Balance of Payments: Accounts and Analysis
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Balance of Balance of
Payments: Payments:
Accounts and Accounts and
AnalysisAnalysis
Thorvaldur Gylfason
Course on External Vulnerabilities and Policies Tunis, February 15-26, 2010
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1. Balance of payments accountsaccounts How BOP accounts are put together Definitions, conventions, presentation Links to other macroeconomic
accounts2. Balance of payments analysisanalysis
Economics of exports, imports, capital flows, exchange rates, etc.
3. Balance of payments projectionsprojections4. External debt and the
international investment position
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Accounting system for macroeconomic analysis in four parts
1. Balance of payments2. National income accounts3. Fiscal accounts4. Monetary accounts
First look at balance of payments accounts per se, and then look at linkages in a separate lecture
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The balance of payments is a statistical statement statistical statement which systematically summarizes, for a specific period of timespecific period of time, the economic transactions of economic transactions of an economy with the rest of an economy with the rest of the worldthe world
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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 external position of the country, including its debt
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The mandate of the IMF is to assess the external position of the its member countries through surveillance (Article IV Article IV ConsultationsConsultations) as well as in the context of the use of Fund resources (program design and program design and reviewreview)
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In a world where national economies are more and more closely integrated, owing to both trade and financial flows, policy makers and economists need to have balance of payments statistics that are recent, reliable, exhaustive, and comparable across countries based on a commonly accepted methodologycommonly accepted methodology
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One of the roles of the IMF is to elaborate and standardize the methods needed to establish establish balance of payments statisticsbalance of payments statisticsSince 1948, the IMF has published a Balance of Payments Manual Balance of Payments Manual laying out the main principles behind the compilation of balance of payments statistics
Six editions: 1948, 1950, 1961, 1977, 1993, 2008
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In this session, we discuss the the balance of payments accounting balance of payments accounting frameworkframework as well as the main main principles for the analysis of the principles for the analysis of the balance of paymentsbalance of payments based on the methodology detailed in the Balance of Payments Manual (6th ed., 2008)
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The balance of payments records transactions between residents and nonresidents
The notion of residence is determined by the center of center of economic interesteconomic interest of units rather than their nationality
E.g., Turks in Germany
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IndividualsResidents of a country if the length of their stay is longer than 12 months But not students and patients
Non-residentsVisitors (tourists, plane or boat crews, seasonal workers, etc.), trans-border workers (residents in the countries where they live), diplomats, members of the army, foreign students (regardless of the length of their stay)
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EnterprisesResidents of the country where they realize their activity, given the presence of at least an establishment in the countryE.g., branches and subsidiaries of foreign enterprises are considered to be residents of the host country
Range of indictors, no definite rules
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Public entitiesEmbassies, consulates, military bases, government entities are counted as residents of their country of origin
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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 positivepositive sign (+) is associated with an amount recorded on the creditcredit side and a negativenegative sign (-) is associated with an entry on the debitdebit side CreditCredit refers to the lender whose loan to the debtor is an
assetassetDebitDebit refers to the debtor whose debt to the lender is a
liabilityliability
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By convention, some transactions are recorded as creditcredit items(+) and others as debitdebit 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 (-)
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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”
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Unrequited transfersTransactions that correspond to a
single flow are recorded as current transfers or as capital transfers resulting in a symmetrical entry under imports (transfers received) or under exports (transfers paid)
Example: EU provides a country with a gift of computers (food aid)The computers are recorded as
imports and capital transfers (current transfers)
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Transactions in two major categories 1.1. Real transactionsReal transactions
Goods, services, and income Current account Current account of the BOP
Involve flowsflows
2.2. Financial transactionsFinancial transactions Reflect changes in foreign assets and
liabilities Capital and financial account Capital and financial account of the BOP
Involve changes in stocksstocks
Flows involve
changes in
underlying
stocks: X – Z +
F = RX = exports, Z = imports,F = capital account, R = reserves, F = DF with DF = net foreign debt
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Double-entry recordingThe sum of credit entries must equal
the sum of debit entriesThe sum of all transactions is zero
Practical problems lead to errors and omissionsDiversity of data sourcesMissing data: e.g., financial
transactions outside banking system (informal sector)
Under- or overvaluation of transactions Smuggling
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The recording period for balance of payments flows is determined by the frequency of data collectionAnnualQuarterlyMonthly
Transactions are recorded on the date of legal change of ownershipAccrual basis, not cash basis
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Transactions must be valued at market price, reflecting “the terms of an exchange between a willing buyer and a willing seller”
The direct exchange of one item of property for another (barter) is valued at a fictitious price used to value traded goods
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Exports and imports are recorded "free-on-board" (f.o.b.)Cost of insurance and transport beyond the
port of departure is not included in the value of the goods; they are recorded under services
If exports and imports are reported in customs data on a c.i.f. basis, i.e., including the cost of insurance and freight, then the cost of insurance and freight needs to be deducted before recording the items at issue in the balance of payments (e.g., on the basis of average costs and percentage)
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Transactions recorded in the balance of payments must be expressed in a common unit of account (e.g., home currency or USD)National currency is used to compare BOP to
other developments in the domestic economy Dollar, SDR, or other major stable
currencies are used for cross-country comparisons, as a precaution in the event of rapid depreciation of the national currency which would make it difficult to interpret the balance of payments
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In order to translate into the chosen unit of account the data that are expressed in the unit of transaction, the exchange rate at the time of the transaction is used
To translate the balance of payments from one unit of account to another (e.g., from US$ to national currency) we use the average exchange rate over the period for trade flows and end-of-period exchange rate for stocks of reservesStocks vs. flows
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Two viewsviews of the balance of payments, that is:
Two ways to present ways to present the balance of paymentsStandard presentation
The accountant or statistician’s viewaccountant or statistician’s viewRecords grossgross amounts, credit and debit
Analytical presentationThe economist’s vieweconomist’s view
Records some items on netnet basis, credit minus debit
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From the statistician or accountant’s point of view, the structure of the balance of payments reflects the recording of foreign transactions based on accounting principles accounting principles Standard presentation Standard presentation in which the
amounts recorded (credit and debit) are gross amounts
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From the economist's point of view, a different presentation facilitates the use of the balance of payments for analytical purposes Analytical presentationAnalytical presentation
Established on the basis of the standard presentation
For certain groups of items the accounting balance is used, that is, the difference between the amounts on the credit and debit sidesE.g., net capital inflow = gross inflow less gross
outflow F = FX – FZ = DF
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Current accountTransactions related to goods,
services, income, and current transfers between residents and non-residents Transactions related to goods are those
relative to the movements of merchandiseExports and imports of goods
Transactions involving services include different categories, e.g., transport, travel, etc.Exports and imports of services
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Transactions related to income involve the remuneration of labor, capital, and landE.g., compensation paid to trans-border
workers, interest payments on external debt, etc.
Transfers are unrequited transactionsPublic and privateIn cash or in kindE.g., foreign aid
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Since the sums of credits and debits offset one another, how can there be an "imbalance" in the external accounts?
Advantage of analytical presentationIt shows significant balances that are useful for economic analysis and shows a possible external imbalance
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The overall balance of payments can be in surplussurplus or in deficitdeficit once we distinguish transactions into two sub-groups and draw a lineline between these two subgroups
When transactions above the line above the line sum up to a deficit, transactions below the below the lineline will sum up to a corresponding surplus, and vice versa
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Trade balanceDifference 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 balanceCurrent account balance plus capital and
financial operations account balance considered not to be “financing” items
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External External transactionstransactions
GoodsGoods ServiceServicess
CapitalCapital
ExportExportss XXgg XXss FFxx
ImportImportss ZZgg ZZss FFzz
ExamplesReal Real transactions
Financial Financial transactions
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Balance of paymentsBOP = XBOP = Xgg + X + Xss + F + Fxx – Z – Zgg – Z – Zss – F – Fz z
= X – Z + F= X – Z + F = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =
Net capital inflow = Net capital inflow = DDFF
Recording external Recording external transactionstransactions
Also called capital and financial
account
The term “capital account” is
1.Old language (BPM4)
2.Shorthand for new language
(BPM5)
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Balance of paymentsBOP = BOP = XXgg + X + Xss + F+ Fxx – Z – Zgg – Z – Zss – F – Fz z
= = XX – Z + F – Z + F = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =
Net capital inflowNet capital inflow
Recording external Recording external transactionstransactions
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Balance of paymentsBOP = XBOP = Xgg + X + Xss + F + Fxx – – ZZgg –– ZZss – F – Fz z
= X – = X – ZZ + F + F = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =
Net capital inflowNet capital inflow
Recording external Recording external transactionstransactions
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Balance of paymentsBOP = XBOP = Xgg + X + Xss + + FFxx – Z – Zgg – Z – Zss –– FFzz
= X – Z + = X – Z + FF = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =
Net capital inflowNet capital inflow
Recording external Recording external transactionstransactions
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AgainBOP = X – Z + F = BOP = X – Z + F = RRwhere
R = reservesR = reservesNote:
X, Z, and F are flowsR is a stock, R is a flow
Balance of Balance of payments and payments and reservesreserves
R = R – RR = R – R-1-1
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BOP = X – Z + F = BOP = X – Z + F = RRwhere R = R – R-1
ImplicationsXX RRFF RRZZ RR
In practiceZZ FF or or RR
Balance of Balance of payments and payments and reservesreserves
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From trade From trade balance to current balance to current accountaccount Trade balance
TB = XTB = Xgg + X + Xnfsnfs – Z – Zgg – Z – Znfsnfs
Xnfs = Xs – Xfs = exports of nonfactor servicesZnfs = Zs – Zfs = imports of nonfactor services
Balance of goods and servicesGSB = TB + YGSB = TB + Yff
Yf = Xfs – Zfs = net factor income Current account balance
CAB = GSB + TR = TB + YCAB = GSB + TR = TB + Yff + TR + TR TR = net unrequited transfers from abroad
Intermediate concept
GSB
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Importance of net Importance of net factor income factor income 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 capitalInterest 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)
YYff > 0 in Pakistan > 0 in Pakistan
YYff < 0 in Argentina < 0 in Argentina
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Capital and Capital and financial accountfinancial accountTwo parts
1.1. Capital account Capital account (esp., capital transfers)
2.2. Financial accountFinancial account1.1. Direct investmentDirect investment
Involves influence of foreign owners2.2. Portfolio investmentPortfolio investment
Includes long-term foreign borrowingDoes not involve influence of foreign owners
3.3. Other investmentOther investmentIncludes short-term borrowing
4.4. Errors and omissionsErrors and omissionsStatistical discrepancy
Is the world’s BOP = 0?!
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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
Capital and Capital and financial accountfinancial account
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Portfolio investmentsEquity participation instruments and debt
instruments, money market instruments Financial derivatives: separate functional category
Other investmentsTrade 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)
Capital and Capital and financial accountfinancial account
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Reserve assetsFinancing items 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 finance the balance of paymentsthe balance of payments, including IMF loans E.g., to maintain adequate foreign
exchange reserves Most successful IMF loans are never “used”
Capital and Capital and financial accountfinancial account
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Overall balance of Overall balance of paymentspaymentsFour main items below the line
1.1. GoldGold2.2. SDRsSDRs3.3. Reserve position in IMFReserve position in IMF4.4. Foreign exchangeForeign exchange
Three-month RuleThree-month Rule: Gross foreign reserve holdings should suffice to cover three months of importscover three months of imports of goods and services
Giudotti-Greenspan RuleGiudotti-Greenspan Rule: Central Bank foreign reserves should not decrease not decrease below short-term foreign commercial below short-term foreign commercial bank liabilities or total liabilitiesbank liabilities or total liabilities
Also included in
capital and financial
account
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Changes in reserve position in IMFRecorded in financial operations
account under reserve assets, below the line
Use of IMF resourcesPurchase 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 SDRsRecorded in financial account as reserve asset flows
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Current accountCurrent account
A. Goods Exports Imports
Trade balanceTrade balanceB. Services
Transport Travel
C. Income Compensation of workers Investment income
D. Current transfers General government Other sectors
Current transactions balanceCurrent transactions balance
= (X-Z) + Y= (X-Z) + YF F + TR+ TRFF
CCapital and financial operations apital and financial operations accountaccount
A. CapitalCapital transfersPurchases/sales of nonproduced nonfinancial assets
B. Financial operations
Direct investment
Portfolio investment
Other investment
C. Errors and omissions
Overall BalanceOverall BalanceD. Net foreign assets
E. Exceptional financing
X-ZX-Z
YYFF
TRTRFF
FDIFDI
NFLNFL
NFNFAA
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Y = C + I + G + X – ZY = C + I + G + X – Z= E + X – ZE + X – Zwhere E = C + I +GE = C + I +G
CAB = X – Z = Y – E CAB = X – Z = Y – E Ignore Yf and TR for simplicity
S = I + G – T + X – Z S = I + G – T + X – Z CAB = S – I + T – GCAB = S – I + T – GCAD = Z – X = E – Y = I – S + G – TCAD = Z – X = E – Y = I – S + G – T
National income National income accountsaccounts
Private
sector deficitPublic
sector
deficit
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Y = C + I + G + X – Z Y = C + I + G + X – Z
GDP = C + I + G + TBGDP = C + I + G + TBGNP = C + I + G + CABGNP = C + I + G + CABGNP – GDP = CAB – TB = YGNP – GDP = CAB – TB = Yff (if TR = 0) (if TR = 0)
GNP = GDP + YGNP = GDP + Yff
GNP > GDP GNP > GDP in Pakistan GNP < GDP GNP < GDP in Argentina
GNDI = GNP + TR = GDP + YGNDI = GNP + TR = GDP + Yff + TR + TR
Links between BOP Links between BOP and national and national accountsaccounts
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YY X - ZX - Z DefinitionDefinition
GDPGDP Trade balance
Goods and nonfactor services
Links between BOP Links between BOP and national and national accountsaccounts
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YY X - ZX - Z DefinitionDefinition
GDPGDP Trade balance
Goods and nonfactor services
GNPGNP Current account excl. transfers
Goods and services
Links between BOP Links between BOP and national and national accountsaccounts
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YY X - ZX - Z DefinitionDefinition
GDPGDP Trade balance
Goods and nonfactor services
GNPGNP Current account excl. transfers
Goods and services
GNDIGNDI Current account incl. transfers
Goods and services plus transfers
Links between BOP Links between BOP and national and national accountsaccounts
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Fiscal accounts Fiscal accounts and links to BOPand links to BOP PublicPublic sector
G – T = G – T = B + B + DDGG + + DDFF
PrivatePrivate sectorI – S = I – S = DDPP –– M M –– BB
Now, add them upG – T + I – S = G – T + I – S = B + B + DDGG + + DDF F + + DDPP –– M M –– B B
== DDGG + + DDF F + + DDPP –– M =M = D D –– M + M + DDFF = - = -R + R + DDFF = Z - = Z -
XX ExternalExternal sector
X – Z = R - DF
M = D + RM = D + R
DDGG + D + DPP = D = D
X – Z + F = X – Z + F = RR
F = DF
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Monetary accounts Monetary accounts and links to BOPand links to BOPMonetary survey
M = D + RM = D + RFrom stocks to flows
M = M = D + D + RRSolve for R
R = R = M M –– DDMonetary approach Monetary approach to balance
of paymentsStill holds that R = X – Z + F
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Foreign exchangeForeign exchange
Real exch
an
ge r
ate
Real exch
an
ge r
ate
Imports
Exports
Earnings from Earnings from
exports of goods, exports of goods,
services, and services, and
capital capital
Payments for Payments for
imports of goods, imports of goods,
services, and services, and
capitalcapital
EquilibriumEquilibrium
Balance of Balance of payments analysispayments analysis
Real exchange rate = eP/P*Real exchange rate = eP/P*
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Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in the balance of
payments
BOP = X + FBOP = X + Fxx – Z – F – Z – Fz z
= X – Z + F= X – Z + F = current account + capital
account = 0
Balance of Balance of payments payments equilibriumequilibrium
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Foreign exchangeForeign exchange
Real exch
an
ge r
ate
Real exch
an
ge r
ate
ImportsImports
Exports
Overvaluation
Deficit
OvervaluationOvervaluationRR R moves
when e is fixed
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Foreign exchangeForeign exchange
Pri
ce o
f fo
reig
n e
xch
ang
ePri
ce o
f fo
reig
n e
xch
ang
e
Supply (exports)
Demand (imports)
Overvaluation
Deficit
Overvaluation
works like a price
ceiling
Overvaluation, Overvaluation, againagain
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Difference between exports and imports of goodsProvides useful information on likely future developments in the current account
Distinction between goods and services may appear arbitrary
Data on merchandise trade can be quickly obtained from customs while data on services may take more time
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Ratio of export prices to import prices: Px/Pz Typically expressed in as an indexPx = Export price indexPZ = 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 importsTerms of trade improve when Px/Pz
risesTerms of trade worsen when Px/Pz falls
Y = E + X – Z = EN/PE + XN/PX – ZN/PZ
(GNPGNP)= EN/PE + XN/PZ – ZN/PZ
(GNIGNI)
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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 worldIncludes change in net foreign assets of
Non-banking sector Banking sector (including monetary
authorities)CAB – F + R because X – Z + F = R
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CAB – F + R because X – Z + F = R
Hence, current account deficit can be financed byAttracting foreign direct investmentforeign direct investmentAccumulating net foreign liabilitiesnet foreign liabilities
I.e., borrowing abroad Running down the net foreign assets net foreign assets
of the monetary authorities
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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 RuleGiudotti-Greenspan Rule
Other factorsCapacity to meet financial obligationsAvailability of external financing
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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
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Another crucial indicator used to assess the external position of a countryA deficitdeficit in the overall balance
means a decreasedecrease in the net net foreign assets foreign assets of the monetary authority except when exceptional exceptional financingfinancing becomes available
Foreign reserves are traditionally held by the monetary authorities in order to finance payments imbalances and to defend the currency
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Exceptional financing Exceptional financing can be needed in an emergency where reserves have fallen to perilously low levels
Three main typesReschedulingRescheduling of external debt obligations
Scheduled payments postponed in agreement with creditors
Debt forgivenessDebt forgiveness Voluntary cancellation by creditors
Payments arrears Payments arrears on external debt service Scheduled payments postponed withoutwithout
agreement with creditors
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Indicators of an appropriate level of foreign reservesRatio of reserves to monthly imports
of goods and services of more than 3
Guidotti-Greenspan Rule Other considerations
Capital mobilityExchange rate regimeComposition of external liabilitiesAccess to foreign borrowing Seasonal nature of imports and
exports
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Current account Current account sustainability and sustainability and debtdebt
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 Another rule: Do not allow reserves to
fall below short-term foreign liabilities2. Run up debts abroad
Where is the limit? Is foreign debt always bad?
Not necessarily if the borrowed funds are used to finance profitable investments
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Debt stockUsually measured in dollars or other
international currenciesbecause debt needs to be serviced debt needs to be serviced
in foreign currency Debt ratio
Ratio of external debt to GDPRatio of external debt to exports
More useful for some purposes, because export earnings reflect the export earnings reflect the ability to service the debtability to service the debt
External debt: External debt: Key conceptsKey concepts
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External debt: External debt: Key Key conceptsconcepts
Debt burdenAlso called debt service ratiodebt service ratioEquals the ratio of amortization
and interest payments to exports
q = debt service ratioA = amortizationr = interest rate DF = foreign debtX = exports
X
rDAq
F
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Interest burdenRatio of interest payments to
exports
X
Aa q = a + bq = a + b
Amortization burdenAlso called repaymentrepayment burdenRatio of amortization to
exports
X
rDb
F
External debt: External debt: Key conceptsKey concepts
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Magnitude of the debtDebt should not become too large
How large is too large?
Measurement of the debtGross or net?
May subtract foreign reserves in excess of three months of imports
Composition of the debtFDI, portfolio equity, long-term loans,
short-term loans
External debt: External debt: Magnitude and Magnitude and compositioncomposition
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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• Giudotti-Greenspan Rule
External debt: External debt: Magnitude and Magnitude and compositioncomposition
Indonesia and
Korea broke the
Giudotti-Greenspan Rule
in 1996
So did
Iceland, big
time, prior to
crisis in 2008
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How can we figure out a country’s debt burden?Divide through definition of qq by
incomeNow we have expressed the debt service ratio in terms of familiar quantities: the interest rate rr, the debt ratio DDFF/Y/Y, and the export ratio X/YX/Y as well as the repayment ratio A/YA/Y
Y
XY
Dr
Y
A
q
F
External debt: External debt: NumbersNumbers
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Suppose that r = 0.06DF/Y = 0.50A/Y = 0.05X/Y = 0.20
4.02.0
08.0
0.2
5.006.005.0q
Here we have a country that has to use 40% of its export 40% of its export earnings earnings to service its external debt
Heavy burden!Heavy burden!
Y
XY
Dr
Y
A
q
F
Numerical exampleNumerical example
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Debt accumulation is, by its nature, a dynamicdynamic phenomenonA 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 circlevicious 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 External debt dynamics dynamics
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Recall balance of payments equation:BOP = X – Z + FBOP = X – Z + F
where
FF = capital inflow = = DDFF where
DDFF = foreign debtCapital 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 flowflow and DF is a stockstock
External External debtdebt dynamicsdynamics
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Now assumeZ = ZZ = ZNN + r + rDDFF
ZZ = total importsZZNN = non-interest importsrrDDFF = interest payments
Further, assumeX = ZX = ZNN
BOP = 0 BOP = 0 A flexible exchange rate ensures equilibrium in balance of payments at all
times
Then, it follows thatBOP = X – Z + BOP = X – Z + DDFF = = 00so that
DDFF = = rDrDFF
In other words:
rD
ΔDF
F
External External debtdebt dynamicsdynamics
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So, now we have:
rD
ΔDF
F
Now subtract growth rate of output from both sides:
g-rY
ΔY
D
ΔDF
F
Y
Yg
External debtExternal debt dynamicsdynamics
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But what is
This is proportional change in debt ratio:
Y
ΔY
D
ΔDF
F
??
Y
D
Y
DΔ
Y
ΔY
D
ΔDF
F
F
F
This is an application of a simple rule of arithmetic:
%%(x/y) = (x/y) = %%x - x - %%yy
External debtExternal debt dynamicsdynamics
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z = x/ylog(z) = log(x) – log(y)
log(z) = log(z) = log(x) - log(x) - log(y)log(y) But what is log(z) log(z) ?
So, we obtain
z
Δz
z
1
dt
dz
dt
dlog(z)Δlog(z)
y
Δy
x
Δx
z
Δz
Q.E.D.
Proof Proof
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We have shown that
grd
Δd
where
Debt ratio
Time
r r g g
r = gr = g
r r g g
Need economic Need economic
growth to keep growth to keep
the debt ratio the debt ratio
under controlunder control
Y
Dd
F
Debt, interest, and Debt, interest, and growth growth
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It is important to keep economic economic growth growth at home aboveabove – or at least not far below – the world rate of world rate of interest 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 high-quality investment is key
What can we learn What can we learn from this? from this?
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Gross foreign debt is not all that matters
Foreign assetsassets matter as wellNet foreign debt equals gross
debt less gross assetsConversely, the difference
between gross assets and gross debt equals the international international investment position (IIP)investment position (IIP)
International International investment positioninvestment position
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Changes in IIP involve changes in stocks measured at different points in timeTransactions (e.g., foreign borrowing)Non-transaction changes (price
changes, exchange rate movements, other changes)
Reconciliation statement: IIPIIPtt = IIP = IIPt-1t-1 + F + Ftt
Ft represents BOP financial account transactions during period t, including various non-transaction changes
International International investment positioninvestment position
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ConceptsConceptsTransactions
Economic flows Economic flows that reflect the creation, transformation, exchange, transfer, or extinction of economic value and involve changes in ownership of financial assets
Non-transactionsPrice changes Price changes reflecting changes in market values of assets or liabilities
Zero for non-traded instrumentsE.g., trade credits, loans, currency and deposits
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ConceptsConceptsNon-transactions
Exchange rate changes Exchange rate changes reflecting impact of changes in exchange rate between currency used for IIP (domestic currency) and currency in which assets or liabilities are denominated
Zero for assets and liabilities denominated in domestic currencyE.g., local equities, domestic currency bonds, etc.
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Other changes in IIPNot a residual or ‘dump’ categoryIncludes appearance or disappearance of assets or liabilities Uncompensated seizure Bankrupties Write-offs Activation of guarantees Classification changes
Generally lumpy and small
ConceptsConcepts
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Relationship to other Relationship to other statisticsstatisticsInternational accounts IIP + BoP = international accounts
o IIP is presented in terms of stocksstockso BoP is presented in terms of flowsflows
Ft in IIP reconciliation statement is the capital and financial account in BoP
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Income in Current AccountCompensation of employees + investment incomeo Payments and receipts on investment measured in IIPo Interest, dividends, distributions yields on investment
Relationship to other Relationship to other statisticsstatistics
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External debtDirect and portfolio debt liabilities and other investment liabilities from IIPo Only liabilities (no assets)o Only debt
Excludes equity (direct and portfolio)Excludes financial derivatives
Relationship to other Relationship to other statisticsstatistics
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In conclusionIn conclusionExternal trade and investment are
crucial determinants of economic development
Excessive external imbalances can jeopardize the benefits of external trade and capital flows
Financial programs are designed to achieve external balance by fostering the buildup of adequate foreign exchange reserves
Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debt Must avoid overvaluation
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In conclusionIn conclusion
The EndThe EndExternal borrowing is a necessary
and natural part of economic developmentThis requires countries that borrow to invest
the funds borrowed in high-quality capitalhigh-quality capitalThis is necessary to be able to service the
debt
If debt burden becomes too heavy, must either reduce deficit or spur reduce deficit or spur growthgrowthIt is always desirable anyway to do
everything possible to encourage economic growth
Rapid growth allows more foreign borrowing without making the debt burden unmanageable
These slides will be
posted on my
website: www.hi.is/~gylfason