Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 9 Trade and the Balance of Payments

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-2 Chapter Objectives Present the accounting system of a nation´s international transactions: current, capital, and financial accounts Explain the relationship among domestic investment, domestic savings, and international flows of goods, services, and financial assets Examine the meaning of international indebtedness and discuss its consequences

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-3 Introduction 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 Lets examine each of these in greater detail…

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-4 Merchandise Trade Balance Lets first define merchandise trade balance part of the current account; measures the difference between exports and imports of goods, but not services –Trade deficit: negative merchandise trade balance –Trade surplus: positive merchandise trade balance In 2002, the U.S. had a trade deficit of $418.0 billion However, the U.S. had a large trade surplus in services ($64.8 billion)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-5 Current Account Current account balance: measures all current, non-capital transactions between a nation and the rest of the world 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-6 TABLE 9.1 Components of the Current Account

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-7 TABLE 9.2 The U.S. Current Account Balance, 2005 (Millions of Dollars)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-8 FIGURE 9.1 U.S. Current Account Balance, 1950–2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-9 U.S. Current Account Deficit U.S. current account deficit looks ominous However, the deficit is not a sign of weakness: U.S. economic boom of the 1990s increased the demand for imports, while sluggish growth abroad limited the expansion if U.S. exports But the U.S. deficit is not sustainable in the long term

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Financial Account Financial account: record of the flow of financial capital to and from a country Two main components –Net changes in the countrys assets abroad –Net changes in the foreign-based assets in the country

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Capital Account Capital account: 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved TABLE 9.3 The U.S. Balance of Payments, 2005 (Millions of Dollars) Balance of payments = current account + capital account + financial account

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Balance of Payments Three accounting caveats 1.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 2.All flows are net changes (differences between assets sold and bought, for example) rather than gross changes 3.As long as the capital account balance is zero, financial account balance = current account balance, but with the opposite sign

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Statistical Discrepancy in 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 –In 2005, U.S. statistical discrepancy was [(–1) (–791,508 – 4, ,499)] = 10,410

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Statistical Discrepancy (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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Financial Flows Financial flows originate in the public and private sectors Some financial flows are very mobile: move quickly in response to investor expectations –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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Five Types of U.S. Financial Flows (A–C) 1.U.S. assets abroad (outflows) A.Official reserve assets: gold bullion, IMFs special drawing rights (SDRs), major currencies B.Government assets: loans to foreign governments, rescheduled loans to foreign governments, payments received on outstanding loans, changes in non-reserve currency holdings (e.g., Mexican pesos) C.Private assets: direct investment, foreign securities, loans to foreign firms and banks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Five Types of U.S. Financial Flows (D–E) 2.Foreign assets in the U.S. (inflows) D.Foreign official assets: gold bullion, IMF´s special drawing rights (SDRs), major currencies E.Other foreign assets: direct investment, U.S. securities and currency, loans to U.S. firms and banks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved TABLE 9.4 Components of the U.S. Financial Account, 2005 (Millions of Dollars)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Largest Share of Financial Flows: Private Assets 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 investmentpaper assets such as stocks and bonds –Both FDI and foreign portfolio investment give their holders a claim in a foreign economys future output –However, holders of FDI have longer time horizons

Copyright © 2008 Pearson Addison-Wesley. All rights reserved TABLE 9.5 Private Flows in the U.S. Financial Account, 2005 (Millions of Dollars)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 –However, current account transactions were less heavily regulated

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Financial Account Liberalization The movement toward open markets over the 1980s and 1990s has 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved National Income and Product Accounts National income and product accounts: accounting system for a countrys total production and 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved National Income and Product Accounts GNP = GDP + foreign investment income received – investment income paid to foreigners + net unilateral transfers

Copyright © 2008 Pearson Addison-Wesley. All rights reserved TABLE 9.6 Variable Definitions

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Understanding National Accounts Interplay of the variables of the national accounts 1.GDP = C + I + G + X – M 2.GNP = GDP + (net foreign investment income + net transfers) 3.GNP = (C + I + G) + (X – M + net foreign investment income + net transfers) 4.GNP in terms of current account balance: GNP = C + I + G + CA 5.GNP is also the value of income received: GNP = C + S + T 6.Since 4 and 5 are equivalent definitions of GNP, C + I + G + CA = C +S + T 7.I + G + CA = S + T 8.S + (T – G) = I + CA

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Understanding National 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 1991–2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved FIGURE 9.2 U.S. Saving and Investment, 1991–2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved TABLE 9.7 Key Macroeconomic Indicators, Percent of GNP, 2004

Copyright © 2008 Pearson Addison-Wesley. All rights reserved International Debt Current account deficits must be financed through inflows of financial capital (loans) Loans from abroad add to a countrys stock of external debt and generate debt service obligations All countries, rich and poor, have external debt

Copyright © 2008 Pearson Addison-Wesley. All rights reserved International Debt (cont.) In many low and middle income countries, external debt leads to financial problems Unsustainable debt occurs for numerous reasons: –Falling commodity prices –Natural disasters –Corruption –Foreign lending behavior

Copyright © 2008 Pearson Addison-Wesley. All rights reserved TABLE 9.8 The Five Largest Developing Country Debtors, 2004

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The International Investment Position If 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The International Investment Position (cont.) A positive international investment position = the home country could sell all its foreign assets and have more than enough revenue to purchase all the domestic assets owned by foreigners –In 2005, the U.S. international investment position = $11,079 billion – $13,625 billion = –$2,546 billion