THE BALANCE OF PAYMENTS CHAPTER FOUR BALANCE OF PAYMENT • The measurement of different forms of international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP) (Note that the resident is a economic concept, and it includes individuals, firms, nonprofit communities, and the government) • BOP influences and is influenced by other variables, such as gross domestic product (GDP), employment levels, price levels, exchange rates, and interest rates • Government policymakers need the data of BOP to evaluate the general competitiveness of domestic industries, to set the exchange or interest rate, to determine the monetary and fiscal policy, etc 4-3 CHAPTER FOUR OVERVIEW • Explain what the balance of payments (BOP) is • Study how to analyze BOP • Discuss the relationship between the BOP and the gross domestic product (GDP), the exchange rate, the interest rate, and the inflation rate • Introduce the history of the degree of the capital mobility and the mechanisms for capital movement THE BALANCE OF PAYMENTS • BOP data is also important for MNEs as it is a gauge of a nation’s competitiveness or health • For a MNE, both home and host country BOP data is important because: – BOP is an indication of pressure on a country’s foreign exchange rate – Change in a country’s BOP may signal the imposition or removal of controls in various sorts of payments, e.g., removal of the capital outflow control may reduce the balance of the financial account in BOP – A forecast of a country’s market potential (especially in the short run), e.g., a country with trade deficit may welcome investments that can increase its exports 4-4 TYPICAL BOP TRANSACTIONS THE ACCOUNTS OF BOP • The BOP is composed of three primary accounts, the Current Account, the Capital Account, and the Financial Account • In addition, the Official Reserves Account tracks government currency transactions • The fourth account, the Net Errors and Omissions Account, is produced to preserve the balance of the BOP • Each of the following represents an international economic transaction that is counted in and captured in the U.S BOP: – A U.S subsidiary of a foreign MNE acts as a distributor for the MNE’s products in the U.S market – A U.S.-based firm manages the construction of a major water treatment facility in a foreign country – The U.S subsidiary of a foreign firm pays profits (usually by distributing dividends to shareholders) back to the parent firm in its home (foreign) country – A Mexican lawyer purchases a U.S corporate bond through an investment broker in the U.S – Later, I will introduce the theoretical double-entry bookkeeping rule of the BOP, and you will understand that BOP should balance – However, it is impossible to record all international transactions associated with a nation, so in practice the organizations to produce BOP reports collect national data for different accounts separately, which could result in the imbalances of the BOP 4-5 THE ACCOUNTS OF BOP 4-7 THE CURRENT ACCOUNT • The Current Account includes all international economic transactions with income or payment flows occurring within the current year It consists of the following four subcategories: – Goods trade • The export and import of goods • The most traditional international economic activities • The current account is typically dominated by this component, which is known as the Balance of Trade (BOT) – Services trade ※ The classification of accounts of the BOP in this chapter follows the definition of the International Monetary Fund (IMF) ※ Because the IMF is the primary sources of statistics for BOPs, its terminologies are more wildly accepted ※ In fact, this system is also used by the Organization for Economic Cooperation and Development (OECD) and United Nations System of National Accounts (UNSNA) • The export and import of services • Including financial services provided by banks to foreign importers and exporters, travel services of airlines, and construction services of domestic firms in other countries • For the major industrial countries, like the U.S., this subaccount grows fast in the past decade 4-6 4-8 THE CURRENT ACCOUNT THE CURRENT ACCOUNT – Income • The deficits in the BOT of the U.S in the past two decades have been wildly debated since merchandise trade is the original core of international trade • Reasons for the deficits in the BOT of the U.S • The dividend income from subsidiaries is the income receipts • The wages and salaries paid to nonresident workers are income payments – Current transfers • The change in ownership of real resources or financial items is called a transfer • Any transfer between countries that is one-way–a gift or grant– is termed a current transfer • For example, funds provided by the U.S government to aid a less-developed nation, or money sent home by migrants and permanent workers abroad ※Although the information of balance of trade (BOT) is so widely quoted in the business press in most countries, this number is somewhat misleading for large industrialized countries because the service trade is not taken into account 4-9 U.S Trade Balance & Balance on Services & Income, 19852007 (billions of US$) – Relatively high income in the U.S creates the import demand – The price of the imported products after passing the exchange rate is cheaper, which may be caused by that many trading partners of the U.S adopt the policy of depreciating their currency against US$ to maintain the competitive power in the U.S market – The biggest bilateral deficits are with China and Japan, which maintain relative weakness of their currencies by buying massive amounts of U.S dollars (usually investing in Treasury bonds) while selling corresponding amounts of their own currencies 4-11 THE CURRENT ACCOUNT – FYI, at the end of 2009, Japan and China held the largest amount of Treasury bonds in the world, each of which owns 768.8 billion and 755.4 billion US$, respectively – Later, you will see the above actions will increase the cash inflow for the financial account and thus cause the surplus of the financial account of the U.S • The deficit in the BOT results in the decline of heavy traditional industries in the U.S (steel, automobiles, automotive parts, textiles) • The consistent surplus in the services trade account may be from travel and passenger fares, transportation services, expenditures by foreign students pursuing studies in the U.S., telecommunications services, financial services, etc ※ The U.S goods trade balance has been consistently negative, but has been slightly offset by the continuous surplus in the balance of services trade 4-10 4-12 THE CAPITAL AND FINANCIAL ACCOUNT DIRECT INVESTMENT • The capital account is made up of capital transfers related to the purchase and sale of fixed assets such as real estates, plants, or equipment, etc • This is the net balance of capital dispersed from and into the U.S for the purpose of exerting control over real assets • If U.S investors hold 10% or more of the voting shares in a foreign company, that company is considered the foreign affiliate of a U.S company, and this investment is classified as a direct investment • The source of concern over foreign direct investment in any country focuses on two topics: control and profit – If a U.S firm purchases a building in another country, this is a cash outflow in the capital account of the U.S • The capital account has been introduced as a separate component in the IMF’s balance of payments only recently • The magnitude of capital transaction is relatively minor, so we include it in principle in the following discussion of the financial account 4-13 4-15 DIRECT INVESTMENT THE FINANCIAL ACCOUNT • Some countries possess restrictions on foreigners to own assets in their country, e.g., domestic land, assets, and industry should be owned only by residents of the country • However, the U.S has few restrictions on what foreign residents or firms can own or control assets in the U.S • As for profit, the concern of possible profit outflow may limit the foreign investment in some countries • The financial account in the balance of payments measures all international economic transactions of financial assets • The financial account is classified into three components, depending on the degree of investor control over the assets or operations – Direct Investment – in which the invested financial assets exerts some explicit degree of control over the real assets – Portfolio Investment – in which the invested financial assets has no control over the real assets – Other Financial Investment – consists of bank deposits, various short-term and long-term trade credits, crossborder loans, currency deposits,, and other A/R and A/P related to cross-border trade – There are evidences indicating that foreign firms in the U.S reinvest most of their profits in their U.S business (at a higher rate than domestic firms in the U.S.) • The capital inflow in the form of direct investment is generally welcomed in the U.S due to the possible increase of jobs, production, services, technology, etc 4-14 4-16 PORTFOLIO INVESTMENT TRANSACTION BOOKKEEPING IN BOP • Before introducing the net errors and omissions and reserves accounts in the BOP, the theoretical bookkeeping process for BOP is introduced first • There are three main elements of the actual process of recording international economic activities: • This is the net balance of capital that flows in and out of the U.S but does not reach the 10% threshold of direct investment • The purchase of debt securities across borders is also classified as portfolio investment because debt securities by definition not provide the buyer with ownership or control • Portfolio investment is motivated by a search for returns rather than to control or manage the asset • The motivating forces for portfolio investment flows are only return and risk, so the series of the flow of portfolio investment is less predictable (Exhibit 3.5) – Identifying what is and is not an international economic transaction – Understanding how the flows of goods, services, assets, and money create debits and credits to the overall BOP – Understanding the bookkeeping procedures for BOP accounting • The rule of thumb aids the understand of BOP accounting: “Follow the cash flow.” 4-17 Financial Account Balances for the United States, 1985-2007 (billions of US$) – Credits (+): cash inflow – Debits (–): cash outflow 4-19 TRANSACTION BOOKKEEPING IN BOP • Ex 1: The U.S exports $2mil goods to the U.K., and 1) the importer in the U.K pays the money into the account of the U.S exporter in the U.K.; or 2) the importer in the U.K uses the money in its account in the U.S to pay the bill ※ Export of goods to foreign country will bring cash inflow for the U.S in the account of Export of goods in Current Account 1) The increase of deposits of U.S firms in foreign banks means a cash outflow for the U.S in the account of Other financial items in Financial Account 2) The decrease of deposits of foreign firms in U.S means a cash outflow for the U.S in the account of Other financial items in Financial Account Debit (–) Export of goods in CA Other financial items in FA 4-18 Credit (+) $2mil $2mil 4-20 TRANSACTION BOOKKEEPING IN BOP TRANSACTION BOOKKEEPING IN BOP • Ex 4: A U.K firm purchases $5mil U.S Treasury bonds and pays the money from its accounts in the U.S banks • Ex 2: The U.S imports $6mil services from the U.K., and 1) the importer in the U.S pays the money into the account of the U.K exporter in the U.S.; or 2) the importer in the U.S use the money in its account in the U.K to pay the bill ※ Purchasing U.S Treasury bonds, which is a portfolio investment, brings cash inflow for the Net portfolio investment in Financial Account of the U.S ※ The decrease of deposits of foreign firms in U.S banks means a cash outflow for Other financial items in Financial Account in the U.S ※ Import of services from foreign countries will cause a cash outflow for the U.S in the account of Import of services in Current Account 1) The increase of deposits of foreign firms in U.S banks means a cash inflow for the U.S in the account of Other financial items in Financial Account 2) For the U.S., drawing money from U.K banks by its residents means a cash inflow in the account of Other financial items in Financial Account Debit (–) Import of services in CA Debit (–) Net portfolio investment in FA Other financial items in FA Credit (+) $5mil $5mil Credit (+) $6mil Other financial items in FA $6mil 4-21 TRANSACTION BOOKKEEPING IN BOP THE BOP AS A FLOW STATEMENT # • The BOP is often misunderstood as many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement • Ex 3: The U.S government transfers $1mil goods as a grant to Nicaragua ※ Export of goods to foreign country should bring cash inflow for the U.S in the account of Export of goods in Current Account ※ Transferring $1mil goods as a grant to foreign country means a cash outflow for the U.S in the account of Transfers in Current Account Debit (–) Export of goods in CA Transfers in CA 4-23 – It does not add up the value of all assets and liabilities of a country on a specific date (as an individual firm’s balance sheet would do) • By recording all international transactions over a period of time such as a year, it tracks the continuing flows of purchases and payments between a country and all other countries • According to the above double-entry bookkeeping rule, the BOP must balance theoretically Credit (+) $1mil $1mil 4-22 4-24 NET ERRORS & OMISSIONS/OFFICIAL RESERVES ACCOUNTS SUGGESTED ANSWERS • The official reserves account (or foreign exchange reserves) is the total reserves held by official monetary authorities within the country • These reserves are normally composed of the major currencies used in international trade and financial transactions (so-called hard currencies like the U.S dollar, Euro, British pound, Japanese yen, gold, or SDRs) • Since the data of the current, capital, financial, and official reserves accounts are collected and recorded separately or there are possibly illegal transfers, errors could occur and thus the BOP may not balance in practice • The net errors and omissions account ensures that the BOP actually balances 4-25 Current account: Credit (+) Debit (-) Balance on current account: Financial account: Capital Inflows Capital outflows Balance on financial account: Capital-account: 4-27 TRANSACTIONS THE U.S BOP FROM 1998-2007 The following transactions (expressed in U.S $ billions) take place during a year Calculate the U.S merchandise-trade, current-account, capital-account, and financial-account balances + : cash inflow (demand) – : cash outflow (supply) a The United States exports $300 of goods and receives payment in the form of foreign demand deposits abroad There is a surplus on the basic balance, which means a net cash inflow of 45 billion US$ to the U.S The U.S government uses its official reserves to buy billion US$, i.e., it creates a net demand of billion US$ by purchasing US$ with its official reserves in the exchange rate markets b The United States imports $225 of goods and pays for them by drawing down its foreign demand deposits c The United States pays $15 to foreigners in dividends drawn on U.S demand deposits here d American tourists spend $30 overseas using traveler's checks drawn on U.S banks here The U.S government sells billion US$ in exchange for increasing official reserves, i.e., providing net supply of US$ by using US$ to purchase foreign currencies e Americans buy foreign stocks with $60, using foreign demand deposits held abroad f The U.S government sells $45 in gold for foreign demand deposits abroad g In a currency support operation, the U.S government uses its foreign demand deposits to purchase $8 from private foreigners in the United States Basic balance 26 4-28 THE BOP IN TOTAL — SURPLUS • A surplus in the BOP  net cash inflow for the domestic country  foreign residents demand the domestic currency to pay the cash to the domestic residents  the demand of the domestic currency exceed the supply of the domestic currency • The domestic currency has the pressure to appreciate • If the government wants to maintain the fixed exchange rate, it can intervene the market by selling its own currency in exchange for other currencies and thus building up its stores of hard currencies, i.e., its foreign exchange reserves THE ANALYSIS OF BOP – Selling its own currency causes a cash outflow (supply) which diminishes the surplus in the BOP 4-29 FIXED AND FLOAT EXCHANGE RATE REGIMES THE BOP IN TOTAL — DEFICIT • Fixed exchange rate regime – The domestic currency, guaranteed by the government, is convertible into a fixed amount of a foreign currency, a basket of currencies, or another measure of value, such as gold – Devaluation (revaluation): A deliberate downward (upward) adjustment to a country’s official exchange rate, also called the parity rate, relative to other currencies – In a fixed exchange rate regime, only a decision by a country’s government (i.e., the central bank) can alter the official value of the currency • Float exchange rate regime – A currency’s value is allowed to fluctuate according to the demand and supply in the foreign exchange market – Depreciation (appreciation): refers to a drop (increase) in the foreign exchange value of a floating currency 4-31 • A deficit in the BOP  net cash outflow for the domestic country  domestic residents demand the foreign currency to pay bills to foreign residents  an excess supply of the country’s currency in foreign exchange markets worldwide • The domestic currency has the pressure to depreciate • To maintain the fixed exchange rate, a government can intervene the market by purchasing it own currency at the expense of its foreign exchange reserves to support the domestic currency value – Buying its own currency causes a cash inflow (demand) which offsets the deficit in the BOP 4-30 4-32 CURRENT AND FINANCIAL/CAPITAL ACCOUNT BALANCES FOR THE U.S., 1992-2007 (BILLIONS OF US$) OFFICIAL RESERVES ACCOUNTS • The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system – In a fixed-rate system, the government decides the fixed exchange rate, also called the parity rate, to exchange for other foreign currencies – For excess supply (demand) of the domestic currency, to prevent the value of the domestic currency from falling (rising), the government should spend its official reserves (domestic currency) to purchase the domestic currency (official reserves) to support (calm down) the value of the domestic currency – Under a floating-rate system, governments have no such responsibility and the role of official reserves is diminished ※ The above figure shows the inverse relationship between the balances of the current account and the capital/financial account in the U.S 4-33 CURRENT AND FINANCIAL ACCOUNT BALANCE RELATIONSHIPS CURRENT AND FINANCIAL ACCOUNT BALANCE RELATIONSHIPS • Since the BOP should balance, it is possible to infer the inverse relation between the current account and the financial account, which are the two major accounts in the BOP • In the examples on Slides 4-21 and 4-22, it is found that the double-entry bookkeeping in theory requires that the current and financial accounts offset for each other • Intuitively, countries experiencing current account deficits “finance” these purchases through equally large surpluses in the financial account (like the U.S.) – For the U.S., both real and financial assets possessed by foreigners increases, the country become a “net debtor” – On the other hand, for Japan, the current account surplus is matched against a financial account deficit 4-35 4-34 • The surplus or deficit in the current account cannot be the signal for the performance of the economy – For the U.S., the well investment environment attracts capital and financial investments and this cash inflow finances the deficits in the current account – For Latin America • In 1980s, there was surplus in the current account, but the pessimistic prospects of the economy caused deficits in the capital and financial accounts • In 1990s, there are better expectations of the future economy, so there are surpluses in the capital and financial accounts, but together with the deficits in the current account – For rapidly growing countries (countries in recession), importing more (less) goods and services will decrease (increase) the balance of the current account or even generate deficits (surpluses) in the current account 4-36 CURRENT AND FINANCIAL ACCOUNT BALANCE RELATIONSHIPS FOR CHINA THE CHINA BOP FROM 1998-2007 There is a surplus on the basic balance, which means a net cash inflow of US$437 billion to China + : cash inflow (demand) – : cash outflow (supply) The China government sells Renminbi equivalent to 461 billion US$ in exchange for increasing official reserves, i.e., providing net supply of Renminbi by using Renminbi to purchase foreign currencies ※ Due to maintain the fixed exchange rate or said to diminish the appreciation pressure, the China government intervenes foreign currency markets by issuing more Renminbi to purchase foreign currencies ※ The results are the increase of foreign exchange reserves and a possible inflation problem 4-37 – The China government conduct a lot of intervention to maintain its balance of payment and thus the relatively fixed exchange rate against the U.S dollar – The appropriate solution is to allow the Renminbi to float and appreciate However, it is not in line with China’s current political plan 4-39 CURRENT AND FINANCIAL ACCOUNT BALANCE RELATIONSHIPS FOR CHINA • The double surplus in China – Surpluses in both the current and financial accounts is called the double surplus phenomenon – This unusual phenomenon reflects how exceptional the growth of the Chinese economy is – Although the current account surplus should create a financial account deficit, the positive prospects of the Chinese economy have drawn such massive capital inflows in recent year and thus the financial account becomes in surplus THE BOP INTERACTION WITH MACROECONOMIC VARIABLES • The underestimated value of Renminbi strengthens the capital inflows • This phenomenon also reflects that China is a world factory– attract international capital, build factories, produce goods, and export them 4-38 4-40 10 THE BOP INTERACTION WITH KEY MACROECONOMIC VARIABLES THE BOP AND GDP • In the same period, a positive current account balance (surplus) contributes directly to increasing the measure of GDP, but a negative current account balance (deficit) decreases GDP • Taking multiple periods into account • A nation’s balance of payments interacts with nearly all of its key macroeconomic variables • Interaction means that the BOP affects and is affected by key macroeconomic factors such as: – – – – Gross Domestic Product (GDP) Exchange rates Interest rates Inflation rates 4-41 THE BOP AND GDP 4-43 THE BOP AND EXCHANGE RATES • A country’s BOP can have a significant impact on the level of its exchange rate and vice versa, depending on that country’s exchange rate regime • In fact, the value of BOP has predicting power for exchange rates on the long-term trend, but performs poor on the short-term movement • Fixed Exchange Rate Countries • In a static (accounting) sense, a nation’s GDP can be represented by the following macroeconomic accounting identity: GDP = C + I + G + X – M where C = consumption spending I = capital investment spending G = government spending X = exports of goods and services M = imports of goods and services X – M = the sum of balances of the first two subaccounts in the current account, which is close to the total balance on the current account and thus used to “approximate” the balance on the current account – GDP ↑  disposable income ↑  consumption ↑  import ↑  balance of current account ↓ – GDP ↑  capital investment ↑  export ↑  balance of current account ↑ ※Thus, in a dynamic sense, the relationship between GDP and balance of the current account is uncertain ※BTW, GDP↑  capital investment ↑  employment rate ↑ (could be offset by the foreign sourcing, i.e., the import of cheaper goods and services from foreign countries), so the BOP also influences the employment rate – Under a fixed exchange rate system, the government is responsible to ensure that the BOP is near zero by intervening markets and matching the demand and the supply of the domestic currency – When there is a deficit for the overall balance, if the country run out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue 4-42 4-44 11 BALANCE OF PAYMENTS AND THE EXCHANGE RATE THE BOP AND EXCHANGE RATES • Floating Exchange Rate Countries – Under a floating exchange rate system, the government has no responsibility to peg its foreign exchange rate – Surplus on the BOP  currency appreciation  price of export goods ↑, price of import goods ↓  export ↓, import ↑  BOT ↓  BOP ↓ – Deficit on the BOP  currency depreciation  price of export goods↓, price of import goods↑ export ↑, import ↓  BOT ↑  BOP ↑ ※Thus, the floating exchange rate regime can adjust the BOP automatically – However, the effect of the change of the exchange rate will not affect the BOP in the right direction immediately – For deficits in the BOP, the effect of currency depreciation will let the deficits get worse in the short run, but moves back toward equilibrium in the long run (J-curve effect discussed later) Credits Exchange rate $ Debits Current Account Exports Imports Unilateral Transfers Balance on Current Account Capital Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance Official Reserve Account P $2,843.7 S ($3,182.8) $19.5 ($154.0) ($473.6) $227.9 $166.9 $395.8 $410.1 $79.4 $15.9 ($406.2) ($14.7) ($40.4) D Q ($15.9) Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-47 4-45 BALANCE OF PAYMENTS AND THE EXCHANGE RATE THE BOP AND EXCHANGE RATES • Managed Floating Regime – Countries adopting this regime have desired exchange rates, but they allow the exchange rate to derivate from the desired level to some extent – They often find that it is necessary to take action to maintain their desired exchange rate levels – In addition to intervening the foreign exchange market, they usually try to alter the exchange rate by influencing the motivations of market participants – For example, to deal with the depreciation pressure from the deficit in the BOP, governments may raise domestic interest rate to attract additional capital from aboard, which creates additional demand for the domestic currency and alleviates the depreciation pressure (in the meanwhile, diminishes the deficit in the BOP) Credits Exchange rate $ Debits Current Account Exports Imports Unilateral Transfers Balance on Current Account Capital Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance Official Reserve Account P $2,843.7 S ($3,182.8) $19.5 ($154.0) ($473.6) $227.9 $166.9 $395.8 $410.1 $79.4 $15.9 ($406.2) ($14.7) ($40.4) D Q ($15.9) As U.S citizens import, they supply dollars to the FOREX market 4-46 Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-48 12 BALANCE OF PAYMENTS AND THE EXCHANGE RATE Credits Debits BALANCE OF PAYMENTS TRENDS Exchange rate $ Current Account Exports Imports Unilateral Transfers Balance on Current Account Capital Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance Official Reserve Account P $2,843.7 S ($3,182.8) $19.5 ($154.0) ($473.6) $227.9 $166.9 $395.8 $410.1 $79.4 $15.9 ($406.2) ($14.7) ($40.4) D Q ($15.9) As U.S citizens export, others demand dollars at the FOREX market Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-49 BALANCE OF PAYMENTS AND THE EXCHANGE RATE Credits • Since 1982 the U.S has experienced continuous deficits on the current account and continuous surpluses on the capital account • During the same period, Japan has experienced the opposite • The U.S and the U.K tend to realize current account deficits, whereas China, Japan, and Germany tend to realize current account surpluses • This “global imbalance” implies that the U.S and U.K generally use up more outputs than they produce, while the opposite holds for China, Japan, and Germany Debits Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-51 BALANCE-OF-PAYMENTS TRENDS: 1982-2011 Exchange rate $ Current Account Exports Imports Unilateral Transfers Balance on Current Account Capital Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance Official Reserve Account P $2,843.7 ($3,182.8) $19.5 ($154.0) ($473.6) $227.9 $166.9 $395.8 $410.1 $79.4 $15.9 ($406.2) ($14.7) ($40.4) S S1 D Q ($15.9) As the U.S government sells dollars, the supply of dollars increases Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-50 Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-52 13 BALANCE-OF-PAYMENTS TRENDS: 1982-2011 MERCANTILISM & THE BALANCE OF PAYMENTS • Mercantilism holds that a country should avoid trade deficits at all costs, even to imposing various restrictions on imports • Mercantilist ideas were criticized in the 18th century by such British thinkers as Adam Smith, David Ricardo, and David Hume • They argued that the main source of wealth in a country is its productive capacity not its trade surpluses Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-53 BALANCE-OF-PAYMENTS TRENDS: 1982-2011 3-55 TOP U.S TRADING PARTNERS, 2012 (IN BILLIONS OF DOLLARS) Rank Country Canada China Mexico Japan Germany United Kingdom Korea, South Brazil Saudi Arabia 10 France 11 Taiwan 12 Netherlands 13 India 14 Venezuela 15 Italy Source: Census Bureau Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved Imports Exports Trade Balance Total Trade 324.2 425.6 277.7 146.4 108.5 54.9 292.4 110.6 216.3 70.0 48.8 54.8 -31.8 -315 -61.4 -76.4 -59.7 -0.1 616.7 536.2 494.0 216.4 157.3 109.8 58.9 32.1 55.7 41.6 38.9 22.3 40.5 38.7 36.9 42.3 43.7 18.1 30.8 24.4 40.7 22.3 17.6 16.0 -16.6 11.6 -37.6 -10.8 -14.5 18.4 -18.2 -21.1 -20.9 101.2 75.8 73.8 72.4 63.2 63.0 62.9 56.4 52.9 Copyright © 2014 by the McGraw-Hill Companies, Inc All rights reserved 3-54 3-56 14 TRADE BALANCES AND EXCHANGE RATES J-CURVE ADJUSTMENT TRADE BALANCES AND EXCHANGE RATES J-CURVE ADJUSTMENT • The reason why the sudden depreciation of the domestic currency deteriorates the trade deficit immediately in the J-curve adjustment • A country’s import and export of goods and services are affected by changes in exchange rates • The transmission mechanism is in principle quite simple: changes in exchange rates change relative process of imports and exports, i.e., changing prices in turn result in changes in quantities demanded through the price elasticity of demand – Most exports were priced in US$, but most imports were contracts denominated in foreign currency – Sudden depreciation: because all the contracts of exports and imports are in effect and the cost to U.S importers rise as they spent more dollars to buy foreign currencies, whereas the revenues earned by U.S exporters remain unchanged, it deteriorates the trade deficit immediately • The “J-curve” adjustment path gives the reason that many countries, e.g., Taiwan in 1997, adopted the devaluation strategy to improve the trade balance 4-57 4-59 THE BOP AND INTEREST RATES EXHIBIT 4.8 – THE J-CURVE EFFECT • Apart from the use of interest rates to intervene the foreign exchange market, the overall level of a country’s interest rates compared to other countries have impact on the financial account of the BOP • Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere • In the case of the U.S., even with low real interest rates, the opposite has occurred due to perceived growth opportunities and political stability, which allows it to finance its large fiscal deficit • However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the current account balance is worsening ※ There are three stages to adjust the deficit of the balance of trade ※ The adjustment path of the trade balance is like the shape of a flattened “J” ※ In the pass-through period, import prices ↑ and export prices ↓ due to the currency depreciation (explained on the next slide) ※ In the quantity adjustment period, import demand ↓ and export demand ↑, so the balance of trade–exports less imports–improves eventually 4-58 4-60 15 THE BOP AND INFLATION RATES • The effect of increasing imports – Due to the comparative advantage theory in international trade, imports of goods and services are usually cheaper and have the potential to lower a country’s inflation rate – Imports ↑  balance on current account ↓  BOP ↓ ※If the BOP declines with the increase of the import, the inflation rates may decrease in the meantime – In addition, imports ↑  foreign competition substitutes for domestic competition  domestic production ↓, employment rate ↓  GDP ↓ (this argument is consistent with the macroeconomic accounting identity, i.e., imports ↑  GDP ↓) 4-61 16 ... 108.5 54. 9 292 .4 110.6 216.3 70.0 48 .8 54. 8 -31.8 -315 -61 .4 -76 .4 -59.7 -0.1 616.7 536.2 49 4.0 216 .4 157.3 109.8 58.9 32.1 55.7 41 .6 38.9 22.3 40 .5 38.7 36.9 42 .3 43 .7 18.1 30.8 24. 4 40 .7 22.3 17.6... $2, 843 .7 S ($3,182.8) $19.5 ($1 54. 0) ( $47 3.6) $227.9 $166.9 $395.8 $41 0.1 $79 .4 $15.9 ( $40 6.2) ($ 14. 7) ( $40 .4) D Q ($15.9) As U.S citizens import, they supply dollars to the FOREX market 4- 46... Official Reserve Account P $2, 843 .7 S ($3,182.8) $19.5 ($1 54. 0) ( $47 3.6) $227.9 $166.9 $395.8 $41 0.1 $79 .4 $15.9 ( $40 6.2) ($ 14. 7) ( $40 .4) D Q ($15.9) Copyright © 20 14 by the McGraw-Hill Companies,