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Lesson 24: Balance of Payments & The Financial Account

Module 1: Macro Fundamental Analysis

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Video Transcript

in this video we’re going to be looking at the capital account tab of the balance payment spreadsheet and we’re going to be looking at here the capital account in the broad sense which as we looked at previously is the capital account in the narrow form and that is capital transfers plus acquisition and disposal of non-produced non-financial assets this is the capital account in the narrow form and this would be items such as land or a patent so assets which do not generate interest and the capital account in the broad sense is the capital account in the narrow sense plus the financial account which deals with transfers of financial assets and liabilities so debt or loans and this deals with transfers of financial assets such as bonds so assets which generate interest and also liabilities or loans and you will also have in this section as well currency so the transfer of money which is registered in the financial accounts as we will see when we look at the double entry bookkeeping part of the spreadsheet so just a side note as well that the capital account has more recently started to become referred to by the imf as the capital account plus financial account so if you hear the term capital account plus financial account or you may just hear the term financial account it is referencing the capital account in the broad sense and the reason you may hear some people just describing it as the financial account is because if we put side by side the current account and the financial account or the capital account in the broad sense you will see that the financial account makes up the bulk of the capital account in the broad sense the capital account in the narrow sense which is the flows associated with capital transfers plus the acquisition slash disposal of non-produced non-financial assets makes up a very very small part of the capital account in the broad sense so it is slightly counter-intuitive that the overall account would be called the capital account in the broad sense and this is why many people often will just refer to it as the financial account because this is the much much bigger part of the capital account in the broad sense as you can see and the capital account in the narrow sense plus the financial account so the capital account in the broad sense is made up or composed of payments made from the rest of the world again as a form of a credit so an outflow of real and financial assets and an inflow or money coming into the economy receipt of money coming into the economy for that outflow of real and financial assets so payments from the rest of the world to the domestic economy and also conversely payments made to the rest of the world in the form of a debit and this is an inflow of real and financial assets for which a payment or a debit is made to the rest of the world from the domestic economy so we have a change in domestic assets purchased by foreign agents in the domestic economy and we have a change in foreign assets purchased by domestic agents so foreign assets purchased by agents within the domestic economy and these can be thought of as private transactions so in other words these are transactions by individuals and businesses excluding official transactions and the official transactions as you can see is down in the official settlements balance which is also part of the capital account in the broad sense or the financial account and the official settlements balance records an increase or decrease in official foreign exchange reserves and these are transactions made by the central bank or the monetary authorities within the economy so these are excluding private transactions from individuals and businesses so the top part of the financial accounts or the capital account in the broad sense can be thought of as private transactions between individuals and businesses and the bottom part of the capital account in the broad sense or the financial accounts can be thought of as official transactions by the central bank within that domestic economy and this is the part that often throws people when they’re looking at the balance of payments because they will ask themselves well how can it be it seems counterintuitive that all of the payments or the flows within the balance of payments in terms of debits and credits must balance to zero by their nature by the way they’re recorded in the double entry bookkeeping system which we’re going to look at next and yet you can still have a balance of payments deficit or a balance of payment surplus how can you have an imbalance for example in the balance of payments and at the same time all of the credits and all of the debits add up to zero or sum to zero that doesn’t necessarily make sense on the surface but we will show you in the next video why that is the case and how that works and you’re going to see that it’s because of changes in the official settlements balance which can cause a balance of payment surplus or a balanced payments deficit whilst at the same time all of the debits and all of the credits including the official reserves or the official settlements balance will still sum to zero and so the key takeaway here is that when you hear somebody talking about a balance of payment surplus or a balance of payments deficit first of all this is not the same as a surplus or a deficit in the current account so a current account surpass or deficit it is not the same as a capital account surplus or deficit it is referencing the official settlements balance and a change in reserves and more specifically if you have a positive official settlements balance this means that domestic currency is coming in and reserves are going out so reserves are being converted into domestic currency so it’s a loss of reserves this loss of reserves is what causes a balance of payments deficit and conversely if there is a negative official settlements balance this means domestic currency is going out and reserves foreign exchange reserves are being accumulated and when we talk about foreign exchange reserves we’re talking about foreign currency foreign bonds gold uh sdrs which is a bit like a form of a currency which is held with the imf and an accumulation of foreign exchange reserves is what is being referenced when you hear the term balance of payment surplus so it’s very important to understand that when you hear about a balance of payment surplus or a balanced payments deficit it is in direct reference to a change in the official settlements balance or an accumulation of foreign reserves when talking about a balance of payment surplus or a loss of foreign exchange reserves when talking about a balanced payments deficit now you may recall on the previous tab we had a minus 200 deficit in the current account and you can see over on this side we have a plus 200 surplus in the capital account in the broad sense or the financial account and this is because the way the debits and credit system works under the double entry bookkeeping rules means that any currency account deficit will result in a capital account surplus and any current account surplus will result in a capital account deficit and this is why we have the plus 200 surplus which is the inverse of what we saw in the current account and this simply means that this economy is financing its current account deficit by borrowing money for example issuing bonds so outflow of real and financial assets may be a bond for a payment from the rest of the world so money coming in as the bond is issued is a form of borrowing and so this economy with the current account deficit is a net borrower in the global marketplace with a capital account surplus so it can get a little bit confusing when talking about the balance of payments but if you keep in your mind that a balance of payments deficit or surplus is in direct reference to a change in official reserves it should make things a little less complicated now what’s interesting and we’re going to look at this more in the next video but if we were to change the official settlements balance here you can see that overall our surplus would decrease in the financial account and so no longer does our total amount in the capital account match what’s in the current account and so in this case what you would see is despite the fact the private transactions are exactly the same as what is reflected in the current account so the inverse 200 which is exactly the same as the negative amount in the current account you can see if we have an official settlements balance of 100 this decreases the overall surplus in the capital account to 100 from 200. so what this means is reserves have gone out so for example this economy may have sold some of its gold reserves and in exchange received u.s dollars so the foreign exchange reserves have been depleted causing a 100 balance of payments deficit by reducing the overall surplus in the capital account from 200 to 100. and at the same time you can see that all of the private transactions still equate to the inverse of what was shown in the current account they still match and conversely if we were to change the official settlements balance to minus 100 here you can see this increases the overall surplus in the capital account in the broad sense and this is because a negative official settlements balance shows that domestic currency has gone out reserves have come in so this economy would be accumulating foreign reserves so it’s converted out of a hundred dollars and in return it’s received a hundred dollars worth of gold so it’s accumulating reserves and this equates to an overall balance of payments surplus of 100 so without the official settlements balance here you can see there is no balance of payment surplus or deficit the capital account in the broad sense or the financial account matches the current account balance inversely so minus 200 in the current account plus 200 in the capital account in the broad sense so changes to the official settlements balance usually take place in fixed exchange rates regimes so when there is a positive official settlements balance this means domestic currency is coming in reserves are being depleted we have a balance of payments deficit and this is to increase the value or prop up the value of the domestic currency the central bank in this case is using its foreign exchange reserves to buy its own currency and this would be defending the bottom of any peg in a fixed exchange rate regime conversely if we have an official settlements balance which is negative this would show that domestic currency is being supplied to the rest of the world reserves are coming in so this central bank would be buying foreign exchange reserves in the global marketplace and using domestic currency to do so so it’s supplying domestic currency accumulating reserves in the process causing an overall balance of payments surplus as foreign exchange reserves increase and in doing so the central bank is decreasing the value of the domestic currency so it’s defending the upper bound of the peg in the fixed exchange rate regime by selling the domestic currency and converting into or buying foreign exchange reserves in a floating exchange rate regime

just change this it should say floating

there is no change in the official settlements balance because there is no central bank intervention and the currency is determined by market forces now we touched on this at the beginning of the course that there are really in reality no real pure floating exchange rate regimes all of the floating exchange rate regimes in the world have some level of intervention so you will tend to see some changes to the official settlements balance in floating exchange rate regimes but they tend to be very small in comparison for example to fixed exchange rate regimes and so as a result although you can apply that to a change in the official reserves of floating exchange rate regimes what you can do in floating exchange rate regimes and regimes where there is little to no change in the official settlements balance is to look and assess as to whether that economy has a current account deficit and is therefore a net borrower in the global marketplace or if that economy is running a current account surplus meaning it is a net lender in the global marketplace