Balance Of Payments

Captures flow of funds and goods.

Definition: The balance of payments is a systematic record of all economic transactions between the residents of a given economy, for example Australia, and the rest of the world.

Capital: Goods that eventually are used in other goods

Transfers: Movement of funds/equipment - a one way thing

Overview of BOP

Balance of Payments:

• The Current Account
  • Trade Balance (X-M)
  • Primary Income Balance
  • Secondary Income Balance
• Capital Financial Account
  • Financial Account
    • Direct Investment
    • Portfolio Investment
    • Financial Derivative
    • Reserve Assets
    • Other Investment
  • Capital Account

The Current Account

Trade Balance (Balance of Trade BoT)

• The value of goods and services that Australian residents export less those than they import.

Primary Income Balance

• The income that Australian residents earn from, minus what they pay to, the rest of the world from working (e.g. wages) and from financial investments (e.g. dividends)

Secondary Income Balance

• The income that Australian residents earn from, minus what they pay to, the rest of the world from the government (e.g. tax payments and refunds)
• Current Transfers: Transactions between Australian residents and the rest of the world where one party provides something to be consumed by another party without receiving anything in return (e.g. emergency food aid)
  • These tend to be one off payments

Capital Financial Account (KFA)

Financial Account

• Direct Investment
  • Occurs when more than 10% of an enterprise is purchased by a foreign investor. Most of this type involves the purchase of land and the setting up of subsidiaries. For example:
    • Someone opens a foreign shop in your country
    • If a foreign entity has a more than 10% of the company
    • Purchase of Machinery, Buildings and factories
• Portfolio Investment (Portfolio: Financial Assets)
  • Occurs when less than 10% of a firm is acquired by a foreign investor. Most of this involves shares, stocks and securities.
    • Direct ownership
  • Most investment tends to be this type of investment because individuals have very minute shares in companies which is very fluid (easily sold).
• Net change in (financial) Reserve Assets
  • Consists mainly of changes in the RBA’s holdings of foreign currency.
    • e.g. Exchange rates
• Financial Derivative
  • The purchase of sale of financial derivatives (i.e. financial contracts between two parties where the value is derived from another financial instrument, such as a bond and share)
    • No intrinsic value
    • A contract or agreement
• Other Investment
  • Transactions that do not fit into one of the other categories. One example is ‘trade credit’, where an importer purchases goods from overseas and does not pay for the goods until they are received.
  • Another example is ‘currency and deposits’, where money is deposited in or withdrawn from banks across borders or banknotes and coins are transferred between countries.

Capital Account

• Capital Transfers
  • Transactions where one party has transferred ownership of something for another party without receiving anything specific in return. For example:
    • Forgiveness of debt
    • Conditional grants for capital projects
    • Transfers of assets between residents and non-residents
• Acquisitions/Disposals of non-produced, non-financial assets
  • Transactions that involve intangible assets (e.g. brand names, copyrights and trademarks) and rights to use land or water (e.g. for fishing or mining)

Net Errors and Omissions (Just need to know about its existence)

Also under capital and financial account heading in the balance of payments figures there is an item entitled Net Errors and Omissions.

This is just an adjustment that is made to the figures because of errors in the data.

Relationship between CA and KFA

Current account is always offset by the capital financial account. There is a balance of payments and hence the sum is zero.

When the balance of one account is in surplus (i.e. has a positive value, representing a credit), the balance of the other account must be in deficit (i.e. has a negative value, representing a debit).

Scenario 1:

• If imports are greater than exports, it has a deficit in its trade balance - since this is the most important component of the current account, it is also likely to have a current account deficit. We are assuming it overwhelms the other balances in the current account.
  • Remember (X-M)
• So, if there is a current account deficit, (the capital account being very small), there must be a financial account surplus - foreign exchange must be provided to pay for the excess of imports over exports.

Scenario 2:

• The surplus on the financial account may arise from investments in physical or financial capital by foreigners, including loans from foreigners.
• It follows, then, that a deficit in the current account is matched by a surplus in the financial account (along with the unimportant capital account).
• WHY?
  • As more (foreign) direct investment flows in (via the financial account) there will be more repatriated profits (income payments) flowing out of the current account, negatively affecting the net income balance and worsening the current account deficit.
  • Surplus of financial account would result in a deficit in the primary income balance.

Scenario 3:

• If the economy’s exports of goods and services are greater than its imports, it has a surplus in its current account – this means it is buying from foreigners less than what it sells to them.
• When there is a surplus on the current account, the country is accumulating foreign exchange (as it earns more foreign exchange from exports than it pays out to buy imports), which it can use to buy assets abroad (direct or portfolio investments, including loans to other countries).
• It follows, then, that a surplus in the current account is matched by a deficit in the financial account.

Double Entry Recording System

For each transaction in the balance of payments, there is a matching credit and debit entry

• Therefore, the overall record of payments must always balance.

For each transaction, there is a matching credit and debit entry

• Credit (positive entry) – exports of goods and services, income receivable, increase in foreign liabilities, export of currency
• Debit (negative entry) – imports of goods and services, income payable, increase in foreign assets, import of currency

Scenario 1:

• An Australian resident purchases a TV from Japan.
  • This is an import and hence is a debit in the trade balance account
  • The money/currency get exported, which is recorded as a credit in the financial account.
    • The second entry is most often in the currency account

Scenario 2:

• Japanese resident buying an Australian government bond for AUD5,000
  • Bond gets exported to Japan -> Financial Portfolio Account
  • AUD5,000 gets imported from Japan

Scenario 3:

• Australian firm sells $10 of iron ore to China
  • AUD10 worth of iron ore exported from Trade Balance Account
  • AUD10 imported into currency account

Scenario 4:

• US firm purchases $5M worth of Australian shares
  • AUD5M worth of shares exported
  • AUD5M currency imported into currency account

Double Entry Table for Success

	Financial (Loans, Dividends, etc.)	Real (Goods and Services)
Outflows	Debit Entry	Credit Entry
Inflows	Credit Entry	Debit Entry

Factors affecting Current Account

Link by describing the factor. What does it affect? And hence what?

• Assume that trade balance is a significant part of current account

Two broad types of factors:

Cyclical Factors - Temporary factors that mainly affect the trade balance:

• Domestic business cycle (Influences M)
  • Affects Trade Balance (X-M) -> which affects Current Account
• World business cycle (Influences X)
  • Affects Trade Balance (X-M) -> which affects Current Account
• Exchange rate (Influences both X and M)
  • Appreciates (Can buy more of a foreign currency) or depreciates (Can buy less of a foreign currency)
  • Appreciation
    • We can buy more (M increases) and foreign countries can buy less (X decreases)
  • Depreciation
    • We can buy less (M decreases) and foreign countries can buy more (X increases)
• Commodity prices/terms of trade
  • Commodities are demand/supply price inelastic…
    • Australia’s exports are made up of a lot of commodities
  • Therefore when prices of commodities increase, revenue from exports increases a lot since the value of exports increase, trade balance increases, hence the current account will be in a surplus
• Relative inflation
  • Lower inflation rate countries will look more appealing to the world
  • If our inflation rate is lower than a foreign country, our imports will decrease while our exports increases

Structural Factors – Fundamental factors that mainly affect the income balance:

• Investment-savings gap
  • We do not have enough people to save money that can be used as an investment into the extraction of natural resources, so this is the gap.
  • To fill in this gap, we would get loans from overseas
• Foreign investment
  • Greater inflow - repatriated profits, wages
• Foreign liabilities

Cyclical factors are temporary and subject to frequent change.

• Cyclical factors help explain the fluctuation in the trade balance

A Structural factor on the other hand is more permanent and only changes gradually

• Structural factors are associated with the primary income balance

Trade Balance and Current Account have a positive relationship

• Trade balance is relatively volatile and is very much influenced by both Australia’s Business Cycle and the World Business Cycle

The current account was in a deficit for a long time up until 2018-ish because we increased out exports both from FTA and Asia-Pacific development

Savings Investments Gap

Australia has S < I

• Australia relies on foreign savings in order to fund its investment
• This does not mean that Australians do not save

We take saving from overseas since not enough saving in Australia. (Investment from overseas but not ALL of it is from overseas)

• But during Covid, inflow in financial account reduced, more people saving so don’t need to borrow. -> Less money flowed out.

Australia relies on foreign investment not because its national saving ratio is low - but because its investment to savings ratio is high.

The need for a high level of investment means that there is an inflow of funds on the financial account (in KFA) and this increases our foreign liabilities.

• Australia will have a deficit on the primary income component of the current account as we meet our obligations (foreign liabilities)

The deficit on the primary income account is the result of the savings-investment gap.

• This usually means that the Current Account will be in a deficit.

In summary:

• If a country’s savings exceeds its investment (S > I), then it will have a current account surplus
• If a country investment is greater than its savings (I > S), Then it will have a current account deficit
• But trade balance has a say in this so it could not always be this case

Covid made savings exceed investment - Before covid investment exceeded savings

Neither CA/KFA deficit or surplus is better, it all depends on the structural and cyclical factors.

For example, Australia’s current account balance will decrease if one or more of the following events occurs:

• A fall in terms of trade - If export prices fall relative to import prices, export receipts will fall and import payments will increase. Normally, whenever the terms of trade fall, the balance on goods and services will also fall.
  • Trade Balance
• A decline in international competitiveness – If productivity levels decline or if real wages rise more than productivity than a country’s exports will be less competitive in overseas markets. A rise in inflation will also reduce a nations competitiveness by increasing the prices of domestic goods relative to foreign goods
  • International competitiveness - prices in international markets
  • Lower productivity means less goods can be produced with the same amount of resources
  • Increase in real wages means that the cost of production increases
  • Trade Balance
• A higher rate of (domestic) economic growth – This will lead to an increase in national income and an increase in both consumption and investment spending boosting the demand for imports and decreasing the trade balance
  • Trade Balance
• An increase in foreign investment will increase the financial account balance - Australia is a country rich in natural resources which attracts a substantial flow of investment. If the rate of return on investment is higher in Australia than the rest of the world then there will be large capital inflow into Australia. This will increase the primary income deficit due to the outflow of investment income (dividends and the interest payments)
  • Savings investment gap
  • A decline in national savings – If savings by either households, firms or the government fall, the current account balance will decrease. When national saving (all saving) is less than investment, the current account will record a deficit.
    • Savings investment gap
  • An increase in domestic investment – If investment increases by either the private or public sector, the current account balance will decrease.
    • Similar to the foreign investment

Negative of current account deficit: If the current account is in deficit because of a decline in competitiveness, then you are falling behind in productivity, and innovation.