Bretton Woods system of fixed but
adjustable exchange rates was an example of a rules based system, though
it still relied primarily on the two traditional mechanisms. Keynes, one of
the architects of the Bretton Woods system had wanted additional rules to
encourage surplus countries to share the burden of rebalancing, as he
argued that they were in a stronger position to do so and as he regarded
their surpluses as negative externalities imposed on the global economy.
Keynes suggested that traditional balancing mechanisms should be
supplemented by the threat of confiscation of a portion of excess revenue
if the surplus country did not choose to spend it on additional imports.
However his ideas were not accepted by the Americans at the time. In
2008 and 2009, American economist Paul Davidson had been promoting
his revamped form of Keynes's plan as a possible solution to global
imbalances which in his opinion would expand growth all round with out
the downside risk of other rebalancing methods.
History of balance of payments issues
Historically, accurate balance of payments figures were not generally
available. However, this did not prevent a number of switches in opinion
on questions relating to whether or not a nations government should use
policy to encourage a favourable balance.
Pre-1820: Mercantilism
Up until the early 19th century, measures to promote a trade surplus such
as tariffs were generally favoured. Power was associated with wealth, and
with low levels of growth, nations were best able to accumulate funds
either by running trade surpluses or by forcefully confiscating the wealth
of others. From about the 16th century, Mercantilism was a prevalent
theory influencing European rulers, who sometimes strove to have their
countries out sell competitors and so build up a "war chest" of gold.
[42][43]
This era saw low levels of economic growth; average global per capita
income is not considered to have significantly risen in the whole 800
years leading up to 1820, and is estimated to have increased on average
by less than 0.1% per year between 1700 - 1820. With very low levels of
financial integration between nations and with international trade
generally making up a low proportion of individual nations GDP, BOP
crises were very rare.
1820–1914: Free trade
Gold was the primary reserve asset during the gold standard era.
From the late 18th century, mercantilism was challenged by the ideas of
Adam Smith and other economic thinkers favouring free trade. After
victory in the Napoleonic wars Great Britain began promoting free trade,
unilaterally reducing her trade tariffs. Hoarding of gold was no longer
encouraged, and in fact Britain exported more capital as a percentage of
her national income than any other creditor nation has since. Great
Britain's capital exports further helped to correct global imbalances as
they tended to be counter cyclical, rising when Britain's economy went
into recession, thus compensating other states for income lost from export
of goods.
According to historian Carroll Quigley, Great Britain could afford to act
benevolently in the 19th century due to the advantages of her
geographical location, her naval power and her economic ascendancy as
the first nation to enjoy an industrial revolution. A view advanced by
economists such as Barry Eichengreen is that the first age of
Globalization began with the laying of transatlantic cables in the 1860s,
which facilitated a rapid increase in the already growing trade between
Britain and America.
Though Current Account controls were still widely used (in fact all
industrial nations apart from Great Britain and the Netherlands actually
increased their tariffs and quotas in the decades leading up to 1914,
though this was motivated more by a desire to protect "infant industries"
than to encourage a trade surplus) , capital controls were largely absent,
and people were generally free to cross international borders without
requiring passports.
A gold standard enjoyed wide international participation especially from
1870, further contributing to close economic integration between nations.
The period saw substantial global growth, in particular for the volume of
international trade which grew tenfold between 1820–1870 and then by
about 4% annually from 1870 to 1914. BOP crises began to occur, though
less frequently than was to be the case for the remainder of the 20th
century. From 1880 - 1914, there were approximately 8 BOP crises and 8
twin crises - a twin crises being a BOP crises that coincides with a
banking crises.
[edit] 1914–1945: Deglobalisation
The favourable economic conditions that had prevailed up until 1914
were shattered by the first world war, and efforts to re-establish them in
the 1920s were not successful. Several countries rejoined the gold
standard around 1925. But surplus countries didn't "play by the rules",
sterilising gold inflows to a much greater degree than had been the case in
the pre-war period. Deficit nations such as Great Britain found it harder to
adjust by deflation as workers were more enfranchised and unions in
particular were able to resist downwards pressure on wages. During the
great depression most countries abandoned the gold standard, but
imbalances remained an issue and international trade declined sharply.
There was a return to mercantilist type "beggar thy neighbour" policies,
with countries competitively devaluing their exchange rates, thus
effectively competing to export unemployment. There were
approximately 16 BOP crises and 15 twin crises (and a comparatively
very high level of banking crises.
1945–1971: Bretton Woods
Following World War II, the Bretton Woods institutions (the
International Monetary Fund and World Bank) were set up to support an
international monetary system designed to encourage free trade while also
offer states options to correct imbalances without having to deflate their
economies. Fixed but flexible exchange rates were established, with the
system anchored by the dollar which alone remained convertible into
gold, The Bretton Woods system ushered in a period of high global
growth, known as the Golden Age of Capitalism, however it came under
pressure due to the inability or unwillingness of governments to maintain
effective capital controls and due to instabilities related to the central role
of the dollar.
Imbalances caused gold to flow out of the US and a loss of confidence in
the United States ability to supply gold for all future claims by dollar
holders resulted in escalating demands to convert dollars, ultimately
causing the US to end the convertibility of the dollar into gold, thus
ending the Bretton Woods system.
[23]
The 1945 - 71 era saw
approximately 24 BOP crises and no twin crises for advanced economies,
with emerging economies seeing 16 BOP crises and just one twin
crises.
[23]
1971–2009: Transition, Washington Consensus, Bretton Woods II
Manmohan Singh, currently PM of India, showed that the challenges
caused by imbalances can be an opportunity when he led his country's
successful economic reform programme after the 1991 crisis.
The Bretton Woods system came to an end between 1971 and 1973.
There were attempts to repair the system of fixed exchanged rates over
the next few years, but these were soon abandoned, as were determined
efforts for the US to avoid BOP imbalances. Part of the reason was
displacement of the previous dominant economic paradigm –
Keynesianism – by the Washington Consensus, with economists and
economics writers such as Murray Rothbard and Milton Friedman
arguing that there was no great need to be concerned about BOP issues.
According to Rothbard:
Fortunately, the absurdity of worrying about the balance of payments is
made evident by focusing on inter-state trade. For nobody worries about
the balance of payments between New York and New Jersey, or, for that
matter, between Manhattan and Brooklyn, because there are no customs
officials recording such trade and such balances.
In the immediate aftermath of the Bretton Woods collapse, countries
generally tried to retain some control over their exchange rate by
independently managing it, or by intervening in the Forex as part of a
regional bloc, such as the Snake which formed in 1971. The Snake was a
group of European countries who tried to retain stable rates at least with
each other; the group eventually evolved into the ERM by 1979. From the
mid 1970s however, and especially in the 1980s and early 90s, many
other countries followed the US in liberalising controls on both their
capital and current accounts, in adopting a somewhat relaxed attitude to
their balance of payments and in allowing the value of their currency to
float relatively freely with exchange rates determined mostly by the
market.
Developing countries who chose to allow the market to determine their
exchange rates would often develop sizeable current account deficits,
financed by capital account inflows such as loans and investments,
though this often ended in crises when investors lost confidence. The
frequency of crises was especially high for developing economies in this
era - from 1973–1997 emerging economies suffered 57 BOP crises and
21 twin crises. Typically but not always the panic among foreign
creditors and investors that preceded the crises in this period was usually
triggered by concerns over excess borrowing by the private sector, rather
than by a government deficit. For advanced economies, there were 30
BOP crises and 6 banking crises.
A turning point was the 1997 Asian BOP Crisis, where unsympathetic
responses by western powers caused policy makers in emerging
economies to re-assess the wisdom of relying on the free market; by 1999
the developing world as a whole stopped running current account deficits
while the US current account deficit began to rise sharply. This new form
of imbalance began to develop in part due to the increasing practice of
emerging economies, principally China, in pegging their currency against
the dollar, rather than allowing the value to freely float. The resulting
state of affairs has been referred to as Bretton Woods II. According to
economics writer Martin Wolf, in the eight years leading up to 2007,
"three quarters of the foreign currency reserves accumulated since the
beginning of time have been piled up". In contrast to the changed
approach within the emerging economies, US policy makers and
economists remained relatively unconcerned about BOP imbalances. In
the early to mid naughties, many free market economists and policy
makers such as US Treasury secretary Paul O'Neill and Fed Chairman
Alan Greenspan went on record suggesting the growing US deficit was
not a major concern. While several emerging economies had intervening
to boost their reserves and assist their exporters from the late 1980s, they
only began running a net current account surplus after 1999. This was
mirrored in the faster growth for the US current account deficit from the
same year, with surpluses, deficits and the associated build up of reserves
by the surplus countries reaching record levels by the early 2000s and
growing year by year. Some economists such as Kenneth Rogoff and
Maurice Obstfeld began warning that the record imbalances would soon
need to be addressed from as early as 2001, joined by Nouriel Roubini in
2004, but it wasnt until about 2007 that their concerns began to be
accepted by the majority of economists.
2009 and later: Post Washington Consensus
Speaking after the 2009 G-20 London summit , Gordon Brown
announced "the Washington Consensus is over". There is now broad
agreement that large imbalances between different countries do matter;
for example mainstream US economist C. Fred Bergsten has argued the
US deficit and the associated large inbound capital flows into the US was
one of the causes of the financial crisis of 2007–2010. Since the crisis,
government intervention in BOP areas such as the imposition of capital
controls or forex intervention has become more common and in general
attracts less disapproval from economists, international institutions like
the IMF and other governments.
In 2007 when the crises began, the global total of yearly BOP imbalances
was $1680bn. On the credit side, the biggest current account surplus was
China with approx. $362Bn, followed by Japan at $213Bn and Germany
at £185BN, with oil producing countries such as Saudi Arabia also having
large surpluses. On the debit side, the US had the biggest current account
deficit at over £700Bn, with the UK, Spain and Australia together
accounting for close to a further $300Bn.
While there have been warnings of future cuts in public spending, deficit
countries on the whole did not make these in 2009, in fact the opposite
happened with increased public spending contributing to recovery as part
of global efforts to increase demand . The emphases has instead been on
the surplus countries, with the IMF, EU and nations such as the US,
Brazil and Russia asking them to assist with the adjustments to correct the
imbalances.
Economists such as Gregor Irwin and Philip R. Lane have suggested that
increased use of pooled reserves could help emerging economies not to
require such large reserves and thus have less need for current account
surpluses. Writing for the FT in Jan 2009, Gillian Tett says she exspects
to see policy makers becoming increasingly concerned about exchange
rates over the coming year.
[65]
In June 2009, Olivier Blanchard the chief
economist of the IMF wrote that rebalancing the world economy by
reducing both sizeable surpluses and deficits will be a requirement for
sustained recovery.
2008 and 2009 did see some reduction in imbalances, but early
indications towards the end of 2009 were that major imbalances such as
the US current account deficit are set to begin increasing again.
[9]
[67]
Japan had allowed her currency to appreciate through 2009, but has only
limited scope to contribute to the rebalancing efforts thanks in part to her
aging population. The Euro used by Germany is allowed to float fairly
freely in value, however further appreciation would be problematic for
other members of the currency union such as Spain, Greece and Ireland
who run large deficits. Therefore Germany has instead been asked to
contribute by further promoting internal demand, but this hasn't been
welcomed by German officials.
[62]
China has been requested to allow the Renminbi to appreciate but until
2010 had refused, the position expressed by her premier Wen Jiabao
being that by keeping the value of the Renmimbi stable against the dollar
China has been helping the global recovery, and that calls to let her
currency rise in value have been motivated by a desire to hold back
China's development.
[63]
After China reported favourable results for her
December 2009 exports however, the Financial Times reported that
analysts are optimistic that China will allow some appreciation of her
currency around mid 2010.
[68]
In April 2010 a Chinese official signalled the government is considering
allowing the renminbi to appreciate,
[69]
but by May analysts were widely
reporting the appreciation would likely be delayed due to the falling value
of the Euro following the 2010 European sovereign debt crisis.
[70]
China
announced the end of the renminbi's peg to the dollar in June 2010; the
move was widely welcomed by markets and helped defuse tension over
imbalances prior to the 2010 G-20 Toronto summit. However the
renminbi remains managed and the new flexibility means it can move
down as well as up in value; two months after the peg ended the renminbi
had only appreciated against the dollar by about 0.8%.
[71]
While some leading surplus countries including China have been taking
steps to boost domestic demand, these have not yet been sufficient to
rebalance out of their current account surpluses. By June 2010, the US
monthly current account deficit had risen back to $50 Billion, a level not
seen since mid 2008. With the US currently suffering from high
unemployment and concerned about taking on additional debt, fears are
rising that the US may resort to protectionist measures.
[72]
The balance of payments (BOP) is the place where countries record their
monetary transactions with the rest of the world. Transactions are either
marked as a credit or a debit. Within the BOP there are three separate
categories under which different transactions are categorized: the current
account, the capital account and the financial account. In the current
account, goods, services, income and current transfers are recorded. In the
capital account, physical assets such as a building or a factory are
recorded. And in the financial account, assets pertaining to international
monetary flows of, for example, business or portfolio investments, are
noted. In this article, we will focus on analyzing the current account and
how it reflects an economy's overall position. (For background reading,
see What Is The Balance Of Payments?)
The Current Account
The balance of the current account tells us if a country has a deficit or a
surplus. If there is a deficit, does that mean the economy is weak? Does a
surplus automatically mean that the economy is strong? Not necessarily.
But to understand the significance of this part of the BOP, we should start
by looking at the components of the current account: goods, services,
income and current transfers.
1. Goods - These are movable and physical in nature, and in order for
a transaction to be recorded under "goods", a change of ownership
from/to a resident (of the local country) to/from a non-resident (in a
foreign country) has to take place. Movable goods include general
merchandise, goods used for processing other goods, and non-
monetary gold. An export is marked as a credit (money coming in)
and an import is noted as a debit (money going out).
2. Services - These transactions result from an intangible action such
as transportation, business services, tourism, royalties or licensing.
If money is being paid for a service it is recorded like an import (a
debit), and if money is received it is recorded like an export
(credit).
3. I ncome - Income is money going in (credit) or out (debit) of a
country from salaries, portfolio investments (in the form of
dividends, for example), direct investments or any other type of
investment. Together, goods, services and income provide an
economy with fuel to function. This means that items under these
categories are actual resources that are transferred to and from a
country for economic production.
4. Current Transfers - Current transfers are unilateral transfers with
nothing received in return. These include workers' remittances,
donations, aids and grants, official assistance and pensions. Due to
their nature, current transfers are not considered real resources that
affect economic production.
Now that we have covered the four basic components, we need to look at
the mathematical equation that allows us to determine whether the current
account is in deficit or surplus (whether it has more credit or debit). This
will help us understand where any discrepancies may stem from, and how
resources may be restructured in order to allow for a better functioning
economy.
The following variables go into the calculation of the current account
balance (CAB):
X = Exports of goods and services
M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers
The formula is:
CAB = X - M + NY + NCT
What Does It Tell Us?
Theoretically, the balance should be zero, but in the real world this is
improbable, so if the current account has a deficit or a surplus, this tells
us something about the state of the economy in question, both on its own
and in comparison to other world markets.
A surplus is indicative of an economy that is a net creditor to the rest of
the world. It shows how much a country is saving as opposed to
investing. What this means is that the country is providing an abundance
of resources to other economies, and is owed money in return. By
providing these resources abroad, a country with a CAB surplus gives
other economies the chance to increase their productivity while running a
deficit. This is referred to as financing a deficit.
A deficit reflects an economy that is a net debtor to the rest of the world.
It is investing more than it is saving and is using resources from other
economies to meet its domestic consumption and investment
requirements. For example, let us say an economy decides that it needs to
invest for the future (to receive investment income in the long run), so
instead of saving, it sends the money abroad into an investment project.
This would be marked as a debit in the financial account of the balance of
payments at that period of time, but when future returns are made, they
would be entered as investment income (a credit) in the current account
under the income section. (For more insight, read Current Account
Deficits.)
A current account deficit is usually accompanied by depletion in foreign-
exchange assets because those reserves would be used for investment
abroad. The deficit could also signify increased foreign investment in the
local market, in which case the local economy is liable to pay the foreign
economy investment income in the future.
It is important to understand from where a deficit or a surplus is
stemming because sometimes looking at the current account as a whole
could be misleading.
Analyzing the Current Account
Exports imply demand for a local product while imports point to a need
for supplies to meet local production requirements. As export is a credit
to a local economy while an import is a debit, an import means that the
local economy is liable to pay a foreign economy. Therefore a deficit
between exports and imports (goods and services combined) - otherwise
known as a balance of trade deficit (more imports than exports) - could
mean that the country is importing more in order to increase its
productivity and eventually churn out more exports. This in turn could
ultimately finance and alleviate the deficit.
A deficit could also stem from a rise in investments from abroad and
increased obligations by the local economy to pay investment income (a
debit under income in the current account). Investments from abroad
usually have a positive effect on the local economy because, if used
wisely, they provide for increased market value and production for that
economy in the future. This can allow the local economy eventually to
increase exports and, again, reverse its deficit.
Conclusion
The volume of a country's current account is a good sign of economic
activity. By scrutinizing the four components of it, we can get a clear
picture of the extent of activity of a country's industries, capital market,
services and the money entering the country from other governments or
through remittances. However, depending on the nation's stage of
economic growth, its goals, and of course the implementation of its
economic program, the state of the current account is relative to the
characteristics of the country in question. But when analyzing a current
account deficit or surplus, it is vital to know what is fueling the extra
credit or debit and what is being done to counter the effects (a surplus
financed by a donation may not be the most prudent way to run an
economy). On a separate note, the current account also highlights what is
traded with other countries, and it is a good reflection of each nation's
comparative advantage in the global economy.
Understanding Capital And Financial Accounts In The Balance Of
Payments
• The current account, the capital account and the financial account
make up a country's balance of payments (BOP). Together these
three accounts tell a story about the state of an economy, its
economic outlook and its strategies for achieving its desired goals.
A large volume of imports and exports, for example, can indicate
an open economy that supports free trade. On the other hand, a
country that shows little international activity in its capital or
financial account may have an underdeveloped capital market and
little foreign currency entering the country in the form of foreign
direct investment. (For an overview of how each of these accounts
functions, see What Is The Balance Of Payments? and
Understanding The Current Account In The Balance Of Payments.)
Here we focus on the capital and financial accounts, which tell the
story of investment and capital market regulations within a given
country.
The Capital and Financial Accounts
Along with transactions pertaining to non-financial and non-produced
assets, the capital account relates to dealings including debt forgiveness,
the transfer of goods and financial assets by migrants leaving or entering
a country, the transfer of ownership on fixed assets, the transfer of funds
received to the sale or acquisition of fixed assets, gift and inheritance
taxes, death levies, patents, copyrights, royalties and uninsured damage to
fixed assets.
Detailed in the financial account are government-owned assets (i.e.
special drawing rights at the International Monetary Fund (IMF) or
foreign reserves), private sector assets held in other countries, local assets
held by foreigners (government and private), foreign direct investment,
global monetary flows related to investment in business, real estate,
bonds and stocks.
Capital that is transferred out of a country for the purpose of investing is
recorded as a debit in either of these two accounts. This is because money
is leaving the economy. But because it is an investment, there is an
implied return. This return - whether a capital gain from portfolio
investment (a debit under the financial account) or a return made from
direct investment (a debit under the capital account) - is recorded as a
credit in the current account (this is where income investment is recorded
in the BOP). The opposite is true when a country receives capital: paying
a return on a said investment would be noted as a debit in the current
account.
What Does This Mean?
Theoretically, the BOP should be zero. Thus, the current account on one
side and the capital and financial account on the other should balance
each other out. When an economy, however, has positive capital and
financial accounts (a net financial inflow), the country's debits are more
than its credits (due to an increase in liabilities to other economies or a
reduction of claims in other countries). This is usually in parallel with a
current account deficit; an inflow of money means that the return on an
investment is a debit on the current account. Thus, the economy is using
world savings to meet its local investment and consumption demands. It
is a net debtor to the rest of the world.
If the capital and financial accounts are negative (a net financial outflow),
the country has more claims than it does liabilities either because of an
increase in claims by the economy abroad or a reduction in liabilities
from foreign economies. The current account should be recording a
surplus at this stage, indicating that the economy is a net creditor,
providing funds to the world.
Liberal Accounts
The capital and financial accounts are intertwined because they both
record international capital flows. In today's global economy, the
unrestricted movement of capital is fundamental to ensuring world trade
and eventually, according to theory, greater prosperity for all. For this to
happen, however, countries are required to have "open", or "liberal"
capital and financial account policies. Today, many developing
economies implement as part of their economic reform program (often in
conjunction with the IMF) "capital account liberalization", a process that
removes restrictions on capital movement. This unrestricted movement of
capital means that governments, corporations and individuals are free to
invest capital in other countries. This then paves the way not only for
more foreign direct investment (FDI) into industries and development
projects, but for portfolio investment in the capital market as well. Thus,
companies striving for bigger markets and smaller markets seeking
greater capital and domestic economic goals can expand into the
international arena, resulting in a stronger global economy.
The benefits the recipient country reaps from an FDI include an inflow of
foreign capital into its country as well as the sharing of technical and
managerial expertise. The benefits for a company making a FDI is the
ability to expand market share into a foreign economy, thus collecting
greater returns. Some have argued that even the country's domestic
political and macroeconomic policies become affected in a more
progressive fashion because foreign companies investing in a local
economy have a valued stake in the local economy's reform process.
These foreign companies become "expert consultants" to the local
government on policies that will facilitate businesses.
Portfolio foreign investments can encourage capital-market deregulation
and stock-exchange volumes. By investing in more than one market,
investors are able to diversify their portfolio risk while increasing their
returns, which result from investing in an emerging market. A deepening
capital market, based on a reforming local economy and a liberalization
of the capital and financial accounts, can thus speed up the development
of an emerging market.
Measures of Balance
As stated at the beginning of this monograph, analysts and government
officials are keenly interested in the balances shown by selected
combinations of balance-of-payments accounts. Three of these measures
are shown on lines 25 to 27 of the table.
The first and simplest of these measures is the balance on goods
and services, which is derived by computing the net excess of debits or
credits in those accounts. In our hypothetical statement there is a net debit
balance, or ?deficit,? of $20 million.
Such a debit balance, reflecting an excess of imports over exports,
indicates that the United States received more real resources (goods and
services) from other countries than it transferred to them during the
period
covered by the statement, while a credit balance would indicate the
reverse. The balance on goods and services is of interest not only as an
approximation of such net transfers of real resources but also because it is
defined in roughly the same way as the ??net exports of goods and
services‘‘
that comprise part of the nation‘s gross domestic product or expenditure.
The second measure, the balance on current account, is the net
excess of debits or credits in the accounts for goods, services, income,
and
unilateral transfers, that is, the balance on all accounts other than the
financial claims, or ?capital,? accounts. Because total debits must equal
total credits in the balance of payments, the balance on the current
accounts must equal the balance on the remaining, or capital, accounts
(except, of course, for the statistical discrepancy). Thus, the current-
account
balance is an approximation of the change in the net claims of U.S.
residents on the rest of the world; it is a major component of the change
in
the country‘s net international investment position, or ?net worth,? vis-a`
-vis
the rest of the world.
As a rule, it is more difficult to interpret the third measure,
?Transactions in U.S. official reserve assets and in foreign official assets
in
the United States.‘‘ From a simple accounting perspective, this balance
measures the difference between the change in U.S. official reserves and
the change in foreign official claims on the United States. A credit
balance,
such as that shown in the statement, indicates that foreign official claims
on
this country have risen more (or fallen less) than U.S. official reserve
assets,
while a debit balance would indicate the reverse. The description of
transaction 8 makes clear that this $25 million credit arose from central
bank
operations in support of the foreign-exchange value of the dollar. The
amount of this credit (support) along with any observed decline in the
foreign-exchange value of the dollar would then provide a joint indication
of the weakness of the dollar in the foreign-exchange markets during the
period in question.
Such interpretations require knowledge of the details of transactions
such as #8, and the details are often difficult to come by. For example,
foreign officials sometimes acquire dollar balances for investment or
reserve purposes rather than as a result of supporting the dollar. In such
cases dollar purchases by foreign central banks testify to the desirability
or
strength of the dollar in the foreign-exchange markets, rather than to its
weakness.
So, a deficit is not necessarily a bad thing for an economy, especially for
an economy in the developing stages or under reform: an economy
sometimes has to spend money to make money. To run a deficit
intentionally, however, an economy must be prepared to finance this
deficit through a combination of means that will help reduce external
liabilities and increase credits from abroad. For example, a current
account deficit that is financed by short-term portfolio investment or
borrowing is likely more risky. This is because a sudden failure in an
emerging capital market or an unexpected suspension of foreign
government assistance, perhaps due to political tensions, will result in an
immediate cessation of credit in the current account.
From Theory to Reality: a Little Control Can Be Good
Aside from political ideologies, some sound economic theories state
why some capital account control can be good. Recall the Asian
financial crises in 1997. Some Asian countries had opened up their
economies to the world, and an unprecedented amount of foreign
capital was crossing borders into these economies, mostly in the
form of portfolio investment (a financial account credit and a
current account debit). This meant that investments were short term
and easy to liquidate instead of more long term and harder to
dispose of quickly.
When speculation rose and panic spread throughout the region, the
first thing that happened was a reversal in capital flows: money was
now being pulled out of these capital markets. Asian economies
now had to pay their short-term liabilities (debits in the current
account) as securities were sold off before capital gains could be
reaped. Not only did stock market activity suffer, but foreign
reserves were depleted, local currencies depreciated and financial
crises set in.
Analysts argue that financial disaster may have been less severe had
there had been some capital account controls. For instance, had the
amount of foreign borrowing been limited (which is a debit in the
current account), short-term obligations would have been limited
and the damage to the economy could have been less severe.
One Step Forward, Two Steps Backward
Lessons from the Asian financial crises have resulted in new
debates about the best way to liberalize capital and financial
accounts. Indeed, the IMF and World Trade Organization have
historically supported free trade in goods and services (current
account liberalization) and are now faced with the complexities of
capital freedom. Experience has proven, however, that without any
controls a sudden reversal of capital flows can not only destroy an
economy, but can also result in increased poverty for a nation.
Effect on various factors due to Deficit in BOP statement
Persistent deficit in the BOP statement of a country indicates a
fundamental disequilibrium in the economy. This may be the cumulative
effect on the variety of factors such as
• Changes in consumer tastes in the country or abroad which reduces
the country‘s exports and increases its imports
• Low competitive strength in world market which adversely affects
exports
• Continuous fall in the country‘s foreign exchange to reserves due to
supply inelasticities of exports, and excessive demand for foreign
goods and services
• Inflationary pressures in the economy which make exports dearer
• Changes in the supply or direction of long-term capital flows
• GDP growth or decline which is likely to affect exports and imports
of a country
Other Items In The BOP Statement
The Balance of Payments statement has three more items, namely
• Errors and Omissions
• Overall Balance(total of Current and Capital Accounts and Errors
and Omissions)
• Monetary Movements
? IMF
? Foreign exchange reserves(increase/decrease)
Errors and Omissions
The large volume of statistical data required for the presentation of the
Balance of Payments statement is collected partly from official records
and partly on the basis of estimates. As a result, the total credits and total
debits are unlikely to match. There is likely to be some statistical
discrepancy in the BOP statement. This is recorded as ?Errors and
Omissions‘‘ in BOP statement
Overall Balance
Overall balance is arrived at by summing up all the items in the current
account , capital account and the errors and omissions figures. It is the net
balance between international receipt and payments of the country. The
Overall Balance may show deficit or surplus depending on whether the
total debits exceeds the total credits or vice versa
IMF
The IMF has created a reserve asset termed SDRs (Special Drawing
Rights) which are allocated to member countries. SDRs may be held as
reserves by member countries and used for settling international
payments between countries. A countries facing overall deficit in the
BOP statement may purchase SDRs from the IMF for meeting the deficit
Foreign Excahange Reserves
Foreign exchange reserves of countries include different types of assests
such as gold, foreign currencies, deposits of foreign currencies in foreign
central banks, investment in foreign government securities and SDR
holdings. These assests are held by the central bank for the purpose of
meeting intenational commitments arising from international transactions.
So when a country faces overall deficit in its BOP statement, it may use
its foreign exchange resereves to meet the deficits
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