The BoP accounts record all transactions between residents of a country and residents of all foreign nations.
It is composed of
- current account
- capital and finance account
- official reserve account
- statistical discrepancy : net errors and omission
Current Account
- export/import of goods and services
- net income: interest earned on foreign assets, interest paid on foreign debt
- Unilateral transfers: workers remittances from abroad, official grants
Capital and Finance Account
- capital transfer: debt forgiveness, transfer of ownership of fixed assets (it is in capital account and the amount is small)
- direct investment: greenfield investments, FDI
- portfolio investment: debt and equity securities
- other investments: deposits and loans
- financial derivatives
CA + KA = Δ reserve
Under a flexible exchange rate regime
CA + KA = 0
BoP is a double entry system of accounts
CA: Surplus + / Deficit -
export + / import -
KA: Net borrowing + / Net lending -
increase in financial assets - ; because money going out
increase in financial liabilities +
Example: import oil
import - ; increase in financial assets +
Example: company export
export + ; increase in financial assets -
increase in financial liabilities +
increase in financial assets -
BoP effect on exchange rate
export ↑ -> CA surplus ↑ -> FX rate ↑
KA surplus ↑ -> demand for local currency ↑ -> FX rate ↑
reduce appreciating pressure on local currency, sell local currency, buy USD
-> reserve ↑
Interpretation of CA
- Trade balance: CA deficits reflect living beyond one's mean
- Difference in national savings and investment
Y = C + I + X - M ; ignore G
Y - C - I = X - M
S - I = X - M
it reflects high investment and low savings rate
- Timing of trade
CA deficit means choose to consume now by borrowing from abroad
CA surplus means choose to consume later by lending to abroad
consumption smoothing
- borrow from future income, and spend today
Role of International Reserves
- reduces currency speculation
- precautionary purpose, as insurance cover to smooth temporary stops in capital flows
FX Intervention
Unsterilized FX intervention
- domestic currency is sold to purchase foreign assets -> increase in international reserves - > increase in money supply -> domestic currency depreciation
Sterilized FX intervention
To counter the effect of FX intervention above, CB sells gov bond, reduces the money supply
Reserves adequacy
Traditional measures:
- Trade based : reserves to monthly import , 3-4 months
- Debt based : reserves to ST external debt , > 100%
- Money based : reserves to M2 ; 5-10% if flexible exchange rate
(flexible exchange rate act as automatic stabilizer)
Drawbacks of Traditional measures
- reserves to months of imports, neglect international financial linkages
- reserves to ST external debt, neglect other liabilities (stock holdings, bond holdings)
- reserves to broad money, neglect external drain on reserves
Having reserves means intervening in FX market?
New approaches:
- BoP stress testing: scenarios looking at all BoP items
- insurance model : cost benefits of holding reserves, eg. negative carry, valuation loss
- balance sheet analysis
**BoP is flow concept, need to look at stock holdings
Case study: China's FX reserves
China's exports are larger than its imports, it is running a positive trade balance. Foreign currency flows into China via trade flows and investment flows. The more foreign currency is floating in its economy, the lower the price of that currency relative to domestic currency will be. This will have appreciation pressure on domestic currency. To offset, the CB will sell domestic currency and buys up the foreign currency. The intervention will build up the FX reserves.
Capital Controls
- produces misallocation and corruption
- not effective in the long run (people will find a way to circumvent the restrictions)
- delay reform, money flow out because domestic investment opportunity maybe not attractive
- better to strengthen econ fundamentals, and improve bank regulation
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