Foreign Exchange Rate Theory: Balance of Payments Model
The balance of payments leads to many confusions because definitions vary. For example, the IMF’s definition is different from the usual or historical definition. Secondly, the relationship between the balance of payments and reserve assets is difficult to grasp, especially in the IMF definition. Thirdly the origin of “errors and omissions” is often unclear. Therefore we give an explanation in around 400 words, that clarifies the relationships.
Balance of Payments (BOP)
The balance of payments (BoP) consist of three main parts or “accounts”:
- The current account
- The second category is the capital account, as called traditionally, or “financial account” according to the IMF and central banks.
- The IMF treats capital transfers as a third category called “capital account”. This relatively small and unimportant account “capital transfers”,1 applies e.g. when governments forgive debt or when migrants move country. For total confusion this account is often called “capital account” (e.g. ECB). Finally the IMF2 unites the big financial account with the small capital transfer account to the “capital and financial account”.
The balance of payments contains different (sub-) accounts. For each account the balance between inflows and outflows is measured. One example is the trade balance for goods. The balance is the value of the inflows during the period considered, for example, money received for goods sold minus money paid for goods purchased in the year 2012.
The components of the current account are accounts such as goods (the trade balance for goods) and services (trade balance for services), but also incomes from investments, labour and transfer payments of residents.
The main components of the capital account (or “broadly defined capital account” as Wikipedia calls it) are the direct investments account (investor has influence on decisions), the portfolio investments account (investor does not have influence on decisions) and the bank, corporate, government and central bank lending accounts (the “other investments” category). Reserve assets, assets bought by the central bank, are also included in the capital account.
The sum of the current account and the capital account movements is zero except for some errors and omissions:
We prefer to use a capital account that is a “narrowly defined capital account” that excludes reserve assets from the capital account. This leads to the following equations:
Since some data, especially in the capital account is difficult to obtain, some errors and omissions arise. The change in reserve assets is easy to obtain via the central bank. Therefore the errors and omissions are parts of the “corrected BOP Balance”, the final Balance of Payments.
or replacing corrected BOP with BOP:
When a country has BOP surpluses then its reserve assets increase.
Balance of Payments Model
The balance of payments model states that a currency is valued based of the balance of payments. The currency of a country with a positive BOP balance (a BOP surplus) must appreciate; while, one with a BOP deficit must devalue over time. The reason, in the case of a BOP surplus, is that the central bank owns more reserves in foreign assets and foreign currency than previously and that means the local currency is therefore a relatively scarce good.
The equivalent in BOP terms, is that the currency appreciates when the BOP is positive, namely when the current account surplus is higher than outflows in the capital accounts (or the historically rare case that inflows in the capital account were higher than current account deficits.)
In the following we look on the accounts of the balance of payments.
The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading sub-divisions, which are:
- The goods and services account (the “overall trade balance”) comprises goods and services produced in the country and is therefore contained in the GDP.
- The primary income account contains factor income from loans and investments abroad. It is not contained in the GDP, but in the GNP and GNI.
- The secondary income account contains transfer payments e.g. from a foreigners who works in the country and sends money to his family abroad. In this case the secondary income account would be negative.
A country which has a current account surpluses is able to accumulate a positive net international investment position over the years. Therefore it has foreign assets that it might sell in case of a crisis to honour creditors. The country’s company’s foreign assets can absorb the crisis effects and satisfy creditor demands. In times of risk averseness, Swiss or Japanese companies repatriate foreign gains into local currency and push the yen or franc upwards. Long-term investors follow this example. Despite the strong franc the Swiss account surplus is still on the rise. During the carry trade era, however, many Swiss companies left foreign incomes in foreign currencies.
The current accounts of the United States and the UK are mostly negative, while China, Germany, Sweden, Switzerland and the oil-exporting nations have often so-called “structural current account surpluses”. Read more for long-term currency movements based on current account balances.
Capital Accounts (or Financial accounts)
Capital accounts contain the following:
- Foreign direct investment (FDI), refers to long term capital investments, such as the purchase or construction of machinery, buildings or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound flow and counts as a surplus item in the capital account. If a nation’s citizens are investing in foreign countries, that is an outbound flow that will count as a deficit. After the initial investment, any yearly profits not re-invested will flow in the opposite direction, but will be recorded in the current account rather than as capital.
- Portfolio investment refers to the purchase of shares and bonds. As with FDI, the income derived from these assets is recorded in the current account; the capital account entry will just be for any international buying or selling of the portfolio assets.
- Other investments include capital flows into bank accounts or provided as loans. Large short term flows between accounts in different nations are commonly seen when the market is able to take advantage of fluctuations in interest rates and / or the exchange rate between currencies. Sometimes this category can include the reserve account.
- Derivatives: contain the activities of FX traders and purchases of options, forwards and swaps that reflect future expectations of exchange rates or investments concerning the country
- Reserve Account.
The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital flows to counteract those originating from the market. Inbound capital flows (from sales of the account’s foreign currency), especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation’s currency, while outbound flows can cause a fall in value (depreciation). If a government (or, if authorized to operate independently in this area, the central bank itself) doesn’t consider the market-driven change to its currency value to be in the nation’s best interests, it can intervene. (source Wikipedia).
A big part of portfolio investments are money market movements that move with higher or lower interest rates into this or that country. Foreign Direct Investments tend to show more stable tendencies, emerging/developing economies have rather inflows while advanced economies see more outflows.
Apart from FX traders, portfolio investments are the component that cause a strong volatility in foreign exchange rates. With the European crisis there was a big outflow of portfolio investments from Europe that helped to push the euro down from 1.32 to 1.23 in June 2012.
Thanks to the cheap euro, the euro zone current account was strongly positive. But it was not sufficiently high to cover the outflows in the capital account, especially in portfolio investments.
The European Central Bank delivers the balance of payments monthly.
Between January and August 2011, the situation was completely different, based on cheap money from QE2, euro zone interest rates rose and portfolio investments moved into China and the euro zone.
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.