Thorvaldur Gylfason

1. International Monetary Fund/Asian Development Bank Course on Financial Programming and Policies Seoul, Korea, 17-28 May 2010 External sector accounts, analysis, and forecasting ThorvaldurGylfason

2. outline • Balance of payments accounts • How BOP accounts are put together • Definitions, conventions, presentation • Links to other macroeconomic accounts • Balance of payments analysis • Economics of exports, imports, capital flows, exchange rates, etc. • Balance of payments forecasting • External debt and the international investment position

3. 1 Balance of payments accounts Accounting system for macroeconomic analysis in four parts • 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

4. Definition of the balance of payments The balance of payments is a statistical statement which systematically summarizes, for a specific period of time,theeconomic transactions of an economy with the rest of the world

5. Introduction 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

6. Balance of payments conventions: Accounting principles • Double entry accounting • Every 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 Credit refers to the lender whose loan to the debtor is an asset Debit refers to the debtor whose debt to the lender is a liability

7. Balance of payments conventions: Accounting principles 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 (-)

8. Balance of payments conventions: Accounting principles • 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”

9. Balance of payments conventions: Accounting principles Transactions in two major categories • Real transactions • Goods, services, and income • Current account of the BOP • Involve flows • Financial transactions • Reflect changes in foreign assets and liabilities • Capital and financial account of the BOP • Involve changes in stocks Flows involve changes in underlying stocks: X – Z + F = DR X = exports, Z = imports, F = capital account, R = reserves, F = DDF with DF = net foreign debt

10. Balance of payments conventions: Errors and omissions • 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

11. Standard Presentation of the balance of payments • 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

12. Standard Presentation of the balance of payments • 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 are unrequited transactions • Public and private • In cash or in kind • E.g., foreign aid

13. analytical Presentation of the balance of payments • 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

14. analytical Presentation of the balance of payments • The overall balance of payments can be in surplus or in deficit once we distinguish transactions into two sub-groups 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

15. analytical Presentation of the balance of payments • 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

16. External transactions Real transactions Financial transactions Examples

17. Recording external transactions The term “capital account” is Old language (BPM4) Shorthand for new language (BPM5) Balance of payments • BOP = Xg + Xs + Fx – Zg – Zs – Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – Fz Net exports of capital = Net capital inflow = DDF Also called capital and financial account

18. Recording external transactions Balance of payments • BOP = Xg + Xs+ Fx – Zg – Zs – Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – Fz Net exports of capital = Net capital inflow

19. Recording external transactions Balance of payments • BOP = Xg + Xs + Fx – Zg–Zs – Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – Fz Net exports of capital = Net capital inflow

20. Recording external transactions Balance of payments • BOP = Xg + Xs + Fx – Zg – Zs–Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – FzNet exports of capital = Net capital inflow

21. 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

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

23. 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 = net unrequited transfers from abroad Intermediate concept GSB

24. Importance of net factor income Yf > 0 in Pakistan Yf < 0 in Argentina 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)

25. Capital and financial account Two parts • Capital account (esp., capital transfers) • Financial account • Direct investment Involves influence of foreign owners • Portfolio investment Includes long-term foreign borrowing Does not involve influence of foreign owners • Other investment Includes short-term borrowing • Errors and omissions Statistical discrepancy Is the world’s BOP = 0?!

26. 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

27. Capital and financial account • Portfolio investments • Equity participation instruments and debt instruments, money market instruments • Financial derivatives: separate functional category • Other investments • Trade 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)

28. 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”

29. Overall balance of payments Also included in capital and financial account Four main items below the line • 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

30. Transactions with IMF • 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

31. Current account A. Goods Exports Imports Trade balance B. Services Transport Travel C. Income Compensation of workers Investment income D. Current transfers General government Other sectors Current transactions balance = (X-Z) + YF + TRF Capital and financial operations account A. Capital Capital transfers Purchases/sales of nonproduced nonfinancial assets B. Financial operations Direct investment Portfolio investment Other investment C. Errors and omissions Overall Balance D. Net foreign assets E. Exceptional financing Overview of the BOP X-Z FDI YF NFL TRF NFA

32. Overview of the BOP

33. 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

34. 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

35. Links between BOP and national accounts

36. Links between BOP and national accounts

37. Links between BOP and national accounts

38. Fiscal accounts and links to BOP M = D + R • 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 DG + DP = D F = DDF X – Z + F = DR

39. 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

40. 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 Real exchange rate = eP/P*

41. 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

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

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

44. Y = E + X – Z = EN/PE + XN/PX – ZN/PZ (GNP) = EN/PE + XN/PZ – ZN/PZ (GNI) Terms of Trade • 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/Pzrises • Terms of trade worsen when Px/Pzfalls

45. Current account balance • 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 + R because X – Z + F = R

46. Current account balance • CAB  – F + R because X – Z + F = R • Hence, current account deficit can be financed by • Attracting foreign direct investment • Accumulating net foreign liabilities • I.e., borrowing abroad • Running down the net foreign assets of the monetary authorities

47. Current account balance • 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

48. Current account balance • 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

49. Current account balance • 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

50. Overall balance • 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 whenexceptional financingbecomes available • Foreign reserves are traditionally held by the monetary authorities in order to finance payments imbalances and to defend the currency