Unit 3 Balance of Payments and Exchange Rates: Structure and Functioning

Balance of Payments and Exchange Rates

Goals

• To understand what is the balance of payments, how it is structured, and how it works
• To understand the relationship between balance of payments and exchange rates od the currencies
• Concepts of coverage rate and openness rate
• Approach to the balance of payments of the most relevant countries

Keywords

• Balance of payments, foreign direct investment, unbalance, openness rate, trade deficit, surplus

Agenda

1. Concept and components
2. The current account
3. The capital account
4. The financial account
5. Coverage rate and openness rate
6. Balance of payments and exchange rates

Concept of Balance of Payments

• Registers the monetary transactions (Payments and receipts) between a country and the rest of the world during a certain period (normally a year).
• By definition, it is always in equilibrium: its balance is 0. Follows the rule of double entry bookkeeping. Every international transaction enters the BoP twice, once as a debit and once as a credit.
• Any transaction resulting in a receipt from foreigners is reflected in the BoP as a credit. Any transaction resulting in a payment to foreigners is recorded as a debit

Limitations of Balance of Payments Data

• Be aware that most products are no longer made in one country. It is the case of the Global Value Chains that spread manufacturing and logistics throughout the world.
• For example, a car or a smartphone may have components manufactured in different countries before being assembled in a final location
• Balance of payments and other statistics often assign 100% of a product's value to a cuntry where it is finally assembled eventhough different countries have participated in the manufacturing
• It is because products in their manufacturing phase cross borders inside the MNC internal market which does nor include monetary transactions and hence is not recorded in the balance of payments
• This can lead to missinterpretations of trade balances

Components and Structure of the Balance of Payments

Structure of the Balance of Payments

Balance on Merchandise Trade Net Services Current Account Net Primary Income Net Secondary Income Balance of Payments Net portfolio Investment Capital Account Net Direct Investment Capital & Financial Account Financial Derivatives Financial Account Net other Investments Net Reserve Assets

Important points: The BOP = 0 A current account deficit (CAD) will exactly offset a CAFA surplus Balance on Merchandise Trade + Net Services = Balance on Goods and Services

The Current Account: Components

• Includes the balance of trade: exports (Incomes) and imports (expenses) of goods
• Balance of services: exports (incomes) and imports (expenses) of services. For example, tourism expenditures, shipping fees, Consultancy services ... )
• Net primary income Including income from factors: Capital income such as international interest and dividends earned abroad, revenues from domestic firms operating internationally or labor income and wages received by workers employed overseas.
• Net secondary income unilateral transfers between countries that do not correspond to any purchases. They can be considered a "gift" (remittances .. )

The Capital Account: Components

• Activities resulting in transfers of wealth between countries are recorded in the capital account:
• Includes the capital balance which is the Incomes less expenses produced by sells or purchases of tangible (A house, a plot of land) and/or intangible assets (copyrights, trademarks ... ) abroad.
• Also included the capital transfers from International public Institutions such as EU transfers to Spanish regions (Fondos de Desarrollo, Fondos de cohesión).

The Financial Account: Components

• Purchase or sale of financial assets: money, stocks, government debt ... are recorded in the Financial account.
• Measures the difference between the acquisition of assets from foreigners and the buildup of liabilities to them.

Financial Account: Investment Types

• Net portfolio investment, including investment in assets up to to 10% of its total value, without a purpose of active management or control of the securities issuer.
• Net foreign direct investment (FDI), involves a long-term relationship and reflects a lasting interest and control in a firm located in another country. It entails productive and not speculative investment in a firm with the goal of control and management. It is considered FDI when the investment is higher than 10% of the capital or voting power of the acquired firm.
• Financial derivatives and other investment Remember unit 1 ??? The most important source of info on FDI is UNCTAD annual World Investment Report.

Net Reserve Assets

Refers to changes by the central bank systems in foreign exchange reserves . Note that exporting firms will have to be paid in their currency, which means that foreign importers will first have to go to the bank and exchange their currency (buy euros in our case) · This fact leads to an increase in the net reserve assets of the exporting country

Net Errors and Omissions

Space for discrepancies to make the BoP zero. The information registered in the BoP comes from multiple sources, registering multiple cross border activities with multiple countries. It is difficult that its net balance is zero, this account is made for this purpose

The Current Account Balance

• The CURRENT ACCOUNT BALANCE is determined by subtracting expenses from incomes within the current account
• A country holds a surplus on ints current account when the sum of the incomes is higher that the expenses (it has exported more than imported)
• A country holds a deficit on ints current account when the sum of the incomes is higher that the expenses (it has exported less than imported)

Current Account Balance Examples

When a Spanish consumer buys a pair American blue jeans, the transaction enters the Spanish BoP as an import (expense) on the current account. When a Spanish company exports shoes to Turkey it is a export (income) on the current account When a British tourist reserves and pays for three nights of hotel in Gran Canaria, this transaction enters the Spanish BoP as an export (Income)

The Capital Account Balance

The CAPITAL ACCOUNT BALANCE is determined by substracting money outflows from money inflow in the capital account When a Spanish citizen purchases or tangible assets abroad (A house, a plot of land) enters the Spanish BoP as outflow in the capital account When a Spanish citizen sells intangible assets (A copyright, to a French firm) it enters Spanish BoP as a inflow in the capital account When the Spanish Government receives Funds from the EU such as the Fondos Next Generation or Fondos de Cohesión these funds hit the BoP as an inflow in the capital account

The Financial Account Balance

• The FINANCIAL ACCOUNT BALANCE is determined by substracting money outflows from money inflow in the financial account
• When a Spanish student buys shares of stock in the NYSE (not above 10% of the firm's capitalization value) it enters the financial account as an outflow

Example 1: Exports and Imports

In 2024 Spain exported products to Colombia for 1000 € and imported products worth of 800 € The exports will be recorded as an income on the spanish current account and as an inflow in the financial account as a net reseves variation (increase in reserves in foreign currency) The imports will be recorded as an expense on the spanish current account and as an outflow in the financial account as a net reserves variation (decrease in reserves in foreign currency) Note that exporting firms will have to be paid in their currency (euros), which means that foreign importers (Colombians) will first have to go to the bank and exchange their currency (buy euros) leading to an increase in the foreign Exchange reserves of the exporting country (pesos colombianos in the European

Example 1: Account Entries

Accountº Incomes/ inflows Expenses/ outflows Current account Balance of trade 1000 800 Account Financial account Net reserves assets 1000 800

Example 2: Imports and Foreign Direct Investment

• A company that manufactures active carbon filters, imports 4,500 euros.
• A Canadian businessman acquires 11% of the shares of CEMETEX S.A., a Spanish cement company, for a value of 300,506 euros.
• Join the entries a) and b) to calculate the balance of payments balances.

Example 2: Import Entry

A company that manufactures active carbon filters imports 4.500 euros. Pays in cash. As it is an import of merchandise, we will record it in the current Account Balance in the heading corresponding to trade balance. Being an import, it constitutes a payment for the country. Account Incomes/inflow Payments/Outflows Current account 4500 Account Financial account • Net Asset variation 4500

Example 2: Foreign Direct Investment Entry

A Canadian businessman acquires 11% of the shares of CEMETEX S.A., a Spanish cement company, for a value of 300.506 euros In this case it is a direct investment, as it is an acquisition of shares of more than 10%. Therefore, the corresponding entry will be in the Financial Account in the Direct Investment heading. Being an import of productive capital, it constitutes an entry of foreign currency, that is, an income Account Income/ Inflows Payments/ Outflows Financial account 300.506 · Foreign direct investment Account Financial account 300.506 • Net Asset variation

Example 2: Balance of Payments Calculation

Join the entries a) and b) to calculate the balance of payments balances. Account income Payment Net CURRENT ACCOUNT Trade balance 4.500 Net trade -4.500 FINANCIAL ACCOUNT Foreign direct Investment 300,506 Net FDI 300.506 Reserves 300.506 4500 NRV 296.006

Trade Indexes

Coverage Rate

Ratio of exports to imports in the current account Exports/Imports · Greater than one Trade surplus · Lower than one Trade déficit

Trade Openness Rate

Measures the cross border trade of a country in relation to its GDP. What part of its GDP is related to the international exposure of a country (Exports+ Imports)/GDP

Trade Indexes: Historical Data

Trade indexes: FIGURA 1-3 Comercio/PIB 45% (en %) Primera 40 Guerra Mundial Gran depresión 35 Reino Unido 30 Segunda Guerra Mundial 25 Europa 20 Canada 15 Australia Japón 10 5 Estados Unidos 0 1890 1913 1920 1930 1940 1950 1960 1970 1980 1990 2000