Balance of Payments: Accounting and Analysis Thorvaldur Gylfason

Outline 1.Balance of payments accounting –How BOP accounts are put together and how they relate to monetary, fiscal, and national income accounts 2.Balance of payments analysis –Economics of exports, imports, exchange rates, etc. 3.Current account sustainability –Foreign debt, and how to keep it in check

Accounting system for macroeconomic analysis in four parts 1.Balance of payments 2.National income accounts 3.Fiscal accounts 4.Monetary accounts First look at balance of payments accounts, and then look at linkages Balance of payments accounting 1

External transactions GoodsServicesCapital Exports XgXgXgXg XsXsXsXs FxFxFxFx Imports ZgZgZgZg ZsZsZsZs FzFzFzFz Examples Real transactions Financial transactions

Balance of payments BOP = X g + X s + F x – Z g – Z s – F z = X – Z + F = current account + capital account Here X = X g + X s Exports of good and services Z = Z g + Z s Imports of good and services F = F x – F z Net exports of capital = Net capital inflow Net capital inflow Recording external transactions

Balance of payments BOP = X g + X s + F x – Z g – Z s – F z = X – Z + F = current account + capital account Here X = X g + X s Exports of good and services Z = Z g + Z s Imports of good and services F = F x – F z Net exports of capital = Net capital inflow Recording external transactions

Balance of payments BOP = X g + X s + F x – Z g – Z s – F z = X – Z + F = current account + capital account Here X = X g + X s Exports of good and services Z = Z g + Z s Imports of good and services F = F x – F z Net exports of capital = Net capital inflow Recording external transactions

Balance of payments BOP = X g + X s + F x – Z g – Z s – F z = X – Z + F = current account + capital account Here X = X g + X s Exports of good and services Z = Z g + Z s Imports of good and services F = F x – F z Net exports of capital = Net capital inflow Recording external transactions

Again =  R BOP = X – Z + F =  Rwhere R = reserves Note: X, Z, and F are flows R is a stock,  R is a flow Balance of payments and reserves  R = R – R -1

Again =  R BOP = X – Z + F =  R where  R = R – R -1 Implications X  R F  R Z  R In practice Z F or  R Balance of payments and reserves

From trade balance to current account nTrade balance TB = X g + X nfs – Z g – Z nfs X nfs = X s – X fs = exports of nonfactor services Z nfs = Z s – Z fs = imports of nonfactor services nBalance of goods and services GSB = TB + Y f Y f = X fs – Z fs = net factor income nCurrent account balance CAB = GSB + TR = TB + Y f + TR TR = unrequited transfers from abroad

Importance of net factor income Net factor income from labor –Remittances from domestic workers abroad (e.g., Turks in Germany) minus those of foreign workers at home Net factor income from capital –Interest receipts from domestic assets held abroad minus interest payments on foreign loans (e.g., Argentina) –Includes also profits and dividends Transfers also matter Y f > 0 in Turkey Y f < 0 in Argentina

Capital account Also called capital and financial account Four main items 1.Direct investment –Involves control by owners 2.Portfolio investment –Includes long-term foreign borrowing –Does not involve control by owners 3.Other investment –Includes short-term borrowing 4.Errors and omissions –Statistical discrepancy

Overall balance of payments Four main items below the line 1.Gold 2.SDRs 3.Reserve position in IMF 4.Foreign exchange Convenient to measure gross foreign reserve holdings in terms of months of import coverage – e.g., 3 months of imports Convenient to measure gross foreign reserve holdings in terms of months of import coverage – e.g., 3 months of imports

Y = C + I + G + X – Z = E + X – Z where E = C + I +G CAB = X – Z = Y – E Ignore Y f and TR for simplicity S = I + G – T + X – Z CAB = S – I + T – G CAD = Z – X = E – Y = I – S + G – T National income accounts Private sector deficit Public sector deficit

Y = C + I + G + X – Z GDP = C + I + G + TB GNP = C + I + G + CAB GNP – GDP = CAB – TB = Y f (if TR = 0) GNP = GDP + Y f GNP > GDP in Turkey GNP > GDP in Turkey GNP < GDP in Argentina GNP < GDP in Argentina GNDI = GNP + TR = GDP + Y f + TR Links between BOP and national accounts

Y X - Z Definition GDP Trade balance Goods and nonfactor services

Links between BOP and national accounts Y X - Z Definition GDP Trade balance Goods and nonfactor services GNP Current account excl. transfers Goods and services

Links between BOP and national accounts Y X - Z Definition GDP Trade balance Goods and nonfactor services GNP Current account excl. transfers Goods and services GNDI Current account incl. transfers Goods and services plus transfers

Fiscal accounts and links to BOP  Public sector G – T =  B +  D G +  D F  Private sector I – S =  D P –  M –  B Now, add them up G – T + I – S =  B +  D G +  D F +  D P –  M –  B =  B +  D G +  D F +  D P –  M –  B =  D G +  D F +  D P –  M =  D G +  D F +  D P –  M =  D –  M +  D F = -  R +  D F = Z - X  D –  M +  D F = -  R +  D F = Z - X  External sector X – Z =  R -  D F M = D + R D G + D P = D X – Z + F =  R F =  D F

Monetary accounts and links to BOP Monetary survey M = D + R From stocks to flows  M =  D +  R Solve for  R  R =  M –  D Monetary approach to balance of payments Still holds that  R = X – Z + F

Foreign exchange Real exchange rate Imports Exports 2 Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium Balance of payments analysis

Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Increase in Q means real appreciation e e refers to foreign currency content of domestic currency Real exchange rate

Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave R unchanged Real exchange rate

Foreign exchange Real exchange rate Imports Exports Overvaluation Deficit Overvaluation R R moves when e is fixed

Foreign exchange Price of foreign exchange Supply (exports) Demand (imports) Overvaluation Deficit Overvaluation works like a price ceiling Overvaluation, again

Supply Demand E Producersurplus Consumersurplus Quantity Price A B C Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) Welfare  R = 0, so R is fixed when e floats

Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss equivalent to the triangle EFG A B C Consumer surplus = AFGH H J Producer surplus = CGH Total surplus = AFGC Welfare, again

Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss that results from shortage (e.g., deficit) A B C H J Shortage Welfare, again

Governments may try to keep the national currency overvalued To keep foreign exchange cheap To have power to ration scarce foreign exchange To make GNP look larger than it is Other examples of price ceilings Negative real interest rates Rent controls Causes and costs of overvaluation

Inflation can result in an overvaluation of the national currency Remember: R = eP/P* Suppose e adjusts to P with a lag Then R is directly proportional to inflation Numerical example Inflation and overvaluation

Time Real exchange rate Average Suppose inflation is 10 percent per year Inflation and overvaluation

Time Real exchange rate 110Average Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Suppose inflation rises to 20 percent per year Inflation and overvaluation

How to correct overvaluation Under a floating exchange rate regime Adjustment is automatic: e moves Under a fixed exchange rate regime Devaluation will lower e and thereby also Q – provided inflation is kept under control Does devaluation improve the current account? The Marshall-Lerner condition

The Marshall-Lerner condition: Theory e T = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps T Let’s do the arithmetic Bottom line is: Devaluation improves the current account as long as Suppose prices are fixed, so that e = Q a = elasticity of exports b = elasticity of imports Valuation effect arises from the ability to affect foreign prices

The Marshall-Lerner condition 11 ab - + Export elasticity Importelasticity

The Marshall-Lerner condition if X

The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, Devaluation improves the current account

Empirical evidence from developing countries Elasticity of exportsimports Argentina Brazil India Kenya Korea Morocco Pakistan Philippines Turkey Average1.11.5

Small countries: A special case Small countries are price takers abroad Devaluation has no effect on the foreign currency price of exports and imports So, the valuation effect does not arise Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged Hence, if a > 0 or b > 0, devaluation improves the current account

The importance of appropriate side measures Remember: It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation To work, nominal devaluation must result in real devaluation

Equilibrium between demand and supply in foreign exchange market establishes Equilibrium real exchange rate Equilibrium in the balance of payments BOP = X + F x – Z – F z = X – Z + F = current account + capital account = 0 Balance of payments equilibrium

Current account sustainability and debt 3 There are two ways to finance a deficit on current account 1.Run down foreign reserves But there is a limit But there is a limit Rule of thumb: Do not bring reserves below three months of imports Rule of thumb: Do not bring reserves below three months of imports 2.Run up debts abroad Where is the limit? Where is the limit? Is foreign debt bad? Not necessarily if the borrowed funds are used for profitable investments

If the world interest rate is lower than the domestic interest rate, the country will be a borrower in world financial markets Domestic firms will want to borrow at the lower world interest rate Domestic households will reduce their saving because the domestic interest rate moves down to the level of the world interest rate Conceptual framework

Real interest rate 0 Saving, investment Saving Investment World interest rate World equilibrium Domestic saving Domestic investment Domestic equilibrium Borrowing Conceptual framework

0 Saving World interest rate Investment World equilibrium Domestic equilibrium A B C D Borrowing Conceptual framework Real interest rate Saving, investment

0 Saving Investment World equilibrium Domestic equilibrium A Consumer surplus before borrowing C B Producer surplus before borrowing Real interest rate Saving, investment Conceptual framework

0 Saving World interest rate Investment World equilibrium Domestic equilibrium A Consumer surplus after borrowing B D C Producer surplus after borrowing Borrowing Conceptual framework Real interest rate Saving, investment

The area D shows the increase in total surplus and represents the gains from borrowing Before tradeAfter tradeChange Consumer surplus AA + B + D+ (B + D) Producer surplus Producer surplusB + C C- B Total surplus Total surplusA + B + CA + B + C + D+ D Conceptual framework

Borrowers are better off and savers are worse off Borrowers are better off and savers are worse off Borrowing raises the economic well- being of the nation as a whole because the gains of borrowers exceed the losses of savers Borrowing raises the economic well- being of the nation as a whole because the gains of borrowers exceed the losses of savers If world interest rate is above domestic interest rate, savers are better off and borrowers are worse off, and nation as a whole still gains If world interest rate is above domestic interest rate, savers are better off and borrowers are worse off, and nation as a whole still gains Gains from trade: Three main conclusions

Debt stock Usually measured in dollars or other international currencies because debt needs to be serviced in foreign currency Debt ratio Ratio of external debt to GDP Ratio of external debt to exports nMore useful for some purposes, because export earnings reflect the ability to service the debt External debt: Key concepts

Debt burden Also called debt service ratio Equals the ratio of amortization and interest payments to exports q = debt service ratio A = amortization r = interest rate D F = foreign debt X = exports

Interest burden Ratio of interest payments to exports q = a + b Amortization burden Also called repayment burden Ratio of amortization to exports External debt: Key concepts

Magnitude of the debt Debt should not become too large How large is too large? Measurement of the debt Gross or net? May subtract foreign reserves in excess of three months of imports Composition of the debt FDI, portfolio equity, long-term loans, short-term loans External debt: Magnitude and composition

Composition of the debt Foreign direct investment Least likely to flee, most desirable Portfolio equity Long-term loans Short-term loans Most volatile, least desirable As a rule, outstanding short-term debt should not exceed foreign reserves External debt: Magnitude and composition Indonesia and Korea broke this rule in 1996

How can we figure out a country’s debt burden? Divide through definition of q by income Now we have expressed the debt service ratio in terms of familiar quantities: the interest rate r, the debt ratio D F /Y, and the export ratio X/Y as well as the repayment ratio A/Y External debt: Numbers

Suppose that r = 0.06 D F /Y = 0.50 A/Y = 0.05 X/Y = 0.20 Here we have a country that has to use 40% of its export earnings to service its external debt Heavy burden! Numerical example

Debt accumulation is, by its nature, a dynamic phenomenon A large stock of debt involves high interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on A large stock of debt involves high interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on Debt accumulation can develop into a vicious circle How do we know whether a given debt strategy will spin out of control or not? How do we know whether a given debt strategy will spin out of control or not? To answer this, we need a little arithmetic External debt dynamics

Recall balance of payments equation: BOP = X – Z + F where F = capital inflow =  D F where D F = foreign debt Capital inflow, F, thus involves an increase in the stock of foreign debt, D F, or a decrease in the stock of foreign claims (assets) So, F is a flow and D F is a stock External debt dynamics

Now assume Z = Z N + rD F Z = total imports Z N = non-interest imports rD F = interest payments Further, assume X = Z N BOP = 0 A flexible exchange rate ensures equilibrium in balance of payments at all times Then, it follows that BOP = X – Z +  D F = 0 so that  D F = rD F  D F = rD F In other words: External debt dynamics

So, now we have: Now subtract growth rate of output from both sides: External debt dynamics

But what is This is proportional change in debt ratio: ? This is an application of a simple rule of arithmetic: %  (x/y) = %  x - %  y External debt dynamics

z = x/y log(z) = log(x) – log(y)  log(z) =  log(x) -  log(y) But what is  log(z) ? So, we obtain Q.E.D. Proof

We have shown that where Debt ratio Time  r  g r = g r  g Need economic growth to keep the debt ratio under control Debt, interest, and growth

It is important to keep economic growth at home above – or at least not far below – the world rate of interest Otherwise, the debt ratio keeps rising over time External deficits can be OK, even over long periods, as long as external debt does not increase faster than output and the debt burden is manageable to begin with A rising debt ratio may also be OK as long as the borrowed funds are used efficiently Once again, high-quality investment is key What can we learn from this?

Let us now study the interaction between trade deficits, debt, and growth Two simplifying assumptions:  D t = aY t (omit the superscript F, so D = D F ) Trade deficit is constant fraction a of output Y t = Y 0 e gt Output grows at constant rate g per year Y t Exponential growth Debt dynamics: Another look

Y time Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate log(Y) time 1 g Pictures of growth

at time T Debt as the sum of past deficits

at time T Debt as the sum of past deficits

Evaluate this integral between 0 and T at time T Debt as the sum of past deficits

Evaluate this integral between 0 and T So, as T goes to infinity, D t becomes infinitely large. But that may be quite OK in a growing economy! at time T Debt as the sum of past deficits

So, as T goes to infinity, D T /Y T approaches the ratio a/g Debt as the sum of past deficits

Suppose Trade deficit is 6% of GNP a = 0.06 Growth rate is 2% per year g = 0.02 Then the debt ratio approaches d = a/g = 0.06/0.02 = 3 This point will be reached regardless of the initial position as long as a and g remain unchanged Debt ratio Time 3 Numericalexample

Suppose that r = 0.06 (as before) D/Y = 3 D/Y = 3 (our new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Here we have a country whose entire export earnings do not suffice to service its debts Heavy burden, indeed! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 2 D/Y = 2 (our new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Heavy burden, still! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 1 D/Y = 1 (new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Heavy burden, still! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 0.4 D/Y = 0.4 (new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Heavy burden, still! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 0.4 D/Y = 0.4 (as before) A/Y = 0.05 (as before) X/Y = 0.30 (new number) Heavy burden, but manageable! Numerical example, again

Must adjust policies Must either Reduce trade deficit by stimulating exports or by reducing imports, or Increase economic growth Otherwise, the debt ratio will reach unmanageable levels, automatically No country can afford an external debt equivalent to three times annual output What to conclude? d = a/g

Because the debt burden then becomes unbearable Recall our earlier numerical example Where we looked at the relationship between the debt ratio and the debt burden Korea is a case in point Its export-oriented growth strategy reduced the numerator and increased the denominator of the debt ratio, thereby quickly reducing the country’s debt burden An import-substitution strategy would reduce both numerator and denominator with an ambiguous effect on the debt burden And why not?

In conclusion The End External borrowing is a necessary and natural part of economic development This requires countries that borrow to invest the funds borrowed in high-quality capital This is necessary to be able to service the debt If debt burden becomes too heavy, must either reduce deficit or spur growth It is always desirable anyway to do everything possible to encourage economic growth Rapid growth allows more foreign borrowing without making the debt burden unmanageable These slides will be posted on my website: