Types of Transactions
Types of Transactions
Current Account T
he current-account balance is very important because it summarizes the real transactions that occur in a country. The current-account balance includes merchandise trade; other goods, services, and income; and unrequited transfers. The merchandise trade balance is critical because of the sheer volume of transactions that takes place. The export of merchandise is a credit because it results in the receipt of payment from abroad. An import is a debit because it results in making payment to the seller abroad. The balance of trade is important, because it is the most basic measure of a country's transactions with the rest of the world. Even though the U.S.
has a large balance-of-trade deficit, it has been improving steadily since 1986. A merchandise import or export involves an exchange where a buyer in one country and a seller in another country exchange something of equal value. However, an unrequited transfer (or unilateral transfer) occurs when consideration is provided to only one party, such as aid to a drought-stricken country.
The key transactions accounted for in the services account are travel and transportation, tourism, fees and royalties, and income on investments. U.S. tourists going abroad result in a debit entry because they are transferring funds abroad to pay for the vacation. Income received from a foreign investment is treated as a credit, much like merchandise exports, because the income results in receipt of payment from foreign sources.
Long-term Capital
The major categories in long-term capital are direct investment, portfolio investment, and loans. The direct investment category reflects U.S. investment abroad and foreign investment in the United States. Foreign investment in the United States has grown steadily since 1985, and it reflects the inflow of cash that offsets the outflow from the balance-of-trade deficit. Note that a balance is given for the current account and long-term capital in Table 8.3 (Total, Groups A & B). That balance is often referred to as the basic balance because it measures the long-term international economic stability of a country. Supposedly it indicates productivity, factor endowments, buyer preferences, international competition, perception of the economy as a haven for investment, and the like. Although the basic balance is negative for the United States, it has been improving since 1987.
Short-term Capital
The short-term capital account represents funds that flow as a result of real transactions, such as the payment for exports and imports, as well as the flow of long-term capital transactions, such as the outflow to pay for direct investments or the inflow to recognize the receipt of investment income. In addition, it also represents speculative flows that exploit short-term interest rates and flows that respond to, say, political uncertainty.
Other Items
The category in Table 8.3 called "net errors and omissions" was defined earlier as the amount necessary to make the debits equal the credits. The items below the line (including categories E to H) represent official financing in the balance of payments. Counterpart items relate to certain changes within the official reserves and need not be discussed in detail here. Category G in Table 8.3 refers to claims that foreign official agencies have on the assets of the country. Category H is changes in the reserve position of the country. It does not represent the actual reserves, just changes in their value.
Surplus and Deficit The terms balance-of-payments deficit and balance-of-payments surplus are often mentioned in the press. As was noted
earlier, the balance of payments must always be in balance because of the concept of double-entry accounting. Thus the idea of a surplus or deficit must
refer to a specific component of the balance of payments. The balances most often cited are the merchandise trade balance in particular and the current-account and basic balances.
Understanding these different balances can be difficult. Japan was hard to understand in mid-1990, because it had the biggest current-account surplus in the world, a growth rate of 5 percent, and an inflation rate one-half that of the industrial countries, but it still had a weak yen and a declining stock market. The problem was that its basic balance was in trouble. The current-account surplus was more than offset by an outflow of capital, and some suggested that the purchasing-power parity value of the yen was closer to 170-200 yen per dollar. The United Kingdom was in the most trouble of the industrial countries, because its current-account deficit was exacerbated by an outflow of capital, so that its basic balance was 10 percent of GNP, the largest of the industrial world. The current-account deficit of the United States was offset by the inflow of capital, but that is an unstable solution in the long run. Germany was in the best situation of all, because it had a huge current-account surplus, like Japan, but a low outflow of capital, so that its basic balance was the largest in the world. This suggests that the German mark should remain strong over the long run, whereas the yen and dollar are basically unstable, and the British pound should eventually weaken.12
If there is a material surplus or deficit in the balances just mentioned, there are three major ways to correct the situation: (1) disrupt trade and cap- ital flows, (2) correct internal economic imbalances, and (3) force or allow the exchange rate to change. It would be illogical to assume that market forces are the sole determinants of trade and capital flows. Governments can and do provide incentives and disincentives in response to their own objec-
fives and pressure from lobbyists. Even at a given level of governmental in-
tervention, disequilibrium still can occur, leading to even more intervention. °
Disrupting trade and capital flows is a cosmetic solution to disequilibrium and requires specific identification of the determinants of the surplus or deficit and the policies to achieve equilibrium. Chapter 5 discussed many ways to restrict trade and capital flows, such as subsidies, tariffs, quotas, and restrictions on the repatriation of dividends. Earlier in this chapter and in Chapter 7, we showed how governments can intervene to support their currencies by buying and selling foreign exchange, using multiple exchange rates, and so on.
The second major way to restore equilibrium is to correct internal economic imbalances. As noted earlier, inflation is one of the major sources of a deficit in the balance of payments. Inflation can be reduced through strict monetary and fiscal policies, high interest rates, and wage and price controls.
However, this approach can lead to an economic slowdown and unemployment, both of which are very unpopular politically. Exports can also be diversified through industrialization and by shifting resources to products that are more competitive in export and import markets. Import-competing industries, where economically feasible, also can be encouraged.
In the final analysis it may be impossible to stave off a change in the exchange rate in order to try to restore equilibrium in the balance of payments. Many countries consider their balance of trade a key factor in determining whether to change the value of their currency. Analysts feel that a depreciation will make domestic products less expensive in international markets, thereby leading to an increase in exports. Simultaneously, the depreciation will make imports more expensive, resulting in a reduction in demand and thus a reduction in imports.
In looking at balance-of-payments data, especially the balance of trade, it is important to understand what is really causing a surplus or deficit. The United States has been beset with significant balance-of-trade deficits in recent years. Interestingly, imports as a percentage of GNP have not changed significantly since 1980, when imports were 10.5 percent of GNP. In 1988 they were 9 percent of GNP, and in 1989 they were 9.7 percent of GNP. However, exports as a percentage of GNP dropped steadily from 10.0 percent in 1980 to 6.7 percent in 1986. In 1988 they were only 6.6 percent of GNP, and in 1989 they were 7.5 percent of GNP. Economic growth in the United States has exceeded that of many other nations, especially the industrial countries that trade with the United States, so imports have climbed along with economic growth. The growth in imports is thus a factor in both the increase in the U.S. economy and an increase in market share in the U.S. economy. Coupled with the drop in exports as a percentage of GNP and the fact that the economies of the United States' major importers have been soft, it is obvious that the United States has some real problems. It would be too simplistic to assume that a weakening of the dollar would solve all of the trade problems of the United States.
Current Account T
he current-account balance is very important because it summarizes the real transactions that occur in a country. The current-account balance includes merchandise trade; other goods, services, and income; and unrequited transfers. The merchandise trade balance is critical because of the sheer volume of transactions that takes place. The export of merchandise is a credit because it results in the receipt of payment from abroad. An import is a debit because it results in making payment to the seller abroad. The balance of trade is important, because it is the most basic measure of a country's transactions with the rest of the world. Even though the U.S.
has a large balance-of-trade deficit, it has been improving steadily since 1986. A merchandise import or export involves an exchange where a buyer in one country and a seller in another country exchange something of equal value. However, an unrequited transfer (or unilateral transfer) occurs when consideration is provided to only one party, such as aid to a drought-stricken country.
The key transactions accounted for in the services account are travel and transportation, tourism, fees and royalties, and income on investments. U.S. tourists going abroad result in a debit entry because they are transferring funds abroad to pay for the vacation. Income received from a foreign investment is treated as a credit, much like merchandise exports, because the income results in receipt of payment from foreign sources.
Long-term Capital
The major categories in long-term capital are direct investment, portfolio investment, and loans. The direct investment category reflects U.S. investment abroad and foreign investment in the United States. Foreign investment in the United States has grown steadily since 1985, and it reflects the inflow of cash that offsets the outflow from the balance-of-trade deficit. Note that a balance is given for the current account and long-term capital in Table 8.3 (Total, Groups A & B). That balance is often referred to as the basic balance because it measures the long-term international economic stability of a country. Supposedly it indicates productivity, factor endowments, buyer preferences, international competition, perception of the economy as a haven for investment, and the like. Although the basic balance is negative for the United States, it has been improving since 1987.
Short-term Capital
The short-term capital account represents funds that flow as a result of real transactions, such as the payment for exports and imports, as well as the flow of long-term capital transactions, such as the outflow to pay for direct investments or the inflow to recognize the receipt of investment income. In addition, it also represents speculative flows that exploit short-term interest rates and flows that respond to, say, political uncertainty.
Other Items
The category in Table 8.3 called "net errors and omissions" was defined earlier as the amount necessary to make the debits equal the credits. The items below the line (including categories E to H) represent official financing in the balance of payments. Counterpart items relate to certain changes within the official reserves and need not be discussed in detail here. Category G in Table 8.3 refers to claims that foreign official agencies have on the assets of the country. Category H is changes in the reserve position of the country. It does not represent the actual reserves, just changes in their value.
Surplus and Deficit The terms balance-of-payments deficit and balance-of-payments surplus are often mentioned in the press. As was noted
earlier, the balance of payments must always be in balance because of the concept of double-entry accounting. Thus the idea of a surplus or deficit must
refer to a specific component of the balance of payments. The balances most often cited are the merchandise trade balance in particular and the current-account and basic balances.
Understanding these different balances can be difficult. Japan was hard to understand in mid-1990, because it had the biggest current-account surplus in the world, a growth rate of 5 percent, and an inflation rate one-half that of the industrial countries, but it still had a weak yen and a declining stock market. The problem was that its basic balance was in trouble. The current-account surplus was more than offset by an outflow of capital, and some suggested that the purchasing-power parity value of the yen was closer to 170-200 yen per dollar. The United Kingdom was in the most trouble of the industrial countries, because its current-account deficit was exacerbated by an outflow of capital, so that its basic balance was 10 percent of GNP, the largest of the industrial world. The current-account deficit of the United States was offset by the inflow of capital, but that is an unstable solution in the long run. Germany was in the best situation of all, because it had a huge current-account surplus, like Japan, but a low outflow of capital, so that its basic balance was the largest in the world. This suggests that the German mark should remain strong over the long run, whereas the yen and dollar are basically unstable, and the British pound should eventually weaken.12
If there is a material surplus or deficit in the balances just mentioned, there are three major ways to correct the situation: (1) disrupt trade and cap- ital flows, (2) correct internal economic imbalances, and (3) force or allow the exchange rate to change. It would be illogical to assume that market forces are the sole determinants of trade and capital flows. Governments can and do provide incentives and disincentives in response to their own objec-
fives and pressure from lobbyists. Even at a given level of governmental in-
tervention, disequilibrium still can occur, leading to even more intervention. °
Disrupting trade and capital flows is a cosmetic solution to disequilibrium and requires specific identification of the determinants of the surplus or deficit and the policies to achieve equilibrium. Chapter 5 discussed many ways to restrict trade and capital flows, such as subsidies, tariffs, quotas, and restrictions on the repatriation of dividends. Earlier in this chapter and in Chapter 7, we showed how governments can intervene to support their currencies by buying and selling foreign exchange, using multiple exchange rates, and so on.
The second major way to restore equilibrium is to correct internal economic imbalances. As noted earlier, inflation is one of the major sources of a deficit in the balance of payments. Inflation can be reduced through strict monetary and fiscal policies, high interest rates, and wage and price controls.
However, this approach can lead to an economic slowdown and unemployment, both of which are very unpopular politically. Exports can also be diversified through industrialization and by shifting resources to products that are more competitive in export and import markets. Import-competing industries, where economically feasible, also can be encouraged.
In the final analysis it may be impossible to stave off a change in the exchange rate in order to try to restore equilibrium in the balance of payments. Many countries consider their balance of trade a key factor in determining whether to change the value of their currency. Analysts feel that a depreciation will make domestic products less expensive in international markets, thereby leading to an increase in exports. Simultaneously, the depreciation will make imports more expensive, resulting in a reduction in demand and thus a reduction in imports.
In looking at balance-of-payments data, especially the balance of trade, it is important to understand what is really causing a surplus or deficit. The United States has been beset with significant balance-of-trade deficits in recent years. Interestingly, imports as a percentage of GNP have not changed significantly since 1980, when imports were 10.5 percent of GNP. In 1988 they were 9 percent of GNP, and in 1989 they were 9.7 percent of GNP. However, exports as a percentage of GNP dropped steadily from 10.0 percent in 1980 to 6.7 percent in 1986. In 1988 they were only 6.6 percent of GNP, and in 1989 they were 7.5 percent of GNP. Economic growth in the United States has exceeded that of many other nations, especially the industrial countries that trade with the United States, so imports have climbed along with economic growth. The growth in imports is thus a factor in both the increase in the U.S. economy and an increase in market share in the U.S. economy. Coupled with the drop in exports as a percentage of GNP and the fact that the economies of the United States' major importers have been soft, it is obvious that the United States has some real problems. It would be too simplistic to assume that a weakening of the dollar would solve all of the trade problems of the United States.
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