List the items under each main BoP account and explain each by giving examples.

Give two debit and two credit item transactions as discussed above (One example given was U.S. foreign direct investment in Mexico entered in U.S. BoP as a debit item)

If there is a significant current account deficit in a country, how would the adjustment back to BoP come about under 1.) fixed exchange rates, 2.) purely floating exchange rates, 3) managed float?

Why is beggar thy neighbor policy is a dangerous one to pursue? Explain the underlying process that leads to self-destruction.

Give your own example of three stages in which the J-Curve effect occurs.

Give a brief historical description of capital mobility and its evolvement over time

Explain capital flight and give three examples of how capital flight might occur. Be sure to use your original examples.

Balance of payments keeps a record of international economic transactions between the residents of a country and foreign residents.

The International Monetary Fund (IMF) is the primary source of statistics for balance of payments and economic performance of member countries around the world.

MNEs, institutional investors, governments use BOP measures to assess the health of specific types of international trade and financial transactions of a country and region of the world relative to home country.

Balance of payments (BoP) is an important indicator of misalignment of exchange rate of country with another. It shows the potential to experience exchange rate gains or losses.

Changes in BoP may reflect imposition or removal of controls over payment of dividends, and interest, license fees, royalty fees and other cash disbursements to foreign firms and investors.

BoP accounts are based on the double entry book keeping system, debit and credit. Regardless of what the transaction is when money flows in the country it is treated as a credit item. When money flows out of the country, it is treated as a debit item. Here are some examples.

When a U.S. firm exports goods to Japan, money flows into the U.S., it is entered in the U.S. BoP as a credit item.

When the U.S. Treasury sells government bonds to China, money flows into the United States and is entered into the BoP (capital account) as a credit item.

When a U.S. MNE undertakes foreign direct investment into Mexico, this transaction is recorded in the U.S. BoP as a debit item.

When a Mexican worker in the U.S. sends money to his or her family in Mexico (remittance) this is recorded in the U.S. BoP as a debit item.

BoP is divided into three major sub accounts; Current Account, Capital Account and Financial Account.

Current account is simply Exports + Imports + Unilateral Transfers

In other words, current account is simply trade balance plus unilateral transfers.

An example of a unilateral transfer would be a U.S. worker working in Philippines sending money to his family back in the U.S. as such this is not a transaction but one way transfer of money. Grants, donations, aid made by the U.S. to other countries is also regarded as a unilateral transfer.

Capital account is comprised of financial assets and the acquisition and disposal of non-produced/nonfinancial assets.

Financial account is comprised of three components; direct investments, portfolio investment and other asset investment.

Here is an example of a generic BoP account

1. Current Account

1. Net exports and imports of goods (balance of trade

2. Net exports and imports of services

3. Net income

4. Net transfers

2. Capital Account

Capital transfers related to the purchase of and sale of fixed assets such as real estate

3. Financial Account

1. Net foreign direct investment

2. Net portfolio investment

3. Other financial items

4. Net Errors and Omissions

Missing data such as illegal transfers

5. Reserves & Related Items

Changes in official monetary reserves including gold, foreign exchange, and IMF position

A + B + C = Basic Balance

Basic Balance + D = Overall Balance

BoP must balance, but then what does it mean when investors, government official say BoP deficit? It relates to specific item of the BoP mainly the current account. Thus a BoP deficit really means a current account deficit where imports exceed exports. It may also mean a trade deficit.

Balance of Payments Interaction with Key Macroeconomic Variables

An economy behaves just like an individual like you and me. You spend as much as you make. For example, if you make $25K a year, you will spend more or less $25 a year. The same holds for an economy. Just keep in mind that Y stand for what an economy earns (income) and others such as consumption expenditure ( C ), investment expenditure ( I ), government expenditure ( G ), net exports (X M) as what an economy spends.

Thus for an economy:

Y = C + I + G + X M

Y is really GDP in an economy so we can write;

GDP = C + I + G + X - M

Here the last terms X M make up the current account balance assuming zero unilateral transfers.

When X increases, GDP increases and when M increases, GDP decreases.

But when GDP grows, so does a representative agents income, when you make more income, you tend to import more goods from abroad, thus M increases.

Growth in GDP leads eventually to higher employment in a country.

BoP data can be summarized into the following identity that can have a significant effect on the exchange rate of the country:

(X M) + (CI CO) + (FI - FO) + FXB = BoP

Where X is exports, M is imports, CI is capital inflows, CO is capital outflows, FI is financial inflows, FO is financial outflows, and FXB is official reserves such as foreign exchange and gold.

Under a system of fixed exchange rates the mechanism at work is as follows:

If the sum of current and capital accounts do not sum to zero, then the government is expected to intervene by either selling or buying foreign reserves.

If the sum of the first two is greater than zero, there is an excess demand for domestic currency, the government must sell domestic currency and purchase foreign currency to bring about an equilibrium, and maintain the fixed exchange rate.

If the sum of the first two terms is less than zero, then there is surplus of domestic currency and the government is expected to buy domestic currency and sell foreign currency to bring about an equilibrium and to maintain the fixed exchange rate. For this the government must maintain sufficient foreign reserves otherwise foreign reserves will be depleted and the country will be in a currency crisis and be forced to devalue.

Under a system of floating exchange rates the mechanism at work is as follows:

Under a purely floating exchange rate system, since the value of the exchange rate is determined in the foreign exchange market by the forces of the supply and demand rather than the government, the government is has no responsibility to peg its foreign exchange rate. If the current and capital accounts do not sum to zero, the exchange rate will automatically adjust to bring BoP balance or in the above equation back to zero (right hand side of the equation).

If a country runs a current account deficit, with other terms on the left hand side of the identity above in balance, there will be an incipient BoP deficit. Since the country now imports more than exports, there will be an excess supply of domestic currency in world markets to buy those imports. Excess supply of domestic currency will bring down the value of the domestic currency against other currencies, until BoP is once again back in equilibrium. Importer will run down foreign exchange reserves to pay for those imported goods in foreign currency. This will also bring BoP back to equilibrium.

Under a system of managed floating the mechanism at work is as follows:

Although the value of the exchange rate is determined in the foreign exchange market, the country may have a target rate to maintain and may deem it necessary to intervene to maintain the exchange rate at this value. They may for example change economic fundamentals and policy variables such as interest rates to affect the exchange rate. This is intended to affect (CI CO). A country may increase interest rates in domestic country attract capital by way of capital inflows. This increases the market demand for domestic currency

Trade Balances & Exchange Rates

Changes in exchange rates, change relative prices of exports and imports which is referred to as the terms of trade (price of exports / price of imports). Countries sometimes deliberately devalue their currency to make their exports cheaper and gain a competitive edge against other countries and artificially create a trade surplus to bolster their foreign exchange reserves. In early times like the gold standard this was known as the beggar thy neighbor policy, which meant making yourself better off at the expense of other countries. However, this was a dangerous policy to pursue since it often triggered retaliation by other countries by devaluating their currencies as well. This often led to currency wars which is not resolved led to trade wars and ultimately to physical wars. To many scholars the cause of world wars in the past was merely because of these trade wars not being resolved. Competitive devaluations are often are self-destructive.

The J-Curve Effect

The trade balance adjustment to exchange rate changes is shaped like the letter J in a two dimensional diagram where Time is on the horizontal axis and trade balance in domestic currency is on the vertical axis (see page 100 on the text book or refer to the internet).

Trade balance adjustment occurs in three stages: 1.) the currency contract period; 2) the pass through period; and 3) the quantity adjustment period.

First assume the trade balance is already in deficit. A devaluation at time t1 initially results in further deterioration of the trade balance before it eventually improves. This phenomenon is termed the J-Curve Effect. Here is an example. Assume a contract is made by the U.S. importer of BMWs of 10 cars at 50,000 euros at the 1 dollar equals 1 euro parity (currency contract period). Now suddenly after the contract dollar is devalued to 1 dollar equals .50 euros (pass through period) . All of sudden this BMW importer has to come up with 1 million dollars (1 dollar to .5 euro parity) instead of 500,000 (1 dollar to 1 euro parity) dollars to be able to import the cars from Germany. Thus imports from abroad now have increased by $500,000 showing an initial deterioration in the trade balance. When a new contract is signed by the U.S. importer however, less BMWs will be imported from Germany (quantity adjustment period) due to higher price of imports in the U.S. thus eventually leading to an improvement in the trade balance.

Capital Mobility

A current account deficit means a capital account surplus holding other influences constant, otherwise the BoP would not balance. Capital mobility refers to the degree to which capital moves freely across borders. Capital was not free to move in and out of a country in early economic times. Here is a brief history.

The Gold Standard (1860-1914). In this era capital openness was growing where countries relied on gold convertibility to maintain confidence in the system.

The Inter-War Years (1914-1945) was characterized by protectionism and isolationism. There were rising barriers to movement of trade and capital, that led to global recession and financial crisis.

The Bretton Woods Era (1945-1971) was a fixed exchange rate system that led to long period of economic recovery and openness in trade and capital flows. According to many researchers, it was the rapid growth in capital mobility that eventually led to the breakdown of the Brettong Woods.

The Floating Era (1971-1997) led to openness of trade and capital mobility by industrialized countries and openness of trade but capital controls by emerging market economies eventually leading to the Asian Financial Crisis in 1997. The crisis was a hard lesson learned that emerging countries can no longer hold back capital mobility.

The Emerging Era (1997-Present) led by emerging economies such as China and India saw opening of markets to global capital. This meant giving up control of their currency or conduct of independent monetary policy as taught by Impossible Trinity. This created pressure on emerging market countries currency to appreciate and hence lose competitiveness.

Capital Flight

Capital flight is the sudden outflow of capital from a country. Capital flight can cause countries to enter into a severe economic crisis. The five mechanisms by which capital flight occur are:

1.) Transfer via the usual international payments mechanisms (regular bank transfers). This is really not a problem for healthy countries

2.) Transfer of physical currency by the bearer. Individuals smuggling cash in the secret components of a suitcase would constitute one example.

3.) Cash is transferred into precious metals, which are then transferred across borders.

4.) Money laundering which is cross-border purchase of assets that are then managed in a way that hides the movement of money and ownership

5.) False invoicing of international trade by under invoicing exported goods or over invoicing of imported goods.