Posted by Connie R. Aponte on August 15, 2014 in INTERNATIONAL CAPITAL |

Effects of Derivatives on Interpretation of BOP Accounting

Among the rationales of balance of payments accounting is to ascertain the stability of capital flows of on-balance sheet movements of assets. Typically, balance of payments accounting data are used to measure how long capital will remain in a country—to distinguish “good” money from hot money. Various categories of the capital accounts have been interpreted as indicative of the nature of capital inflows or outflows. Foreign direct investment, for example, has been considered a more stable form of investment than portfolio investment or the foreign acquisition of bank claims.

Foreign acquisition of short term fixed interest products is generally regarded as a speculative flow. Balance of payments accounts are also used to measure the foreign exchange position of a country’s consolidated balance and, in times of crisis, to determine the potential outflow of foreign exchange through speculation or covering operations by holders of domestic liquid assets.

The revolution in global finance and notably the explosion in the use of derivative products have rendered the use of balance of payments capital account data even more problematic than it has been in the past. Balance of payments accounting data use on-balance ‘ sheet categorizations, and they are based on value accounting principles to book and categorize asset values. They ignore almost completely the existence of derivatives and their role in reallocating who bears market risk. This would not be a problem of a magnitude greater than the normal caveats on balance of payments accounting data except that there has been a massive explosion in the use of derivative products and especially in the use of cross-border products.

For example, the acquisition of a large block of equity is classified as foreign direct investment, but a foreign buyer may be acquiring the block simply to hedge a short position in equity established through a derivative position. In the case of the equity swap described above, the foreign investment firm that sells the swap must acquire the shares to form a hedge. If the swap is large enough, the hedging operation may be booked as foreign direct investment because the offshore swap position is not included in the capital accounts, although the investment house in fact is making a short term floating rate loan in foreign currency.

Declines in equity values or exchange rate will then generate instantaneous exchange market pressure as margin calls are made or positions are closed. This is contrary to the general view among central banks that stock market investment will not likely generate exchange market pressure in a crisis because the losses will already have been absorbed in a resultant crash. Stock market money is therefore regarded as less “hot.” If the buyer of the swap is a domestic resident’, the capital import effectively takes the form of short term, foreign currency denominated borrowing, but the leveraged equity risk, and even the long term control, remains in the hands of the domestic resident. Thus, the “direct investment” turns into the hottest of money. In a similar manner, direct investment in the form of reinvestment of profits can be converted into short term funding through an equity swap. payday loan companies

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