1 International Finance Chapter 6 Balance of Payments I: The Gains from Financial Globalization

2 Chapter Introduction Continuing our discussions on the balance of payments and net foreign wealth, in this chapter, we will try to gain some insight on: Constraints on international borrowing and lending Gains on consumption and investment for an open economy with a long-run view International diversification

3 Chapter Outline Long-Run Budget Constraint Gains on consumption smoothing Gains on efficient investment

4 Long-Run Budget Constraint How much a country can borrow? Instead of a static approach, we adopt a dynamic approach to study an economy as it evolves over time, aka an intertemporal approach. The LRBC tells us how and why a country must live within its means in the long run.

5 Long-Run Budget Constraint You borrow $100,000 with10% annual interest rate. What happens to your debt if you pay neither principal nor interest? Pyramid or Ponzi scheme. Sustainable? In the long run, lenders will not allow debt to grow larger, which is the essence of the long-run budget constraint.

6 Long-Run Budget Constraint Here are some of the assumptions we make: Prices are perfectly flexible. Analysis is done in real terms. The country is a small open economy. The country cannot influence prices in world markets for goods and services. All debt carries a real interest rate r*, the world real interest rate, which is constant. The country can lend or borrow an unlimited amount at this interest rate.

7 Long-Run Budget Constraint Here are some of the assumptions we make: The country pays r* on its liabilities L and get paid r* on its assets A. Hence, the net interest income equals to r* (A-L), or r*W, where W is the external net wealth. There are no unilateral transfers, no capital transfer, and no capital gains on W. So, there are only two nonzero items in the current account: the trade balance and net factor income from abroad, r*W.

8 Long-Run Budget Constraint The change in external net wealth from end of year N − 1 to end of year N: Solving for wealth at the end of year N:

9 Long-Run Budget Constraint We assume that all debts owed or owing must be paid off, and the country must end that year with zero external wealth. At the end of year 1: Then: The two-period budget constraint equals: At the end of year 0, The Budget Constraint in a Two-Period Example

10 Long-Run Budget Constraint Present Value Form By dividing the previous equation by (1 + r* ), we find a more intuitive expression for the two-period budget constraint: The Budget Constraint in a Two-Period Example

11 Long-Run Budget Constraint If N runs to infinity, we get an infinite sum and arrive at the equation of the LRBC: A debtor (surplus) country must have future trade balances that are offsetting and positive (negative) in present value terms. The Budget Constraint in an infinite period

12 Long-Run Budget Constraint A Long-Run Example: The Perpetual Loan The formula below helps us compute PV(X) for any stream of constant payments: For example, the present value of a stream of payments on a perpetual loan, with X = 100 and r* = 0.05, equals:

13 Long-Run Budget Constraint Implications of the LRBC for Gross National Expenditure and Gross Domestic Product Since

14 Long-Run Budget Constraint The long-run budget constraint says that in the long run, in present value terms, a country’s expenditures (GNE) must equal its production (GDP) plus any initial wealth. The LRBC therefore shows how an economy must live within its means in the long run.

15 Long-Run Budget Constraint In reality, are lending rates equal to borrowing rates in international debt markets? Do all countries have the same creditworthiness? How would exchange rates affect the value of a country’s net foreign wealth?

Sovereign Ratings and Public Debt Levels: Advanced Countries Versus Emerging Markets and Developing Countries, 1995 to

17 Gains on Consumption Smoothing We assume that an economy prefers a smooth path of intertemporal consumption. Is it easier for an open economy to achieve consumption smoothing than a closed one?

18 Gains on Consumption Smoothing The Basic Model Production of GDP (Q) employs labor as the only input and is subject to shocks. GNE = C, assuming I and G are zero. W −1 = 0. The subject country is small and it finances at the world real interest rate r* (= 5% per year in our example).

19 Gains on Consumption Smoothing The Basic Model is a special case of the LRBC: or,

20 Gains on Consumption Smoothing Closed vs. Open Economy: No shocks to GDP Output equals consumption. Trade balance is zero. Consumption is smooth. No gains from financial globalization!

21 Gains on Consumption Smoothing Closed Economy: Temporary Shocks to GDP Output equals consumption. Trade balance is zero. Consumption is not smooth.

22 Gains on Consumption Smoothing Open Economy: Temporary Shocks to GDP A trade deficit is run when output is temporarily low. Consumption is smooth. The lesson is clear: When output fluctuates, a closed economy cannot smooth consumption, but an open one can.

23 Gains on Consumption Smoothing In general: Initially, Q = C and W = 0. The LRBC is satisfied. Now, GDP falls by ΔQ at t = 0 and then returns to its prior value for t ≥ 1. Consumption changes by ΔC for periods. ΔC < ΔQ since consumption is assumed to be smoothed. In an open economy, a trade deficit (ΔQ – ΔC) would occur at t = 0. So would external net wealth.

24 Gains on Consumption Smoothing A loan of ΔQ − ΔC in year 0 requires interest payments of r*(ΔQ − ΔC) in later years. If the subsequent trade surpluses of ΔC are to cover these interest payments, then we know that ΔC must be chosen so that: Rearranging to find ΔC:

25 Gains on Consumption Smoothing Smoothing consumption when a shock is permanent With a permanent shock, output will be lower by ΔQ in all years, so the only way either a closed or open economy can satisfy the LRBC while keeping consumption smooth is to cut consumption by ΔC = ΔQ in all years. consumers can smooth out temporary shocks—they have to adjust a bit, but the adjustment is far smaller than the shock itself— yet they must adjust immediately and fully to permanent shocks.

26 Gains on Efficient Investment For an open economy, global allocation of capital stock provides opportunities for investments, technological advancement, and economic growth. Built upon the Basic model, the new production function has two inputs – labor and capital. The LRBC, therefore, includes I as a component of GNE. Government spending is still assumed to be zero.

27 Gains on Efficient Investment

28 Gains on Efficient Investment Initially, Q = 100, C = 100, I = 0, TB = 0, and W = 0. An Open Economy with Investment and a Permanent Shock The economy runs a trade deficit to finance investment and consumption in period 0 and runs a trade surplus when output is higher in later periods. Consumption is smooth.

29 Gains on Efficient Investment Generalizing Suppose that a country starts with zero external wealth, constant output Q, consumption C equal to output, and investment I equal to zero. An investment opportunity appears requiring ΔK units of investment spending in year 0. This investment will generate an additional ΔQ units of output in year 1 and all later years. The present value of these additions to output is, Investment will increase the present value of consumption if and only if ΔQ/r* ≥ ΔK.

30 Gains on Efficient Investment Investment will increase the present value of consumption if and only if ΔQ/r* ≥ ΔK. Rearranging, Dividing by ΔK, investment is undertaken when Firms will take on investment projects as long as the marginal product of capital, or MPK, is at least as great as the real interest rate.

31 Gains on Efficient Investment Following a large increase in oil prices in the early 1970s, Norway invested heavily to exploit oil fields in the North Sea. Norway took advantage of openness to finance a temporary increase in investment by running a very large current account deficit. The Oil Boom in Norway

32 Gains on Efficient Investment Can Poor Countries Gain from Financial Globalization? If the world real interest rate is r* and a country has investment projects for which MPK exceeds r*, then the country should borrow to finance those projects. Production Function Approach where θ is a number between 0 and 1 that measures the contribution of capital to production, or the elasticity of capital with respect to output. θ is estimated to be 1/3.

33 Gains on Efficient Investment Hence, the marginal product of capital is Assuming countries have the same level of productivity, A = 1, our model implies that the poorer the country, the higher its MPK, the more profitable investing in the country.

34 Gains on Efficient Investment Why Doesn’t Capital Flow to Poor Countries? If poor and rich countries share the same level of productivity (a common production function), then MPK must be very high in poor countries, as shown in panel (a). For example, if B represents Mexico and R the United States, we would expect to see large flows of capital to poor countries, until their capital per worker k and, hence, output per worker q rise to levels seen in the rich world (movement from point B to point R). The result is convergence.

35 Gains on Efficient Investment So, why doesn’t capital flow from rick to poor countries? In our model, we assume countries have the same level of productivity. In reality, poor countries have much lower level of productivity than rich ones. Notice that MPK is an increasing function of A. With a smaller A, poor countries become less attractive to foreign capital.

36 Gains on Efficient Investment Why Doesn’t Capital Flow to Poor Countries? (continued) This doesn’t happen in reality. Poor and rich countries have different levels of productivity (different production functions) and so MPK may not be much higher in poor countries than it is in rich countries, as shown in panel (b). The poor country (Mexico) is now at C and not at B. Now investment occurs only until MPK falls to the rest of the world level at point D. The result is divergence. Capital per worker k and output per worker q do not converge to the levels seen in the rich country.

37 Gains on Efficient Investment

38 Gains on Efficient Investment Some thoughts on productivity A Technical efficiency (technology, management skills, etc.) Social efficiency (cultures, public policies, religions, etc.) Country specific risk (risk premium) Also, is foreign aid effective?