The Balance of International Payments
Last month’s column outlined the importance of exchange rates in affecting a country’s import and exports and hence, its trade balance. Exchange depreciation makes the country more competitive while appreciation makes it less competitive. Exports give rise to inpayments of funds, which are considered positive items, while imports result in outpayments which are considered negative items. U.S. imports are usually far greater than exports and as a result, the trade balance is in deficit, or negative, in most years.
But a country’s international transactions include more than just commodity trade. Apart from commodity trades, international transactions include services such as:
- Banking: where banks in one country provide services to customers in another country
- Insurance: where insurance companies in one country provide services and charge premiums to customers in another country
- Education: where students from one country study in educational institutions of another country
- Legal: where law firms from one country provide services to citizens or companies of another country
- Consulting: where consulting companies from one country provide services to companies of another country
In all cases, money flows in both directions. The transactions that gives rise to an inflow of money we count as an export and hence they are considered positive items. Transactions that result in an outflow of funds are counted as imports and therefore are valued as negative items. In most years, the U.S. had a large surplus (or positive balance) of service transactions, meaning that exports exceeded imports; but not as large as the negative trade balance. So when the two are combined to obtain a balance on goods and services, the outcome is negative in most years.
Finally, we add financial (capital) flows into the U.S., which is positive, and out of the U.S., which is negative, to obtain the total picture of U.S. economic transactions with the rest of the world. This statement is called the country’s Statement of International Transaction or its balance of payments. The same presentation is made for every country. For the U.S., in most years the net overall number is negative. In other words, the U.S. needs to pay out more dollars than it takes in so its balance of payments is negative.
How is that negative balance settled? For the most part, it is settled by debt — the U.S. owes the money to foreigners. In other words, over the years we accumulate debt in trillions of dollars to foreign governments and/or private entities, which is U.S. liability and foreigners’ assets. Much of the money is “invested” by foreigners in U.S. government bonds of various durations, considered the safest asset in the world. Foreign central banks count these bonds their international reserves; countries need such reserves to tide themselves over in situations of excessive deficits or debts to foreigners, sometimes resulting in financial crisis.
Since WWII, the U.S. dollar has been the prime mode of such reserves. Apart from reserves, the dollar also serves as an “international transactions currency,” meaning that many private transactions between people and companies in countries not involving the U.S. are financed in dollars and the prices of many international commodities, such as oil, are quoted in dollars. The dollar is more than just the currency of the U.S., it is an international reserve and transactions currency.
The suitability of the dollar to serve as an international reserve currency can be traced back to the post WWII era, when much of the world was in ruins and the U.S. was the only source of goods for post-war reconstruction and development. But the dollar remains so suitable for this purpose because:
- It is backed by the largest economy in the world.
- It is a stable currency in terms of prices of goods and services, because of U.S. price stability.
- The U.S. capital market is huge – foreign central banks can always place their funds in assets (such as bonds) that are convenient to them and sell such assets as they see fit.
- The U.S. goods, services and financial markets are open to the world and are free of restrictions.
While there have been discussions of other currencies such as the euro serving as reserve assets and some do, most assets like this are denominated in U.S. dollars. And people in most countries are aware of their currencies’ dollar exchange rates. Indeed, some countries attach or peg their currency to the U.S. dollar and fluctuate with it against the euro and the yen.
Finally, at the end of WWII the western powers convened a conference in Bretton Woods, N.H. to develop a postwar international financial system. They set up two institutions: The World Bank, to serve the development needs of developing countries and the International Monetary Fund (IMF) to oversee financial relationships, such as exchange rates, and provide loans to countries in financial need. Both institutions are located in Washington, D.C.