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IFT Notes for Level I CFA® Program

R17 International Trade and Capital Flows

Part 5



4.  The Balance of Payments

The balance of payments (BOP) is a double-entry bookkeeping system that summarizes a country’s economic transactions with the rest of the world for a particular period of time. In simple terms, it is a record of all the country’s international transactions.

Analyzing the BOP is an important element in assessing a country’s macroeconomic environment, its monetary and fiscal policies, and its long-term growth potential. Investors use data on trade and capital flows to evaluate a country’s overall level of capital investment, profitability, and risk.

4.1. Balance of Payment Accounts         

International receipts are credit items, while international payments are debit items.

Balance of payment accounts
Debits Credits
(Increase in assets, Decrease in liabilities) (Decrease in assets, Increase in liabilities)
Value of imported goods and services. Payments for imports of goods and services.
Purchases of foreign financial assets. Payments for foreign financial assets.
Receipt of payments from foreigners. Value of exported goods and services.
Increase in debt owed by foreigners. Payment of debt by foreigners.
Payment of debt owed to foreigners. Increase in debt owed to foreigners.

Credit (+): This represents funds flowing into the country, and demand for domestic currency in the forex market.
Debit (-): This represents funds flowing out of the country, and supply of domestic currency in the forex market.

4.2. Balance of Payment Components

BOP is composed of the following three components:

  • Current account (CA): measures the flow of goods and services.
  • Capital account (KA): measures transfer of capital.
  • Financial account (FA): records investment flows.

The basic rule of BOP is that the sum of all its components must equal to zero.

Current account consists of the following four accounts:

  • Merchandise trade: All commodities and manufactured goods bought, sold or given away. Net export of goods = export – import of goods
  • Services include tourism, transportation, engineering, and business services such as legal services, management consulting, and accounting. Fees related to patents on new technology, software, books and movies are also considered as a current account.
  • Net export of services = export – import of services.
  • Income receipts: Income derived from ownership of assets, such as dividend and interest payments, and income from foreign investments.
  • Net income receipts = Investment income on foreign assets owned by nationals – Payments on domestic assets owned by foreign nationals.
  • Unilateral transfers of assets: One-way transfer of assets such as remittances from nationals working abroad (private transfers), gifts from foreign countries, foreign aid etc.

Capital account

  • Capital transfersDebt forgiveness, migrants’ transfers (goods and service belonging to migrants as they leave the country), gift and inheritance taxes etc.
  • Sales and purchases of non-produced, non-financial assets: Rights to natural resources, and the sale and purchase of intangible assets such as patents, copyrights, etc.

Note: Patents related to the services sector go in the current account, the rest is accounted in the capital account. For example: selling the rights to exploration is a capital account.

Financial account

  • Financial assets abroad that includes official reserve assets, government assets, and private assets. These include gold, foreign currencies, foreign securities, the country’s reserve in the IMF, and direct foreign investment.
  • Foreign-owned financial assets in the domestic country that include official assets and other foreign assets.

The exhibit below is from example 10 in the curriculum. You may look at the various items under current account, capital account, and financial account and relate it to the ones we saw above.

  (USD millions)
(Credits +, Debits -) 1970 1980 1985 1990 2000 2009
Current Account
Exports of goods and services and income receipts 68,387 344,440 387,612 706,975 1,421,515 2,159,000
Exports of goods and services 56,640 271,834 289,070 535,233 1,070,597 1,570,797
Income receipts 11,748 72,606 98,542 171,742 350,918 588,203
Imports of goods and services and income payments -59,901 -333,774 -483,769 -759,290 -1,779,241 -2,412,489
Imports of goods and services -54,386 -291,241 -410,950 -616,097 -1,449,377 -1,945,705
Income payments -5,515 -42,532 -72,819 -143,192 -329,864 -466,783
Unilateral current transfers, net -6,156 -8,349 -21,998 -26,654 -58,645 -124,943
Capital Account
Capital account transactions. net -7,220 -1 -140
Financial Account
U.S. owned assets abroad , ex derivatives (increase/financial outflow (-)) -9,337 -86,967 -44,752 -81,234 -560,523 -140,465
Foreign-owned assets in the United States, ex derivatives (increase/financial inflow (+)) 7,226 62,037 144,231 139,357 1,038,224 305,736
Financial derivatives, net N/A N/A N/A N/A N/A N/A
Statistical discrepancy (sum of above items with sign reversed) -219 22,613 18,677 28,066 -61,329 162,497

4.3. Paired Transactions in the BOP Bookkeeping System

Note: This section is not highly testable. It cites various examples to illustrate how BOP bookkeeping entries are done.

Commercial exports: A company in Germany sells technology equipment to a South Korean auto manufacturer for a total price of EUR 50 million, including freight charges of EUR 1 million to be paid within 90 days. The merchandise will be shipped via a German cargo ship.

Let us look at how the transaction is recorded from Germany’s perspective.

Current account (under exports) credit entries:

Technology equipment: + €49 million

Freight services: + €1 million

Financial account (debit entry):

Money owed by foreigners to Germany: €50 million

Commercial imports: A German utility company imports gas from Russia valued at EUR 45 million, and agrees to pay the Russian company within three months.

Current account (under imports) debit entry:

Gas imported: €45 million

Financial account credit entry:

Money owed by Germany to Russia: €45 million

Loans to borrowers abroad: A German commercial bank purchases EUR 100 million in intermediate-term bonds issued by a Ukrainian steel company. The bonds are denominated in euros, so payment is made in euros.

Financial account – debit and credit entry:

German holdings of Ukrainian bonds (German investment in a foreign country, private long-term claims): €100 million

Deposits issued by the Ukrainian steel company (foreign private short-term claim): €100 million

Example

  1. What are the three BOP components?

Solution: Current account, Capital account, and Financial account.

  1. Consider Turkey’s balance of payments. Where will each of the following be recorded?

a. Sell gas exploration rights to a Russian company.

Solution: Capital account

b. Sell software-related patents and services to a Canadian company.

Solution: Current account

c. Borrow $100 million euro from a German bank.

Solution: Financial account

d. Receive a $5 million dividend from an equity investment in the U.S.

Solution: Current account, as it is income received on an investment

4.4. National and Economic Accounts and the Balance of Payments

Note: The curriculum describes this section in great detail. Most of the questions in this section are based on this equation.

The derivation of this relationship is shown in the curriculum. We will look at it briefly here.

In a closed economy, all goods and services are produced and consumed within the country i.e. nothing is traded.

GDP = National income of the country Y = C + I + G

where:

C = Consumption

I = Investment

G = Government Expenditure

In an open economy, some of the produce is exported (X), while some money is spent on importing goods and services (M). For such an economy which is often the case, the GDP consists of four components: consumption, domestic investment, government spending, and net exports.

Now, Y = C + I + G + (X – M)

where: X – M = Net Exports = Current Account

Rearranging the above equation, we get current account CA = X – M = Y – (C + I + G)

If (C + I + G) represents expenditure, then the current account CA is the difference between what a country produces (Y) and what it spends (C + I + G).

CA Surplus → The country exports more than it imports; produces more than it spends, or net lending to other economies; CA > 0.

CA Deficit → The country imports more than it exports, or net borrowing from other economies; CA < 0.

Current account surplus results from:

  • High private savings
  • Low private investment
  • Government surplus

Conversely, current account deficit results from:

  • Low private savings
  • High private investment
  • Government deficit

What is the impact on the current account for each of the following?

  • Higher consumption
  • Solution: Higher consumption means savings are low, low savings imply current account is low (deficit).
  • Higher government spending
  • Solution: Higher government spending implies low current account (deficit)
  • Higher investments
  • Solution: Higher investments imply low current account.


Economics International Trade and Capital Flows Part 5