Balance of Payments

Balance of Payments

The balance of payments is a record of all economic transactions between residents of a country and The rest of the world over a given period. It must balance in an accounting sense (total credits $=$ total debits, with the balancing item being errors and omissions).

Current Account

1. Balance of trade in goods: exports minus imports of physical goods (visible trade)
2. Balance of trade in services: exports minus imports of services (invisible trade) — tourism, banking, insurance, transport, education, consulting
3. Primary income: earnings from investments abroad minus payments to foreign investors (dividends, interest, profits) plus compensation of employees working abroad
4. Secondary income (current transfers): unilateral transfers such as remittances, foreign aid, and pensions

Capital Account

Records transfers of capital that do not affect national income:

• Debt forgiveness
• Transfers of fixed assets (e.g., migration-related transfers of personal assets)
• Capital transfers associated with the acquisition or disposal of fixed assets

The capital account is small relative to the current and financial accounts.

Financial Account

Records transactions in financial assets and liabilities:

• Direct investment: cross-border investment in enterprises where the investor acquires a lasting interest ( defined as $10\%$ or more of voting power). Includes both greenfield investment (establishing new facilities) and mergers and acquisitions
• Portfolio investment: cross-border purchases of shares and bonds without acquiring control
• Other investment: bank deposits, trade credits, loans
• Reserve assets: changes in a country”s official foreign exchange reserves held by the central bank (gold, foreign currency, SDRs, IMF reserve position)

The Balance of Payments Identity

$\mathrm{Current\ Account} + \mathrm{Capital\ Account} + \mathrm{Financial\ Account} + \mathrm{Statistical\ Discrepancy} = 0$

A current account deficit must be financed by a surplus on the capital and financial accounts (net Capital inflows). A current account surplus corresponds to net capital outflows.

Current Account Imbalances

Causes of current account deficits:

• Excessive domestic consumption relative to production
• Lack of international competitiveness (high production costs, low productivity)
• Overvalued exchange rate
• High reliance on imported capital goods for development
• Strong domestic currency reducing export competitiveness

Consequences of persistent deficits:

• Growing external debt and debt-servicing costs
• Downward pressure on the exchange rate
• Vulnerability to capital flow reversals (“sudden stop”)
• Loss of confidence among foreign investors

When a deficit may not be problematic:

• If the deficit reflects productive investment in capital goods that will generate future export capacity
• If it is financed by stable, long-term FDI rather than short-term portfolio flows
• If the country has a strong institutional framework and credible policy environment

Consequences of persistent surpluses:

• Underconsumption (domestic households forego current consumption)
• May contribute to global imbalances (e.g., China’s surplus mirroring the US deficit)
• May provoke trade tensions and accusations of currency manipulation
• Low domestic demand may constrain growth

Foreign Direct Investment and Multinational Corporations

Types of FDI

• Horizontal FDI: the firm invests in the same industry abroad as it operates at home (e.g., Toyota building car factories in the US). Motivated by market-seeking behaviour (bypassing trade barriers, being closer to consumers)
• Vertical FDI: the firm invests in different stages of the supply chain abroad (e.g., an electronics company establishing component manufacturing in Vietnam). Motivated by efficiency-seeking (lower costs) or resource-seeking (access to raw materials)
• Conglomerate FDI: investment in an unrelated industry abroad

Motives for FDI

• Market-seeking: accessing large or growing consumer markets (e.g., FDI in China, India)
• Resource-seeking: accessing natural resources, raw materials, or low-cost labour
• Efficiency-seeking: exploiting cost differences across countries (e.g., manufacturing in low-wage countries)
• Strategic asset-seeking: acquiring technology, brands, or distribution networks through mergers and acquisitions

Benefits of FDI for Host Countries

• Capital inflows: supplementing domestic savings, particularly important for developing countries
• Technology transfer and knowledge spillovers: local firms and workers gain access to advanced technology, management practices, and production techniques
• Job creation and skill development: FDI creates direct employment and indirect employment through supply chains
• Export development: FDI often targets export-oriented production, improving the host country’s trade balance
• Tax revenue: profits generated by foreign-owned firms are subject to local taxation
• Infrastructure development: some FDI projects include investment in roads, ports, and utilities

Costs of FDI for Host Countries

• Profit repatriation: a significant portion of profits may flow back to the home country, reducing the net benefit of capital inflows
• Environmental degradation: firms may exploit weaker environmental regulations in host countries (pollution havens hypothesis)
• Exploitation of labour: low wages, poor working conditions, and weak labour protections
• Crowding out: foreign firms may outcompete domestic firms, leading to consolidation and reduced domestic entrepreneurship
• Cultural disruption: large foreign firms may dominate local markets and undermine traditional economic activities
• Enclave economies: FDI may create isolated zones with few linkages to the domestic economy (limited backward and forward linkages)
• Vulnerability: dependence on FDI creates vulnerability to decisions made by foreign corporations (e.g., sudden divestment)

Factors Attracting FDI

• Large market size and growth potential
• Political stability, rule of law, and effective governance
• Skilled labour force at competitive wages
• Favourable tax regimes and investment incentives (tax holidays, special economic zones)
• Infrastructure quality (transport, energy, communications)
• Trade openness and membership of regional trade agreements
• Intellectual property protection

Multinational Corporations (MNCs)

MNCs are firms that own and control production facilities in more than one country. They account for A significant share of global trade, investment, and employment.

Impact on host countries:

• Can bring capital, technology, jobs, and management expertise
• May dominate key sectors, creating dependency and reducing policy autonomy
• Transfer pricing (setting prices for intra-firm transactions to shift profits to low-tax jurisdictions) can reduce tax revenues in host countries

Impact on home countries:

• MNCs benefit from access to global markets, resources, and talent
• May lead to job losses at home as production is relocated abroad (offshoring)
• Profits earned abroad are repatriated, contributing to the home country’s current account and tax base

Balance of Payments in Depth (HL Extension)

Detailed Account Structure

Current Account:

Financial Account:

Note: the sign convention for reserve assets is reversed. An increase in reserves (buying foreign Currency) is recorded as a debit (-), because it represents a capital outflow from the domestic Economy.

The Balance of Payments Identity

$\mathrm{CA} + \mathrm{KA} + \mathrm{FA} + \mathrm{EO} = 0$

Where CA = Current Account, KA = Capital Account, FA = Financial Account, EO = Errors and Omissions.

A current account deficit ($\mathrm{CA} < 0$) must be financed by:

• A capital account surplus ($\mathrm{KA} > 0$)
• A financial account surplus ($\mathrm{FA} > 0$): net capital inflows

The Current Account and the Exchange Rate

Under a floating exchange rate, the current account should self-correct through the exchange rate Mechanism:

1. A current account deficit means the supply of domestic currency (from importers selling domestic currency to buy foreign currency) exceeds demand (from exporters converting foreign earnings)
2. The exchange rate depreciates
3. Exports become cheaper, imports become more expensive
4. The trade balance improves (assuming the Marshall-Lerner condition holds)

In practice, self-correction may be slow due to the J-curve effect and inelastic short-run demand.

Sustainability of Current Account Deficits

A current account deficit is sustainable if financed by:

• FDI inflows: long-term, stable, and productive. FDI finances investment that generates future export capacity
• Long-term borrowing: mature debt profiles with manageable repayment schedules
• Reserve drawdowns: using accumulated reserves (temporary)

A current account deficit is unsustainable if financed by:

• Short-term portfolio flows (“hot money”): volatile and subject to sudden reversal
• Excessive borrowing: leading to debt accumulation beyond repayment capacity
• Reserve depletion: reserves are finite and cannot be run down indefinitely

FDI: Advantages and Disadvantages (HL Extension)

For Host Countries

Advantages:

1. Capital formation: FDI supplements domestic savings, particularly important in developing countries where savings rates are low
2. Technology transfer: MNCs bring advanced production techniques, management practices, and quality standards. Spillovers occur through labour turnover, supply chain linkages, and demonstration effects
3. Employment: direct job creation in the MNC’s operations, plus indirect employment through supply chains and multiplier effects
4. Export development: FDI often targets export markets, improving the host country’s trade balance and integration into global value chains
5. Human capital development: training programmes raise worker skills, which may diffuse to the broader economy
6. Tax revenue: MNC profits are subject to corporate taxation (subject to transfer pricing concerns)
7. Infrastructure: some FDI projects include investment in roads, ports, power, and telecommunications that benefit the broader economy

Disadvantages:

1. Profit repatriation: a significant share of MNC profits flows back to the home country, reducing the net benefit of capital inflows. , profit outflows exceed new FDI inflows
2. Crowding out: MNCs may outcompete domestic firms through superior technology, scale, and marketing, leading to consolidation and reduced domestic entrepreneurship
3. Environmental degradation: weak environmental regulations in host countries may attract “pollution haven” FDI, where MNCs relocate polluting activities
4. Exploitation: low wages, poor working conditions, and weak labour protections in export processing zones
5. Limited linkages: if MNCs import inputs and export finished goods with minimal domestic sourcing, backward and forward linkages are weak, limiting spillovers
6. Vulnerability: dependence on a few large MNCs creates vulnerability to decisions made abroad (divestment, relocation)
7. Tax avoidance: transfer pricing and profit shifting can significantly reduce tax revenues

For Home Countries

Advantages:

1. Repatriated profits: income from foreign operations contributes to the current account
2. Market access: FDI provides access to growing foreign markets that may be difficult to serve through exports alone (bypassing trade barriers)
3. Lower costs: offshoring production to lower-cost countries reduces costs, increasing profitability and potentially lowering consumer prices at home
4. Competitiveness: global operations allow firms to exploit comparative advantages across locations, enhancing overall efficiency

Disadvantages:

1. Job losses: offshoring production destroys jobs at home, particularly in manufacturing. Workers displaced may face long-term unemployment or wage depression
2. Technology transfer abroad: investing abroad may create future competitors (e.g., Western firms transferring technology to Chinese partners who later compete globally)
3. Tax base erosion: profit shifting to low-tax jurisdictions reduces home-country tax revenues
4. Dependency: reliance on foreign production creates supply chain vulnerability (as demonstrated by COVID-19 disruptions)

Worked Examples: International Economics (HL Extension)

FDI and Development: Extended Analysis (HL Extension)

Types of FDI

1. Horizontal FDI: the firm replicates its production process in the host country to serve the local market (market-seeking). Common in manufacturing and services. E.g., Toyota building assembly plants in the US, UK, and Thailand
2. Vertical FDI: the firm locates different stages of production in different countries to exploit factor cost differences (efficiency-seeking). Common in labour-intensive manufacturing. E.g., Apple designing in California, assembling in China
3. Export-platform FDI: the firm establishes production in a host country to export to third countries. E.g., electronics firms in Singapore exporting to the US and EU

Determinants of FDI

Pull factors (host country characteristics):

1. Market size: GDP and GDP per capita determine the potential market for goods and services
2. Labour costs: lower wages attract labour-intensive manufacturing (but skill levels matter)
3. Natural resources: resource-seeking FDI targets countries with mineral, oil, or agricultural endowments
4. Infrastructure: transport, energy, and telecommunications infrastructure reduce production and distribution costs
5. Institutional quality: rule of law, property rights, and contract enforcement reduce the risk of FDI
6. Tax incentives: lower corporate tax rates, tax holidays, and special economic zones attract FDI

Push factors (home country characteristics):

1. Saturated domestic markets: firms seek growth in emerging markets
2. High production costs: firms relocate labour-intensive activities to lower-cost countries
3. Regulatory constraints: environmental and labour regulations may push firms to relocate

FDI and Economic Development: Empirical Evidence

Positive effects:

1. Capital formation: FDI contributes to gross fixed capital formation, especially in capital-scarce developing countries
2. Technology transfer: MNCs bring advanced technology, management practices, and organisational know-how. Borensztein, De Gregorio, and Lee (1998) find that FDI has a positive effect on growth only when the host country has a minimum threshold of human capital (secondary school enrolment > 0.69 years)
3. Export competitiveness: FDI can help host countries integrate into global value chains
4. Employment: FDI creates jobs, though often in specific sectors and regions
5. Productivity spillovers: domestic firms may benefit from proximity to MNCs through labour mobility, supply chain linkages, and demonstration effects

Negative effects:

1. Crowding out: FDI may displace domestic firms that cannot compete with MNCs
2. Enclave economies: FDI in extractive industries may have limited linkages to the domestic economy (low multiplier effects)
3. Profit repatriation: MNC profits flow to the home country, reducing the net benefit to the host country
4. Environmental degradation: weak environmental regulation may attract polluting industries
5. Labour exploitation: FDI in low-wage countries may involve poor working conditions

FDI Spillovers: Formal Analysis

The spillover effect of FDI on domestic firms can be modelled as:

$\text{TFP}_{d,i} = \alpha + \beta \text{FDI}_{s,j} + \gamma X_i + \epsilon_i$

Where:

• $\text{TFP}_{d,i}$ = total factor productivity of domestic firm $i$
• $\text{FDI}_{s,j}$ = FDI presence in sector $j$ (e.g., share of sector employment or output)
• $X_i$ = firm characteristics (size, age, export status)
• $\beta$ = spillover coefficient

Empirical estimates of $\beta$ are mixed:

• Positive spillovers: Aitken and Harrison (1999) find positive horizontal spillovers in Venezuela, but only for firms with above-average technology
• Negative spillovers (market stealing): Javorcik (2004) finds negative horizontal spillovers in Lithuania (FDI competes with domestic firms) but positive backward spillovers (domestic suppliers benefit from MNC demand)
• Conditional spillovers: the magnitude and direction of spillovers depend on the technology gap between MNCs and domestic firms, the absorptive capacity of domestic firms, and the degree of competition

Common Pitfalls

• Confusing the current account with the capital account. The current account records trade in goods/services, income, and transfers; the capital account records financial flows
• Assuming a current account deficit is always bad. It may reflect strong domestic investment opportunities attracting foreign capital
• Forgetting that the balance of payments must sum to zero (current account + capital account + financial account + errors & omissions = 0)
• Confusing FDI (long-term investment in productive capacity) with portfolio investment (short-term financial asset purchases)
• Ignoring the relationship between the current account and the savings-investment gap ($CA = S - I$)

Summary

• The balance of payments records all international transactions; it consists of the current account, capital account, and financial account
• The current account includes trade in goods and services, primary income, and secondary income (transfers)
• FDI involves long-term investment in productive capacity; portfolio investment is shorter-term
• A current account deficit must be financed by a capital/financial account surplus
• Multinational corporations can bring technology transfer and employment but may also exploit labour and repatriate profits
• Key calculations: current account balance, trade balance, net factor income