Chapter Six

Chapter 6
The Balance of
Learning Objectives
To understand the fundamental principles of how
measure international business activity,
the balance
of payments
To examine the similarities of the current and
accounts of the balance of payments
To understand the critical differences between trade in
merchandise and services and why international investment
activity has recently been controversial in the United States
To review the mechanical steps of how exchange rates are
transmitted into altered trade prices and eventually trade
To understand how countries with different government
policies toward international trade and investments, or
different levels of economic development, differ in their
balance of payments
The measurement of all international
economic transactions between the
residents of a country and foreign
residents is called the balance of
payments (BOP)
The two major sub accounts of the
balance of payments are:
Current account
Capital account
Fundamentals of Balance of
Payments Accounting
The balance of payments must balance
Subaccounts may be imbalanced
Three main elements to the process of
measuring international economic
activity include:
Identifying what is and is not an international
economic transaction
Understanding how the flow of goods, services,
assets, and money creates debits and credits to
the overall BOP
Understanding the bookkeeping procedures for
BOP accounting
Defining International Transactions
Identifying many
transactions is
ordinarily not difficult
However, some
transactions are not
The BOP as a Flow Statement
The BOP is often
believed to be a balance
sheet rather than a cash
flow statement
There are two types of
business transactions
that dominate the BOP:
Real assets
Financial assets
BOP Accounting: DoubleEntry Bookkeeping
BOP employs an
technique called
In this age-old
method every
transaction produces
a debit and a credit
of the same amount
A debit is created
An asset is increased
A liability is decreased
An expense is
A credit is created
An asset is decreased
A liability is increased
An expense is
BOP Accounting: DoubleEntry Bookkeeping
The measurement of all international
transactions in and out of a country
over a year is a difficult task
Mistakes, errors, and statistical
discrepancies will and do occur
Current and capital account entries are
recorded independent of one another,
not together as this accounting method
would prescribe
The Accounts of the Balance
of Payments
The BOP is comprised of two
primary subaccounts:
Current Account
Financial/Capital Account
Two additional and important
subaccounts of the BOP include:
Net Errors and Omissions Account
Official Reserves Account
The Current Account
This account includes all
international economic
transactions with income or
payment flows occurring within
the year, the current period
It consists of four subcategories:
Goods trade
Services trade
Current transfers
This account is typically dominated
by Goods Trade
The Current Account
The Balance on Trade (BOT) refers specifically
to the balance of exports and imports of goods
trade only
The deficits in the BOT of the past decade have
been an area of concern for the U.S.
Merchandise trade is the core of international
trade and has three major components:
Manufactured goods
The most encouraging news for U.S.
manufacturing trade is the growth of exports
in recent years
The Capital and Financial
This account of the BOP measures
all international economic
transactions of financial assets
It is divided into two major
Capital Account
Financial Account
The Capital Account
The Capital Account is made up of
transfers of:
Financial assets
The acquisition and disposal of
nonproduced/nonfinancial assets
The Financial Account
The Financial Account consists
of three components:
Direct investment
Portfolio investment
Other asset investments
The contents of this account
are for all intents and purposes
the same as those of the
Capital Account under IMFs
BOP accounting framework
used prior to 1996
Net Direct Investment
This is the net balance of capital
dispersed out of and into the U.S. for
the purpose of exerting control over
Follows the 10% ownership threshold
The source of concern over foreign
investments in any country focuses on
two topics:
Portfolio Investment
This is the net balance of capital that
flows in and out of the U.S., but does
not reach the 10% ownership threshold
of direct investment
It is capital invested in activities that
are purely profit-motivated rather than
ones made in the prospect of controlling
or managing the investment
These have shown much more volatile
behavior than net direct investments
over the past decade
Other Investment
This category consists of:
Short-term trade credits
Long-term trade credits
Cross-border loans from all types of
financial institutions
Currency deposits
Bank deposits
Other accounts receivable
Accounts payable
Official Reserves Account
This is the total currency
and metallic reserves held
by official monetary
authorities within the
Its significance depends on
whether the country is
operating under:
A fixed exchange rate regime
A floating exchange rate
The Balance of Payments--Total
The International Monetary Fund (IMF) is the
multinational organization that collects the
BOP statistics for over 160 different countries
around the globe
The current, capital, and financial accounts
combine to form the basic balance and is one
of the most frequently used summary
measures of the BOP
The current, capital, financial, and net errors
and omissions accounts combine to form the
summary measure known as the overall
balance or official settlements balance
The Balance of Payments and
Economic Crises
The sum of cross-border international
economic activity can be used by
international managers to forecast
economic conditions and in some cases,
the likelihood of economic crises
The mechanics of international
economic crises often follow a similar
path of development
The Asian Crisis
The roots of this currency crisis extended
from a fundamental change in the
economics of the region
It started as early as 1990 in Thailand
The most visible roots were the excesses in
capital flows into Thailand in 1996 and
early 1997
Corporate socialism, corporate governance,
banking liquidity and management are
underlying causes that apply to every
nation facing economic crisis
Capital Mobility
The degree to which capital moves
freely cross-border is critical to a
country’s balance of payments
The ability of capital to move involves
economic and political factors
Obstfeld and Taylor (2001) studied
the globalization of capital markets
and argued the post-1860 era can be
subdivided into four distinct periods
Capital Flight
Capital flight is the sudden and
shocking outflow of capital
from a nation’s economy in
which it is perceived there is
political, economic, or currency
crises forthcoming
Five primary mechanisms exist
by which capital may be moved
from one country to another
The Cases of China and
The Chinese
balance of
payments serves
as an interesting
example of one
country’s ongoing
efforts to manage
its current and
financial accounts
Turkey’s economic
and financial crisis
of 2000-2001
serves as a prime
example of how a
country’s balance
of payments can
deteriorate or
essentially collapse
in a very short
period of time

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