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International Monetary Fund/Asian Development Bank Course on Financial Programming and Policies Seoul, Korea, 17-28 May 2010 Thorvaldur Gylfason 1. Balance of payments accounts How BOP accounts are put together Definitions, conventions, presentation Links to other macroeconomic accounts 2. Balance of payments analysis Economics of exports, imports, capital flows, exchange rates, etc. 3. Balance of payments forecasting 4. External debt and the international investment position Accounting system for macroeconomic analysis in four parts 1. 2. 3. 4. Balance of payments National income accounts Fiscal accounts Monetary accounts Now look at balance of payments accounts per se, looked before at linkages in a separate lecture 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 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 Double Every entry accounting transaction must result in two entries of equal amounts, one on the credit side and one on the debit side 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 By convention, some transactions are recorded as credit items(+) and others as debit items (-) Exports of goods and services Credit (+) Imports of goods and services Debit (-) Income and transfers received Credit (+) Income and transfers paid out Debit (-) Increase in foreign liabilities Credit (+) Increase in foreign assets Debit (-) 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” Transactions in two major categories 1. Real transactions Goods, services, and income Current account of the BOP Involve flows X = exports, Z = imports, 2. Financial transactions F = capital account, R = reserves, F = DDF with DF = net foreign debt Reflect changes in foreign assets and liabilities Capital and financial account of the BOP Involve changes in stocks 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 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 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 Public are unrequited transactions and private In cash or in kind E.g., foreign aid 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 The overall balance of payments can be in surplus or in deficit once we distinguish transactions into two subgroups and draw a line between these two subgroups When transactions above the line sum up to a deficit, transactions below the line will sum up to a corresponding surplus, and vice versa 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 External transactions Goods Exports Imports g X Z g Services Capital s X Z s Real transactions F x z F Financial transactions Recording external transactions Balance of payments BOP = Xg + Xs + Fx – Zg – Zs – Fz =X–Z+F = current account + capital account Here X = Xg + Xs Exports of good and services Z = Zg + Zs Imports of good and services F = Fx – Fz Net exports of capital = Net capital inflow = DDF Recording external transactions Balance of payments BOP = Xg + Xs + Fx – Zg – Zs – Fz =X–Z+F = current account + capital account Here X = Xg + Xs Exports of good and services Z = Zg + Zs Imports of good and services F = Fx – Fz Net exports of capital = Net capital inflow Recording external transactions Balance of payments BOP = Xg + Xs + Fx – Zg – Zs – Fz =X–Z+F = current account + capital account Here X = Xg + Xs Exports of good and services Z = Zg + Zs Imports of good and services F = Fx – Fz Net exports of capital = Net capital inflow Recording external transactions Balance of payments BOP = Xg + Xs + Fx – Zg – Zs – Fz =X–Z+F = current account + capital account Here X = Xg + Xs Exports of good and services Z = Zg + Zs Imports of good and services F = Fx – Fz Net exports of capital = Net capital inflow Balance of payments and reserves Again BOP = X – Z + F = DR where R = reserves Note: X, Z, and F are flows R is a stock, DR is a flow Balance of payments and reserves BOP = X – Z + F = DR where DR = R – R-1 Implications X F Z DR DR DR In practice Z F or DR From trade balance to current account Trade balance TB = Xg + Xnfs – Zg – Znfs Xnfs = Xs – Xfs = exports of nonfactor services Znfs = Zs – Zfs = imports of nonfactor services Balance of goods and services GSB = TB + Yf Yf = Xfs – Zfs = net factor income Current account balance CAB = GSB + TR = TB + Yf + TR GSB TR = net unrequited transfers from abroad 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) Capital and financial account Two parts 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 Capital and financial account 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 Portfolio investments Equity participation instruments and debt instruments, money market instruments Financial derivatives: separate functional category Other Trade investments 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 Reserve assets Financing items below the line in 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” Overall balance of payments Four main items below the line 1. 2. 3. 4. Gold SDRs Reserve position in IMF Foreign exchange Three-month Rule: Gross foreign reserve holdings should suffice to cover three months of imports of goods and services Giudotti-Greenspan Rule: Central Bank foreign reserves should not decrease below short-term foreign commercial bank liabilities or total liabilities 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 Current account Capital and financial operations A. Goods Exports Imports Trade balance B. Services Transport Travel A. Capital Capital transfers Purchases/sales of nonproduced nonfinancial assets account X-Z C. Income Compensation of workers Investment income D. Current transfers General government Other sectors YF TRF Current transactions balance = (X-Z) + YF + TRF B. Financial operations FDI Direct investment Portfolio investment NFL Other investment C. Errors and omissions Overall Balance D. Net foreign assets E. Exceptional financing NFA National income accounts Y=C+I+G+X–Z = E+X–Z where E = C + I +G CAB = X – Z = Y – E Ignore Yf and TR for simplicity S=I+G–T+X–Z CAB = S – I + T – G CAD = Z – X = E – Y = I – S + G – T Links between BOP and national accounts Y=C+I+G+X–Z GDP = C + I + G + TB GNP = C + I + G + CAB GNP – GDP = CAB – TB = Yf (if TR = 0) GNP = GDP + Yf GNP > GDP in Pakistan GNP < GDP in Argentina GNDI = GNP + TR = GDP + Yf + TR Links between BOP and national accounts Y X-Z Definition GDP Trade balance Goods and nonfactor services Links between BOP and national accounts Y X-Z Definition GDP Trade balance Goods and nonfactor services GNP Current Goods and account excl. services transfers Links between BOP and national accounts Y X-Z GDP Trade balance GNP GNDI Definition Goods and nonfactor services Current Goods and account excl. services transfers Current Goods and account incl. services plus transfers transfers Fiscal accounts and links to BOP Public sector G – T = DB + DDG + DDF Private sector I – S = DDP – DM – DB Now, add them up G – T + I – S = DB + DDG + DDF + DDP – DM DDG + DDF + DDP – DM = DD – DM + DDF = -DR + DDF External sector X – Z = DR - DDF – DB = =Z-X Monetary accounts and links to BOP Monetary survey M =D+R From stocks to flows DM = DD + DR Solve for DR DR = DM – DD Monetary approach to balance of payments Still holds that DR = X – Z + F Real exchange rate Balance of payments analysis Imports Exports Foreign exchange Balance of payments equilibrium Equilibrium between demand and supply in foreign exchange market establishes Equilibrium real exchange rate Equilibrium in the balance of payments BOP = X + Fx – Z – Fz =X–Z+F = current account + capital account =0 Real exchange rate Overvaluation Deficit R Imports Overvaluation Exports Foreign exchange Price of foreign exchange Overvaluation, again Supply (exports) Overvaluation Deficit Demand (imports) Foreign exchange Y=E+X–Z = EN/PE + XN/PX – ZN/PZ (GNP) = EN/PE + XN/PZ – ZN/PZ (GNI) Ratio of export prices to import prices: Px/Pz Typically expressed in as an index Px = Export price index PZ = 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 Px/Pz rises Terms of trade worsen when Px/Pz falls 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 + DR because X – Z + F = DR – F + DR because X – Z + F = DR Hence, current account deficit can be financed by CAB Attracting foreign direct investment Accumulating net foreign liabilities I.e., borrowing abroad Running down the net foreign assets of the monetary authorities 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 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 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 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 Another crucial indicator used to assess the external position of a country 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 Exceptional financing can be needed in an emergency where reserves have fallen to perilously low levels Three main types Rescheduling of external debt obligations Debt forgiveness Scheduled payments postponed in agreement with creditors Voluntary cancellation by creditors Payments arrears on external debt service Scheduled payments postponed without agreement with creditors 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 DR = 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 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 Exports and imports of goods Exports and imports of services Factor income Unrequited transfers Assume small open economy Project volume of import demand P Z f Y , Z P Z = volume of imports Y = domestic real GDP (+) PZ/ P = import prices relative to domestic GDP deflator (-) Assume small open economy Project volume of export demand PX X f Y *, P * X = volume of exports Y* = foreign real GDP (+) PX/ P* = export prices relative to foreign GDP deflator (-) Assume small open economy Project volume of export supply PX X f Y , P X = volume of exports Y = domestic real GDP (+) PX/ P = export prices relative to domestic GDP deflator (+) 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) 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) Private 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 transfers Grants in cash and in kind Need information from donors Need compatibility with grant projections in government finance statistics Capital 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 transfers direct investment Depends on investment opportunities, profitability of investments, tax incentives, economic growth, and political and social stability of the country Portfolio Equity investment 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 Current account sustainability and debt There are two ways to finance a deficit on current account 1. 2. 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 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 External debt: Key concepts Debt stock Usually measured in dollars or other international currencies because debt needs to be serviced in foreign currency Debt ratio Ratio of external debt to GDP Ratio of external debt to exports More useful for some purposes, because export earnings reflect the ability to service the debt External debt: Key concepts Debt burden Also called debt service ratio Equals the ratio of amortization and interest payments to exports A rD q X F q = debt service ratio A = amortization r = interest rate DF = foreign debt X = exports External debt: Key concepts Interest burden Ratio of interest payments to exports Amortization burden Also called repayment burden Ratio of amortization to exports F rD b X A a X q=a+b External debt: Magnitude and composition 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 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: Numbers How can we figure out a country’s debt burden? Divide through definition of q by income F A D r Y Y q X Y Now we have expressed the debt service ratio in terms of familiar quantities: the interest rate r, the debt ratio DF/Y, and the export ratio X/Y as well as the repayment ratio A/Y Numerical example Suppose that r = 0.06 DF/Y = 0.50 A/Y = 0.05 X/Y = 0.20 Here we have a country that has to use 40% of its export earnings to service its external debt F A D r Y q Y X Y 0.05 0.06 0.5 0.08 q 0.4 0.2 0.2 External debt dynamics 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 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 Recall balance of payments equation: BOP = X – Z + F where F = capital inflow = DDF where DF = foreign debt Capital inflow, F, thus involves an increase in the stock of foreign debt, DF, or a decrease in the stock of foreign claims (assets) So, F is a flow and DF is a stock External debt dynamics Now assume Then, it follows that BOP = X – Z + DDF = 0 so that DDF = rDF Z = ZN + rDF Z = total imports ZN = non-interest imports rDF = interest payments Further, assume X = ZN BOP = 0 In other words: ΔD F r F D A flexible exchange rate ensures equilibrium in balance of payments at all times External debt dynamics So, now we have: ΔD r F D F Now subtract growth rate of output from both sides: ΔD ΔY r-g F D Y F DY g Y External debt dynamics But what is ΔD F ΔY F D Y ? This is proportional change in debt ratio: DF Δ F Y ΔD ΔY F DF D Y Y This is an application of a simple rule of arithmetic: %D(x/y) = %Dx - %Dy Proof z = x/y log(z) = log(x) – log(y) Dlog(z) = Dlog(x) - Dlog(y) But what is Dlog(z) ? dlog(z) dz 1 Δz Δlog(z) dt dt z z So, we obtain Δz Δx Δy z x y Q.E.D. Debt, interest, and growth We have shown that Δd rg d Debt ratio rg where F D d Y r=g rg Time What to conclude? 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 Once again, high-quality investment is key Another perspective rg D / Y const. in equilibrium DD / D DY / Y a g D / Y DD / DY ( DD / Y ) /( DY / Y ) where a = current account deficit/GDP g = growth of GDP What to conclude? Must adjust policies Must either 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 And why not? Because the debt burden then becomes unbearable Recall our earlier numerical example Where we looked at the relationship between the debt ratio and the debt burden Korea is a case in point Its export-oriented growth strategy reduced the numerator and increased the denominator of the debt ratio, thereby quickly reducing the country’s debt burden An import-substitution strategy would reduce both numerator and denominator with an ambiguous effect on the debt burden International investment position Gross foreign debt is not all that matters Foreign assets matter as well Net foreign debt equals gross debt less gross assets Conversely, the difference between gross assets and gross debt equals the international investment position (IIP) International investment position 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: IIPt = IIPt-1 + Ft Ft represents BOP financial account transactions during period t, including various non-transaction changes 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 In conclusion External borrowing is a necessary and natural part of economic development This requires countries that borrow to invest the funds borrowed in high-quality capital This is necessary to be able to service the debt 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