International Financial Management
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Balance of Payments
Reading: Ch.3
1
FIN6108
International Financial Management
At the end of this topic, you should be able to:
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Describe the importance of balance of payments (BOP)
Distinguish the main components in the BOP account
Tell the twin surpluses in China’s BOP account
Analyze the implications of a surplus / deficit BOP account on exchange
rate movements and on official reserves
Explain how BOP interact with macroeconomic variables
Describe how the trade-balance adjusts as a result of a change in exchange
rate: The J-curve
Distinguish capital mobility, capital controls and capital flight
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The Balance of Payments
3
The measurement of all international economic transactions (e.g., imports
& exports of goods & services and cross-border investments in businesses,
bank accounts, bonds, stocks, and real estate) between the residents of a
country and foreign residents is called the balance of payments (BOP).
Residents
of a
country
Residents
of foreign
countries
International
economic
transactions
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4
BOP data is important for government policymakers and MNEs as it is a gauge of a
nation’s competitiveness or health:
BOP provides information concerning the demand for and supply of a country’s
currency.
(e.g., if UK exports more than imports, pound sterling is likely to appreciate)
A country’s BOP data signals its potential as a business partner for the rest of the
world.
(e.g., a country with BOP deficit may try to reduce imports and discourage
capital outflow)
BOP data can be used to evaluate the performance of the country in international
economic competition.
(e.g., year-after-year trade deficits may imply the country’s industries lack
international competitiveness)
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The BOP as a Flow Statement
5
The BOP is NOT a balance sheet, BUT it is a cash flow statement.
By recording all international transactions over a period of time (e.g., a
year), it tracks the continuing flows of purchases and payments between a
country and other countries.
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6
TWO types of business transactions dominate the balance of payments:
(1) Exchange of Real Assets: the exchange of goods (e.g., computers,
watches, etc.) & services (e.g., banking, travel services, etc.) for other
goods & services or for money.
(2) Exchange of Financial Assets: the exchange of financial claims
(e.g., stocks, bonds, loans, and purchases or sales of companies) for other
financial claims or money.
Although assets can be identified as belonging to distinct groups, it is
easier to think of all assets simply as goods that can be bought or sold
(e.g., a clock vs. a bond).
Transactions of these assets/goods lead to cash flows into / out of a
country.
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Fundamentals of BOP Accounting
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The BOP must balance unless something has not been counted or has
been counted improperly.
So, it is incorrect to state that the BOP is in disequilibrium.
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BOP Accounts
8
The BOP is composed of four accounts:
(1) Current Account
(2) Capital Account and Financial Account
(3) Official Reserves Account (tracks government currency transactions)
(4) Net Errors and Omissions Account is produced to preserve the balance
of the BOP
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Balance of Payments Accounts
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Capital &
Financial
Account
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The Current Account (CA)
10
CA includes all international economic transactions with income or
payment flows occurring within one year, the current period. It consists of
the following 4 sub-categories:
Goods trade (includes exports & imports of tangible goods like
wheat, clothes, computers, etc.)
Services trade (includes payments & receipts for legal, consulting,
royalties, insurance premiums, tourist expenditures, etc.)
Factor income (consists largely of payments & receipts of interest,
dividends, & other income of previously-made foreign investments)
Current transfers (includes foreign aids, gifts, private grant, etc.)
CA typically dominated by the first component which is known as the
Balance of Trade (BOT) even though it excludes services trade
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The US Current Account (CA) 2015-2021 (US$ Millions)
11 https://data.imf.org/regular.aspx?key=62805740 (visit IMF data and choose United States)
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The Capital and Financial Account
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The Capital and Financial Account (KAFA) measures all international
economic transactions of financial assets.
It is divided into 2 major components:
(a)The Capital Account: made up of the acquisition & disposal of non-
produced/non-financial assets.
(e.g., land, patents, copyrights, trademarks & franchises, etc.)
The magnitude of capital transactions covered is minor.
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(b) The Financial Account measures international economic
transaction of financial assets
assets can be classified in a number of different ways including the length
of the life of the asset (maturity) and the nature of the ownership (public
or private).
The Financial Account focuses on the degree of investor control over the
assets or operations.
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(b) The Financial Account consists of 3 main components:
(i) Direct
Investment
in which the investor exerts some explicit degree of
control over the assets (e.g., build a factory or purchase
a company in another country)
(ii) Portfolio
Investment
in which the investor has no control over the assets
(iii) Other
Investment
consists of various short-term and long-term trade
credits, cross-border loans, currency deposits, bank
deposits and other accounts receivable and payable
related to cross-border trade
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(i) Direct investment
This is the net balance of capital dispersed from and into the domestic
country for the purpose of exerting control over assets.
(e.g., in U.S., foreign direct investment arises from 10% ownership of
voting shares in a domestic firm by foreign investors)
Some countries possess restrictions on what foreigners may own in their
country (the media industry in particular).
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(ii) Portfolio Investment
This is the net balance of capital that flows in and out of the domestic
country but does not reach the threshold (e.g., 10% in US) of direct
investment.
The purchase of debt securities (e.g., bonds) across borders is classified
as portfolio investment because debt securities by definition do not
provide the buyer with ownership or control.
Portfolio investment is motivated by a search for returns rather than to
control or manage the investment.
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(iii) Other investment
Consists of various short-term & long-term trade credits, cross-border
loans from all types of financial institutions, currency deposits and bank
deposits, and other accounts receivable and payable related to cross-
border trade.
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The US Capital and Financial Accounts and Components, 2015 - 2021 (US$ Millions)
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Official Reserves Accounts and Net Errors & Omissions
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The Official Reserves Account is the total reserves held by official monetary
authorities within the country.
These reserves are normally composed of the major currencies used in
international trade and financial transactions (e.g., US$, euro, Japanese
yen, gold and SDRs).
The significance of official reserves depends generally on whether the
country is operating under a fixed exchange rate regime or a floating
exchange rate system.