CHAPTER 3
THE BALANCE OF PAYMENTS
1. Balance of Payments Defined. What is the balance of payments?
The measurement of all international economic transactions between the residents of
2. BOP Data. What institution provides the primary source of similar statistics for
balance of payments and economic performance worldwide?
The primary source of similar statistics for balance of payments and economic
3. Importance of BOP. Business managers and investors need BOP data to anticipate
changes in host country economic policies that might be driven by BOP events. From
the perspective of business managers and investors list three specific signals that a
country’s BOP data can provide.
▪ Changes in a country’s BOP may signal the imposition or removal of controls
over payment of dividends and interest, license fees, royalty fees, or other cash
disbursements to foreign firms or investors.
4. Flow Statement. What does it mean to describe the balance of payments as a flow
statement?
The BOP is often misunderstood because many people infer from its name that it is a
balance sheet, whereas in fact it is a cash flow statement. By recording all
international transactions over a period of time such as a year, the BOP tracks the
5. Economic Activity. What data can a nation’s BOP provide about a country’s
economy?
Reading through the BOP can provide detailed information about the
performance of the country on international markets and the economic
competitiveness of its forms. If a country is experiencing recurrent current
6. Balance. If the BOP always “balances,” then how do countries run a BOP deficit or
surplus?
The cumulative international economic transactions of the BOP should balance.
These include the three main component accounts: current account, capital account,
and financial account, in addition to the statistical discrepancies and official reserves.
But each of the three component accounts can either show a deficit or a surplus.
7. BOP Accounting. If the BOP were viewed as an accounting statement, would it be a
balance sheet of the country’s wealth, an income statement of the country’s earnings,
or a funds flow statement of money into and out of the country?
A country’s balance of payments is similar to a corporation’s funds flow statement in
8. Current Account Surpluses. Explain the main causes behind the current account
surpluses that Asian emerging economies have maintained during the last two
decades.
Asian emerging economies have maintained a current account surpluses for the last
two or three decades. This is mainly due to the fact that their economic growth
strategies are dependent on export-oriented policies. These policies include a
devaluated domestic currency that provides more competitiveness for local industries
9. Real Versus Financial Assets. What is the difference between a “real” asset and a
“financial” asset?
Real assets are goods (merchandise) and useful services. Financial assets are financial
10. Direct Versus Portfolio Investments. What is the difference between a direct
foreign investment and a portfolio foreign investment? Give an example of each.
Which type of investment is a multinational industrial company more likely to make?
A direct investment is made with the intent that the investor will have a degree of
control over the asset acquired. Typical examples are the building of a factory in a
11. Negative Net International Investment Position. What does a country’s consistent
negative net international investment position indicate?
The net international investment position (NIIP) is the difference between the
accumulated stock of the country’s claims on foreigners and the accumulated stock of
foreign claims on domestic residents. The NIIP can be thought of as a nation’s
international balance sheet. The accumulated stock and liabilities include assets such
as shares, bonds, private assets, direct investment (such as subsidiaries and branches
the result of fluctuations in asset prices and/or exchange rates.
12. The Financial Account. What are the primary sub-components of the financial
account? Analytically, what would cause net deficits or surpluses in these individual
components?
The main components and possible examples are:
Debit: An American buys shares of stock of a European food chain on the
Frankfurt Stock Exchange.
Credit: The government of Korea buys United States treasury bills to hold as part
13. Classifying Transactions. Classify the following as a transaction reported in a sub-
component of the current account or the capital and financial accounts of the two
countries involved:
a. A U.S. food chain imports wine from Chile. Debit to U.S. goods part of current
account, credit to Chilean goods part of current account.
c. Singaporean parents pay for their daughter to study at a U.S. university. Credit to
U.S. current transfers in current account; debit to Singapore current transfers in
current account.
e. A British Company imports Spanish oranges, paying with eurodollars on deposit
in London. A debit to the goods part of Britain’s current account; a credit to the
goods part of Spain’s current account.
f. The Spanish orchard deposits half the proceeds in a Eurodollar account in
London. No recording in the U.S. balance of payments, as the transaction was
between foreigners using dollars already deposited abroad. A debit to the income
receipts/payments of the British current account; a credit to the income
receipts/payments of the Spanish current account.
h. An American multinational enterprise buys insurance from a London insurance
broker. A debit to the services part of the U.S. current account; a credit to the
services part of the British current account.
j. Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can
fly the return segment of a flight back to Hong Kong. Hong Kong keeps its
balance of payments separate from those of the People’s Republic of China.
Hence a debit to the goods part of Hong Kong’s current account; a credit to the
goods part of the U.S. current account.
l. The U.S. army buys food for its troops in South Asia from vendors in Thailand. A
debit to the goods part of the U.S. current account; a credit to the goods part of the
Thai current account.
m. A Yale graduate gets a job with the International Committee of the Red Cross
working in Bosnia and is paid in Swiss francs. A debit to the income part of the
Swiss current account; a credit to the income part of the Bosnia current account.
This assumes the Yale graduate spends her earnings within Bosnia; should she
deposit the sum in the United States then the credit would be to the income part of
the U.S. current account.
o. A Colombian drug cartel smuggles cocaine into the United States, receives a
suitcase of cash, and flies back to Colombia with that cash. This would not get
captured in the goods part of the U.S. or the Colombian current accounts.
Assuming the cash was “laundered” appropriately, from the point of view of the
smugglers, bank accounts in the U.S. or somewhere else (probably not Colombia,
possibly Switzerland) would be credited. This imbalance would end up in the
errors and omissions part of the U.S. balance of payments.
doubtful that the goods or services transaction would get reported or recorded,
although on a net basis changes in bank balances would reflect half of the
transaction.
q. A Norwegian shipping firm pays U.S. dollars to the Egyptian government for
passage of a ship through the Suez Canal. If the Norwegian firm paid with dollar
balances held in the U.S. and the Suez Canal Authority of Egypt redeposited the
proceeds in the U.S. no entry would appear in the U.S. balance of payments.
Norway would debit a purchase of services, and Egypt would credit a sale of
services.
s. An American tourist pays for a hotel in Paris with his American Express card. A
debit would be recorded in the services part of the U.S. current account; a credit
would be recorded in the services part of the French current account.
t. A French tourist from the provinces pays for a hotel in Paris with his American
Express card. A French resident most likely has a French-issued credit card,
issued by the French subsidiary of American Express. In this instance, no entry
would appear in either country’s balance of payments. If, later, the French
subsidiary of American Express paid a dividend back to the U.S., that would be
recorded in the income part of the current accounts.
14. The Balance. What are the main summary statements of the balance of payments
accounts and what do they measure?
▪ The balance on goods (also called the balance of trade) measures the balance on
imports and exports of merchandise.
▪ The balance on current account expands the balance on goods to include receipts
and expenses for services, income flows, and unilateral transfers.
▪ The overall balance (also called the official settlements balance) is the total
change in a country’s foreign exchange reserves caused by the basic balance plus
any governmental action to influence foreign exchange reserves.
15. Twin Surpluses. Why is China’s twin surpluses – a surplus in both the current and
financial accounts – considered unusual?
China’s surpluses in both the current and financial accounts – termed the twin surplus
in the business press – is highly unusual. Ordinarily, countries experiencing large
current account deficits fund these deficits through equally large surpluses in the
financial account, and vice versa.
16. Capital Mobility – United States. The U.S. dollar has maintained or increased its
value over the past 20 years despite running a gradually increasing current account
deficit. Why has this phenomenon occurred?
The U.S. dollar has maintained or increased its value over the past 20 years despite
17. Capital Mobility — The Eurozone. Low interest rates should normally lead to
capital outflows to other countries and currencies in the search for higher interest
rates. Explain why the opposite has occurred in the Eurozone.
18. BOP Transactions. Identify the correct BOP account for each of the following
transactions.
a. A German based pension fund buys U.S. government 30-year bonds for its
investment portfolio.
Financial account: portfolio investment liabilities
Chapter 3 The Balance of Payments▪ 21
c. Hong Kong students pay tuition to the University of California, Berkeley.
Current account: Services: credit
Current account: Services: credit
f. A U.S. tourist pays for a restaurant meal in Bangkok.
Current account: Services: debit
19. BOP and Inflation. What are the direct and indirect relationships between the
balance of payments and inflation?
The current account and the level of imports have the potential to lower or raise a
country’s inflation rate. If the inflation rate in the exporting country rises, then
imported inflation will result. Moreover, if the domestic currency devalues, imported
20. J-Curve Dynamics. What is the J-Curve adjustment path?
A country’s trade balance may change, as a result of an exchange rate change, in the
shape of a flattened “j”. International economic analysis characterizes the trade
balance adjustment process as occurring in three stages: 1) the currency contract
21. Pass Through. Explain the exchange rate pass through and whether it always holds
true.
Exchange rate pass through indicates the degree to which importers and exporters
22. Restrictions on Capital Mobility. What factors seem to play a role in a
government’s choice to restrict capital mobility?
There is a spectrum of motivations for capital controls, with most associated with
either insulating the domestic monetary and financial economy from outside markets
or political motivations over ownership and access interests. Capital controls are just
as likely to occur over capital inflows as they are over capital outflows. Although
23. Dutch Disease. Can controls of capital inflow solve the Dutch Disease in resource-
rich countries?
The economies of resource-rich countries can suffer from serious problems in the
case of excessive capital inflows. In freely floating foreign exchange systems,
massive capital inflows can lead to considerable currency appreciation. This
phenomenon has come to be known as the Dutch Disease as it was first witnessed by
24. Globalization and Capital Mobility. How does capital mobility typically differ
between industrialized countries and emerging market countries?
Emerging market countries, by definition, have relatively small and undeveloped
financial systems and sectors. Outside of some potential foreign direct investment
opportunities, they offer few choices for capital to flow in of substance. Industrialized