National Finances March 27, 2013

Nations’ Financial Positions A nation’s financial position can be understood both in absolute terms and in terms relative to other countries. In both dimensions, a country’s position may change over time, and do so quite dramatically. Sometimes, such shifts in financial position also signal changes in wealth, but a nation’s financial position is not always equal to its wealth. For example, the US is now in a poor shape in terms of finances. However, its wealth, as measured in annual terms and in terms of its tangible and intangible wealth is still very, very large.

Measures of National Financial Position Balance of payments: the IMF definition of the summary financial position of a nation, composed of the current account, capital flows and changes in reserves. Current account: mostly constituted by the balance of trade that shows the relationship between the value of imports vs. the value of exports. If the value of imports exceeds that of exports for a reporting period, the current account will show a deficit, and if the reverse, it will show a surplus. Also part of the current account are the balance of government transactions (the purchasing and selling of goods and services), foreign aid grants, and remittances: funds sent to the home country by corporations or individuals located outside the country.

Capital Flows Total investments and loans foreigners citizens, corporations and governments make in a country minus the investments and loans that a nation’s citizens, government and corporations make in other countries. Made up of foreign direct investment: ownership of tangible property, such as real estate, corporations or manufacturing facilities, and indirect portfolio investment: holding of stocks, bonds or the making of loans. Thus, net capital flows can be made up in various ways, depending on the balance of foreign investment in one’s country and the amount of foreign investment one’s citizen’s make in other countries.

Capital Flows Impacts: it is generally good that a state has positive capital flows because such flows tend to stimulate economic activity by making capital available for start ups, expansion, research and development and other uses. However, a large proportion of foreign investment that constitutes a positive capital flow will result in large going outside the country, thus negatively impacting the current account. Large investments outside the nation that would lead to a negative flow might starve a nation of necessary capital, but help its current account. Large, unregulated inflows of capital seeking high returns may also have harmful effects, such as raising interests rates, the inflation of an economic bubble, and the threat that such capital may suddenly be pulled. Such large inflows are sometimes called hot money.

Financial Measures The overall balance of payments is reflected in changes in foreign exchange reserves. A negative balance of payments results in a nation having to draw upon its reserves to make up the difference by selling SDR’s or paying over hard currency. A positive balance of payments will result in a nation adding to its foreign exchange reserves. Question: what is the balance of payments situations of: The US? Taiwan? The PRC?

Wealth and Debt Standing wealth: the amount of wealth a country possesses at any one time: Foreign currency reserves Value of infrastructure Capital goods, such as factories and machinery Homes, cars and other items held by individuals Countries can also, like individuals, accumulate debts by borrowing money to: Pay for a trade deficit Pay the differences between citizens’ consumption and their income To finance government-sponsored economic stimulus programs by means of Keynesian deficit spending in the national budget– spur growth by stimulating demand in the economy.

International Debt Sometimes countries borrow from their own citizens to pay for national budget deficits or deficits in the balance of payments. But more often they finance their debts internationally by selling bonds on the international market or arranging loans from consortia of banks or from the IMF. If they are unable to meet the obligations of a loan, in the form of interest and principal repayments, then they may need to: a)Refinance the debt: find some way of rolling it (negotiate a new loan to pay off the old loan) over to ease current payments in favor of higher payments in the future, or perhaps at a lower rate of interest (the rates for borrowing money).

International Debt b) Default: acknowledgment that a country cannot repay debt and therefore cannot make payments. 1) Lenders and investors settle for some fraction of the debt (haircut) 2) Arrange for another institution to help with the debt by negotiating with lenders and providing capital assistance in tandem with efforts by the country to arrange financing through additional taxation (bailout). Why did the Eurozone countries and the IMF provide a bailout of Greece and Cyprus? Results in the inability to use the foreign financial markets for some period of time because investors will not risk lending their money.

Relative Positions in the World US: Militarily most powerful Largest economy in the world Hard currency Most technologically advanced in important areas It is, therefore, in generally good shape. However, it is not as powerful economically as it once was in terms of its relative position in the world economy. That is, relatively speaking, it is a declining power and has been since its peak in the early 1950s.

US Early 1950s: US economy twice as large as the next six largest combined. Held half of the world’s financial reserves. Large trade and balance of payments surplus. 1980: Share of world economy half that in 1950s. Held less than ten percent of the world’s financial reserves. Beginning of long-term trade and balance of payments deficits. Beginning of persistent budget deficits 1990s, 2000s: did well immediately after the end of the Cold War, but began experiencing economic problems in early 2000s that were deepened by 9/11 and subsequent wars in Iraq and Afghanistan. Banking sector failure in 2009, and consequent deeper budget deficits. National debt: the cumulative amount of debt a nation owes as a result of deficit spending in the national budget: rose from $1 trillion early 1980s, to $3 trillion by the end of the 1980s, to 15 trillion in GDP is about 15.8 trillion. Current account deficit: about $ billion annually

Source: Daniel Kurz, CFA Institute

US vs. PRC, India, Germany, Russian Federation and Brazil, GDP