Topic 4 - The Balance of International Payments

The Balance
of
International
Payments
MGT 003
TOPIC 4
Learning Objectives:
At the end of the lesson, the student will be able to:
1. Explain the balance of payments for a country;

2. Describe foreign exchange market and its components.
Introductory Anecdote
-The Dollar as Safe Haven and Reserve
Currency
◈ “The Great Recession” – global economic and financial crises of
2008-2009; crushing financial markets; wealth losses in the trillion dollars;
failures of banking; securities; and business firms; unprecedented
government stimulus packages increasing deficit spending; record low
government interest rates; rising unemployment; and excessively expanded
trade.
◈ Rationale of holding dollars:
1. Dollar was perceived as an asset that could weather global financial storms
due to the belief that US can endure the crises.
2. US dollar is a reserve asset in many countries.
Introduction
◈ Balance of payment accounts document trade
and finance, foreign investment, and other Discussion Question.
important trends in international activities

between countries.
◈ Forex- major changes in world monetary
system
◈ In 1973, the gold standard for benchmarking
or pegging currencies was replaced to flexible
exchange rate system Why currency change?
Currency values can change;
◈ one factor is different price levels on different countries for the same good
and services– Price imbalances can be due to mispricing or due to
inflation across countries.
◈ Varying interest rates across countries. According to Parity Theories,
price levels and debt costs should be the same in different countries after
considering exchange rates.
◈ Economic prospects of countries.
The Balance of International Payments
◈ Balance of payments – a statement of account that shows all transactions between the residents of one country and the rest of the world
for a given period of time usually one year.
Every Quarter and every calendar year
◈ An objective standard that shows how well the country’s economy and government policies are performing.
◈ All trades conducted both by private and public sectors are accounted for in the BOP to determine how much money is going in and out of
a country.
◈ BOP should always balance (= 0).
◈ Two major components:
(1) current account (2) financial account
“ Flow of funds” in analysis, money moving into a country is a credit (+ sign), while money leaving the same country is a debit ( - sign).
The Current Account
◈ Current Account – the activities of consumers and businesses in the
economy with respect to the four subaccounts: trade balance, services
balance, income balance, and net transfers.
◈ Earnings on investments, both public and private, are also put into the current
account.
a. Trade balance – the net of merchandise exports (+ sign as incoming dollars
when merchandise exported) and merchandise imports (- sign as dollars leave
the country to pay for imports)
? When country a country imports more than exports, it has a merchandise trade
deficit
The Current Account
b. Service balance- (shipping, airlines, consulting, insurance, banking, tourism,
software development, etc.) is the net of exports of services (+ sign when they are
sold overseas) and imports of services (- sign when they are purchased from
overseas).
Discussion Question:
A surplus in service balance indicate that a

country is competitive in its service industry.
Yes, or No?
◈ Income balance – the net of investment income from abroad(+ sign
reflects earnings from overseas investment)and investment
payments to foreigners (- sign indicates payments are sent
overseas)
◈ Balance of transfers – the net of transfer payments going overseas
outflows ( - sign means that payment is going abroad as foreign aid,
retirement benefits, etc) and inflows from abroad (+ sign reflects
repayment of foreign aid loans, etc).
◈ Current Account balance – the sum of four subaccounts equals the
current account balance, which is more important than the trade
balance
? A country with a current account surplus is called a capital surplus
country
The Financial Account
◈ Financial account –consists of domestic-country-owned assets abroad, foreign-owned
assets in the domestic country, and net financial derivatives
- describes the 2nd half of a country’s balance of payments
◈ Risk premium – the added return required by investors for risk associated with a
security or asset
? The financial account of the BOP consists of three subaccounts:
1) US owned assets abroad
2) Foreign owned assets in US
3) Net financial derivatives
(+) is inflow (-) outflow of funds to and from the country being analyzed.
◈ Foreign Direct Investment – encompasses purchases of fixed assets (such
as factories and equipment) abroad used in the manufacture and sales of
goods and services for local consumption or exports.
◈ Security Investments
◈ Statistical discrepancy – reconciles any imbalance between the current

account and financial account to ensure that all debit and credit entries in
the balance of payments statement sum to zero.
Reality Check 4-1 - Group Activity
Have you ever thought you had some money left over but did not?
You started P500 in cash that was gradually spent on coffee and a few
everyday items you picked at the store. When you went to see a movie at a
local theatre, you unexpectedly did not have enough money left to buy a ticket
and had to borrow some cash from a friend.
Question:
How was your current account and financial account affected by these
transactions, specifically the balance of payments? How can you explain the
shortage of cash?
The Foreign Exchange Market
◈ Foreign exchange markets – a global network of international banks and
currency traders that trade different countries currencies
◈ Consists of a network on international banks (who work with exporters and

importers) and currency traders (who buy, sell, and speculate in currencies).
◈ A 24 hour market with international financial institutions connected by
means of sophisticated telecommunication system
The Exchange Rate
◈ Exchange rate – the price at which one currency can be converted to
another currency
◈ Independent floating exchange rate system – system that sets the
values of major currencies based on their demand and supply in world
currency markets
? Exchange rates between US dollar rate, euro and yen are market determined
◈ Managed floating exchange rates system – rate system that determines
the value of some currencies partly by demand and supply in the foreign
exchange market and partly by active government intervention in the foreign
exchange market ( by means of central bank purchase and sales of its own
currencies to manage currencies) (ex. Indonesian Rupiah, Thai baht,
Russian ruble, Indian rupee, and Singapore dollar
◈ Fixed exchange rate system – system in which the country pegs its
currency at a fixed rate to major currency or basket of currencies, while the
exchange rate fluctuates within a narrow margin around a central rate.
(Chinese yuan, Malaysian Ringgit, and Saudi Arabian riyal).
Components of the Foreign Exchange
Market
◈ Spot market – exchange that trades
currencies on a real-time basis for immediate
delivery
◈ Banks earn a transaction fee for forex
services
◈ Bid (purchase/buy) and ask (offer/sell) prices
of the foreign currency will be posted in banks
◈ Bid-ask spread – is the difference of bid and
ask prices for a currency; represents the
transaction fee earned by the bank.
◈ Direct quotes – give the prices of a foreign currency in dollars
◈ Indirect quotes – are the reciprocal of direct quote, or the prices of a dollar
in a foreign currency terms
? Ex. 1€= $1.40 (one euro cost 1.40 dollar) direct quote
? Indirect quote would be 1/1.40 = 0.71 USD/EURO or $1 = € 0.71 (i.e.,
one-dollar costs 0.71 euros)
? Forward market enables purchases and sales of currencies in the future with
prices (known as forward rate) established at a previous time.
◈ Informal OTC market run by banking institutions.
Summary
◈ The BOP account provides details about the flows of funds over time
between a country and the rest of the world.
◈ The current account in the BOP provides information on the trade balance,
service balance, income balance, and net transfers.
◈ The financial account in the BOP shows how the current account is
financed. It is affected by FDI and security investments across borders.
THANK YOU!

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The Balance

At the end of the lesson, the student will be able to:

1. Explain the balance of payments for a country;

important trends in international activities

A surplus in service balance indicate that a

◈ Statistical discrepancy – reconciles any imbalance between the current

◈ Consists of a network on international banks (who work with exporters and

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