Transcript International Monetary System

The International
Monetary System
and the Balance
of Payments
Griffin & Pustay
Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall
International Business, 6th Edition
chapter 7
Chapter Objectives
• Discuss the role of the international
monetary system in promoting
international trade and investment
• Explain the evolution and functioning of
the gold standard
• Summarize the role of the World Bank
Group and the International Monetary
Fund in the post-World War II international
monetary system established at Bretton
Woods
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Chapter Objectives (continued)
• Explain the evolution of the flexible
exchange rate system
• Describe the function and structure of the
balance of payments accounting system
• Differentiate among the various
definitions of a balance of payments
surplus and deficit
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International Monetary System
The international monetary system
establishes the rules by which
countries value and exchange their
currencies and provides a mechanism for
correcting imbalances between a
country’s international payments and
receipts.
The international monetary system exists because most countries
have their own currencies. A means of exchanging these currencies is
needed if business is to be conducted across national boundaries.
The cost of converting foreign money into a firm’s home currency—a
variable critical to the profitability of international operations—depends
on the smooth functioning of the international monetary system.
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Balance of Payments
The Balance of Payments (BOP)
Accounting System records
international transactions and
supplies vital information about the
health of a national economy and
likely changes in its fiscal and
monetary policies.
International businesspeople also monitor the international
monetary system’s accounting system, the balance of payments.
BOP statistics can be used to detect signs of trouble that could
eventually lead to governmental trade restrictions, higher interest
rates, accelerated inflation, reduced aggregate demand, or
general changes in the cost of doing business in any given
country.
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History of the International
Monetary System
•
The Gold Standard
•
The Sterling-Gold Standard
•
The Collapse of the Gold Standard
•
The Bretton Woods Era
•
The End of the Bretton Woods Era
•
The international monetary system can trace its roots to the allure of
gold and silver, both of which served as media of exchange in early
trade between tribes and in later trade between city-states. The coming
slides will present the evolution of the IMS from the gold standard to the
modern day.
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The Gold Standard
Countries agree to buy or sell their
paper currencies in exchange for gold
on the request of any individual or firm
and to allow the free export of gold
bullion and coins.
•
In 1821 the United Kingdom became the first country to adopt the gold
standard. During the nineteenth century, most other important trading
countries—including Russia, Austria-Hungary, France, Germany, and the
United States—did the same.
•
As long as firms had faith in a country’s pledge to exchange its currency
for gold at the promised rate when requested to do so, many actually
preferred to be paid in currency. Transacting in gold was expensive.
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Fixed Exchange Rate System
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•
The gold standard effectively created a fixed exchange rate
system. An exchange rate is the price of one currency in terms
of a second currency. Under a fixed exchange rate system the
price of a given currency does not change relative to each other
currency. The gold standard created a fixed exchange rate
system because each country tied, or pegged, the value of its
currency to gold. The United Kingdom, for example, pledged to
buy or sell an ounce of gold for 4.247 pounds sterling, thereby
establishing the pound’s par value, or official price in terms of
gold. The United States agreed to buy or sell an ounce of gold
for a par value of $20.67. The two currencies could be freely
exchanged for the stated amount of gold, making £4.247 = 1
ounce of gold = $20.67. This implied a fixed exchange rate
between the pound and the dollar of £1 = $4.867, or
$20.67/£4.247.
Sterling-Based Gold Standard
•
British pound sterling was the most important currency from 1821 to
1918.
•
Most firms would accept either gold or British pounds.
•
The international monetary system during this period is often called a
sterling-based gold standard. The pound’s role in world commerce
was reinforced by the expansion of the British Empire, including presentday Canada, Australia, New Zealand, Hong Kong, Singapore, India,
Pakistan, Bangladesh, Kenya, Zimbabwe, South Africa, Gibraltar,
Bermuda, and Belize. In each colony, British banks established branches
and used the pound sterling to settle international transactions among
themselves. Because of the international trust in British currency,
London became a dominant international financial center in the
nineteenth century, a position it still holds. The international reputations
and competitive strengths of such British firms as Barclays Bank,
Thomas Cook, and Lloyd’s of London stem from the role of the pound
sterling in the nineteenth-century gold standard.
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The Collapse of the Gold
Standard
• Economic pressures of WWI
• Countries suspended pledges to buy or
sell gold at currencies’ par values
• Gold standard readopted in 1920s
• Dropped during Great Depression
• British pound allowed to float in 1931
– Float: value determined by supply and
demand
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•
During World War I, the sterling-based gold standard unraveled. With the
outbreak of war, normal commercial transactions between the Allies
(France, Russia, and the United Kingdom) and the Central Powers
(Austria-Hungary, Germany, and the Ottoman Empire) ceased. The
economic pressures of war caused country after country to suspend their
pledges to buy or sell gold at their currencies’ par values. After the war,
conferences at Brussels (1920) and Genoa (1922) yielded general
agreements among the major economic powers to return to the prewar
gold standard. Most countries readopted the gold standard in the 1920s
despite the high levels of inflation, unemployment, and political instability
that were wracking Europe. The resuscitation of the gold standard
proved to be short lived, however, due to the economic stresses
triggered by the worldwide Great Depression. The Bank of England was
unable to honor its pledge to maintain the value of the pound. On
September 21, 1931, it allowed the pound to float, meaning that the
pound’s value would be determined by the forces of supply and demand
and the Bank of England would no longer redeem British paper currency
for gold at par value. After the UK abandoned the gold standard, a
“sterling area” emerged as some pegged their currencies to the pound.
Other countries tied the value of their currencies to the U.S. dollar or the
French franc. The harmony of the international monetary system
degenerated further as some engaged in a series of competitive
devaluations of their currencies. By deliberately and artificially lowering
(devaluing) the official value of its currency, each nation hoped to make
its own goods cheaper in world markets, thereby stimulating its exports
The Bretton Woods Era
•
44 countries met in Bretton Woods, New Hampshire, in 1944
•
Goal: to create a postwar economic environment to promote worldwide
peace and prosperity
•
Renewed gold standard on modified basis (dollar-based)
•
Created International Bank for Reconstruction and Development and
International Monetary Fund
•
Determined not to repeat the mistakes that had caused World War II,
Western diplomats desired to create a postwar economic environment
that would promote worldwide peace and prosperity. In 1944 the
representatives of 44 countries met at a resort in Bretton Woods, New
Hampshire, with that objective in mind. The Bretton Woods conferees
agreed to renew the gold standard on a greatly modified basis. They
also agreed to the creation of two new international organizations that
would assist in rebuilding the world economy and the international
monetary system: the International Bank for Reconstruction and
Development and the International Monetary Fund. These
organizations are discussed further on the following slides.
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International Bank for Reconstruction and Development (the World Bank)
•
Goal 1: to help finance reconstruction of European economies
–
Accomplished in mid-1950s
•
Goal 2: to build economies of the world’s developing countries
•
The International Bank for Reconstruction and Development (IBRD) is the official
name of the World Bank. Established in 1945, the World Bank’s initial goal was to
help finance reconstruction of the war-torn European economies. With the assistance
of the Marshall Plan, the World Bank accomplished this task by the mid-1950s. It then
adopted a new mission—to build the economies of the world’s developing countries.
•
As its mission has expanded over time, the World Bank has created three affiliated
organizations: 1) The International Development Association, 2) The International
Finance Corporation, and 3) The Multilateral Investment Guarantee Agency.
•
Together with the World Bank, these constitute the World Bank Group (see next
slide). The World Bank is owned by its 184 member countries. To reach decisions, the
World Bank uses a weighted voting system that reflects the economic power and
contributions of its members. The United States currently controls the largest bloc of
votes (16 percent), followed by Japan (8 percent), Germany (4 percent), the United
Kingdom (4 percent), France (4 percent), and six countries with 3 percent each:
Canada, China, India, Italy, Russia, and Saudi Arabia. To finance its lending
operations, the World Bank borrows money in its own name from international capital
markets. Interest earned on existing loans it has made provides it with additional
lending power. New lending by the World Bank averaged $11 billion per year from
2001 to 2005.
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Figure 7.2 Organization of the
World Bank Group
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According to its charter, the World Bank may lend only for “productive purposes” that
will stimulate economic growth within the recipient country. The World Bank cannot
finance a trade deficit, but it can finance an infrastructure project, such as a new
railroad or harbor facility, that will bolster a country’s economy. It may lend only to
national governments or for projects that are guaranteed by a national government,
and its loans may not be tied to the purchase of goods or services from any country.
Most important, the World Bank must follow a hard loan policy; that is, it may make
a loan only if there is a reasonable expectation that the loan will be repaid. In
response to criticism from poor countries, the World Bank established the
International Development Association (IDA) in 1960. The IDA offers soft loans,
loans that bear some significant risk of not being repaid. IDA loans carry no interest
rate, although the IDA collects a small service charge (currently 0.75 percent) from
borrowers. The loans also have long maturities (normally 35 to 40 years). The two
other affiliates of the World Bank Group have narrower missions. The International
Finance Corporation (IFC), created in 1956, is charged with promoting the
development of the private sector in developing countries. Acting like an investment
banker, the IFC, in collaboration with private investors, provides debt and equity
capital for promising commercial activities. The other World Bank affiliate, the
Multilateral Investment Guarantee Agency (MIGA), was set up in 1988 to
overcome private-sector reluctance to invest in developing countries because of
perceived political riskiness. MIGA encourages direct investment in developing
countries by offering private investors insurance against noncommercial risks.
Objectives of the
International Monetary Fund
•
To promote international monetary cooperation
•
To facilitate the expansion and balanced growth of international
trade
•
To promote exchange stability, to maintain orderly exchange
arrangements among members, and to avoid competitive
exchange depreciation
•
To assist in the establishment of a multilateral system of
payments
•
The Bretton Woods attendees believed that the deterioration of
international trade during the years after World War I was
attributable in part to the competitive exchange rate devaluations
that plagued international commerce. To ensure that the postWorld War II monetary system would promote international
commerce, the Bretton Woods Agreement called for the creation
of the International Monetary Fund (IMF) to oversee the
functioning of the international monetary system. Article I of the
IMF’s Articles of Agreement lays out the organization’s
objectives.
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Objectives of the
International Monetary Fund
(continued)
• To give confidence to members by
making the general resources of the IMF
temporarily available to them and to
correct maladjustments in their balances
of payments
• To shorten the duration and lessen the
degree of disequilibrium in the
international balances of payments of
members
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Membership in the IMF
•
Open to any country willing to agree to rules and regulations
•
185 member countries as of 2008
•
Membership requires payment of a quota
•
Membership in the IMF is available to any country willing to agree to its rules and
regulations. As of April 2006, 184 countries were members. To join, a country must
pay a deposit, called a quota, partly in gold and partly in the country’s own
currency. The quota’s size primarily reflects the global importance of the country’s
economy, although political considerations may also have some effect.
•
The size of a quota is important for several reasons:
1.
A country’s quota determines its voting power within the IMF.
2.
A country’s quota serves as part of its official reserves.
3.
The quota determines the country’s borrowing power from the IMF. Each IMF
member has an unconditional right to borrow up to 25 percent of its quota from the
IMF. IMF policy allows additional borrowings contingent on the member country’s
agreeing to IMF-imposed restrictions—called IMF conditionality—on its economic
policies.
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A Dollar-Based Gold Standard
•
Countries agreed to peg the value of currencies to gold
•
U.S. $ keystone of system
•
Fixed exchange rate system
•
Adjustable peg
•
Functioned well in times of economic prosperity
•
The Breton Woods system worked well as long as countries were experiencing
economic prosperity. However, beginning in the late 1960s, British productivity
decreased relative to that of its major international competitors, and the pound’s
value weakened. The Bank of England had to intervene continually in the
foreign currency market, selling gold and foreign currencies to support the
pound. In so doing, however, the Bank’s holdings of official reserves, which
were needed to back up the country’s Bretton Woods pledge, began to dwindle.
International currency traders began to fear the Bank would run out of reserves.
As that fear mounted, international banks, currency traders, and other market
participants became unwilling to hold British pounds in their inventory of foreign
currencies. They began dumping pounds on the market as soon as they
received them. A vicious cycle developed: As the Bank of England continued to
drain its official reserves to support the pound, the fears of the currency-market
participants that the Bank would run out of reserves were worsened.
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The End of the Bretton Woods System
• Susceptible to speculative “runs on the
bank”
• U.S. $ became only source of liquidity
necessary to expand international trade
• People questioned the ability of U.S. to
meet obligations (Triffin Paradox)
• IMF created special drawing rights
(SDRs) – paper gold
• Bretton Woods system ended August 15,
1971
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•
These runs on the British and French central banks were a precursor to a run on
the most important bank in the Bretton Woods system—the U.S. Federal
Reserve Bank. Because the supply of gold did not expand in the short run, the
only source of the liquidity needed to expand international trade was the U.S.
dollar. Under the Bretton Woods system, the expansion of international liquidity
depended on foreigners’ willingness to continually increase their holdings of
dollars. Foreigners were perfectly happy to hold dollars as long as they trusted
the integrity of the U.S. currency, and during the 1950s and 1960s the number of
dollars held by foreigners rose steadily. As foreign dollar holdings increased,
however, people began to question the ability of the United States to live up to its
Bretton Woods obligation. This led to the Triffin paradox: foreigners needed to
increase their holdings of dollars to finance expansion of international trade, but
the more dollars they owned, the less faith they had in the ability of the United
States to redeem those dollars for gold. The less faith foreigners had in the
United States, the more they wanted to rid themselves of dollars and get gold in
return. If they did this, however, international trade and the international
monetary system might collapse because the United States did not have enough
gold to redeem all the dollars held by foreigners.
•
As a means of injecting more liquidity into the international monetary system
while reducing the demands placed on the dollar as a reserve currency, IMF
members agreed in 1967 to create special drawing rights (SDRs). IMF
members can use SDRs to settle official transactions at the IMF. Thus, SDRs are
sometimes called “paper gold.”
The End of the Bretton Woods System
• As a means of injecting more liquidity into
the international monetary system while
reducing the demands placed on the
dollar as a reserve currency, IMF
members agreed in 1967 to create
special drawing rights (SDRs). IMF
members can use SDRs to settle official
transactions at the IMF. Thus, SDRs are
sometimes called “paper gold.”
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Performance of the International Monetary
System since 1971
•
Most currencies began to float
•
Value of U.S. $ fell relative to most major currencies
•
Group of Ten agreed to restore fixed exchange rate system with restructured rates
of exchange
•
In a dramatic address on August 15, 1971, President Richard M. Nixon announced
that the United States would no longer redeem gold at $35 per ounce. The Bretton
Woods system was ended. In effect, the bank was closing its doors. After Nixon’s
speech, most currencies began to float, their values being determined by supply
and demand in the foreign-exchange market. The value of the U.S. dollar fell
relative to most of the world’s major currencies. The nations of the world, however,
were not yet ready to abandon the fixed exchange rate system. At the
Smithsonian Conference, held in Washington, D.C. in December 1971, central
bank representatives from the Group of Ten agreed to restore the fixed exchange
rate system but with restructured rates of exchange between the major trading
currencies. The U.S. dollar was devalued to $38 per ounce but remained
inconvertible into gold, and the par values of strong currencies such as the yen
were revalued upward. Currencies were allowed to fluctuate around their new par
values by ±2.25 percent, which replaced the narrower ±1.00 percent range
authorized by the Bretton Woods Agreement.
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International Monetary System
since 1971
• Development of floating exchange rate
system
– Supply and demand for a currency determine
its price in the world market
– Managed float – central banks can affect
supply and demand
• Legitimized in 1976 with the Jamaica
Agreement
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•
Free-market forces disputed the new set of par values established by the
Smithsonian conferees. Speculators, believing the dollar and the pound
were overvalued, sold both and hoarded currencies they believed were
undervalued, such as the Swiss franc and the German mark. The Bank
of England was unable to maintain the pound’s value within the ±2.25
percent band and in June 1972 had to allow the pound to float
downward. The United States devalued the dollar by 10 percent in
February 1973. By March 1973 the central banks conceded they could
not successfully resist free-market forces and so established a flexible
exchange rate system. Under a flexible (or floating) exchange rate
system, supply and demand for a currency determine its price in the
world market. Since 1973, exchange rates among many currencies have
been established primarily by the interaction of supply and demand. The
current arrangements are often called a managed float (or, a dirty
float) because exchange rates are not determined purely by privatesector market forces. The new flexible exchange rate system was
legitimized by an international conference held in Jamaica in January
1976. According to the resulting Jamaica Agreement, each country was
free to adopt whatever exchange rate system best met its own
requirements. The United States adopted a floating exchange rate.
Other countries adopted a fixed exchange rate by pegging their
currencies to the dollar or some other currency. Still others adopt
crawling pegs, where the peg was allowed to change gradually over
time.
Table 7.1 The Groups of
Five, Seven, and Ten
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Table 7.2 Key Central Banks
Country
Bank
Canada
Bank of Canada
European Union
European Central Bank
Japan
Bank of Japan
United Kingdom
Bank of England
United States
Federal Reserve Bank
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European Union
•
Believed flexible system would hinder ability to create integrated
economy
•
Created European Monetary System to manage currency relationships
•
ERM participants maintained fixed exchange rates among their
currencies
•
Facilitated creation and adoption of euro
•
The strategy adopted by European Union (EU) members is based in the
belief that flexible exchange rates would hinder their ability to create an
integrated European economy. In 1979 EU members created the
European Monetary System (EMS) to manage currency relationships
among themselves. Most EMS members chose to participate in the EU’s
exchange rate mechanism (ERM). ERM participants pledged to
maintain fixed exchange rates among their currencies within a narrow
range of ±2.25 percent of par value and a floating rate against the U.S.
dollar and other currencies. The exchange rate mechanism facilitated
the creation of the EU’s single currency, the euro.
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International Debt Crisis
• OPEC quadrupled world oil prices
– Resulted in inflationary pressures in
oil-importing countries
– Exchange rates adjusted
– Transfer of wealth
• Countries borrowed more than they could
repay
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•
The flexible exchange rate system instituted in 1973 was immediately put to a
severe test. In response to the Israeli victory in the Arab-Israeli War of 1973, Arab
nations imposed an embargo on oil shipments to countries such as the United
States and the Netherlands, which had supported the Israeli cause. As a result, the
Organization of Petroleum Exporting Countries (OPEC) succeeded in quadrupling
world oil prices from $3 a barrel in October 1973 to $12 a barrel by March 1974.
This rapid increase in oil prices caused inflationary pressures in oil-importing
countries. The new international monetary arrangements absorbed some of the
shock caused by this upheaval in the oil market, as exchange rates adjusted to
account for changes in the value of each country’s oil exports or imports. The
higher oil prices acted as a tax on the economies of the oil-importing countries.
Many of the oil-exporting countries went on spending sprees, using their new
wealth to improve their infrastructures or to invest in new facilities (such as
petroleum refineries) to produce wealth for future generations. The unspent
petrodollars were deposited in banks in international money centers such as
London and New York City. The international banking community then recycled
these petrodollars through its international lending activities to help revive the
economies damaged by rising oil prices. The international banks were too
aggressive in recycling these dollars. Many countries borrowed more than they
could repay. The financial positions of these borrowers became precarious after the
oil shock of 1978-1979 when the price of oil triggered another round of worldwide
inflation. Interest rates on these loans rose, as most carried a floating interest rate,
further burdening the heavily indebted nations. The international debt crisis formally
began when Mexico requested a rescheduling of its debts, a moratorium on
repayment of principal, and a loan from the IMF to help it through its debt crisis. In
total, more than 40 countries in Asia, Africa, and Latin America sought relief from
their external debts.
Approaches to Resolve the
International Debt Crisis
The Baker Plan
The Brady Plan
The 1985 Baker Plan (named after then U.S. Treasury Secretary James
Baker) stressed the importance of debt rescheduling, tight IMF-imposed
controls over domestic monetary and fiscal policies, and continued lending to
debtor countries in hopes that economic growth would allow them to repay
their creditors. In Mexico’s case, the IMF agreed to provide a loan package
only if private foreign banks holding Mexican debt agreed to reschedule their
loans and provide Mexico with additional financing. However, the debtor
nations made little progress in repaying their loans. Debtors and creditors alike
agreed that a new approach was needed.
The 1989 Brady Plan (named after the first Bush administration’s treasury
secretary Nicholas Brady) focused on the need to reduce the debts of the
troubled countries by writing off parts of the debts or by providing the countries
with funds to buy back their loan notes at below face value.
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1985 Baker Plan (named after then U.S. Treasury
Secretary James Baker) stressed the importance of
debt rescheduling, tight IMF-imposed controls over
domestic monetary and fiscal policies, and continued
lending to debtor countries in hopes that economic
growth would allow them to repay their creditors. In
Mexico’s case, the IMF agreed to provide a loan
package only if private foreign banks holding
Mexican debt agreed to reschedule their loans and
provide Mexico with additional financing. However,
the debtor nations made little progress in repaying
their loans. Debtors and creditors alike agreed that a
new approach was needed.
•
It helps policy makers understand the performance of each country’s
economy in international markets. It also signals fundamental
changes in the competitiveness of countries and assists policy
makers in designing appropriate public policies to respond to these
changes. International businesspeople need to pay close attention
to countries’ BOP statistics for several reasons, including the
following:
•
1. BOP statistics help identify emerging markets for goods and
services.
•
2. BOP statistics can warn of possible new policies that may alter a
country’s business climate, thereby affecting the profitability of a
firm’s operations in that country.
•
3. BOP statistics can indicate reductions in a country’s foreignexchange reserves, which may mean that the country’s currency will
depreciate in the future, as occurred in Thailand in 1997. Exporters
to such a country may find that domestic producers will become
more price competitive.
•
4. As was true in the international debt crisis, BOP statistics can
signal increased riskiness of lending to particular countries.
•
The 1989 Brady Plan (named after the first Bush administration’s treasury
secretary Nicholas Brady) focused on the need to reduce the debts of the
troubled countries by writing off parts of the debts or by providing the
countries with funds to buy back their loan notes at below face value.
•
It helps policy makers understand the performance of each country’s
economy in international markets. It also signals fundamental changes in the
competitiveness of countries and assists policy makers in designing
appropriate public policies to respond to these changes. International
businesspeople need to pay close attention to countries’ BOP statistics for
several reasons, including the following:
•
1. BOP statistics help identify emerging markets for goods and services.
•
2. BOP statistics can warn of possible new policies that may alter a country’s
business climate, thereby affecting the profitability of a firm’s operations in
that country.
•
3. BOP statistics can indicate reductions in a country’s foreign-exchange
reserves, which may mean that the country’s currency will depreciate in the
future, as occurred in Thailand in 1997. Exporters to such a country may find
that domestic producers will become more price competitive.
•
4. As was true in the international debt crisis, BOP statistics can signal
increased riskiness of lending to particular countries.
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The Balance of Payments
Accounting System
The BOP accounting system is a
double-entry bookkeeping system
designed to measure and record all
economic transactions between
residents of one country and residents of
all other countries during a particular
time period.
Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall
•
It helps policy makers understand the performance of each country’s
economy in international markets. It also signals fundamental changes in
the competitiveness of countries and assists policy makers in designing
appropriate public policies to respond to these changes. International
businesspeople need to pay close attention to countries’ BOP statistics
for several reasons, including the following:
•
1. BOP statistics help identify emerging markets for goods and services.
•
2. BOP statistics can warn of possible new policies that may alter a
country’s business climate, thereby affecting the profitability of a firm’s
operations in that country.
•
3. BOP statistics can indicate reductions in a country’s foreign-exchange
reserves, which may mean that the country’s currency will depreciate in
the future, as occurred in Thailand in 1997. Exporters to such a country
may find that domestic producers will become more price competitive.
•
4. As was true in the international debt crisis, BOP statistics can signal
increased riskiness of lending to particular countries.
Figure 7.4
The Asian Contagion
The Asian currency crisis erupted in July 1997, when Thailand, which had
pegged its currency to a dollar-dominated basket of currencies, was forced to
unpeg its currency, the baht, after investors began to distrust the abilities of Thai
borrowers to repay their foreign loans and of the Thai government to maintain
the baht’s value. Not wanting to hold a currency likely to be devalued, foreign
and domestic investors converted their bahts to dollars and other currencies. The
Thai central bank spent much of its official reserves desperately trying to
maintain the pegged value of the baht. After Thailand was forced to abandon the
peg on July 2, the baht promptly fell 20 percent in value. As investors realized
that other countries in the region shared Thailand’s overdependence on foreign
short-term capital, their currencies also came under attack and their stock
markets were devastated. Indonesia was hit the worst by the so-called Asian
contagion (see Figure 7.4). Aftershocks of the crisis spread to Latin America and
Russia, and the Russian government effectively defaulted on its foreign debts. All
told, the IMF and the Quad countries pledged over $100 billion in loans to help
restore these countries to economic health.
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Balance of Payments (BOP)
Accounting System
• Measures and records all economic
transactions between residents of one
country and residents of all other
countries during specified time period
• Provides understanding of performance
of each country’s economy in
international markets
• Signals fundamental changes in country
competitiveness
• Assists policy makers in designing
appropriate public policies
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Four Important Aspects of the
BOP Accounting System
• Records international transactions made in
some time period
• Records only economic transactions
• Records transactions between residents of
one country and all other countries
– Residents include individuals, businesses,
government agencies, nonprofit organizations
• Uses a double-entry system
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•
Four important aspects of the BOP accounting system need to be highlighted:
•
1. The BOP accounting system records international transactions made during
some time period, for example, a year.
•
2. It records only economic transactions, those that involve something of monetary
value.
•
3. It records transactions between residents of one country and residents of all
other countries. Residents can be individuals, businesses, government agencies,
or nonprofit organizations, but defining residency is sometimes tricky. Persons
temporarily located in a country—tourists, students, and military or diplomatic
personnel—are still considered residents of their home country for BOP purposes.
Businesses are considered residents of the country in which they are incorporated.
•
4. The BOP accounting system is a double-entry system. Each transaction
produces a credit entry and a debit entry of equal size. In most international
business dealings, the first entry in a BOP transaction involves the purchase or
sale of something—a good, a service, or an asset. The second entry records the
payment or receipt of payment for the thing bought or sold. Debit entries reflect
uses of funds; credit entries indicate sources of funds. Under this framework,
buying things creates debits, and selling things produces credits.
Major Components of the BOP
Accounting System
Current Account
Capital Account
Official Reserves
Errors and Omissions
The BOP accounting system can be divided conceptually into four major
accounts. The first two accounts—the current account and the capital
account—record purchases of goods, services, and assets by the private and
public sectors. The official reserves account reflects the impact of central
bank intervention in the foreign-exchange market. The last account—errors
and omissions—captures mistakes made in recording BOP transactions.
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Types of Current Account
Transactions
•
Exports and imports of goods
•
Exports and imports of services
•
Investment income
•
Gifts
•
The goods account records sales and purchases of goods. The
difference between a country’s exports and imports of goods is
called the balance on merchandise trade. The services
account records sales and purchases of such services as
transportation, tourism, medical care, telecommunications,
advertising, financial services, and education. The difference
between a country’s exports of services and its imports of
services is called the balance on services trade. The third type
of transaction recorded in the current account is investment
income. The fourth type of transaction in the current account is
unilateral transfers, or gifts between residents of one country
and another. Unilateral transfers include private and public gifts.
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Capital Account
Foreign Direct
Investment
Portfolio
Investment
The second major account in the BOP accounting system is the capital account, which records
capital transactions—purchases and sales of assets—between residents of one country and those of
other countries. Capital account transactions can be divided into two categories: foreign direct
investment (FDI) and portfolio investment.
FDI is any investment made for the purpose of controlling the organization in which the investment is
made, typically through ownership of significant blocks of common stock with voting privileges.
Under U.S. BOP accounting standards, control is defined as ownership of at least 10 percent of a
company’s voting stock. A portfolio investment is any investment made for purposes other than
control. Portfolio investments are divided into two subcategories: short-term investments and longterm investments. Short-term portfolio investments are financial instruments with maturities of
one year or less. Included in this category are commercial paper; checking accounts, time deposits,
and certificates of deposit held by residents of a country in foreign banks or by foreigners in
domestic banks; trade receivables and deposits from international commercial customers; and
banks’ short-term international lending activities, such as commercial loans. Long-term portfolio
investments are stocks, bonds, and other financial instruments issued by private and public
organizations that have maturities greater than one year and that are held for purposes other than
control.
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Table 7.4 Capital Account Transactions
Current account transactions invariably affect the short-term component of the
capital account. The first entry in the double-entry BOP accounting system
records the purchase or sale of something—a good, a service, or an asset. The
second entry typically records the payment or receipt of payment for the thing
bought or sold. In most cases, this second entry reflects a change in someone’s
checking account balance, which in the BOP accounting system is a short-term
capital account transaction.
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Table 7.5 BOP Entries, Capital Account
Debt (Outflow)
Portfolio (short-term)
Portfolio (long-term)
Foreign direct
investment
Credit (Inflow)
Receiving a payment from a
foreigner
Making a payment to a
foreigner
Buying a short-term foreign
asset
Selling a domestic shortterm asset to a foreigner
Buying back a short-term
domestic asset from its
foreign owner
Selling a short-term
foreign asset acquired
previously
Buying back a long-term
domestic asset from its
foreign owner
Selling a domestic longterm asset to a foreigner
Buying a foreign asset for
purposes of control
Selling a long-term
foreign asset previously
acquired
Buying back from its foreign
owner a domestic asset
Selling a domestic asset
to a foreigner
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•
Capital inflows are credits in the BOP accounting system. They
can occur in two ways:
1. Foreign ownership of assets in a country increases.
2. Ownership of foreign assets by a country’s residents declines.
•
Capital outflows are debits in the BOP accounting system. They
also can occur in two ways:
1. Ownership of foreign assets by a country’s residents increases.
2. Foreign ownership of assets in a country declines.
Official Reserves Account
• Records level of official reserves
• Four types of assets
– Gold
– Convertible currencies
– SDRs
– Reserve positions at the IMF
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Official Reserves Account
Reserve
positions
Gold
Assets
SDRs
Convertible
securities
The third major account in the BOP accounting system, the official reserves
account, records the level of official reserves held by a national government.
These reserves are used to intervene in the foreign-exchange market and in
transactions with other central banks. Official reserves comprise four types of
assets: 1) Gold, 2) Convertible currencies, 3) SDRs, and 4) Reserve positions at
the IMF. Official gold holdings are measured using a par value established by a
country’s treasury or finance ministry. Convertible currencies are currencies that
are freely
exchangeable in world currency markets.
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Errors and Omissions
•
BOP must balance
•
Current Account + Capital Account + Official Reserves Account = 0
•
Current Account + Capital Account + Official Reserves Account + Errors
and Omissions = 0
The last account in the BOP accounting system is the errors and omissions account. One truism of the
BOP accounting system is that the BOP must balance. In theory, the following equality should be
observed:
Current Account + Capital Account + Official Reserves Account = 0.
However, this equality is never achieved in practice because of measurement errors. The errors and
omissions account is used to make the BOP balance in accordance with the following equation:
Current Account + Capital Account + Official Reserves Account + Errors and Omissions = 0.
Sometimes, errors and omissions are due to deliberate actions by individuals who are engaged in
illegal activities such as drug smuggling, money laundering, or evasion of currency and investment
controls imposed by their home governments. Politically stable countries, such as the United States,
are often the destination of flight capital, money sent abroad by foreign residents seeking a safe haven
for their assets, hidden from the sticky fingers of their home governments. Given the often illegal nature
of flight capital, persons sending it to the United States often try to avoid any official recognition of their
transactions, making it difficult for government BOP statisticians to record such transactions. Residents
of other countries who distrust the stability of their own currency may also choose to use a stronger
currency, such as the dollar or the euro, to transact their business or keep their savings.
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Table 7.6. U.S. Balance of Payments in 2007
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Defining BOPs Surpluses and Deficits
Official Settlements Balance reflects
changes in a country’s official
reserves; essentially, it records the
net impact of the Central Bank’s
intervention in the foreign-exchange
market in support of the local
currency
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