1. 16–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 16 The Balance of Payments – Net Exports and International Capital Flows

2. 16–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 16: The Balance of Payments – Net Exports and International Capital Flows The balance of payments Capital flows and the relationship between the capital and the current accounts The determinants of international capital flows Saving, investment and capital inflows The saving rate and the trade deficit

3. 16–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Balance of Payments (BOP) Is divided into: –current account –capital account

4. 16–4 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Current Account Records international transactions in goods and services (including factor services) and gifts Payments to foreign-provided factor services are measured by interest on foreign debt and profits earned by foreign-owned companies

5. 16–5 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Australia’s Current Account Normally in deficit (CAD) Balance of merchandise trade in deficit since 2001 (new development) Balance of trade in services moving towards balance Net income always in deficit

6. 16–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Net Income Item Australia’s net income from international transactions in factor services is negative This is because we are a net debtor nation And because foreigners own more equity and real estate here than we own in foreign countries

7. 16–7 Australia’s Current Account

8. 16–8 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Capital Account Records international transactions in assets, as opposed to goods and services Assets include bank deposits, government and private bonds, equities in firms, real estate and gold

9. 16–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Capital Inflows and Outflows The purchase of a foreign asset is a capital outflow The sale of a domestic asset to foreigners is a capital inflow The capital account measures net inflows in a given period

10. 16–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Sectors of the Capital Account Official sector transactions are undertaken by the Australian Government and the RBA Non-official sector transactions are undertaken by financial institutions, firms and households

11. 16–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Confusing Official Terminology The capital account of the BOP comprises a financial account and a ‘capital’ account The latter is relatively small and measures cancellation of debts of poor countries and funds taken in and out by migrants The former measures portfolio and direct investment and changes in RBA holdings of gold and forex The financial account is the one we are interested in

12. 16–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Capital Account of BOP Current account deficit (CAD) necessarily implies capital account surplus This is because, when we spend more on foreign goods and services than we sell, foreigners increase their claims on Australian assets by the difference (When a household spends more than it earns, it finances the deficit by selling its assets – debt and the family silver) Likewise, current account surplus (e.g. Japan) implies Japanese capital account deficit

13. 16–13 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Determinants of Capital Flows Relative domestic and foreign interest rates Perceptions of opportunities for profitable equity investments at home and abroad

14. 16–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Risks in Capital Flows Risk of loss of capital –political risk –risk of default by borrower –risk of bankruptcy of foreign business Exchange-rate risk

15. 16–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Exchange-Rate Risk The exchange rate may change between the time that you buy forex to buy a foreign asset and the time that you sell forex to bring home your capital If the foreign currency appreciates over this period you will make a capital gain in terms of domestic currency, because the domestic currency value of the foreign currency will have risen If the foreign currency depreciates over this period you will make a capital loss in terms of domestic currency Either way, there is a risk

16. 16–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Domestic & Foreign Interest Rate If domestic interest rates get too far below foreign interest rates, there will be a capital outflow If there are free exchange rates, the domestic currency will fall This fall will continue until the market perceives that the domestic currency is ‘too cheap’ If there are fixed exchange rates, the domestic money supply will fall, and domestic interest rates will have to rise back toward the foreign interest rate

17. 16–17 Interest Rates, Risk and Capital

18. 16–18 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Saving, Investment and the CAD Y = C + I + G + X – M Y = C + S + tax CAD = [I – S] + [G – tax] CAD = [I – S] if there is no government saving or dissaving when there is a balanced fiscal budget The CAD is driven by the excess of domestic investment over domestic saving

19. 16–19 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank National Saving and Investment Domestic investment (I) is financed by national saving (NS) and foreign saving The use of foreign saving is capital inflow (KI) I = NS + KI so KI = I – NS NS = private saving plus government saving (the fiscal surplus) A country with a CAD and a capital account surplus is investing more at home than it is saving Likewise a country with a current account surplus and a capital account deficit is saving more than it is investing at home

20. 16–20 National Saving and Investment

21. 16–21 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Australia and Japan Australia has many undeveloped natural resources and thus many investment opportunities Japan has a high propensity to save but limited undeveloped resources So it is natural for Japanese saving to exceed domestic investment (current account surplus) And it is natural for Australian domestic investment to exceed saving (current account deficit)

22. 16–22 Australian S, I and CAD

23. 16–23 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The First Benefit of Capital Flows In the absence of international capital flows, a country’s domestic investment would be be limited to its domestic saving

24. 16–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Costs of Using Foreign Saving Interest on foreign debt Profits on foreign-owned business Loss of national sovereignty if debt cannot be serviced Domestic interest rates cannot be set without regard to international financial markets

25. 16–25 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Benefits of Using Foreign Saving For a given rate of domestic investment, it permits a higher level of domestic consumption For a given level of domestic consumption, it permits a higher rate of domestic investment and a more rapid rate of development of domestic resources Foreign direct investment may help us ‘learn how to do it’ – we have learned a lot from US and Japanese car makers and US mining companies

26. 16–26 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Maximising Net Benefit Borrow to invest in projects only where the rate of return is greater than the rate of interest Do not borrow for risky projects because, if the project fails, debt must be repaid with interest Risky projects should be financed with foreign equity, not debt – because then if the project fails there is no obligation to repay

27. 16–27 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Another Benefit of Capital Flows In the absence of capital flows, a country would have to balance its trade in goods and services with every single one of its trading partners (bilateral balancing) Capital flows allow multilateral balancing because our trade surplus with one country is held as a credit or claim against that country (a capital outflow) which is used to pay for our trade deficits with third countries

28. 16–28 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Bilateral Balancing is Inefficient Bilateral balancing is like barter trade – it decreases specialisation and efficiency This is because we could only export to countries that we wish to import from And because the value of our exports to those countries would be limited to the value of what we wish to import from them

29. 16–29 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank On Balance Capital flows are helpful to the world economy But individual borrowing countries need to ensure that: –capital inflows are invested productively –there is an appropriate balance between equity and debt –capital flows are not used to finance speculation in rising asset prices, which ultimately crash leading to financial crises