BUAD633—- BALANCE OF PAYMENTS AND BALANCE OF

TRADE

Week Two Lecture : Dr Barngetuny

INTRODUCTION

Learning Objectives
➢ Vividly understand the concepts of BOT and BOP and economic impact
➢ Describe why and how imbalances arise now then and how to control them.

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INTRODUCTION-CONT.

Balance of payments (BOP) accounts are an accounting record of all monetary

transactions between a country and the rest of the world.
These transactions include payments for the country's exports and imports of
goods & services, financial capital, and financial transfers.
A country has to deal with other countries in respect of 4 items:-  Visible
items which include all types of physical goods exported and imported.
Invisible items which include all those services whose export and import are
not visible. e.g. transport services, medical services etc.
 Unilateraltransfers ( One way)
 Capital transfers which are concerned with capital receipts and capital
payment.

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INTRODUCTION-CONT.

Balance of Trade
--The balance of trade forms part of the current account, which includes other
transactions such as income from the net international investment position as
well as international aid. If the current account is in surplus, the country’s net
international asset position increases correspondingly. Equally, a deficit
decreases the net international asset position.
--The trade balance is identical to the difference between a country’s output and
its domestic demand (the difference between what goods a country produces
and how many goods it buys from abroad; this does not include money re-spent
on foreign stock, nor does it factor in the concept of importing goods to
produce for the domestic market).

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Definition-
According to Kindle Berger, "The balance of payments of a country is a
systematic record of all economic transactions between the residents of the
reporting country and residents of foreign countries during a given period of
time".
Characteristics
It is a systematic record of all economic transactions between one country and
the rest of the world.
 It includes all transactions, visible as well as invisible.
 It relates to a period of time. Generally, it is an annual statement.  It adopts
a double-entry book-keeping system. It has two sides: credit side and debit side.
Receipts are recorded on the credit side and payments on the debit side.
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BOP includes two types of accounts CAPITAL ACCOUNT AND CURRENT
ACCOUNT
CAPITAL ACCOUNT
 Capital Transfers
 Private transactions
 Official transactions
 Banking capital
 FDI – foreign direct investment
 Portfolio investment ( FPI or FII)

Visible + Invisible + Unilateral+ Capital transfers = Current Account

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Current Account Balance
 BOP on current account is a statement of actual receipts and payments in
short period.
 It includes the value of export and imports of both visible and invisible
goods. There can be either surplus or deficit in current account.
 The current account includes:- export & import of services, interests, profits,
dividends and unilateral receipts/payments from/to abroad.

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Financing deficits and surpluses
 The financing of a deficit is achieved by:

Selling gold or holdings of foreign exchange,

such as US dollars, yen or euros, or:
 Borrowing from other Central Banks or

the International Monetary Fund (IMF).

 A surplus will be disposed of by: Buying gold or currencies. Paying off debts.

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H

Causes of Disequilibrium
1Natural causes – e.g. floods, earthquake etc.
2. Economic causes – e.g. Cyclical Fluctuations, Inflation, Demonstration
Effect etc.
3. Political causes – e.g. international relation, political instability, etc.
4. Social factors – e.g. change in taste and preferences etc.

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How to correct the Balance of Payment?
1. Monetary measures –

 Deflation - Deflation means falling prices. Deflation has been used as a

measure to correct deficit disequilibrium. A country faces deficit when its
imports exceeds exports.
 Deflation is brought through monetary measures or through fiscal measures
like higher taxation, reduction in public expenditure, etc.
 Deflation would make our items cheaper in foreign market resulting a rise in
our exports. At the same time the demands for imports fall due to higher
taxation and reduced income.
 This would build a favourable atmosphere in the balance of payment
position. However Deflation can be successful when the exchange rate remains
fixed. 11
Exchange Depreciation - Exchange depreciation means decline in the rate of
exchange of domestic currency in terms of foreign currency. This device
implies that a country has adopted a flexible exchange rate policy.  Suppose
the rate of exchange between Kenya shillings and US dollar is $1 = Ksh. 100. If
Kenya experiences an adverse balance of payments with regard to U.S.A, the
Kenyan demand for US dollar will rise.  The price of dollar in terms of
Shillings will rise. Hence, dollar will appreciate in external value and Shilling
will depreciate in external value. The new rate of exchange may be say $1 =
Ksh. 110. This means 10% exchange depreciation of the Kenyan currency. 
Exchange depreciation will stimulate exports and reduce imports because
exports will become cheaper and imports costlier. Hence, a favourable balance
of payments would emerge to pay off the deficit.

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Devaluation - Devaluation refers to deliberate attempt made by monetary
authorities to bring down the value of home currency against foreign currency.
 When devaluation is effected, the value of home currency goes down against
foreign currency, Let us suppose the exchange rate remains $1 = Ksh. 100
before devaluation. Let us suppose, devaluation takes place which reduces the
value of home currency and now the exchange rate becomes $1 = Ksh. 200. 
After such a change our goods becomes cheap in foreign market. This is
because, after devaluation, dollar is exchanged for more Kenyan currencies
which push up the demand for exports. At the same time, imports become
costlier as Kenya have to pay more currencies to obtain one dollar.Thus
demand for imports is reduced.  Generally devaluation is resorted to where
there is serious adverse balance of payment problem.

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2.Non-Monetary Measures –
 Export Promotion –  The government can adopt export promotion
measures to correct disequilibrium in the balance of payments. This includes
substitutes, tax concessions to exporters, marketing facilities, credit and
incentives to exporters, etc.  The government may also help to promote
export through exhibition, trade fairs; conducting marketing research & by
providing the required administrative and diplomatic help to tap the potential
markets.

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Quotas –  Under the quota system, the government may fix and permit the
maximum quantity or value of a commodity to be imported during a given
period. By restricting imports through the quota system, the deficit is reduced
and the balance of payments position is improved.
Tariffs –  Tariffs are duties (taxes) imposed on imports. When tariffs are
imposed, the prices of imports would increase to the extent of tariff. The
increased prices will reduced the demand for imported goods and at the same
time induce domestic producers to produce more of import substitutes. Non-
essential imports can be drastically reduced by imposing a very high rate of
tariff.

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INTRODUCTION-CONT.

Measuring the balance of trade can be problematic because of problems with

recording and collecting data.
illustration,
when official data for the entire world’s countries are added up, exports exceed
imports by almost 1%; it appears the world is running a positive balance of
trade with itself.
This cannot be true, because all transactions involve an equal credit or debit in
the account of each nation. The discrepancy is widely believed to be explained
by transactions intended to launder money or evade taxes, smuggling and other
visibility problems. However, especially for developed countries, accuracy is
likely.
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INTRODUCTION-CONT.

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measures all international economic transactions between residents & foreign
residents.

• Monetary and fiscal policy must take the BOP into account at the national
level
• BOP data may be important
– Indicates pressure on exchange rate
– May signal burden/ removal of controls over payments, dividends,
interest.
– Helps forecast country’s market potential

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 A record of international transactions between residents of one country and
the rest of the world
 International transactions include exchanges of goods, services or assets
 “Residents” means businesses, individuals and government agencies,
including citizens temporarily living abroad but excluding local subsidiaries
of foreign corporations.

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The Balance of Payments is the statistical record of a country’s international
transactions over a certain period of time presented in the form of double-
entry bookkeeping.

Why is it useful to examine a country’s BOP?

The BOP provides detailed information about the supply and demand of the
country’s currency.
• The trade statistics in the Current Account, for example, show the
composition of trade – what a country imports and what it exports.
• The Capital Account shows inflows and outflows of capital in various
categories.
Viewed over time, BOP data can explain important developments in a country’s
comparative advantage and international competitiveness.

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INTRODUCTION-CONT.

Balance of trade (BOT) is the difference between the value of a country's

exports and the value of a country's imports for a given period. Balance of trade
is the largest component of a country's balance of payments (BOP). Sometimes
the balance of trade between a country's goods and the balance of trade
between its services are distinguished as two separate figures.

The balance of trade is also referred to as the trade balance, the international
trade balance, the commercial balance, or the net exports.

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Balance of Trade
 The difference between a country's imports and its exports. Balance of trade
is the largest component of a country's balance of payments.  Debit items
include imports, foreign aid, domestic spending abroad and domestic
investments abroad.  Credit items include exports, foreign spending in the
domestic economy and foreign investments in the domestic economy.  When
exports are greater than imports than the BOT is favourable and if imports are
greater than exports then it is unfavourable

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 BOP vs. BOT
 BOP  BOT
1. It is a broad term. 1. It is a narrow term.
2. It includes all transactions related 2. It includes only visible items.
to visible, invisible and capital
transfers.
3. It is always balances itself.
3. It can be favourable or unfavourable.
4. BOP = Current Account + Capital
4. BOT = Net Earning on
Account + or - Balancing item (
Export - Net payment for imports.
Errors and omissions)
5. Following are main factors
5. Following are main factors
which affect BOT
which affect BOP
a) cost of production
a) Conditions of foreign lenders.
b) availability of raw materials
b) Economic policy of Govt.
c) Exchange rate
c) all the factors of BOT
d) Prices of goods manufactured at
home
INTRODUCTION-CONT.

 A country that imports more goods and services than it exports in terms of
value has a trade deficit or a negative trade balance. Conversely, a country
that exports more goods and services than it imports has a trade surplus or
a positive trade balance.
 A positive balance of trade indicates that a country's producers have an
active foreign market. After producing enough goods to satisfy local
demand, there is enough demand from customers abroad to keep local
producers busy. A negative balance of trade means that currency flows
outwards to pay for exports, indicating that the country may be overly
reliant on foreign goods.
 A country's balance of trade is calculated by the following formula:

BOT=Exports−Imports
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 ​
INTRODUCTION-CONT.

Factors that can Affect the Balance of Trade Include

➢ The cost of production (land, labor, capital, taxes, incentives, etc.) in the
exporting economy vis-à-vis those in the importing economy; ➢ The cost and
availability of raw materials, intermediate goods and other inputs;
➢ Exchange rate movements;
➢ Multilateral, bilateral and unilateral taxes or restrictions on trade;
➢ Non-tariff barriers such as environmental, health or safety standards;
➢ The availability of adequate foreign exchange with which to pay for imports;
and
➢ Prices of goods manufactured at home (influenced by the responsiveness of
supply)

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INTRODUCTION-CONT.

Monetary balance of trade is different from physical balance of trade (which is

expressed in number of raw materials, known also as Total Material
Consumption). Developed countries usually import a lot of raw materials from
developing countries. Typically, these imported materials are transformed into
finished products, and might be exported after adding value. Financial trade
balance statistics conceal material flow. Most developed countries have a large
physical trade deficit, because they have a large ecological footprint. Civil
society organizations point out the predatory nature of this imbalance, and
campaign for ecological debt repayment.

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INTRODUCTION-CONT.

Economies such as Japan and Germany which have savings surpluses, typically
run trade surpluses. China, a high-growth economy, has tended to run trade
surpluses. A higher savings rate generally corresponds to a trade surplus.
Correspondingly, the U.S. with its lower savings rate has tended to run high
trade deficits, especially with Asian nations

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INTRODUCTION-CONT.

Views on Economic Impact

Classical Theory
From Classical economic theory, those who ignore the effects of long run trade
deficits may be confusing David Ricardo’s principle of comparative advantage
with Adam Smith’s principle of absolute advantage, specifically ignoring the
latter. The economist Paul Craig Roberts notes that the comparative advantage
principles developed by David Ricardo do not hold where the factors of
production are internationally mobile.
Global labor arbitrage, a phenomenon described by economist Stephen S.
Roach, where one country exploits the cheap labor of another, would be a case
of absolute advantage that is not mutually beneficial.

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INTRODUCTION-CONT.

Small trade deficits are generally not considered to be harmful to either the
importing or exporting economy.

However, when a national trade imbalance expands beyond prudence

(generally thought to be several percent of GDP, for several years), adjustments
tend to occur. While unsustainable imbalances may persist for long periods (cf,
Singapore and New Zealand’s surpluses and deficits, respectively), the
distortions likely to be caused by large flows of wealth out of one economy and
into another tend to become intolerable.

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INTRODUCTION-CONT.

In simple terms, trade deficits are paid for out of foreign exchange reserves,
and may continue until such reserves are empty, at which point, the importer
can no longer purchase abroad. This is likely to have exchange rate
implications: a loss of value in the deficit economy’s currency relative to the
surplus economy’s currency will change the relative price of tradable goods and
facilitate a return to balance or (quite commonly in historical data) an over-
shooting into surplus, the other direction.
When an economy is unable to export enough physical goods to pay for its
physical imports, it may be able to find funds elsewhere: Service exports, for
example, are more than sufficient to pay for Hong Kong’s domestic goods
import.

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INTRODUCTION-CONT.

In poor countries, foreign aid may compensate, while in developed economies a

capital account surplus caused by sales of assets often offsets a current-account
deficit. There are some economies where transfers from nationals working
abroad contribute significantly to paying for imports. The Philippines,
Bangladesh and Mexico are examples of transfer-rich economies.
A country may rebalance the trade deficit by use of quantitative easing at home.
This involves a central bank printing money and making it available to other
domestic financial institutions at small interest rates, which increases the
money supply in the home economy. Inflation usually results, which devalues
in real terms the debt owed to foreign creditors if that debt was instantiated in
the home currency

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INTRODUCTION-CONT.

Adam Smith on the Balance of Trade

--Smith introduced the concept that free trade would benefit individuals and
society as a whole. He believed that governments should not impose policies
that interfered with free trade, domestically and abroad.
--For Smith the goal of economic policy of a country was not to increase
exports to its colonies and other nations and to limit imports from them, and in
this way to end up with a favorable balance of trade. In other words, the goal
was not an increase in the amount of precious metal for the sovereign
(bullionism). For Smith the goal should be to open up new free-trade markets
and to increase competition. International trade not only increases the division
of labor, but it decreases also the likelihood of domestic monopolies. In
general, trade does increase "the exchangeable value of the annual produce of
the land and labor of the country" for everyone.
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TRADE BALANCES AND INTEREST RATES

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
Theoretically, this is straightforward; in reality global business is more complex

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TRADE BALANCES AND INTEREST RATES

Fixed Exchange Rate Countries

Under a fixed exchange rate system, the government bears the responsibility to
ensure that the BOP is near zero

Floating Exchange Rate Countries

Under a floating exchange rate system, the government has no responsibility to
peg its foreign exchange rate

Managed Floats
Countries operating with a managed float often find it necessary to take action
to maintain their desired exchange rate values

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TRADE BALANCE ADJUSTMENT TO EXCHANGE RATE CHANGES: THE J-CURVE

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CAPITAL MOBILITY

What does capital mobility mean?

If capital is mobile, then it means it is easy and seamless to move capital from
one country to another. Perfect capital mobility would imply no transaction or
other costs in moving capital from one country to another.
Cross-border capital movements benefited long-term growth of recipients East
Asia, Latin America, and Russia.
However, because of potential reverse outflows, especially of portfolio and
mutual funds, capital movements increased their vulnerability to crises.
Not surprisingly, financial crises occurred in Mexico (1994), Southeast and
East Asia (1997-99), and Argentina (2001-02) following substantial capital-
account liberalization & increases in capital flows.

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CAPITAL MOBILITY

Inefficiency & poor national economic management in some African & Latin
American countries.
Widespread adjustment among primary product producers resulted in price
collapse.
Floating exchange rate system increased external shocks for LDCs
Volatility in the value of leading reserve currencies.
LDC governments compelled to guarantee private debt.
Overvalued domestic currencies & restrictions on international trade hurt
current account balance
Substantial capital flight from foreign aid, loans, and investment.

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CAPITAL MOBILITY

Capital Mobility
• The degree to which capital moves freely across
borders is critically important to a country’s balance
of payments
• The United States’ financial account surplus has at
least partially offset the current account deficits
over the last 20 or more years
• China has run a surplus in each of these accounts in
recent years

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Capital Mobility-Cont.

The free flow of capital in and out of an economy can potentially destabilize
economic activity or can contribute significantly to an economy’s development
Thus, Bretton Woods Agreement was careful to promote free movement of
capital for current account transactions (e.g., foreign exchange or deposits) but
less so for capital account transactions (e.g., foreign direct investment)
1970s - 1990s saw growth in capital openness, the financial crisis of 1997/1998
stopped that due to destructive capital outflows and contagion

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Capital Mobility-Cont.
The authors argue that the post-1860 era can be subdivided into four distinct
periods with regard to capital mobility.
1860-1914 – continuously increasing capital mobility as the gold standard was
adopted and international trade relations were expanded
1914-1945 – global economic destruction, isolationist economic policies,
negative effect on capital movement between countries
1945-1971 – Bretton Woods era say a great expansion of international trade
1971-2097 – floating exchange rates, economic volatility, rapidly expanding
cross-border capital flows
China and India attempt to open their markets

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CAPITAL MOBILITY

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CAPITAL MOBILITY

Capital Controls
A capital control is any restriction that limits or alters the rate or direction of
capital movement into or out of a country
Free movement of capital is more the exception than the rule
Exhibit 4.13 outlines several methods of and purposes for capital controls
Dutch Disease – is the name given to the problem of a substantial currency
appreciation due to the demand for a specific natural resource – faced by
several resource-rich smaller nations

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CAPITAL CONTROLS

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CAPITAL MOBILITY

Capital Flight
Although no single definition of capital flight exists, it has been characterized
as occurring when capital transfers by residents' conflict with political
objectives.
Many heavily indebted countries have suffered capital flight, compounding
their debt service problems.
Capital can be moved via international transfers, with physical currency,
collectables or precious metals, money laundering or false invoicing of
international trade transactions.

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CAPITAL MOBILITY

Capital Flight

Definition: resident capital outflow (cannot measure readily with definitions

characterizing flight as illegal or abnormal).
Propensity to flee from external borrowing as high as 30-50% or more in many
LDCs.
Results from differences in perceived risk-adjusted returns in source & haven
countries.
Source countries: slow growth, overvalued currencies, inflation, confiscatory
taxation, limitations on convertibility, poor investment climate, & political
instability.
Haven countries: US’s abandonment of income taxation on nonresident bank-
deposit interest & much other investment income. 45
CAPITAL MOBILITY

Capital Flight
Congo – Brazzaville diamond exporter in 1970s & early 1980s from diamonds
smuggled from Congo – Kinshasa.
President Mobutu’s stashing of funds in Swiss banks & Western real estate was
enough to pay Zaire’s debt.
Other predatory rulers from failed states had similar problems.
Acquired Investments Deposited in Switzerland is Africa’s second AID
epidemic (Africa Research Bulletin 1991).
Capital flight symptomatic of financial repression & economic
underdevelopment not cause of it (de Vries 1987).
Limited policy prescriptions in weak states.
In desperate situation, exchange controls may be essential.
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