The balance of payments(10/11/2009)

What is the balance of payments explain briefly (7)/Explain the main accounts and subdivisions of the balance of payments

The BOP is an accounting summary of various transactions that have taken place between a country and its trading partners over a year.

 The balance of payments is different from a national balance sheet. A national balance sheet is a statement of a country’s assets and liabilities.

Such transactions are normally aggregated according to the type ofexchanges that have occurred – for example, whether the transaction represents a trade ingoods, services or an exchange of financial assets or claims.

For example the South African Balance of payments consist of the following :

- The Current Account

-The Financial Account

-Unrecorded transactions

-The official reserves

Explain the main accounts and subdivisions of the balance of payments (15)or Discuss South Africa Balance of payments .Name and discuss all items /Discuss current account of the South African balance of payments.

The Current Account

Subdivided into, trade account, net service receipts, net income receipts and current transfers.

  • Trade account-trade in physical goods. Trade balance not shown explicitly. Is calculated by subtracting merchandise imports from merchandise exports plus net gold exports. (X+NX- I)
  • Large deficit on SA’s current account due to large merchandise imports. This means that SA borrows in order to spend. (credit)
  • Service items – are transport of goods and passengers between countries
  • Income items are interest, dividends and foreign branch profits.
  • Current transfers – foreign payments and receipts of government social security payments and taxes, private transfers of income (gifts, donations).

The Financial Account

Records exchanges of international asset

Subdivided into: direct investment, portfolio investment and other investment

  • Direct investment foreign investment in South Africa and investments abroad by South Africans.
  • Portfolio investment is the purchase and sale of financial instruments such as bonds, treasury bills and equities.
  • Other investment includes all financial transactions not part of direct or portfolio investment. Main item is trade credit.

Direct investment is considered more desirable than portfolio investment because it shows stronger commitment to invest. It is more stable and has lasting positive effects on the domestic economy. Portfolio investment on the other hand is characterised by speculative “hot money” flows which may prove disruptive and difficult for monetary authorities to control.Direct investment may also bring with it much needed scarce skills and technology.

Unrecorded transactions

Arises from the use of a double entry accounting system to reconcile the balance of payments.

Serves as a residual that ensures that the balance of payment accounts always balance.

The official reserves

Records changes in the official gold and foreign exchange reserves. Changes in gold and foreign exchange reserves are also referred to as the below the line or 'accommodating' foreign exchange flows.

Transactions not related to changes in official reserves are called autonomous or above the line flows.

Any imbalance in these flows is accommodated by the required change in official reserves.

The balance of payment always balances by definition and therefore does not present any economic problems for the country concerned. True or false

This statement is true.

The BOP always balances but it does not mean there can never be any problems. The economic significance of changes in the balance of payments must be clearly distinguished from the balance of payments as an accounting statement.

Gold and foreign exchange reserves are not inexhaustible.

Autonomous flows can be accommodated temporarily by below the line flows or foreign credit. Long before the reserves are exhausted, monetary and fiscal policy will be necessary to prevent full blown balance of payments crises.

The right measures will depend on whether the country concerned has a fixed or floating exchange system.

Imbalances above the line may be significant even if they don't require any change in official reserves. E.g. foreign exchange outflows corresponding to a current account deficit may be more or less balanced by inflows corresponding to a financial account surplus, that is, non-residents may be willing to finance the deficits.

However such borrowings must be repaid with interest. This borrowing from foreign lender cannot go on forever. Lenders may no longer be willing to finance further deficits. This will require tough monetary and other policies.

Large current account surpluses are not without their own problems. Under flexible exchange rate system large current account surpluses may lead to a sharp appreciation of the currency thereby reducing foreign demand for exports and increasing domestic demand for imports in the short run. This may lead to reduced aggregate demand, production and employment in the short run.

A current account deficit is not necessarily bad and a surplus good. A current account deficit implies that a country is consuming more than it is producing. Imports add to consumer welfare. Exports represent a sacrifice in the production of goods and services that are not available for domestic consumption.

Changes in the foreign reserves reflect changes in the domestic money supply. A decrease in the reserves means that people are exchanging domestic currency for foreign currency and therefore a decrease in the domestic money supply.

Conversely an increase in the domestic supply implies that people are exchanging foreign currency into domestic currency and thus increasing the domestic money supply.

Explain the difference between autonomous and accommodating foreign exchange flows and their significance with regards with balance of payment

Autonomous foreign exchange reserves / Accommodating foreign exchange flows
Above the line / below the line
Transactions not related to changes in official reserves / Transactions related to changes in official reserves
Autonomous transactions arise from the fundamental differences between countries in prices, incomes, interest rates, tastes / Accommodating transactions, which are not undertaken for their own sake, but rather have their source in other (autonomous) transactions elsewhere in the balance of payments.
Accommodating transactions reflect increases or decreases of the net foreign liquidity of a country. They are, therefore, the best measure of surplus or deficit in the balance of payments. / Accommodating transactions are the residualmoneyflows (including flows of official reserves) that occur to fill any gaps left by autonomous transactions.

Discuss the current account of the South African balance of payments

The Current Account

Subdivided into, trade account, net service receipts, net income receipts and current transfers.

  • Trade account-trade in physical goods. Trade balance not shown explicitly. Is calculated by subtracting merchandise imports from merchandise exports plus net gold exports. (X+NX- I)
  • Large deficit on SA’s current account due to large merchandise imports. This means that SA borrows in order to spend. (credit)
  • Service items – are transport of goods and passengers between countries
  • Income items are interest, dividends and foreign branch profits.
  • Current transfers – foreign payments and receipts of government social security payments and taxes, private transfers of income (gifts, donations).

Discuss the following accounts of the balance of payments

  1. Trade account
  2. Unrecorded transactions
  3. Change in net gold and other foreign reserves owing to balance of payments transactions
  1. Trade account 10/11/2009

The trade account comprises trade in physicalgoods. The trade balance is not shown explicitly in the South African balance of paymentsbut can easily be calculated by subtracting the value of merchandise imports from the valueof merchandise exports and net gold exports. Note that because of South Africa’s historical

dependence on gold exports, the trade account is recorded as a separate item immediately

below merchandise exports.

  1. Unrecorded transactions(10/11/2009)

Unrecorded transactions arise from the use of a double-entry accounting system to reconcile the balance of payments. The net sum of debit and credit entries arising frombalance of payments transactions should equal the change in the country’s net gold andforeign exchange reservesHowever, owing to errors in and omissions

from various sources in the compilation of the different divisions of the balance of payments, this is seldom the case. The difference between the recorded change in the net gold andforeign exchange reserves and the sum of the current, capital transfer and financial accountbalances is classified as unrecorded transactions. Thus, in practice, the value of unrecordedtransactions serves as a residual that ensures that the balance of payments accountsalways balance.

  1. Change in net gold and other foreign reserves owing to balance of payments transactions(10/11/2009)

Changes in the net gold and foreign exchange reserves are sometimes also referred to as accommodating or “below-the-line” foreign exchange flows, in contrast to autonomous “above-the-line” flows. Autonomous flows or payments simply mean balance of payments transactions not related to changes in the official reserves. Any imbalance in these payments is met or accommodated by the required change in the official reserves

Explain what is meant by portfolio investment and direct investment. Is the one more desirable than the other. Evaluate

OR

Discuss direct investment as well as portfolio investment with regard to the South African balance of payments

Direct investment refers to foreign investments in South Africa (changes in foreign liabilities

or inflows) and investments abroad by South African residents (changes in foreign assets or

outflows) where the companies or other organisations concerned have a significant share of

such investment.

The share should be significant in that there should be an intention to havea say in the control or management of the investment.

In South Africa, this is defined as atleast a 10 per cent share of the voting rights in the investment undertaking concerned. Notethat a negative sign implies an outflow of foreign exchange resulting from an increase inoutward investment by South African residents.

Portfolio investment is the purchase and sale of financial claims such as bonds, treasurybills and equities.

Unlike direct investments, there is no intention by the investor to exerciseany control over portfolio investments.

The justification for such investments is based purelyon the expected financial gain or return on investment.

Portfolio investments are notoriouslyfickle because changes in expected returns may trigger speculative buying or selling activity.

Evaluate the significance of imbalances that may occur within the balance of payments (15)

The BOP always balances but it does not mean there can never be any problems. Gold and foreign exchange reserves are not inexhaustible.

 Autonomous flows can be accommodated temporarily by below the line flows or foreign credit.

Long before the reserves are exhausted, monetary and fiscal policy will be necessary to prevent full blown balance of payments crises.

 The right measures will depend on whether the country concerned has a fixed or floating exchange system.

Imbalances above the line may be significant even if they don't require any change in official reserves. E.g. foreign exchange outflows corresponding to a current account deficit may be more or less balanced by inflows corresponding to a financial account surplus, that is, non residents may be willing to finance the deficits.

 However such borrowings must be repaid with interest. This borrowing from foreign lender cannot go on forever. Lenders may no longer be willing to finance further deficits. This will require tough monetary and other policies.

Large current account surpluses are not without their own problems. Under flexible exchange rate system large current account surpluses may lead to a sharp appreciation of the currency thereby reducing foreign demand for exports and increasing domestic demand for imports in the short run. This may lead to reduced aggregate demand, production and employment in the short run.

A current account deficit is not necessarily bad and a surplus good. A current account deficit implies that a country is consuming more than it is producing. Imports add to consumer welfare.

Exports represent a sacrifice in the production of goods and services that are not available for domestic consumption.

Changes in the foreign reserves reflect changes in the domestic money supply. A decrease in the reserves means that people are exchanging domestic currency for foreign currency and therefore a decrease in the domestic money supply.

Conversely an increase in the domestic supply implies that people are exchanging foreign currency into domestic currency and thus increasing the domestic money supply.

Discuss the functions of foreign exchange markets

Transfer of purchasing power from one currency to another.

Banks with excess supply of foreign exchange sell their excess foreign exchange to other banks with shortage. If a country’s total demand for foreign exchange exceeds total foreign exchange earnings, the exchange rate changes to equilibrate total demand and total supply. If adjustment in the exchange rate is not allowed, banks must borrow from the country’s central bank.

On the other hand, an excess supply of foreign exchange with no adjustment must be exchanged for national currency at the central bank. This increases the foreign exchange reserves held by the central bank.

The central bank acts as the seller and buyer of last resort when the nation’s foreign exchange earnings and expenditures are not equal. It either decreases its foreign exchange reserves or adds to them

Credit function

Credit is needed when goods are sold and allows the buyer time to resell the goods and make payment.

The foreign exchange market also provides credit for foreign trade. Like all the traders, international trade also requires credit. It takes time to move the goods from seller to purchaser and during this period, the transaction must be financed. When the exporter does not need credit for the manufacture of export goods, credit is necessary for the transit of goods. When the special credit facilities of the foreign exchange market are used, the foreign exchange department of a bank or the bill market is used; the foreign exchange department of the bank or the bill market of one country or the other extends the credit facilities to finance the foreign trade.

Providing facilities for hedging and speculation

The foreign exchange market by providing facilities of buying and selling at spot or forward exchange, enables the exporters and importers to hedge their exchange risks arising from change in the foreign exchange rate. The forward market in exchange also enables those banks, which are unlikely to run any considerable exchange position to cover their commitments.

Explain the difference between foreign exchange arbitrage, speculation and hedging

Arbitrage

The exchange rate between any two currencies is kept the same in different monetary centres by arbitrage.

Arbitrage is the purchase of a currency where it is cheaper for sale where it is more expensive in order to make a profit.

Example: Assume that the USD/GBP exchange rate is 1, 9500 in the London foreign exchange market but only 1, 9000 in the New York foreign exchange market. A bank or a large company with, say, GBP 10 000 000 starting capital can make arbitrage profits as follows:

Sell GBP to buy USD 19 500 000 (GBP 10 000 000 x 1, 9500) in the London market.

Sell USD to buy GBP 10 263 158 (USD 19 500 000 ÷ 1,9000) in the New York market.

Profit is GBP 263 158 (GBP 10 263 158 – GBP 10 000 000).

The basic reason for a forward foreign exchange market is that it allows importers and

exporters to hedge the risk of changes in exchange rates that may affect their domestic

currency payments and receipts respectively (despite the fact that the forward exchange

market may also be used to speculate in foreign currencies, as explained below).

Example: A South African importer orders a consignment of television sets from Japan.

Payment is on delivery of the consignment in three months’ time. The importer knows how

much must be paid in Japanese yen, but not in rand because he does not know what the

JPY/ZAR exchange rate will be in three months’ time. To cover the risk of an unfavourable

change in the exchange rate, the importer applies at his bank to buy the required amount of

Japanese yen in three months’ time at the ruling three-month forward JPY/ZAR exchange

rate. The importer is then committed to a forward exchange contract (FEC) on the agreed

terms.

Suppose the yen cost of the consignment is JPY 500 000 000 and the three-month forward

JPY/ZAR exchange rate is 16,5000 (remember that the yen is quoted indirectly against the

rand, that is, as the number of yen per rand). To hedge against an unfavourable change in

the spot JPY/ZAR exchange rate, the following transactions take place:

Speculation

Foreign exchange speculation is the attempt to profit from changes in exchange rates.

It is based on expected changes in exchange rates over time and thus necessarily involves uncertainty and risk.

The speculator deliberately assumes an open position in particular currencies and is thus exposed to the risk of adverse changes in the exchange rate

Although substantial profits stand to be made if the speculator has guessed exchange rate movements correctly,massive losses will occur if exchange rates do not move as anticipated

Hedging

Ahedgeis an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization.

A hedge can be constructed from many types of financial instruments, includingstocks,exchange-traded funds,insurance,forward contracts,swaps,options, many types ofover-the-counterandderivativeproducts, andfutures contracts.

Explain the different types of exchange rates and their use in economic analysis