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Chapter 2
Balance of Payment
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Objectives of the Chapter
Definition Components of BOP
Factors Affecting International Trade Flows
Correcting BOT DFIs by US Firms
DFIs in US
Factors affecting DFIs Factors affecting International Portfolio Investment
Agencies Help correcting BOP
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DefinitionA balance of payments (BOP) sheet is an accounting record of
all monetary transactions between a country and the rest of the
world. Sloman, John (2004)
A record of all transactions made between one particular
country and all other countries during a specified period oftime.
Balance of payments may be used as an indicator of economic
and political stability.
The BOP summarizes international transactions for a specific
period, usually a year, and is prepared in a single currency,
typically the domestic currency for the country concerned.
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A negative balance of payments means that more
money is flowing out of the country than coming
in.
A Positive balance of payments means that more
money is flowing in the country than going out
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Positive & Negative BOP
Sources of funds for a nation, such as exports or the
receipts of loans and investments, are recorded as
positive or surplus items.
Uses of funds, such as for imports or to invest in
foreign countries, are recorded as a negative or
deficit item.
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Components of BOP Current Account
Capital Account
Official ReserveA
ccount
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Current Account
a) Balance ofTrade
Merchandise (Exports & Imports)
Services (Exports & Imports)
b) Factor Income
c) Unilateral Transfers
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Factor IncomeIncome from:
Dividends
Interest
Income earned by workers overseas Compensation of employeesIncome of workers employed in an economy where they are not resident
- (Eg: Pak workers in Microsoft Corporation)
Income of residents employed by nonresident entities
- (Eg: People working in Pierre Cardin situated in Pakistan)
Personal transfer
It consist of all current transfers in cash or in kind made or received by residenthouseholds to or from nonresident households.
- (Eg: Mr. A sending money from Pakistan to his friend in US)
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c) Unilateral Transfers
Aids
Grants
Gifts
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CapitalA
ccounta) Foreign Direct Investment ---
b) Portfolio Investment
c) Other Capital
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Foreign Direct Investment
Investment in real assets in foreign countries
such as:
Land
Building
Existing plant
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Statistical Discrepancy
It represents errors due to unrecorded transactionsinvolving smuggling and other capital
Also known as Errors & Omissions
Many experts believe that it is the result of large
hidden capital flows, and so the item has beenplaced in the capital account part of the BOP
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Factors Affecting BOT Inflation
National Income
Government Restrictions
Exchange Rates
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HIGH INFLATION
Current Account (-) Dr
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HIGH INCOME LEVEL
Current Account (-) Dr
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Government Restrictions Tariffs
Quotas
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EXCHANGE RATES Current Account (-) Dr
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Correcting the trade deficit
Any policy that increases demand for countrys
goods and services
It will increase the Balance of Trade
Solution
If export price becomes attractive --
Floating rate may correct the deficit --
Trade deficit may experience an stable currency --
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If export price becomes attractive
It will increase the Balance of Trade
This can occur when a country has:
o Low inflation
o Low currency value
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Floating rate may correct the deficit
What is Deficit When country is spending more on foreign goods
When country is receiving less from exports
It means More supply of home currency for sale
The value of its currency should decrease
This decrease will encourage more foreign demand of home madeproducts
Therefore CA will increase
But this technique may not always work
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Trade deficit may experience an stable currency
Again Recall DEFICIT Spending more on foreign goods
Receiving less from exports
Resulting in low value of currency
NOW
Investment in securities becomes attractive for foreigners
Increased demand of home currencyUpward pressure on home currency
Therefore the trade imbalance will be offset by positive
capital account
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Weak Currency may not always be the solution
Counter pricing by competitors
- Once low priced items seem more attractive to the foreign customers
- The competing countries may also lower the price
Impact of other weak currencies
- The home currency does not necessarily weaken against all
currencies at the same time
Eg: It is possible that the Pakistani rupee may weaken against Indiancurrency, So Pakistan may stop buying Indian products
but It may start buying from other countries where Pak Rupee is still
stable i.e. Bangladesh, Srilanka, Iran etc
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Pre-arranged International Transaction
If the home currency is lower in value
It is not possible that every country will frequently start buying from
here
Till the time countries become aware about the cheap product
Lower rate may not be available till that time
Due to time lag it is not always possible
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Inter Company Trade
Importers and exporters under the same ownership have unique
relationship
Many firms use to buy the products from their subsidiaries
This type of trade makes 50% of trade
Trade between countries may not affect exchange rates
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Outflow Inflow
Inflow Outflow
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Correcting BOP
When all components of the BOP sheet are included
It must balance
It must sum to zero
There can be no overall surplus or deficit.
Eg: - If a country imports more than it exports
- Its trade balance will be in a deficit
But It has to be balancedBy running down reserves or by receiving loans
from other countries.
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Lets rename it the imbalance of payments
and announce its normal.
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The Official Reserve Account
It is the foreign currency and securities held by the
Govt.
Usually by its Central bank
It is used to balance the payments from year to year
It increases when there is a trade surplus
It decreases when there is a deficit
Sometimes the Central Bank use it to change the
exchange rate when the government perceives as more
favorable
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Agencies that help to Correct
BOP Deficit
IMF
IBRD
WTO International Financial Corporation
International Development Association
Bank of International Settlements Regional Development Agencies
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IMF
A result of UN Monetary & Financial Conferencein 1944
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Objectives of IMF
To promote Cooperation among countries
To promote stability in exchange rates
To provide temporary funds to member countries
attempting to correct imbalances of international
transactions
To promote free mobility of funds across countries
To promote free trade
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Compensatory Financing Facility (CFF)
This facility is mainly used by developing countries
Each country is assigned a quota
The amount of fund that a member country can borrow
depends upon its quota
The country must be willing to work with IMF to resolve
the problem
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SDRs An international reserve asset created by IMF in 1969
The financing by IMF is measured in SDRs
IMF allocates it to member countries to supplement
currency reserves
It is not a currency but a unit of account
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The SDR basket and Its Valuation
Total 1.260651
Currency Amountin 1 SDR
(1)
Exchange
Rate vs
US $
(2)
US $
Equivalent
(1) * (2)
USD 0.5770 1.00000 0.577000
Euro 0.0984 1.42550 0.140269
GBP 0.4260 0.88140 0.375476
Euro 21.0000 125.07000 0.167906
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IBRD
Established in 1944 Structural Adjustment Loan (SAL) in 1980
It spread its funds through co-financing:
Official Aid Agencies
(projects)
Export credit agencies
Commercial Banks
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Correcting BOP Problems
Roberts,Richard (1999)
The fundamental function of International Monetary System is toprovide mechanisms to correct imbalances.
Even a mixture of at least the first two methods may be used.
Methods:
There are three possible methods to correct BOP imbalances Adjustments of exchange rates
Adjustment of a nations internal prices along with its levels of demand
Rules based adjustment
Note: Improving productivity and competitiveness can also help to enhance theexports through other means BUT
It is generally assumed that a nation is always trying to develop and sell itsproducts to the best of its abilities.