CHAPTER 3 BALANCE OF PAYMENTS

QUESTIONS

1. Define balance of payments.

Answer: The balance of payments (BOP) can be defined as the statistical record of a country’s
international transactions over a certain period of time presented in the form of double-entry
bookkeeping.

2. Why would it be useful to examine a country’s balance of payments data?

Answer: It would be useful to examine a country’s BOP for at least two reasons. First, BOP
provides detailed information about the supply and demand of the country’s currency. Second,
BOP data can be used to evaluate the performance of the country in international economic
competition. For example, if a country is experiencing perennial BOP deficits, it may signal that
the country’s industries lack competitiveness.

3. The United States has experienced continuous current account deficits since the early
1980s. What do you think are the main causes for the deficits? What would be the
consequences of continuous U.S. current account deficits?

Answer: The current account deficits of U.S. may be attributable to (i) the strong dollar and
undervalued currencies of trading partners such as China and Japan at times (ii) high
consumption and low savings in the U.S. and low consumption and high savings in major
trading partners, (iii) weak competitiveness of U.S. industries, especially manufacturing sector. If
U.S. deficits continue, the dollar may eventually depreciate substantially and the confidence in
dollar may suffer.

4. In contrast to the United States, Japan has realized continuous current account surpluses.
What could be the main causes for these surpluses? Is it desirable to have continuous current
account surpluses?

Answer: Japan’s continuous current account surpluses may have reflected a weak yen and high
competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from
appreciating more than it did. At the same time, foreigners’ exports to Japan were hampered by
closed nature of Japanese markets. Continuous current account surpluses disrupt free trade by

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promoting protectionist sentiment in the deficit country. It is not desirable especially when it is
brought about by the mercantilist policies.

5. Comment on the following statement: “Since the United States imports more than it exports,
it is necessary for the United States to import capital from foreign countries to finance its current
account deficits.”

Answer: The statement presupposes that the U.S. current account deficit causes its financial
account surplus. In reality, the causality can be running in the opposite direction: U.S. financial
account surplus may cause the country’s current account deficit. Suppose foreigners find the
U.S. a great place to invest and send their capital to the U.S., resulting in U.S. financial account
surplus. This capital inflow will strengthen the dollar, hurting the U.S. export and encouraging
imports from foreign countries, causing current account deficits.

6. Explain how a country can run an overall deficit or surplus on its balance of payments.

Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve
transactions. For example, an overall BOP deficit can be supported by drawing down the central
bank’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the
central bank’s reserve holdings.

7. Explain official reserve assets and its major components.

Answer: Official reserve assets are those financial assets that can be used as international
means of payments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges,
(iii) special drawing rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges
are by far the most important official reserves.

8. Explain how to compute the overall balance and discuss its significance.

Answer: The overall balance is determined by computing the cumulative balance of payments
including the current account, capital account, financial account, and the statistical
discrepancies. The overall balance is significant because it indicates a country’s international
payment gap that must be financed by the government’s official reserve transactions.

9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of
U.S. treasury bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio
investment on the U.S. balance of payments.

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Answer: As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in
the long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to
foreigners. If foreign funds are used productively and contributes to the competitiveness of U.S.
industries, however, U.S. BOP may improve in the long run.

10. Describe the balance of payments identity and discuss its implications under the fixed and
flexible exchange rate regimes.

Answer: The balance of payments identity holds that the combined balance on the current,
capital, and financial accounts should be equal in size, but opposite in sign, to the change in the
official reserves: BCA + BKA + BFA = - BRA. Under the pure flexible exchange rate regime,
central banks do not engage in official reserve transactions and, as a result, BRA would be
close to zero. Thus, the overall balance must balance, i.e., BCA + BFA = - BKA. Under the fixed
exchange rate regime, however, a country can have an overall BOP surplus or deficit as the
central bank will accommodate it via official reserve transactions.

11. Exhibit 3.6 indicates that in 2013, China had a current account surplus and at the same
time a financial account surplus. Explain how this can happen?

Answer: In 2013, China experienced a current account surplus since it exported more to the rest
of the world than it imported from the rest of the world. At the same time, China also attracted
financial inflows that exceed its financial outflows. As a result, China experienced an overall
surplus on its BOP in 2013, which must have increased its reserve holdings.

12. Explain how each of the following transactions will be classified and recorded in the debit
and credit of the U.S. balance of payments:

(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank
account kept in New York City.
(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express
card.
(3) A Indian immigrant living in Los Angeles sends a check drawn on his U.S. bank account as a
gift to his parents living in Mumbai.
(4) A U.S. computer programmer is hired by a British company for consulting and gets paid from
the U.S. bank account maintained by the British company.
Answer:

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Transactions Credit Debit

Japanese purchase of U.S. T bonds 

Japanese payment using NYC account 

U.S. citizen having a meal in Paris 

Paying the meal with American Express 

Gift to parents in Bombay 

Receipts of the check by parents (goodwill) 

Export of programming service 

British payment out of its account in U.S. 

13. Construct the balance of payment table for Germany for year 2018 which is comparable in
format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial
Statistics published by IMF or search for useful websites for the data yourself.

Answer: A summary of the German Balance of Payments for 2018 (in $ billion)

Credits Debits
Current Account

[1] Exports 1,869.9

[1.1] Goods 1,527.1

[1.2] Services 342.8

[2] Imports −1,630.3

[2.1] Goods −1,264.6

[2.2] Services −365.7

[3] Primary income 257.3 −149.5

[4] Secondary income 80.8 −136.9

Balance on current account 291.3

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 Credits Debits
[[1]+[2]+[3]+[4]]

Capital Account 51.3 −48.9

Balance on capital account 2.4

Financial Account

[5] Direct investment 105.3 −159.1

[6] Portfolio investment −51.4 −110.0

[6.1] Equity securities 1.1 −34.0

[6.2] Debt securities −52.5 -48.5

[6.3] Derivatives, net −27.5

[7] Other investment 99.4 −154.7

Balance on financial account −270.5

[[5]+[6]+[7]]

[8] Statistical discrepancies −22.7

Overall balance 0.5

Official Reserve Account −0.5

Source: Balance of Payments and International Investment Position Statistics, IMF

Note: It is noted that Germany experienced ‘divestment’ by foreigners in portfolio investment in

2018. It is also noted that the above numbers may be affected somewhat by the government
updating of the economic data. One salient feature of the above table is that Germany realized
a significant merchandise trade surplus but a deficit in service trade, suggesting that Germany’s
comparative advantage may be in the manufacturing sector, not in service sector.

PROBLEMS

PROBLEM 1
Examine the summary of the balance of payments of the United States for 2019 provided below.
Compute and discuss the balance on the current account and its subaccounts.
a. Balance on the U.S. trade in goods, in services, and in goods and services combined.

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b. Balance on the U.S. primary income.
c. Balance on the U.S. secondary income.
d. Balance on the U.S. current account.

A Summary of the U.S. Balance of Payments for 2019 (in $ billion)

Credits Debits
Current Account

[1] Exports 2,528.4

[1.1] Goods 1,652.1

[1.2] Services 876.3

[2] Imports −3,104.7

[2.1] Goods −2,513.6

[2.2] Services −591.1

[3] Primary income 1,124.9 −893.0

[4] Secondary income 159.2 −286.9

Balance on current account −472.1

[[1]+[2]+[3]+[4]]

Capital Account 0.1 −6.5

Balance on capital account −6.4

Financial Account (excluding

official reserves)

[5] Direct investment 302.2 −122.2

[6] Portfolio investment 218.9 −13.5

[6.1] Equity securities −244.1 163.4

[6.2] Debt securities 421.3 −149.9

[6.3] Derivatives, net 41.7

[7] Other investment 276.4 −203.6

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 Credits Debits
Balance on financial account 485.2

[[5]+[6]+[7]]

[8] Statistical discrepancies −2.0

Overall balance 4.7

Official Reserve Account −4.7

Source: The U.S. Bureau of Economic Analysis

SOLUTION:
a. The U.S. exported goods worth $1,652.1 billion and imported goods worth $2,513.6
in 2019. Hence, the balance in the U.S. goods trade was -$861.5 billion in 2019.
Since the U.S. imported more goods than it exported, it had a deficit in goods trade
resulting in net cash outflow.
$1,652.1 billion − $2,513.6 = −$861.5 billion

The U.S. had a surplus of $285.2 billion on services traded, resulting in net cash
inflow.
$876.3 billion − $591.1 billion = $285.2 billion.

However, the deficit in the goods trade was larger than the surplus in services trade,
and the combined balance in goods and services trade was -$576.3 billion.
$2,528.4 billion − $3,104.7 billion = −$576.3 billion or
$285.2 billion − $861.5 billion = −$576.3 billion

b. The amount of primary income the U.S residents received from foreigners ($1,124.9
billion) exceeded that of primary income the U.S residents paid out to foreigners
($893.0 billion), realizing a surplus of $231.9 billion.
$1,124.9 billion − $893.0 billion = $231.9 billion

c. The amount of secondary income the U.S residents paid out to foreigners ($286.9
billion) exceeded that of secondary income the U.S residents received from
foreigners ($159.2 billion), realizing a net current transfer payment of $127.7 billion.
Hence, the secondary income balance was -$127.7 billion in 2019.
$159.2 billion − $286.9 billion = −$127.7 billion

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 d. The total debit in the current account exceeded the total credit resulting in a deficit of
-$472.1 billion in the current account for the United States.
Balance on exports and imports + Balance on primary income + Balance on
secondary income = −$576.3 billion + $231.9 billion −$127.7 billion = −$472.1 billion

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