1. Debt sustainability; balance of payments
Session 10
MSc Economic Policy Studies
Alan Matthews

2. Lecture objectives Introduce debt dynamics and debt sustainability
Describe and understand the balance of payments accounts
Do international payments imbalances matter?
Addressing international payments imbalances
Reading: McAleese Chapter 15 (pp ), 20

3. Source and forecasts: Goodbodys Sept 2010

6. (D/Y)t = (1 + (r - g)(D/Y)t-1 + d + b
The debt equation
(D/Y)t = (1 + (r - g)(D/Y)t-1 + d + b
where D is debt, r is nominal interest rate, g is nominal growth rate, d is primary deficit and b is bank capitalisation costs
The debt/GDP ratio this year is equal to the ratio last year, plus the primary deficit, plus bank costs, plus interest charged on last year’s debt less growth rate of GDP
Why the primary deficit? Because interest rates are not something government can control

7. Solving for the stable debt-to-GDP ratio
(D/Y)t = (1 + (r – g))(D/Y)t-1 + d
Expanding,
(D/Y)t = (D/Y)t-1 + r(D/Y)t-1 - g(D/Y)t-1 + d
We set (D/Y)t = (D/Y)t-1 and cancel terms
0 = r(D/Y)t-1 - g(D/Y)t-1 + d
Moving d to the other side and dividing through
-d/(r-g) = (D/Y)*

8. Debt sustainability If g > r, we don’t have a problem
If d is negative (primary surplus), debt/GDP ratio is heading to zero
If d is positive (primary deficit), debt/GDP ratio is headed for a stable and well-defined number
If r > g, then stable debt/GDP ratio requires we run a primary surplus
If primary surplus is too small (if when divided by (r-g) it is less than current D/Y ratio), then debt/GDP ratio will grow without bound

9. Debt sustainability
Is there a magic number for the debt/GDP ratio beyond which markets lose confidence in state’s ability to repay?
Continued borrowing is consistent with varying levels of debt/GDP ratio
Solvency limit is historically conditioned by evidence of willingness to run that primary surplus
May also be important whether debt is owed to foreigners or to domestic residents
Recent IMF Staff Paper suggests that currently Greece, Italy, Japan, and Portugal appear to have the least fiscal space, with Iceland, Ireland, Spain, the United Kingdom, and the United States also constrained in their degree of fiscal manoeuver

10. Comments on Irish situation
Irish scenarios demonstrated in attached debt spreadsheet
Note distinction between gross and net debt
Distinction is cash positions held by the NTMA and financial assets held in the NPRF
Adding interest expenditure to the required primary surplus means overall government budget may still be in deficit
Interest payments may rise to 5.4% GDP in 2014 (Goodbodys)
Overall deficit constrained by separate EU rules

11. CSO Student Corner on balance of payments
The balance of payments is a set of accounts showing all economic transactions between residents of the home country and the rest of the world in any one year
The current account in the balance of payments records all visible and invisible trade
The capital account covers mainly capital transfers (EU grants and migrants’ net worth)
The financial account in the balance of payments is a record of a country’s transactions in foreign financial assets and financial liabilities
CSO Student Corner on balance of payments

12. Balance of payments statement
Current account
Goods trade (merchandise trade)
Services
Trading and investment income
Current unilateral transfers
Balance on current account
Capital account
Financial account
Balance on financial account
Foreign direct investment
Portfolio capital
Other investment
Change in official reserves
Net errors and omissions
2010, €bn 37 -9
-29 -1 13 8 94
-89
-12
Irish data. Source: CSO Balance of international payments release, Mar 2011

13. Some definitions
Merchandise trade similar to balance of trade account (see Lecture 6) but valued at fob prices for both exports and imports
Invisibles refers to balance of services trade, investment income and current transfers (net current receipts from EU and Irish Aid expenditure)
Capital account transfers refer mainly to capital receipts under EU structural funds
Financial account includes long-term capital flows (FDI and portfolio investment) and other flows which are mainly short-term loans and transactions in financial derivatives
Reserve assets are non-euro denominated liquid assets and gold owned by the Central Bank

14. Further definitions
Sometimes distinction is made between autonomous and accommodating transactions in the balance of payments
Former are seen as ‘active’ transactions, responding to real changes in competitiveness conditions, while latter are ‘passive’
Example: consider reactions to an increased demand for imports
Line is drawn under the basic balance, but increasingly less distinct as capital markets become more liquid

15. Irish balance of payments trends
Year
Merch-andise
Invisibles
Balance on current account
Services
Trading & invest-ment income
Current transfers
Total Invisible
2001
30,494
-13,259
-18,295
305
-31,249
-757
2002
35,442
-13,779
-23,664
707
-36,736
-1,295
2003
32,604
-11,091
-21,947
432
-32,606 -2
2004
31,812
-9,721
-23,578
306
-32,993
-1,181
2005
28,218
-9,303
-24,870
265
-33,908
-5,690
2006
25,031
-6,797
-24,033
-506
-31,336
-6,304
2007
19,811
-1,121
-27,825
-990
-29,936
-10,124
2008
23,811
-7,670
-25,155
-1,154
-33,979
-10,169
2009
32,367
-8,416
-27,901
-901
-37,218
-4,853
2010
37,147
-8,520
-28,567
-1,172
-38,259
-1,113

16. Borrowers and lenders, debtors and creditors
The balance of payments is a flow concept
It shows whether a country is a net borrower or a net lender in any year
A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it.
A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.
The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.
Does it matter if a country is a debtor nation? Depends on how the borrowing has been used.
The stock of foreign investment determines whether a country is a debtor or a creditor
Developing countries

17. International Investment Position
The international investment position (IIP) is a point in time statement of the value and composition of the balance sheet stock of an economy's foreign financial assets (i.e. the economy's financial claims on the rest of the world) and its foreign financial liabilities (or obligations to the rest of the world).
The change in the IIP between beginning and end of period is equal by definition to the current account balance over that period (allowing for valuation changes reflecting changes in exchange rates and asset prices)
Note reconciliation is also difficult due to large BOP balancing item ‘net errors and omissions’

18. Ireland’s IIP
Source: CSO Quarterly International Investment Position, Dec 2010

19. Source: Honohan, 2006

20. Source: Honohan, 2006

21. Understanding the balance of payments current account
First, some national income accounting
Recall total income Y is defined from expenditure side as
Y = C + I + G + X – M
Y can also be defined as
Y = C + S + T
In equilibrium, these two definitions are identical
(I - S) + (G – T) = (M – X)
Balance of payments deficit = excess investment over savings plus government budget deficit

22. Interpreting a current account deficit
Two views
A deficit is a sign that a country is spending more than it earns, a weakness which must be corrected by either/both reducing expenditure or switching expenditure from imports in favour of exports
A deficit is a sign of strength because it means the country is sufficiently profitable to attract continued flows of foreign capital (focus on the basic balance)

23. The importance of sustainability
“A country is said to have a balance of payments problem when the current account deficit and the accumulated international investment position have reached a level where continuance of the deficit is no longer judged sustainable” – McAleese
Issues
Time dimension
Size of deficit in relation to GDP and debt position
Method of financing of deficit
Related to use of deficit (investment or consumption?)
Growth position
Sustainability a matter of market confidence

24. Source: http://www.voxeu.org/index.php?q=node/2820 EA = Euro Area

25. Why an unsustainable current account deficit matters
Adds to cost of foreign borrowing
Greater exposure to the volatility of international capital markets with potential for lack of confidence scenario (Asian crisis 1997)
Asset ownership moves into foreign hands
Arguably, within the euro zone a country’s balance of payments no longer matters, but it remains an important symptom of underlying problems

26. Interpreting a current account deficit
McAleese ‘tale of three deficits’
US deficit
Developing countries’ debt
Deficits in Euroland

27. Sustainability of the US current account deficit
How sustainable is the deficit?
Will it keep downward pressure on the US dollar?
US deficit was running at around 6% of US GDP
US dollar has depreciated by 40% relative to the euro between Jan 2002 and Jan 2004

28. The US deficit is sustainable
“Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar's value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit. The U.S. economy's higher return on capital than Europe or Japan for the last 20 years caused private foreign investors to buy U.S. stocks and bonds and other assets. In addition, foreign governments, particularly of China, Japan and other Asian states, have steadily increased their purchases of U.S. dollars as reserve backing for their own currencies.”
- Cato Institute economist Richard Rahn, Jan 2004
Note similarity to Box 20.1 in MacAleese

29. The US deficit is not sustainable
High productivity growth and booming stock markets in the 1990s drove a wedge between private investment and savings
US household savings now fallen to 1% of GDP
US fiscal policy now hugely expansionary
Foreigners will lose their appetite to hold US assets, causing interest rates to rise and restricting demand

30. Prospects for a soft US landing
US economy insulated from the worst effects of an international financial crisis
Because of its size
The fact that most of its obligations are denominated in its own currency
International role of the dollar underpins demand for it
Damage may be felt as much by other countries as by the US

31. Correcting a balance of payments imbalance
Automatic adjustment mechanisms
Start with adverse shock to exports
-> fall in demand for imports used as inputs to production
-> fall in aggregate demand leads to fall in imports
-> monetary factors such as fall in real balances
-> supply side adjustments through changes in relative prices of traded/nontraded goods

32. Correcting a balance of payments imbalance
Recall (I - S) + (G – T) = (M – X), problem is to reduce excessive (M-X)
Expenditure reduction policies
Increase S
Reduce I
Reduce G – T through restrictive fiscal policies
Expenditure switching policies
Commercial policy (tariffs, etc)
Improved cost competitiveness
Exchange rate changes

33. Restoring Ireland’s competitiveness
Within the EU, commercial policy and exchange rate changes are ruled out
Expenditure reduction policies (i.e. fiscal tightening) can lead to severe economic contraction and rise in unemployment
Reduction in nominal wages required to mimic a real devaluation, but how to achieve?

34. Financial balances
Derived from flow-of-funds data (CSO institutional accounts)
Based on the identity that the three balances (private, government and foreign) must sum to zero
Households are highly indebted and need to deleverage (i.e. run financial surpluses)
Government is highly indebted and needs to run financial surpluses
Implies need for substantial current account surplus
At eurozone level, implies strong depreciation in euro to achieve, i.e. competitive devaluation

36. Global imbalances

37. Source: OECD Economic Outlook Nov 2010

38. Global imbalances

39. Global imbalances
Source: IMF World Economic Outlook, Oct 2010

40. Challenges for the G20
How to address global imbalances when OECD countries are undertaking significant fiscal contraction?
Excess of global savings
Export-led growth model of China, Germany, Japan
Currency appreciation by surplus countries?
Alternatives?