Balancing payments, savings and external wealth

Eco 328Balancing payments, savings and external wealth

2

• If we use superscripts “H” and “F” to denote home and foreign assets, we can break down the financial account as the sum of the net exports of each type of asset:

• FA equals:

o the additions to external liabilities (the home-owned assets moving into foreign ownership, net)

o minus the additions to external assets (the foreign-owned assets moving into home ownership, net).

Accounting for Home and Foreign Assets

assets external toaddit ionsNet

=assetsforeign ofimport Net

sliabilit ie external toaddit ionsNet

=assets home ofexport Net assetsforeign ofexport Net assets home ofexport Net

)()()()( F

A

F

A

H

A

H

A

F

A

F

A

H

A

H

A EXIMIMEXIMEXIMEXFA

3

• Recall that gross national disposable income is

• In addition, the home economy can free up resources by engaging in net sales (or purchases) of assets. We calculate these extra resources using our previous definitions:

How the Balance of Payments Accounts Work:

income fromcountry home to

available Resources

CAGNENUTNFIATBGNEGNDIY

esasset trad toduecountry home theto

available resources Extra

purchases viaimported assets allof Value

gifts asimported

assets allof Value

importedassets all

of Value

sales viaexported assets allof Value

gifts asexported

assets allof Value

exportedassets all

of Value

][][ KAFAKAKAIMEXKAIMKAEX OUTINAAINAOUTA

4

• Adding the last two expressions, we have the value of the total resources available to the home country for expenditures. This total value is equal the total value of home expenditure on final goods and services, GNE:

• Cancelling GNE from both sides we obtain the result known as the balance of payments identity or BOP identity:


GNEKAFACAGNE

esasset trad toduecountry home thetoavailable resources Extra

income toduecountry home toavailable Resources

0=++account Financialaccount CapitalaccountCurrent

FAKACA

5

• The components of the BOP identity allow us to see the details behind why the accounts must balance.

• If an item has a plus sign, it is called a balance of payments credit or BOP credit.

• If an item has a minus sign, it is called a balance of payments debit or BOP debit.


CA = (EX - IM )+ (EXFS - IMFS )+ (UTIN -UTOUT )

KA = (KAIN -KAOUT )

FA = (EXAH - IMA

H )+ (EXAF - IMA

F )

6

• We have to understand one simple principle: every market transaction (whether for goods, services, factor services, or assets) has two parts.

• If party A engages in a transaction with a counterparty B, then A receives from B an item of a given value, and in return B receives from A an item of equal value.


BOP credits:

Current account (CA): Exports of goods and services (+EX);

Exports of factor services (+EXFS);

Unilateral transfers received (+UTIN).

Capital account (KA): Capital transfers received (+KAIN).

Financial account (FA): Exports of home and foreign assets (+EXH

A , +EX FA ).

7

BOP Debits:

Current account (CA): Imports of goods and services (−IM);

Imports of factor services (−IMFS);

Unilateral transfers given (−UTOUT).

Capital account (KA): Capital transfers given (−KAOUT).

Financial account (FA): Imports of home and foreign assets (−IMH

A , −IMFA).

8

The Double-Entry Principle in the Balance of Payments

1. CA: Drinks in Paris bar −IM −$110

FA: Bar’s claim on AMEX +EXH +$110

2. CA: Arkansas wine exported to Denmark

EX +$36

CA: Jutland wine imported to United States

−IM −$36

3. FA: George’s French tech stocks -IMF −$10,000

FA: BNP claim againstCitibank

+EXH +$10,000

9

A

A

A

The Double-Entry Principle in the Balance of Payments

4. CA: Relief supplies exportedto Bam

+EX +$5,000

CA: George’s charitable gift −UTOUT −$5,000

5. KA: U.S. grant of debt relief −KAOUT −$1,000,000,000

FA: Decline in U.S. external assets +EXF +$1,000,000,000

10

A

11

2012

12

• The current account is also the difference between national saving (S = Y − C − G) and investment:

• This equation, often written as CA = S – I , is called the current account identity even though it is just a rearrangement of the national income identity. Thus,

• S is greater than I if and only if CA is positive, or in surplus.

• S is less than I if and only if CA is negative, or in deficit.

What the Current Account Tells Us

CAISGCY

13

• The current account is also the difference between national saving (S = Y − C − G) and investment:

• This equation, often written as CA = S – I , is called the current account identity even though it is just a rearrangement of the national income identity.

• A current account deficit measures how much a country spends in excess of its income

• or—equivalently—how it saves too little relative to its investment needs.

What the Current Account Tells Us

CAISGCY

14

Saving, Investment, and Current Account Trends: Industrial Countries

15

Savings

• We define private saving (Sp) as that part of after-tax private sector disposable income Y that is not devoted to private consumption C.

• We define government saving (Sg) as the difference between tax revenue T received by the government and government purchases G.

• Private saving plus government saving equals total national saving, S

Sp Y T C

Sg T G

gp SSGTCTYGCYS saving Governmentsaving Private

)()(

Savings

Government saving is positive when tax revenue exceeds government consumption (T > G) and the government runs a budget surplus.

If the government runs a budget deficit, however, government consumption exceeds tax revenue (G >T ), and public saving is negative.

As you can see, the taxes cancel out when we put private and government saving together

16

gp SSGTCTYGCYS saving Governmentsaving Private

)()(

17

Private Saving Trends: Industrial Countries

18

Public saving is clearly more volatile than private saving. Japan ran massive surpluses in the late 1980s and early 1990s.

The United States briefly ran a government surplus in the late 1990s but has since racked up massive deficits

Public Saving Trends: Industrial Countries

19

Do government deficits cause current account deficits?

Often they go together - “twin deficits”. Foreigners finance our deficits.

They sell goods and services to us and then accumulate US assets rather than buying US goods and services. Many of these assets are treasury securities.

We can use the equation just given and the current account identity to write

The theory of Ricardian equivalence asserts that a fall in public saving is fully offset by a contemporaneous rise in private saving.

From the data, however, we see private saving does not fully offset government saving in practice.

The current account might move independently of saving (public or private) due to changes in the level of investment in the last equation.

CA Sp Sg I

23

• A country that has a current account surplus is called a (net) lender. By the BOP identity, it must have a deficit in its asset accounts.

• Any lender, on net, buys assets (acquiring IOUs from borrowers). For example, China is a large net lender.

• A country that has a current account deficit is called a (net) borrower. By the BOP identity, it must have a surplus in its asset accounts.

• Any borrower, on net, sells assets (issuing IOUs to lenders). As we can see, the United States is a large net borrower.

24

U.S. Balance of Payments and Its Components, 1990-2012

25

External Wealth

• Just as a household is better off with higher wealth, all else equal, so is a country.

• “Net worth” or external wealth with respect to the rest of the world (ROW) can be calculated by adding up all of the home assets owned by ROW and then subtracting all of the ROW assets owned by the home country.

• In 2012, the United States had an external wealth of about –$4,474 billion. This made the United States the world’s biggest debtor in.

26

• The level of a country’s external wealth (W) equals

• A country’s level of external wealth is also called its net international investment position or net foreign assets.

If W > 0, home is a net creditor country: external assets exceed external liabilities.

If W < 0, home is a net debtor country: external liabilities exceed external assets.

The Level of External Wealth

LA

W

ROWby owned

assets Home

homeby owned

assetsROW = wealth External

27

• There are two reasons a country’s level of external wealth changes over time.

1. Financial flows: As a result of asset trades, the country can increase or decrease its external assets and liabilities.Net exports of home assets cause an equal increase in the level of external liabilities and hence a corresponding decrease in external wealth.

2. Valuation effects: The value of existing external assets and liabilities may change over time because of capital gains or losses. In the case of external wealth, this change in value could be due to price effects or exchange rate effects.

Changes in External Wealth

28

• Adding up these two contributions to the change in external wealth (ΔW), we find

• Since −FA = CA + KA, substituting this identity

Changes in External Wealth

losses capital minus gains Capital=

effectsValuation =

assets ofexport Net

wealthexternal

on gains Capital

account

Financial

wealthexternal

in Change

FA

W

losses capital minus gains Capital

=effectsValuat ion

received transfers capitalNet

=

incomeUnspent

=

wealthexternal

on gains Capital

account

Capital

account

urrentC

wealthexternal

in Change

KACAW

a country can increase its external wealth in oneof only three ways:

o Through its own thrift (a CA surplus, so expenditure is less than income)

o By the charity of others (a KA surplus, by receiving net gifts of wealth)

o With the help of windfalls (having positive capital gains)

Similarly, a country can reduce its external wealth by doing any of the opposites.

29

31

Are these valuation effects significant?

• For the past 30 years the United States has almost always had a financial account surplus, reflecting a net export of assets to the rest of the world to pay for chronic current account deficits.

• If there were no valuation effects, then the change in the level of external wealth should equal the cumulative net import of assets over the intervening period.

• But valuation effects or capital gains can generate a significant difference in external wealth.

• From 1988 to 2012 these effects reduced U.S. net external indebtedness in 2012 by more than half compared with the level that financial flows alone would have predicted.

• Capital gains always have a “zero sum” property—by symmetry, an increase in the dollar value of the home country’s external assets is simultaneously an increase in the dollar value of the rest of the world’s external liabilities.

Capital gains have cut hour external debt in half!

32

-8000000

-7000000

-6000000

-5000000

-4000000

-3000000

-2000000

-1000000

0

1000000

NFA CumCA

33

• External wealth is only part of a country’s total wealth, the sum of the home capital stock (all nonfinancial assets in the home economy, denoted K) plus amounts owed to home by foreigners (A) minus amounts owed foreigners by home (L):

• Changes in the value of total wealth can then be written as follows:

External Wealth and Total Wealth

wealthExternal

assets alnonfinanci Home

)-(+ = wealthTotal LAK

losses) minus (gains effectsValuation disposals) minus ns(acquisito Addit ions

–on

gains Capital+

on

gains Capital+

– to

Additions +

to

Additions =

wealthtotal

in Change

LAKLAK

34

• Additions to the domestic capital stock K are simply investment, denoted I. Additions to external wealth, A – L, equal net additions to external assets minus net additions to external liabilities

• Now, using the BOP identity, we know that CA + KA + FA = 0so that minus the financial account –FA must equal CA + KA, hence we can write


losses) minus (gains effectsValuation

economy home theintoassets ofimport Net

= toAdditions

economy home in theassets toAdditions

=K toAdditions –on

gains Capital+

on

gains Capital+)(

wealthtotal

in Change

LAK

FAI

LA


–on

gains Capital+

on

gains Capital

wealthtotal

in Change

LAKKACAI

35

• The BOP identity makes the connection between external asset trade and activity in the current account. We take the connection one step further using the current account identity, S = I + CA, which allows us to write

• The message of this expression is clear. As we all probably know from personal experience, there are only three ways to get more (or less) wealthy: do more (or less) saving (S), receive (or give) gifts of assets (KA), or enjoy the good (bad) fortune of capital gains (losses) on your portfolio. What is true about individuals’ wealth is also true for the wealth of a nation in the aggregate.



–on

gains Capital+

on

gains Capital

wealthtotal

in Change

LAKKAS

Balancing payments, savings and external wealth

Economy & Finance

Transcript of Balancing payments, savings and external wealth