The balance of payments: Net exports and international capital flows

The balance of payments: Net exports and international capital flows
Chapter 15 The balance of payments: Net exports and international capital flows Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Learning objectives What types of transactions are recorded in the current account of the balance of payments? What types of transactions are recorded in the capital account of the balance of payments? How do capital flows relate to the current and capital account balances? What factors influence the international flows of capital? What is the effect that international capital flows have on the relation between national savings and investment? How are a country’s savings, trade imbalance and current account balance related? Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Chapter organisation 15.1 The balance of payments 15.2 Capital flows and the relationship between the capital and the current accounts 15.3 The determinants of international capital flows 15.4 Saving, investment and capital inflows 15.5 The saving rate and the trade and current account deficits Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The balance of payments
The balance of payments (BoP) s a record of all the transactions made between the residents of one country with the residents of all other countries. These sorts of transactions include: imports and exports of goods and services monetary gifts sent to Australian students by relatives living overseas Australian firms borrowing money from overseas financiers. The BoP consists of the current account and the capital account. The balance of payments (BoP) is a record of all the transactions made between the residents of one country with the residents of all other countries. These sorts of transactions include imports and exports of goods and services; monetary gifts sent to Australian students by relatives living overseas; and Australian firms borrowing money from overseas financiers. The BoP consists of the current account and the capital account. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The structure of the current account
Figure 15.1 The structure of the current account This figure shows the structure and components of the current account. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The current account This records all transactions that involve a transfer of goods and services or a direct transfer of income. Exports and imports are measured free on board (f.o.b.) which means the freight and insurance charges are assumed to be borne by the purchasers. The difference between imports and exports is known as the balance on merchandise trade. If negative, imports exceed exports. This records all transactions that involve a transfer of goods and services or a direct transfer of income. Exports and imports are measured free on board (f.o.b.) which means the freight and insurance charges are assumed to be borne by the purchasers. The difference between imports and exports is known as the balance on merchandise trade. If negative, imports exceed exports. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The current account (cont.)
Net services records the freight, insurance and other charges associated with buying and selling commodities. The net services balance is the difference between the amount the domestic country spends on these services in other countries and the amount foreign residents spend on them domestically. The net income balance comprises direct income payments, such as interest, dividend and royalty payments, and also labour and property income. Net services records the freight, insurance and other charges associated with buying and selling commodities. The net services balance is the difference between the amount the domestic country spends on these services in other countries and the amount foreign residents spend on them domestically. The net income balance comprises direct income payments, such as interest, dividend and royalty payments, and also labour and property income. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The current account (cont.)
Current transfers record one-off transactions in the current account that aren’t easily classified elsewhere, for example, the funds newly arrived migrants bring with them. The balance of the merchandise trade, net income and net current transfers gives the current account balance. When the balance is negative, it is known as a current account deficit. When the balance is positive, it is known as a current account surplus. Current transfers record one-off transactions in the current account that aren’t easily classified elsewhere, for example, the funds newly arrived migrants bring with them. The balance of the merchandise trade, net income and net current transfers gives the current account balance. When the balance is negative, it is known as a current account deficit; when positive, a current account surplus. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Australia’s current account balance and its components
Figure 15.2 Australia’s current account balance and its components This figure shows Australia’s current account balance and its components from 1959 to From the figure, it is clear that although Australia has nearly always had a deficit on the current account balance, the balance on merchandise trade has often been in surplus. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The structure of the capital account
Figure 15.3 The structure of the capital account This figure shows the structure and components of the capital account. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The capital account The capital account records all international transactions that involve the acquisition of either an asset or a liability. As with the current account, an inflow of foreign currency is recorded as a credit, and an outflow of foreign currency is a debit. For example, an Australian firm negotiating a loan from a foreign firm is recorded as a credit. A foreign firm buying shares in an Australian company is recorded as a debit. The capital account records all international transactions that involve the acquisition of either an asset or a liability. As with the current account, an inflow of foreign currency is recorded as a credit, and an outflow of foreign currency is a debit. For example, an Australian firm negotiating a loan from a foreign firm is recorded as a credit. A foreign firm buying shares in an Australian company is recorded as a debit. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The capital account (cont.)
The capital account is divided between two sectors. The official sector records the transactions of the government sector and the central bank. The non-official sector records the transactions of private-sector firms, financial institutions and households. The capital account is divided between two sectors: the official sector records the transactions of the government sector and the central bank; the non-official sector records the transactions of private-sector firms, financial institutions and households. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Net capital transfers balance records the cancellation of debts of poor countries and funds taken in and out by migrants. The net acquisition/disposal of non-produced, non-financial assets records sales of embassy land or patents and copyrights, etc. These balances comprise the capital account, which is a relatively small component of the whole capital account! Net capital transfers balance records the cancellation of debts of poor countries and funds taken in and out by migrants. The net acquisition/disposal of non-produced, non-financial assets records sales of embassy land or patents and copyrights, etc. These balances comprise the capital account, which is a relatively small component of the whole capital account! Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The important part of the capital account is the balance on the financial account, which records direct and portfolio investment balances of net foreign investment in Australia and Australian investment abroad, plus changes in the Reserve Bank’s holdings of foreign exchange and gold. The balance on the capital account will be the same value as the balance on the current account, though with the opposite sign. The important part of the capital account is the balance on the financial account, which records direct and portfolio investment balances of net foreign investment in Australia and Australian investment abroad, plus changes in the Reserve Bank’s holdings of foreign exchange and gold. The balance on the capital account will be the same value as the balance on the current account, though with the opposite sign. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Capital flows Purchases and sales of real and financial assets across international borders are called international capital flows. From the perspective of a particular country, purchases of domestic assets by foreigners are called capital inflows, and purchases of foreign assets by domestic households and firms are called capital outflows. The difference between the two flows are net capital inflows, or net capital outflows. Purchases and sales of real and financial assets across international borders are called international capital flows. From the perspective of a particular country, purchases of domestic assets by foreigners are called capital inflows, and purchases of foreign assets by domestic households and firms are called capital outflows. The difference between the two flows are net capital inflows, or net capital outflows. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Capital flows (cont.) International capital flows allow countries to invest in more productive investment opportunities than would be possible relying only on national savings. In a closed economy, we have seen that national saving and investment are equal. In an open economy, where capital flows are possible, savings from other countries can finance investments. International capital flows allow countries to invest in more productive investment opportunities than would be possible relying only on national savings. In a closed economy, we have seen that national saving and investment are equal. In an open economy, where capital flows are possible, savings from other countries can finance investments. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Capital flows and the current account balance
In any given period, the current account balance and the balance on the capital account sum to zero: CAB + KAB = 0 This is true by definition. In practice, due to errors of measurement and the non-reporting of some transactions, a balancing item makes this identity correct. In any given period, the current account balance and the balance on the capital account sum to zero: CAB + KAB = 0 This is true by definition. In practice, due to errors of measurement and the non-reporting of some transactions, a balancing item makes this identity correct. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Example: Capital flows and the current account balance
Suppose an Australian resident purchases a $ Japanese car and writes a cheque for $ The Japanese company can manage the money in one of the following ways: They could use the $ to buy Australian-produced components for their plant, or holidays for their executives, or some other Australian goods, or They could buy a real asset, financial asset or shares in an Australian company, or simply leave the money in the bank (an asset acquired by foreigners), or They could swap the $AU with a third party for another currency (e.g. yen), but the third party would still have the same two choices with that money as described above. Suppose an Australian resident purchases a $ Japanese car and writes a cheque for $ The Japanese company has these options with the money. Firstly, they could use the $ to buy Australian-produced components for their plant, or holidays for their executives, or some other Australian goods. In this case, Australian imports = exports, so CAB = 0 and our CAB + KAB = 0 identity is true. Secondly, they could buy a real asset, financial asset or shares in an Australian company, or simply leave the money in the bank (an asset acquired by foreigners). The import would not be offset by an export so CAB = –$40 000, and there is a capital inflow of $40 000, so KAB = +$ Finally, they could swap the $AU with a third party for another currency (e.g. yen), but the third party would still have the same two choices with that money as described above, and therefore the identity still holds. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Determinants of capital flows
Why would foreigners want to acquire Australian assets, and conversely, why would Australians want to acquire assets abroad? The factors that determine attractiveness of any asset are return and risk. A higher real domestic interest rate, if all other factors such as risk and returns abroad are held constant, promotes net capital inflows, as money from abroad is invested, and domestic investors reduce their capital outflows. Why would foreigners want to acquire Australian assets, and conversely, why would Australians want to acquire assets abroad? The factors that determine attractiveness of any asset are return and risk. A higher real domestic interest rate, if all other factors such as risk and returns abroad are held constant, promotes net capital inflows, as money from abroad is invested, and domestic investors reduce their capital outflows. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Net capital inflows and the real interest rate
Figure 15.4 Net capital inflows and the real interest rate This figure shows the relationship between net capital inflows and the real interest rate. Specifically, it shows that holding constant the degree of risk and the real returns available abroad, a high real interest rate in the home country will induce foreigners to buy domestic assets, increasing capital inflows. A high real rate in the home country also reduces the incentive for domestic savers to buy foreign assets, reducing capital outflows. Thus, all else being equal, the higher the domestic real interest rate, r, the higher will be net capital inflows, KI. Note that, especially in the case of small open economies like Australia, large capital flows would eliminate any sustained differences in the interest rates between the domestic and foreign interest rates. For example, a higher domestic real rate would induce a large inflow of capital seeking Australian assets and increasing their price. Equivalently, an increase in the price of a financial asset is equivalent to lowering of the interest rate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Capital flows and risk Figure 15.5 An increase in risk reduces net capital inflows Risk has the opposite effect on capital flows. For a given real interest rate, an increase in the riskiness of the domestic assets reduces the net capital inflows, as domestic assets become less attractive to domestic and foreign purchasers. This shifts the capital inflows curve to the left for any given real interest rate. On this figure, an increase in the riskiness of domestic assets arising, for example, from an increase in political instability, reduces the willingness of foreign and domestic savers to hold domestic assets. The supply of capital inflows declines at each value of the domestic real interest rate, shifting the KI curve to the left. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Saving, investment and capital inflows
In a closed economy, we have seen that national saving and investment are equal. In an open economy, where capital flows are possible, savings from other countries can finance domestic investments. Therefore, we can write: NS + KI = I In a closed economy, we have seen that national saving and investment are equal. In an open economy, where capital flows are possible, savings from other countries can finance domestic investments. Therefore, we can write: NS + KI = I Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Saving, investment and capital inflows (cont.)
NS = national saving, which is private saving plus government saving, KI is the net capital inflow and I is investment. If KI is negative there is a net capital outflow, which means domestic savings are larger than required to finance domestic investment, and the excess can be lent to other countries. We have previously seen the saving–investment diagram for a closed economy. Now we can review it for an open economy. NS = national saving, which is private saving plus government saving, KI is the net capital inflow and I is investment. If KI is negative there is a net capital outflow, which means domestic savings are larger than required to finance domestic investment, and the excess can be lent to other countries. We have previously seen the saving–investment diagram for a closed economy. Now we can review it for an open economy. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The saving–investment diagram for a small open economy
Figure 15.6 The saving–investment diagram for a small open economy In this figure, the total supply of saving in an open economy is the sum of national saving, NS, and net capital inflows, KI. The domestic demand for saving for purposes of capital investment in shown by the curve labelled I. Given a particular level of world interest rates, the total supply of saving, including capital inflows, will be equal to the domestic demand for saving. If, for some reason, that an interest rate in the rest of the world of r0 also defines the domestic interest rate of a small, open economy, at that interest rate, the level of investment demand exceeds the national saving available in the economy. Net capital inflows would occur. Similarly, if the world interest rate was r1 , net capital outflows would occur. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Benefits of capital inflows
The Solow-Swan model for a closed economy shows the importance of savings for a country’s economic growth. Savings are also important in an open economy, and a country that attracts significant foreign capital has a larger pool of savings to finance more investment than just domestic savings. The convergence hypothesis, where relatively poor countries grow rapidly, applies particularly well to open economies. Politically stable countries that safeguard the rights of foreign investors grow more quickly than countries without those characteristics as capital flows are very sensitive to risk. The Solow-Swan model for a closed economy shows the importance of savings for a country’s economic growth. Specifically, savings are also important in an open economy, and a country that attracts significant foreign capital has a larger pool of savings to finance more investment than just domestic savings. The convergence hypothesis, where relatively poor countries grow rapidly, applies particularly well to open economies. Politically stable countries that safeguard the rights of foreign investors grow more quickly than countries without those characteristics as capital flows are very sensitive to risk. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Costs of capital inflows
Foreign financing for domestic capital formation means that interest and dividend payments must be made to the foreign financier. A debt crisis can occur if the domestic investments made leave insufficient income to pay foreign creditors. An advantage to using domestic savings only to finance capital formation is that the returns accrue to domestic investors, rather than go abroad. Foreign financing for domestic capital formation means that interest and dividend payments must be made to the foreign financier. A debt crisis can occur if the domestic investments made leave insufficient income to pay foreign creditors. An advantage to using domestic savings only to finance capital formation is that the returns accrue to domestic investors, rather than go abroad. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The saving rate and the trade deficit
Australia has often run a trade deficit, with imports exceeding exports. Economists argue a low rate of saving may be the primary cause of trade deficits. The link between national saving and the trade deficit can be seen: Y = C + I + G + NX Y – C – G – I = NX NS – I = NX (as Y – C – G = NS) Australia has often run a trade deficit, with imports exceeding exports. Economists argue a low rate of saving may be the primary cause of trade deficits. The link between national saving and the trade deficit can be seen: Y = C + I + G + NX Y – C – G – I = NX NS – I = NX (as Y – C – G = NS) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

The saving rate and the trade deficit (cont.)
Therefore, if we hold I constant, a high rate of saving leads to a high level of net exports and a low level of saving a low level of net exports. Further, if NS < I, NX will be negative, i.e. a trade deficit. Therefore, for constant domestic I, low saving rates will tend to be associated with trade deficits, and high saving rates with trade surpluses. Therefore, if we hold I constant, a high rate of saving leads to a high level of net exports and a low level of saving a low level of net exports. Further, if NS < I, NX will be negative, i.e. a trade deficit. Therefore, for constant domestic I, low saving rates will tend to be associated with trade deficits, and high saving rates with trade surpluses. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

This makes sense, as a low-saving, high-spending economy spends part of their income on imports, so imports would be likely to be high. They also consume a large proportion of their domestic production, reducing goods available to export. If a country has a trade deficit and their net income flows and current transfers are negative, the current account balance will be in deficit too. This makes sense, as a low-saving, high-spending economy spends part of their income on imports, so imports would be likely to be high. They also consume a large proportion of their domestic production, reducing goods available to export. If a country has a trade deficit and their net income flows and current transfers are negative, the current account balance will be in deficit too. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

A country with a current account deficit will be receiving net capital inflows. This makes sense too. A country with a low national saving rate will not have sufficient savings of its own to finance domestic investment. Therefore, a low rate of national saving tends to create a trade deficit, as well as promote the capital inflows that accompany the current account deficit. A country with a current account deficit will be receiving net capital inflows. This makes sense too. A country with a low national saving rate will not have sufficient savings of its own to finance domestic investment. Therefore, a low rate of national saving tends to create a trade deficit, as well as promote the capital inflows that accompany the current account deficit. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Australia’s recent savings and investment performance
Figure 15.7 Recent trends in national saving and investment (per cent of GDP) in Australia This figure shows the difference between national saving and investment in Australia 1994–2011. There is a clear imbalance between savings and investment. Over this period, the current account deficit in Australia has been running at about 4.5% of GDP. The current account deficit shows that Australia relies heavily on foreign savings to finance domestic capital formation. Payments must be made overseas on this foreign investment, which may be risky if economic growth slows. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Summary The current account on the balance of payments records all transactions that involve the transfer of ownership of commodities or a direct transfer of income between the domestic country and the rest of the world. The capital account on the balance of payments records capital inflows and outflows, as well as changes to the central bank’s holding of gold and foreign exchange reserves. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Summary (cont.) The higher the real interest rate in a country and the lower the risk of investing there, the higher its capital inflows. A low rate of national saving is the primary cause of trade deficits. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

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