Global Imbalances: BOP Flashcards
What is the Balance of payments?
Record of all flows and payments between residents of one country and the rest of the world in a given period.
What does BOP include?
Current account (CA), Financial/capital account (FA) and Official reserve account (ORA)
What is a credit/debit in a BOP
credit: event that records foreign exchange earned (inflow of foreign exchange). Exports
Debit: Event that records foreign exchange spent (outflow of foreign exchange). Imports
Debits/credits are recorded independently (not double-entry)
What does BOP account for?
Number of $s coming in and out of a country.
Involves the measurement of all the reasons why a currency is supplied/demanded
Why is it incorrect to state BOP is in disequilibrium?
Because BOP must balance. The “net errors and omissions account” is created to preserve the balance
What is the current account in BOP?
All international transactions with income or payment flows occur within a year. Includes four subcategories:
1. Goods trade and import of goods
2. Service trade
3. Income
4. current transfers
CA is normally dominated by goods trade and import of goods which is known as Balance of Trade (BOT). Normally this excludes serivce trade but merchandise trade is the core of international trade. Manufacturing was the basis of industrial evolution and comparative advantage in international trade
What is the financial account in BOP?
Exchange of financial assets, the degree of control over assets/operations is used to classify financial assets.
Net foreign investment (FDI): Direct investment, acquired with the goal of controlling the company (10% threshold)(honda builds plant in ohio)
Portfolio investment (FPI): german resident buys japanese government bonds
What are foreign portfolio investments?
Net balance of capital flows in and out of the country that does not meet the 10% threshold of direct investment. Debt securities across borders is a portfolio investment as debt securities by definition do not provide buyer any ownership or control.
What is capital flight?
When financial flows are very mobile, capital moves quickly in response to investor expectations.
- mobile financial flows –> economic volatility
- Sudden outflows –> economic financial crisis
This is why portfolio investment is often more volatile
What is the Official reserves account in BOP?
It is the total reserves held by the official monetary authorities within a country. Normally gold and major currencies.
ORA measures the change in official reserves (e.g. Us sells $s for pounds to depreciate the $ or the U.S. government buys $s with ¥ to support the $ against the ¥)
Importance depends on if the country is using a fixed or floating exchange rate
What are the characterists of a floating exchange system?
No government intervention, the markets are allowed to work. Supply = Demand.
Demand for $ is created from exports and foreign investment in the US.
Supply of $ is created from imports and U.S. investment in foreign countries
What is the role of the government in managing exchange rates and its BOP? (Fixed, floating and managed float)
Fixed: Government bears responsibility to ensure that BOP is near zero
Floating: Government has no repsonsiblity
Managed float: Government often finds it necessary to take action to maintain desired exchange rate
What are the characteristics of a fixed exchange system?
The price of the currency is fixed by the government. The central bank intervenes whenever its currency deviated from stated values by more than certain percentage.
- excess market demand for undervalued currency is supplied by the government
- excess supply for overvalued currency is absorbed by the government
Therefore central bank must maintain the rate and buy/sell at fixed rate
What is China’s twin surpluses?
- High surplus in both current and financial accounts (normally invese relationship betwene teh two for free floating currency)
- Twin surpluces are blanaced by official reserves: Official reserves show a deficit, therefore not breaking the reuls.
-Reserves allow china to manage value of chinese Yuan and its impact on competition in world economy
What are the macroeconomic factors that impact BOP and can be impacted by BOP?
Exchange rates, interest rates, inflation rates
How do exchange rate adjustments under flexible exchange rates affect the BOP?
Under flexible exchange rates, there is a price adjustment in the currency, the central bank does not intervene and there is no change in official reserves.
There could be a currency intervention where they intervene to stop currency depreciation but this is rare amongs flexible currencies
How do exchange rate adjustments under fixed exchange rates affect BOP?
There is no price adjustment but the central bank MUST provide the quantity adjustment to keep the currency par to fixed value.
How do interest rates affect BOP?
Low interest rates should stimulate capital outflow as people seek higher rates elsewhere. Opposite has occured in the US due to growth opportunities and political stability (reason for the large fiscal deficit to be allowed)
How does BOP affect inflation rates?
Imports can decrease a country’s inflation rates as substitutes for domestic products mainstains a low rate of inflation than what it would have been without imports. (high volume of global trade = pro-competition)
HOWEVER increased lower-priced imports cause lower employment and GDP will be lower and current account will be more negative.
imports could also increase inflation
What is the relationship between trade balances and exchange rates?
Exchange rates change through the relative price of imports and exports, and changing prices therefore create changes in quantities demanded through price elasticity.
Seems straight forward but its more complex in reality. There are three stages in short/intermediate/long term and it takes time. Supply chains are very importants
Review Trade adjustment tp exchange rates
The J-Curve (Slide 33)
What is the source of output growth?
Increases in labor, increases in captal, increase in efficiency of these two
What is the ultimate budget constraint for a country?
The total output that a country produces. It can use more output only if it borrows from foreigners.
Why do policymakers and global businesses care about BOP?
It gauges a nation’s competitiveness and health.
For MNE home and host country BOP data is important:
1. Indicates pressure on exchange rate
2. Imposes or removes control of certain payments (dividends, interest, licensing, cash disbursement)
3. It is a forecast of a country’s market potential (especially short run)
Why is it important to understand global imbalances in BOP?
It helps understand the broader implications and consequences of current account imbalances.
Gives cues on how nation can avoid crisis brought by volatile financial flows and minimize affects of financial crises.
Lessons taught by 2008 financial crisis and COVID economic crisis.
What is the international position of a country which spends more than its income? (CA deficit)
- imports > exports
- invests > savings
- and/or gov. budget deficit - overspending financed with investment by foreigners so with flexible exchanges rates, there will be FA surplus
What is the international position of a country which spends less than its income?
- exports > imports
- savings > investments
- and/or gov budget surplus
What happens when a country has a current account deficit?
(Link between global imbalances and domestic economy)
- Country must borrow from the rest of the world to finance the deficit
- foreigners accumulate domestic securites and therefore domestic currency falls, therefore raising exports and therefore output (income)
- Domestic interest rates rise which lowers consumption and investment
- Increase in national output relative to spending reduce CA deficit
Is a CA deficit sustainable?
It will likely lead to currency depreciation, however we must consider the FA as attractive investment opportunities at home can explain persistent strenth of domestic currency.
E.g. US who has domestic spending > total output
How do you cope with current account imbalances? What are the effects of these strategies?
Through protectionism (tarrifs, quotas, import restrictions)
However this decreases demand of foreign currency and therefore an increase in domestic currency
Domestic goods are more expensive than abroad and therefore exports decrease
EVERYONE LOSES!
Are current account deficits always a bad thing?
- casued by economic growth (imports rise faster than exports)
- growing country offers attractive returns on capital (attracts foreign investors)
- country in recession likely to experience a CA surplus
