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Chapter 2: The Global Flow of Funds INTRODUCTION AND SUMMARY A nation's international transactions are captured in their balance of payments (130P). Essentially an accounting balance sheet, the BOP is divided into two ledgers. The current account measures trade in goods and services, while the capital account documents trade in financial assets. A country's accounts must balance, meaning that any deficit in the current account must be offset by a surplus in the capital account. Thus by definition, a country with a current account deficit consumes more than it produces and must borrow savings from abroad. Economic theory provides little guidance on the optimal level of the current account. The macroeconomic impact of a current account imbalance depends on how a nation uses the imported capital as well as how much it has borrowed from abroad in the past. As with any borrower, a nation's ability to service its future foreign debts without drawing down future consumption turns on whether it uses the capital to finance current consumption or investment. Persistent current account deficits generally lead to a rise in a country's net external indebtedness and a growing risk premium on its debt. In addition, if foreign capital inflows do not balance the current account, then changes in interest rates, exchange rates, and other economic variables usually result. Empirically, we observe a positive relationship between a nation's accumulated current account deficit and the real long-term interest rates that a government pays on its debt. In addition, countries that run chronically large current account deficits tend to suffer currency depreciation over time. The short-term relationship between a nation's current account balance and its currency is difficult to predict because it depends on a broad set of factors. An appreciating currency dampens foreign demand for a nation's goods and services while making foreign goods cheaper so it usually raises the country's merchandise trade balance. Furthermore, if a country is running a large current account deficit, then the adjustment of the deficit toward balance typically requires that the real value of that country's currency fall relative to the currency of its major trading partners to improve the country's trade balance. However, whether a country's current account balance will respond to an adjustment in the currency value depends on other factors such as the state of the economy and the desirability of a country's assets in international markets. This chapter is organised around three major topics: First, we define the BOP and describe the standard national income identities as they relate to the 130P. A case study of the US-Japan bilateral trade balance is used to illustrate these concepts. Second, we explain the macroeconomic implications of the 130P, principally as it relates to inflation and interest rates. New Zealand's current account problems in the mid-1980s demonstrates how extreme saving - investment imbalances can damage an economy. Lastly, we describe both the short-term and long-term influences of the BOP on exchange rates. Recent trends in the US current account illustrate the structural impact of different sources of current account deficits. DEFINING THE BALANCE OF PAYMENTS Fundamental supply and demand for currency is derived from international trade in goods and services, foreign direct investment, or capital flows. The balance of payments is the broadest bookkeeping legend of a country's commercial transactions with the rest of the world. The two portions of the BOP are the current account, comprised of all cross-border goods and services trade; and the capital account, in which international asset transactions are measured. It is important to understand a country's balance sheet because entries in the BOP usually involve a foreign currency transaction. The current account is the sum of a country's merchandise trade balance, service balance, and unilateral transfers within a period of time. The merchandise trade balance is the difference between the value of what a country exports and what it imports. The service balance is composed of interest payments, dividends, freight and insurance, and tourism. The unilateral transfers balance aggregates such items as governmental aid and the repatriation of foreign earnings. Cross-border financial transactions for a given period are measured in a country's capital account. These transactions can be associated with either international trade or simple portfolio shifts in the form of government or private bonds, equities, or bank deposits. A country's balance of payments accounts must balance. The capital account exactly offsets the current account which means that a current account surplus exactly equals a capital account deficit and vice-versa. Thus, the net change in the ownership of foreign assets is represented by the current account. A current account deficit resulting from a trade deficit must be offset by an equal amount of foreign borrowing or investment or by running down the central bank's foreign exchange reserves. Nations with large reserves of foreign assets can sustain modest current account deficits without a major macroeconomic adjustment. Nations that must chronically borrow abroad to finance their current account deficit remain at the mercy of foreign creditors to finance the debt. BALANCE OF PAYMENT IDENTITIES Another way to regard the current account balance follows the identity of national income accounts. Recall that in equilibrium an open economy's total output (Y) equals consumption (C), plus investment (.1), plus government spending (G), plus net exports (X - IM). Symbolically, this statement can be represented by: Y = C + 1 + G + (X - IM). It is also a basic identity that total output (i.e., GDP) can either be consumed (C), saved (S), or taxed by the government (T): Y = C + S + T. These two expressions for Y are necessarily equivalent in equilibrium. Netting out consumption from both sides and rearranging terms involving the government on the left-hand side and the private sector on the right reveals: G - T = (S - 1) - (X - IM). In other words, the government balance, (G - T), equals the economy's private saving balance, (S - I), minus the trade balance, (X -.IM). Since any imbalance in the current account must be balanced by an equal and opposite amount in the capital account, we can replace the current account balance term, (X -IM), in the previous expression with net capital flows: G - T = (S - I) + net capitalflows. The elements of a country's balance of payments can be expressed in terms of its savings and investment balance: current account = (S - I) - (G - T) = capital account This equation is the basic current account identity: the current account balance is equal to private after-tax savings minus private investment spending minus government savings. Intuitively, if the supply of after-tax savings falls short of a nation's private investment demand and government deficit, then the economy will run a current account deficit. The national income identity means that one or more of three things must happen to reduce or eliminate a current account deficit. First, with static investment and the public deficit,, private savings must rise. Second, holding savings and the government deficit constant, the propensity of private firms to invest must fall. Or third, for a given quantity of private savings and investment, the government's budget deficit (i.e., the government's lack of propensity to save) must decline. CASE STUDY: THE US-JAPAN BILATERAL BALANCE To illustrate these concepts, we examine the bilateral relationship between the US and Japan. The US is currently running a large annual current account deficit, largely as a result of a private savings imbalance (overall US government accounts are closing in on balance). In contrast, Japan has a substantial surplus of domestic savings that finances an oversized public sector deficit. These imbalances are reflected in a sizable and politically sensitive bilateral trade imbalance between the two nations. In an integrated world financial system, Japanese investors must recycle their large trade surpluses by either direct or indirect lending to the US. There are several possible policies that could close this trade imbalance. First, the US could persuade the Japanese to open their markets more to international competition so that the US could export more to Japan. This structural solution is a longer-term response to the situation. Second, changes in macroeconomic policy could narrow the bilateral US-Japan trade balance. If the Japanese officials employed a loose monetary policy and a more expansionary fiscal policy, then domestic demand would rise and their trade surplus would drop. Conversely, the US could reduce its government budget deficit and perhaps even run surpluses to reduce its trade 4eficit. In fact, officials in both countries have adopted policies along these lines. MACROECONOMIC IMPLICATIONS OF THE BOP The macroeconomic ramifications of a nation's international transactions depend crucially on two factors: why a nation runs its current account balance and how much it has borrowed in the past. A current account deficit or surplus can be either a positive or negative development for an economy, depending on the source of the imbalance. However, over the long term, nations that run chronic current account deficits have higher inflation rates and pay higher real interest rates than nations that do not. At the conclusion of this section, we present a case study of New Zealand's external account problems in the mid 1980s. The example illustrates that if foreign capital inflows do not offset burgeoning, unchecked current account deficits, then changes in interest rates, exchange rates, and other economic variables will occur. A country's current account position can be either beneficial or detrimental to an economy. Just as households cannot borrow indefinitely to maintain their current consumption in excess of income and firms cannot use debt to cover their operating losses forever, nations cannot use foreign savings to finance current consumption without end. However, if foreign capital is advanced to purchase investment equipment that will produce a long-lasting stream of returns that can service future foreign claims on its output, then running a current account deficit may be reasonable and beneficial for an economy. A current account deficit stemming from an inflow in capital to finance an economy's physical or tangible investment spending is generally not problematic. Indeed, countries in the early stage of development usually run current account deficits to finance their expansion. For example, South Korea ran a current account deficit averaging 5% of GDP in the 1970s, a move designed to finance its rapid growth. In the past decade, Korean real GDP growth has averaged 9.5 % and the nation has run a current account surplus averaging 1% using the productive investments it made in the 1970s. Conversely, a large current account surplus may stem from insufficient domestic investment opportunities that leaves excess capital to be exported abroad. This capital outflow could negatively affect domestic growth. Japan has consistently run a current account surplus averaging 2.4% of GDP in the past decade. Domestic investment of close to 30% of GDP in the past five years was 60% higher than either US or European Union investment. These investments did little to benefit the Japanese economy, however, because growth in this period consistently lagged both the US and Europe. Current account deficits that result from excess consumption (i.e., inadequate domestic savings) are usually detrimental to an economy. In the early 1980s, the US experienced a dramatic widening of its current account deficit due to a sharp rise in the government budget deficit, i.e., public dissavings, together with a decline in the private savings rate. Private investment remained basically constant. This set of events suggests that imported foreign capital was being used to finance consumption rather than investment. Government expenditures channeled into consumption make it difficult for succeeding generations to repay the loans because there is no income stream generated. Large public sector budget deficits are not the only source of unhealthy, consumption-led current account deficits. The case of Mexico illustrates how a country can run into trouble with a large current account deficit, even if it does not result from poor public finances. Mexico's current account deficit in 1994 was close to 8% of GDP while its official budget deficit was under 1%. The experience in Mexico demonstrates that private borrowers such as banks that incur too much debt can be quickly shut off from international capital if foreign investors believe that a country is not credit worthy. It is still too early to know whether the structural reforms put in place following the 1994 devaluation of the Mexican peso will lead to long-run, more sustainable growth. In addition to the source of the current account imbalance, the degree of past borrowing is also critical in determining its macroeconomic impact. A country running a modest deficit such as Germany after many years as an international creditor might not be adversely affected, even if the deficit is being used to finance current consumption. In short, persistent current account deficits generally boost a nation's net external debt causing a rise in both the credit and inflation risk premia on those assets and higher borrowing costs. The rapid growth of external debt can harm a nation's economic performance because it is inflationary. Countries who are running current account deficits are essentially over-consuming relative to domestic output, a basic inflationary condition. Nations-that borrow foreign capital also have significant incentive to inflate their way out of their debt. This situation can feed upon itself because countries with poor current account and inflation experiences are often forced to cheapen their currencies (a classic inflationary exercise) to attract the foreign capital needed to roll-over their external debt. This observation is well supported by historical record. We find a -80% correlation between the average current ac6ount to GDP and the annual inflation rate in a cross-section of nations between 1970 and 1995. Switzerland, the Netherlands, Japan, Belgium, and Germany have been net exporters of capital in the past 25 years and these countries have also had some of the lowest annual average inflation rates. Empirically, we also observe that countries that have had large current account deficits pay higher real interest rates (i.e., net of expected inflation) on average in world financial markets. Japan provides an example of the advantages of running external surpluses. Because there is considerable excess savings in the Japanese economy, risk-adjusted rates of return have been driven down on domestic assets in Japan. As a result, Japanese government bond yields are among the lowest in the world. Risk premia on debtor countries' assets tend to rise when they most need foreign capital, i.e., during periods when financial liquidity is being constrained by major central banks. For example, when the US Federal Reserve began raising short rates in 1994, countries with higher outstanding external deficits suffered disproportionately relative to those without such records. Australia, which had been running current account deficits of over 4% of GDP, witnessed a 360-basis-point increase in its government bond yields in 1994. Because government fiscal savings or, more frequently, dissavings is a large component of their country's savings-investment balance, we observe a strong relationship between an economy's government budget deficit relative to output and the government's real borrowing costs. Until very recently Canadian, Italian, UK, and Swedish government budget balances were considerably above those recorded in other major developed countries. As a result, government bond yields in these countries have generally been significantly above average. The converse is also true. Nations that do not accumulate large public debts pay lower average real interest rates. For example, Switzerland has an average net public debt figure substantially below average so Swiss real long-term interest rates have been significantly below US rates. CASE STUDY. NEW ZEALAND'S 1980S CURRENT ACCOUNT NIGHTMARE New Zealand's experiences in the early 1980s provides an example of what can happen to a nation that accumulates extreme savings-investment imbalances. It ran annual current account deficits averaging 6.2% of GDP. Government consumption was a principle source of the imbalance. New Zealand's general government fiscal deficit peaked in 1982 at 6.6% of GDP. New Zealand was on the verge of default on its public external debt. Policy makers were overwhelmed by an uncontrollable domestic inflation and high long-term interest rates. The NZ$ depreciated by over 50% in five short years. International bankers refused to provide New Zealand with any more credit in 1984, so the economy ground to a halt in the second half of the decade. In response to this crisis, New Zealand's political leaders took dramatic steps to reform their nation's economic policies. To correct the current account imbalance, government finances were tightly disciplined, for instance, reducing subsidies to farmers, cutting social welfare benefits, and deregulating the labour market. The economy opened up to international competition to build a globally competitive export sector. Officials made the central bank independent and gave monetary policy makers a strict inflation target so that the nation could build credibility in international financial markets. Today, slightly more than a decade later, the results have been impressive. The government of New Zealand has run fiscal surpluses for the past four years and it is committed to the goal of paying off its foreign debt. New Zealand has managed to run a modest trade surplus of US$2.8 billion in the past three years. Economic growth has averaged 3.9% since 1992, double the rate at which the economy grew in 1980s. Unemployment has fallen 4.5% from its peak in 1992 to just 6.1% today. Annual underlying inflation has averaged only 2.0% within this period. Economic reforms associated with the financial collapse significantly improved New Zealand's long-run economic performance and raised its citizens standard of living. CYCLICAL BOP INFLUENCES ON EXCHANGE RATES Over short periods, exchange rates both influence and are influenced by the current account balance in a complex, non-linear fashion. Since a nation's balance of payments must balance, equilibrium must be simultaneous in two markets: the goods market (i.e., the current account) and the financial market (i.e.-, the capital account). Disturbances in one market may have important implications for how the other market will clear. Once again, the reason for and duration of a nation9s current account imbalance has important implications for its short-run effect if only on the exchange rate. First, we examine a shock in the goods market. The standard economic view holds that a country's currency depreciates when its trade deficit widens. Take the case in which there is a positive shock to domestic demand. Imports usually expand faster than exports and the trade deficit grows. To achieve equilibrium in the capital account, domestic interest rates usually need to rise and the currency depreciates to attract counter-balancing inflows of foreign capital. The financial market's response to a demand shock depends on the anticipated reaction of policy makers. Countries with strong, independent, and credible central banks usually witness currency appreciation in response to a positive demand shock as investors anticipate the move to a restrictive monetary policy stance. For instance, the DM appreciated in the wake of the unification boom even though the current account fell into deficit. Investors correctly predicted that the Bundesbank would offset easier fiscal policy with a tighter monetary stance. A country's borrowing history is important in this process. If a country has a large external surplus, such as Japan, then a cyclical or transitory deterioration of the trade balance may have little consequence for the currency. In other cases, a shock to domestic demand that leads investors to expect higher interest rates will significantly raise the risk premium for inflation on the nation's debt assets. For instance, Italy's large stock of existing government debt means that higher expected short-term interest rates worsen the country's fiscal balance and they are also typically associated with a weaker currency. Another link between a nation's external accounts and its currency works through the capital account. Suppose that a nation's superior investment opportunities attract an inflow of foreign capital. Disequilibrium within the capital account will induce an appreciation of the nation's currency. In the goods market, domestic products become more expensive relative to foreign substitutes. In equilibrium, the country experiences a larger trade deficit to offset the higher capital inflows. Thus, the domestic currency may appreciate even though the trade deficit widens. In the early 1980s, the US began running sizable trade and current account deficits because of a sizable fiscal expansion. Indeed, since the consumption share of GDP was rising (as opposed to the investment share), America was borrowing from abroad to finance a presumably "unhealthy" consumption binge. Meanwhile, foreign investors saw the US as a relatively attractive place to invest their extra capital given that the US was drawing down its savings and offered superior risk-adjusted returns. Indeed, returns on US$ assets rose to levels that induced foreigners to accumulate US$ assets at a rate in excess of the rising current account deficit. This portfolio shift caused the trade-weighted US$ to appreciate by over 65% between 1980 and 1985. Finally, adjustment lags between real and financial markets can complicate the analysis. Sometimes the causality may run from the exchange rate to the current account balance. Empirically, we observe that trade flows respond to exchange rate movements with a lag of four to eight quarters. Within this adjustment period, current account surpluses may fall in the wake of a significant appreciation of the exchange rate rather than vice-versa. In Canada's case for example, the C$ tends to impact the current account because Canada and the US have a close and open trading arrangement that is almost immediately affected by changes in the exchange rate. The empirical evidence linking the level of a nation's contemporary current account balance to the performance of its currency is mixed. We examined the contemporaneous correlation between annual changes in 13 nations' current account balances (as a percentage of GDP) and their trade-weighted exchange rate between 197 9 and 1996. If countries with current account surpluses have appreciating currencies, then we should observe a positive correlation between these series. In fact, we observe that in four cases - the US, Italy, Finland, and Spain, the correlation is moderately negative. Five other cases exhibit a correlation less than 20% - Germany, the UK, Canada, Australia, and Sweden. The case with the strongest correlation Correlation Between Annual Current Account Balance and the Trade-Weighted Exchange Rate: 1979-1996 Country Correlation Switzerland 77.7 France 73.9 Japan 59.8 New Zealand 45.3 Canada 17.7 Sweden 8.1 Germany 7.5 UK 7.3 Australia 4.0 USA -26.5 Italy -27.2 Spain -30.0 Finland -34.9 — Switzerland at 77.7% — is statistically uninteresting because both the current account surplus and the currency rise without variation throughout the entire sample period. Given the multiplicity of channels through which current account balances and currencies interact, these weak correlation results are not surprising. STRUCTURAL BOP INFLUENCES ON CURRENCY VALUATION The linkage between a nation's long-run savings-investment balance and their currency's value is more pronounced. When a nation has run a large current account deficit over a long period of time, financing the outstanding international obligations may be more important to setting the value of the currency than short-run developments in the trade accounts. Persistent current account deficits are generally negative for a nation's currency. Chronically large external deficits mean that the world accumulates claims on the country's future output. Inevitably, the country becomes a debtor. As foreign obligations mount, risk adverse creditors require higher expected returns to take the debtor country's obligations into their portfolio. This relationship could work through both greater inflation expectations and a higher credit premium. Foreign investors must be compensated for this risk in the form of higher interest rates and a weaker currency, all else being equal. In short, these high relative expected returns become necessary to balance the current and capital accounts. In contrast to the short-term statistical analysis above, we observe a strong positive structural relationship between long-term current account trends and movements in a nation's currency. We examined the accumulated current account balances and trade-weighted exchange rates in a cross-section of countries between 1991 and 1995. We find a solid 64% correlation between the average current account balance and the average percentage change in the trade-weighted exchange rate. In summary, it is difficult to establish a causal short-term relationship between current account balances and currency values because so many elements of the economy may change in tandem. Over longer horizons, a strong external position generally translates into a structurally strong currency. CASE STUDY: TRENDS IN THE US CURRENT ACCOUNT From a structural perspective, the growing US current account deficit has been a principle concern to investors because it could potentially weaken the US$. The US current account deficit is forecast to be roughly US$187 billion in 1997, up from US$165 billion in 1996. On a relative basis, the US deficit is 2.3% of GDP, a figure that is the highest within the G7, but small compared to some of the imbalances observed in other major advanced economies. On an absolute basis, the US must currently attract all of the excess savings in the G7 to finance its current account imbalance. Fifteen years of large current account deficits have pushed the US from being a net international creditor to being the world's largest net international debtor. The US net external debt is over US$ 1.1 trillion, or close to 14% of GDP. At the present rate of accumulation, the US net external debt/GDP ratio should rise above 20% within the next three years. Naturally, given the huge absolute size of this imbalance, it is reasonable to expect that the risk premium on US assets should rise. Rapidly accumulating current account deficits and the need for external capital would ordinarily weigh down the US$. Based on the discussion above, the two questions that arise are: (1) why is the current account deficit so large and (2) can we expect these trends to continue? One can easily contrast US current account deficits in the past six years from those amassed in the 1980s. The majority of the US current account deficit during the Reagan era was attributable to a substantial rise in the US government budget deficit. Effectively, government dissavings increased while investment was constant and US private savings drifted slightly lower. In the past five years, however, US government budget deficits have consistently fallen as the budget deficit to GDP ratio has dropped. At the same time, the private savings rate has declined to roughly offset the improvement made by less government dissavings. With net national savings essentially unchanged, the larger US current account deficit accumulated in recent years has largely resulted from an increase in the propensity to invest. Private investment as a percentage of GDP rose almost 25 % to 15.6% of GDP since 1991. This trend accounts for a significant fraction of the increase in the current account imbalance in the past several years. In short, recent US current account deficits have been an investment-led phenomenon that ought to enable the US to better finance the foreign claims on its future output. Looking forward, the outlook for the US current account seems relatively benign. Historically, increases in the rate of investment spending are unlikely to be sustained, prompting ever greater investment-savings imbalances. In addition, strong economic growth and new-found fiscal discipline has reduced the government budget deficit to just 0.6% of GDP, a 27 year low. US political leaders have adopted a balanced budget package that will continually reduce the government's draw on national savings in coming years. Assuming that already low private savings rate will be maintained, trends in investment and government budgets should result in a lower US current account deficit as a percentage of GNP in coming years. In conclusion, our analysis suggests that US net external debt as a percentage of GDP should soon settle at a sustainable level. In this case, foreign investors are unlikely to demand a significantly higher risk premium on US assets to rollover the outstanding stock of US obligations. Over the long-run, ongoing US savings and investment trends may indeed be a favourable structural development for the US$. John Simpson