Financial Management in the International Corporation Exchange Rates and International Parity Condit

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2. International Balance of Payments
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Today we will examine...

1. International flows of capital and goods
what, how, and why. 2. Deficits and surpluses
good, bad, and ugly.3. Lots of recent examples.
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Macroeconomic Identities

• Gross National Product (GNP) can be decomposed
  into
• GNP C I G EX - IM

- Consumption - Investment - Government
Spending - Net Exports (Trade Balance) Identity
applies to household or regional scales as well.
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Macroeconomic Identities

• GNP C I G EX - IM
• S GNP - C - G

National Savings is defined as National Income
not consumed by individuals or the government.
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Macroeconomic Identities

• GNP C I G EX - IM
• S GNP - C - G
• Together
• Exports - Imports Investment - Savings 0

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Macroeconomic Identities

• GNP C I G EX - IM
• S GNP - C - G
• Together
• Exports - Imports Investment - Savings 0
• Roughly -6 19
  14 of GNP
• (for the US, 2004)

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Balance of Payments Equation

• Exports - Imports Investment - Savings 0

Current Account
The Current Account reflects the net flow of
goods, services
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Balance of Payments Equation

• Exports - Imports Investment - Savings 0

Current Account Capital Account
If Investment is larger than Savings, the
shortfall must be made up by net inflows of
foreign capital in the Capital Account...
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Balance of Payments Equation

• Exports - Imports Investment - Savings Change
  in Reserves

Current Account Capital Account Official
Balance
...or by a net decline in central bank reserves
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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

• Key idea
• Goods flows must be accompanied by capital flows
  (or changes in central bank reserves).
• Consider the following
• I live in Russia and export caviar and vodka to
  the U.S., they sell for dollars.
• My exports create a positive Russian Current
  Account.

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

• Key point
• Goods flows must be accompanied by capital flows
  (or changes in central bank reserves).
• Consider the following
• I live in Russia and export caviar and vodka to
  the U.S., they sell for dollars.
• My exports of caviar and vodka create a positive
  Russian Current Account.

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

• I dont want dollars. I cant use dollars to buy
  an apartment in Moscow. I need Rubles.
• Who will trade me Rubles for my dollars?
• An American exporter who receives Rubles for
  exports of jeans? Perhaps.
• But what would this do to the Current Account
  surplus?

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

• I dont want dollars. I cant use dollars to buy
  an apartment in Moscow. I need Rubles.
• Who will trade me Rubles for my dollars?
• An American exporter who receives Rubles for
  exports of jeans? Perhaps.
• But what would this do to the Current Account
  surplus?

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

• So what if there is a persistent Current Account
  surplus - i.e. I cant find any American
  exporters who have earned Rubles that theyd like
  to exchange for dollars?
• Another possibility
• I find a Russian investor whod like to purchase
  a condo in Miami Beach. She needs dollars to pay
  for the purchase.
• I exchange dollars for Rubles. She purchases the
  condo, creating a capital account deficit for
  Russia.

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

-

• So what if there is a persistent Current Account
  surplus - i.e. I cant find any American
  exporters who have earned Rubles that theyd like
  to exchange for dollars?
• Another possibility
• I find a Russian investor whod like to purchase
  a condo in Miami Beach. She needs dollars to pay
  for the purchase.
• I exchange dollars for Rubles. She purchases the
  condo, creating a capital account deficit for
  Russia.

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

• What if there are no (private) investors in
  Russia willing to purchase assets in the U.S.?
• One final possibility
• The Central Bank of Russia is willing to purchase
  my dollars.
• The Bank gives me Rubles for my dollars.
• The Banks foreign exchange reserves increase,
  offsetting the Current Account surplus.

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves

• What if there are no (private) investors in
  Russia willing to purchase assets in the U.S.?
• One final possibility
• The Central Bank of Russia is willing to purchase
  my dollars.
• The Bank gives me Rubles for my dollars.
• The Banks foreign exchange reserves increase,
  offsetting the Current Account surplus.

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Balance of Payments Equation
Current Account Capital Account Changes in
Reserves
Trade Exports () Imports (-) Dividends
() Interest payments (,-) Private transfers
(,-) Official transfers (,-)
Foreign Direct Investments (,-) Portfolio
investment (,-) Borrowing and Lending (,-)
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Balance of Payments Equation

• Current Account Capital Account Change in
  Reserves
• 2006 -230.3B 216.6B -13.4B
• In 2006, the US paid for its 1045.5B in imports
  by
• - selling (exporting) 815.5B worth of goods.
• - selling (exporting) 216.6B (net) worth of
  private assets
• - selling (exporting) 13.4B (net) worth of
  government assets to foreign central banks
  (mostly U.S. bonds).

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BOP Examples

• US Current Account Deficit (they live far beyond
  their means), Capital Account Surplus (the
  largest debtor).
• Japan has large Current Account Surplus (too much
  export) and very large Capital Account Deficit
  (large investment in foreign stocks, real estate,
  the largest creditor).
• Germany traditionally had Current Account
  Surplus. Since 1991 it had been experiencing
  Current Account Deficit (due to German
  reunification).

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Deficits and Surpluses
Current Account Capital Account Changes in
Reserves

• Which is worse a current account deficit or a
  current account surplus?

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Deficits and Surpluses
Current Account Capital Account Changes in
Reserves

• For a country to run a current account deficit,
  there must exist a country running a current
  account surplus or capital account deficit.
• Current account deficit means that a country
  spends more than it produces. It has to borrow
  money from abroad.
• As long as foreign money spent wisely, they can
  repay their debt.
• Current account deficit has negative meaning if
  there is no capital mobility, then current
  account deficit means drawing down reserves which
  leads to BOP crises.

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• Important Question
• How likely are the flows to reverse?
• Poor countries borrow a lot -gt current account
  deficit.
• If investment is profitable, they export more but
  need to serve their past debt -gt current account
  deficit.
• When debt is repaid, current account deficit -gt
  current account surplus.
• Borrow young, lend old, invest wisely.

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• Between 1996 and 1998 Thailand has moved from a
  current account deficit of about 9 of GDP to a
  current account surplus of 8 of GDP.
• Why is it a crises?
• Why is it painful to make such a move in such a
  short period of time?

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• Between 1996 and 1998 Thailand has moved from a
  current account deficit of about 9 of GDP to a
  current account surplus of 8 of GDP.
• Why is it a crises?
• Why is it painful to make such a move in such a
  short period of time?
• Current account deficit (expenditures gt
  production) -gt capital was flowing into country.
• Capital flows stopped with foreigners unwilling
  to invest. It was a fear that capital is not used
  efficiently.
• Accumulated debt must be serviced.
• Thailand must consume less than it produces so
  that it can export capital to service its debt.
• If capital inflow had been used better, it would
  have been possible to service debt out of
  increased income.

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Key Points

• 1. The Balance of Payments equation is important
  for understanding the nature and health of a
  countrys interactions with international capital
  and goods markets.
• 2. The equation tells us that the current and
  capital account must be of opposite sign (i.e.
  goods and assets must flow on net in opposite
  directions)or differences must be offset by
  changes in government reserve levels.
• Current Account Deficit is not necessarily bad
  for the economy.
• Current Account Surplus is not necessarily good
  for the economy.

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Key Points

• 1. The Balance of Payments equation is important
  for understanding the nature and health of a
  countrys interactions with international capital
  and goods markets.
• 2. The equation tells us that the current and
  capital account must be of opposite sign (i.e.
  goods and assets must flow on net in opposite
  directions)or differences must be offset by
  changes in government reserve levels.
• Current Account Deficit is not necessarily bad
  for the economy.
• Current Account Surplus is not necessarily good
  for the economy.