BSc Financial Economics

International Finance

Professor Anne Sibert

International Finance

Lecture 1

Balance of Payments Accounting

Learning Objectives

• To be able to explain the main and sub-accounts of the balance of payments and their relationship to each other.

• To understand the principles of double-entry bookkeeping.

• To be able to record transactions and present a balance of payments table.

• To understand the relationship between the balance of payments and a nation’s budget constraint.

• To understand the relationship between the balance of payments and the national income accounts.

Definition: The balance of payments is a record of transactions between residents of a country and residents of the rest of the world.

The balance of payments is use to:

• project exchange rates

• assess the health of the economy

• assess the credit worthiness of an economy

Balance of payments accounting is based on the principles of double-entry bookkeeping : each transaction is recorded twice, once as a debit and once as a credit.

Definition. Assets are economic resources which are expected to benefit future activities.

Definition. Liabilities are outsiders claims against assets.

Definition. Credit : this means “right”.

Definition. Debit : this means “left”.

George’s Shoe Store

Account NameThis account records

Inventory The purchase and sale of shoes

Accounts Payable Debts incurred and paid

Cash Cash acquired and disbursed

Accounts Receivable Loans made and repaid

ASSET ACCOUNTSLIABILITY ACCOUNTS

Left-hand balances Right-hand balances

Increased by entries on the left

Increased by entries on the right

Decreased by entries on the right

Decreased by entries on the left

George sells £500 of shoes. Payment is due in 30 days.

INVENTORY

Increases Decreases(1) £500

ACCOUNTS RECEIVABLE

Increases(1) £500

Decreases

In 30 days, George receives payment in cash.

ACCOUNTS RECEIVABLE

Increases(1) £500

Decreases(2) £500

CASH

Increases(2) £500

Decreases

George buys new inventory for £800. Payment is due in 30 days.

INVENTORY

Increases(3) £800

Decreases(1) £500

ACCOUNTS PAYABLE

Decreases

Increases(3) £800

Recalling our previous definitions, we now have

DEBITS CREDITS

Left-hand side entriesRight-hand side entries

Increases in assets Decreases in assets

Decreases in liabilities

Increases in liabilities

Thus, we have

1. Debit accounts receivable £500; Credit inventory £500

2. Debit cash £500; Credit Accounts Receivable £500

3. Debit inventory £800; Credit Accounts Payable £800

Credits are entered as positive numbers; Debits are entered as negative numbers.

George’s Shoe Store

Inventory -£300

Accounts Receivable

0

Cash -£500

Accounts Payable

+£800

A nation’s balance of payments is a record of transactions between residents of that nation and

residents of the rest of the world.

We are talking about residents – not citizens. Tourists, military and diplomatic personnel and temporary migrants are not residents. A permanent migrant is a resident, even if not a citizen.

Example: A subsidiary of a Korean automobile firm located in the UK sells cars to Korea. This is a UK export and a Korean import.

A Country’s Budget Constraint

Net sales of goods and services + Net Interest income + Net gifts received from foreigners = Change in home holdings of foreign assets – Change in foreign holdings of home assets

The left-hand side: change in net worthThe right-hand side: change in asset

holdings

Current Account

• The Current Account is a record of transactions affecting the left-hand side of the budget constraint.

• It is a measure of the change in a country’s net worth.

• It is a record of trade in goods in services (including the services of capital and labour) and gifts.

Current Account

• Merchandise Trade• Services• Income• Current Transfers

Merchandise Trade

This is trade in physical goods such as computers and automobiles.

It is often broken down intoMerchandise exportsMerchandise imports

Services

• This is trade in invisible or intangible goods.

• Examples are: shipping, travel, communications, financial services, insurance, tourism

• The sum of merchandise trade and services is called the trade balance

Current Transfers

These are one-sided transactions such as government grants, pension payments, and private gifts.

The Capital Account

• A complication arose because debt forgiveness was distorting balance of payments numbers.

• It was decided to include only gifts that would be consumed within a year in the current account and to make up a new account called the Capital Account that would include long-term gifts such as debt forgiveness.

• Thus, the left-hand side of the budget constraint should actually be the Current Account plus the Capital Account.

• The Capital Account is unimportant for the UK or the US.

Is this an increase or a decrease in an asset?

Is this a debit or a credit?

Is it entered as a positive or a negative number

A country buys a good or a service

Increase (it has more goods and services)

Debit Negative

A country sells a good or a service

Decrease (it has fewer goods and services)

Credit Positive

Thus we have:

Exports – Credits – Positive Entry

Imports – Debits – Negative Entry

A positive balance on the current account means that a country sold more than it bought

A negative balance on the current account means that a country bought more than it sold

The UK Current Account 2006

0

50000

100000

150000

200000

250000

300000

350000

MerchandiseTrade

Services Income Transfers

CreditsDebits

In millions, Pink Book

G-7 Current Accounts as a Share of GDP 2007

-8

-6

-4

-2

0

2

4

6

Canada France Germany Italy Japan UK US

Source: IMF estimate

Current Account Deficit as a Share of GDP

0

1

2

3

4

5

6

7

UKUS

The Financial Account

• This is the right-hand side of the government’s budget constraint.

• The financial account is a record of capital flows between residents of a country and the rest of the world.

One way to break down capital flows is by the type of transaction.

There are two main types of capital flows

1. Direct investment: When residents of a country acquire shares in a foreign business with the intent of exercising management control. This is typically defined as purchasing 10 percent of a firm’s stock.

2. Portfolio investment: Investment without the intention of exercising management control.

Portfolio investment used to be further broken down between short- and long-term flows. But, secondary markets exist for many long-term financial assets and this has become increasingly meaningless. Once can also break it down between foreign claims on the home country and home claims on foreigners.

Home purchase of a foreign asset

Capital outflow

Increase in an asset Debit

Negative entry

Foreign sale of a home asset

Capital outflow

Decrease in a liability Debit

Negative entry

Home sale of a foreign asset

Capital inflow

Decrease in an asset Credit

Positive entry

Foreign purchase of a home asset

Capital inflow

Increase in a liability Credit

Positive entry

Reserve Account

• A special sub-account of the financial account is the reserve account.

• The reserve account is a record of changes in the home country’s official (government) assets.

• When fixed exchange rates were more prevalent this used to be separate from the financial account.

Foreign Reserves

• For most countries the most important component is their foreign exchange reserves. This is the foreign currency held by the central bank.

• When a central bank intervenes in the exchange market to influence the value of its currency it uses its foreign exchange reserves.

The central bank buys foreign exchange

This is an increase in an asset debt

Negative entry

The central bank sells foreign exchange

This is a decrease in an asset credit

Positive entry

Reserve Account Balance

• Negative balance (debit, increase in an asset): Reserves rose.

• Positive balance (credit, decrease in an asset): Reserves fell.

• Another definition of the balance of payments is minus one times the reserve account balance.

• A positive (negative) balance of payments: reserves rose (fell)

Errors and Omissions

• Each transaction is entered once as a debit and once as a credit; that is, once as a positive number and once as the same negative number.

• So, all of the transactions should sum to zero.

• In practice, it does not work out that way.

Errors and Omissions

• Data on merchandise trade comes from customs declarations.

• Trade in services is typically estimated by various sampling techniques; errors can be substantial.

• Reporting of capital flows and investment income is highly imperfect; people try to hide these to evade taxes.

• The Statistical Discrepancy or Errors and Omissions is the amount we need to add or subtract to make things add up to zero.

Balance of Payments

Current Account

Merchandise Trade

Exports

Imports

Services

Income

Current Transfers

Capital Account

Financial Account

Direct Investment

Portfolio Investment

Home claims on Foreigners

Foreign Claims on the Home Country

Reserves

Errors and Omissions

Examples for the Mythical Country of Pongoland

Which account is credited?Which account is debited?

A European importer buys 3 million pongos worth of equipment from a Pongoland firm. Payment is made

with a cheque drawn on a Pongoland bank.

• The equipment is a Merchandise Export.

• It is a decrease in an asset, so credit Merchandise Exports 3 million.

• The cheque is a Foreign Claim on Pongoland. It is a decrease in a liability so debit Foreign Claims 3 million.

Pongoland imports 1.2 million pongos of food from Latin America. Payment is made with cheques drawn on Pongoland banks.

• The food is a Merchandise Import.• It is an increase in an asset so debit

Merchandise Imports 1.2 million.• The payment is a Foreign Claim on

Pongoland.• It is an increase in a liability so credit

Foreign Claims 1.2 million.

Pongoland tourists spend 400,000 pongos while travelling in Europe. They pay with

Pongoland travellers’ cheques.• The tourism is a Service.• It is an increase in an asset so debit

Services .4 million.• The travellers’ cheques are a Foreign

Claim on Pongoland.• They are an increase in a liability, so

credit Foreign Claims .4 million.

A Pongoland company purchases 20 percent of a European Company for 800,000 pongos.

It pays with cheques drawn on Pongoland banks.

• Debit Direct Investment .8 million.• Credit Foreign Claims .8 million

The government of Pongoland provides foreign aid to a country in the form of

300,000 million of agricultural products.

• Debit Current Transfers .3 million• Credit Exports .3 million

Pongoland investors receive 200,000 pongos from their foreign investments. They are

paid with cheques drawn on foreign banks.

• The earnings are Income. • They are no longer owed the income

so this is a decrease in an asset. Or, view this as an export of the services of capital. Credit Income .2 million.

• The cheques are Pongoland Claims on Foreigners.

• This is an increase in an asset; debit Pongoland Claims.

The Balance of Payments and the National Accounts

• Y = C + I + G + X where Y is output or income, C is private domestic consumption, I is private domestic investment, G is government spending (assumed to be consumption) and X is exports minus imports, or net exports or the current account.

• Y – C – G = S = I + X, where S is income minus total private and government consumption, or savings.

• X = S – I : the current account is domestic investment minus saving