National accounting in an open economy Gianni Vaggi April 2014

The components of GDP: closed and open economy Closed economy GDP ( Y ) is the sum of the following:  Consumption (C)  Investment (I)  Government expenditures (G) Y = C + I + G Open Economy plus Net Exports (NX) Y = C + I + G + NX

Saving, Investments and Trade  National saving S (private and public) is the income of the nation that is left after paying for current consumption and government purchases: S = Y - C - G = I + NX S = I + NX NX = (X – M) = Trade Balance or Balance of Goods and services For the moment suppose that NX is the only component of the Current Account of the BoP

Saving, Investments and Trade S – I = X – M (S p – I p ) + (T – G) = (X – M)  S p private savings  I p private investments  Ttaxes  Ggovernment expenditures

The Current Account Balance In the BoP the Current account balance (CA) is the sum of three items:  Trade balance (X-M),  Net income transfers (interest payments, dividends, etc.;)= Net Primary Income = NPI  Net unilateral transfers (gifts, donations, remittances, international aid, etc.)= Net Secondary Income = NSI

The Current Account Balance CA = [(X-M) + NPI + NSI] Sometimes (NPI + NSI) are called Net Factor Income = NFI and NPI is called Net Incomes and NSI is called Net transfers

The Financial and the Capital Account The Financial Account, FA, has largely absorbed what was formerly called the Capital account!! In the BoPCA + FA = 0 Current Account Balance + Financial Account Balance = 0 Net of Changes in reserves, R. The overall balance of payments also includes movements of Official reserves, if private transactions do not match exactly. Suppose: ∆R = 0. FA = NCF = Net Capital Flows NCF = (Inflows – Outflows)

The Current and Capital Accounts NCF can be +/- depending on CA If CA = +10thenFA = -10 Which means: Outflows >Inflows Therefore:NCF = -10 And CA = - NCF

The Equality of Current Account and Net Capital Flows For an economy as a whole CA, and NCF must balance: CA= [(X-M) +NPI+NSI] = FA (+/-) = NCF(+/-)  This holds true because every transaction that affects one side of the BoP must also affect the other side by the same amount.  In principle the sign of FA (+/-) depends on that of CA

Saving, Investment, and International Flows Y = C + I +G+[(X-M) + NPI + NSI] (S – I) = [(X-M) + NPI + NSI]= CA = FA= NCF Saving = Domestic Investment + Net Capital Flows S = I + NCF

Saving, Investment, and International Flows Investments may be financed either by national saving (S) or by foreign saving (NCF): I = S – NCF Remember that in general the sign of FA (+/-) and NCF depends on the Current Account Balance, CA,…BUT… with large international flows…

National accounting in an indebted open economy Gianni Vaggi April 2014

The national accounting in an indebted open economy Suppose D 0 = 100 to be repaid in 10 years and i = 5%, each year:  iD interest payments = 5  Δ D principal repayment = 10 iD + Δ D = DSDebt Service

The national accounting in an indebted open economy Remember : FA = NCF = Net Capital Flows = (Inflows – Outflows)  FA = [(Inflows - Other Outflows) - Δ D] = dD/dt Δ D<0 in an indebted economy Δ D is an outflow because debt must be repaid dD/dt is the change of the debt stock during the year, which depends also on inflows and other outflows in the FA.  CA = [(X-M) + (NPI – iD) + NSI]

The national accounting in an indebted open economy CA+FA = 0  Suppose an indebted economy where there are only foreign debt related flows: (Inflows - Other Outflows) = 0  and no other item in NPI and NSI other than – iD [(X-M) - iD] - Δ D = 0 (X-M) = iD + Δ D = DS Take the example: DS = = 15 (X-M) - iD = Δ D

The national accounting in an indebted open economy IF then IF the trade balance is 15 and exactly covers the debt service, then the overall debt decreases by Δ D = D 0 - D 1, according to the original scheduled payments or: - Δ D = = -10 = -dD/dt IF then IF the trade balance is 5 and covers interests only, then Δ D = 0 and the overall debt does not change: dD/dt=0 IF then IF the trade balance is less than 5 and, then the overall debt increases: dD/dt=>0

The Current Account Balance Now suppose there are other financial flows in the CA In the BoP the Current account balance (CA) is the sum of three items:  Trade balance (X-M)  Net income transfers (interest payments, dividends, etc.;)= Net Primary Income = NPI  Net unilateral transfers (remittances, international aid, etc.)= Net Secondary Income = NSI

The national accounting in an indebted open economy  Net primary income:  Interests on foreign debt  Dividends (on portfolio investments);  Earnings of FDIs, profit repatriation  Rents on land and natural resources;  Compensation of employees (cross-border workers).  Net secondary income:  Personal transfers (i.e. remittances);  Current) International cooperation,ODA

The national accounting in an indebted open economy Consider the following flows: -iD are outflows in NPI = -5 Compensation of employees are often included in remittances NSI includes- remittances - international aid, ODA

The national accounting in an indebted open economy Remember: [(X-M) + NPI + NSI ] = CA Current Account Balance and CA + FA = 0 [(X-M) - iD + NSI ] + (- Δ D ) = 0 [(X-M) + NSI ] = iD + Δ D = DS = 15

Debt sustainability - 1  D = overall foreign debt  Y = GDP  g n = (dY/dt)/Y is the nominal growth rate  Thresholds < 0  d(D/Y)/dt < 0 The latter: Domar 1944

Debt sustainability - 2 By total differentiation of D/Y: d(D/Y)/dt = [ (dD/dt)*Y - (dY/dt)*D ]/ Y 2 = (dD/dt)Y - [ (dY/dt)/Y ] * (D/Y) = (1/Y) [ dD/dt - g n * D ] But dD/dt = [i n D - (X – M)]

Debt sustainability - 3 i = (i n - dp/dt) and g = (g n - dp/dt) dp/dt inflation rate on debt d(D/Y)/dt = (i - g)D/Y - (X - M)/Y i, g are the real interest rate and the GDP growth rate d(D/Y)/dt = i n D/Y - g n D/Y - (X - M)/Y

Debt sustainability - 4 But there are also other financial flows: Current Account (CA)= [ (X-M) + NPI + NSI ] NICA = [CA – iD] = Non-Interest Current Account NICA = [CA – iD] = [(X-M) + NPI + NSI] - iD NICA largely depends on the trade balance, but not only.

Debt sustainability - 5 The correct sustainability formula is d(D/Y)/dt = (i - g)D/Y - NICA /Y

Debt sustainability – 6- and national public debt NICA is the equivalent for foreign debt of the concept of Primary surplus (net of interests) for domestic(public) debt (T – G) = Primary surplus [(T – G) – iD] (<0) = overall Fiscal Deficit = FD FD/Y must not exceed 3%