Balance of Payments: International Transactions & Exchange Rates
Understanding the Balance of Payments
The Balance of Payments (BoP) statistics are used to measure a country’s trade in goods, services, and financial assets with other countries. It records all international economic transactions:
- Revenue transactions involve currency inflows into the country.
- Payment transactions involve currency outflows from the country.
- The balance is the difference between revenues and payments.
The BoP is structurally supported by two main accounts:
1. Current Account Balance
This account reflects the flow of goods, services, income, and current transfers.
Goods and Services Balance
This shows the difference between goods and services sold abroad (exports) and those purchased from abroad (imports). It comprises:
- Services Balance: Records only the imports and exports of services.
- Trade Balance: Records only the exports and imports of goods. This is a key indicator of a country’s competitiveness. It is positive (surplus) if a country earns more from exports than it spends on imports, and negative (deficit) if the opposite occurs.
Net Current Transfers
This shows the difference between funds or remittances sent by nationals working abroad back to their home country and those sent by immigrants established in the country to their countries of origin.
Income Balance
This records the difference between income that a country’s nationals receive from abroad (e.g., dividends, interest) and the income sent abroad by foreign nationals residing in the country.
2. Financial Account Balance
This account records financial transactions between a country and other countries. It identifies the difference between sales and purchases of financial assets abroad. The sum of the financial account balance (BF) and the current account balance (BCC) must theoretically equal zero (BCC + BF = 0). If a country spends more than it produces (current account deficit), someone else must finance this difference (financial account surplus).
Categories of Financial Flows
- Direct Investment: Investments made abroad by residents or made in the reporting country by non-residents, intended to be permanent or long-term (e.g., buying a controlling interest in a foreign company).
- Portfolio Investment: Investments made abroad by residents or in the reporting country by non-residents with a speculative purpose or for a limited period (e.g., buying foreign stocks or bonds without gaining control).
- Reserve Movements: Changes in the holdings of official reserves (e.g., foreign currency, gold) held by a country’s central bank.
Factors Influencing Capital Flows
Key factors include:
- Investment returns versus risk
- Tax policies
- Corporate operations (e.g., mergers and acquisitions)
Understanding Financial Crises
For capital flows to be sustainable, the countries receiving the capital must use it productively to generate sufficient returns to repay the principal and interest to the lending countries. If doubts arise about a country’s ability to grow sufficiently to repay the borrowed capital, international financial crises can occur. This often leads to a halt in foreign capital flows into that country. Frequently, these crises generate contagion effects, spreading to other countries.
Exchange Rates Explained
The exchange rate is the value at which one unit of a country’s currency is exchanged for another country’s currency.
Appreciation and Depreciation
These terms describe exchange rate variations. When a country’s currency gains value relative to another, it is said to have appreciated. Conversely, if it loses value, it has depreciated.
Real Exchange Rate
This represents the changes in currency values adjusted for changes in price levels (inflation) between the countries.
Purchasing Power Parity (PPP)
PPP is a measure used to compare the cost of a standard basket of goods and services across different countries, effectively calculating a theoretical exchange rate based on relative price levels.
Effective Exchange Rate
This is an index representing the weighted average exchange rate of a country’s currency relative to a basket of other major currencies.
Exchange Rate Regimes
This refers to how governments manage or control their country’s exchange rate. There are two main types:
1. Fixed Exchange Rates
The country’s authorities fix the value of the currency against another currency or a basket of currencies, regardless of market supply and demand.
- Devaluation: Occurs when the authorities officially lower the fixed value of the currency against foreign currencies.
- Revaluation: Occurs when the authorities officially raise the fixed value of the currency against foreign currencies.
To maintain a fixed rate different from the market equilibrium, governments must intervene using their foreign currency reserves (buying their currency if it’s too weak, selling it if it’s too strong).
2. Flexible or Floating Exchange Rates
The exchange rate is determined primarily by market forces (supply and demand for the currency). However, authorities, usually central banks, may intervene occasionally to counteract sudden disturbances or excessive volatility.