Project 2　Balance of Payment Accounting

The sort of dependence that results from exchange， i.e.， from commercial transactions， is a reciprocal dependence. We cannot be dependent upon a foreigner without his being dependent on us. Now， this is what constitutes the very essence of society. To sever natural interrelations is not to make oneself independent， but to isolate oneself completely.

——Frederic Bastiat

Learning Objectives

This project provides a type of navigational map to the understanding of balance of payment and the multitude of economic， political， and business issues which it involves. But our emphasis is far from descriptive， as a deep understanding of trade and capital flows is integral to the management of multinational enterprises. In fact， the second half of the project emphasizes a more detailed analysis of how elements of the balance of payment affect trade prices and market volumes， as well as how capital flows， capital controls， and capital flight alter the cost and ability to do business internationally. The project concludes with the Mini Case， Global Remittances， an element of the current account in the balance of payment and the subject of significant controversy globally.

Task 1　Balance of Payment Accounts

1.1　Definition of the Balance of Payment

International business transactions occur in many different forms over the course of a year. The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payment（BOP）. The balance of payment is the record of the economic and financial flows that take place over a specified time period between residents and non-residents of a given country. The International Monetary Fund （IMF） compiles statistics on each country’s cross-border transactions and publishes a monthly summary of BOP statistics， although it is a common practice for most countries to supply BOP data on an annual basis.

To precisely understand this definition， we first need to be able to identify who is a resident and who is a non-resident. Resident is defined to include all economic units domiciled in the reporting country， Non-resident is anyone who is not domiciled in the reporting country. It is important to note that citizenship and residency are not necessarily the same thing from the viewpoint of the BOP statistics. The term residents of a country comprise the general government， individuals， private non-profit bodies serving individuals， and enterprises， all defined in terms of their residential relationship to the territory of that country. Usually， any individual or firm who works or lives in a country for more than one year， no matter what nationality they are， would be regarded as the resident of that country.

For the purposes of BOP statistics， the subsidiaries of a multinational corporation are treated as being a resident in the country in which they are located even if their shares are actually owned by domestic residents. A foreign student who studies in a domestic school is regarded as the domestic resident. Some exceptions regarding the resident are international organizations such as the International Monetary Fund， the World Bank， United Nations and so forth. These institutions are treated as being non-residents even though they may actually be located in the reporting country. Foreign embassies and foreign military bases are also in this category. For example， although U.S. embassy in Beijing is located in Beijing， salaries paid by the embassy to the Chinese staffs are included in China’s balance of payment because they are regarded as transactions with a non-resident. Tourists are regarded as being non-residents if they stay in the reporting country for less than a year.

The criterion for a transaction to be included in the BOP is that it must involve a transaction between a resident of the reporting country and a non-resident of that country. Purchases and sales between residents from the same country are excluded.

Meanwhile， BOP reflects economic and financial flows which are international transactions in goods， services and financial assets or liabilities. Each of the following examples is a typical international transaction that is counted and recorded in China’s balance of payment.

（1）A Beijing car dealer imports 50 Porsche； Panama from a German automobile distributor.

（2）The Chinese subsidiary of a U.S. firm， Hewlett-Packard， pays dividends back to its parent firm in California.

（3）A Chinese tourist purchases a Canon camera in Tokyo， Japan.

（4）The Chinese government provides a low interest rate loan to North Korea.

（5）China National Petroleum issues company stocks in New York Stock Exchange.

It should be noted that the BOP must tracks the continuing flows of purchase and payments between a country and the rest of the world， and it does not add up the value of all assets and liabilities of a country on a specific date like a balance sheet does for an individual company.

1.2　The Importance of BOP

Home-country and host-country BOP data are important to business managers， investors， consumers， and government officials， because the data influences and is influenced by other key macroeconomic variables such as gross domestic product， employment levels， price levels， exchange rates， and interest rates. Monetary and fiscal policy must take the BOP into account at the national level. Business managers and policy must take the BOP into account at the national level. Business managers and investors need BOP data to anticipate changes in host-country economic policies that might be driven by BOP events. BOP data is also important for the following reasons.

（1）The BOP is an important indicator of pressure on a country’s foreign exchange rate， and thus of the potential for a firm trading with or investing in that country to experience foreign exchange gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange controls.

（2）Changes in a country’s BOP may signal the imposition or removal of controls over payment of dividends and interests， license fees， royalty fees， or other cash disbursements to foreign firms or investors.

（3）The BOP helps to forecast a country’s market potential， especially in the short run. A country experiencing a serious trade deficit is not as likely to expand imports as it would be if running a surplus. It may， however， welcome investments that increase its exports.

1.3　Fundamentals of Balance of Payment Accounting

The BOP must balance. If it does not， something has not been counted or has been counted improperly. Therefore it is incorrect to state that the BOP is in disequilibrium. It cannot be. The supply and demand for a country’s currency may be imbalanced， but supply and demand are not the same thing as the BOP. A subaccount of the BOP， such as the merchandise trade balance， may be imbalanced， but the entire BOP of a single country is always balanced.

There are three main elements of the actual process of measuring international economic activity.

（1）Identifying what is and is not an international economic transaction；

（2）Understanding how the flow of goods， services， assets， and money create debits and credits to the overall BOP；

（3）Understanding the bookkeeping procedures for BOP accounting.

1.3.1　Defining International Economic Transactions

Identifying international transactions is ordinarily not difficult. The export of merchandise—goods such as trucks， machinery， computers， telecommunications equipment and so forth—is obviously an international transaction. Imports such as French wine， Japanese cameras， and German automobiles are also clearly international transactions. But this merchandise trade is only a portion of the thousands of different international transactions that occur in the United States or any other country each year.

Many other international transactions are not so obvious. The purchase of a glass figure in Venice， Italy， by a U.S. tourist is classified as a U.S. merchandise import. In fact， all expenditures made by U.S. tourists around the globe for services （meals， hotel accommodations）， but not for goods， are recorded in the U.S. balance of payment as imports of travel services in the current account. The purchase of a U.S. Treasury bill by a foreign resident is an international financial transaction and is duly recorded in the financial account of the U.S. balance of payment.

1.3.2　The BOP as a Flow Statement

The BOP is often misunderstood because many people infer from its name that it is a balance sheet， whereas in fact it is a cash flow statement. By recording all international inactions over a period of time such as a year， the BOP tracks the continuing flows of purchases and payments between a country and all other countries. It does not add up the value of all assets and liabilities of a country on a specific date like a balance sheet does for an individual firm.

Two types of business transactions dominate the balance of payment.

（1）Exchange of Real Assets. The exchange of goods （for example， automobiles， computers， watches， textiles） and services （for example， banking services， consulting services， travel services） for other goods and services （barter） or for money.

（2）Exchange of Financial Assets.The exchange of financial claims （for example， stocks， bonds， loans， purchases or sales of companies） for other financial claims or money.

1.3.3　Balance of Payment Accounting

All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how many foreign currencies are going in and out of a country. If a country has received foreign currencies， this is known as credit， and if a country has paid or given foreign currencies， the transaction is counted as a debit. Theoretically， the BOP should be zero， meaning that assets （credits） and liabilities （debits） should balance. But in practice this is rarely the case and thus， the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

In theory， a so-called double-entry bookkeeping system is employed to record all economic and financial flows. A double-entry bookkeeping system records both sides of any two-party transaction with two separate and offsetting entries： a debit entry and a credit entry. Any international transaction that results in a credit entry would also generate an offsetting debit entry， and a transaction that results in a debit entry would also generate an offsetting credit entry. In other words， every credit （debit） is matched by a debit （credit） somewhere to conform to the principle of double-entry bookkeeping system. The result is that the sum of all the debit entries， in absolute value， are equal to the sum of all the credit entries. That is， with everything in the country’s balance of payments always“balances”.

A debit entry records a transaction that results in a domestic resident asking a payment abroad. A debit entry has a negative value in the BOP statistics. A credit entry records a transaction that results in a domestic resident receiving a payment from abroad. A credit entry has a positive value in the BOP statistics.

1.4　Accounts of the Balance of Payment

Before considering some examples of how different types of economic transactions between residents and non-residents get recorded in the BOP， we need to consider the various accounts that make up the BOP. The BOP is divided into three main categories： the current account， the capital and financial account and the official reserves account. Each general account is then subdivided into categories such as exports， imports， direct investment， portfolio investment， etc..

1.4.1　The Current Account

The current account includes all international economic transactions with income or payment flows occurring within the year， the current period. The current account consists of four subcategories：goods trade，services trade，income，current transfer.

（1）Goods trade.The export and import of goods. Merchandise trade is the oldest and most traditional form of international economic activity. The value of goods exports is recorded in the credit side （plus sign） of the BOP， and the value of goods imports is recorded in the debit side （minus sign）. Combining the exports and imports of goods gives the goods trade balance or balance of trade （BOT）. The BOT is typically the biggest bulk of a country’s BOP as it makes up total imports and exports. When this balance is negative， the result is BOT deficit， meaning the country imports more than exports merchandise. The BOT surplus， on the other hand， means that the country’s exports exceed imports.

Transaction 1： goods export

Suppose a Chinese exporter sells 2，000 T-shirts to a Wal-Mart store in Newark， New Jersey.The price of the T-shirts is 20，000. China’s BOP will show a credit or a source of 20，000 of exports.

We mentioned earlier that balance of payment accounting is based on a double-entry bookkeeping system. A credit or source of 20，000 implies a debit or use of an equal amount. Suppose the Wal-Mart store pays for the T-shirts through Citigroup in New York. Now the Chinese exporter has a short-term claim of 20，000 on the Citibank. Expressed in T-accounts China’s BOP will look like this：

Transaction 2：goods import

A Shanghai retailer buys 300，000 worth of Laptops from Sony in Japan. The merchandise is billed in U.S. dollars and the retailer pays for the merchandise with a check drawn on Bank of China， Shanghai Branch.

In this case， the computer import represents an increase in China’s tangible assets and is a use of external purchasing power. The check drawn by the Chinese retailer on a Shanghai branch of Bank of China represents an increase of short-term liabilities owned by a Chinese resident to a non-resident and is a source of external purchasing power. For China’s BOP expressed in T-accounts， this transaction will appear as follows：

Imports Short-term Liabilities

From Transactions 1 and 2 we can calculate China’s trade balance for the period which is equal to：

Balance of trade = Exports-Imports =20，000-300，000=-280，000

（2）Services trade. The export and import of services.Common international services are financial serviced by banks to foreign importers and exporters， travel services of airlines， and construction services of domestic firms in other countries. The services trade is sometimes called invisible trade. The services exports are credit items and services imports are debit items. For the major industrial countries， this subaccount has shown the fastest growth in the past decade.

Transaction 3：travelling expenses （service export）

Mr. Williams， an American， decides to go to China for his three-week vacation.He buys a round trip ticket on Air China for 2，500. His expenses in China for hotels， food， transportation and souvenirs come to the equivalent of 15，000. He pays the ticket in cash with dollars and obtains the RMB equivalent of 15，000 that he spends in China by selling dollars to a Chinese bank.

The 2，500 that Mr. Wi11iams pays Air China will be credited to passenger services in the balance of payment and the 15，000 that he spends in China will be credited to travel for a total of 17，500 of exports of services for Chinese economy. On the other hand， Air China increased its cash dollar holdings by 2，500 while the Chinese bank increased its cash dollar holdings by the 15，000 for a total increase of 17，500 for Chinese economy， For China’s BOP expressed in T-accounts， these transactions will appear as follows：

The service export generates a source of 17，500 worth of external purchasing power. This is offset by an increase of 17，500 worth of cash dollar holdings in the account “short-term claims”.

Service Exports Short-term Liabilities

（3）Income. Predominantly current income associated with investments that were made in previous periods， which reflects receipts and payments of interest， dividends and profits from investment.Income receipts represent the rewards for investment in overseas companies， bonds and equity， while payment’s reflect the rewards to foreign residents for their investment in the domestic economy. Therefore， income receipts received by domestic residents are credits， whereas income payments made to foreign residents are debits.

Transaction 4： income

Hewlett-Packard in Shanghai， a wholly owned Chinese subsidiary of the HP in California， has after-tax profits of the equivalent of 100，000 and declares a dividend of 50，000. The California headquarters uses the dividend to purchase long-term bonds issued by the Shanghai government.

As a wholly owned subsidiary， HP Shanghai represents a direct investment for HP California.Therefore， a total profit of 100，000 including retained earnings and the declared dividend is counted as investment payment for China’s BOP and a use of external purchasing power. Since the HP Shanghai declares only half of its profits as dividend， it implies that the company will retain the other half. Therefore， the rest 50，000 will be used as reinvestment by the HP Shanghai. The non-distributed profits or retained earnings of 50，000 represent an increase in HP’s direct investment in China. HP California is a US resident enterprise and， hence， Chinese residents’ liabilities on non-residents have increased by 50，000. By the same token， the long-term government bonds purchased by H.P California with the dividend represent a 50，000 increase in non-resident portfolio investment. In T-accounts for China’s BOP， these transactions will be recorded as follows：

Investment Income Direct Investment

（4）Current transfers. The financial settlements associated with the change in ownership of real resources or financial items. Any transfer between countries that is a one-way gift or grant is termed a current transfer. This subaccount can be further divided into private and government unilateral transfers. Examples of unilateral transfers are migrant workers’ remittances to their families back home as well as gifts， inheritances， and prizes， funds provided by the government to aid in the development of a less-developed country， the payment of pensions to non-residents， contributions to international organizations and so forth.

Transaction 5：unilateral transfer

Mr. Wang， who is a Chinese citizen but has been a resident of the United States for several years，transfers 10，000 from his account at a New York branch of Citicorp into his mother’s account at Bank of China， Shanghai Branch. There is no commercial quid pro quo involved in the operation. Thus， the transaction falls under the heading “immigrant worker’s remittance” and represents a unilateral transfer and a source of external purchasing power for Chinese economy. The offsetting use of external purchasing power is the increase in Bank of China’s short-term claims to the Citibank. These transactions will be recorded in China’s BOP as follows：

This completes the components of the current account. For most countries the current account is dominated by the balance of trade， which is the balance of export and import of merchandise. The BOT is widely quoted in the business press in most countries. For developed countries， the BOT is somewhat misleading， in that services trade is not included.

Table 2.1 presents all the information resulting from Transactions 1 through 5. Although we were considering transactions related to the current account， the double-entry system made it necessary to consider transactions related to the capital and financial account as well. As we can see， at the end of Transaction 5 China has a current account deficit of 352，500. This deficit was offset by a 352，500 surplus in the capital and financial account. In fact， because of the double-entry bookkeeping system， the balance of the current and capital and financial accounts will always be equal to zero.

Link It Up：The Global Current Account Surplus

One country’s surplus is another country’s deficit. That is， individual countries may and do run current account deficits and surpluses， but it should be， theoretically， a zero sum game But according to the IMF’s most recent World Economic Outlook， however， the world is running a current account surplus.

At least that is what the statistics say.

The rational explanation is that the statistics as reported to the IMF by its member countries are in error. Those errors are most likely both accidental and intentional. The IMF believed for many years that the most likely explanation was under-reporting of foreign investment income by residents of the wealthier industrialized countries， as well as under-reporting of transportation and freight charges. In more recent years when the imbalance has shifted from deficit to surplus， several studies have argued that it is most likely the result of improved data collection and reporting on trade in international services.

Many alternative explanations focus on intentional misreporting of international current account activities. Over or under-invoicing has long been a ploy used in international trade to avoid taxes， capital controls， or purchasing restrictions. Other arguments， like under-reporting of foreign income for tax avoidance and the complexity of intracompany transactions and transfer prices， are all potential partial explanations.

But in the end the theory says it can’t be， but the numbers says it is. As noted by the Economist， planet Earth appears to be running a current account surplus in its trade with extraterrestrials （“Are aliens buying Louis Vuitton handbags？”）.

1.4.2　Capital and Financial Account

The capital and financial accounts of the balance of payment measure all international economic transactions of financial assets.

（1）The Capital Account.The capital account now refers to the acquisition or disposal of financial and non-financial assets （for example， a physical asset such as land， building or machinery） and non-produced assets， which are needed for production but have not been produced， like a mine used for the extraction of diamonds. This account has been introduced a separate component in the IMF’s balance of payment only recently.

（2）The Financial Account. The credits and debits of the financial account transactions are like exports and imports of goods and services. For example， if a non-resident buys Chinese financial assets， China is exporting financial assets. The transaction is viewed as a credit entry from the Chinese perspective. If a Chinese resident purchases stocks from the New York Stock Exchange， China is importing financial assets. The transaction is then viewed as a debit entry. The financial account consists of three components： direct investment， portfolio investment， and other asset investment.

Direct Investment

This investment measure is the net balance of capital dispersed from and into the United States for the purpose of exerting control over assets. If a U.S. firm builds a new automotive parts facility in another country or actually purchases a company in another country， this is a direct investment in the U.S. balance of payment accounts. When the capital flows out of the United States， it enters the balance of payment as a negative cash flow. If， however， a foreign firm purchases a firm in the United States， it is a capital inflow and enters the balance of payment positively. Whenever 10% or more of the voting shares in a U.S. company are held by foreign investors， the company is classified as the U.S. affiliate of a foreign company， and as a foreign direct investment. Similarly， if U.S. investors hold 10% or more of the control in a company outside the United States， that company is considered the foreign affiliate of a U.S. company.

Transaction 1：direct investment

An affiliate of Volkswagen in China has net profit of 250，000. The VW headquarters decides to reinvest it. The VW affiliate in China is a resident of China， but the VW headquarters is the non-resident. When VW does not take the profit and reinvest it， it makes the direct investment to China. This is the example of retained earnings which are regarded as the direct investment. It is a foreign direct investment in China which is recorded in the credit side of China’s BOP. The offsetting use of the external purchasing power is the increase of China’s short-term claims to the foreigner.

Direct Investment short-term claims

Portfolio Investment

This is net balance of capital that flows in and out of the United States but does not reach the 10% ownership threshold of direct investment. If a U.S. resident purchases shares in a Japanese firm but does not attain the 10% threshold. We define the purchase as a portfolio investment （and in this case an outflow of capital）.The purchase or sale of debt securities （like U.S. Treasury bills） across borders is also classified as portfolio investment， because debt securities by definition do not provide the buyer with ownership or control.

Portfolio investment is capital invested in activities that are purely profit motivated （return）， rather than ones made to control or manage the investment.Purchases of debt securities， bonds，interest-bearing bank accounts， and the like are intended only to earn a return. if they provide no vote or control over the party issuing the debt.

Transaction 2：portfolio investment

A Chinese buys 50，000 Dell computer’s equity. He pays for the stocks with his bank deposits in New York Bank. The transaction represents the capital outflows out of China. This is the China’s portfolio investment to the U.S. for China’s. BOP， it will be recorded as follows：

Portfolio Investment short-term claims

Other Investment

Other investment groups all the capital transactions that have not been included in direct investment or portfolio investment. It consists of various short-term and long-term loans， foreign currency deposits， and trade credits. These investments are quite sensitive to both changes in relative interest rates between countries and the a participated change in the exchange rate. If China’s interest rate is higher than other countries’ and the value of RMB is expected to be up， China will experience capital inflows， as investors would like to deposit or invest in China to have higher returns.

1.4.3　Official Reserves Account

The Official Reserves Account is the total reserves held by official monetary authorities within the country. These reserves are normally composed of the major currencies used in international trade and financial transactions （so-called“hard currencies” like the U.S. dollar， European euro， Japanese yen； gold； and special drawing rights， SDRs）.

The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange system. If a country’s currency is fixed， the government of the country officially declares that the currency is convertible into a fixed amount of some other currency. For example， the Chinese Yuan was fixed to the U.S. dollar for many years. It was the Chinese government’s responsibility to maintain this fixed rate， also called parity rate. If for some reason there was an excess supply of Chinese Yuan on the currency market， to prevent the value of the Yuan from falling， the Chinese government would have to support the Yuan’s value by purchasing Yuan on the open market （by spending its hard currency reserves， its official reserves） until the excess supply was eliminated. Under a floating rate system， the Chinese government possesses no such responsibility and the role of official reserves is diminished.

1.4.4　Net Errors and Omissions

The double-entry bookkeeping system is employed in theory， but not in practice. In reality， there is not a system available whereby officials can simultaneously record the credit side and debit side of each transaction. Current and financial entries are collected and recorded separately. Thus， there will be serious discrepancies between debits and credits.Officials collect information from multiple sources that vary in coverage and reliability. For example， merchandise trade figures are derived from customs records and freight charges from reports by shipping organizations. Service transactions such as the consulting fees can easily escape detection.Capital and financial account information is derived from reports by financial institutions indicating changes in their liabilities and claims to foreigners； these data are not matched with specific current account transactions. Short-term capital movements are particularly difficult to track， especially when there is intent to evade exchange controls， taxes and other restrictions. Capital movements may also lead or lag the transactions they are meant to finance.For example， an export shipped in the month of November or December may not be paid for until January or February of the following year. For those reasons， the balance of payment always presents a“balancing” debit or credit as net errors and omissions. The net errors and omissions account ensures that the BOP actually balances because it offsets the accumulated net difference in the other accounts.

Task 2　Disequilibrium of Balance of Payment

Table 2.2 is a simplified version of U.S. balance of payment in 2010. The Bureau of Economic Analysis （ BEA） under the U.S. department of Commerce reports the BOP statistics each quarter during the year. We selected major items from the BEA complete version when we compiled this simplified version. It should be pointed out that the present U.S. balance of payment includes just two main accounts： the current account and the capital and financial account. The official reserves account is just a subaccount of the financial account. In order to make it consistent with our introduction of the BOP accounts， we separate the official reserves account from the financial account.

If we add all the account balances in Table 2.2 up，we’ll see the result is zero. BOP always balances since each credit in the account has a corresponding debit elsewhere. So what does BOP deficit or surplus mean？ However， while the overall BOP always balances this does not mean that each of the individual accounts that make up the BOP is necessarily in balance. For instance， the current account of the 2010 U.S. balance of payment was negative；-470，242 billion； the capital and financial account had a surplus of 236，935 billion. When talking about a BOP balance， economists use the following measure to refer to BOP deficit or surplus.

（1）current account （CA）+capital and financial account （KA）=0（BOP balance）；

（2）current account （CA）+capital and financial account （KA）> 0（BOP surplus）；

（3）current account （CA）+capital and financial account （KA）<0（BOP deficit）.

The balance of current account and capital and financial account is also referred to as the basic balance. When the balance of payment is said to be in surplus or deficit， it is the basic balance that is actually in surplus or deficit. For the 2010 U.S. balance of payment， the current account deficit was 470，242 billion and the capital and financial account surplus was 236，935 billion. It seems that the U.S. had BOP deficit of 233，307 billion. But the statistical discrepancy was 235，141 billion in the credit side， which means some transactions were not reported or omitted when the statistics were made. Adding those two figures up， we find the 2010 U.S. BOP had a surplus of 1，834 （236，935+235，141-470，242） which exactly matched the official reserves account balance.

A surplus in the BOP implied that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase in value or intervene and accumulate additional foreign currency reserves in the official reserves account. This intervention would occur as the government sold its own currency in exchange for other currencies， thus building up its stores of hard currencies.

A deficit in the BOP implied an excess supply of the country’s currency on world markets， and the government would then either devalue the currency or expend its official reserves to support its value.

Task 3　Trade Balance and Exchange Rate

3.1　The Balance of Payment Interaction with Key Macroeconomic Variables

A nation’s balance of payment interacts with nearly all of its key macroeconomic variables. Interacts means that the balance of payment affects and is affected by such key macroeconomic factors as the following：

（1）Gross Domestic Product （GDP）；

（2）The exchange rate；

（3）Interest rates；

（4）Inflation rates.

3.1.1　The BOP and GDP

In a static accounting sense. A nation’s GDP can be represented by the following equation：

GDP=C+I+G+X-M

C=consumption spending

I=capital investment spending

G=government spending

X=exports of goods and services

M=imports of goods and services

X-M=the balance on current account （when including current income and transfers）

Thus， a positive current account balance （surplus） contributes directly to increasing the measure of GDP， but a negative current account balance （deficit） decreases GDP.

In a dynamic （cash flow） sense， an increase or decrease in GDP contributes to the current account deficit or surplus. As GDP grows， so does disposable income and capital investment. Increased disposable income leads to more consumption， a portion of which is supplied by more imports. Increased consumption eventually leads to more capital investment.

Growth in GDP also should eventually lead to higher rates of employment. However， some of that theoretical increase in employment may be blunted by foreign sourcing （that is， the purchase of goods and services from other enterprises located in other countries）.

3.1.2　The BOP and Exchange Rates

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP data：

BOP=（X-M）+（CI-CO）+（FI-FO）+FXB

X=exports of goods and services

M=imports of goods and services

X-M=current account balance

CI=capital inflows

CO=capital outflows

CI-CO=capital account balance

FI= financial inflows

FO=financial outflows

FI-FO=financial account balance

FXB=official monetary reserves such as foreign exchange and gold

（1）Fixed Exchange Rate Countries.Under a fixed exchange rate system， the government bears the responsibility to ensure a BOP near zero. If the sum of the current and capital accounts does not approximate zero， the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero， a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate， the government must then intervene in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero.

If the sum of the current and capital accounts is negative， an exchange supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances to allow it to intervene effectively. If the country runs out of foreign exchange reserves， it will be unable to buy back its domestic currency and will be forced to devalue. For fixed exchange rate countries， then， business managers use BOP statistics to help forecast devaluation or revaluation of the official exchange rate. Normally a change in fixed exchange rates is technically called devaluation or revaluation， while a change in floating exchange rates is called either depreciation or appreciation.

（2）Floating Exchange Rate Countries. Under a floating exchange rate system， the government of a county has no responsibility to peg the foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically （in theory） alter the exchange rate in the direction necessary to obtain a BOP near zero. For example， a country running a sizable current account deficit with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. As is the case with all goods in excess supply， the market will rid itself of the imbalance by lowering the price. Thus， the domestic currency will fall in value， and the BOP will move back toward zero. Exchange rate markets do not always follow this theory， particularly in the short to intermediate term.

（3）Managed Floats. Although still relying on market conditions for day-to-day exchange rate determination， countries operating with managed floats often find it necessary to take actions to maintain their desired exchange rate values. They therefore seek to alter the market’s valuation of a specific exchange rate by influencing the motivations of market activity， rather than through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates， thus influencing the economic fundamentals of exchange rate determination. A change in domestic interest rates is an attempt to alter capital account balance， especially the short-term portfolio component of these capital flows， in order to restore an imbalance caused by the deficit in current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This will alter market forces and create additional market demand for domestic currency. In this process， the government signals exchange market participants that it intends to take measures to preserve the currency’s value within certain ranges. The process also raises the cost of local borrowing for businesses， however， and so the policy is seldom without domestic critics. For managed-float countries， business managers use BOP trends to help forecast changes in the government policies on domestic interest rates.

3.1.3　The BOP and Interest Rates

Apart from the use of interest rates to intervene in the foreign exchange market， the overall level of a country’s interest rates compared to other countries does have an impact on the financial account of the balance of payment.Relatively low real interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country currencies. However， in the case of the United States， the opposite fact has occurred. Despite relatively low real interest rates and large BOP deficits on current account， the U.S. BOP financial account has experienced offsetting financial inflows due to relatively attractive U.S. growth rate prospects， high levels of productive innovation， and perceived political safety. Thus， the financial account inflows have helped the United States to maintain its lower interest rates and to finance its exceptionally large fiscal deficit.

3.1.4　The BOP and Inflation Rates

Imports have the potential to lower a country’s inflation rate. In particular， imports of lower-priced goods and services places a limit on what domestic competitors charge for comparable goods and services. Thus， foreign competition substitutes for domestic competition to maintain a lower rate of inflation than might have been the case without imports.

On the other hand， to the extent that lower-priced imports substitute for domestic production and employment， gross domestic product will be lower and the balance on current account will be more negative.

3.2　Trade Balance and Exchange Rate

A country’s import and export of goods and services is affected by changes in exchange rates. The transmission mechanism is in principle quite simple： changes in exchange rates change relative prices of imports and exports， and changing prices in turn result in changes in quantities demanded through the price elasticity of demand. Although the theoretical economics appear straightforward， the reality of global business is a bit more complex.

The balance of trade influences currency exchange rates through its effect on the supply and demand for foreign exchange. When a country’s trade account does not net to zero—that is， when exports are not equal to imports—there is relatively more supply or demand for a country’s currency， which influences the price of that currency on the world market.

Currency exchange rates are quoted as relative values，the price of one currency is described in terms of another. For example， one U.S. dollar might be equal to 11 South African rand. In other words， an American business or person exchanging dollars for rand would buy 11 rand for every dollar sold， and a South African would buy 1 for every 11 rand sold.

However， these relative values are influenced by the demand for currency， which is in turn influenced by trade. If a country exports more than it imports， there is a high demand for its goods and thus for its currency. Supply and demand dictate that when demand is high， prices rise and thus the currency appreciates in value. On the other hand， if a country imports more than it exports， there is relatively less demand for its currency， so prices should decline. In this case， a currency depreciates or loses value.For example， candy bars are the only product on the market and South Africa imports more candy bars from the United States than it exports， so it needs to buy more dollars relative to rand sold. Because South Africa’s demand for dollars outstrips America’s demand for rand， the value of the rand falls. In this situation， the rand might fall to 15 relative to the dollar. Now， for every 1 sold， an American gets 15 rand. To buy 1， a South African has to sell 15 rand.

As a currency depreciates， the relative attractiveness of exports from that country grows. For example， assume an American candy bar costs 1. Before the depreciation， a South African could buy an American candy bar for 11 rand. Afterward， the same candy bar costs 15 rand， a huge price increase. On the other hand， a South African candy bar costing 5 rand has become much cheaper by comparison： 1 now buys three South African candy bars instead of two. South Africans might start buying fewer dollars because American candy bars have become quite expensive， and Americans might start buying more rand because South African candy bars have become cheaper. This in turn begins to affect the balance of trade：South Africa starts exporting more and importing less， reducing the trade deficit.This example assumes that the currency is on a floating regime， meaning that the market determines the value of the currency relative to others. In cases where one or both currencies are fixed or pegged to another currency， the exchange rate does not move so readily in response to a trade imbalance.

3.3　Capital Mobility

（1）Definition of capital mobility.Easy for physical assets and finance to move across geographical boundaries.

（2）Definition of capital immobility.When capital faces restrictions on the free movement.

3.3.1　What is capital？

Capital principally refers to physical capital—durable goods used in the production process—machines， factories. This physical capital is determined by levels of investment. When people refer to capital， they also may mean “financial capital” or “short-term capital”. This is not physical machines， but money and liquid assets. This kind of capital can be much more mobile. For example， a multinational may move some of its financial capital from Europe to Australia to take advantage of higher interest rates in Australia.

Therefore capital flows can involve：

（1）Foreign Direct Investment （FDI），e.g. Nissan building a factory in England；

（2）Portfolio Flows，short-term capital， e.g. taking advantage of different interest rates and moving saving accounts to a different country；

（3）Bank transfers.

3.3.2　What does capital mobility mean？

（1）If capital is mobile， then it means it is easy and seamless to move capital from one country to another.

（2）Perfect capital mobility would imply no transaction or other costs in moving capital from one country to another.

（3）Capital immobility means it is difficult and expensive to move capital between countries.

3.3.3　What determines capital mobility？

（1）Tariffs/taxes on capital flows. Capital flows may be taxed by the government，e.g. tax on investment or capital gains tax on profitable capital flows. High levels of tax will discourage capital flows.

（2）Restrictions on capital flows. Some countries may impose restrictions on the amount of capital that can be taken into and out of a country（Foreign exchange controls）.For example， in the period of hyperinflation， Zimbabwe imposed capital controls on individuals taking foreign currency out of the country.

（3）Rules and Regulations. Governments can impose rules which increase the cost of moving capital from one country to another.

（4）Exchange Rate Volatility.If a country has a volatile exchange rate， this may discourage capital inflows as investors are worried about devaluation in the exchange rate which reduces the profitability of investment（This is an indirect factor）.

3.3.4　Impact of Capital Mobility

（1）FDI. If capital is mobile， then it will be easier to attract Foreign Direct Investment into your country. It will also increase investment opportunities abroad.

（2）Better rate of return.With improved capital mobility， it will be easier to move financial capital around to gain higher yields and interest rates.

（3）Real exchange rates parity. If capital is mobile it should reduce differences in real exchange rates. If goods are relatively cheaper in the U.S.， it should encourage people to buy goods there and transfer capital to low-cost countries.

（4）It could help equalize incomes between different countries，e.g. with perfect capital mobility， it may encourage European firms to invest in developing countries who have lower wage rates. These capital inflows could help raise wages in developing economies.