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International Capital Flows and the Current Account 1 Issues and Applications • Global capital markets and the current account • Debt crises in less developed countries • Sovereign risk 2 Balance of Payments Accounting: The Current Account (CA) • The current account (CA): measures a country’s trade in currently produced goods and services • A negative CA implies that a country is importing more than it is exporting 3 U.S. Current Account 4 The Capital and Financial Account (KFA) • The capital and financial account (KFA) measures a country’s trade in financial assets • Note that selling assets (e.g. bonds) is equivalent to borrowing and leads to inflow of capital, that is the rest of the world is lending money to us 5 The Link Between CA and KFA • The current account an the capital financial account sum to zero CA+KFA=0 • This equation is an Accounting Identity! 6 Example • Suppose a country has exports equal to $50 billion and imports of $90 billion---so this country’s current account is (assume: NFP=0) CA = 50 - 90 = -40 • The only option available is for the country to borrow $40 billion from the rest of the world---that is a capital inflow of $40 billion, KFA=+$40 billion. CA + KFA = 0 7 Savings, Investment and the Current Account • We know from the Introduction that NX + NFP = CA = S – I • Focusing on S – I is equivalent to looking at the CA or the KFA 8 Current Account and Borrowing • An economy with income Y can have consumption plus investment being greater than Y • How can it do this? • The answer is simple: BORROW • Suppose income is $100 bl and overall consumption (that is C+I+G) is $120 bl. • Current account for this economy is $100-$120 bl = -$20 bl • Economy issues debt to borrow $20 bl, hence KFA is equal to $20 bl • CA + KFA = (-$20) + $20 = 0 9 U.S. Current Account (1998) Net exports Net income from assets (NFP) Net unilateral transfers Current account balance (CA) -164.3 -12.2 -44.1 -220.6 In billions of U.S. dollars 10 Savings, Investment, and CA 11 U.S. Net International Debt $2.5 trillion is approx. 25% of GDP 12 Sources of Funds for US borrowing • What finances US current account deficits: – Sale of US treasury debt – Sale of Corporate debt – Equities 13 Foreigners own 37% of all US Treasuries, 21% of all corporate debt, and 11% of all secondary US equities 14 15 Global Capital Markets • Financial markets in New York, London, Frankfurt, Tokyo • Each country has savings • All these savings enter global financial markets • Each country has needs for investment in new plant and equipment • The job of the global financial markets is to efficiently allocate the global pool of savings to investment opportunities in different countries 16 Determinants of Savings • Aggregate savings is income minus consumption: s=y–c–g • Aggregate savings is the sum of private savings and government savings – Govt. Savings are Net Tax Revenue-Govt. expenditure s = sp + sg 17 Determinants of National Saving Fig. 1 r r s1 S • Fig. 3 s1 s2 • • S s2 s1 S r Fig. 2 An increase in expected real interest rate causes desired national saving to rise, see Fig 1. An increase in G financed through increased government debt, causes desired aggregate savings to fall, Fig. 2. An increase in Y causes desired national saving to rise. Part of the extra income is saved to provide for future consumption, Fig. 3. 18 Determination of the Current Account Variables subscripted by w refer to global variables, and those subscripted by arg refer to Argentina. 19 Current Account • The global capital markets determine the world real interest rate • A country’s savings and investment determines its current account 20 Good Prospects and the Current Account 21 Growth and the Current Account 22 Recessions and the Current Account 1 0 -1 -2 -3 -4 Mar-00 Mar-98 Mar-96 Mar-94 Mar-92 Mar-90 Mar-88 Mar-86 Mar-84 Mar-82 Mar-80 Mar-78 Mar-76 Mar-74 Mar-72 Mar-70 Mar-68 Mar-66 Mar-64 Mar-62 -5 Mar-60 CA (percentage of GDP) 2 Year Current account deficit falls during recessions and rises during booms What happened in the 2001 recession? It was a worldwide recession 23 24 CA surplus in Japan, Why? Savings Rate 25 Sovereign Debt and Risk 26 External Debt and Default • Excluding the possibility of default implies that the external debt must be paid off with future current account surpluses • External debt to GDP is a key indicator of sustainability of external debt • External debt to GDP rises – if growth rate of GDP falls – if the cost of external borrowing rises 27 External Debt Rise in external debt increases likelihood of default. 28 Sovereign Risk 29 Risk And Sovereign Debt • Debt issued by sovereign countries is also called sovereign debt • Countries cannot be taken to court if they default on their borrowings • This leads to sovereign risk which is reflected in the cost of borrowing 30 Current Account Reversals 31 Current Account as a share of GDP 15 Percent 10 Thailand 5 0 Indonesia Malaysia -5 -10 -15 1995 1996 1997 1998 199932 Determinants of Sovereign Risk • Sovereign risk ratings are almost entirely determined by macroeconomics of the country • Lower Per-Capita income, Higher inflation, and Higher External Debt --- lower the country’s credit rating 33 Macro-economy and Sovereign Risk Fiscal balance and external balance are relative to GDP. External debt refers to foreign currency debt relative to exports. 34 Debt Crises 35 The LDC Debt Crises • Prior to 1979 many of the developing countries ran large current account deficits • There was also an investment boom in many of the Latin American countries • This was primarily caused as a run-up in commodity prices such as coffee and oil • Global recession in 1979-82 lowered demand for exports 36 The LDC Debt Crises • Interest rates on dollar denominated adjustable rate debt rose • Debt to exports and debt to GDP rose dramatically • In August 1982 Mexico declared a moratorium on interest payments. This led to the debt crises 37 Debt and Current Account 1979 and 1982 38 Capital Market Equilibrium for the World Economy 39 Global Capital Markets Variables subscripted by w refer to global variables, and those subscripted by arg refer to Argentina. 40 An Increase in future TFP Expectations of better growth prospects for the future increase investment today Investment determined by (i) real interest rate (ii) future prospects 41 A Decline in Savings A fall in Savings can raise the interest rate and lower investment 42