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International Capital Flows
and the Current Account
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Issues and Applications
• Global capital markets and the current account
• Debt crises in less developed countries
• Sovereign risk
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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
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U.S. Current Account
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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
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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!
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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
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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
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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
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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
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Savings, Investment, and CA
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U.S. Net International Debt
$2.5 trillion is approx. 25% of GDP
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Sources of Funds for US borrowing
• What finances US current account deficits:
– Sale of US treasury debt
– Sale of Corporate debt
– Equities
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Foreigners own 37% of all US Treasuries, 21% of all
corporate debt, and 11% of all secondary US equities
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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
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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
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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.
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Determination of the Current Account
Variables subscripted by w refer to global variables,
and those subscripted by arg refer to Argentina.
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Current Account
• The global capital markets determine the world
real interest rate
• A country’s savings and investment determines its
current account
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Good Prospects and the Current Account
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Growth and the Current Account
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Recessions and the Current Account
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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)
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Year
Current account deficit falls during recessions and rises during booms
What happened in the 2001 recession? It was a worldwide recession
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CA surplus in Japan, Why?
Savings Rate
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Sovereign Debt and Risk
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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
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External Debt
Rise in external debt increases likelihood of default.
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Sovereign Risk
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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
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Current Account Reversals
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Current Account as a share of GDP
15 Percent
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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
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Macro-economy and Sovereign Risk
Fiscal balance and external balance are relative to GDP. External debt refers to
foreign currency debt relative to exports.
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Debt Crises
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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
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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
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Debt and Current Account 1979 and 1982
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Capital Market Equilibrium
for the World Economy
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Global Capital Markets
Variables subscripted by w refer to global variables,
and those subscripted by arg refer to Argentina.
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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
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A Decline in Savings
A fall in Savings can raise the interest rate and lower investment
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