Balance of Payments: Analysis and Forecasting Thorvaldur Gylfason Tunis, February 2006

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.Balance of payments forecasting –How to forecast exports, imports, capital flows, etc.

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., in 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 Five main financing 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 Convenient to measure gross foreign reserve holdings in terms of months of import coverage – e.g., 3 months 5.Exceptional financing Debt rescheduling Debt rescheduling Accumulation of payments arrears Accumulation of payments arrears

Overall balance of payments Five ways to finance a BOP deficit 1.Drawing on gold reserves 2.Using SDRs 3.Using IMF resources 4.Running down foreign exchange reserves … by running down foreign assets or accumulating foreign liabilities … by running down foreign assets or accumulating foreign liabilities 5.Resorting to exceptional financing Deferring debt repayments via rescheduling or accumulation of external arrears Deferring debt repayments via rescheduling or accumulation of external arrears

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 = Y – C – T = 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 where Y f > 0 GNP > GDP in Turkey where Y f > 0 GNP < GDP in Argentina where Y f < 0 GNP < GDP in Argentina where Y f < 0 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 Two sides of the same coin

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 Q unchanged Real exchange rate

Foreign exchange Real exchange rate Imports Exports Overvaluation Deficit Overvaluation R R moves when e is fixed If not, e moves Fixed vs. flexible e

Foreign exchange Price of foreign exchange Supply (exports) Demand (imports) Overvaluation Deficit Overvaluation works like a price ceiling Overvaluation, again Excess demand for foreign exchange makes its price rise

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 under a flexible exchange rate Balance of payments equilibrium

Balance of payments adjustment and policy Price level GNP Aggregate supply Aggregate demand P Y Equilibrium An increase in prices induces producers to produce more, so that aggregate supply increases An increase in prices induces consumers to buy less, so that aggregate demand decreases

Experiment: Export boom Price level GNP AS AD

GNP AS AD AD’ A B Exports increase, so that aggregate demand expands Experiment: Export boom

Price level GNP AS AD Excess demand drives prices up AD’ A B C Experiment: Export boom

Price level GNP AS AD AD’ A B As the price level rises, so does GNP along the upward-sloping AS curve Experiment: Export boom

An export boom stimulates aggregate demand because Y = C + I + G + X - Z Therefore, all other comparable boosts to aggregate demand will have same effect: Consumption C (e.g., through lower taxes) Investment I (e.g., via lower interest rates) Government spending G (directly!) GNP will rise when AD increases as long as AS curve slopes up Comment on experiment

Economic policy instruments Exogenous variables n n Fiscal policy: Government spending, taxes n n Monetary policy: Money, credit, interest rates n n Exchange rate policy: Exchange rate (if fixed) n n Structural policy: Liberalization, privatization, etc. Economic objectives or targets Endogenous variables n n GNP level or growth n n Price level or inflation n n Employment, unemployment n n BOP, exchange rate (if flexible), external debt Economic policy Demand management Supplymanagement

Apply policy instruments to attain given economic objectives External balance External balance: conduct monetary, fiscal, and exchange rate policy so as to make the balance of payments position sustainable Key to financial programming Not only crisis management in short run Internal balance Internal balance: conduct policy so as to foster rapid, sustainable economic growth with low inflation and unemployment Key to economic and social prosperity Aims of economic policy

Price level GNP AS AD M up; G up; t down; e down W up Internal balance The AS schedule is the economy’s cost curve Wages are an important part of domestic cost of production

Price level GNP AS AD M up; G up; t down A B An increase in M or G or a decrease in t increases both Y and P for given W AD’ Credit expansion

Price level GNP AS AD W up AS’ A B An increase in W increases P, but reduces Y An increase in the price of imported oil has the same effect: stagflation Wage increase

Price level GNP AS AD e down W up AD’ AS’ A B When e decreases, W often also rises, so that P increases, but Y may either rise or fall. Even if W stays put, AS will shift to the left as devaluation raises the price of oil and other imported inputs. Devaluation

Effects of changes in policy and wages: An overview GtMeW Y+ P+

GtMeW Y+- P+-

GtMeW Y+-+ P+-+

GtMeW Y+-+-(?) P+-+-

GtMeW Y+-+-(?)- P+-+-+

Price level GNP AS AD Balance of payments adjustment I A Suppose, at A, there is a deficit in the balance of payments (B  0) Then, to reduce deficit, consider lowering e (devaluation) to strengthen current account: this increases demand (shifts AD right) M or G down, t up e or F up End result is still point A, but now with balance of payments equilibrium (B = 0). Level of GNP is unchanged, but its composition has changed. Need to offset increase in demand by reducing M or G or raising t to prevent inflation from weakening B again

Price level GNP AS AD Balance of payments adjustment II A Suppose, at A, there is a deficit in the balance of payments (B  0) Then, to reduce deficit, consider reducing M or G or raising t to reduce demand (shift AD left) M or G down, t up e down End result is still point A, but now with balance of payments equilibrium (B = 0). Level of GNP is unchanged, but its composition has changed Can offset decrease in aggregate demand by lowering e

Price level GNP AS AD Balance of payments adjustment III A M or G down, t up e down Choice among alternative policy packages depends on initial position  If reserves are low and output is low (unemployment is high), devaluation may be advisable  If reserves are low and inflation is high, monetary and fiscal restraint may be in order  As a rule, do both at once

Task at hand  Develop financial program for 2000  Use information available up to 1999, plus forecasts Two steps  Prepare baseline scenario assuming unchanged economic policy  If baseline scenario is unsatisfactory, then design financial program with better policies and better results Balance of payments forecasting 3 The baseline scenario is a financial program, based on policies already in place

To prepare baseline scenario, need to complete four sets of forecasts  National income accounts Inflation, growth Inflation, growth  Balance of payments accounts Exports, imports, capital flows, reserves Exports, imports, capital flows, reserves  Fiscal accounts Government spending, tax revenues, credit Government spending, tax revenues, credit  Monetary accounts Money, credit, foreign reserves Money, credit, foreign reserves Financial programming framework Mutually consistent, or interlocking, forecasts

For example, based on what we know in 1999, what will BOP be in 2000?  Exports  Imports Including interest payments on foreign debt Including interest payments on foreign debt  Capital flows Including foreign borrowing and FDI Including foreign borrowing and FDI  Reserve movements Including target for reserves Including target for reserves Financial programming framework

Exogenous vs. endogenous variables  All variables are endogenous, but some are more endogenous than others Key exogenous BOP variables  Exports  Capital inflows  Reserves (target) Chief endogenous BOP variable  Imports Role of forecasting

Forecasts of exogenous variables enable us to forecast endogenous variables For example, once we have forecast X, F, and  R, we can derive the forecast of Z as a residual: Z = X + F –  R Forecast of Z needs to be consistent with forecasts of inflation and growth Role of forecasting

History and targets  Record history, establish targets Forecasting  Make forecasts for balance of payments, output and inflation, money Policy decisions  Set domestic credit at a level that is consistent with forecasts as well as foreign reserve target Role of forecasting

1)Make forecasts, set reserve target R * –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual D = M – R * Financial programming step by step Do this in the right order

Known at beginning of program period: M -1 = 800, D -1 = 650, R -1 = 150 Recall: M = D + R X -1 = 700, Z -1 = 800, F -1 = 150 Recall:  R = X – Z + F So,  R -1 = 700 – = 50 So,  R -1 = 700 – = 50 Current account deficit, overall surplus Current account deficit, overall surplus R -1 /Z -1 = 150/800 = Equivalent to 2.25 months of imports Equivalent to 2.25 months of imports Weak reserve position Weak reserve position History 2.25 months = 9 weeks

X grows by 10%, so X = 770 F increases by 20%, so F = 180 Suppose R * is set at 220, up from 150 Level of imports is consistent with R * is Z = X + F + R -1 – R * = – 220 = 880 Reserve target is equivalent to 3 months of imports R * /Z = 220/880 = 0.25 Forecast for balance of payments BOP fore- casts

Increase in Z from 800 to 880, i.e., by 10%, is consistent with R * equivalent to 3 months of imports Now, recall that Z depends on PY where P is price level and Y is output Hence, if income elasticity of import demand is 1, PY can increase by 10% E.g., 3% growth and 7% inflation E.g., 3% growth and 7% inflation  Depends on aggregate supply schedule Forecast for real sector

If PY can increase by 10%, then, if income elasticity of money demand is 1, M can also increase by 10% Recall quantity theory of money MV = PY Constant velocity means that %  M = %  PY = %  P + %  Y Hence, M can expand from 800 to 880 Forecast for money ˜ M = D + R Recall M = D + R

Having set reserve target at R * = 220 and forecast M at 880, we can now compute level of credit that is consistent with our reserve target So, D = 880 – 220 = 660, up from 650  D/D -1 = 10/650 = 1.5% Restrictive: implies decline in real terms Restrictive: implies decline in real terms Need to divide permissible credit expansion between public sector and private sector Need to divide permissible credit expansion between public sector and private sector Determination of credit

Financial programming step by step: Recap Sequence of steps R * Z Y M D Z = X + F + R -1 – R * Z = mPY MV = PY D = M – R * Notice that Z now means nominal imports, not real imports as before Forecasts of X and F play a key role: Lower forecasts mean lower D for given R *

Need BOP forecasts to be able to design financial programs Specifically, need forecasts of  Exports (exogenous)  Imports (endogenous)  Capital movements (exogenous) Forecasts must be consistent with economic developments at home and abroad, and with one another Forecasting

From supply side, disaggregate View main categories of exports separately View main categories of exports separately Obtain price forecasts from international organizations, industry groups Obtain volume forecasts by surveying domestic producers. Recall that supply depends on price  Exports of coffee: P c X c  Exports of tea: P t X t  Exports of rice: P r X r Total exports: PX = P c X c + P t X t + P r X r Total exports: PX = P c X c + P t X t + P r X r Forecasting exports 1 Small country assumption: Export prices are exogenous

Divide through export equation by X to get expression for export price P P = (X c /X)P c + (X t /X) P t + (X r /X) P r Hence, aggregate export price index is a weighted average of export prices for individual commodities, with weights reflecting their relative importance to total exports Forecasting exports 1

From supply side, another method without disaggregation Forecasting exports 2 Standard supply equation: Supply depends on relative price as well as output capacity X = export volume (real exports) e = nominal exchange rate (kw/$) p x = price of exports in $ p d = price of domestically produced goods in kw Y = output capacity at home ++ Now defined as price of foreign exchange

Forecasting exports 2 a = income elasticity of exports b = price elasticity of exports General formulation Exponential formulation with price and income effects expressed as elasticities

Forecasting exports 2 a = income elasticity of exports b = price elasticity of exports General formulation Exponential formulation with price and income effects expressed as elasticities

Forecasting exports 2 Why?

So, if x rises by 15%, z rises by 10%, and w rises by 5%, then y rises not by 20% but by 20.5% because (115*110/105) = Simpler formula works only for small changes

Digression on arithmetic real rate of interest Suppose nominal interest rate is 50% (i = 0.5) and rate of inflation is 200% (  = 2). What, then, is the real rate of interest? No, it is -50% -150% ?!

From demand side, yet another method without disaggregation Forecasting exports 3 Standard demand equation: Demand varies inversely with relative price and directly with income X = export volume (real exports) p x = price of exports in $ P w = price of similar goods in world markets in $ Y w = world demand -+

Forecasting exports 3 a = income elasticity of exports b = price elasticity of exports Similar story as before Where to get elasticities? Estimate them from available data or borrow them from comparable countries

From demand side, without disaggregation Forecasting imports 1 Standard demand equation: Demand varies inversely with relative price and directly with income Z = import volume (real imports) e = nominal exchange rate (kw/$) p z = price of imports in $ p d = price of domestically produced goods in kw Y = domestic demand (GNP) -+ Now defined as price of foreign exchange

Forecasting imports 1 m = income elasticity of imports c = price elasticity of imports General formulation Exponential formulation with price and income effects expressed as elasticities

Forecasting imports 1 Similar story as before

From supply side, without disaggregation Forecasting imports 2 Standard supply equation: Supply varies directly with relative price and with income Z = import volume (real exports) p z = price of imports in $ p w = price of similar goods in world markets in $ Y w = world output capacity ++

Principles are the same as for goods Service exports (e.g., travel receipts) depend on income abroad and relative prices Service exports (e.g., travel receipts) depend on income abroad and relative prices Service imports (e.g., transportation) depend on income at home and relative prices Service imports (e.g., transportation) depend on income at home and relative prices Interest payments reflect multiple of foreign debt outstanding and interest rate payable on the debt Interest payments reflect multiple of foreign debt outstanding and interest rate payable on the debt Transfers, private and public, depend on past trends, income abroad, official commitments, special relationships (e.g., EU) Transfers, private and public, depend on past trends, income abroad, official commitments, special relationships (e.g., EU) Forecasting services

This is more difficult Foreign borrowing: depends on plans of domestic authorities, commitments of foreign lenders, interest rates at home and abroad Foreign borrowing: depends on plans of domestic authorities, commitments of foreign lenders, interest rates at home and abroad Foreign direct investment: depends on domestic market size, labor skills, investment and export opportunities, macroeconomic stability, track record, growth prospects, stability and transparency of regulations Foreign direct investment: depends on domestic market size, labor skills, investment and export opportunities, macroeconomic stability, track record, growth prospects, stability and transparency of regulations Errors and omissions: depends on trends, political and economic events Errors and omissions: depends on trends, political and economic events Forecasting capital flows

Forecasting reserves The End This is easy Baseline scenario: reserve movements are simply the sum of the current account and the capital account: Baseline scenario: reserve movements are simply the sum of the current account and the capital account:  R = X – Z + F Financial program: reserve movements are a policy variable, programmed so as to meet a given target of reserves at the end of the program period, set, e.g., in terms of months of import coverage Financial program: reserve movements are a policy variable, programmed so as to meet a given target of reserves at the end of the program period, set, e.g., in terms of months of import coverage These slides will be posted on my website: