International Finance — The Balance of Payments, the Marshall–Lerner Condition and the J-Curve

International Finance — The Balance of Payments Records Every Transaction Twice

The balance of payments records transactions between residents and non-residents over a period. If export proceeds are received and deposited abroad, a goods export and the acquisition of a financial asset are recorded together. Because of double-entry bookkeeping, the accounts as a whole balance in accounting terms, including errors and omissions.

1. The current and financial accounts are not moral scores of surplus and deficit

Through the national accounts identity, the current account is linked to the gap between domestic saving and domestic investment.

A deficit caused by high-productivity investment and one caused by overconsumption or fiscal imbalance have different long-run meanings.

2. For depreciation to improve the trade balance, quantities must respond enough

Under simple conditions — export and import prices set in their own currencies and initially balanced trade, among others — a depreciation of the domestic currency improves the trade balance only if the sum of the absolute price elasticities of export and import demand exceeds 1.

If the export elasticity is 0.7 and the import elasticity 0.5, the sum is 1.2 and the long-run condition for improvement is met. If they are 0.3 and 0.4, the sum is 0.7, and after a depreciation the trade balance can worsen depending on foreign-currency prices and contract terms.

3. The J-curve is the lag in contracts and volume adjustment

Right after the exchange rate jumps, existing contract volumes may stay the same while only the won price of imports rises. Over time, as consumers find substitutes and firms change production and distribution networks, export and import volumes respond and the current account can improve. The explanation is that the path over time looks like a J.

But the J-curve does not appear in every country and period. Dependence on imported intermediates, the share of foreign-currency invoicing, firms’ exchange-rate pass-through, supply constraints and global demand change the path.

4. Do not read simultaneous moves in the exchange rate and current account as simple causation

A recession can cut imports and, through risk aversion, push up the exchange rate at the same time. The correlation between the rise in the exchange rate and the improvement in the current account then includes the fall in domestic demand, not just the price effect of depreciation. Without identifying the underlying shock, one cannot conclude that “a weak currency created the surplus”.

5. In the statistics, check the compilation standard and sign conventions first

Revisions of the balance of payments manual can change the classification of the capital and financial accounts and sign conventions. Distinguish monthly and quarterly preliminary figures from final annual figures, and check whether data are seasonally adjusted.

The next chapter analyses how fiscal and monetary policy differ under different exchange-rate regimes in the open-economy IS-LM-BP model.

Check your understanding

If domestic saving is 34% of GDP and domestic investment 30%, the current account is about +4% of GDP. If saving stays the same but high-productivity equipment investment raises the investment rate to 36%, the current account turns to −2%. Even the same deficit should be read differently when it comes from higher investment rather than overconsumption. Whether this deficit is sustainable depends on how much the investment raises future exports and income.

References

• Bank of Korea, Economic Statistics System ECOS
• IMF, Balance of Payments Manual
• World Bank, World Development Indicators