1. Balance of Payments: Accounts and Analysis Thorvaldur Gylfason Course on External Vulnerabilities and Policies Tunis, February 15-26, 2010

2. accounts 1.Balance of payments accounts  How BOP accounts are put together  Definitions, conventions, presentation  Links to other macroeconomic accounts analysis 2.Balance of payments analysis  Economics of exports, imports, capital flows, exchange rates, etc. projections 3.Balance of payments projections 4.External debt and the international investment position

3. 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 per se, and then look at linkages in a separate lecture

4. statistical statement specific period of time economic transactions of an economy with the rest of the world The balance of payments is a statistical statement which systematically summarizes, for a specific period of time, the economic transactions of an economy with the rest of the world

5. external position The information on the economic transactions and financial flows between a country and the rest of the world, systematically summarized in its balance of payments, is necessary to analyze the external position of the country, including its debt

6. Article IV Consultations program design and review The mandate of the IMF is to assess the external position of the its member countries through surveillance (Article IV Consultations) as well as in the context of the use of Fund resources (program design and review)

7. commonly accepted methodology In a world where national economies are more and more closely integrated, owing to both trade and financial flows, policy makers and economists need to have balance of payments statistics that are recent, reliable, exhaustive, and comparable across countries based on a commonly accepted methodology

8. establish balance of payments statistics One of the roles of the IMF is to elaborate and standardize the methods needed to establish balance of payments statistics Balance of Payments Manual Since 1948, the IMF has published a Balance of Payments Manual laying out the main principles behind the compilation of balance of payments statistics  Six editions: 1948, 1950, 1961, 1977, 1993, 2008

9. the balance of payments accounting frameworkmain principles for the analysis of the balance of payments In this session, we discuss the balance of payments accounting framework as well as the main principles for the analysis of the balance of payments based on the methodology detailed in the Balance of Payments Manual (6 th ed., 2008)

10.  The balance of payments records transactions between residents and nonresidents center of economic interest  The notion of residence is determined by the center of economic interest of units rather than their nationality  E.g., Turks in Germany

11.  Individuals  Residents of a country if the length of their stay is longer than 12 months But not students and patients  Non-residents  Visitors (tourists, plane or boat crews, seasonal workers, etc.), trans-border workers (residents in the countries where they live), diplomats, members of the army, foreign students (regardless of the length of their stay)

12.  Enterprises  Residents of the country where they realize their activity, given the presence of at least an establishment in the country E.g., branches and subsidiaries of foreign enterprises are considered to be residents of the host country Range of indictors, no definite rules

13.  Public entities  Embassies, consulates, military bases, government entities are counted as residents of their country of origin

14.  Double entry accounting  Every transaction must result in two entries of equal amounts, one on the credit side and one on the debit side positive credit negative debit  Typically, a positive sign (+) is associated with an amount recorded on the credit side and a negative sign (-) is associated with an entry on the debit side Creditasset Credit refers to the lender whose loan to the debtor is an asset Debitliability Debit refers to the debtor whose debt to the lender is a liability Creditasset Credit refers to the lender whose loan to the debtor is an asset Debitliability Debit refers to the debtor whose debt to the lender is a liability

15. creditdebit By convention, some transactions are recorded as credit items(+) and others as debit items (-)  Exports of goods and services Credit (+)  Imports of goods and servicesDebit (-)  Income and transfers receivedCredit (+)  Income and transfers paid outDebit (-)  Increase in foreign liabilitiesCredit (+)  Increase in foreign assetsDebit (-)

16.  A reduction in foreign liabilities is recorded on the debit side, with a negative sign (-)  A reduction in foreign assets is recorded on the credit side, with a positive sign (+)  Due to this convention,  An increase in foreign reserves is recorded on the debit side, i.e., with a negative sign (-)  A reduction in reserves is recorded on the credit side, i.e., with a positive sign (+) We “pay” for increased reserves like we pay for imports Likewise, a decrease in reserves generates “receipts”

17.  Unrequited transfers  Transactions that correspond to a single flow are recorded as current transfers or as capital transfers resulting in a symmetrical entry under imports (transfers received) or under exports (transfers paid)  Example: EU provides a country with a gift of computers (food aid)  The computers are recorded as imports and capital transfers (current transfers)

18. Transactions in two major categories 1.Real transactions  Goods, services, and income Current account Current account of the BOP flows Involve flows 2.Financial transactions  Reflect changes in foreign assets and liabilities Capital and financial account Capital and financial account of the BOP stocks Involve changes in stocks Flows involve changes in underlying stocks: X – Z + F =  R X = exports, Z = imports, F = capital account, R = reserves, F =  D F with D F = net foreign debt X = exports, Z = imports, F = capital account, R = reserves, F =  D F with D F = net foreign debt

19.  Double-entry recording  The sum of credit entries must equal the sum of debit entries  The sum of all transactions is zero  Practical problems lead to errors and omissions  Diversity of data sources  Missing data: e.g., financial transactions outside banking system (informal sector)  Under- or overvaluation of transactions Smuggling

20.  The recording period for balance of payments flows is determined by the frequency of data collection  Annual  Quarterly  Monthly  Transactions are recorded on the date of legal change of ownership  Accrual basis, not cash basis

21.  Transactions must be valued at market price, reflecting “the terms of an exchange between a willing buyer and a willing seller”  The direct exchange of one item of property for another (barter) is valued at a fictitious price used to value traded goods

22.  Exports and imports are recorded "free-on- board" (f.o.b.)  Cost of insurance and transport beyond the port of departure is not included in the value of the goods; they are recorded under services  If exports and imports are reported in customs data on a c.i.f. basis, i.e., including the cost of insurance and freight, then the cost of insurance and freight needs to be deducted before recording the items at issue in the balance of payments (e.g., on the basis of average costs and percentage)

23.  Transactions recorded in the balance of payments must be expressed in a common unit of account (e.g., home currency or USD)  National currency is used to compare BOP to other developments in the domestic economy  Dollar, SDR, or other major stable currencies are used for cross-country comparisons, as a precaution in the event of rapid depreciation of the national currency which would make it difficult to interpret the balance of payments

24. 24  In order to translate into the chosen unit of account the data that are expressed in the unit of transaction, the exchange rate at the time of the transaction is used  To translate the balance of payments from one unit of account to another (e.g., from US$ to national currency) we use the average exchange rate over the period for trade flows and end-of-period exchange rate for stocks of reserves  Stocks vs. flows

25. views  Two views of the balance of payments, that is: ways to present  Two ways to present the balance of payments  Standard presentation accountant or statistician’s view The accountant or statistician’s view gross Records gross amounts, credit and debit  Analytical presentation economist’s view The economist’s view net Records some items on net basis, credit minus debit

26. accounting principles  From the statistician or accountant’s point of view, the structure of the balance of payments reflects the recording of foreign transactions based on accounting principles  Standard presentation  Standard presentation in which the amounts recorded (credit and debit) are gross amounts

27.  From the economist's point of view, a different presentation facilitates the use of the balance of payments for analytical purposes  Analytical presentation Established on the basis of the standard presentation For certain groups of items the accounting balance is used, that is, the difference between the amounts on the credit and debit sides E.g., net capital inflow = gross inflow less gross outflow F = F X – F Z =  D F

28.  Current account  Transactions related to goods, services, income, and current transfers between residents and non-residents Transactions related to goods are those relative to the movements of merchandise Exports and imports of goods Transactions involving services include different categories, e.g., transport, travel, etc. Exports and imports of services

29.  Transactions related to income involve the remuneration of labor, capital, and land  E.g., compensation paid to trans-border workers, interest payments on external debt, etc.  Transfers are unrequited transactions  Public and private  In cash or in kind  E.g., foreign aid

30.  Since the sums of credits and debits offset one another, how can there be an "imbalance" in the external accounts?  Advantage of analytical presentation  It shows significant balances that are useful for economic analysis and shows a possible external imbalance

31. surplusdeficit line  The overall balance of payments can be in surplus or in deficit once we distinguish transactions into two sub- groups and draw a line between these two subgroups above the line below the line  When transactions above the line sum up to a deficit, transactions below the line will sum up to a corresponding surplus, and vice versa

32.  Trade balance  Difference between exports and imports of goods (net exports)  Current account balance  Difference between amounts recorded on the credit and debit side of goods, services, income, and current transfers  Overall balance  Current account balance plus capital and financial operations account balance considered not to be “financing” items

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

34. 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  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow =  D F Recording external transactions Also called capital and financial account The term “capital account” is 1.Old language (BPM4) 2.Shorthand for new language (BPM5) The term “capital account” is 1.Old language (BPM4) 2.Shorthand for new language (BPM5)

35. 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  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow Recording external transactions

36. 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  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow Recording external transactions

37. 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  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow Recording external transactions

38. Again  BOP = X – Z + F =  R where  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

39.  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

40. 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 = net unrequited transfers from abroad Intermediate concept GSB

41. Importance of net factor income Net factor income from labor  Compensation of domestic guest workers abroad (e.g., Pakistanis in the Gulf) minus that 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 are unrequited transactions  Public or private, disbursed in cash or in kind (e.g., foreign aid) Y f > 0 in Pakistan Y f < 0 in Argentina Y f > 0 in Pakistan Y f < 0 in Argentina

42. Capital and financial account Two parts 1.Capital account 1.Capital account (esp., capital transfers) 2.Financial account 1.Direct investment Involves influence of foreign owners 2.Portfolio investment Includes long-term foreign borrowing Does not involve influence of foreign owners 3.Other investment Includes short-term borrowing 4.Errors and omissions Statistical discrepancy Is the world’s BOP = 0?!

43.  Foreign direct investment (FDI)  Investments that a non-resident entity realizes with the aim of acquiring a durable interest in a resident enterprise (long-term relationship and influence on the enterprise’s management)  The investor holds at least 10% of the shares or the voting rights in the enterprise Capital and financial account

44.  Portfolio investments  Equity participation instruments and debt instruments, money market instruments Financial derivatives: separate functional category  Other investments  Trade credits, short-term and long-term loans, including loans from World Bank  Typically recorded on the basis of the instrument or on the basis of their maturity (short term vs. long term) Capital and financial account

45.  Reserve assets  Financing items  Financing items below the line in the balance of payments finance the balance of payments  Transactions involving the assets of which monetary authorities consider that they dispose in order to finance the balance of payments, including IMF loans E.g., to maintain adequate foreign exchange reserves Most successful IMF loans are never “used” Capital and financial account

46. Overall balance of payments Four main items below the line 1.Gold 2.SDRs 3.Reserve position in IMF 4.Foreign exchange Three-month Rule cover three months of imports Three-month Rule: Gross foreign reserve holdings should suffice to cover three months of imports of goods and services Giudotti-Greenspan Rule not decrease below short-term foreign commercial bank liabilities or total liabilities Giudotti-Greenspan Rule: Central Bank foreign reserves should not decrease below short-term foreign commercial bank liabilities or total liabilities Also included in capital and financial account

47.  Changes in reserve position in IMF  Recorded in financial operations account under reserve assets, below the line  Use of IMF resources  Purchase of foreign currency from IMF leads to Increase in foreign assets of the Central Bank (-, negative sign) Financial liability to the IMF (+, positive sign) Gross reserves go up, net reserves stay put  Use of SDRs  Recorded in financial account as reserve asset flows

48. Current account A. Goods Exports Imports Trade balance Trade balance B. Services Transport Travel C. Income Compensation of workers Investment income D. Current transfers General government Other sectors Current transactions balance = (X-Z) + Y F + TR F = (X-Z) + Y F + TR F C apital and financial operations account A. Capital Capital transfers Purchases/sales of nonproduced nonfinancial assets B. Financial operations Direct investment Portfolio investment Other investment C. Errors and omissions Overall Balance D. Net foreign assets E. Exceptional financing X-Z YFYFYFYF TR F FDI NFL NFA

50. Y = C + I + G + X – Z E + X – Z  = E + X – Z E = C + I +G  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

51. 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 GNP > GDP in Pakistan GNP < GDP GNP < GDP in Argentina GNDI = GNP + TR = GDP + Y f + TR Links between BOP and national accounts

52. Y X - Z Definition GDP Trade balance Goods and nonfactor services Links between BOP and national accounts

53. 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

54. 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 Links between BOP and national accounts

55. Fiscal accounts and links to BOP Public  Public sector  G – T =  B +  D G +  D F Private  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 =   D G +  D F +  D P –  M =   D –  M +  D F = -  R +  D F = Z - X External  External sector  X – Z =  R -  D F M = D + R D G + D P = D X – Z + F =  R F =  D F

56. 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  Monetary approach to balance of payments  Still holds that  R = X – Z + F

57. Foreign exchange Real exchange rate Imports Exports Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium Balance of payments analysis Real exchange rate = eP/P*

58. 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 = X – Z + F = current account + capital account = 0 Balance of payments equilibrium

59. Foreign exchange Real exchange rate ImportsImports Exports Overvaluation Deficit Overvaluation R R moves when e is fixed

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

61. 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) 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

62. Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss equivalent to the triangle EFG 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

63.  Difference between exports and imports of goods  Provides useful information on likely future developments in the current account  Distinction between goods and services may appear arbitrary  Data on merchandise trade can be quickly obtained from customs while data on services may take more time

64.  Ratio of export prices to import prices: P x /P z  Typically expressed in as an index  P x = Export price index  P Z = Import price index Expressed in the same currency as the prices included in the export price index  Indicator of the purchasing power of exports in terms of imports  Terms of trade improve when P x /P z rises  Terms of trade worsen when P x /P z falls Y = E + X – Z GNP = E N /P E + X N /P X – Z N /P Z (GNP) GNI = E N /P E + X N /P Z – Z N /P Z (GNI) Y = E + X – Z GNP = E N /P E + X N /P X – Z N /P Z (GNP) GNI = E N /P E + X N /P Z – Z N /P Z (GNI)

65.  Crucial indicator used to assess the external position of a country  The current account balance is equal to the change in net foreign assets with respect to the rest of the world  Includes change in net foreign assets of Non-banking sector Banking sector (including monetary authorities)  CAB  – F +  R because X – Z + F =  R

66.  CAB  – F +  R because X – Z + F =  R  Hence, current account deficit can be financed by foreign direct investment  Attracting foreign direct investment net foreign liabilities  Accumulating net foreign liabilities I.e., borrowing abroad net foreign assets  Running down the net foreign assets of the monetary authorities

67.  When does a current account deficit become a source of concern?  When it is a lasting (structural) deficit rather than a temporary (cyclical) deficit  When it is financed by short-term external borrowing or by a protracted reduction in net foreign assets Giudotti-Greenspan Rule  When foreign exchange reserves are low in terms of months of imports or in terms of the Giudotti-Greenspan Rule  Other factors  Capacity to meet financial obligations  Availability of external financing

68.  When does a current account deficit become a source of concern?  When continued current account deficits, reflecting the behavior of the government and the private sector, require drastic adjustment of economic policies in order to avoid a crisis, e.g., Collapse of exchange rate Default on external debt payments

69. solvent  A country is solvent if the present value of future current account surpluses is at least equal to its current external debt  The concept is simple, but putting it into practice is complicated If the projections of future surpluses are sufficiently large, any current account deficit could be consistent with the notion of solvency

70.  Another crucial indicator used to assess the external position of a country deficit decreasenet foreign assets exceptional financing  A deficit in the overall balance means a decrease in the net foreign assets of the monetary authority except when exceptional financing becomes available  Foreign reserves are traditionally held by the monetary authorities in order to finance payments imbalances and to defend the currency

71.  Exceptional financing  Exceptional financing can be needed in an emergency where reserves have fallen to perilously low levels  Three main types  Rescheduling  Rescheduling of external debt obligations Scheduled payments postponed in agreement with creditors  Debt forgiveness Voluntary cancellation by creditors  Payments arrears  Payments arrears on external debt service without Scheduled payments postponed without agreement with creditors

72.  Indicators of an appropriate level of foreign reserves  Ratio of reserves to monthly imports of goods and services of more than 3  Guidotti-Greenspan Rule  Other considerations  Capital mobility  Exchange rate regime  Composition of external liabilities  Access to foreign borrowing  Seasonal nature of imports and exports

73.   R = X - Z + F = CAB + FDI + NFL  Need projections of  Current account variable  Capital and financial operations account variables  This gives projections of the change in net foreign assets

74.  Developments in the global economy  Developments and policies in the domestic economy  Establish relations between the components of the BOP and the main factors that influence them

75.  Exports and imports of goods  Exports and imports of services  Factor income  Unrequited transfers

76.  Assume small open economy  Project volume of import demand Z = volume of imports Y = domestic real GDP (+) P Z / P = import prices relative to domestic GDP deflator (-) Z = volume of imports Y = domestic real GDP (+) P Z / P = import prices relative to domestic GDP deflator (-)

77.  Assume small open economy  Project volume of export demand X = volume of exports Y* = foreign real GDP (+) P X / P* = export prices relative to foreign GDP deflator (-) X = volume of exports Y* = foreign real GDP (+) P X / P* = export prices relative to foreign GDP deflator (-)

78.  Assume small open economy supply  Project volume of export supply X = volume of exports Y = domestic real GDP (+) P X / P = export prices relative to domestic GDP deflator (+) X = volume of exports Y = domestic real GDP (+) P X / P = export prices relative to domestic GDP deflator (+)

79.  Transport service (credit)  Sale of transport and other business services (freight and insurance) by residents (carriers) to nonresidents  Depends on value of exports  Transport service (debit)  Purchase of transport and other business services (freight and insurance) by residents from nonresidents  Depends on value of imports  Travel  Depends on domestic GDP and competitiveness (prices, exchange rate)

80.  Compensation of employees  Seasonal or border workers who work in national territory but live in neighboring countries or vice versa  Depends on trends  Interest payments  Estimated by entity responsible for managing external debt (interest rates, outstanding balance of debt, and new borrowing)  Income from direct investment  Profits and dividends depend on stock of foreign investment in the country (debit side) or on the country’s investment abroad (credit side)

81.  Private transfers  Transfers from emigrant workers to their country of origin  Depends on economic situation in country of origin and host country, exchange rate, tax regime  Public transfers  Grants in cash and in kind  Need information from donors  Need compatibility with grant projections in government finance statistics

82.  Capital transfers  Grants in cash (for investment) and in kind having the nature of investments  Need information from donors  Need compatibility with grant projections in government finance statistics  Foreign direct investment  Depends on investment opportunities, profitability of investments, tax incentives, economic growth, and political and social stability of the country

83.  Portfolio investment  Equity participation instruments and debt instruments, money market instruments, and, separately, financial derivatives  Depends on access to international markets, restrictions on capital flows, relative interest rates, exchange rate, political and social situation in the country

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

85. borrower  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

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

87. 0 Saving World interest rate Investment World equilibrium Domestic equilibrium A B C D Borrowing Real interest rate Saving, investment Conceptual framework

88. 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

89. 0 Saving World interest rate Investment World equilibrium Domestic equilibrium A Consumer surplus after borrowing B D C Producer surplus after borrowing Borrowing Real interest rate Saving, investment Conceptual framework

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

91.  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 above  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

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

93. Debt burden debt service ratio 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

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

95. 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

96. 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 Giudotti-Greenspan Rule External debt: Magnitude and composition Indonesia and Korea broke the Giudotti-Greenspan Rule in 1996 So did Iceland, big time, prior to crisis in 2008

97. How can we figure out a country’s debt burden? q Divide through definition of q by income r D F /Y X/Y A/Y 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

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

99. dynamic 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 vicious circle Debt accumulation can develop into a vicious circle 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

100. Recall balance of payments equation: BOP = X – Z + F where F=  D F F = capital inflow =  D F where D F 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) flowstock So, F is a flow and D F is a stock External debt dynamics

101. Now assume Z = Z N + rD F Z Z = total imports Z N Z N = non-interest imports rD F 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 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

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

103. 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

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

105. 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

106. economic growth above world rate of interest 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 high-quality investment Once again, high-quality investment is key What can we learn from this?

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

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

109. at time T Debt as the sum of past deficits

110. at time T Debt as the sum of past deficits

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

112. 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! 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

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

117. 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... ag... as long as a and g remain unchanged Debt ratio Time 3 Numericalexample

118. 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

119. 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

120. 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

121. 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

122. 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 X/Y = 0.30 (new number) Heavy burden, but manageable! Numerical example, again

123. Must adjust policies Must either Reduce trade deficit 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

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

125. Gross foreign debt is not all that matters assets Foreign assets matter as well Net foreign debt equals gross debt less gross assets international investment position (IIP) Conversely, the difference between gross assets and gross debt equals the international investment position (IIP) International investment position

126. Changes in IIP involve changes in stocks measured at different points in time  Transactions (e.g., foreign borrowing)  Non-transaction changes (price changes, exchange rate movements, other changes)  Reconciliation statement: IIP t = IIP t-1 + F t IIP t = IIP t-1 + F t F t represents BOP financial account transactions during period t, including various non-transaction changes International investment position

127. Concepts Transactions Economic flows Economic flows that reflect the creation, transformation, exchange, transfer, or extinction of economic value and involve changes in ownership of financial assets Non-transactions Price changes Price changes reflecting changes in market values of assets or liabilities Zero for non-traded instruments E.g., trade credits, loans, currency and deposits

128. Concepts Non-transactions Exchange rate changes Exchange rate changes reflecting impact of changes in exchange rate between currency used for IIP (domestic currency) and currency in which assets or liabilities are denominated Zero for assets and liabilities denominated in domestic currency E.g., local equities, domestic currency bonds, etc.

129. Other changes in IIP Not a residual or ‘dump’ category Includes appearance or disappearance of assets or liabilities  Uncompensated seizure  Bankrupties  Write-offs  Activation of guarantees  Classification changes Generally lumpy and small Concepts

130. Relationship to other statistics International accounts  IIP + BoP = international accounts stocks o IIP is presented in terms of stocks flows o BoP is presented in terms of flows  F t in IIP reconciliation statement is the capital and financial account in BoP

131. Income in Current Account Compensation of employees + investment income o Payments and receipts on investment measured in IIP o Interest, dividends, distributions yields on investment Relationship to other statistics

132. External debt Direct and portfolio debt liabilities and other investment liabilities from IIP o Only liabilities (no assets) o Only debt Excludes equity (direct and portfolio) Excludes financial derivatives Relationship to other statistics

133. In conclusion External trade and investment are crucial determinants of economic development Excessive external imbalances can jeopardize the benefits of external trade and capital flows Financial programs are designed to achieve external balance by fostering the buildup of adequate foreign exchange reserves Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debt  Must avoid overvaluation

134. In conclusion The End External borrowing is a necessary and natural part of economic development high-quality capital This requires countries that borrow to invest the funds borrowed in high-quality capital This is necessary to be able to service the debt reduce deficit or spur growth 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: www.hi.is/~gylfason