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Lesson 25: Balance of Payments & Exactly How it Balances!

Module 1: Macro Fundamental Analysis

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Video Transcript

in this video we’re going to look at the double entry bookkeeping tab of the balance of payment spreadsheet and we’re going to look at how the credit and the debits of the balance of payments sum to zero and why they sum to zero and how even with an equal weighting of credits and debits so for every credit added there is a debit also added of equal value and for every debit there is a credit value added of equal value and how despite that you can still have a balance of payment surplus or deficit with the sum of the current account balance the capital account balance and the official reserve balance still coming to zero so we’re going to do that by going through some examples of hypothetical transactions and first of all we need to start with our key over here so you can see that a credit is an outflow so a decrease in real resources a decrease in financial assets so real resources being said goods or services decreasing financial assets maybe you sell a bond therefore your financial assets have decreased and for this you have received the credit you’ve received money in or an increase in liabilities so this is taking on more debt or taking on a loan if you take out a loan you increase your liabilities you essentially export the debt and for that outflow of debt you receive money in return to receive a credit you’ve taken out a loan and conversely we have debits which represents an inflow so an increase in real resources so an increasing goods of services and increasing financial assets so the buying perhaps of a bond or a decrease in liabilities so the reduction of debt if you pay back a loan you are reducing your debt and at the same time you are sending money out in order to reduce your debt so let’s now go through some hypothetical transaction examples and we’re going to start off with the importation of 100 million dollars worth of machinery so this would represent a debit because we have an increase in real resources this economy has imported machinery to the value of 100 million dollars so we have 100 million dollars worth of machinery coming in so the value of that machinery is 100 million and for this debit there is recorded an equal value in the credit part of the capital account because this is representative of the money which has gone out to an outflow of the money to pay for the 100 million dollars worth of machinery and the reason they match of course is because that is what the deal was because the machinery is worth 100 million and so the machinery which was sold required 100 million dollars worth of currency to pay for it so the 100 million dollar value of the machinery matches the 100 million dollars which was sent to pay for the machinery and you can see this causes a current account deficit of 100 million and at the same time we have a surplus of 100 million in the financial account so remember the capital account in the broad sense is the capital account in the narrow sense which is a tiny tiny portion of the capital account overall in the broad sense and also the financial account which is the much much larger piece of the capital account which we looked at in previous videos so because we are talking about machinery which is a good we are registering the debit in the current account under the balance of trade and the credit because it is the money which is paid for the machinery it’s the exportation of the money is registered as a credit or an outflow in the financial account in the capital account we then have the importation of 200 million dollars worth of cars this again is registered as a debit in the current account because we are talking once again about an increase in real resources or goods in this case in the form of cars and an equal value is therefore registered in the financial account in the overall broad capital account as an outflow of 200 million dollars so 200 million dollars worth of cars have come in 200 million dollars of dollars have left to pay for those cars or that importation and you can see the balance of payments balances out here so the deficit in the current account so the money which has gone out to pay for these goods is matched by a surplus in the capital account or in the financial account we then have hundred million dollars worth of uk stock now because this is not a good or a service this is a financial asset so importing 100 million dollars worth of uk stock is an increase in financial assets this is registered therefore in the financial account itself and because we have an increase in financial assets we’ve imported this economy as imported 100 million dollars worth of uk stock this is recorded as a debit in the financial account

and at the same time it is also recorded as a credit in the financial account because the money going out is recorded in the financial account and the financial assets coming in are also recorded in the financial account in the cattle account in the broad sense so you can see here we still have an equal amount in terms of the surplus in the capital account offsetting the 300 million deficit in the current account we then have the exportation of 100 million dollars worth of electrical equipment so this is a decrease in real resources as 100 million dollars worth of electrical equipment has left the economy this is an outflow of goods registered as a hundred million dollar credit in the current account this money coming in to the current account credit in for the outflow of resources in this case and at the same time there is an equal 100 million dollars recorded in the financial account and that is to represent the money which has come into the economy for the exportation of these goods in the form of electrical equipment we then have the exportation of 50 million dollars worth of consultancy services so because this is a service it goes in the balance of trade it goes in the current account this is a 50 million dollar credit because it’s an outflow of services which have required payment or a receipt of money coming into the economy and that incoming money is registered in the financial account for 50 million dollars so up here what’s been exported is the consultancy services and over here this is the payment for those which matches the value of the services of course we then have the exportation of 150 million dollars worth of us bonds this is going to be a decrease in financial assets and again because this is u.s bonds this is not going to be registered in the current account the financial assets themselves or the outflow of financial assets is going to be registered in the financial account so a decrease in financial assets as they export the bonds out of the us in this case would hypothetically the u.s economy and this outflow or decrease in financial assets is going to be registered as a credit in the financial account

there is also going to be an equal value registered as a debit in the financial account to represent the money which has come into the economy so an inflow of funds into the economy to pay for the outflow of financial assets and in fact this is 150 million isn’t it both of these should actually be 150 million

because of what we have up here and you can see once we get to this point we still have the balancing of the current account deficit in this case and also this being offset by the surplus in the capital account because of the nature of the double entry bookkeeping system now what about if we have a central bank transaction here and the central bank exports or it sells 100 million dollars worth of gold this is going to be a decrease in foreign exchange reserves and this decrease in foreign exchange reserves this outflow is going to be registered in the official settlements balance as a credit because it’s an outflow of gold to the value of a hundred million dollars at the same time a debit is recorded in the financial account of 100 million

and this is to represent the dollars coming into the economy to offset the outflow of the gold now you can see it’s registered in the capital account here because if it was registered in the official settlements balance then this would never change obviously this would just remain the same at all times it would always be zero so it is not registered in the official settlements balance and of course it is not registered in the current account and this is what throws a lot of people off because you can see here now we have an official settlements balance of 100 million this has caused a deficit in the balance of payments we do not any longer have the current account matching the overall capital account but when we have the current account and the capital account and the official settlements balance all added together we still get zero so the entire balance of payments balances but because of the transactions in the official settlements balance or because of transactions taking place in terms of the foreign exchange reserves of the economy so they’ve either sold gold for example in order to get dollars in or they may have bought gold and in that case they would have had to use dollars they would have sold dollars in order to do that but you can see that this is what is meant by a balance of payments deficit so the depleting of reserves the gaining of u.s dollars equals official settlements balance positive because this is a credit the outflow of gold has caused money to come in so there has been a credit for this outflow of gold and this has caused a of payments deficit as this economy is losing reserves it’s depleting its foreign exchange reserves conversely if we were to take we could swap this around

and let’s say in this case the central bank decided to purchase gold using dollars this would be an inflow of gold into the foreign exchange reserves and this would result in a negative official settlements balance because adding to reserves losing us dollars is an official settlement’s balance negative and this causes a balance of payment surplus because this economy or the central bank in this case is adding to its reserves its foreign exchange reserves and for this inflow of gold there would have to be an outflow registered in the financial account of equal value and this overall takes the balance of payments back to zero despite the fact that we have a balance of payment surplus in this case because the central bank is adding to its reserves so you can see the current account and the capital account no longer match up because of the transactions involving foreign exchange reserves but when all three of these are added together because of the nature of the double entry bookkeeping system the total amount comes to zero in other words everything balances now finally if we look at the balancing item what is the balancing item so let’s take this back to what we had before so we had an outflow of gold a losing of foreign exchange reserves depleting of reserves and an inflow of the equal value of u.s dollars for that gold which was sold giving us an official settlements balance of 100 million so this is a depletion of reserves positive official settlements balance balance of payments deficit everything else down here actually sums to zero still because of the debits and credits double entry bookkeeping system but we also have the balancing item as we discussed before and this is falls into the financial account here the capital account and the balancing item is because in reality the total amount of debits and credits in the current account and a capital account don’t sum exactly to zero and all this is it’s just because of mistakes or errors in the recording process because there’s a number of reasons you could have because of the black market within an economy so some of the transactions get missed you could have timing issues so for example a good worth a hundred dollars is purchased and it’s recorded as a debit of a hundred dollars for the good and also recorded as a hundred dollars as a credit of outflow of money to pay for that good but you may find that actually only thirty dollars has been paid for initially and the rest of the money is paid at a later date so there’s a timing issue which is taking place it doesn’t mean that these transactions haven’t happened everything has to ultimately balance to zero because of the way a credit and a debit is put into the balance of payments it just reflects some errors in the recording of the balance of payments that’s all it reflects these transactions have still happened and taken place but they’ve just been recorded slightly wrong and as a result you might see something like this in reality you may see the electrical equipment being put down as 98 and you may see the exportation of bonds being put down as 145 just because of some of the errors and so what will happen is you will see that ultimately the current account and the capital account and the official settlements balance will come to -7 and the balancing item is just simply an accounting measure which is put in to balance the overall balance of payments so it’s just a way of saying okay well we know that the balance of payments will always balance so this minus seven is not necessarily correct so we need to add seven to bring the entire balance of payments back to zero because somewhere along the line due to transactions in the black market or some issues involving cash payments or some timing issues there has just been some missed transactions or rather the transactions which have taken place have not been recorded properly because the other problem as well is that the balance of payments will come from different data sources so for example you will have data in the capital account or the financial account which is provided by a bank and then you will have data which is provided by customs for the importation or the exportation of goods and you can see discrepancies between those two sets of data as well so the key takeaway here is that the current accounts balance the capital account balance in the broad sense and the official settlements balance will always sum to zero if it doesn’t it’s only because some of the transactions have been recorded incorrectly and therefore a balancing item is added just to bring this back to the real amount or the real value which is zero and a balance of payments deficit or surplus is directly referencing a change in the official settlements balance and transactions on the central bank level regarding an economy’s foreign exchange reserves so following on from the double entry bookkeeping system we want to look at how we can take views on currencies depending on what is happening in the balance of payments so we discussed previously that changes to the official settlements balance are primarily in relation to fixed or pegged exchange rates regimes we know from videos at the beginning of the course that we actually try and filter these out because they have inherently a lack of volatility because the currencies are being pegged they are facing intervention from the central bank and therefore a reduction in the volatility of the currency means that there is less risk and less reward associated with that currency so in a floating exchange rate regime we can take out the official settlements balance all together

and let’s just for argument’s sake here let’s just take this back

and say there are no statistical discrepancies in the data here and everything balances to zero as it should well what we want to be looking at then since there is no change or very little change in reality there will be a little change to the official settlements balance because there are no pure floating regimes they are managed regimes and so there will be some intervention from the central bank and you can assess that when you’re looking at the supply and demand of the currency but if there is very little to no change in the official settlements balance we want to be looking at whether that economy or that country is a net borrower or a net lender in the global marketplace so does this economy have a current account deficit or a surplus are they sending more money abroad than they are receiving for goods and services primarily and income and also transfers so do they have a current account deficit or another way of looking at this is the economy a net importer or a net exporter if the country or the economy is a net importer all things considered this will cause a current account deficit this means that the currency is in supply to the rest of the world and the economy is a net borrower this provides a short currency bias on the underlying currency of course as the current account deficit increases this provides a stronger short currency bias and as the deficit maybe starts to come back into balance or possibly towards a surplus this would provide a weaker short currency bias equally and inversely if the economy has a current account surplus they are more of a net exporter than they are a net importer this means that there is demand for the currency so instead of the currency being in supply instead of domestic residents converting out of the currency supplying it to the rest of the world for goods and services they are exporting goods and services and their currency is in demand so people from outside the domestic economy demand their currency to purchase their goods and services this means that that economy is a net lender in the global marketplace and this provides a long currency bias on the underlying currency so current account deficit short currency buyers current account surplus long currency bias and remember we’re talking about a bias here it doesn’t mean go out and short the currency of every economy with a current account deficit we’re putting all of the pieces of the puzzle together