International_Finance

FIN 405: International Finance YU SUMMER 2010 Monday 28 June 2010 Chapter 3 Supplement: Balance of Payment (BOP) Impact on the Country Currency Value 1) BOP Definition BOP is a statistical record of a country’s transactions with the rest of the world. Transactions can be financial, merchandise or services. 2) The Impact of the BOP on the country’s currency appreciation or depreciation BOP provides detailed information concerning the demand and supply of a country’s currency. Example: if US imports more than it exports, this means the supply of dollars is likely to exceed the demand in the foreign exchange market. This means that the US dollar would be under a pressure to depreciate against other currencies. On the other hand, if Exports are higher than imports, the US dollar would appreciate (foreign demand for the US dollar would increase in order to for foreigners to buy more US goods). When a country’s currency depreciates against other currencies, the country’s exports tend to rise and imports fall, improving the trade balance. This is called J-Curve effect. Trade Balance change Time While the currency is in decline (depreciation) the trade balance will start deteriorating but later on, it will rise from deficit to surplus ( as exports increase and imports decrease) BOP deficit will lead to a country’s restriction of foreign imports and discourage capital outflow. BOP surplus, will favour less restrictions on foreign imports. A constant BOP deficit can be translated as a negative sign on a country international competitiveness or poor domestic economic indicators (poor quality products, etc... 3) BOP Accounting Any transaction that results in a receipt from foreigners will recorded a credit with a + sign. Any transaction that gives rise to a payment to foreigners will be recorded as a debit with minus sign. Example: If Boeing Corporation sold (exported) a 747 aircraft to Japan Airlines for $50 million, and that Japan Airlines (JAL) pays from its dollar bank account kept with Chase Manhattan NY, then the receipt of $50 million by Boeing will be recorded as a credit (+) which will be matched by a debit (-) of the same amount representing reduction of the US bank’s liabilities. Recording the transaction Transaction description Credit Debit Boeing’s export +$50 million Withdrawal from US bank (Chase M NY) -$50million 4) How to reduce Current Account (CA) deficit' * A current account deficit implies that a country used up more output than it produced. * A country must finance its CA deficit either by borrowing from foreigners or by drawing down on its previously accumulated foreign wealth (Foreign reserves). On the other hand a CA surplus acquires IOUs from foreigners, there by increasing a country’s foreign wealth. 5)The Current Account is divided into four categories 1)Merchandise Trade: represents export or import of tangible goods like oil, wheat, clothes, automobiles, computers and so on. 2)Invisible trade or Services include payments or receipts for legal, consulting, engineering services, royalties for patents and intellectual properties, insurance premiums, shipping fees and tourist expenditures. 3)Factor Income: This is the third category of the CA. It includes payments or receipts of interest, dividends and other income on foreign investments that were previously made. If US investors receive interests on their holdings of foreign bonds, it will be recorded as a credit to the BOP. On the other hand, interest Payments by US borrowers to foreign creditors is a debit to the US BOP. 4)Unilateral Transfer: this is the fourth category of the CA. Example Foreign aid, gifts and grants. Unilateral transfer is a debit account. 5) The Capital Account (KA) The KA balance measures the difference between US sales of assets to foreigners and US purchases of foreign assets. US sales are exports and represent a capital inflow. US purchases are imports and are capital outflow KA is divided into three categories: 1) Direct investment (FDI): represents purchases of real assets (plants) or acquisition of a percentage shares of a foreign business etc... 2) Portfolio investment represents sales or purchases of foreign financial assets such as stocks and bonds and options 3) Other investment includes transactions in currency, bank deposits and trade credits. Higher interest rates in USA, means more foreign investment into US financial market. 6) Official Reserve Account is used when a country must make a net payment to foreigners because of its BOP deficit. The central bank or the Federal Reserve must use its foreign reserve to pay for the deficit. The Foreign reserve assets include gold, foreign exchanges and SDRs (special Drawing rights) or borrow from foreign central banks. 7) The BOP Identity BCA + BKA + BRA = 0 Where BCA = Balance on the current account BKA = balance on the capital account BRA = balance on the reserve account 8) The relationship between BOP and the National Income Account GDP = Y = C+I+G+ (X-M) Private Saving (S) is defined as the amount left from National Income (Y) after consumption and taxes are paid: S = Y – C –T or S = Y –C-T or S= C+I+G +X-M-C-T, noting that BCA = X-M hence; (S-I) + (T-G) + X –M = BCA. In order to reduce trade deficit or BCA, S must increase or T must increase or X must increase I must decrease or G must decrease or M must decrease Example: ( 100 – 100) + (150 – 140) + 170 – 200) = -20 What to do to eliminate BCA deficit of 20 million' Solution A) : Increase Saving by 20 million, hence S = 120, or Solution B) Increase Taxes. This is a last resort solution, since increasing taxes would not be easily accepted by the citizens of any country, Or Solution C) increase exports: it takes time to increase quality prior to increase exports Solution D) Decrease imports; this way the black market will be flooded with illegally imported goods and the prices will be manipulated'