Spring Semester 03-04 Akila Weerapana

Lecture 6: The Balance of Payments Accounts

I. INTRODUCTION
In Econ 102, you studied basic concepts about National Income Accounting such as how to measure output and prices for the entire economy. Todays lecture focuses on a similar system of accounts that tracks international transactions between countries: known as the Balance of Payments Accounts. You may also recall that studying the National Income Accounts was not exactly the most enthralling portion of Econ102. Unfortunately, the Balance of Payments accounts is only marginally more interesting a topic. However, a working knowledge of the BOP Accounts provides a good basis for developing an understanding of issues like currency crises, the impact of capital ows etc.; much like National Income Accounting provides a good basis for studying economic growth and economic uctuations. A solid understanding of the BOP accounts will help you understand many policy discussions in a comprehensive fashion.

II. BALANCE OF PAYMENTS ACCOUNTS

The large number of international transactions can be summarized into three categories. 1. Current Account transactions: tracks transactions that involve current income and expenditure, usually transactions in goods and services. 2. Capital Account transactions: primarily tracks transactions involving buying and selling of assets. 3. Ocial Settlements Balance transactions: tracks transactions between ocial government authorities. The Current Account (CA) A positive value for the current account is called a current account surplus; a negative value is called a current account decit. The current account mainly consists of 4 types of transactions: 1. Exports and imports of goods Exports of goods are credits (+) to the current account Imports of goods are debits (-) to the current account The dierence between exports and imports of goods is called the merchandise trade balance. Since the 1970s, the U.S. has run a merchandise trade decit: in recent times the merchandise trade decit has reached all-time highs 2. Exports and imports of services

 Exports of services are credits to the current account (+) Imports of services are debits to the current account (-). This category consists of items such as tuition paid to universities by international students, money spent on travel by tourists, banking, insurance, consulting services etc. Unlike the case of goods, the U.S. typically runs a surplus in the service account (exports of services exceed imports of services) although this is beginning to change rapidly with the advent of outsourcing. 3. Interest payments on international investments. Interest, dividends and other income received on U.S. assets held abroad are credits (+) Interest, dividends and payments made on foreign assets held in the U.S. are debits (-). Since 1994, the U.S. has run a net debit in the investment income account: more payments are made to foreigners than foreigners make to U.S. investors. 4. Unilateral transfers Remittances by U.S. citizens working abroad, unilateral aid to the U.S. from other countries pensions paid by foreign countries to their citizens living in the U.S. count as credits (+). Remittances by foreigners working in the U.S., unilateral aid from the U.S. to other countries, pensions paid to U.S. citizens living abroad count as debits (-). As expected the U.S. runs a decit in unilateral transfers. The sum of these components is known as the current account balance. A negative number is called a current account decit and a positive number called a current account surplus. As expected, given that it runs a surplus only in the services component of the current account, the U.S. runs a substantial current account decit. Intuitively, think of credits to the current account as transactions involving receipt of income to U.S. resident and debits to the current account as transactions involving payment of income to foreigners. The transactions can involve goods, services, investment income, pension income or other unilateral transfers. The Capital Account (KA) The current account does not include the purchase and sale of nancial and non-nancial assets. All such transactions are reected in the capital account portion of the BOP accounts. Once again, a positive value for the capital account is called a capital account surplus, a negative value is called a capital account decit. The capital account consists primarily of three types of transactions: 1. Purchase and Sale of Assets Purchases of U.S. assets by foreigners are credits to the capital account (+) Purchases of foreign assets by U.S. residents are debits to the capital account (-)

What counts as an asset? Purchases of stocks or bonds (nancial investment) or purchases of a part or whole of foreign based companies (direct investment). The capital account is where the BOP accounts starts to get tricky. Since U.S. residents can also sell some of the foreign assets they had purchased before, we need to track the sale of assets as well. The easiest way is to record the sale of assets in the BOP in the exact opposite way we record the purchase of assets (i.e. think of a $500 sale as a purchase of a -$500 asset). Therefore, Sales of U.S. assets by foreigners count as debits to the capital account (-) Sales of foreign assets by U.S. residents count as credits to the capital account (+) 2. Making and Repaying Loans Increases in loans to U.S. residents by foreigners counts as credits (+) Increases in loans to foreigners by U.S. residents counts as debits (-) As with assets, we have to track repayment of loans as well as tracing new loans. Thus, repayment of existing loans has to be recorded in the exact opposite fashion as the making of a new loan. Decreases of loans to U.S. residents (U.S. repayment) by foreigners is a debit (-) Decreases of loans to foreigners by U.S. residents (foreign repayment) is a credit (+) 3. Changes in Holdings of Currency Increases in dollar holdings by foreigners counts as a credit to the capital account (+) Increases in holdings of foreign currency by U.S. residents counts as a debit (-) The easiest way to think about currency is to treat it as another asset. So foreigners holding more U.S. currency is treated just like foreigners holding more U.S. assets. Similarly, U.S. residents holding more foreign currency is treated just like U.S. residents holding more foreign assets. Accordingly decreases in holding of foreign currency are treated like sales of assets. Decreases in dollar holdings by foreigners counts as a debit to the capital account (-) Decreases in holdings of foreign currency by U.S. residents counts as a credit (+) The Ocial Settlements Balance Account (OSB) The ocial statements balance reports the net change in foreign exchange reserves and ocial government borrowing. The easiest way to think of the OSB account is to treat it as being identical to the capital account except that the transactions involve an ocial government entity. So we record inows to the ocial government as credits to the OSB and outows from the ocial government as debits to the OSB. For the most part, think of ocial currency reserves as being the primary entry of interest in the OSB account. Increases in dollar reserves held by foreign central banks count as credits to the OSB (+)

 Increases in holdings of foreign currency reserves by U.S. central banks count as debits (-) As in the KA case, we have to keep track of decreases as well as increases in reserves. The best way is to think of a decrease as a negative increase so the above categories get reversed. Decreases in dollar reserves held by foreign central banks count as debits to the OSB (-) Decreases in holdings of foreign currency reserves by U.S. central banks count as credits (+) Summary The current account tracks current income and current expenditure. Income counts as credits, while expenditures are debits. Income and expenditure can be on either goods or services. The current account also records transfers to/from other countries and payments/receipts on existing borrowing. The capital account tracks inows and outows of money (capital) used to buy/sell assets. These assets can take the form of currency, direct investment, nancial investment or loans. Inows of capital through the sale of assets is a credit, outows of capital count as a debit. The OSB is identical to the capital account except that the transactions usually involve a government entity. The recording is done the same way: inows of foreign exchange count as credits, outows count as debits.

III. THE RELATIONSHIP BETWEEN CA, KA AND OSB The most important feature of the Balance of Payments Accounts is that it is a double-entry system of accounts: a positive entry in the BOP accounts has a corresponding negative entry elsewhere in the BOP accounts. Similarly, a negative entry in the BOP accounts has to have a countering positive entry elsewhere in the BOP accounts. This implies that the current, capital and ocial settlements balances must sum to zero. So the following relationship must hold among the component parts of the BOP: CA + KA + OSB = 0 This can be intuitively understood as follows. The current account balance is the dierence between current income and current expenditures. A current account decit implies that expenditures exceed revenues. If expenditures exceed revenues, then the country needs to nance the additional expenditure either by borrowing from abroad (KA credit), selling assets to someone living abroad (KA credit), or by reducing holdings of foreign currency (KA credit or OSB credit). Conversely, suppose that the current account has a surplus, i.e. there was a net inow of income to the U.S. This net inow must be spent on either buying foreign assets (KA debit), making new loans (KA debit), paying o old loans (KA debit) or for accumulating foreign currency (either a KA debit or an OSB debit).

 Therefore a current account decit is NECESSARILY accompanied by a capital account surplus and/or by an ocial settlements balance surplus. Similarly, a current account surplus is NECESSARILY accompanied by a capital account decit and/or by an ocial settlements balance decit. Some examples of the double-entry bookkeeping system can be helpful. Case 1: Mr. A. Phile pays $65,000 in cash to Jaguar of U.K. for a new XJ8 convertible. Jaguar deposits the dollars into its U.S. bank account. Current Account = -$65,000 [Imports (debit)] Capital Account: = $65,000 [Jaguar has increased holdings of U.S. currency (credit)].

Case 2: Dell buys $15,000,000 worth of hard-disk drives from a South Korean company and sells $25,000,000 worth of computers to another Korean company. Dell now has $10 million that it lends to Daewoo, which is struggling to build cars. Current Account: $10,000,000 [Exports $25,000,000 (credit), Imports $15,000,000(debit)] Capital Account: - $10,000,000 [Increased loans to foreigners $10,000,000(debit)] Case 3: I buy $10,000 worth of shares of MushyPeas-R-Us by borrowing money from a British broker. Capital Account $0 [U.S. Purchase of Foreign Asset $10,000 (debit), Foreign loan to U.S. resident $10,000 (credit)]

IV. THE BALANCE OF PAYMENTS The sum of the current account balance and the capital account balance is referred to as the Balance of Payments. Note that this is a term distinct from the BOP accounts, This is a little confusing but such is the arcane world of the BOP accounts. The Balance of Payments represents the dierence between total receipts from foreign nongovernmental entities and total payments to foreign non-governmental entities. A negative value reects the fact that total receipts from foreigners is less than total payments to foreigners. A positive value reects the fact that we total receipts from foreigners exceeds total payments to foreigners. It is also important to distinguish between the bilateral BOP accounts: the state of international transactions between the U.S. and another country, and the multilateral BOP accounts: most of our analysis thus far has applied to multilateral BOP accounts.

V. CAN CURRENT ACCOUNT DEFICITS INDICATE THE HEALTH OF AN ECONOMY? One very important artefact of understanding BOP accounting is that it sheds light on some important public policy debates. Very often these debates ignore fundamental principles of BOP accounting and can lead to disastrous policy remedies for problems that may not really exist. For instance, the U.S. has recently been running all time record trade decits and, accordingly, pretty sizeable current account decits as well.

 The public hand wringing over the allegedly disastrous impact of substantial current account decits leads to the question of whether having a CA decit is necessarily a bad omen for the economic health of a country. Should running a current account surplus be a goal that a country should strive to achieve? Is a country with a current account surplus always better o than a country with a current account decit? The most important thing to keep in mind is that the current account decit will be accompanied by a combined capital account and OSB surplus of equal magnitude. Politicians, and other experts will often bemoan current account decits and laud capital account surpluses without realizing that they in fact go hand in hand. We have to realize that the underlying causes of a current account decit can be very dierent Consider the United States in the late 1990s - we had a booming economy, rapidly increasing stock market and limitless growth prospects. As a result, we would attract a lot of investment from abroad, bringing about a KA surplus. However, since the U.S. government holds very few reserves (OSB = 0) this KA surplus MUST be accompanied by a CA decit. Contrast this with Russia in the late 1990s - a shrinking economy, rapidly decreasing stock market and terrible growth prospects. As a result, Russia had substantial capital ight money leaving the country bringing about a KA decit. If Russia had a exible exchange rate (it initially did not, but eventually did) this KA decit MUST be accompanied by a CA surplus. In the above two examples, the CA decit was inversely related to the health of the economy: the strong economy was running a CA decit and the weak economy was running a CA surplus. In reality though, there is NO relationship between the two. Two more examples will help illustrate the fact. Consider the country of Sao Tome, a small African country that recently discovered substantial deposits of oil. In time, Sao Tome will see a substantial increase in exports, bringing about a CA surplus. In other words economic prosperity will accompany a CA surplus in Sao Tome. Finally, consider the current state of Iraq. With very few exports of oil, it needs to import virtually all its consumption needs. Iraq will therefore run a CA decit, and economic weakness will be associated with a CA decit. Simply put, there is no relationship between CA decits and the state of the economy. We only know that CA decits are associated with surpluses in either the capital or OSB accounts, i.e. inows of capital and that CA surpluses are associated with decits in either the capital or OSB accounts, i.e. outows of capital.

V. RECENT CHANGES TO BOP ACCOUNTING SYSTEMS This method of BOP accounting described above was in use for a long time, and your textbook (and most other textbooks) provide the same method of accounting. However, in the last couple of years the IMF and the United States have switched to a dierent method of calculating the BOP accounts.

 The new system breaks all transactions into two categories: the Current Account and the Capital and Financial Account. The change is fairly trivial: the mapping is given below. We will, in this class, use the old method to be consistent with the textbook. When looking up data for your projects, you may have to appeal to the new system, hence the mapping below. Transactions Current Account Transactions (other than debt relief) Debt Relief Private Capital Account Transactions Ocial Capital Account Transactions Old System Current Account Current Account Capital Account OSB New System Current Account Capital Account Financial Account Financial Account