Trade and the Balance of Payments Chapter 9 Trade and the Balance of Payments

Learning Objectives Define the current and financial accounts of a country’s trade and payments. List and explain the importance of the three components of the current account. List and explain the importance of three main types of international capital flows. Use a simple algebraic model to relate the current account to savings, investment, and the general government budget balance.

Learning Objectives (cont.) Discuss the pros and cons of current account deficits. Define a country’s international investment position and relate changes in it to the current account balance.

Introduction: The Current Account The international transactions of a nation are divided into three separate accounts Current account: record of the goods and services into and out of the country Financial account: record of the flow of financial capital to and from the country Capital account: record of some specialized types of relatively small capital flows Let’s examine each of these in greater detail…

The Trade Balance Let’s first define the trade balance- measures the difference between exports and imports of goods and services Trade deficit: negative trade balance In 2008, the U.S. had a trade deficit of $695.0 billion Trade surplus: positive merchandise trade balance However, the U.S. had a large trade surplus in services ($144 billion)

The Current Account Balance Current account balance: Measures all current, non-capital transactions between a nation and the rest of the world The current account has three main components: Goods and services = the value of goods and services exported – the value of imports Investment income = income from investments abroad – income paid to foreigners on their U.S. investments Unilateral transfers = any foreign aid or other transfers received by foreigners – that given to foreigners

TABLE 9.1 Components of the Current Account

TABLE 9.2 The U.S. Current Account Balance, 2011

FIGURE 9.1 U.S. Current Account Balances, 1960-2011

U.S. Current Account Balance Large deficits in the current account began around 1982, and have been more or less a constant feature of the U.S. economy since The second began in the early 1990s and continues today

U.S. Current Account Balance (cont.) A current account deficit is not a sign of weakness: in the U.S., the economic boom of the 1990s increased the demand for imports, while sluggish growth abroad limited the expansion if U.S. exports However, everyone agrees the U.S. deficit is not sustainable in the long term

Introduction to the Financial and Capital Accounts Financial account: A record of the flow of financial capital to and from a country Financial account is divided into three categories: Net changes in the country’s assets abroad Net changes in the foreign-based assets in the country Net change in financial derivatives

Introduction to the Financial and Capital Accounts (cont.) Assets include bank accounts, stocks and bonds, and real property such as factories, businesses, and real estate Financial derivatives are complex financial contracts traded in a variety of forms; until recently they were not included in the balance of payments Value of financial derivatives is derived from the value of a variable such as interest rates, exchange rates, or commodity prices

Introduction to the Financial and Capital Accounts (cont.) Capital account: A record of the transfers of specific types of capital, such as: Debt forgiveness Personal assets that migrants take with them abroad The transfer of real estate and other fixed assets, such as a military base or an embassy building

Introduction to the Financial and Capital Accounts (cont.) Two points about the capital and financial accounts: First, both accounts present the flow of assets during the year, not the stock of assets that have accumulated Second, all flows are “net” changes rather than “gross” changes Net changes are informative because they measure the monetary value of the change in a country’s financial stake in foreign economies

Introduction to the Financial and Capital Accounts (cont.) Three accounting caveats: Both the capital account and the financial account present the flow of assets during the year in question and not the stock of assets that have accumulated over time All flows are net changes (differences between assets sold and bought, for example) rather than gross (stock) changes As long as the capital account balance is zero, financial account balance = current account balance, but with the opposite sign

Introduction to the Financial and Capital Accounts (cont.) The current, capital, and financial accounts are interdependent Current account measures flow of goods and services Capital and financial accounts measure flow of financing Therefore, sum of capital account and financial accounts equal to current account with opposite sign

TABLE 9.3 The U.S. Balance of Payments, 2011 Balance of payments = current account + capital account + financial account

Statistical Discrepancy in the Balance of Payments Statistical discrepancy: The amount by which the sum of the current, capital, and financial accounts is off the total of zero Statistical discrepancy is calculated as the sum of the current, capital, and financial accounts, with the sign reversed

Statistical Discrepancy in the Balance of Payments (cont.) Statistical discrepancy exists because the record of all the transactions in the balance of payments is incomplete – Errors tend to lie in the financial account calculation, as it is the hardest to measure correctly

TABLE 9.4 Components of the U.S. Financial Account, 2011

Types of Financial Flows Financial flows originate in the public and private sectors Some financial flows are very mobile and represent short-run tendencies: Mobility of financial flows brings economic volatility Upon sudden financial outflows, a country can sink into a financial crisis The volatility of financial flows has increased concern about the various types of flows

Types of Financial Flows (cont.) U.S. assets abroad (outflows) Official reserve assets: currencies of the largest and most stable economies (US dollars, EU euros, British pounds, Japanese yen including gold and Special Drawing Rights SDR) U.S. Government assets: loans and rescheduled loans to foreign governments, received on outstanding loans, changes in non-reserve currency holdings (e.g., Mexican pesos) U.S. Private assets: direct investment, foreign securities, loans to foreign firms and banks

Types of Financial Flows (cont.) Foreign assets in the U.S. (inflows) A. Foreign official assets: gold bullion, IM´s special drawing rights (SDRs), major currencies B. Other foreign assets: direct investment, U.S. securities and currency, loans to U.S. firms and banks 3. Net change in financial derivatives

Types of Financial Flows (cont.) Subcomponents of private assets: foreign direct investment (FDI), foreign securities, loans to foreign firms and banks FDI: tangible items: real estate, factories, warehouses, transportation facilities, and other physical (real) assets Securities and loans can be considered foreign portfolio investment - paper assets such as stocks and bonds Both FDI and foreign portfolio investment- claim in a foreign economy’s future output; FDI have longer time horizons

TABLE 9.5 Private Flows in the U.S. Financial Account, 2011

Role of Expectations in Financial Flows Shifts in expectations can lead to sudden stoppages of financial inflows The result is a destabilizing of outflows of financial capital This occurrence has been labeled a sudden stop Sudden stops have been involved in the most financial crises in last 30 years

Limits on Financial Flows Until recently, most nations limited the movement of financial flows related financial account transactions across their borders The European Union liberalized financial flows between member countries only in 1993

Limits on Financial Flows (cont.) The movement toward open markets over the 1980s and 1990s resulted in the lifting of controls on financial flows Developing countries, in particular, have liberalized financial account transactions in order to get access to financial capital for development Although financial flows can be volatile, economists agree that free flows are best for economic efficiency

TABLE 9.6 The U.S Financial Accounts, 2007-2008 (Billions of Dollars)

The Current Account and the Macroeconomy Why study the balance of payments? Balance of payments help understand the broader implications of current account imbalances and how to tame current account deficits Balance of payments give cues how nations can avoid crises brought by volatile financial flows and how they can minimize the damage of financial crises if such occur

The National Income and Product Accounts National income and product accounts (NIPA): internal, domestic accounting systems the countries use to keep track of total production and total income Two fundamental concepts of the system: Gross domestic product (GDP): the value of all final goods and services produced within a country’s borders during a period of time (usually a year) Gross national product (GNP): the value of all final goods and services produced by the labor, capital, and other resources of a country within the country as well as abroad

The National Income and Product Accounts (cont.) GNP = GDP + foreign investment income received – investment income paid to foreigners + net unilateral transfers

Table 9.7 Variable Definitions

The National Income and Product Accounts (cont.) Interplay of the variables of the national accounts GDP = C + I + G + X – M GNP = GDP + (net foreign investment income + net transfers) GNP = (C + I + G) + (X – M + net foreign investment income + net transfers) GNP in terms of current account balance: GNP = C + I + G + CA GNP is also the value of income received: GNP = C + S + T Since 4 and 5 are equivalent definitions of GNP, C + I + G + CA = C +S + T I + G + CA = S + T S + (T – G) = I + CA

The National Income and Product Accounts (cont.) S + (T – G) = I + CA summarizes the current account balance, investment, and public and private savings in the economy The following figure illustrates the equation in the U.S. in 1990-2007

FIGURE 9.2 U.S. Savings and Investment, 1990–2010

The National Income and Product Accounts (cont.) The four macroeconomic variables demonstrate there is not a fixed relationship between the current account balances and government budget balances, or between savings and investment The four variables are determined by the other three A change in any one of them influences all of them

Are Current Account Deficits Harmful? The relationship between the current account balance, investment, and total national savings is an identity Consequently, it does not tell us why an economy runs a current account deficit or surplus

International Debt Debt is defined as money owed to nonresidents with must be paid in a foreign currency Current account deficits must be financed through inflows of financial capital (loans) Loans from abroad add to a country’s stock of external debt and generate debt service obligations

International Debt (cont.) All countries, rich and poor, have external debt In many low and middle income countries, external debt leads to financial problems Unsustainable debt occurs for numerous reasons: Sudden drop in commodity prices Natural disasters Corruption Foreign lending behavior

The International Investment Position When a country runs a current account deficit, it borrows from abroad and increases its indebtedness If a country runs a current account surplus, it lends to foreigners and reduces its overall indebtedness International investment position = domestically owned foreign assets –foreign owned domestic assets

The International Investment Position (cont.) Total of all domestic assets owned by foreigners, subtracted from the total of all foreign assets owned by residents of the home country

The International Investment Position (cont.) Costs and benefits of capital inflows enables countries to invest more makes it possible for governments and consumers to spend more (save less) capital inflows take the form of direct investment, may bring new technologies (technology transfer) new management techniques