Chapter 9 Trade and the Balance of Payments

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 © 2011 Pearson Addison-Wesley. All rights reserved.

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… Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.1 Components of the Current Account Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.2 The U.S. Current Account Balance, 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.2 (continued) The U.S. Current Account Balance, 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

FIGURE 9.1 U.S. Current Account Balances, 1950-2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

U.S. Current Account Deficit There were two periods of large current account deficits in the U.S.: - The first lasted through most of the 80’s - The second began in the early 1990s and continues today Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

U.S. Current Account Deficit (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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Introduction to the Financial and Capital Accounts: Financial Account 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Introduction to the Financial and Capital Accounts: Financial Account (cont.) Assets include bank accounts, stocks and bonds, and real property such as factories, businesses, and real estate Financial derivatives are complex financial contracts and only recently 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Capital Account 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

The Three Accounts are Interdependent 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.3 The U.S. Balance of Payments, 2008 Balance of payments = current account + capital account + financial account Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.3 (continued) The U.S. Balance of Payments, 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Balance of Payments 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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 In 2008, U.S. statistical discrepancy was [(–1)  (–706,068 + 506,013)] = 200,055 Copyright © 2011 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 © 2011 Pearson Addison-Wesley. All rights reserved.

Table 9.4 Components of the U.S. Financial Account, 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Types of 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 © 2011 Pearson Addison-Wesley. All rights reserved.

Main Categories of U.S. Financial Flows U.S. assets abroad (outflows) U.S. Official reserve assets: gold bullion, IMF’s Special Drawing Rights (SDRs), EU euros, British pounds, or Japanese yen U.S. 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) U.S. Private assets: direct investment, foreign securities, loans to foreign firms and banks Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Main Categories of U.S. Financial Flows (con’t.) Foreign assets in the U.S. (inflows) A. Foreign official assets: gold bullion, IMF´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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Largest Share of Financial Flows: Private Assets 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 give their holders a claim in a foreign economy’s future output However, holders of FDI have longer time horizons Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.5 Private Flows in the U.S. Financial Account, 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9. 5 (continued) Private Flows in the U. S TABLE 9.5 (continued) Private Flows in the U.S. Financial Account, 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2011 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 Copyright © 2011 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 © 2011 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 © 2011 Pearson Addison-Wesley. All rights reserved.

The National Income and Product Accounts National income and product accounts: accounting system for a country’s 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 © 2011 Pearson Addison-Wesley. All rights reserved.

The National Income and Product Accounts (cont.) GNP = GDP + foreign investment income received – investment income paid to foreigners + net unilateral transfers Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.6 The U.S Financial Accounts, 2007-2008 (millions of dollars) Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9. 6 (continued) The U TABLE 9.6 (continued) The U.S Financial Accounts, 2007-2008 (millions of dollars) Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Table 9.7 Variable Definitions Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Understanding National Accounts 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 Copyright © 2011 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 1990-2007 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

FIGURE 9.2 U.S. Savings and Investment, 1990–2007 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Understanding National 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

International Debt Debt is defined as money owed o 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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: Falling commodity prices Natural disasters Corruption Foreign lending behavior Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

TABLE 9.8 The Five Largest Developing Country Debtors, 2007 Copyright © 2011 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 © 2011 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.