Balance of Payments: Accounting and Analysis

1. Balance of Payments: Accounting and Analysis Thorvaldur Gylfason

2. Outline • Balance of payments accounting • How BOP accounts are put together and how they relate to monetary, fiscal, and national income accounts • Balance of payments analysis • Economics of exports, imports, exchange rates, etc. • Current account sustainability • Foreign debt, and how to keep it in check

3. 1 Balance of payments accounting • Accounting system for macroeconomic analysis in four parts • Balance of payments • National income accounts • Fiscal accounts • Monetary accounts First look at balance of payments accounts, and then look at linkages

4. External transactions Real transactions Financial transactions Examples

5. 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 + ZsImports of good and services • F = Fx – Fz Net exports of capital = • Net capital inflow

6. 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 + ZsImports of good and services • F = Fx – Fz Net exports of capital = • Net capital inflow

7. 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 + ZsImports of good and services • F = Fx – Fz Net exports of capital = • Net capital inflow

8. 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 + ZsImports of good and services • F = Fx – Fz Net exports of capital = • Net capital inflow

9. 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 DR = R – R-1

10. Balance of payments and reserves • Again • BOP = X – Z + F = DR where DR = R – R-1 • Implications XDR FDR ZDR In practice ZF or DR

11. 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

12. Importance of net factor income Yf > 0 in Turkey Yf < 0 in Argentina • 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

13. Capital account • Also called capital and financial account • Four main items • Direct investment • Involves control by owners • Portfolio investment • Includes long-term foreign borrowing • Does not involve control by owners • Other investment • Includes short-term borrowing • Errors and omissions • Statistical discrepancy

14. Overall balance of payments • Four main items below the line • 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

15. 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 Private sector deficit Public sector deficit

16. 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 Turkey • GNP < GDP in Argentina GNDI = GNP + TR = GDP + Yf + TR

17. Links between BOP and national accounts

18. Links between BOP and national accounts

19. Links between BOP and national accounts

20. Fiscal accounts and links to BOP M = D + R DG + DP = D • Public sector • G – T = B + DG + DF • Private sector • I – S = DP– M – B • Now, add them up • G – T + I – S = • B + DG + DF + DP– M – B = • DG + DF + DP– M = • D – M + DF = -R + DF = Z - X • External sector • X – Z = R - DF F = DDF X – Z + F = DR

21. Monetary accounts and links to BOP • Monetary survey • M = D + R • From stocks to flows • M = D + R • Solve for R • R = M – D • Monetary approach to balance of payments • Still holds that DR= X – Z + F

22. 2 Balance of payments analysis Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

23. Real exchange rate Increase in Q means real appreciation e refers to foreign currency content of domestic currency Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

24. Real exchange rate 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

25. Overvaluation R moves when e is fixed R Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

26. Overvaluation, again Overvaluation works like a price ceiling Supply (exports) Price of foreign exchange Overvaluation Demand (imports) Deficit Foreign exchange

27. Welfare DR = 0, so R is fixed when e floats Price Consumer surplus Supply A Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) B E Producer surplus Demand C Quantity

28. Welfare, again Consumer surplus = AFGH Producer surplus = CGH Price Welfare loss Total surplus = AFGC Supply A F Price ceiling imposes a welfare loss equivalent to the triangle EFG J B E Price ceiling H G Demand C Quantity

29. Welfare, again Price Welfare loss Supply A F Price ceiling imposes a welfare loss that results from shortage (e.g., deficit) J B E Price ceiling H G Demand C Shortage Quantity

30. 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

31. 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

32. Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 Average 105 100 Time

33. Inflation and overvaluation Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Time

34. 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

35. The Marshall-Lerner condition: Theory Suppose prices are fixed, so that e = Q 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 Valuation effect arises from the ability to affect foreign prices a = elasticity of exports b = elasticity of imports

36. The Marshall-Lerner condition + - Import elasticity Export elasticity a b 1 1

37. The Marshall-Lerner condition X if

38. 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, Devaluation improves the current account

39. Empirical evidence from developing countries Elasticity of Elasticity of exports imports Argentina 0.6 0.9 Brazil 0.4 1.7 India 0.5 2.2 Kenya 1.0 0.8 Korea 2.5 0.8 Morocco 0.7 1.0 Pakistan 1.8 0.8 Philippines 0.9 2.7 Turkey 1.4 2.7 Average 1.1 1.5

40. 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

41. The importance of appropriate side measures Remember: 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

42. 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

43. 3 Current account sustainability and debt There are two ways to finance a deficit on current account • Run down foreign reserves • But there is a limit • Rule of thumb: Do not bring reserves below three months of imports • Run up debts abroad • Where is the limit? Is foreign debt bad? Not necessarily if the borrowed funds are used for profitable investments

44. 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

45. Real interest rate Domestic equilibrium World interest rate World equilibrium Borrowing Domestic saving Domestic investment Conceptual framework Saving Investment 0 Saving, investment

46. Real interest rate Conceptual framework Saving A Domestic equilibrium B D World interest rate World equilibrium C Borrowing Investment 0 Saving, investment

47. Real interest rate Consumer surplus before borrowing A B C Producer surplus before borrowing Conceptual framework Saving Domestic equilibrium World equilibrium Investment 0 Saving, investment

48. Real interest rate Consumer surplus after borrowing A B D C Borrowing Producer surplus after borrowing Conceptual framework Saving Domestic equilibrium World interest rate World equilibrium Investment 0 Saving, investment

49. Conceptual framework Before trade After trade Change Consumer surplus A A + B + D + (B + D) Producer surplus B + C C - B Total surplus A + B + C A + B + C + D + D The area D shows the increase in total surplus and represents the gains from borrowing

50. Gains from trade: Three main conclusions • Borrowers are better off and savers are worse off • Borrowing raises the economic well-being 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