EC563: International Finance

The Balance of PaymentsLecture of 21st January

Balance of payments accounts Record all economic transactions between domestic residents and foreignersCurrent account: trade in goods and services plus income flows Capital account: activities involving transfers of assets between countriesFinancial account: transactions involving the purchase/sale of financial assetsOfficial reserve transactions (official settlements balance): transactions involving the central bankNet errors and omissions

BOP: definitions and conventionsIn the current account, credit items are exports of merchandise and services, income inflows and current transfer receivables while debit items are imports, income outflows and transfer payables.In the capital account, capital transfer receivables are recorded as credits and payables as debits. The transactions in the financial account are generally presented on an assets/liabilities basis. Increases in foreign assets or reductions in foreign liabilities are shown with a minus sign, (i.e. as debits), while decreases in assets or increases in liabilities are shown as positive numbers (i.e. as credits). In the case of direct investment, the asset/liability presentation is replaced by the so-called directional one, i.e. direct investment abroad (approximating to the assets concept) and direct investment in Ireland (which closely equates to liabilities).

Definitions and conventions (cont)Direct investment is a category of investment that, based on an equity ownership of at least 10%, reflects a lasting interest by a resident in one economy in an enterprise resident in another economy.Portfolio investment covers the acquisition and disposal of equity and debt securities which cannot be classified under direct investment or reserve assets transactions. The securities involved are traded (or tradable) in financial markets. Debt securities cover bonds and notes, with an original maturity term of more than one year, and money market instruments with original maturity of one year or less. Other investment covers assets and liabilities other than those classifiable to direct investment, portfolio investment or reserve assets. It includes loans, currency and deposits, short and long-term trade credits and financial derivatives. http://www.cso.ie/en/media/csoie/surveysandmethodologies/surveys/bop/documents/pdfs/Background_notes_updated_jun2011.pdf

Ireland: BOP accounts NB: A minus sign connotes an outflow

(m)CurrentCapital*Financial*FinancialErrors etc(Private)(Reserves)2003-293-3,1421,7701,2802004-8672792,6241,177-3,2122005-5,690264-1,9581,4725,9122006-6,3042234,683871,3112007-10,1243912,063-12-1,9662008-10,1694716,210-78-6,0102009-3,763-1,252-1,139796,07420101,782-6737,2715-8,38420112,002-2639,746329-11,81520127,250-2,05697512-6,182

Ireland: private financial account payments balances* Minus sign connotes an outflow i.e. where the net acquisition of overseas assets bydomestic residents exceeds the net acquisition of domestic assets by non-residents

(bn)Direct*P/folio*Other*200315.3-40.021.62004-23.114.311.42005-37.052.717.72006-16.68.113.220072.6-7.316.72008-24.2-45.786.12009-0.622.6-23.1201015.486.0-94.1201117.826.9-34.9201215.4-0.2-14.2

Ireland:composition of portfolio flows* * Note that the change in both assets and liabilities can be either positive or negative

(bn)20112012EquityAssets6.3-11.5Liabilities61.381.8Bonds etcAssets-2.5-55.6Liabilities-18.3-11.6MMIsAssets-6.5-6.5Liabilities-13.53.2TotalAssets-2.6-73.6Liabilities29.673.4

Why net errors and omissions?Sheer volume of transactionsDifference sources and methodsUnderreporting because of tax avoidance/evasionTiming of trade-related payments

The BOP always balancesSum of credits and debits should always be zeroWhy? Because each payment is simultaneously a receipt*So, what is meant by a BOP surplus or deficit?Significance of the current accountRelevance of the official settlements balance* To understand this point it may be helpful to think of the BOP as a recordof all transactions involving the exchange of domestic currency

Some important relationshipsY = C + I + GY = C + I + G + X MCA = X MY (C + I + G) = CAS = Y C GS = I [closed economy]S = I + CA [open economy]S I = CA**or, using Copelands notation and defining S as Y C:S I = B + G

More important relationshipsSp = Y T CSg = T GS = Y C G = (Y T C) + (T G) = Sp + SgSp = I + CA Sg = I + CA (T G)Sp* = I + CA + (G T)CA = (Sp I) (G T)(*): Private saving can take three forms

Significance of current accountMeasures difference between national income and domestic spendingMeasures the extent of net borrowing from the rest of the worldMeasures the rate at which a countrys net foreign wealth/indebtedness is growingNet International Investment Position (NIIP): if positive/negative, country is a net creditor/debtor* NIIP is also affected by exchange rate movements: consider the impact ofa dollar depreciation on the NIIP of the US

Factors behind changes in NIIPCurrent account balancesExchange rate movementsMovements in asset pricesWhy did US net foreign liabilities grow more slowly than current account deficit? Why in general is the change in a countrys net international investment position different from its current account balance?

US current account deficit (% of GDP)

Chart1

1.3

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Sheet1

(bn)20112012($bn)19962004

(m)CurrentCapitalFinancialFinancialErrors etcEquityAssets6.3-11.519911.3

PrivateReservesLiabilities61.381.8US-120-66619922.4

2003-293-3,1421,7701,280Bonds etcAssets-2.5-55.6Japan6617219933.4

2004-8672792,6241,177-3,212Liabilities-18.3-11.6Euro zone795319943.4

2005-5,690264-1,9581,4725,912MMIsAssets-6.5-6.5Asia-4118019952.6

2006-6,3042234,683871,311Liabilities-13.53.2Mid East111619962.1

2007-10,1243912,063-12-1,966TotalAssets-2.6-73.6Source: Bernanke (2005)19971.6

2008-10,1694716,210-78-6,010Liabilities29.673.419981.6

2009-3,763-1,252-1,139796,07419992.7

20101,782-6737,2715-8,38420003.1

20112,002-2639,746329-11,81520012.6

20127,250-2,05697512-6,18220023.5

20034.4

20045

20055.4

(bn)DirectP/folioOther20064.2

200315.3-40.021.620075

2004-23.114.311.420085.3

2005-37.052.717.720093.1

2006-16.68.113.220103.3

20072.6-7.316.720112.6

2008-24.2-45.786.120122.6

2009-0.622.6-23.1

201015.486.0-94.1

201117.826.9-34.9

201215.4-0.2-14.2

Sheet2

Sheet2

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Sheet3

Global current account imbalances, 1996-2004

($bn)19962004US-120-666Japan66172Euro zone7953Asia-41180Mid East1116Source: Bernanke (2005)

Does the current account matter?Very large US current account deficitsSuppose ROW became unwilling to finance these what would happen?Deficit would need to be reduced how would this be brought about?Combination of adjustment mechanisms: (i) rise in US interest rates; (ii) dollar depreciation; (iii) tightening of US fiscal policy; (iv) faster growth in US trading partners.

Current account imbalances and the financial crisisThe excess savings view: Ben Bernanke and the world savings glutExcess of savings over investment in surplus countries (China; oil producers)That excess flowed into deficit countries (the US), easing monetary conditionsInterest rates and risk premia fell and an asset price bubble developedThe global financial crisis ensued

Bernankes 2005 speech*Delivered against the backdrop of a large and growing current a/c deficit (over 5% of GDP in 2004)Common view at the time was that the deficit was primarily home grownBernankes starting point was that it was necessary to adopt an international perspectiveConclusion: there has been a big rise in the global supply of saving; this helps to explain the US deficit and the low level of interest rates

* The Global Saving Glut and the US Current Account Deficit

Bernanke: why did US national saving fall?Was it due to a (rising) government deficit? No: (i) consider 1996-2000; (ii) consider other countries with budget deficits*Ultimate source lies in the changing patterns of saving in the rest of the world, especially developing countries * Consider Ireland in the mid-noughties: a large current account deficitcombined with a government budget surplus

The effect of fiscal policy on the current accountCA = (Sp I) (G T)A rise in the budget deficit will weaken the current account cet par.

But will an increase in the budget deficit leave (Sp I) unchanged?

Bernanke: why have developing countries become large savers?Experience of financial crises in late 1990sSwitch to building up large war chests of external reservesPromotion of export-led growth by preventing currency appreciationStrong precautionary motive amongst households Oil producers: sharp rise in oil prices

Bernanke: how did this result in reduced saving in US?Capital inflows initially raised equity prices and, in turn, consumer spendingSubsequently, low real interest rates became the main mechanismfollowed by strongly rising house pricesSomething of the same pattern evident in other countries e.g. Spain, UK

Policy implications of the saving glut viewCombination of surpluses in developing countries and deficits elsewhere not desirable (Why?)Lowering US government deficit would have a modest effect on current account (Why?)Create tax incentives to saveEncourage developing countries to re-enter world capital markets in their more natural role as borrowers

Evidence that casts doubt on excess saving hypothesisSupposed link between US deficit and long-term interest rates looks tenuous (both deficit and bond yields fell sharply post-2007)Co-existence of depreciating dollar and growing appetite for US assets through much of noughties looks odd.Link between US deficit and emerging market saving rate is weak (deficit falling since 2007, EM saving continued to rise)Absence of clear link between global savings rate and real interest rates: the latter have been trending downwards since early 1990s.Credit booms have not been confined to deficit countries e.g. Japans pre-banking crisis credit boom in 1990s; US credit boom before Great Depression.

More evidence that casts doubt on excess saving hypothesis The countries seen at the origin of the net capital flowswere amongst those least affected by the crisis, at leastthrough their financial exposures. Financial institutions inother countries (notably Europe) were hardest hit.In fact, before the crisis erupted, the main concern wasthat a flight from US dollar assets induced by unsustainablecurrent account deficits would precipitate turmoil. Thescenario that materialised was very different. Indeed, asthe crisis unfolded, the US dollar actually appreciated.

Borio and Disyatat (2012)

Critique of excess savings viewDoes not distinguish clearly between saving (a real concept) and financing (a cashflow concept)Does not distinguish between net and gross financial flowsGlobal configuration of current account balances is misleading guide to global pattern of financial flowsIs not informative about potential risks associated with financial flows

Back to the BOP identityCurrent account = Change in resident holdings of foreign assets - change in resident liabilities to non-residents

= Net capital outflow

= Saving - investmentNote: 1. Gross flows bear little relationship to net flows 2. Gross flows capture only a fraction of international transactions because the gross flows are themselves net 3. Current account is silent on the financing of domestic investment 4. Pattern of global financial flows cannot be inferred from current account pattern (that country A is running a deficit with country B does not imply that B is financing As deficit) 5. Misleading to pair the current account with specific gross flows (eg movements in external reserves)

Empirical evidence on global financial flows (and stocks)Growth of global gross capital flows has dwarfed current account positions and is mostly attributable to flows amongst advanced countriesPre-crisis, the increase in gross financial claims on the US was three times greater than the increase in net claims.*Bulk of gross flows into the US were from private sector, not from official sector.The most important geographic source of inflows was Europe, not emerging markets.Global current account imbalances narrowed marginally in 2008, but gross capital flows collapsed.Pre-crisis holdings of privately-issued US mortgage-backed securities were concentrated in advanced countries (even if total holdings of US debt securities were very high in China and Japan)* In other words, even without trade deficits, the US would have attractedlarge financial inflows.

ReferencesBen Bernanke (2005): The Global Saving Glut and the US Current Account Deficit, Homer Jones Lecture, St LouisBorio & Disyatat (2011): Global Imbalances and the Financial Crisis Link or No Link?, BIS WP No. 3146Copeland: Exchange Rates and International Finance (5th ed), pp21-26Krugman, Obstfeld & Melitz: International Economics, Ch.13Pilbeam: International Finance, Ch.2

Further readingBlanchard and Milesi-Ferretti (2009): Global Imbalances In Midstream?Lane and McQuade (2013): Domestic Credit Growth and International Capital Flows, ECB WP 1566Obstfeld and Rogoff (2009): Global Imbalances and the Financial Crisis Products of Common CausesObstfeld (2012): Does the Current Account Still Matter?Jorda, Schularick and Taylor (2011): Financial Crises, Credit Booms and External ImbalancesSchularick and Wachtel (2012): The Making of Americas Imbalances

*Why are capital inflows/outflows treated as credits/debits in the BOP? A capital inflow (eg foreign borrowing) may be thought of as the export of an IOU, i.e. a foreign resident makes a payment to a domestic resident for a bond. Another way of thinking of it is that (in a world of separate currencies), foreign borrowing creates demand for domestic currency. (How?)Official settlements balance comprises two main elements: (i) changes in forex reserves; (ii) transactions with the likes of the IMF. Why is a fall in foreign exchange reserves recorded as a credit in the BOP? Because it signifies that the Central Bank is selling an asset to a non-resident or, equivalently, creating demand for domestic currency.Reasons for errors and omissions: (i) sampling errors; (ii) leading and lagging trade flows are recorded when the goods are actually exported/imported, not when they are paid for.*One way to better understand the logic behind the treatment of financial account transactions is to view domestic financial assets acquired by foreigners as exports and to view overseas financial assets acquired by domestic residents as imports. Ditto w.r.t. direct investment. Another way, is to view the acquisition of overseas assets as an outflow, hencae negative; an increase in liabilities to foreigners as an inflow, hence positive. Yet another way is to think of anything that increases the demand for domestic currency as a positive and vice versa.*

Main features: (i) trends in current account; (ii) pattern of net private financial flows; (iii) relatively small capital numbers; (iv) likewise wrt reserves; (v) v large numbers for net errors. Logic behind treatment of transactions in reserves: an increase in reserves means a net increase in overseas assets by a domestic resident and, as such, will be ascribed a negative sign in the BOP statement.*Note that (i) there is no clear trend in evidence in any of these series; (ii) that even in years (eg 2008) when the overall net figure is strongly positive, not all the components are positive and (iii) that each item in the table is measured net and that the two aggregates which are netted to arrive at this figure are themselves measured net. Take -0.2bn as an example. *Interpretation: take 2012 Total for example. Net acquisition of overseas assets by domestic residents: 73.6bn (Gross figure would obviously be much higher); net acquisition of domestic assets by non-residents: 73.4bn. Note that the 73.6bn breaks down 11.5bn equity, 55.6bn bonds and 6.5bn MMIs. Note that the 73.4bn breaks down as 81.8bn equity and 3.2bn MMIs, offset by net divestment of 11.6bn bonds.*Contrast the perspectives provided by CA = EX IM and CA = S - I*US foreign assets tend to be denominated in foreign currency; liabilities in dollars. So, when dollar declines, dollar value of assets tends to rise while dollar value of liabilities tends to remain constant.**Consider the closed economy where there is zero saving i.e. where all output is consumed. Is financing also zero in this case? Of course not: all expenditure transactions must be financed, whether by cash or by borrowing. Moreover, in this or any other sort of economy, financing is also needed for transactions in financial assets. NB: the change in financial assets and liabilities in any given period brs no relationship to saving (and investment) in the national accounts sense.*3. Take the example of an Irish private resident buying US Treasury bonds. His/her acquisition of the bonds per se represents a gross outflow but, this has to be financed> suppose its financed by the individual running down his/her US dollar deposits. This constitutes a reduction in gross outflows.4. Even in circumstances where the current account is zero, all domestic investment might be financed by a loan from aboad. In this case, the increase in liabilities vis-a-vis non-residents is matched by the acquisition of a deposit vis-a-vis them.*2008: in the US case, net capital flows declined by just $20bn in 2008 but gross inflows and outflows collapsed, the former by $1.6trn.*