international finance balance of

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NBAE 5540, Fall 2008

Lecture 2: Balance of Payments andForeign Investment

NBAE 5540 : International Finance

© Gordon Bodnar, 2008

Professor Gordon Bodnar

Balance of Payment Balance of Payments (BOP)

a record of transactions between the residents of

BOP accounting uses double-entry bookkeeping.

Credit (+) transactions represent demands for US dollars

result from purchases by foreigners of goods, services,goodwill, financial and real assets, gold, or foreignexchange from Americans

» export of good/service or financial equivalent of IOU

Debit - transactions re resent su lies of US dollars

NBAE 5540: Lecture 2, Slide # 2

result from purchases by Americans of goods, services,goodwill, financial and real assets, gold and foreignexchange from foreigners

» import of good or f inancial equivalent of IOU

The BOP is usually divided into two components the current account and the capital (financial) account




Current Account

Movements of goods and services, incomepayments, and goodwill

ex orts of oods and services, X sale of goods/services produced in the US to foreigners

exports give rise to a demand for dollars; recorded as (+)

» exports of goods are known as merchandise trade

» exports of services include foreigners’ expenditures on UStourism, transportation, education, royalties and businessservices

imports of goods and services, M


purchase of goods/services produces abroad by residents

imports give rise to supply of dollars; recorded as (-)

» services also include US tourism and travel expendituresabroad, payments for communications, financial and computerservices, royalties and license fees, and many types of otherbusiness services

Net Exports = Trade Balances Balance on merchandise trade:

TBG = XG - MG (values) or TBG = XG + MG (BOP)

a measure of the net trade position in tangible goods

the difference between the value of merchandise exports andimports or the sum of the BOP value of merchandise exports(credit) plus the BOP value of merchandise imports (debit)

» US historically runs large deficits on this account (~3-5% GDP)

Balance on services:

= - = +


va ues)

)

a measure of the net trade position in services (intangibles)

the difference between the value of service exports and importsor the sum of the BOP value of service exports (credit) plus theBOP value of service imports (debit)

» US historically runs small surpluses on this account (~1% GDP)




Other Components of Current Account Balance of payments on income payments, I

the net income payments made for the use factors of production(capital or direct labor)

I I - I (values) I I I (BOP)

measures only the payments for the use of non resident capital(dividends or interest) and non resident labor

» US historically runs surplus on this account (~0.5% GDP)

Unilateral transfers, Tr the net implicit value of goodwill flowing from unilateral

a ments into and out of the countr


unilateral payments include foreign aid, non-military assistance,pensions, private gifts and donations to parties overseas

the “goodwill” is the offset entry to the unilateral flow of moneyex: a transfer of funds to foreigners is recorded as a debit underunilateral transfers (import of goodwill)

» US historically runs a deficit on this account (~0.5% GDP)

US Trade BalancesMerchandise, Services, and Income, plus Unilateral Transfers

1960-2007

1.0%

2.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

% o

f G D P

Merchandise Services


-7.0%

-6.0%

-5.0%

1 9 6 0

1 9 6 3

1 9 6 6

1 9 6 9

1 9 7 2

1 9 7 5

1 9 7 8

1 9 8 1

1 9 8 4

1 9 8 7

1 9 9 0

1 9 9 3

1 9 9 6

1 9 9 9

2 0 0 2

2 0 0 5

Income Payments Unilateral TransfersTotal Balance




Current Account Balance

Current Account Balance (CA) the sum of total exports (BOP) and total imports including income

flows (BOP) plus net unilateral transfers (BOP)

CA = XT + MT + Tr (BOP accounting)» where XT , MT, and Tr are the BOP values of exports, imports and

transfers sent abroad (credits for USD inflows, debits for USD outflows)

or CA = XT - MT - Tr (values)» where XT, MT, and Tr are simply the USD values of exports, imports and

transfers sent abroad

the current account indicates the broad balance of trade including


goods, services, income payments (for capital rental) andunilateral transfers of goodwill (gifts)

if the CA is not zero, exports do not balance with importsand transfers, then the imbalance must be offset with nettrade in financial assets

this is the capital/financial account of the BOP

Capital and Financial Account International flow of financial assets over period

» capital account line refers to non financial assets

financial account consists of two main categories

US official reserve assets, net» liquid assets held by the FED and Treasury, includes gold and FX

US government assets other than official reserves (net)» new loans and loan repayments involving US government

private assets abroad» investments by US private firms/individuals in foreign assets

direct investment - investment with ≥ 10 percent ownership


- ,

Foreign owned assets in the US (Net) (increase is a credit)

foreign official assets in the US (single official category)

» US dollar assets held by foreign governments in the US

other foreign assets in the US» net changes in holdings of US assets by private foreigners

» again by direct investment and portfolio investment classifications




Balance on Capital/Financial Account Balance on capital account (KA)

the balance on capital account is the result of the trade in financialassets between the US and the rest of the world

KA = Δ US owned assets abroad + Δ Foreign owned assets in US

debits credits

KA is the difference between the net outflow of US money intoforeign assets and the net inflows of foreign money into US assets

when KA > 0

foreigners are increasing their ownership of local assets more than


» the US is decreasing its net foreign asset position

» the US is a net foreign borrower

when KA < 0

US residents are increasing their ownership of foreign assets morethan foreigners are increasing their ownership of local assets

» the US is increasing its net foreign asset position

» the US is a net foreign creditor

KA and Change in Net Foreign Assets KA is also the opposite of the change in the

country’s net foreign asset (-ΔNFA) position

assets from changes in underlying asset prices and exchangerate changes

so the net balance on capital flows, KA = -ΔNFA when KA > 0 => ΔNFA < 0 so residents experience a decrease

in their net foreign asset position

the country is a net foreign borrower for that period» the decreased their net forei n asset osition / increased their


indebtedness to the rest of the world

when KA < 0 => ΔNFA > 0 so residents experience an increasein their net foreign asset position

the country is a net foreign lender for that period» they increased their net foreign asset position / decreased their

indebtedness to the rest of the world




Relation Between CA and KA Because of double-entry accounting, the current

account and the capital account balances sum to 0:

CA + KA = 0

since CA + KA = 0 and KA = - ΔNFA, by substitution wehave

CA = NFA

the current account is the change in the country’s net foreignasset position

» ignoring valuation and XR effects on existing assets


borrowing or lending money to the rest of the world

CA deficit means that a country is borrowing money from the rest ofthe world

» this is how they afford to import more than they export or what they do

CA surplus means that a country is lending money to the rest of theworld

CA and NFA Implication of this relation: CA = ΔNFA

a trade deficit implies a country is decreasing its netforeign assets s occurs y

» selling some of its foreign assets back to foreigners

» selling some of its domestic assets to foreigners

» obtaining credit (borrowing) from foreign country

either way a country must decrease its net foreign assets(increase its net foreign liabilities) to fund the trade deficit

you pay for the extra goods you import by reducing your pile ofassets either forei n or domestic or borrowin from forei n


sources

US experience the US experience of continuing CA deficits imply that the US

has been decreasing its net foreign assets position

it has been selling its assets and borrowing from the rest of theworld to finance its trade deficits




Other Concern over KA It is also possible to think of the KA = PKA + OKA

the sum of private and official (gov’t) capital accountsPKA = private capital account balance

= Δ in private ownership of assets abroad + Δ in private foreign ownership of local assets

OKA = official capital account balance

= Δ in official ownership of assets abroad + Δ in official foreign ownership of local assets

OKA is important because it mostly reflects a country’s netchange in FX reserves, ΔR

countries maintain FX reserves, R, in order to facilitate officialpayments and to maintain value of / stabilize local currency

» for countries trying to control their XR, having FX reserves is critical


no e e re a on a o ows rom e en y

CA + KA = 0 => CA + PKA + OKA = 0 => CA + PKA = -OKA

-OKA = CA + PKA is a measure of the change in FX reservesexample: when a current account deficit (CA <0) is not fully funded by

net private borrowing (PKA < CA) then OKA > 0 which means thegovernment is using FX reserves to balance out relation (ΔR <0)

so -OKA = change in FX reserves = ΔR

0

500

US Current Account Balance and NIIP1976 - 2007

Annual Trade balance

-1,000

-500

1 9 7 6

1 9 7 8

1 9 8 0

1 9 8 2

1 9 8 4

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

S D ( b i l l i o n s )

Net Investment

Position

Since 1976, cumulative US tradedeficits sum to over $6.6T. The US Net

Investment Position is only about -$2.5T, largely because the US started

with a $0.5T sur lus and has seen

NBAE 5540: Lecture 2, Slide # 14-2,500

-2,000

-1,500

greater capital appreciation of its assetsabroad compared to the ROW’s assetsin the US and the USD depreciation.

Note that in 1987 the US became a netdebtor nation, soon thereafter the largest

in the world




Is CA Deficit a Problem? First lets look at how the CA relates to economy

from national income accounting we have Absorption: Y = C + I + G + (X - M)

xpen ures: = + + + rY = National Income or GNP; C=consumption, I=private investment;G= government purchases, X=exports, M=imports;S= private savings; T=taxes;Tr = net unilateral transfers to foreigners (debit – opposite of BOP accounting measurement)

setting the two equal we have :C + I + G + (X - M) = Y = C + S + T + Tr X - M - Tr = S - I + T - G


rewr ng: = - -Current Net Private Net Publi c

Account = Savings + Savings

the current account is definitionly equal to the sum ofnet private savings and net public savings CA deficits indicate a shortfall in national savings

6.0%

8.0%

Current Account, Net Public

Savings, and Net Private SavingsFrom 1980 - 1995 the CAdeficit was the result of

negative net public

0.0%

2.0%

4.0%

9 6 0

9 6 3

9 6 6

9 6 9

9 7 2

9 7 5

9 7 8

9 8 1

9 8 4

9 8 7

9 9 0

9 9 3

9 9 6

9 9 9

0 0 2

0 0 5

% o

f G D P

r vate

Savings (S-I)

sav ngs, u ec ne s nce1997 is more related to

negative net privatesavings

NBAE 5540: Lecture 2, Slide # 16-8.0%

-6.0%

-4.0%

-2.0%

Public

Savings (T-G)

Current Account

Balance (CA)




Are CA Deficits Good or Bad? Current accounts reflect a tradeoff between

consumption (savings) and investment today good side of CA deficit is it allows more C or I for given Y

a s e o e c s mp es grea er c a ms on u ure

CA deficits are not a problem… if good investments are occurring to produce higher future Y to

repay lending

in this case the CA deficit might be allowing greater investmentthan otherwise or than without having to forego C today

» examples: Japan and Korea after the wars, or new technologies


CA deficits are more of a problem… if imported funds only finance current consumption and no

investment for future Y

in this case income for consumption in the future will be lower

» have a big party now and leave the bill for future generations

no general answer to CA question as it is case specific

Savings and Investment in the US As for the US, it is difficult to determine if CA

deficit is good or bad gross private domestic investment has since strong since 1991

art of US economic boom durin the 1990s

gross private savings has slowed down, especially in late90s,but has picked up again, along with investment

but is it the cause or the result of consumption smoothing inresponse to higher future income due to high investment

24.0%

Gross

Investment


12.0%

16.0%

.

1 9 6 0

1 9 6 2

1 9 6 4

1 9 6 6

1 9 6 8

1 9 7 0

1 9 7 2

1 9 7 4

1 9 7 6

1 9 7 8

1 9 8 0

1 9 8 2

1 9 8 4

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

% o f G D P

Gross

Savings




More Detail on US Savings Decline1960- 2007

20.0%

25.0%

Gross Savings

5.0%

10.0%

15.0%

Net Savings

Depreciation

Personal Net Savings


-5.0%

0.0%

1 9 6 0

1 9 6 3

1 9 6 6

1 9 6 9

1 9 7 2

1 9 7 5

1 9 7 8

1 9 8 1

1 9 8 4

1 9 8 7

1 9 9 0

1 9 9 3

1 9 9 6

1 9 9 9

2 0 0 2

2 0 0 5

Corporate Net Savings

Government Net Savings

The CA Deficit Cannot Grow Forever Depends on foreigners’ willingness to finance the deficit this relates to their interest in holding USD assets

current deficits in nominal size (~$750b) can continue indefinitely

foreign debt will top out at about 50%

current deficits at 5-6% of GDP can also continue if US grows

net foreign debt grows to 100% of GDP, but trade in G&S has tomove to balance unless return on foreign debt less than 5%

» foreigners may be willing to hold that many USD assets

what can’t happen is the deficit as % of GDP to continue to grow

this is unsustainable as forei n debt ratio would row continuousl


» at some point foreigners refuse to provide any additional borrowing

at that point US must balance its accounts with national savings

with foreign debt service, trade in G&S would have to be in surplus

this would likely requires large relative price adjustments large USD depreciation or other form of USD price decrease




CA Deficits and Financial Crises

CA deficits can trigger financial crisis growing CA deficits fuel fears of solvency which lead to

depreciation as investors rush to get out of domesticcurrency this rush leads to a faster and farther fall in the currency

resulting large depreciation of XR can have harmful domesticeffects

domestic agents (banks) with loans in foreign currencies unableto repay with weaker domestic currency and default

this can lead to a domestic bankin crisis with resultin ne ative


impacts of domestic economy

» lack of financing makes it impossible for exporters to sell despite the

competitive advantage of the exchange rate drop this is a rough description of what happened in Mexico in 1994

and in SE Asia in 1997

key policy lesson is to control size of CA deficits

Net Investment Position of the US Lets look at the stock of NFA instead of flows

BOP transactions only shows the flows of capital it does not tell us about the stocks of outstanding international

assets and liabilities

we need the Net International Investment Position account this account is analogous to the balance sheet of a firm

it is divided into two parts US assets abroad and Foreign assets in US

looks like the capital account of the BOP table


change in figures for US over time are staggering using market values the net investment position of the US

changed from a +$97B in 1985 to a -$2.5T in 2006

reflects an net increase in foreign ownership of the US of morethan $2.6T over the past 20 years due to trade deficits

» 2006 US net liabilities to foreigners are about 18% of GDP




How Much Does the US Own?

For 30 years after WWII, the US was theworld's major provider of foreign investment

US consistently ran current account surpluses throughoutthe 50s and 60s

by 2006 the US owned approximately $13.8 trillion ofassets outside of the US

almost all of which (less $300b) are private assets

this has grown from about $1.1 trillion in 1985

» a growth rate of around 12%/year


breakdown of US assets abroad (2006)

$2.9 trillion is direct investment (market prices) $9.2 trillion is portfolio investment

» inlcudes $1.1T in bonds; $4.3T in stocks; $3T in bank assets

US official reserve assets ($219b) consist primarily of gold($165b) and FX reserves ($40b)

How Much Do Foreigners Own? Prior to 1980 most foreign investment in the US

consisted of foreign government ownership in 1985 forei ners owned about 1.2 trill ion, .

» about 20% of this was US Treasury securities

by 2006, foreigners owned $16.3 trillion

by now it is mostly private assets, $12.3 trillion

» this grew from $1.0 trillion in private assets in 1985

» a growth rate of ~14%/year

breakdown (2006)


$2.1 trillion in direct foreign investment in the US (at market value) $10.2 trillion in private portfolio investment in the US

» $594B in Treasury securities, $364B in US currency, $2.7T in bonds;$2.5T in equities, and and $3.3T in bank assets

$2.7 trillion foreign official assets in the US (up from $1,567b in 2003)

» $2.1T in US Treasury securities (>40% of total held by public)




International Investment

Distinguish between different forms of foreigninvestment:

investment made by other governments/official agencies

» typically by central banks

private investment foreign direct investment

involves foreign control of businesses and properties (FDI)

» US defines control as 10% or more ownership


» typically long term investment not easily reversed

portfolio investment

involves ownership of private and governmentsecurities and bank deposits and passive equity stakes (lessthan 10%)

» also known as indirect investment or “hot money” due to its easeof movement and reinvestment

U.S. Direct Investment Position

Abroad by Major Area1982

Asia andPacific14%

Middle East2%

2003

Canada Africa

1%Middle East

Europe44%

Africa

Canada20%

International3%

Europe

52%

Latin America

20%

Asia andPacific

16%

10%


14%

Largest Countries (2003) :

U.K - $272b Canada $192b Netherlands $178b Switzerland $86b

Bermuda $84b Germany $80b Luxembourg $66b Mexico $62b

Singapore $57b Ireland $55b France $47b Hong Kong $44b

Australia $40b Spain $38b Brazil $29b Belgium $25b

Historical cost basis for more info see http://www.bea.doc.gov/bea/di/di1usdbal.htm




Foreign Direct Investment Position

in the United States by Major Area

1982 2003

Europe67%

Latin Am11%

Canada

9%

Asia andPacific

9%

e as4%

Latin Am4%

Asia and Pacific15%

Canada8%

e as

1%

Euro e


Largest Countries (2003) :U.K - $230b Japan $159b Germany $148b Netherlands $146b

France $143b Switzerld $112b Canada $105b Luxembourg $104b

UK Carrib $28b Ireland $26b Australia $24b Sweden $19b

Historical cost basis for more info see http://www.bea.doc.gov/bea/di/di1usdbal.htm

73%

international finance balance of

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