INTERNATIONAL FINANCE IMQF course in International Finance Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

Introduction International finance – macroeconomic side of international economics (international macroeconomics) Examination of behaviour of monetary variables – quantity of money and various prices measured in currency units (wage rates, price levels, foreign exchange (FX) rates, etc.) Strong internationalization (globalization) of the economies in the last 50 years boosts importance of foreign sector Shift to market-based exchange rate regime (1973), oil prices volatility, integration of developing countries in global economy, EMU, currency crises New developments in macroeconomic theory: rational expectations in financial markets, credible commitment in monetary policy, intertemporal optimization of saving behavior, etc. By inserting foreing sector into analysis, important assumptions get altered Rigid (or „sticky“) prices and wages; free movement of capital; market-determined exchange rates, etc.

Outline of the Course Topics: Balance of payments accounts (Chapter 15) FX market and trade elasticities (Chapter 16) National income and trade balance (Chapter 17) Spending and the exchange rate in the Keynesian model (Chapter 18) Money supply, price level and the balance of payments (Chapter 19) Developing countreis and other small open economics with nontraded goods (Chapter 20) Mundell-Fleming model with partial international capital mobility (Chapter 22) Fiscal and monetary policy under modern financial market conditions (Chapter 23) Crises in emerging markets (Chapter 24.1 and 24.2) Supply and inflation (Chapter 26.1) Expectations, money and determination of FX rate (Chapter 27.1 and 27.2)

Lectures, Literature and Examination Normally Tuesday and Thursday starting at 18h Attendance is mandatory (up to 1 absence is accepted) Readings Caves, R., Frankel, J., and R. Jones, (2007) World Trade and Payments: an Introduction, 10th edition, Pearson International Edition Examination and grading Written exam – 100 points Classroom presentation – up to 10 points Clasroom discussion – up to 5 points Homework?

The Balance of Payments Accounts IMQF course in International Finance Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

Outline of the Chapter Balance of Payments Accounts Topics: Breakdown of accounts Recording individual transactions Double-entry bookkeeping Balances Statistical errors

Structure of the Economy Economy consists of four interconnected sectors: Real sector (production of goods and non-financial services) Financial sector (provision of financial services to other sectors) Government sector (provision of goods and services to individuals and companies) Foreign sector (exports and imports of goods and services, cross-border flows of capital)

The Balance of Payments - Breakdown of Accounts The Balance of Payments (BoP) accounts definition Statistical record of all economic transactions taking place between its residents and the rest of the world Three types of accounts within BoP: Current account (CA): record of trade in goods and services and other current transactions (no trade in assets) Private capital account (KA): record of assets traded among private entities Official reserve transactions account (ORT): record of trade in assets when at least on one side monetary authority (central bank) is involved

Breakdown of Accounts - Current Account Current Account (CA) components: Merchandise balance: account of trade in goods Services balance: transportation, tourism and business and professional services Investment income: interest, dividends, etc. …payment for the capital „working abroad“ (capital itself is recorded under KA) Unilateral transfers: government grants (foreign aid) and private remittances They appear under CA, not under KA, because they do not create any obligations in the future

Breakdown of Accounts - Private Capital Account Private Capital Account, i.e. Capital Account (KA) components: Foreign direct investments (FDI) When resident of one country acquire control over a business enterprise in another country (e.g. acquisition of more than 10% of shares within 1 year timeline)…otherwise, it is recorded under portfolio investments Greenfield vs brownfield Long-term portfolio investments: International transactions in financial assets with maturity greater than 1 year (securities, bank loans, etc.) Short-term capital flows International transactions in financial assets with maturity of less than 1 year (treasury bills, commercial papers, certificates of deposits, etc.)

Breakdown of Accounts - Official Reserve Transactions Official Reserve Transactions (ORT) components: Changes in foreign central bank’s holdings of domestic assets Changes in the domestic central bank’s holdings of foreign assets (gold, IMF credits and SDR, FX reserves)

Breakdown of Accounts Accounts Cumulative balance CURRENT ACCOUNT (CA) Merchandise …Merchandise balance Services - transportation - tourism - business and professional services …Balance of goods and services Investment income …Balance of goods, services and income Unilateral transfers - government grants - private remittances …Current account balance PRIVATE CAPITAL ACCOUNT (KA) Direct investment Portfolio investment - long term …Basic balance - short term …overall Balance of Payment OFFICIAL RESERVE TRANSACTIONS (ORT) Change in foreing CB holding of domestic assets Change in domestic CB holding of foreign assets - gold - IMF credit and SDRs - FX reserves

Recording Individual Transactions Key principle: whatever enters the country is recorded as debit (e.g. import), and whatever leaves the country is recorded as credit (e.g. export) How do we record in Serbia IT services, provided by Serbian IT company to the US-based electric power company? Gifts and other transfers recorded under unilateral transfers Remittances paid by Serbian migrants living in Austria to their relatives in Serbia: debit in Austria, credit in Serbia KA and ORT: acquisition of foreign assets – debit („import of assets from abroad“) and vice versa Direct investment made by Serbian company in B&H (debit in Serbia) Investment of Scottish bank in Serbia’s T-bills (credit in Serbia) When the National Bank of Serbia buys Euro, as a reserve asset (debit in Serbia)

Double-entry Bookkeeping Every transaction booked twice - debit and credit, because otherwise the BoP would imply that someone is giving up something for nothing Is there such case? Paying for imports (e.g. import of gas in Serbia from Russia) Debit: balance of goods, in Serbia Credit: short-term capital account, in Serbia (regardless if payment is in cash, bank cheque, or loan) Paying for asset purchases (e.g. German company buys a hotel in Serbia) Debit: banking flows in Serbia Credit: direct investment

The Balances Net flows usually matters more than gross flows Positive balance: when credit outweights debit e.g. positive trade balance – the country exports more than it imports -- Merchantilistic semantic Negative balance: when debit outweights credit The adding-up constraint: If country is running CA deficit and its ORT=0, than KA = -CA If KA=0, than ORT=-CA

The Balances BP reveals whether the country is spending beyond its means and whether there is net supply of foreign currency or net demand for domestic currency If BP is positive, the ORT is negative, i.e. the central bank is adding on its FX reserves If BP is negative, the ORT is positive, i.e. the central bank is selling FX reserves Negative Balance of trade in goods and services (deficit) can be financed either by: investment income and transfers borrowings and investments (KA) or reserve loss (ORT) Negative CA balance (deficit) can be financed either by investments/borrowings (KA) or by reserve loss (ORT) CA is autonomous, while KA and ORT are accomodating Negative BoP (deficit) can be financed by reserve loss (ORT) BP is autonomous, while ORT is accomodating

The Balances Balance of goods and services is the point of connection between the international payment statistics and national income accounts Balance of goods and services (X-M) is part of GDP Balance of goods, services and income Net exports of goods and services + net investment income Current account balance Net exports of goods and services + net investment income + net transfers BoP National accounts Balance of goods and services Gross domestic product Balance of goods, services and income Gross national product Current account balance Total national income

Accommodating Transactions? Traditional view: autonomous transactions (above the line) cause change in accommodating transaction CA and KA alter the ORT Modern view: as the exchange rate is floating (e.g. managed floating FX regime), can the change in ORT affect the CA? If a country is running short on reserves, will it reduce its import? If a country is running large KA surplus, will it be more prone to import? Case of Yugoslavia in early 1980s

Statistical Errors Statistics does not observe directly debit and credit side of the transaction some transactions are valued incorrectly or one side of transaction is ommitted Therefore, if debit does not equal credit, the difference between the sum of debit and the sum of credit is called „statistical discrepancy“ or „errors and ommissions“ e.g. unmeasured net inflow of money (capital flights going informally) What should be the World total sum of the current account balances?

EU: CA Statistics

Problem 1 (pp. 288) Transaction Debit Credit Effect on CA Effect on BoP US imports BMW from Germany; pays by check US tourists spend Swiss francs in Geneva US investor buys 2-year Canadian treasury note; pays by check China buys nuclear reactor from US; pays in gold (no CB involved) Dutch holding company buys controlling interest in an Americal firm; pays in dollars