Quiz 4: The Balance of Payments

Business

a. Boeing sells airplanes to china, so the export of goods from U.S, it will be credited to the merchandise account and the payment by china by taking a loan from consortium of international banks, wherein there is reduction of foreign ownership of U.S assets will be debited to capital account. img b. Mitsubishi purchases U.S Treasury Bonds. Investment in U.S assets will be credited to investment income account of the current account, and the using Bank of America to pay for the bonds will lead to its reduction in deposits. img c. Eli lily sends a dividend cheque to canadian investor who deposits the cheque in Bank of Montreal. So the payment of dividend is outflow for U.S BOP but there is also foreign deposit increase. img d. U.S treasury authorizes the New York Federal Reserve to intervene in foreign exchange market. img e. The president of U.S sends troops to Latin America. Government of Brazil and Mexico each donate $1billion to U.S which was raised by selling U.S Treasury bonds. img f. Honda of America receives $275 million from its parent company to construct state of the art manufacturing facility at ohio. img

Balance of payments is a record of all monetary transactions between a country and the rest of the world. It is prepared in a single currency, which is the domestic currency of that country. There are two major accounts of BOP, which are the Current account and the Capital account. Some countries have renamed the capital account as the "financial account". The  current account  shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. The  capital account  records the net change in ownership of foreign assets. Current Account records the following transactions: a. Transactions related to Goods and services (imports, the purchases made by the country from foreign residents, and exports, which are sales of goods and services to foreign residents) b. Transactions which are related with the flows from of income from ownership of foreign assets (dividend and interest paid to domestic residents who own foreign financial assets, as well as dividends and interest paid to foreign residents who own domestic financial assets). c. Transfers of money between countries in form of; foreign aid, gifts and grants. The purchases and sales of foreign assets either financial or real assets by domestic residents as well as the purchases or sales of domestic assets either financial or real assets by foreign residents get recorded in Capital account. Capital account is further divided into two parts; regular capital account and an official settlements account. All transactions other than those involving international reserves get recorded into regular capital account. Thus, the transactions involving purchase or sale of official international reserve assets by a nation's central bank are recorded in official reserves account. International reserves are the assets of the central bank that are not denominated in the domestic currency. Thus to summarize BOP has two major accounts, the current account and the capital account and each of these records transactions varying from goods and services, unilateral transfers and international reserves.

By considering the situation of LN, a hypothetical Latin American country, the following calculations are made: a. The balance of payments always sums to zero. That is: img img It is given in the case that the interest outflow is required for a net private foreign debt of $75 billion and a public debt of $55 billion. Hence, the interest payment is calculated as: img Now the total interest payment would be img It is given that there will be an interest income of $18 billion of reserves which would earn an interest of 4%. The interest income is calculated as: img After calculating the interest earned and income payment the deficit on interest account is calculated as: img Since, LN's imports are more than exports; there would be a trade deficit of img Now the current account deficit is calculated as: img img This deficit of $15.73 billion has to be balanced by a surplus on a private sector capital account surplus and by a surplus on the official settlement account. If the central bank can provide the international reserves of $13 billion (i.e it has to drop down the international reserves from $18billion to $5billion) out of $15.73 of finance requirement, then the minimum net capital inflow required by La Nacion would be $2.73 billion. b. If there is a capital inflow of $2.73 billion in 2011, then the reserves have decreased to $5 billion and the company's debt has also increased by $2.73 billion. Hence there will be a certain change in the total net foreign debt at the end of 2011. Total net foreign debt is calculated as img At the end of the year 2010 the net foreign debt was img At the end of 2011, the net foreign debt will be: img Hence, at the end of the year 2011, there is an increase in the foreign debt by img The increase in the net foreign debt is a deficit in the current account by $15.73 billion.