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Thorvaldur Gylfason Outline 1. Balance of payments accounting – How BOP accounts are put together and how they relate to monetary, fiscal, and national income accounts 2. Balance of payments analysis – Economics of exports, imports, exchange rates, etc. 3. Current account sustainability – Foreign debt, and how to keep it in check Balance of payments accounting Accounting system for macroeconomic analysis in four parts 1. 2. 3. 4. Balance of payments National income accounts Fiscal accounts Monetary accounts First look at balance of payments accounts, and then look at linkages External transactions Goods Exports Imports X g g Z Services Capital X s Z Real transactions s x F F z 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 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 Again 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 TR = unrequited transfers from abroad Importance of net factor income Net factor income from labor – Remittances from domestic workers abroad (e.g., Turks in Germany) minus those 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 also matter Capital account Also called capital and financial account Four main items 1. Direct investment – Involves control by owners 2. Portfolio investment – – Includes long-term foreign borrowing Does not involve control by owners 3. Other investment – Includes short-term borrowing 4. Errors and omissions – Statistical discrepancy Overall balance of payments Four main items below the line 1. 2. 3. 4. Gold SDRs Reserve position in IMF Foreign exchange Convenient to measure gross foreign reserve holdings in terms of months of import coverage – e.g., 3 months of imports 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 GNP GNP GNP = C + I + G + TB = C + I + G + CAB – GDP = CAB – TB = Yf (if TR = 0) = GDP + Yf GNP > GDP in Turkey 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 Definition GDP Trade balance Goods and nonfactor services GNP Current account excl. transfers Current account incl. transfers Goods and services GNDI Goods and services plus 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 – DB = DDG + DDF + DDP – DM = DD – DM + DDF = -DR + DDF = Z - X External sector X – Z = DR - DDF 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 Payments for imports of goods, services, and capital Imports Earnings from exports of goods, services, and capital Exports Foreign exchange Real exchange rate eP Q P* Increase in Q means real appreciation Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Real exchange rate eP Q P* Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave R unchanged Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Overvaluation Real exchange rate R Deficit Imports Overvaluation Exports Foreign exchange Price of foreign exchange Overvaluation, again Supply (exports) Overvaluation Deficit Demand (imports) Foreign exchange Welfare Price A B C Consumer surplus E Producer surplus Supply Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) Demand Quantity Welfare, again Price Welfare loss A J F B E Total surplus = AFGC Supply Price ceiling imposes a welfare loss equivalent to the triangle EFG Price ceiling H G C Consumer surplus = AFGH Producer surplus = CGH Demand Quantity Welfare, again Price Welfare loss A J F B E Price ceiling imposes a welfare loss that results from shortage (e.g., deficit) Price ceiling H G C Supply Shortage Demand Quantity Causes and costs of overvaluation Governments may try to keep the national currency overvalued To keep foreign exchange cheap To have power to ration scarce foreign exchange To make GNP look larger than it is Other examples of price ceilings Negative real interest rates Rent controls Inflation and overvaluation Inflation can result in an overvaluation of the national currency Remember: R = eP/P* Suppose e adjusts to P with a lag Then R is directly proportional to inflation Numerical example Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 105 100 Average Time Inflation and overvaluation Real exchange rate Suppose inflation rises to 20 percent per year Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag 120 110 Average 100 Time How to correct overvaluation Under a floating exchange rate regime Adjustment is automatic: e moves Under a fixed exchange rate regime Devaluation will lower e and thereby also Q – provided inflation is kept under control Does devaluation improve the current account? The Marshall-Lerner condition The Marshall-Lerner condition: Theory Valuation effect arises from the ability to affect foreign prices T = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps T Let’s do the arithmetic Bottom line is: Devaluation improves the current account as long as a b 1 a = elasticity of exports b = elasticity of imports The Marshall-Lerner + condition B eX Z B eX (e) Z (e) dB dX dZ X e de de de a dB dX X e de de b e X dZ e Z X e de Z e 1 1 The Marshall-Lerner condition dB dX e X dZ e Z X e de de X e de Z e dB X aX bX 1 a b X de dB 0 de if a b 1 X The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, a b 1 Empirical evidence from developing countries Argentina Brazil India Kenya Korea Morocco Pakistan Philippines Turkey Average 1.4 Elasticity of exports 0.6 0.4 0.5 1.0 2.5 0.7 1.8 0.9 2.7 1.1 Elasticity of imports 0.9 1.7 2.2 0.8 0.8 1.0 0.8 2.7 1.5 Small countries: A special case Small countries are price takers abroad Devaluation has no effect on the foreign currency price of exports and imports So, the valuation effect does not arise Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged Hence, if a > 0 or b > 0, devaluation improves the current account The importance of appropriate side measures Remember: eP Q P* It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation To work, nominal devaluation must result in real devaluation 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 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 2. Run up debts abroad Where is the limit? Is foreign debt bad? Not necessarily if the borrowed funds are used for profitable investments Conceptual framework 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 Real interest rate Saving Domestic equilibrium World equilibrium Borrowing 0 Domestic saving Domestic investment World interest rate Investment Saving, investment Conceptual framework Real interest rate Saving A Domestic equilibrium World equilibrium B C D Borrowing World interest rate Investment 0 Saving, investment Conceptual framework Real interest rate Consumer surplus before borrowing Saving A Domestic equilibrium World equilibrium 0 B C Producer surplus before borrowing Investment Saving, investment Conceptual framework Real interest rate Consumer surplus after borrowing A Domestic equilibrium World equilibrium B C D Borrowing Producer surplus after borrowing 0 Saving World interest rate Investment Saving, investment Conceptual framework Before trade After trade Change Consumer surplus A A+B+D + (B + D) Producer surplus B+C C -B A+B+C A+B+C+D +D Total surplus The area D shows the increase in total surplus and represents the gains from borrowing Gains from trade: Three main conclusions Borrowers are better off and savers are worse off Borrowing raises the economic wellbeing of the nation as a whole because the gains of borrowers exceed the losses of savers 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 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 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 r F D F 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 can we learn from this? 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 Debt dynamics: Another look Let us now study the interaction between trade deficits, debt, and growth Two simplifying assumptions: DDt = aYt (omit the superscript F, so D = DF) Y Exponential growth Trade deficit is constant fraction a of output Yt = Y0egt Output grows at constant rate g per year t Pictures of growth Y log(Y) g 1 time time Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate Debt as the sum of past deficits T DT ΔD t dt 0 at time T Debt as the sum of past deficits T DT ΔD t dt at time T 0 T T 0 0 DT ΔD t dt aY0egt dt Debt as the sum of past deficits T DT ΔD t dt at time T 0 T T 0 0 DT ΔD t dt aY0egt dt 1 gt DT ΔD t dt aY0e dt aY0 e g 0 0 T T gt Evaluate this integral between 0 and T Debt as the sum of past deficits T DT ΔD t dt at time T 0 T T 0 0 DT ΔD t dt aY0egt dt So, as T goes to infinity, Dt becomes infinitely large. But that may be quite OK in a growing economy! 1 gt DT ΔD t dt aY0e dt aY0 e g 0 0 T T gt Evaluate this integral between 0 and T 1 gt 1 gT DT ΔD t dt aY0e dt aY0 e aY0 e 1 g g 0 0 T T gt Debt as the sum of past deficits DT a Y0egt Y0 YT g YT Debt as the sum of past deficits DT a Y0egt Y0 YT g YT DT a Y0egt Y0 a Y0 1 YT g YT g YT Debt as the sum of past deficits DT a Y0egt Y0 YT g YT DT a Y0egt Y0 a Y0 1 YT g YT g YT DT a Y0egt Y0 a Y0 a 1 1 e gT YT g YT g YT g Debt as the sum of past deficits DT a Y0egt Y0 YT g YT DT a Y0egt Y0 a Y0 1 YT g YT g YT DT a Y0egt Y0 a Y0 a 1 1 e gT YT g YT g YT g So, as T goes to infinity, DT/YT approaches the ratio a/g lim T DT a YT g Numerical example Suppose Debt ratio 3 Trade deficit is 6% of GNP a = 0.06 Growth rate is 2% per year Time 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 ... ... as long as a and g remain unchanged Numerical example, again Here we have a Suppose that country whose entire export r = 0.06 (as before) earnings do not D/Y = 3 (our new number) suffice to service its debts A/Y = 0.05 (as before) X/Y = 0.20 (as before) A DF r Y q Y X Y 0.05 0.06 3 q 1.15 0.2 Numerical example, again Suppose that r = 0.06 (as before) D/Y = 2 (our new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) A DF r Y q Y X Y 0.05 0.06 2 q 0.85 0.2 Numerical example, again Suppose that r = 0.06 (as before) D/Y = 1 (new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) A DF r Y q Y X Y 0.05 0.06 1 q 0.55 0.2 Numerical example, again Suppose that r = 0.06 (as before) D/Y = 0.4 (new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) A DF r Y q Y X Y 0.05 0.06 0.4 q 0.37 0.2 Numerical example, again Suppose that r = 0.06 (as before) D/Y = 0.4 (as before) A/Y = 0.05 (as before) X/Y = 0.30 (new number) A DF r Y q Y X Y 0.05 0.06 0.4 q 0.25 0.3 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 In conclusion These slides will be posted on my website: www.hi.is/~gylfason 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