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Balance Of Payments

Introduction: A countrys balance of payments is commonly defined as the record oftransactions between its residents and foreign residents over a specified period. A Countrysbalance of payments summarizes its international transactions. Countries prepare balance of

payments on monthly, quarterly and yearly basis.Each transaction is recorded in accordance with the principles of double-entrybookkeeping, meaning that the amount involved is entered on each of the two sides of thebalance-of-payments accounts. Consequently, the sums of the two sides of the complete balance-of-payments accounts should always be the same, and in this sense the balance of paymentsalways balances.

However, there is no bookkeeping requirement that the sums of thetwo sides of a selected number of balance-of-payments accounts should be the same, and ithappens that the (im)balances shown by certain combinations of accounts are of considerableinterest to analysts and government officials. It is these balances that are often referred to assurpluses or deficits in the balance of payments.

It can focus on the following main aspects :1) Economic and financial situation of a country in short run.2) It refer to income and expenditure or changes in levels of outstanding assets and

liabilities.3) Changes in supply and demand for foreign exchange, hence an impact on exchange rates,

reserve assets and on foreign exchange markets.4) Capital flight and debt crises.

TheoryThe BOP is divided into two main categories according to the broad nature of the transactions.

These categories are:

1. The Current Account2. The Capital and Financial Account

1. Current AccountThe current account includes

y Merchandise Trade. Merchandise trade records the value of exports and imports, oftangible goods. The difference between exports and imports of tangible goods is the tradebalance.

y Goods and Services covers Travel services,Communication services,Constructionservices,Insurance services ,Financial services, Computer and informationservices,Royalties and licences fees, Personal, cultural and recreational services, andGovernment services

y Income covers the compensation of employees, i.e. salaries, wages and benefits ofseasonal and other nonresident workers.

y Current transfers-.Current transfers cover transactions such as taxes on income,workers' remittances, and premiums and claims on non-life insurance.

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2. Capital and Financial Account :The Capital and Financial Account records transactions that directly affect the wealth and debt ofthe country. The account is sub-divided into two main categories:

y The Capital Account- The Capital Account covers1) Capital transfers - Capital transfers include the transfer of ownership of fixed assets,the transfer of funds linked to disposal/acquisition of fixed assets and the

cancellation of debt by creditors2) The acquisition/disposal of non-produced, non-financial assets.It mainly involves

intangibles such as patents and leases. It also includes purchases and sales of land byforeign embassies.

y The Financial Account:The Financial Account covers(i) Direct investment,(ii) Portfolio investment,

(iii) Other investments (trade credits, loans, currencies and deposits)(iv) Changes in reserves.

The U.S. Current Account Deficit.

1) What are the causes of the U.S.current account deficit?

1) Escalating Current Account Deficits (2000-2005)y

In 2000, the dot-com, bubble burst mild recession in 2001 and 2002.

y Oil prices increased the value of U.S. petroleum imports from $68 billion in 1999 to$104 billion in 2002.

y The respond of government was with a fiscal stimulus in the form of tax cut and theFederal Reserve in the form of low interest rates.

y Between 2000 and 2004, all for the net supply of the US treasury was purchased byforeigners and between 80% and 90% by foreign central banks.

y Low interest rates shown clearly in residential real estate many purchased against theasset and let asset price appreciation substitute for a savings It drove high levels of household debt.

y In contrast to Asian central banks and European central banks did not intervene the issue.the dollar depreciated 54% against euro and 36%against the pound in 2004.

2) The interwar period: after war was over inflation in Europe and high level of Europeandebt to the United States.

3) New gold standards and intervene of the US in it also created the problem.4) In the initial years of the Breton woods arrangement, current account regulated but after

European demand shortage of dollar created the economic problem.5) Also Vietnam War which major increases in the military expenditure .dollar became over

valued and buying dollar increased the foreign domestic supply, which led to inflationabroad.

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2) Has it been the financial crises in the U.S. ?

y If we consider the inter war period for the financial crises as the war started the worldwide holding of the foreign assets fell .the gold standards fell monetary policy around the

world became directed towards the domestic goals.y After the war ended inflation in Europe and high debt of Europe to the U.S.and new gold

policy .To stop the out flow of the gold US intervened and that created excess credit inthe country. In 1928 and 1929 , the federal reserve raised the interest rates to respond thespeculative bubble but failed to stop the stock market crash.

y Bretton Wood s system of fixed exchange rates 1951 initially it worked very well After1965, the US economy began to overheat and inflation began to rise in the face of themajor increase in social spending and increasing military expenditure of Vietnam war.Later in the 1971 new par values were set for currencies not backed by gold and thatforced the system collasp.1973 oil crises exuberated the things.

y Recently crash of the house debt .dot com bubble burst leading to mild recession.y Taking in to consideration all above the reasons question ones answer was supporting

the fact that financial crises of the US.

3) Will the world keep funding U.S in the same manner as in the past?Answer : In 1993,95 % of domestic saving around the world in to domestic saving .By 2002 itfall to the 80 %.In Particular Global savings flowed into the United states with its favorableinvestment climate, strong investor policy protection framework, and expected real rates ofreturns higher than any other countries. In 2004 ,former U.S. Treasury secretary Larry Summersused the term balance of Financial terror to refer the situation in which the united states wasrelying on the cost to rest of the world of not financing the U.S. current account deficit as

assurance that financing would continue. There was no guaranty that the Asian central Bankwould continue support the dollar. In mid March 2005 ,Yoon Jeung Hyun ,south koreas topbanking regulator ,Japanese Prime minister Junichiro Koizumi and recently in 2009 Chinaspriemer Wen Jiabao shown the concern over the investment in US. President Obama retorted that There is no safer place in the world for investment other than US.

Regardless of valuation effects U.S. liabilities to foreigners remain far in excess of U.S.claims on foreigners. The net investment income portion of the current account of the USremained positive.US received more income from its investment abroad than foreigners receivedon their U.S. assets.(Exhibit 4 a). This shows that world will keep funding the US as in the past.

4) Will US be able to sustain its current account deficit ?

Answer : The U.S. current account deficit grew throughout most of the 1990s and into 2000. But,clearly, the U.S. current account deficit as a share of GDP cannot increase foreverwithoutdisrupting the U.S. economy or the global economy. A sustainable current account is one thatchanges in an orderly fashion through market forces without causing harsh movements in othereconomic variables, such as the exchange rate.Following are some of the points that will give strength to sustain current account deficit:-

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1) First, in general, the average experience of industrial economies on which the estimate isbased might not be applicable to the United States because the United States economicand financial importance in the world economy may make it different.

2) Second, the economic situation in the United States in the 1980s and early 1990s is quitedifferent from the economic situation today.

3) Third, the United States holds a special position in international financial markets. As thedollar is an international reserve currency, the demand for dollars and dollar-denominatedassets is relatively strong.

4) After remaining low and stable in the early 1990s, the net international debt-GDP ratiofor the United States rose throughout most of the decade. By 1998, net international debthad reached a 20-year high of 12.6 percent of GDP. In 1999, net international debt fellslightly, to 11.6 percent of GDP. A net international debt-GDP ratio of nearly 12 percentmight suggest that the U.S. external position is unsustainable. However, comparing theU.S. net international debt-GDP ratio with that of other countries reveals that the U.S.situation is not particularly troubling.

5) Because foreign investors recognize that U.S. assets are relatively safe and offerfavorable yields compared with many other countries assets, net capital inflows into theUnited States are likely to remain healthy at least in the near future.

The most likely scenario is that the U.S. current account deficit will narrow within thenext few years, in an orderly manner. Therefore U.S will be able to sustain currentaccount deficit.