CH-3 Balance of Payments – International Financial Management : Book Guide

CHAPTER 3 BALANCE OF PAYMENTS ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Define balance of payments. Answer: The balance of payments (BOP) can be defined as the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. 2. Why would it be useful to examine a country’s balance-of-payments data? Answer: It would be useful to examine a country’s BOP for at least two reasons. First, BOP provides detailed information about the supply and demand of the country’s currency. Second, BOP data can be used to evaluate the performance of the country in international economic competition. For example, if a country is experiencing perennial BOP deficits, it may signal that the country’s industries lack competitiveness. 3. The United States has experienced continuous current account deficits since the early 1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous U.S. current account deficits? Answer: The current account deficits of U.S. may be attributable to (i) the strong dollar and undervalued currencies of trading partners such as China, (ii) high consumption and low savings in the U.S., (iii) weak competitiveness of U.S. industries, especially manufacturing sector. If U.S. deficits continue, the dollar may eventually depreciate substantially and the confidence in dollar may suffer. 4. In contrast to the United States, Japan has realized continuous current account surpluses. What could be the main causes for these surpluses? Is it desirable to have continuous current account surpluses? Answer: Japan’s continuous current account surpluses may have reflected a weak yen and high competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from appreciating more than it did. At the same time, foreigners’ exports to Japan were hampered by closed nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by the mercantilist policies. 5. Comment on the following statement: “Since the United States imports more than it exports, it is necessary for the United States to import capital from foreign countries to finance its current account deficits.” Answer: The statement presupposes that the U.S. current account deficit causes its capital account surplus. In reality, the causality may be running in the opposite direction: U.S. capital account surplus may cause the country’s current account deficit. Suppose foreigners find the U.S. a great place to invest and send their capital to the U.S., resulting in U.S. capital account surplus. This capital inflow will strengthen the dollar, hurting the U.S. export and encouraging imports from foreign countries, causing current account deficits. 6. Explain how a country can run an overall balance-of-payments deficit or surplus. Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve transactions. For example, an overall BOP deficit can be supported by drawing down the central bank’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central bank’s reserve holdings. 7. Explain official reserve assets and its major components. Answer: Official reserve assets are those financial assets that can be used as international means of payments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges, (iii) special drawing rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most important official reserves. 8. Explain how to compute the overall balance and discuss its significance. Answer: The overall balance is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall balance is significant because it indicates a country’s international payment gap that must be financed by the government’s official reserve transactions. 9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of U.S. treasury bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio investment on the U.S. balance of payments. Answer: As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in the long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to foreigners. If foreign funds are used productively and contributes to the competitiveness of U.S. industries, however, U.S. BOP may improve in the long run. 10. Describe the balance-of-payments identity and discuss its implications under the fixed and flexible exchange rate regimes. Answer: The balance of payments identity holds that the combined balance on the current and capital accounts should be equal in size, but opposite in sign, to the change in the official reserves: BCA + BKA = -BRA. Under the pure flexible exchange rate regime, central banks do not engage in official reserve transactions. Thus, the overall balance must balance, i.e., BCA = - BKA. Under the fixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as the central bank will accommodate it via official reserve transactions. 11. Exhibit 3.5 indicates that in 1999, Germany had a current account deficit and at the same time a capital account deficit. Explain how this can happen? Answer: In 1999, Germany experienced an overall BOP deficit, which must have been accommodated by the central bank, e.g., drawing down its reserve holdings. 12. Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments: (1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account kept in New York City. (2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express card. (3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a gift to his parents living in Mumbai. (4) A U.S. computer programmer is hired by a British company for consulting and gets paid from the U.S. bank account maintained by the British company. Answer: _________________________________________________________________ Transactions Credit Debit _________________________________________________________________ Japanese purchase of U.S. T bonds  Japanese payment using NYC account  U.S. citizen having a meal in Paris  Paying the meal with American Express  Gift to parents in Bombay  Receipts of the check by parents (goodwill)  Export of programming service  British payment out its account in U.S.  _________________________________________________________________ 13. Construct the balance of payment table for Germany for year 2010 which is comparable in format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial Statistics published by IMF or search for useful websites for the data yourself. Answer: A summary of the German Balance of Payments for 2010 (in $ billion) Credits Debits Current Account (1) Exports 1,788.4 (1.1) Merchandise 1,282.5 (1.2) Services 253.6 (1.3) Factor income 252.3 (2) Imports -1,529.5 (2.1) Merchandise -1,073.1 (2.2) Services -276.2 (3.3) Factor income -180.2 (3) Unilateral transfer 23.1 -74.2 Balance on current account 207.8 [(1) + (2) + (3)] Capital Account (4) Direct investment 28.0 -93.0 (5) Portfolio investment 39.8 -231.4 (5.1) Equity securities -3.1 -30.4 (5.2) Debt securities (5.3) Derivatives 65.9 -23.0 -200.9 ----- (6) Other investment 234.0 -162.2 Balance on capital account -184.8 [(4) + (5) + (6)] (7) Statistical discrepancies -20.9 Overall balance 2.1 Official Reserve Account -2.1 Source: IMF, International Financial Statistics Yearbook, 2012. Note: Capital account in the above table corresponds with the ‘Financial account’ in IMF’s balance of payment statistics. IMF’s ‘Capital account’ balance is included in ‘Other investment’ in the above table. It is noted that Germany experienced ‘divestment’ by foreigners in equity security investment in 2010. It is also noted that the above numbers may be affected somewhat by the government updating of the economic data. One salient feature of the above table is that Germany realized a significant merchandise trade surplus but a deficit in service trade, suggesting that Germany’s comparative advantage may be in the manufacturing sector, not in service sector. 14. Discuss the possible strengths and weaknesses of SDRs versus the dollar as the main reserve currency. Do you think the SDR should or could replace the U.S. dollar as the main global reserve currency? Answer: Being a basket currency, SDR has a relatively stable exchange value. However, IMF, that issues SDRs, has no mandate to function as the world central bank. In addition, there is no liquid bond market for SDR. The U.S. dollar, on the other hand, has deep, liquid markets and is backed by the most powerful country in the world. The dollar’s credibility as the dominant global currency, however, is being hurt by fiscal and trade deficits and the declining share of the U.S. in the world output. PROBLEMS 1. The U.S. Balance of Payments for year 2000. Solution: Merchandise -1224.43 Balance on current account -444.69 Balance on capital account 793.91 Statistical discrepancies -348.92 MINI CASE: MEXICO’S BALANCE OF PAYMENTS PROBLEM Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings and a major currency devaluation in December 1994, followed by the decision to freely float the peso. These events also brought about a severe recession and higher unemployment in Mexico. Since the devaluation, however, the trade balance has improved. Investigate the Mexican experiences in detail and write a report on the subject. In the report, you may: (a) document the trend in Mexico’s key economic indicators, such as the balance of payments, the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.; (b) investigate the causes of Mexico’s balance of payments difficulties prior to the peso devaluation; (c) discuss what policy actions might have prevented or mitigated the balance of payments problem and the subsequent collapse of the peso; and (d) derive lessons from the Mexican experience that may be useful for other developing countries. In your report, you may identify and address any other relevant issues concerning Mexico’s balance of payment problem. International Financial Statistics published by IMF provides basic macroeconomic data on Mexico. Suggested Solution to Mexico’s Balance-of-Payments Problem To solve this case, it is useful to review Chapter 2, especially the section on the Mexican peso crisis. Despite the fact that Mexico had experienced continuous trade deficits until December 1994, the country’s currency was not allowed to depreciate for political reasons. The Mexican government did not want the peso devaluation before the Presidential election held in 1994. If the Mexican peso had been allowed to gradually depreciate against the major currencies, the peso crisis could have been prevented. The key lessons that can be derived from the peso crisis are: First, Mexico depended too much on short-term foreign portfolio capital (which is easily reversible) for its economic growth. The country perhaps should have saved more domestically and depended more on long-term foreign capital. This can be a valuable lesson for many developing countries. Second, the lack of reliable economic information was another contributing factor to the peso crisis. The Salinas administration was reluctant to fully disclose the true state of the Mexican economy. If investors had known that Mexico was experiencing serious trade deficits and rapid depletion of foreign exchange reserves, the peso might have been gradually depreciating, rather than suddenly collapsed as it did. The transparent disclosure of economic data can help prevent the peso-type crisis. Third, it is important to safeguard the world financial system from the peso-type crisis. To this end, a multinational safety net needs to be in place to contain the peso-type crisis in the early stage. Balance of Payments Chapter Three Chapter Outline • Balance of Payments Accounting • Balance of Payments Accounts – The Current Account – The Capital Account – Statistical Discrepancy – Official Reserves Account • The Balance of Payments Identity • Balance of Payments Trends in Major Countries Balance of Payments Accounting • The balance of payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. Note: When we say “a country’s balance of payments” we are referring to the transactions of its citizens and government. Balance of Payments Example • Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle frames from Mercian Bicycles in Darby, England. • There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood’s bank account. • This will lead to a rise in the supply of dollars and the demand for British pounds. Balance of Payments Accounts • The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. • They are composed of the following: – The Current Account – The Capital Account – The Official Reserves Account – Statistical Discrepancy The Current Account • Includes all imports and exports of goods and services. • Includes unilateral transfers of foreign aid. • If the debits exceed the credits, then a country is running a trade deficit. • If the credits exceed the debits, then a country is running a trade surplus. The Capital Account • The capital account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets. • In 2009, the U.S. enjoyed a $281.1 billion capital account surplus—absent of U.S. borrowing from foreigners, this “finances” our trade deficit. • The capital account is composed of Foreign Direct Investment (FDI), portfolio investments, and other investments. Statistical Discrepancy Credits Debits Current Account 1 Exports $2,843.7 2 Imports ($3,182.8) 3 Unilateral Transfers $19.5 ($154.0) Balance on Current Account ($473.6) Capital Account 4 Direct Investment $227.9 ($406.2) 5 Portfolio Investment $166.9 ($14.7) 6 Other Investments $395.8 $40.4 Balance on Capital $410.1 7 AccountStatistical Discrepancies $79.4 Overall Balance $15.9 Official Reserve Account ($15.9) • There are going to be some omissions and misrecorded transactions—so we use a “plug” figure to get things to balance. • Exhibit 3.1 shows a discrepancy of $79.40 billion in 2011. The Official Reserves Account • Official reserves assets include gold, foreign currencies, SDRs, and reserve positions in the IMF.The Balance of Payments Identity BCA + BKA + BRA = 0 where BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account Under a pure flexible exchange rate regime, BCA + BKA = 0 U.S. Balance of Payments Data 2011 Credits Debits Current Account 1 Exports $2,843.7 2 Imports ($3,182.8) 3 Unilateral Transfers $19.5 ($154.0) Balance on Current Account ($473.6) Capital Account 4 Direct Investment $227.9 ($406.2) 5 Portfolio Investment $166.9 ($14.7) 6 Other Investments $395.8 ($40.4) Balance on Capital $410.1 7 AccountStatistical Discrepancies $79.4 Overall Balance $15.9 Official Reserve Account ($15.9) U.S. Balance of Payments Data 2011 U.S. Balance of Payments Data 2011 U.S. Balance of Payments Data 2011 U.S. Balance of Payments Data 2011 U.S. Balance of Payments Data 2011 Credits Debits Current Account 1 Exports $2,843.7 2 Imports ($3,182.8) 3 Unilateral Transfers $19.5 ($154.0) Balance on Current Account ($473.6) Capital Account 4 Direct Investment $227.9 ($406.2) 5 Portfolio Investment $166.9 ($14.7) 6 Other Investments $395.8 ($40.4) Balance on Capital $410.1 7 AccountStatistical Discrepancies $79.4 Overall Balance $15.9 Official Reserve Account ($15.9) Including that, the balance of payments identity should hold: BCA + BKA = – BRA ($473.6) + $410.1+ $15.9= ($15.9) Balance of Payments and the Exchange Rate Credits Debits Current Account 1 Exports $2,843.7 2 Imports ($3,182.8) 3 Unilateral Transfers $19.5 ($154.0) Balance on Current Account ($473.6) Capital Account 4 Direct Investment $227.9 ($406.2) 5 Portfolio Investment $166.9 ($14.7) 6 Other Investments $395.8 ($40.4) Balance on Capital $410.1 7 AccountStatistical Discrepancies $79.4 Overall Balance $15.9 Official Reserve Account ($15.9) Exchange rate $ Q Balance of Payments and the Exchange Rate As U.S. citizens import, they supply dollars to the FOREX market. Balance of Payments and the Exchange Rate As U.S. citizens export, others demand dollars at the FOREX market. Balance of Payments and the Exchange Rate As the U.S. government sells dollars, the supply of dollars increases. Sovereign Wealth Funds • Government-controlled investment funds are playing an increasingly visible role in international investments. • SWFs are mostly domiciled in Asian and MidEast countries and usually are responsible for recycling foreign exchange reserves of these countries swelled by trade surpluses and oil revenues. The J-Curve Effect Following a currency depreciation, the trade balance may at first deteriorate before it improves. The shape depends on the elasticity of the imports and exports. As an example, consider an imported good for which there is no domestic producer. If demand is price inelastic, then following a depreciation the trade balance gets worse (until domestic production begins). Balance of Payments Trends • 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. Balance-of-Payments Trends: 19822011 Balance-of-Payments Trends: 1982- Balance-of-Payments Trends: 19822011 Balance of Payments Trends • 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. Mercantilism and 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. Top U.S. Trading Partners, 2012 (in billions of dollars) Rank Country Imports Exports Trade Balance Total Trade 1 Canada 324.2 292.4 -31.8 616.7 2 China 425.6 110.6 -315 536.2 3 Mexico 277.7 216.3 -61.4 494.0 4 Japan 146.4 70.0 -76.4 216.4 5 Germany 108.5 48.8 -59.7 157.3 6 United Kingdom 54.9 54.8 -0.1 109.8 7 Korea, South 58.9 42.3 -16.6 101.2 8 Brazil 32.1 43.7 11.6 75.8 9 Saudi Arabia 55.7 18.1 -37.6 73.8 10 France 41.6 30.8 -10.8 72.4 11 Taiwan 38.9 24.4 -14.5 63.2 12 Netherlands 22.3 40.7 18.4 63.0 13 India 40.5 22.3 -18.2 62.9 14 Venezuela 38.7 17.6 -21.1 56.4 15 Italy 36.9 16.0 -20.9 52.9 Source: Census Bureau 3-29 The following slides cover the appendix to Chapter 3. Relationship between Balance of Payments and National Income Accounting • National income (Y), or gross domestic product (GDP), is equal to the sum of the nominal consumption of goods and services (C), private investment (I), government spending (G), and the difference between exports (X) and imports (M): Y ≡ GDP ≡ C + I + G + (X – M) Relationship between Balance of Payments and National Income Accounting • Private savings is defined as the amount left from national income after consumption and taxes (T) are paid: S ≡ Y – C – T or S ≡ C + I + G + (X – M) – C – T • Note that BCA ≡ X – M; we can rearrange the last equation as S – I) + (T – G) ≡ X – M ≡ BCA Relationship between Balance of Payments and National Income Accounting (S – I) + (T – G) ≡ X – M ≡ BCA • This shows that there is an intimate relationship between a country’s BCA and how it finances its domestic investment and pays for government spending. • If (S – I) < 0, then a country’s domestic savings is insufficient to finance domestic investment. • Similarly, if (T – G) < 0, then tax revenue is insufficient to cover government spending and a government budget deficit exists. Relationship between Balance of Payments and National Income Accounting (S – I) + (T – G) ≡ X – M ≡ BCA • When BCA < 0, government budget deficits and/or part of domestic investment are being financed by foreigncontrolled capital. • To reduce a BCA deficit, one of the following must occur: – For a given level of S and I, the government budget deficit (T – G) must be reduced. – For a given level of I and (T – G), S must be increased. – For a given level S and (T – G), I must fall. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605