International Finance

#2. Chapter 2: The balance of payments

By Nguyen Thu Luan

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Objectives

 To learn two essential tools to understand

macroeconomic linkages between countries.

 (1) National Income Accounting:

◦ A useful tool to understand the cause of business cycle
of an economy.
◦ Without this tool, we cannot say anything about which
kind of policy response we should use to a particular
recession or boom of the economy.
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Objectives (cont’d)

 (2) Balance of Payments:

◦ An important analytical tool when we consider the
external relationship of a country concerned.

 Questions:
◦ The US has recorded huge amount of trade deficits for
the last several decades. Is it sustainable?
◦ Without the understanding of the balance of payments
as well as the national income accounting, we cannot
answer the above question.
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Case Study 1: Trade Friction
between Japan and the US
 Background:
◦ Japan records large amounts of trade surplus to the
World, especially to the US, for the last few decades.
◦ The yen/dollar exchange rates appreciated sharply
from 1985.
◦ But, Japan’s trade surplus did not decline. It actually
increased from 1984 to 1987.

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Trade Friction between Japan and the
US (cont’d)
 The US government wanted to reduce the trade
deficit against Japan in the 1980s.
 In 1985, G7 countries agreed to the depreciation
of the US dollar (“Plaza Accord”).
 Did the depreciation of the US dollar surely
reduce the trade deficit against Japan?
◦ No.
◦ Why US trade deficits did not decline even after a sharp
depreciation of the dollar?
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Two different views
 1) Exchange rate works for the adjustment of trade
account imbalances.
◦ Exchange rates did not work well for such adjustments

 2) Trade surplus/deficit is determined by the

saving and investment relationship of a country
concerned.
◦ Need to understand the National Income Accounting.

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Balance of Payments
 Questions:
◦ Why is a government typically concerned about a large
current account deficit (or surplus)?
◦ How does the US finance its large amount of trade deficit?
◦ The US has not been in danger of repaying its foreign debt
even though it continues to record large amount of trade
deficits. In contrast, developing economies often get into
danger in repaying foreign debts and suffer from capital
flight, if they have large trade deficits for several years.
Why?

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Balance of Payments (BOP)
 A balance of payments accounts keep track of both a
country’s payments to and its receipts from foreigners.
◦ Debit (-): a negative sign any transaction resulting in a
payment.
◦ Credit (+): a positive sign any transaction resulting in
a receipt from foreigners.
 Rule of double-entry bookkeeping:
◦ Every international transaction automatically enters the
balance of payments twice, once as a credit and once as a
debit.

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Three types of transactions
recorded in BOP (1)
1. Current account:
◦ Transaction that involve the export or import
of goods or services.

 How to record the transactions:

◦ Debit (-): importing goods and services
Payment to foreigners.
◦ Credit (+): exporting goods and services
Receipt from foreigners.
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Three types of transactions
recorded in BOP (2)
2. Financial account:
◦ Transactions that involve the purchase or sale
of financial assets (e.g. FDI, portfolio
investment, international bank loans, etc).

 How to record the transactions:

◦ Debit (-): importing (purchasing) assets.
◦ Credit (+): exporting (selling) assets.

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Three types of transactions
recorded in BOP (3)
3. Capital account:
◦ Certain other activities resulting in transfers
of wealth between countries.

◦ E.g. The US government forgives $1 billion

in debt owed to the government of the
Philippines. The US wealth declines by $1
billion, which is recorded as debt in the US
capital account.
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Example 1 of paired transactions
Credit Debit

Car purchase Current account - USD 20,000

(US good import)

Sale of bank Financial account + USD 20,000

deposit (US asset export)

◦ Example 1: US residents buy an automobile from Toyota

with a USD 20,000 cheque.
 Toyota’s US salesperson deposits the check in Toyota’s
account at Citibank in US.
 Toyota has received (imported), and Citibank has exported a
US asset (cheque). 12
Example 2 of paired transactions
Cred it Deb it

Vietnam p urchase Financial acco unt + USD 1 millio n

of a MS share (US asset exp o rt)

US d ep osit of Financial acco unt - USD 1 millio n

Vietnam payment (US asset impo rt)

 Example 2: Vietnamese resident purchases a newly issued share

of stock in Microsoft (MS) with a USD 1 million cheque.
◦ Vietnamese acquisition of the MS stock create a USD 1 million
credit in the US financial account.
◦ Vietnamese resident has exported, and the US bank (Citibank) has
imported, a Vietnamese asset (cheque).

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Balance of Payments Accounts

 The fundamental Balance of Payments

Identify:
◦ Current Account + Financial Account + Capital Account
=0
A detailed description of the balance of
payments accounts:
◦ Must see Table 12-2 in Krugman & Obstfeld,
International Economics: Theory and Policy, Seventh
Edition, 2006, p.295.
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Table 12-2: US balance of payments
accounts for 2003 (billions of USD)
Credit Debit
Current Account 1) Exports + 1,314.9
2) Imports -1,778.1
3) Net unilateral transfers -67.4
Balance on C.A. (= 1+ 2+ 3) -530.7
Capital Account 4) -3.1
Financial Account 5) US assets held abroad -283.4
6) Foreign assets held in US + 829.2
Balance of F.A (= 5+ 6) + 545.8
Statistical discrepancy -12.0

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Statistical Discrepancy
 Definition:
◦ The sum of (i) current account balance, (ii) capital account
and (iii) financial account balance, with opposite sign.
 Why the sum is not equal to zero given the rule of
double-entry bookkeeping?
◦ Information about the offsetting debit and credit items
associated with a given transaction may be collected from
different sources.
◦ It is very difficult to keep track of the complicated financial
transactions (i.e. financial account) between residents of
different countries.

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Official Reserve Transactions
 Definition:
◦ The purchase or sale of official reserve assets by central bank

 Official international reserves:

◦ Foreign assets (mainly US dollar assets) held by central banks
as a cushion against national economic misfortune.

 Official foreign exchange intervention:

◦ Central banks often buy or sell international reserves in
private asset markets to affect macroeconomic conditions in
their economies.

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Example 3 of paired transactions
Credit Debit

US purchase of a Current account - USD 1 million

Germany car (US good import)

Bundesbank buys Financial account + USD 1 million

$ assets (US asset export)

 Example 3: A US auto dealer imports a car from Germany, and

Bundesbank purchases a US $ 1 million cheque from German car
seller.
◦ German car seller receives a US $ 1 million cheque from US auto
dealer. Bundesbank buys the cheque in exchange for German money
◦ Bundesbank’s international reserves rise by US $ 1 million.
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Official Reserve Transactions (cont’d)

 Balance of Official Reserve Transactions:

◦ US balance of ORT = (i) – (ii)
◦ (i) = The net increase in foreign official reserve claims on
the US
◦ (ii) = The net increase in the US official reserves.

◦ See Table 12-2. $250.1 billion (= $248.6+$1.5)

balance is the US BORT in 2003.

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Official Reserve Transactions (cont’d)

 Official Settlements Balance:

(= Balance of Payments)
◦ The bookkeeping offset to the balance of official reserve
transactions (ORT).
◦ It indicates the payment gap that official reserve
transactions need to cover.

◦ See Table 12-2. $250.1 billion balance is to measure the

degree to which monetary authorities in USA and abroad
joined with other lenders to cover the US current account
deficit.
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Table: Calculating the US Official Settlements
Balance for 2003 (USD billion)

Credit Debit
Current Account 1) Balance on current account -530.7
Capital Account 2) Balance on capital account -3.1
Non-reserve F.A. 3) Balance on N.F.A + 295.7
4) Statistical discrepancy -12.0
5) Official settlements balance -250.1
(= Balance of Payment)
(= 1+ 2+ 3+ 4)
Official reserve 6) US official reserve assets held + 1.5
transactions (ORT) abroad (increase - )
7) Foreign official reserve assets + 248.6
held in US (increase + )
Balance of ORT (= 6 + 7) + 250.1 16

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Official Reserve Transactions (cont’d)

 Official Settlements Balance:

◦ It played an important historical role as a measure of
disequilibrium in international payments, and for many
countries it still plays this role.
◦ E.g. A negative official settlements balance (a deficit)
may signal a crisis (If a country continues to run a deficit
for years), because it means that a country is running
down its international reserve assets or incurring debts to
foreign monetary authority. (See the above Table).

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GDP Components
 GDP is generally divided into 4 different types of
expenditure.
◦ Y = C + I + G + (EX – IM)
 Y = GDP
 C = Consumption
 I = Investment
 G = Government purchases
 EX – IM = CA = Current account balance
 The difference between export of goods and services and
imports of goods and services.
 Current account surplus: EX > IM.
 Current account deficit: EX < IM.
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National Income Identity: Saving and
Current Account
 National saving (S)
◦ A portion of output (Y) that is not devoted to household
consumption (C) or government purchase (G).
◦ S=Y–C–G
 Modified national income identity:
◦ Y = C + I + G + CA
◦ (Y – C – G) = I + CA
◦ S = I + CA

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National Income Identity: Saving and
Current Account (cont’d)
 Implication 1:
◦ (S – I) = CA
◦ A country’s current account balance is identically
equal to national saving minus investment.
◦ E.g. If a country’s saving rate is quite high and,
hence, national saving always exceeds
investment, the country has a current account
surplus.
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National Income Identity: Saving and
Current Account (cont’d)
 Implication 2:
◦ Suppose there are only two countries in the
world
◦ If a country X has a current account surplus, it
automatically means that country Y has a current
account deficit. (CAY <0)
◦ If country Y, investment must exceed national
saving. (SY – IY < 0).
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National Income Identity: Private and
Government Saving
 Private saving (Sp):
◦ A part of disposable income that is saved.
◦ Sp = (Y – T) – C (T: net taxes)
 Government saving (Sg):
◦ Net tax revenue minus government purchases.
◦ Sg = T – G.

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National Income Identity: Private and
Government Saving (cont’d)
 Rewriting identity:
◦ S = Y – C – G = (Y – C – T) + (T – G)
= Sp + Sg
◦ S = Sp + Sg = I + CA
◦ CA = (Sp – I) – (G – T) <Equation 1>
 Implication:
◦ CA will increase, (1) If Sp exceeds I or (2) If government
budget deficit (G-T) decrease.
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Case Study 1 (again!)
 Issue: the effect of government deficits on the
current account.
 Example 1:
◦ “Twin deficits” generated by the President Regan
policies in the early 1980s.
◦ By slashing taxes and raising government expenditures
deficit and increased current account deficit.
◦ The twin deficits story can be explained by using
Equation 1.

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Case Study 2
 Example 2:
◦ European countries’ efforts to cut their government
budget deficits before the launch of their new currency,
the euro.
◦ Background: EU had agreed that a member country with
a large government deficit could not adopt the euro.
◦ We would have expected the EU’s current account
surplus to increase as a result of improvement in fiscal
budget. Is it correct?

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National Income Accounts for the whole EU
(percentage of GNP)

Year CA Sp I G-T

1995 0.6 25.9 19.9 -5.4

1996 1.0 24.6 19.3 -4.3

1997 1.5 23.4 19.4 -2.5

1998 1.0 22.6 20.0 -1.6

1999 0.2 21.8 20.8 -0.8

So urce: Organization for Economic Cooperation and Development, OECD Economics Outlook 68
(December 2000), Annex Tables 27, 30, and 52 (with investment calculated as the residual).

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Case Study 2 (cont’d)
 Findings from Table:
◦ While the government deficit (G-T) declined
substantially from -5.4% in 1995 to -0.8% in
1999, the current account (CA) did not change
much during the period.
◦ Our logic based on Equation 1 cannot be
applicable to the EU case.
◦ Why?

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Case Study 2 (cont’d)
 Reasons:
◦ Equation 1 is just an identity, and is not based on
any theory of economic behavior.
◦ Private saving, investment, the current account,
and the government deficit are jointly
determined variables.
◦ We cannot fully determine the cause of a current
account change using Equation 1.

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Case Study 3:
Current Account Imbalances
 “A saving grace” (The Economist, July 5th
2003, p.69).

 This article discusses:

◦ The recent decline in Japan’s saving rate.
◦ Its effect on Japan’s current account surplus.

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Case Study 3:
 Example 3: Japanese Household Saving
◦ In the early 1980s, Japanese household were among the
world’s champion savers.
◦ Now, they are so no longer. Surprisingly, their saving rate
is now roughly the same as that of Americans.
◦ Japanese household saving rate: 23% (1975) 14%
(1990) 6.9% (2001) 2% (in the 1st quarter of 2003).
◦ Euro Area (typically above 10%), USA (3,5%).

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Case Study 3 (cont’d)
 Such a sharp fall in saving seems puzzling,
because:
◦ 1) Deflation causes people to put off buying things in the
expectation that they will be able to get them more cheaply
next year.
◦ 2) Japanese households have suffered from a slump in asset
prices (a loss of wealth), so they should be saving more to
rebuild their nest-eggs.
◦ 3) As the Recardian equivalence suggested, household should
now be anticipating higher future taxes to repay the extra
government debt, by saving more today
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Case Study 3 (cont’d)
 Explanations for the fall saving over the past two
decades:
◦ 1) The life-cycle hypothesis: During their working years people
spend less than they earn, leading to accumulation of wealth.
More retired people there are, the lower the saving rate will be.

◦ 2) Fall in inflation rate People need to save less to maintain

their real wealth.

◦ 3) The maturing in 2001 of a lot of high-yielding, ten-year postal

savings deposits.

◦ 4) Most of the fall in the saving rate is accounted for by those

over 60 The life-cycle hypothesis.

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Case Study 3 (cont’d)
 An economist at HSBC estimated:
◦ Japan’s rate could drop by another 5 percentage points
from its 2001 level (6.9%).

 Many economists forecasted:

◦ US saving rate would rise to at least 6% over the next
few years.

 Question: Are they right?

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Case Study 3 (cont’d)
 Question:
◦ If Japanese households continue to save less, will Japan’s
current account move into deficit?
◦ Answer Not necessarily.

 Explanation:
◦ The behavior of households and government has been
offset by a marked increase in saving by firms (see
Figure of the handout).
◦ The corporate sector is running a big financial surplus,
because firms have slashed investment and started to
repay debts. 39
Case Study 3 (cont’d)
 Further Question:
◦ What if business investment rebounds?
◦ Would the current account surplus then vanish?
◦ Again, not necessarily.

 Explanation:
◦ Changes in the financial balance of one sector can cause
offsetting shifts elsewhere.
[Link]
payments/
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Questions
1. Which one of the following expressions is the
most accurate?
(a) CA = EX – IM
(b) CA = IM – EX
(c) CA = EX = IM
(d) CA = EX + IM
(e) None of the above

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Questions
2. The official settlements balance or balance of payments is the
sum of
(a) The current account balance, the capital account balance, the
non reserve portion of the financial account balance, the
statistical discrepancy.
(b) The current account balance and the capital account balance.
(c)The current account balance, the capital account balance, the
non reserve portion of the finanacial account balance.
(d) The current account balance and the non reserve portion of the
finanacial account balance.
(e) None of the above.

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Questions
3. The United States issues a $10,000 debt forgiveness to
Argentina. How is this accounted for in the U.S. balance of
payment?
(a) Financial account, U.S. asset import
(b) Current account, Argentina transfer payment
(c) Current account, U.S. service export.
(d) Financial account, U.S. asset export
(e) Current account, Argentina good import

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